Alliance Fiber Optics Products, Form 10-QSB

10QSB 1 f92296e10qsb.htm FORM 10-QSB Alliance Fiber Optics Products, Form 10-QSB

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-QSB

(Mark One)


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

For the quarterly period ended June 30, 2003


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

For the transition period from to

Commission File Number 0-31857

ALLIANCE FIBER OPTIC PRODUCTS, INC.

(Exact name of small business issuer as specified in its charter)


Delaware		77-0554122

(State or other jurisdiction of Incorporation or organization)		(I.R.S. employer identification number)

735 North Pastoria Avenue, Sunnyvale, California 94085

(Address of Principal Executive Offices)

(408) 736-6900

(Issuer’s telephone number)

On August 6, 2003, 35,790,417 shares of the Registrant’s Common Stock, $0.001 par value per share, were outstanding. Transitional Small Business Disclosure Format (Check One): Yes o No x

TABLE OF CONTENTS


PART I: FINANCIAL INFORMATION
	ITEM 1: FINANCIAL STATEMENTS
		Consolidated Balance Sheets
		Consolidated Statements of Operations
		Consolidated Statements of Cash Flows
		NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
	ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3: CONTROLS AND PROCEDURES
PART II: OTHER INFORMATION
	ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
	ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURE
EXHIBIT INDEX
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

ALLIANCE FIBER OPTIC PRODUCTS, INC.

FORM 10-QSB

QUARTERLY PERIOD ENDED JUNE 30, 2003

INDEX


			Page

Part I: Financial Information				1
	Item 1: Financial Statements			1
		Consolidated Balance Sheets at December 31, 2002 and June 30, 2003		1
		Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2002 and 2003		2
		Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2002 and 2003		3
		Notes to Consolidated Financial Statements		4
	Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations			8
	Item 3: Controls and Procedures			23
Part II: Other Information				24
	Item 4: Submission of Matters to a Vote of Security Holders			24
	Item 6: Exhibits and Reports on Form 8-K			25
Signatures				26

PART I: FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

ALLIANCE FIBER OPTIC PRODUCTS, INC.
Consolidated Balance Sheets
(Unaudited; in thousands, except share data)


			Dec. 31,			June 30,
			2002			2003

Assets
Current assets:
	Cash and cash equivalents		$	11,759		$	14,456
	Short-term investments			31,216			24,878
	Accounts receivable, net			1,133			1,224
	Inventories, net			2,930			2,982
	Prepaid expense and other current assets			967			755

		Total current assets		48,005			44,295
Property and equipment, net				5,313			4,870
Other assets				362			364

		Total assets	$	53,680		$	49,529

Liabilities and Stockholders’ Equity
Current liabilities:
	Accounts payable		$	706		$	1,147
	Income tax payable			140			140
	Accrued expenses			2,156			1,778
	Accrued excess facility charge-short term			892			926

		Total current liabilities		3,894			3,991
Accrued excess facility charge-long term				547			78
Other long-term liabilities				276			287

		Total liabilities		4,717			4,356

Commitments and contingencies (Note 9)
Stockholders’ equity:
	Common stock, $0.001 par value: 250,000,000 shares authorized; 35,580,871 and 35,777,907 shares issued and outstanding at December 31, 2002 and June 30, 2003, respectively			35			35
	Additional paid-in-capital			105,053			104,771
	Receivables from stockholders			(1,636	)		(1,138	)
	Deferred stock-based compensation			(2,420	)		(1,569	)
	Accumulated deficit			(51,987	)		(56,792	)
	Accumulated other comprehensive loss			(82	)		(134	)

	Stockholders’ equity			48,963			45,173

		Total liabilities and stockholders’ equity	$	53,680		$	49,529

The accompanying notes are an integral part of these Consolidated Financial Statements.

ALLIANCE FIBER OPTIC PRODUCTS, INC.
Consolidated Statements of Operations
(Unaudited; in thousands, except per share data)


			Three Months Ended June 30,						Six Months Ended June 30,

			2002			2003			2002			2003

Revenues			$	3,665		$	2,609		$	7,197		$	4,985
Cost of revenues				4,789			2,155			9,743			4,447

	Gross profit (loss)			(1,124	)		454			(2,546	)		538

Operating expenses:
	Research and development			2,216			1,399			4,597			2,795
	Sales and marketing			546			522			1,536			1,093
	General and administrative			1,086			880			2,285			1,829

		Total operating expenses		3,848			2,801			8,418			5,717

Loss from operations				(4,972	)		(2,347	)		(10,964	)		(5,179	)
Interest and other income, net				486			207			799			374

Loss before income taxes				(4,486	)		(2,140	)		(10,165	)		(4,805	)
Income tax provision				10			—			22			—

Net loss			$	(4,496	)	$	(2,140	)	$	(10,187	)	$	(4,805	)

Net loss per share:
		Basic and diluted	$	(0.13	)	$	(0.06	)	$	(0.30	)	$	(0.14	)

Shares used in computing net loss per share:
		Basic and diluted		34,546			35,069			34,455			35,057

The accompanying notes are an integral part of these Consolidated Financial Statements.

ALLIANCE FIBER OPTIC PRODUCTS, INC.
Consolidated Statements of Cash Flows
(Unaudited, in thousands, except share data)


					Six Months Ended June. 30,

					2002			2003

Cash flows from operating activities:
	Net loss				$	(10,187	)	$	(4,805	)
	Adjustments to reconcile net loss to net cash used in operating activities:
		Depreciation				832			671
		Amortization of stock-based compensation				638			499
		Impairment/write down in property and equipment				972			—
		Provision for inventory				3,157			33
		Changes in assets and liabilities:
			Accounts receivable, net			966			(91	)
			Inventories, net			(168	)		(85	)
			Prepaid expenses and other assets			111			214
			Accounts payable			(97	)		441
			Income tax payable			(13	)		—
			Accrued expenses			260			(344	)
			Other long-term liabilities			60			(458	)

				Net cash used in operating activities		(3,469	)		(3,925	)

Cash flows from investing activities:
	Proceeds (purchase) from short-term investments					(2,981	)		6,289
	Purchase of property and equipment					(459	)		(249	)

				Net cash (used in) provided by investing activities		(3,440	)		6,040

Cash flows from financing activities:
	Proceeds from issurance of common stock under ESPP					151			62
	Proceeds from the exercise of common stock options					28			6
	Proceeds from the repayment of notes receivable					88			514

				Net cash provided by financing activities		267			582

Net (decrease) increase in cash and cash equivalents						(6,642	)		2,697
Cash and cash equivalents at beginning of period						16,947			11,759

Cash and cash equivalents at end of period					$	10,305		$	14,456

Non-cash investing and financing activities:
	Repurchase of common stock via cancellation of notes receivable from stockholders				$	116		$	—

The accompanying notes are an integral part of these Consolidated Financial Statements.

ALLIANCE FIBER OPTIC PRODUCTS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. The Company

Alliance Fiber Optic Products, Inc. (the “Company”) was incorporated in California on December 12, 1995 and reincorporated in Delaware on October 19, 2000. The Company designs, manufactures and markets fiber optic components for communications equipment manufacturers. The Company’s headquarters is in Sunnyvale, California and it has operations in Taiwan and China.

2. Basis of presentation

The consolidated financial information as of June 30, 2003 included herein is unaudited, has been prepared by the Company in accordance with generally accepted accounting principles in the United States of America, and reflects all adjustments, consisting only of normal recurring adjustments, which in the opinion of management are necessary to state fairly the Company’s consolidated financial position, results of its consolidated operations, and consolidated cash flows for the periods presented.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates, and such differences may be material to the financial statements.

These financial statements should be read in conjunction with the Company’s audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002. The results of operations for the three and six months ended June 30, 2003 are not necessarily indicative of the results to be expected for any future periods.

3. Stock-based Compensation

The Company accounts for stock-based compensation arrangements in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”. In addition, the Company complies with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” Equity instruments issued to non-employees are accounted for in accordance with the provisions of SFAS No. 123, SFAS 148 and Emerging Issues Task Force (“EITF”) Issue No. 96-18, which require the award to be recorded at its fair value.

Pro forma information regarding net income (loss) and net income (loss) per share is required by SFAS No. 123, which also requires that the information be determined as if the Company had accounted for its stock based awards under the fair value method. The fair value of these stock based awards was estimated using the Black-Scholes model.

Had compensation cost been determined based upon the fair value on the grant date, consistent with the methodology prescribed under SFAS No. 123, the Company’s pro forma net loss and pro forma basic and diluted net loss per share under SFAS No. 123 would have been as follows (in thousands, except per share data):


		Three Months						Six Months
		Ended Jun. 30,						Ended Jun. 30,

		2002			2003			2002			2003

Net loss, as reported:		$	(4,496	)	$	(2,140	)	$	(10,187	)	$	(4,805	)
Add: Stock-based employee compensation expense included in reported net income			139			107			474			500
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards			-408			(38	)		(1,497	)		(511	)

Pro forma net loss:		$	(4,765	)	$	(2,071	)	$	(11,210	)	$	(4,816	)

Net loss per share attributable to common stockholders, basic and diluted:
	As reported	$	(0.13	)	$	(0.06	)	$	(0.30	)	$	(0.14	)
	Pro forma	$	(0.13	)	$	(0.06	)	$	(0.33	)	$	(0.14	)
	Shares used in EPS calculation (basic and diluted)		35,546			35,069			34,455			35,057

4. Inventories (in thousands)


		Dec. 31,			June 30,
		2002			2003

Inventories		$	2,218		$	2,138
	Finished goods	$	2,218		$	2,138
	Work-in-process		854			1,068
	Raw materials		2,740			2,748
	Less: Reserve for excess and obsolete inventory		(2,882	)		(2,972	)

		$	2,930		$	2,982

5. Impairment of Property and Equipment

In the third quarter of 2002, as a result of the business decline and reduced headcount in the United States, the Company consolidated its operations in the United States from three buildings into two buildings in Sunnyvale, California. As a consequence, the Company recorded excess facility charges of $1.8 million during 2002, comprised of $1.6 million of future non-cancelable lease payments, which are expected to be paid over the next two years, and $0.2 million of fixed assets that were written-off. Cash payments in the quarters ended March 31, 2003 and June 30, 2003 each amounted to $0.2 million and an additional $1.0 million remains on the consolidated balance sheet in accrued facility charges at June 30, 2003.

6. Net Loss Per Share

Basic net loss per share is computed by dividing net loss for the period by the weighted average number of shares of common stock outstanding during the period. Diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of common and potential common equivalent shares outstanding during the period. The calculation of diluted net loss per share excludes potential common shares if the effect is anti-dilutive. Potential common shares are composed of shares of common stock subject to repurchase and common stock issuable upon the exercise of stock options. As the Company is in a net loss position, diluted net loss per share is the same as basic net loss per share.

The following table sets forth the computation of basic and diluted net loss per share for the periods indicated (in thousands, except per share data):


			Three Months						Six Months
			Ended June 30,						Ended June 30,

			2002			2003			2002			2003

Numerator:
	Net loss		$	(4,496	)	$	(2,140	)	$	(10,187	)	$	(4,805	)

Denominator:
	Shares used in computing net loss per share:
		Weighted average number of shares outstanding		35,433			35,609			35,424			35,597
		Less: Weighted average number of shares subject to repurchase		(887	)		(540	)		(969	)		(540	)

		Basic and diluted		34,546			35,069			34,455			35,057

Net loss per share:
		Basic and diluted	$	(0.13	)	$	(0.06	)	$	(0.30	)	$	(0.14	)

All outstanding stock options and shares subject to repurchase by the Company have been excluded from the calculation of diluted net loss per share as all such securities were anti-dilutive for all periods presented. The total number of shares excluded from the calculation of diluted net loss per share is as follows (in thousands):

Three Months

Six Months

Ended June 30,

2002

2003

2002

2003

Options to purchase common stock and shares subject to repurchase

4,177

3,377

4,259

3,377

7. Comprehensive Loss

Comprehensive income (loss) is defined as the change in equity of a company during a period resulting from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners. The components of comprehensive loss are as follows (in thousands):


		Three Months						Six Months
		Ended June 30,						Ended June 30,

		2002			2003			2002			2003

Net loss		$	(4,496	)	$	(2,140	)	$	(10,187	)	$	(4,805	)
Cumulative translation adjustments			91			(3	)		78			(4	)
Unrealized gain (loss) on short-term investments			56			(45	)		(57	)		(48	)

	Total comprehensive loss	$	(4,349	)	$	(2,188	)	$	(10,166	)	$	(4,857	)

8. Geographic Segment Information

The Company operates in a single industry segment. This industry segment is characterized by rapid technological change and significant competition.

The following is a summary of the Company’s revenues generated from, and identifiable assets situated in, geographic segments (in thousands):


		Three Months Ended June 30,				Six Months Ended June 30,

		2002		2003		2002		2003

Revenues
	United States	$	3,657	$	2,456	$	7,186	$	4,682
	Taiwan		8		153		11		303

		$	3,665	$	2,609	$	7,197	$	4,985


			Dec. 31,		June 30,
			2002		2003

Identifiable Assets
	United States		$	47,054	$	42,799
	Taiwan			5,773		5,076
	China			853		1,653

		Total	$	53,680	$	49,528

9. Contingencies

From time to time, the Company may be involved in litigation in the normal course of business. As of the date of these financial statements, the Company is not aware of any material legal proceedings pending or threatened against the Company.

10. Recent Accounting Pronouncements

In May 2003, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 requires that certain financial instruments, which under previous guidance could be accounted for as equity, be classified as liabilities in statements of financial position. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and is otherwise effective for the Company in the first quarter of 2004. The Company does not expect the adoption of SFAS No. 150 to have a significant impact on the Company’s results of operations or financial position.

ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

When used in this discussion, the words “expects,” “anticipates,” “believes”, “estimates,” “plans,” and similar expressions are intended to identify forward-looking statements. These statements, which include statements as our sources of revenue, anticipated revenue levels, our profitability, those actions necessary to achieve and maintain profitability, the fluctuation of our cost of revenues as a percentage of revenues and the factors contributing to these fluctuations, our net and operating losses, our negative cash flow, our gross profit as a percentage of revenues, the amount and mix of our anticipated expenditures and expenses, expenditures required to remain competitive, increases or decreases in the level of our expenses, the need for additional inventory reserves or provisions, customer demand for our products, strategies to increase business including increasing sales to customers outside of the United States, our reliance on our OPMS products’ sales levels, reliance on the commercial success of our DWDM-related products, our success being tied to relationships with key customers, our ability to establish and maintain relationships with key customers, the adequacy of our capital resources and need for additional funding, the impact of the adoption of recent accounting pronouncements on our results of operations or financial position, period-to-period comparisons of our operating results, our plans for a reverse stock split, our ability to obtain raw materials and components and maintain and develop supplier relationships, our anticipated use of resources, our ability to maintain appropriate inventory, factors that affect a customer’s decision to choose a supplier, our competitors, competition in our industry, our competitive advantage and consolidation in our industry are subject to risks and uncertainties that could cause actual results to differ materially from those projected. These risks and uncertainties include, but are not limited to, those risks discussed below, further decreased demand for and sales of our products, our ability to realize the benefits of our investment strategy, continued domestic and international economic instability, as well as competition including the impact of competitive products and pricing, timely design acceptance by our customers, our success in attracting new customers, loss of a key customer, our customers not adopting our new products, failure to accurately predict market needs, timely introduction of new technologies, our ability to ramp new products into volume production, our ability to attract and retain highly skilled personnel, loss of a key supplier, industry wide shifts in supply and demand for optical components and modules, industry overcapacity, financial stability in foreign markets and the matters discussed in “Factors That May Affect Results.” These forward-looking statements speak only as of the date hereof. The Company expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in the Company’s expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s Annual Report on Form 10-K, its Consolidated Financial Statement and the Notes thereto, for the year ended December 31, 2002.

The following discussion should be read in conjunction with our unaudited Consolidated Financial Statements and Notes thereto.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of our financial conditions and results of operations are based on our unaudited Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, bad debts, inventories, asset impairments, income taxes, contingencies, and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values for assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

For additional information regarding our critical accounting policies and estimates, see the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K, for the year ended December 31, 2002.

Overview

We were founded in 1995 and commenced operations to design, manufacture and market fiber optic interconnect products, which we call our Optical Path Management Solution, or OPMS, products. We started selling our dense wavelength division multiplexing, or DWDM, and other wavelength management products in July 2000. Since introduction, sales of DWDM-related products have fluctuated with the overall market for these products.

From our inception through June 30, 2003, we derived substantially all of our revenues from our OPMS product line. Revenues from our DWDM products represented approximately 8.6% of total revenues for the year ended December 31, 2002. For the six months ended June 30, 2003, our DWDM products contributed revenues of $0.7 million, or 14.4% of total revenues. For the six months ended June 30, 2002 and June 30, 2003, our top ten customers comprised 53.4% and 47.4% of our revenues, respectively. For the six months ended June 30, 2002, one customer accounted for 10.3% of our total revenues. No customer accounted for 10% or more of revenues in the six months ended June 30, 2003.

We market and sell our products predominantly through our direct sales force. For the six months ended June 30, 2002 and 2003, revenues derived from sales to customers located outside of North America were 9.2% and 9.5%, respectively.

Our cost of revenues consists of raw materials, components, direct labor, manufacturing overhead and production start-up costs. We expect that our cost of revenues as a percentage of revenues will fluctuate from period to period based on a number of factors including:

• changes in manufacturing volume;

• costs incurred in establishing additional manufacturing lines and facilities;

• inventory write-downs and impairment charges related to manufacturing assets;

• mix of products sold;

• changes in our pricing and pricing from our competitors;

• mix of sales channels through which our products are sold; and

• mix of domestic and international sales.

Research and development expenses consist primarily of salaries and related personnel expenses, fees paid to outside service providers, materials costs, test units, facilities, overhead and other expenses related to the design, development, testing and enhancement of our products. We expense our research and development costs as they are incurred. We believe that a significant level of investment for product research and development is required to remain competitive.

Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in marketing, sales and technical support functions, as well as costs associated with trade shows, promotional activities and travel expenses. We intend to continue to invest in our sales and marketing efforts, both domestically and internationally, in order to increase market awareness and to generate sales of our products. However, we cannot be certain that our expenditures will result in higher revenues. In addition, we believe that our future success depends upon establishing successful relationships with a variety of key customers.

General and administrative expenses consist primarily of salaries and related expenses for executive, finance, administrative, accounting and human resources personnel, insurance and professional fees for legal and accounting support.

In connection with the grant of stock options to employees and consultants, we recorded deferred stock-based compensation of approximately $26.8 million in stockholders’ equity prior to our initial public offering, representing the difference between the estimated fair market value of our common stock and the exercise price of these options at the date of grant. Deferred stock-based compensation is being amortized using the graded vesting method, under which each option grant is separated into portions based on its vesting terms which results in acceleration of amortization expense for the overall award. The deferred stock-based compensation balance of $1.6 million as of June 30, 2003 will be fully amortized on an accelerated basis by December 1, 2004.

Results of Operations

The following table sets forth the relationship between various components of operations, stated as a percentage of revenues for the periods indicated:


			Three Months						Six Months
			Ended Jun. 30,						Ended Jun. 30,

			2002			2003			2002			2003

Revenues				100.0	%		100.0	%		100.0	%		100.0	%
Cost of revenues:				130.7			82.6			135.4			89.2

	Gross profit (loss)			(30.7	)		17.4			(35.4	)		10.8
Operating expenses:
	Research and development:			60.5			53.6			63.9			56.0
	Sales and marketing:			14.9			20.0			21.3			21.9
	General and administrative:			29.6			33.8			31.7			36.7

		Total operating expenses		105.0			107.4			116.9			114.6
Loss from operations				(135.7	)		(90.0	)		(152.3	)		(103.8	)
Interest and other income, net				13.3			7.9			11.1			7.4

Loss before income taxes				(122.4	)		(82.1	)		(141.2	)		(96.4	)
Income tax provision				0.3			—			0.3			—

Net loss				(122.7	%)		(82.1	%)		(141.5	%)		(96.4	%)

Revenues. Revenues were $3.7 million and $2.6 million for the three months ended June 30, 2002 and 2003, respectively. Revenues decreased 29.7% from the quarter ended June 30, 2002 to the same period in 2003 primarily due to decreased volume shipments of and decreased demand for our OPMS products as a result of poor market conditions. Revenues from our DWDM-related products were $0.5 million and $0.3 million for the three months ended June 30, 2002 and 2003, respectively. Revenues were $7.2 million and $5.0 million for the six months ended June 30, 2002 and 2003 respectively. Revenues from our DWDM-related products were $0.6 million and $0.7 million for the six months ended June 30, 2002 and 2003, respectively.

Cost of Revenues. Cost of revenues was $4.8 million and $2.2 million for the three months ended June 30, 2002 and 2003, respectively. Cost of revenues as a percentage of net revenues decreased from 129.7% for the three months ended June 30, 2002 to 84.6% for the three months ended June 30, 2003. Cost of revenues for the three month period ended June 30, 2002 was primarily impacted by write-offs for excess and obsolete inventory resulting from a slowdown in telecommunications capital spending and the general downturn in the United States economy which resulted in a charge of $0.8 million for DWDM-related material and $0.1 million for OPMS-related material. Cost of revenues was

$9.7 million and $4.4 million for the six months ended June 30, 2002 and 2003, respectively. Cost of revenues for the six months ended June 30, 2002 was primarily impacted by write-offs for excess and obsolete inventory resulting from a slowdown in telecommunications capital spending and the general downturn in the United States economy which resulted in a charge of $2.0 million for DWDM-related material and $1.1 million for OPMS-related material.

Gross Profit (loss). We incurred a gross loss of $1.1 million for the three months ended June 30, 2002, and earned a gross profit of $0.5 million for the same period in 2003. We incurred a gross loss of $2.5 million, or (35.4%) of revenues, for the six months ended June 30, 2002, and we earned a gross profit of $0.5 million, or 10.8% of revenues, for the same period in 2003. The improvement for the three month and six month periods ended June 30, 2003 when compared to the same periods in 2002 was mainly due to lower excess and obsolete inventory charges and lower product costs for DWDM-related material.

We expect our gross profit as a percentage of revenues to continue to be negatively impacted in the near term by low production volumes and the under-utilization of our manufacturing operations. We had approximately $0.8 million in DWDM-related net inventory and $2.1 million in OPMS-related net inventory on hand at June 30, 2003. Although we take steps to manage future inventory levels, we may have to record additional inventory reserves in future periods if there is a decrease in demand.

Research and Development Expenses. Research and development expenses decreased from $2.2 million, or 60.5% of revenues, for the three months ended June 30, 2002 to $1.4 million, or 53.6% of revenues, for the same period in 2003. Research and development expenses decreased from $4.6 million, or 63.9% of revenues, for the six months ended June 30, 2002 to $2.8 million, or 56.1% of revenues, for the same period in 2003. The decrease for both the three month and six month periods was primarily due to lower headcount levels and related expenditures, as well as tighter controls over discretionary spending. We expect research and development expenses on our product development efforts to remain relatively flat due to the uncertainty about customer demand for our products in the current economic environment.

Sales and Marketing Expenses. Sales and marketing expenses remained flat at $0.5 million for each of the three months ended June 30, 2002 and June 30, 2003 but increased as a percentage of revenues from 14.9% for the three months ended June 30, 2002, to 20.0% for the three months ended June 30, 2003 due to decreased revenues. Sales and marketing expenses decreased from $1.5 million, for the six months ended June 30, 2002 to $1.1 million for the six months ended June 30, 2003 primarily due to lower sales force expenses resulting from a reduction in headcount during 2002. As a percentage of revenues, sales and marketing expenses increased from 21.3% in the six months ended June 30, 2002 to 21.9% for the same period in 2003. We expect sales and marketing expenses to remain relatively flat due to uncertainty about customer demand for our products in the current economic environment.

General and Administrative Expenses. General and administrative expenses decreased from $1.1 million for the three months ended June 30, 2002 to $0.9 million for the same period in 2003. As a percentage of revenues, general and administrative expenses increased from 29.6% in the three months ended June 30, 2002 to 33.7% for the same period in 2003. General and administrative expenses decreased from $2.3 million for the six months ended June 30, 2002 to $1.8 million for the same period in 2003. As a percentage of revenues, general and administrative expenses increased from 31.7% in the six months ended June 30, 2002 to 36.7% for the same period in 2003. The decrease in expenses for both the three month and six month periods was primarily due to lower headcount levels and related expenditures. We expect our quarterly general and administrative expenses to remain approximately at the same level throughout the remaining quarters of 2003.

Stock-based compensation. Total stock-based compensation remained flat at $0.1 million for each of the three months ended June 30, 2002 and June 30, 2003. Stock-based compensation decreased from $0.6 million for the six months ended June 30, 2002 to $0.5 million for the six months ended June 30, 2003.

Interest and Other Income, Net. Interest and other income, net, was $0.5 million and $0.2 million for the three months ended June 30, 2002 and 2003, respectively. Interest and other income, net, was

$0.8 million and $0.4 million for the six months ended June 30, 2002 and 2003, respectively. The decrease from 2002 to 2003 was due to a lower cash balance and lower interest rates.

Income Taxes. We had no income tax expense for the three months and six months ended June 30, 2003. We reported income tax expense of $0.01 million and $0.02 million for the three months and six months ended June 30, 2002, respectively.

Liquidity and Capital Resources

Since inception, we have financed our operations primarily through private sales of convertible preferred stock and bank debt. Additionally, in November 2000, we completed our initial public offering of common stock, raising approximately $44.4 million, net of costs and expenses. At June 30, 2003, we had cash and cash equivalents of $14.5 million and short-term investments of $24.9 million.

Net cash used in operating activities was $3.5 million and $3.9 million for the six months ended June 30, 2002 and 2003, respectively. For the six months ended June 30, 2003, net cash used was primarily due to our net loss of $4.8 million, offset by non-cash adjustments, including depreciation and amortization of $1.2 million. For the six months ended June 30, 2002, net cash used in operating activities was due to losses of $10.2 million, offset by non-cash adjustments including inventory provision of $3.2 million, write down of property and equipment of $1.0 million and depreciation and amortization of $1.5 million.

Cash used in investing activities was $3.4 million for the six months ended June 30, 2002. Cash generated by selling short-term investments was $6.3 million for the six months ended June 30, 2003. In the six months ended June 30, 2002, $3.0 million was invested in high-grade, short-term investments, while $0.5 million was used to acquire property and equipment. In the six months ended June 30, 2003, $0.2 million was used to acquire property and equipment.

Cash generated by financing activities was $0.3 million and $0.6 million for the six months ended June 30, 2002 and 2003, respectively, resulting from proceeds from the exercise of options to purchase shares of our common stock and common stock issued through our Employee Stock Purchase Plan. Cash generated also included net proceeds from the repayment of notes receivable of $0.1 million and $0.5 million for the six months ended June 30, 2002 and 2003, respectively.

In July and December 2000, we entered into leases for 10,500 and 10,600 square feet of space, respectively, near our existing facility in Sunnyvale, California. In September 2002, we consolidated our operations in California into two buildings and vacated the 10,600 square foot facility. As a result of the consolidation, we recorded an excess facility charge of $1.8 million in the year ended December 31, 2002. Additionally, in December 2000, the Company purchased approximately 8,200 square feet of space immediately adjacent to our leased facility in Tu-Cheng City, Taiwan for $0.8 million. In April 2001, we entered into a lease in China but cancelled it, without penalty, in the third quarter of 2001. We had a lease for a facility near the Shenzhen area of China totaling approximately 12,000 square feet, which expired in December 2002. In August 2002, we entered into a new lease for 62,000 square foot facility near the same Shenzhen area which will expire in July 2007.

We believe that our current cash, cash equivalents and short-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, our future growth, including potential acquisitions, may require additional funding. If cash generated from operations is insufficient to satisfy our long-term liquidity requirements, we may need to raise capital through additional equity or debt financings or additional credit facilities. If additional funds are raised through the issuance of securities, these securities could have rights, preferences and privileges senior to holders of common stock, and the terms of any debt facility could impose restrictions on our operations. The sale of additional equity or debt securities could result in additional dilution to our stockholders, and additional financing may not be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain additional financing, we may be required to reduce the scope of our planned product development and marketing efforts, which could harm our business, financial condition and operating results.

Recent Accounting Pronouncements

FACTORS THAT MAY AFFECT RESULTS

We have a history of losses, expect future losses and may not be able to generate sufficient revenues in the future to achieve and sustain profitability.

We incurred net losses of approximately $10.2 million and $4.8 million in the first six months of fiscal 2002 and 2003, respectively, and expect that our net losses and negative cash flows will continue for the foreseeable future as we continue to invest in our business. As of June 30, 2003, we had an accumulated deficit of approximately $56.8 million.

Although we continue to experience low demand for our products, we are hopeful that demand for our products will increase in the future. If this happens, we expect we will incur significant expenses for expansion of our manufacturing operations, research and development, sales and marketing, and administration, and in developing direct sales and distribution channels. Given our early stage of development, the rate at which competition in our industry intensifies, and the significant downturn in demand for our products, we may not be able to adequately control our costs and expenses or achieve or maintain adequate operating margins. As a result, to achieve and maintain profitability, we will need to generate and sustain substantially higher revenues while maintaining reasonable cost and expense levels. We may not be able to achieve and sustain profitability on a quarterly or an annual basis.

Our quarterly and annual financial results have historically fluctuated due primarily to introduction of, demand for, and sales of our products, and future fluctuations may cause our stock price to decline.

We believe that period-to-period comparisons of our operating results are not a good indication of our future performance. Our quarterly operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a number of factors. For example, the timing and expenses associated with product introductions, the timing and extent of product sales, the mix of products sold and significant decreases in the demand for our products have caused our operating results to fluctuate in the past. Because we incur operating expenses based on anticipated revenue trends, and a high percentage of our expenses are fixed in the short term, any delay in generating or recognizing revenues or any decrease in revenues could significantly harm our quarterly results of operations. Other factors, many of which are more fully discussed in other risk factors below, may also cause our results to fluctuate. Many of the factors that may cause our results to fluctuate are outside of our control. If our quarterly or annual operating results do not meet the expectations of investors and securities analysts, the trading price of our common stock could significantly decline.

Our Optical Path Management Solution (OPMS) products have historically represented substantially all of our revenues, and if we are unsuccessful in commercially selling our DWDM-related products, our business will be seriously harmed.

Sales of our OPMS products accounted for over 88% of our revenues in the three months ended June 30, 2003, 86% of our revenues for the six months ended June 30, 2003, and substantially all of our historical revenues. We expect to substantially depend on these products for our near-term revenues. Any significant decline in the price of, or demand for, these products, or failure to increase their market acceptance, would seriously harm our business. In addition, we believe that our future growth and a

significant portion of our future revenues will depend on the commercial success of our DWDM-related products, which we began shipping commercially in July 2000. Demand for these products declined sharply starting in mid fiscal 2001. If demand for these products does not increase and our target customers do not adopt and purchase our DWDM-related products, our revenues may decline further and we may have to write-off additional inventory that is currently on our books.

We are experiencing a decrease in market demand due to overcapacity in our industry and an economy that is stymied by international terrorism, war and political instability.

Since 2001, the United States economy has experienced and continues to experience a significant slowdown in consumption and demand. During the past few years, telecommunication companies have decreased their spending which has resulted in excess inventory, overcapacity and a decrease in demand for our products. We may experience further decreases in the demand for our products due to a weak domestic and international economy as the fiber optics industry copes with the effects of oversupply of products, international terrorism, war and political instability. Even if the general economy experiences a recovery, the activity of the United States telecommunications industry may lag behind the recovery of the overall United States economy.

If we cannot attract more optical communications equipment manufacturers to purchase our products, we may not be able to increase or sustain our revenues.

Our future success will depend on our ability to migrate existing customers to our new products and our ability to attract additional customers. Some of our present customers are relatively new companies. The growth of our customer base could be adversely affected by:

• customer unwillingness to implement our products;

• any delays or difficulties that we may incur in completing the development and introduction of our planned products or product enhancements;

• the success of our customers;

• new product introductions by our competitors;

• any failure of our products to perform as expected; or

• any difficulty we may incur in meeting customers’ delivery requirements or product specifications.

The downturn in the economy has affected the telecommunications industry. Telecommunications companies have cut back on their capital expenditure budgets, which has decreased and may continue to further decrease demand for equipment and parts, including our products. This decrease has had and may continue to have an adverse effect on the demand for fiber optic products and negatively impact the growth of our customer base.

The market for fiber optic components is increasingly competitive, and if we are unable to compete successfully our revenues could decline.

The market for fiber optic components is intensely competitive. We believe that our principal competitors are the major manufacturers of optical components and integrated modules, including vendors selling to third parties and business divisions within communications equipment suppliers. Our principal competitors in the components market include Avanex, Corning, DiCon Fiberoptics, Gould, JDS Uniphase, Lucent, Luminent (a subsidiary of MRV Communications, Inc.), Oplink, Stratos Lightwave and Tyco Electronics. We believe that we primarily compete with diversified suppliers for the majority of our product line and to a lesser extent with niche companies that offer a more limited product line. Competitors in any portion of our business may also rapidly become competitors in other portions of our business. In addition, our industry has recently experienced significant consolidation, and we anticipate that further consolidation will occur. This consolidation has further increased competition.

Many of our current and potential competitors have significantly greater financial, technical, marketing, purchasing, manufacturing and other resources than we do. As a result, these competitors may be able to respond more quickly to new or emerging technologies and to changes in customer requirements, to devote greater resources to the development, promotion and sale of products, to negotiate lower prices on raw materials and components, or to deliver competitive products at lower prices.

Several of our existing and potential customers are also current and potential competitors of ours. These companies may develop or acquire additional competitive products or technologies in the future and subsequently reduce or cease their purchases from us. In light of the consolidation in the optical networking industry, we also believe that the size of suppliers will be an increasingly important part of a purchaser’s decision-making criteria in the future. We may not be able to compete successfully with existing or new competitors, nor can we ensure that the competitive pressures we face will not result in lower prices for our products, loss of market share, or reduced gross margins, any of which could harm our business.

New and competing technologies are emerging due to increased competition and customer demand. The introduction of products incorporating new or competing technologies or the emergence of new industry standards could make our existing products noncompetitive. For example, there are technologies for the design of wavelength division multiplexers that compete with the technology that we incorporate in our products. If our products do not incorporate technologies demanded by customers, we could lose market share causing our business to suffer.

If we fail to effectively manage our operations, specifically given the recent sudden and dramatic downturn in demand for our products, our operating results could be harmed.

We rapidly expanded our operations domestically and internationally in the final two quarters of 2000. We have had to carefully manage and re-evaluate this expansion given the sudden and dramatic downturn in demand for our products that began in 2001 and continues to date. As of June 30, 2003, we had a total of 78 full-time employees in Sunnyvale, California, 160 full-time employees in Taiwan, and 80 full-time employees in China. Matching the scale of our operations with the recent demand fluctuations, combined with the challenges of expanding and managing geographically dispersed operations, has placed, and will continue to place, a significant strain on our management and resources. To manage the expected fluctuations in our operations and personnel, we will be required to:

• improve existing and implement new operational, financial and management controls, reporting systems and procedures;

• hire, train, motivate and manage additional qualified personnel, especially if we experience a significant increase in demand for our products;

• effectively expand or reduce our manufacturing capacity, attempting to adjust it to customer demand; and

• effectively manage relationships with our customers, suppliers, representatives and other third parties.

In addition, we will need to coordinate our domestic and international operations and establish the necessary infrastructure to implement our international strategy. If we are not able to manage our growth in an efficient and timely manner, our business will be severely harmed.

Our success also depends, to a large degree, on the efficient and uninterrupted operation of our facilities. We have expanded our manufacturing facilities in Taiwan and manufacture many of our products there. During the third quarter of 2002, we entered into a new lease for a new facility in China, which continues through July 2007. There is significant political tension between Taiwan and China. If there is an outbreak of hostilities between Taiwan and China, our manufacturing operations may be disrupted or we may have to relocate our manufacturing operations. Tensions between Taiwan and

China may also affect our facility in China. Relocating a portion of our employees could cause temporary disruptions in our operations and divert management’s attention.

Because of the time it takes to develop fiber optic components, we incur substantial expenses for which we may not earn associated revenues.

The development of new or enhanced fiber optic products is a complex and uncertain process. We may experience design, manufacturing, marketing and other difficulties that could delay or prevent the development, introduction or marketing of new products and enhancements. Development costs and expenses are incurred before we generate revenues from sales of products resulting from these efforts. Our total research and development expenses were approximately $4.6 million and $2.8 million for the six months ended June 30, 2002 and 2003, respectively. We intend to continue to invest a substantial amount of funds in our research and product development efforts, which could have a negative impact on our earnings in future periods.

If we are unable to develop new products and product enhancements that achieve market acceptance, sales of our fiber optic components could decline, which could reduce our revenues.

The communications industry is characterized by rapidly changing technology, frequent new product introductions, changes in customer requirements, evolving industry standards and, more recently, significant variations in customer demand. Our future success depends on our ability to anticipate market needs and develop products that address those needs. As a result, our products could quickly become obsolete if we fail to predict market needs accurately or develop new products or product enhancements in a timely manner. Our failure to predict market needs accurately or to develop new products or product enhancements in a timely manner will harm market acceptance and sales of our products. If the development or enhancement of these products or any other future products takes longer than we anticipate, or if we are unable to introduce these products to market, our sales will not increase. Even if we are able to develop and commercially introduce them, these new products may not achieve the widespread market acceptance necessary to provide an adequate return on our investment.

Current and future demand for our products depends on the continued growth of the Internet and the communications industry, which is experiencing rapid consolidation, realignment, oversupply of product inventory and reduction in demand for fiber optic products.

Our future success depends on the continued growth of the Internet as a widely used medium for communications and commerce, and the growth of optical networks to meet the increased demand for capacity to transmit data, or bandwidth. If the Internet does not continue to expand as a medium for communications and commerce, the need to significantly increase bandwidth across networks and the market for fiber optic components may not continue to develop. If this growth does not continue, sales of our products may continue to decline which would adversely affect our revenues. Our customers have experienced an oversupply of inventory due to lower demand for their products that has resulted in a decrease of orders for our products. Future demand for our products is uncertain and will depend heavily on the continued growth and upgrading of optical networks, especially in the metropolitan, last mile and enterprise access segments of the networks.

Decreased spending by telecommunication companies over the past two years has resulted in decreased demand for our products. The rate at which communication service providers and other fiber optic network users have built new fiber optic networks or installed new systems in their existing fiber optic networks has fluctuated in the past and these fluctuations may continue in the future. These fluctuations may result in reduced demand for new or upgraded fiber optic systems that utilize our products and, therefore, may result in reduced demand for our products. Declines in the development of new networks and installation of new systems have resulted in a decrease in demand for our products, an increase in our inventory, and erosion in the average selling prices of our products.

The communications industry is experiencing rapid consolidation and realignment, as industry participants seek to capitalize on the rapidly changing competitive landscape developing around the Internet and new communications technologies such as fiber optic networks. As the communications

industry consolidates and realigns to accommodate technological and other developments, our customers may consolidate or align with other entities in a manner that results in a decrease in demand for our products.

The optical networking component industry has in the past, is now, and may in the future experience declining average selling prices, which could cause our gross margins to decline.

The optical networking component industry has in the past experienced declining average selling prices as a result of increasing competition and greater unit volumes as communication service providers continue to deploy fiber optic networks. Average selling prices are currently decreasing and may continue to decrease in the future in response to product introductions by competitors, price pressures from significant customers, greater manufacturing efficiencies achieved through increased automation in the manufacturing process and inventory build-up due to decreased demand. Average selling price declines may contribute to a decline in our gross margins, which could harm our results of operations.

We will not attract new orders for our fiber optic components unless we can deliver sufficient quantities of our products to optical communications equipment manufacturers.

Communications service providers and optical systems manufacturers typically require that suppliers commit to provide specified quantities of products over a given period of time. If we are unable to commit to deliver quantities of our products to satisfy a customer’s anticipated needs, we will lose the order and the opportunity for significant sales to that customer for a lengthy period of time. In addition, we would be unable to fill large orders if we do not have sufficient manufacturing capacity to enable us to commit to provide customers with specified quantities of products. However, if we build our manufacturing capacity and inventory in excess of demand, as we have done in the past, we may produce excess inventory that may have to be reserved or written off.

We depend on a limited number of third parties to supply key materials, components and equipment, such as ferrules and lenses, and if we are not able to obtain sufficient quantities of these items at acceptable prices, our ability to fill orders would be limited and our operating results could be harmed.

We depend on third parties to supply the raw materials and components we use to manufacture our products. To be competitive, we must obtain from our suppliers, on a timely basis, sufficient quantities of raw materials and components at acceptable prices. We obtain most of our critical raw materials and components from a single or limited number of suppliers and generally do not have long-term supply contracts with them. As a result, our suppliers could terminate the supply of a particular material or component at any time without penalty. Finding alternative sources may involve significant expense and delay, if these sources can be found at all. Difficulties in obtaining raw materials or components in the future may delay or limit our product shipments, which could result in lost orders, increase our costs, reduce our control over quality and delivery schedules and require us to redesign our products. If a supplier became unable or unwilling to continue to manufacture or ship materials or components in required volumes, we would have to identify and qualify an acceptable replacement. A delay or reduction in shipments or any need to identify and qualify replacement suppliers would harm our business. All of our graded index, or GRIN, lenses, which are incorporated into substantially all of our filter-based DWDM products, are obtained from one supplier, Nippon Sheet Glass.

Because we experience long lead times for materials and components, we may not be able to effectively manage our inventory levels, which could harm our operating results.

Because we experience long lead times for materials and components and are often required to purchase significant amounts of materials and components far in advance of product shipments, we may not effectively manage our inventory levels, which could harm our operating results. We recorded significant charges for excess and obsolete inventory in the quarters ended March 31, 2002, June 30, 2002 and September 30, 2002. Alternatively, if we underestimate our raw material requirements, we may have inadequate inventory, which could result in delays in shipments and loss of customers. If we purchase raw materials and increase production in anticipation of orders that do not materialize or that

shift to another quarter, we will, as we have in the past, have to carry or write off excess inventory and our gross margins will decline. Either situation could cause our results of operations to be below the expectations of investors and public market analysts, which could, in turn, cause the price of our common stock to decline. The time our customers require to incorporate our products into their own can vary significantly and generally exceeds several months, which further complicates our planning processes and reduces the predictability of our forecasts. Even if we receive these orders, the additional manufacturing capacity that we add to meet our customer’s requirements may be underutilized in a subsequent quarter.

We depend on key personnel to operate our business effectively in the rapidly changing fiber optic components market, and if we are unable to hire and retain appropriate management and technical personnel, our ability to develop our business could be harmed.

Our success depends to a significant degree upon the continued contributions of the principal members of our technical sales, marketing, engineering and management personnel, many of whom perform important management functions and would be difficult to replace. We particularly depend upon the continued services of our executive officers, particularly Peter Chang, our President and Chief Executive Officer; David Hubbard, our Vice President, Sales and Marketing; Wei-shin Tsay, our senior Vice President of Product Development; Anita Ho, our Acting Chief Financial Officer and Corporate Controller, and other key engineering, sales, marketing, finance, manufacturing and support personnel. In addition, we depend upon the continued services of key management personnel at our Taiwanese subsidiary. None of our officers or key employees is bound by an employment agreement for any specific term, and may terminate their employment at any time. In addition, we do not have “key person” life insurance policies covering any of our employees.

Our ability to continue to attract and retain highly skilled personnel will be a critical factor in determining whether we will be successful in the future. We may have difficulty hiring skilled engineers at our manufacturing facilities in the United States, Taiwan and China. If we are not successful in attracting, assimilating or retaining qualified personnel to fulfill our current or future needs, our business may be harmed.

If we are not able to achieve acceptable manufacturing yields and sufficient product reliability in the production of our fiber optic components, we may incur increased costs and delays in shipping products to our customers, which could impair our operating results.

Complex and precise processes are required for the manufacture of our products. Changes in our manufacturing processes or those of our suppliers, or the inadvertent use of defective materials, could significantly reduce our manufacturing yields and product reliability. Because the majority of our manufacturing costs are relatively fixed, manufacturing yields are critical to our results of operations. Lower than expected production yields could delay product shipments and impair our operating results. We may not obtain acceptable yields in the future.

In some cases, existing manufacturing techniques, which involve substantial manual labor, may not allow us to cost-effectively meet our production goals so that we maintain acceptable gross margins while meeting the cost targets of our customers. We may not achieve adequate manufacturing cost efficiencies.

Because we plan to introduce new products and product enhancements regularly, we must effectively transfer production information from our product development department to our manufacturing group and coordinate our efforts with those of our suppliers to rapidly achieve volume production. In our experience, our yields have been lower during the early stages of introducing new product to manufacturing. If we fail to effectively manage this process or if we experience delays, disruptions or quality control problems in our manufacturing operations, our shipments of products to our customers could be delayed.

Because the qualification and sales cycle associated with fiber optic components is lengthy and varied, it is difficult to predict the timing of a sale or whether a sale will be made, which may cause us to have excess manufacturing capacity or inventory and negatively impact our operating results.

In the communications industry, service providers and optical systems manufacturers often undertake extensive qualification processes prior to placing orders for large quantities of products such as ours, because these products must function as part of a larger system or network. This process may range from three to six months and sometimes longer. Once they decide to use a particular supplier’s product or component, these potential customers design the product into their system, which is known as a design-in win. Suppliers whose products or components are not designed in are unlikely to make sales to that customer until at least the adoption of a future redesigned system. Even then, many customers may be reluctant to incorporate entirely new products into their new systems, as this could involve significant additional redesign efforts. If we fail to achieve design-in wins in our potential customers’ qualification processes, we will lose the opportunity for significant sales to those customers for a lengthy period of time.

In addition, some of our customers require that our products be subjected to standards-based qualification testing, which can take up to nine months or more. While our customers are evaluating our products and before they place an order with us, we may incur substantial sales and marketing and research and development expenses, expend significant management efforts, increase manufacturing capacity and order long lead-time supplies. Even after the evaluation process, it is possible a potential customer will not purchase our products. In addition, product purchases are frequently subject to unplanned processing and other delays, particularly with respect to larger customers for which our products represent a very small percentage of their overall purchase activity. Accordingly, our revenues and operating results may vary significantly and unexpectedly from quarter to quarter.

If our customers do not qualify our manufacturing lines for volume shipments, our optical networking components may be dropped from supply programs and our revenues may decline.

Customers generally will not purchase any of our products, other than limited numbers of evaluation units, before they qualify our products, approve our manufacturing process and approve our quality assurance system. Our existing manufacturing lines, as well as each new manufacturing line, must pass through various levels of approval with our customers. For example, customers may require that we be registered under international quality standards. Our products may also have to be qualified to specific customer requirements. This customer approval process determines whether the manufacturing line achieves the customers’ quality, performance and reliability standards. Delays in product qualification may cause a product to be dropped from a long-term supply program and result in significant lost revenue opportunity over the term of that program.

Our fiber optic components are deployed in large and complex communications networks and may contain defects that are not detected until after our products have been installed, which could damage our reputation and cause us to lose customers.

Our products are designed for deployment in large and complex optical networks. Because of the nature of these products, they can only be fully tested for reliability when deployed in networks for long periods of time. Our fiber optic products may contain undetected defects when first introduced or as new versions are released, and our customers may discover defects in our products only after they have been fully deployed and operated under peak stress conditions. In addition, our products are combined with products from other vendors. As a result, should problems occur, it may be difficult to identify the source of the problem. If we are unable to fix defects or other problems, we could experience, among other things:

• loss of customers;

• damage to our reputation;

• failure to attract new customers or achieve market acceptance;

• diversion of development and engineering resources; and

• legal actions by our customers.

The occurrence of any one or more of the foregoing factors could cause our net loss to increase.

The market for fiber optic components is new and unpredictable, characterized by rapid technological changes, evolving industry standards, and significant changes in customer demand, which could result in decreased demand for our products, erosion of average selling prices, and could negatively impact our revenues.

The market for fiber optic components is new and characterized by rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. Because this market is new, it is difficult to predict its potential size or future growth rate. Widespread adoption of optical networks, especially in the long-haul, metropolitan, last mile, and enterprise access segments of the networks, is critical to our future success. Potential end-user customers who have invested substantial resources in their existing copper lines or other systems may be reluctant or slow to adopt a new approach, such as optical networks. Our success in generating revenues in this emerging market will depend on:

• the education of potential end-user customers and network service providers about the benefits of optical networks; and

• the continued growth of the long-haul, metropolitan, last mile, and enterprise access segments of the communications network.

If we fail to address changing market conditions, sales of our products may decline, which would adversely impact our revenues.

Effective at the beginning of trading on November 8, 2002, the listing of our common stock was transferred to the Nasdaq SmallCap Market and if we are unable to maintain our listing on the Nasdaq SmallCap Market, the price and liquidity of our common stock may decline.

Beginning at the commencement of trading on November 8, 2002, our common stock was listed on the Nasdaq SmallCap Market. The transfer of our common stock to the Nasdaq SmallCap Market may result in decreased liquidity of our common stock and may further decrease the price per share of our common stock.

As a result of the transfer to the Nasdaq SmallCap Market, we may become subject to certain sections of the California Corporations Code that may affect our charter documents. For example, we may not be able to continue to have a classified board or continue to eliminate cumulative voting. In addition, certain provisions of our Certificate of Incorporation that call for supermajority voting may need to be approved by stockholders every two years or be eliminated. Also, in the event of a reorganization, stockholders may have certain dissenting stockholder rights.

There can be no assurance that we will be able to satisfy all of the quantitative maintenance criteria for continued listing on the Nasdaq SmallCap Market including a continued minimum bid price of $1.00 per share. As of July 23, 2003 we were in compliance with the quantitative maintenance criteria. If we are unable to continue to comply with any of these criteria in the future, we may be delisted from the Nasdaq SmallCap Market, which could further decrease the price per share and the liquidity of our common stock, and make it more difficult for us to raise capital in the future.

In addition, many companies that face delisting as a result of closing bid prices that are below the Nasdaq SmallCap Market’s continued listing standards seek to maintain the listing of their securities by effecting reverse stock splits. However, reverse stock splits do not always result in a sustained closing bid price per share. Although three proposals related to reverse splits were approved by our stockholders

at the 2003 Annual Meeting of Stockholders, we have not yet implemented a reverse stock split. We will continue to evaluate this option.

If we fail to protect our intellectual property rights, competitors may be able to use our technologies, which could weaken our competitive position, reduce our revenues or increase our costs.

The fiber optic component market is a highly competitive industry in which we, and most other participants, rely on a combination of patent, copyright, trademark and trade secret laws, confidentiality procedures and licensing arrangements to establish and protect proprietary rights. The competitive nature of our industry, rapidly changing technology, frequent new product introductions, changes in customer requirements and evolving industry standards heighten the importance of protecting proprietary technology rights. Since the United States Patent and Trademark Office keeps patent applications confidential until a patent is issued, our pending patent applications may attempt to protect proprietary technology claimed in a third party patent application. Our existing and future patents may not be sufficiently broad to protect our proprietary technologies as policing unauthorized use of our products is difficult and we cannot be certain that the steps we have taken will prevent the misappropriation or unauthorized use of our technologies, particularly in foreign countries where the laws may not protect our proprietary rights as fully as United States laws. Our competitors may independently develop similar technology, duplicate our products, or design around any of our patents or other intellectual property. If we are unable to adequately protect our proprietary technology rights, others may be able to use our proprietary technology without having to compensate us, which could reduce our revenues and negatively impact our ability to compete effectively.

Litigation may be necessary to enforce our intellectual property rights or to determine the validity or scope of the proprietary rights of others. As a result of any such litigation, we could lose our proprietary rights and incur substantial unexpected operating costs. Any action we take to protect our intellectual property rights could be costly and could absorb significant management time and attention. In addition, failure to adequately protect our trademark rights could impair our brand identity and our ability to compete effectively.

We may be subject to intellectual property infringement claims that are costly to defend and could limit our ability to use some technologies in the future.

Our industry is very competitive and is characterized by frequent intellectual property litigation based on allegations of infringement of intellectual property rights. Numerous patents in our industry have already been issued, and as the market further develops and participants in our industry obtain additional intellectual property protection, litigation is likely to become more frequent. From time to time, third parties may assert patent, copyright, trademark and other intellectual property rights to technologies or rights that are important to our business. In addition, we may in the future enter into agreements to indemnify our customers for any expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. Any litigation arising from claims asserting that our products infringe or may infringe the proprietary rights of third parties, whether the litigation is with or without merit, could be time-consuming, resulting in significant expenses and diverting the efforts of our technical and management personnel. We do not have insurance against our alleged or actual infringement of intellectual property of others. These claims could cause us to stop selling our products, which incorporate the challenged intellectual property, and could also result in product shipment delays or require us to redesign or modify our products or to enter into licensing agreements. These licensing agreements, if required, would increase our product costs and may not be available on terms acceptable to us, if at all.

Although we are not aware of any intellectual property lawsuits filed against us, we may be a party to litigation regarding intellectual property in the future. We may not prevail in any such actions, given their complex technical issues and inherent uncertainties. Insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed. If there is a successful claim of infringement or we fail to develop non-infringing technology or license the proprietary rights on a timely basis, our business could be harmed.

If we fail to increase sales of our products to optical communications equipment manufacturers outside of North America, growth of our business may be harmed.

For the year ended December 31, 2002 and the six months ended June 30, 2003, sales to customers located outside of North America were 9.6% and 9.5% of our revenues, respectively. In order to expand our business, we must increase our sales to customers located outside of North America. We have limited experience in marketing and distributing our products internationally and in developing versions of our products that comply with local standards. Our international sales will be limited if we cannot establish relationships with international distributors, establish additional foreign operations, expand international sales channels, hire additional personnel and develop relationships with international communications equipment manufacturers. Even if we are able to successfully continue international operations, we may not be able to maintain or increase international market demand for our products.

The outbreak of Severe Acute Respiratory Syndrome, or SARS, poses a risk to the Company’s business.

The outbreak of SARS has developed into an international health concern, especially in Asia. We have manufacturing facilities located in Taiwan and China. An outbreak of SARS among our employees in Asia could disrupt our Asian manufacturing operations for an extended period of time, which could limit our ability to supply our products to our customers in sufficient quantities on a timely basis. A shutdown of our Asian facilities due to fear of spread of infection or because of a quarantine could result in our inability to supply our customers. If we are unable to fulfill demand for our products, our relationships with our customers would be harmed and our revenues could be impacted. We also rely on companies in Asia for many of the components necessary to manufacture our products. If our suppliers experience a significant disruption in their businesses as a result of SARS, we may not be able to obtain the parts necessary to make our products which could negatively impact our revenues. In addition, if any of our customers experiences a significant disruption in their business as a result of SARS, they may delay or cancel purchases of our products which could harm our business. Also, certain of our key employees travel to Asia to oversee our Asian operations and to meet with our suppliers and customers. If any of our key employees are infected with SARS on such a trip or if these employees are quarantined when they return to the United States, our business could be negatively impacted. These conditions and uncertainties make it difficult for us, our suppliers and our customers to accurately forecast and plan future business activities.

Because our manufacturing operations are located in active earthquake fault zones in California and Taiwan, and our Taiwan location is susceptible to the effects of a typhoon, we face the risk that a natural disaster could limit our ability to supply products.

Our primary manufacturing operations are located in Sunnyvale, California and Tu-Cheng City, Taiwan, both active earthquake fault zones. These regions have experienced large earthquakes in the past and may likely experience them in the future. In September 2001, a typhoon hit Taiwan causing businesses, including our manufacturing facility, and the financial markets to close for two days. Because the majority of our manufacturing operations are located in Taiwan, a large earthquake or typhoon in Taiwan could disrupt our manufacturing operations for an extended period of time, which would limit our ability to supply our products to our customers in sufficient quantities on a timely basis, harming our customer relationships.

ITEM 3: CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures. We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Acting Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-QSB, our Chief Executive Officer and Acting Chief Financial Officer have concluded that, subject to the limitations noted above, our disclosure controls and procedures were effective to ensure that material information relating to us, including our consolidated subsidiaries, is made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-QSB was being prepared.

(b) Changes in internal controls. There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with the evaluation described in Item 3(a) above that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On May 16, 2003, we held our 2003 Annual Meeting of Stockholders, at which meeting our stockholders approved the following:

(a) Election of Class III directors:


	For	Withheld

Gwong-Yih Lee	30,988,445 shares	382,171 shares
James C. Yeh	30,988,445 shares	382,171 shares

The terms of directors Peter Chang and Kenny Liu continued beyond the 2003 Annual Meeting of Stockholders. Richard Black was elected to the Board of Directors in April 2003.

(b) Ratification of the appointment of PricewaterhouseCoopers LLP as independent auditors of the Company for the current fiscal year:


For	Against	Abstain

31,332,939 shares	16,107 shares	21,571 shares

(c) Amendment of the Company’s Amended and Restated Certificate of Incorporation to effect a 1-for-6 reverse split of the issued and outstanding shares of the Company’s common stock:


For	Against	Abstain

30,653,087 shares	716,359 shares	1,170 shares

(d) Amendment of the Company’s Amended and Restated Certificate of Incorporation to effect a 1-for-8 reverse split of the issued and outstanding shares of the Company’s common stock:


For	Against	Abstain

30,637,270 shares	731,801 shares	1,545 shares

(e) Amendment of the Company’s Amended and Restated Certificate of Incorporation to effect a 1-for-10 reverse split of the issued and outstanding shares of the Company’s common stock:


For	Against	Abstain

30,657,145 shares	712,751 shares	720 shares

ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits


Exhibit
Number		Title

	31.1	Rule 13a–14(a) certification of Chief Executive Officer.

	31.2	Rule 13a–14(a) certification of Chief Financial Officer. Statement of Chief Executive Officer under Section 906 of

	32.1**	the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350). Statement of Chief Financial Officer under Section 906 of

	32.2**	the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350).

In accordance with Item 601(b)(32)(ii) of Regulation S-K and SEC Release Nos. 33-8238 and 34-47986, Final Rule: Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-QSB and will not be deemed “filed” for purpose of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.

(b) Reports on Form 8-K.

On April 30, 2003, we filed a Current Report on Form 8-K furnishing under Item 12 the Company’s press release relating to its financial results for the quarter ended March 31, 2003,

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


Dated: August 8, 2003

	ALLIANCE FIBER OPTIC PRODUCTS, INC.

	By	/s/ Anita K. Ho

		Anita K. Ho Acting Chief Financial Officer and Corporate Controller (Principal Financial and Accounting Officer and Duly Authorized Signatory)

EXHIBIT INDEX


Exhibit
Number		Title

	31.1	Rule 13a-14(a) certification of Chief Executive Officer.

	31.2	Rule 13a-14(a) certification of Chief Financial Officer. Statement of Chief Executive Officer under Section 906 of

	32.1**	the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350). Statement of Chief Financial Officer under Section 906 of

	32.2**	the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350).

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	•		changes in manufacturing volume;

	•		costs incurred in establishing additional manufacturing lines and facilities;

	•		inventory write-downs and impairment charges related to manufacturing assets;

	•		mix of products sold;

	•		changes in our pricing and pricing from our competitors;

	•		mix of sales channels through which our products are sold; and

	•		mix of domestic and international sales.

	•		customer unwillingness to implement our products;

	•		any delays or difficulties that we may incur in completing the development and introduction of our planned products or product enhancements;

	•		the success of our customers;

	•		new product introductions by our competitors;

	•		any failure of our products to perform as expected; or

	•		any difficulty we may incur in meeting customers’ delivery requirements or product specifications.

	•		improve existing and implement new operational, financial and management controls, reporting systems and procedures;

	•		hire, train, motivate and manage additional qualified personnel, especially if we experience a significant increase in demand for our products;

	•		effectively expand or reduce our manufacturing capacity, attempting to adjust it to customer demand; and

	•		effectively manage relationships with our customers, suppliers, representatives and other third parties.

	•		loss of customers;

	•		damage to our reputation;

	•		failure to attract new customers or achieve market acceptance;

	•		diversion of development and engineering resources; and

	•		legal actions by our customers.

	•		the education of potential end-user customers and network service providers about the benefits of optical networks; and

	•		the continued growth of the long-haul, metropolitan, last mile, and enterprise access segments of the communications network.