---

UNITED STATES SECURITIES
AND EXCHANGE COMMISSIONWashington, D.C. 20549
_________________

# FORM 10-KSB

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

# For the fiscal year
ended December 31, 2004

# OR

[  ]       
          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
registrant as specified in its charter)

|                                              |                                  
|--------------------------------------------- | ---------------------------------
|Delaware                                      | 77-0554122                       
|(State or other jurisdiction of incorporation | (IRS Employer Identification No.)
|or organization)                              |                                  

275 Gibraltar Drive, Sunnyvale, CA 94089(Address of principal
executive offices)

Issuers telephone
number: (408) 736-6900

# Securities registered
to Section 12(b) of the Act: None

# Securities registered pursuant
to Section 12(g) of the Act:Common Stock, par
value $0.001 per shareSeries A Participating
Preferred Stock Purchase Rights

Check
whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d)
of the Exchange Act during the past 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 [   ]

Check
if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B
is not contained in this form, and no disclosure will be contained, to the best of
registrants knowledge, in definitive proxy or information statements incorporated by
reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB.
[   ]

The
issuers revenues for its fiscal year ending December 31, 2004: $14,558,362

The aggregate
market value of the voting and non-voting common equity held by non-affiliates (based upon
the closing sale price on the Nasdaq SmallCap Market on March 8, 2005) was approximately
$29,525,536.

As
of March 8, 2005 there were 39,022,496 shares of Common Stock, $0.001 per share par
value, outstanding.

# DOCUMENTS INCORPORATED
BY REFERENCE

Items 9
(as to directors and Section 16(a) Beneficial Ownership Reporting Compliance), 10, 11
(as to Beneficial Ownership), 12 and 13 of Part III incorporate by reference
information from the registrants proxy statement to be filed with the Securities and
Exchange Commission in connection with the solicitation of proxies for the
registrants 2005 Annual Meeting of Stockholders to be held on May 20, 2005.



---

# ALLIANCE FIBER OPTIC
PRODUCTS, INC.

# TABLE OF CONTENTS

# 2004 FORM 10-KSB

| |               |                                                                                                                         |     
| | ------------- | ----------------------------------------------------------------------------------------------------------------------- | ----
| |               |                                                                                                                         | Page
| | PART I        |                                                                                                                         | 1   
| |               | Item 1. Description of Business                                                                                         | 1   
| |               | Item 2. Description of Property                                                                                         | 7   
| |               | Item 3. Legal Proceedings                                                                                               | 7   
| |               | Item 4. Submission of Matters to a Vote of Security Holders                                                             | 8   
| |               | Executive Officers of the Registrant                                                                                    | 8   
| | PART II       |                                                                                                                         | 9   
| |               | Item 5. Market for Common Equity, Related Stockholder Matters and Small Business Issuer Purchases of Equity Securities  | 9   
| |               | Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations                           | 10  
| |               | Item 7. Financial Statements                                                                                            | 29  
| |               | Item 8. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure                            | 51  
| |               | Item 8A. Controls and Procedures                                                                                        | 51  
| |               | Item 8B. Other Information                                                                                              | 51  
| | PART III      |                                                                                                                         | 52  
| |               | Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act | 52  
| |               | Item 10. Executive Compensation                                                                                         | 52  
| |               | Item 11. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters                 | 52  
| |               | Item 12. Certain Relationships and Related Transactions                                                                 | 53  
| |               | Item 13. Exhibits                                                                                                       | 54  
| |               | Item 14. Principal Accountant Fees and Services                                                                         | 55  
| | SIGNATURES    |                                                                                                                         | 56  
| | EXHIBIT INDEX |                                                                                                                         | 57  

i

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# PART I

# Item 1. Description of
Business

When
used in this Report, the words expects, anticipates,
believes, estimates, plans, intends,
could, will, may and similar expressions are intended
to identify forward-looking statements. These are statements that relate to future periods
and include statements as to our operating results, revenues, sources of revenues, cost of
revenues, gross margins, net and operating losses, profitability, the amount and mix of
anticipated investments, expenditures and expenses, our liquidity and the adequacy of our
capital resources, anticipated working capital and capital expenditures, reliance on our
OPMS products, our cash flow, trends in average selling prices, our reliance on the
commercial success of our DWDM-related products, plans for future products and
enhancements of existing products, features, benefits and uses of our products, demand for
our products, our success being tied to relationships with key customers, industry trends
and market demand, acquisitions of complementary businesses, products or technologies, our
efforts to protect our intellectual property, potential indemnification agreements,
increases in the number of possible license offers and patent infringement claims, our
competitive position, sources of competition, consolidation in our industry, our
international strategy, our employee relations, the adequacy of our internal controls, the
effect of recent accounting pronouncements and our critical accounting policies and
estimates. Forward-looking statements 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, as well as
risks related to the development of the metropolitan, last mile access, and enterprise
networks, customer acceptance of our products, our ability to retain and obtain customers,
industry-wide overcapacity and shifts in supply and demand for optical components and
modules, our ability to meet customer demand and manage inventory, fluctuations in demand
for our products, declines in average selling prices, development of new products by us
and our competitors, increased competition, inability to obtain sufficient quantities of a
raw material product, loss of a key supplier, integration of acquired businesses or
technologies, financial stability in foreign markets, foreign currency exchange rates,
costs associated with being a public company, delisting from the Nasdaq SmallCap Market,
failure to meet customer requirements, our ability to license intellectual property on
commercially reasonable terms, economic stability, and the risks set forth below under
Item 6, Managements Discussion and Analysis or Plan of Operation.
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.

In
the sections of this report entitled Business and Managements
Discussion and Analysis of Financial Condition and Results of Operations  Factors
That May Affect Results, all references to Alliance Fiber Optic
Products, AFOP, we, us, our or the
Company mean Alliance Fiber Optic Products, Inc. and its subsidiaries, except
where it is made clear that the term means only the parent company.

AFOP,
OPIS and SPECTRAMUX are our trademarks. We may also refer to trademarks of other
corporations and organizations in this document.

# Overview

Alliance
Fiber Optic Products designs, manufactures and markets a broad range of high performance
fiber optic components, and integrated modules incorporating these components, for leading
and emerging communications equipment manufacturers. We offer a broad range of products
including interconnect devices that are used to connect optical fibers and components,
couplers and splitters that are used to divide and combine optical power, and dense
wavelength division multiplexing, or DWDM, devices that separate and combine multiple
specific wavelengths. Our emphasis on design for manufacturing and our comprehensive
manufacturing expertise enable us to produce our products efficiently and in volume
quantities. Our product scope and ability to integrate our components into optical modules
enable us to satisfy a wide range of customer requirements throughout the optical
networking market. Our customers deploy our products in long-haul networks that connect
cities, metropolitan networks that connect areas within cities, last mile access networks
that connect to individual businesses and homes, and enterprise networks within
businesses.

We
were incorporated in California in December 1995. In October 2000, prior to our initial
public offering, we reincorporated in Delaware as Alliance Fiber Optic Products, Inc.

1

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# Industry Background

The
popularity of the Internet and the growing number of data intensive Internet-based
applications and services has fueled a significant increase in the volume of data traffic.
This traffic growth has increased the demands on communication networks originally
developed to primarily transport voice traffic. To meet this demand, many communications
service providers have and are designing and installing new networks based on fiber optic
technology, which provides greater data-carrying capacity, or bandwidth, and increased
transmission speeds compared to existing communications networks. Until recently, most of
the fiber deployed had been dedicated to long-haul networks. However, the demands for
high-speed network access and bandwidth are shifting the focus towards more complex
metropolitan networks and last mile access networks, which require an increasing number of
connections and components.

Optical
fiber is currently being deployed across the following segments of communications
networks: long-haul, metropolitan, last mile access, and enterprise.

Long-haul
networks.Long-haul networks connect the communications networks of cities around the
world and transport large amounts of data and voice traffic. To solve congestion problems,
service providers have invested significant resources in the deployment of optical
infrastructure. As a result, current long-haul networks provide high bandwidth for
transmitting data over very long distances. The build-out of long-haul networks represents
an important step in improving network infrastructure to support increased demand for new
services and greater traffic volumes.

Metropolitan
networks. Metropolitan networks connect long-haul networks to last mile access
networks within urban areas. Due to the increase in data traffic and the demand for
enhanced services, the existing metropolitan network infrastructure has become a
bottleneck for the provision of communications services to business and residential end
users. As a result, service providers are making investments in infrastructure to reduce
capacity constraints in metropolitan networks.

Last
mile access networks. Last mile access networks connect business and residential end
users to their service provider in order to provide increased bandwidth to the end user.
Traditional access networks use the existing copper wire based infrastructure, which is
slow compared to the high-speed networks commonly used within businesses. Established and
new service providers are beginning to deploy fiber technologies in the last mile access
network in order to provide high bandwidth connectivity to the end user.

Enterprise
networks.Local area networks serving the business community have utilized fiber optic
links for over a decade. Historically these links have connected vertical backbone
requirements between various floors of copper-based networks within office buildings. Over
the last several years, as the bandwidth of local networks has increased, optical fiber
has become a pervasive medium for horizontal network links especially in the storage
network environment.

Service
providers are seeking to maximize the performance and capacity of both new and existing
optical networks through advances in optical technology. Wavelength division multiplexing,
or WDM, has been used for several years to increase system capacity by combining different
light signals at different wavelengths, on a single optical fiber. Each wavelength
represents a separate high-bandwidth channel that can carry data. Multiplexing devices
combine, or multiplex, these different wavelengths at one end of the optical network, and
demultiplexing devices, or demultiplex, separate them at the other end. WDM technology has
been enhanced with the introduction of dense wavelength division multiplexing, or DWDM,
which permits the wavelengths to be spaced more closely together. The tighter spacing
allows even more wavelengths to be transmitted on one optical fiber. The use of WDM and
DWDM technology is well established in the long-haul market and is increasingly utilized
in the metropolitan and last mile access markets.

Fiber
optic components are used within optical networks to create, combine, isolate, amplify,
split, direct and perform various other functions on the optical signals. Fiber optic
components are divided into two broad categories, active and passive components. Active
components require power to operate and use electrical signals to create, modulate or
amplify optical signals. Passive optical components guide, mix, filter, route, adjust and
stabilize optical signals transmitted through an optical network.

2

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# Market Conditions

In
periods prior to 2004, communication equipment manufacturers purchased optical transport
systems and related devices in anticipation of an extremely rapid increase in demand for
bandwidth. While demand for bandwidth continues to increase, this demand has grown at a
far slower pace than previously anticipated. As a result, communication equipment
manufacturers ended up with excess inventories of optical systems and devices that now
create a barrier to new sales opportunities.

This
situation has created challenges for suppliers in the optical communication industry. Due
to decreased unit shipments as a result of overcapacity in the industry and the resulting
competition for fewer sales opportunities, average selling prices have declined as
companies compete for significantly smaller market opportunities.

Over
the past year, the optical components industry has experienced a slight increase in
business levels. Recent orders for our products have been utilized both for upgrades of
existing networks and new network builds. In addition, certain large telecommunications
service providers have recently announced that they plan to deploy new broadband access
networks based on fiber optic technologies for residential users. These fiber-to-the-home
networks, or FTTH, are expected to significantly increase the capacity and expand the
types of services that can be utilized by residential users. It remains difficult,
however, to predict the timing or extent of an industry recovery and the potential impact
to our business from this or any other deployment initiatives.

# Products

Our
passive optical products support the needs of current and next generation optical network
systems applications. Our Optical Path Management Solution, or OPMS, product family
provides a comprehensive line of optical interconnect devices, couplers and splitters and
related optical products, as well as customized integrated modules incorporating these
devices. Our Wavelength Management Solutions, or WMS, include WDM and DWDM components and
modules that utilize thin film filter technologies to separate optical signals. Our
advanced optical devices include our all-fiber optical depolarizer, which reduces the
degree of polarization of a light source, our automatic variable optical attenuator, which
controls the amount of power in an optical fiber, and our switchable optical drop/add
module, which inserts or extracts specific wavelengths in a DWDM system.

The
following is a discussion of our current product offerings and the products that we are
developing.

OPMS
Products.In nearly all fiber optic networks, the optical fiber, passive
optical components and active optical devices must be joined using optical interconnection
systems. Our OPMS platform provides fundamental component support for these applications
as well as standard and custom value added integrated solutions that address the need for
higher functionality and modularity. All of the OPMS products described below are in
production and are shipping to customers.

OPMS
Modules.The evolution of optical components is driven by the increasing need for
packaging density, module performance and overall cost effectiveness. We design and
package our various OPMS components to provide integrated modules for our customers. Our
integrated modules are designed to reduce our customers system design requirements
and ease implementation.

Optical
Connectors, Adapters and Cable Assemblies. Optical connectors and adapters are
precision devices that connect fibers together. Optical cable assemblies are used to
bridge relatively short distances with optical paths. We offer a broad range of industry
standard connection products that support a wide range of fiber and fiber cable types.
Further, with our integrated design and manufacturing capability, we are able to customize
these products to meet our customers needs for compact size and special features. We
specialize in providing our customers with high performance custom cable assemblies to
serve in conjunction with our optical interconnection solutions at all interface points in
the optical communications network.

Fused
and Planar Fiber Optical Splitters and Couplers. Fused and planar fiber optical
splitters and couplers are branching devices that are used to split optical power from a
single fiber, or set of fibers, into a different set of fibers. They are often used to
distribute optical signals to multiple locations for processing. These devices utilize
signal and power sharing features to reduce the total cost of delivering bandwidth to
end-users. Our optical splitters and couplers reduce insertion loss, or the power loss
incurred when inserting components into an optical path, and deliver high performance,
including uniform optical wavelength splitting.

3

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Optical
Tap Couplers and Ultra Low Polarization Dependent Loss Tap Couplers. Optical tap
couplers are fused fiber branching devices that split off a portion of light to allow for
optical monitoring and feedback. These devices are used extensively in fiber amplifier
power control. They are also utilized in transmission equipment for performance monitoring
and control. Our ultra low polarization dependent loss devices offer low levels of
sensitivity to polarization, which is a characteristic of light that can cause a reduction
in the power of optical signals. These devices enable more effective monitoring and
management of optical networks.

Amplifier
WDM Couplers. Amplifier WDM couplers are used with specialized fibers to combine or
separate specific wavelengths of light associated with standard telecommunications optical
amplifier requirements. Our amplifier WDM couplers are stable low power loss components
with high power handling capability.

Optical
Fixed Attenuators. Optical fixed attenuators diminish the optical power within a given
optical path without interference or reduction in optical signal quality. Typically this
function is embedded in an optical connector or adapter element to simplify optical
network installation. We utilize attenuated fiber that reduces power while preserving
performance characteristics, including optical signal quality and reliability.

Fused
Fiber WDM Couplers. Fused fiber WDM couplers are used to combine and separate optical
signals transmitted on different wavelengths. This function provides the first level of
bandwidth expansion for a network by increasing a fibers signal carrying capacity.
Fused fiber WDM couplers may also be used to add additional functionality to the network
such as network status monitoring. Our fused fiber WDM couplers provide a cost effective
way to minimize loss and maximize wavelength isolation.

Filter-Based
Wavelength Management Products. In recent years, wavelength division multiplexing has
become the preferred method of increasing bandwidth throughout optical networks. Our
filter-based products serve WDM and DWDM systems as core passive elements that direct and
manage larger numbers of optical signal channels. Our wavelength management products also
enable network DWDM systems to manage and monitor a large number of optical signals by
separating these signals into different paths that can be processed individually. All of
the Filter-Based Wavelength Management Products described below are in production and are
shipping to customers.

Filter
WDMs. Our thin film filter based WDMs are used to combine and separate optical
signals. Our filter-based products allow for higher isolation and narrower wavelength
separations than fused fiber technology. Our filter WDMs are designed for a range of
network applications including combining active and passive components and wavelength
monitoring, splitting and separating tasks.

Amplifier
Filter WDMs. Amplifier filter WDMs utilize thin film filter technology to maintain
wavelength separation in demanding applications. In addition, filter technology allows for
narrow wavelength separation. Our amplifier filter WDMs are designed for a range of
applications, such as splitting wavelengths and connecting lasers used in wavelength
amplification.

DWDMs.
          Dense wave division multiplexers, or DWDMs, are integrated optical modules that
          combine, or multiplex, and separate, or demultiplex, multiple optical signals of
          different wavelengths on a single fiber. The separation of wavelengths are so
          narrow, or dense, that a large number of channels (greater than 10) can be
          combined within the band of usable wavelengths of the fiber itself. We utilize
          proprietary thin film technology in the development and manufacture of our DWDM
          products. This technology delivers excellent performance characteristics,
          including narrow channel separation and wide channel bandpass, which is the
          range of frequencies that will pass through a filter. Thin film filter
          technology allows for a range of solutions for 200 GHz, 100 GHz and 50 GHz
          International Telecom Union wavelength spacing applications, which permit 40
          channels, 80 channels, and 160 channels, respectively, to be transmitted across
          a single fiber. Our DWDMs directly address the scalable channel plans found in
          metropolitan and last mile access network applications.

CWDMs.
          Coarse wavelength division multiplexers, or CWDMs, are integrated optical
          modules that multiplex or demultiplex multiple optical signals of different
          wavelengths on a single fiber. Our CWDM product separate wavelength into 20 nm
          spacing to cover the complete fiber optical communication spectrum from 1270 nm
          to 1610 nm. With the unique low insertion loss and flat band-pass profile, CWDMs
          provide the most economic and efficient wavelength division multiplexing
          solutions for metropolitan and access networks. Our CWDM product covers 4
          channel, 8 channel, and 16 channel mux and demux applications, and upgradability
          for both 4 channel and 8 channel type. We also offer optical add-drop modules
          (OADMs) for CWDM networks, with the capability of adding or dropping from one to
          15 channels. In addition to the CWDM mux, demux and optical add/drop modules, we
          also offer complete rackmount CWDM solutions to customers so they can easily
          mount our CWDM products directly on their system rack. We believe CWDM products
          directly address the metropolitan and access markets competitive
          wavelength management needs.

4

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CCWDMs.
          Compact coarse wavelength division multiplexers, or CCWDMs, are integrated
          optical modules that are designed to significantly improve optical performance,
          while reducing manufacturing costs, in a package less than 1/4 the size of
          conventional CWDM modules. It features high wavelength accuracy and stability,
          low insertion loss, high isolation, low polarization dependent loss and an
          epoxy-free optical path. The Telcordia 1209/1221-qualified CCWDM builds on
          AFOPs proprietary optical bench platform, and we believe it has the
          smallest footprint of any comparable CWDMs. With a channel spacing of 20 nm and
          wide bandpass characteristics it allows for datacom or telecom network
          applications with low-cost uncooled lasers. These CCWDM Mux/Demuxes are
          available in four or eight channels and include an expansion port for 16 channel
          systems.

Add/Drop
DWDM Filters.Add/drop DWDM filter products are used to insert or extract specific
wavelengths in a DWDM system. While a large number of channels can be transmitted through
a single fiber network, often only selected channels of information are required at a
particular location. Our 200 GHz, 100 GHz and 50 GHz add/drop components use high
performance filter technology and operate with very little optical power loss in order to
provide high channel separation and high stability.

Advanced
Optical Devices.As the capacity and complexity of optical networks increases, future
systems face significant challenges. Performance characteristics such as stability,
channel balance and power loss due to polarization become difficult to manage without the
addition of optical control devices. Our advanced optical devices serve to add further
control in next generation networks and network measurement equipment. All of the Advanced
Optical Devices described below are in production and are shipping to customers.

Automatic
Variable Optical Attenuators. Automatic variable optical attenuators are designed to
control the optical power in a fiber. They are often combined with an active system
component to maintain optical power on a network even if the input signal is changing
power. Our automatic variable optical attenuators are specifically designed for
application in DWDM networks for use with individual channel source elements such as
add/drop transmitters. The cost and performance characteristics of our automatic variable
optical attenuators are specifically targeted to allow for the use of these devices in
volume as principal DWDM channel stabilization components.

Planar
Lightwave Circuit Splitters. Our optical Splitters reduce insertion loss, or the power
loss incurred when inserting components into an optical path, and deliver high
performance. These devices enable more effective monitoring and management of optical
networks.

# Intellectual Property

We
rely on a combination of patent, copyright, trademark and trade secret laws, as well as
confidentiality agreements and licensing arrangements, to establish and protect our
proprietary rights. As of December 31, 2004, we had 35 United States patents issued
or assigned to us and had 31 United States patent applications pending. The 35 U.S.
patents expire between September 2013 and November 2022. We also had 45 foreign patents
issued, and 26 foreign patent applications pending. Our foreign patents issued will expire
between September 2009 and April 2023. We also utilize unpatented proprietary know-how and
trade secrets and employ various methods to protect them.

From
time to time, third parties, including our competitors, may assert patent, copyright and
other intellectual property rights to technologies that are important to us. We expect we
will increasingly be subject to license offers and infringement claims as the number of
products and competitors in our market grows and the functions of products overlap.
Patents of third parties may be determined to be valid, or some of our products may
ultimately be determined to infringe them. Other companies may pursue litigation with
respect to those or other claims. The results of any litigation are inherently uncertain.
In the event of an adverse result in any litigation with respect to intellectual property
rights relevant to our products that could arise in the future, we could be required to
obtain licenses to the infringing technology, to pay substantial damages under applicable
law, to cease the manufacture, use and sale of infringing products or to expend
significant resources to develop non-infringing technology. Licenses may not be available
from third parties either on commercially reasonable terms or at all. In addition,
litigation frequently involves substantial expenditures and can require significant
management attention, even if we ultimately prevail. Accordingly, any infringement claim
or litigation against us could significantly harm our business, operating results,
financial condition, or cash flows. As of December 31, 2004, there were no infringement
claims or litigation pending against us.

5

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# Customers

We
sell our products to communications equipment manufacturers that incorporate our products
into their systems that they in turn sell to network service providers. In certain cases,
we sell our products to other component manufacturers for resale or inclusion in their
products. In the year ended December 31, 2004, we sold our products to more than 200
customers. One customer accounted for 11% of our revenues in the years ended December 31,
2004 and 2003, respectively. No individual customer accounted for 10% or more of our
revenues in the year ended December 31, 2002.

# Sales, Marketing and
Technical Support and Product Management

Sales.
          Our direct sales force markets and sells our products primarily in the United
          States. We also maintain a sales support staff in Taiwan to service customers
          based in the Asia Pacific region. Our direct sales force and technical marketing
          personnel maintain close contact with our customers and provide technical
          support.

Marketing.We have a number of marketing programs to support the sale and distribution
          of our products and to inform existing and potential customers about the
          capabilities and benefits of our products. Our marketing efforts include
          participating in industry trade shows and technical conferences, advertising in
          trade journals and communicating through our corporate website and direct mail.

Technical
Support and Product Management. We maintain a technically knowledgeable support staff
that is critical to our development of long-term customer relationships. Our technical
support and product management staff works closely with our customers to understand their
product requirements, to assist customers with utilizing our product line, and to develop
customized product solutions.

# Competition

The
fiber optic component industry is highly competitive and subject to rapid technological
change. We believe that the principal differentiating factors in the fiber optic component
market are support for multiple optical interfaces, high optical power, wavelength
selection, manufacturing capacity, reliable and compact packaging, price, product
innovation and reliability of product performance. Based on our assessment of the
performance and price of similar competitive product offerings, we believe that our
products compare favorably, although we cannot assure that they will continue to do so.

Our
principal competitors in the components market include Avanex Corporation, DiCon
Fiberoptics, Inc., JDS Uniphase Corp., Oplink Communications, Inc., Stratos International,
Inc. and Tyco Electronics Corporation. We estimate that we have approximately 25
competitors in the components market as of December 31, 2004. We believe that we primarily
compete with diversified suppliers for the majority of our product line and to a lesser
extent with a large number of niche companies that offer a more limited product line.
Competitors throughout the optical component industry, including those who sell active
components, may rapidly become competitors in portions of our business. Competitors who
provide both active and passive components may have a competitive advantage because they
provide a more complete product solution than we provide. In addition, our industry has
recently experienced significant consolidation, and we anticipate that further
consolidation will occur. This consolidation has further increased and we believe will
further increase competition. We expect significant pricing pressure from our competitors
that may negatively affect our margins. We cannot assure you that we will be able to
compete successfully with existing or future competitors or that competitive pressures
will not seriously harm our business, operating results and financial condition.

# Product Development

As
of December 31, 2004, we had a total of 36 engineers and technicians that are
directly involved in research and development of our products located in the United
States, Taiwan and China. Our engineering team has extensive design, packaging, processing
and software experience in optical components, interfaces and systems.

Our
primary product development center is located in Sunnyvale, California, where we opened
our Photonics Technology Center in March 2001. Our Taiwanese subsidiary also engages in
product development. Our research and development expenses were $5.6 million,
$5.6 million and $7.3 million for the years ended December 31, 2004, 2003 and
2002, respectively. We spend a substantial proportion of our financial resources to
develop new technologies and products to serve the next generation communication markets.

6

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# Sources and Availability
of Raw Materials

We
make significant purchases of key materials, components and equipment, including ferrules,
graded index lenses, or GRIN lenses, filters and other components from third party
suppliers. We obtain most of our critical raw materials and components from a single or
limited number of suppliers. When possible, we also develop and maintain alternative
sources for essential materials and components. However, there is only one supplier of
GRIN lenses. The inability to obtain sufficient quantities of these materials or
components may result in delays, increased costs, and reductions in our product shipments.

# Manufacturing

We
currently manufacture the majority of our OPMS and optical amplifier products at our
facility in Tu-Cheng City, Taiwan. We manufacture our filter-based and advanced products
at our headquarters in Sunnyvale, California and at our facility near Shenzhen, China.

Each
of our facilities maintains comprehensive in-house manufacturing processes, including
component and integrated module design, integration, production, and testing. We plan to
continue to invest resources in manufacturing management, engineering and quality control.

We
have established a quality management system, or QMS, which is designed to ensure that the
products we provide to our customers meet or exceed their requirements. Our Taiwan
facility and our United States facility are both ISO 9001-2000 certified in manufacturing.

# Employees

As
of December 31, 2004, we had 494 full-time employees, including 59 located in the
United States, 274 in Taiwan and 161 in mainland China. Of our 494 full-time employees, 36
are engaged in product development, 383 are engaged in manufacturing production, 17 are
engaged in sales, marketing, application support and customer service, and 58 are engaged
in general and administration. None of our employees are represented by a labor union. We
have not experienced any work stoppages and we consider our relations with our employees
to be good.

# Available Information

AFOPs
internet address is www.afop.com. AFOP makes available free of charge through a
hyperlink on our website our annual reports on Form 10-KSB, quarterly reports on Form
10-QSB, current reports on Form 8-K, and amendments to those reports filed or furnished
pursuant to Section 13(a) of the Exchange Act as soon as reasonably practicable after the
material is furnished to the SEC. Our website and the information contained therein or
connected thereto is not intended to be incorporated into this Annual Report on Form
10-KSB.

# Item 2. Description of
Property

In
the United States, we lease a total of approximately 34,800 square feet of administrative,
sales, marketing, product development and manufacturing space in one building located in
Sunnyvale, California pursuant to a lease that expires in July 2010.

In
Taiwan, we lease a total of approximately 38,800 square feet in one facility located in
Tu-Cheng City, Taiwan. These leases expire at various times from 2005 to 2007.
Additionally, in December 2000, the Company purchased approximately 8,200 square feet of
space immediately adjacent to the leased facility for $0.8 million, bringing the total
square footage to approximately 47,000 square feet. Of this total, 33,400 square feet is
used for manufacturing and 13,600 square feet is used for administration and product
development.

In
Taiwan, we also lease a total of approximately 33,100 square feet in one facility located
in Hu-Kou, Taiwan pursuant to a lease that expires in January 2006.

In
August 2002, we entered into a lease for a 62,000 square foot facility near the Shenzhen,
China area which will expire in July 2007.

7

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# Item 3. Legal Proceedings

From
time to time we may be involved in litigation relating to claims arising in the ordinary
course of business. As of the date of this Form 10-KSB, there are no material legal
proceedings pending against us or, to the best of our knowledge, threatened against us.

# Item 4. Submission of
Matters to a Vote of Security Holders

None

# Executive Officers of the
Registrant

Our
executive officers as of December 31, 2004 are as follows:

Peter C.
          Chang, 47, has served as our Chairman of the Board, Chief Executive Officer,
          President and Secretary since our formation in December 1995. From 1990 through
          1995, Mr. Chang was Division Manager at Hon Hai Holding. From 1984 through
          1988, he was an engineer at AlliedSignal Inc. and from 1988 through 1990 was a
          member of the technology staff at Lucent Bell Labs. Mr. Chang received a
          B.S. in Mechanical Engineering from the National Taiwan University and an M.S.
          in Mechanical Engineering from Notre Dame University.

David A.
          Hubbard, 45, has served as our Vice President, Sales and Marketing since
          October 1996. From February 1995 to September 1996, Mr. Hubbard was
          Director of Marketing/Business Development at Tracor/AEL Industries.
          Mr. Hubbard received his M.S. from University of Connecticut and his B.S.
          from State University of New York.

Wei-Shin
Tsay, Ph.D., 53, has served as our Senior Vice President, Product Development
since August 2000. From 1996 through August 2000, Dr. Tsay held various management
positions in engineering, operations, and marketing at JDS Uniphase. From 1994 through
1996, Dr. Tsay held various product management positions at Lucent
Microelectronics/Optoelectronics Strategic Business Unit. From 1982 through 1994, Dr. Tsay
held various engineering and technical management positions at Bell Labs. Dr. Tsay
received an M.S. in Manufacturing Systems Engineering from Lehigh University, a Ph.D. in
physics from the University of Rochester and a B.S. in Physics at the National Tsing-Hua
University in Hsin-Chu, Taiwan.

Anita
K. Ho, 58, has served as our Acting Chief Financial Officer since July 2002. From
October 2000 to the present, Ms. Ho has served as our Corporate Controller. From 1998 to
2000, Ms. Ho was a Finance Manager at 3Com Corporation. From 1995 through 1998, Ms. Ho was
a member of the finance staff at 3Com Corporation. Ms. Ho received a B.S. in Accounting
from Soochow University in Taipei, Taiwan.

8

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# PART II

# Item 5. Market for
Common Equity, Related Stockholder Matters and Small Business Issuer Purchases of Equity
Securities

The
Companys common stock, par value $0.001, was traded on the Nasdaq National Market
under the ticker symbol AFOP until November 8, 2002, when it began to trade on
the Nasdaq SmallCap Market under the same ticker symbol. The following table summarizes
the high and low closing prices for our common stock as reported on the Nasdaq National
Market and SmallCap Market, as applicable.

| | High                |       | Low |      
| | ------------------- | ----- | --- | -----
| |                     |       |     |      
| | 2003                |       |     |      
| | First Quarter 2003  | $0.62 |     | $0.45
| | Second Quarter 2003 | $0.83 |     | $0.48
| | Third Quarter 2003  | $1.85 |     | $0.81
| | Fourth Quarter 2003 | $2.70 |     | $1.56
| | 2004                |       |     |      
| | First Quarter 2004  | $2.67 |     | $1.33
| | Second Quarter 2004 | $1.57 |     | $0.82
| | Third Quarter 2004  | $0.98 |     | $0.77
| | Fourth Quarter 2004 | $1.52 |     | $0.74

As
of March 21, 2005, the Companys common stock was held by 85 stockholders of record
(not including beneficial holders of common stock held in street name). The Company
has never declared or paid dividends on its capital stock and does not anticipate paying
any dividends in the foreseeable future.

# Securities Authorized
for Issuance Under Equity Compensation Plans

Information
regarding securities authorized for issuance under our equity compensation plans can be
found under Item 11 of this Annual Report on Form 10-KSB.

9

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# Item 6. Managements
Discussion and Analysis of Financial Condition and Results of Operations

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

# Recent Accounting
Pronouncements

In
March 2004, the Financial Accounting Standards Board (FASB) approved the consensus reached
on the Emerging Issues Task Force (EITF) Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments. 
EITF 03-1 provides guidance for identifying impaired investments and new disclosure
requirements for investments that are deemed to be temporarily impaired. On September 30,
2004, the FASB issued a final staff position EITF Issue No. 03-1-1 that delays the
effective date for the measurement and recognition guidance included in paragraphs 10
through 20 of EITF 03-1. Quantitative and qualitative disclosures required by EITF 03-1
remain effective and have been adopted for our fiscal 2004 financial statements. We will
evaluate the effect, if any, of EITF Issue No. 03-1 when formal guidance is released.

In
November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB
No. 43, Chapter 4". This statement amends the guidance in ARB No. 43, Chapter 4,
Inventory Pricing to clarify the accounting for abnormal amounts of
idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS 151
requires that those items be recognized as current-period charges. In addition, this
statement requires that allocation of fixed production overheads to costs of conversion be
based upon the normal capacity of the production facilities. The provisions of SFAS 151
are effective for inventory cost incurred in fiscal years beginning after June 15, 2005.
As such, we are required to adopt these provisions at the beginning of fiscal 2007. We are
currently evaluating the impact of SFAS 151 on our consolidated financial statements.

In
December 2004, the FASB issued SFAS No. 153, Exchanges of Non-monetary Assets, an
amendment of APB Opinion No. 29". SFAS 153 replaces the exception from fair value
measurement in APB Opinion No. 29 for non-monetary exchanges of similar productive assets
with a general exception from fair value measurement for exchanges of non-monetary assets
that do not have commercial substance. A non-monetary exchange has commercial substance if
the future cash flows of the entity are expected to change significantly as a result of
the exchange. SFAS 153 is to be applied prospectively, and is effective for non-monetary
asset exchanges occurring in fiscal periods after the date of issuance of SFAS 153. We do
not believe the impact of adoption of SFAS 153 will be significant to our overall results
of operations or financial position.

In
December 2004, the FASB issued SFAS No. 123R, Share-Based Payment (SFAS
123R), which requires companies to measure and recognize compensation expense for all
stock-based compensation to employees at fair value. SFAS 123R will be effective for all
interim fiscal periods beginning after June 15, 2005, and thus will be effective for our
company beginning the third quarter of 2005. Retroactive application of the provisions of
SFAS 123R to the beginning of the fiscal year that includes the effective date is
permitted, but not required. We are currently evaluating the impact of SFAS 123R on our
financial statements.

# Critical Accounting
Policies and Estimates

Managements
discussion and analysis of our financial condition and results of operations are based on
our 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.

10

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We
believe the following critical accounting policies affect managements more
significant judgments and estimates used in the preparation of the Companys
Consolidated Financial Statements:

We
follow SEC Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition in Financial
Statements for recognizing revenue. Specifically, we recognize revenues upon the
shipment of our products to our customers provided that we have received a purchase order,
the price is fixed, the collection of the resulting receivable is reasonably assured and
transfer of title and risk of loss has occurred. Subsequent to the sale of our products,
we have no obligation to provide any modification or customization, upgrades,
enhancements, or post-contract customer support.

Allowances
are provided for estimated returns. Provisions for return allowances are recorded at the
time revenue is recognized based on our historical returns, current economic trends and
changes in customer demand. Such allowances are adjusted periodically to reflect actual
and anticipated experience. Material differences may result in the amount and timing of
our revenue for any period if management made different judgments or utilized different
estimates.

Our
inventory provision for estimated losses to be incurred on sale or disposal of inventory
is based on assumptions about future demand and market conditions. If actual demand or
market conditions are less favorable than those projected by management, additional
inventory provisions may be required. We utilized $0.1 million of previously reserved
excess inventory in the year ended December 31, 2004. We recorded provisions of $1.0
million, $0.1 million and $2.6 million for excess DWDM-related inventory in the years
ended December 31, 2004, December 31, 2003 and December 31, 2002, respectively. We
recorded provisions of $0.3 million, $0.1 million and $1.9 million for excess OPMS-related
inventory in the years ended December 31, 2004, December 31, 2003 and December 31, 2002,
respectively.

We
review the valuation of long-lived assets and assess the impairment of the assets whenever
events or changes in circumstances indicate that the carrying value may not be recoverable
due to: significant underperformance relative to expected historical or projected future
operating results; significant changes in the manner of our use of the assets or the
strategy for the overall business; and significant negative industry or economic trends.
When we determine that the carrying value of long-lived assets may not be recoverable
based on the existence of one or more of the above indicators of impairment, we measure
any impairment based on a projected discounted cash flow method using a discount rate
determined by our management to be commensurate with the risk inherent in our current
business model. We recorded an asset impairment charge of $0.3 million for the year ended
December 31, 2004 related to non-production related equipment from the transceiver product
line which was discontinued. We did not record any impairments for the year ended December
31, 2003. We recorded an asset impairment charge within cost of revenues of $1.0 million
for non-functional or damaged equipment and machinery in Taiwan which were used for the
production of fused fiber products for the year ended December 31, 2002.

We
estimate our income taxes in each of the jurisdictions in which we operate. This process
involves us estimating our actual current tax exposure together with assessing temporary
differences resulting from differing treatment of items for tax and accounting purposes.
These differences result in deferred tax assets and liabilities, which are included in our
Consolidated Balance Sheets. We must then assess the likelihood that our deferred tax
assets will be recovered from future taxable income and to the extent we believe that
recovery is not likely, we must establish a valuation allowance. To the extent we
establish a valuation allowance or increase this allowance in a period, we must include an
expense within the tax provision in our Statements of Operations. To date, we have
recorded a full allowance against our deferred tax assets as we believe it is more likely
than not that such benefit will not be realized.

# Overview

We
were founded in December 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 have broadened our OPMS product line which now includes attenuators and
fused fiber products. In early 1999, we started forming a new product line based in part
on our proprietary technology. 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.

11

---

We
market and sell our products predominantly through our direct sales force, which we began
building in early 1998. From our inception through December 31, 2004, we derived a
substantial portion all of our revenues from our OPMS product line. Our DWDM-related
products contributed as a percentage of revenue 27%, 21% and 8% for the years ended
December 31, 2004, 2003 and 2002, respectively. In the years ended December 31, 2004,
2003 and 2002, our top 10 customers comprised 53%, 49%, and 50% of our revenues,
respectively. One customer accounted for 11% of our revenues in 2004 and 2003,
respectively; no individual customer accounted for 10% or more of our revenues in 2002.

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:

|  |                                                                              
|- | -----------------------------------------------------------------------------
|o | changes in manufacturing volume;                                             
|  |                                                                              
|o | costs incurred in establishing additional manufacturing lines and facilities;
|  |                                                                              
|o | inventory write-downs and impairment charges related to manufacturing assets;
|  |                                                                              
|o | mix of products sold;                                                        
|  |                                                                              
|o | changes in our pricing and pricing from our competitors;                     
|  |                                                                              
|o | mix of sales channels through which our products are sold; and               
|  |                                                                              
|o | 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, so accordingly we plan to continue to invest amounts similar to our
spending levels in 2004 in our product development efforts.

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 the
costs associated with trade shows, promotional activities and travel expenses. We intend
to continue to invest amounts similar to our spending levels in 2004 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 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. We expect most of these expenses
to remain flat in absolute dollars with the exception of professional and legal services
which we expect will increase due to increased rates and fees and costs associated with
compliance with new laws and regulations .

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. We expect non-cash compensation expense, which was
$0.3 million in the year ended December 31, 2004, to increase in future periods
due to the implementation of new accounting rules associated with stock option and
employee stock purchase plans which will occur in the third quarter of 2005.

In
July 2000, we issued 4,700,000 shares of Series C convertible preferred stock at a price
of $5.50 per share. The difference between the issuance price and the deemed fair value of
the preferred stock on the date of the transaction resulted in a deemed preferred stock
dividend of $14.8 million, which was fully recognized in the quarter ended
September 30, 2000.

In
November 2000, we completed our initial public offering by issuing 4,500,000 shares of
common stock at a price of $11.00 per share. The proceeds of the offering, net of costs
associated with the registration and issuance of the shares, totaled $44.4 million.

12

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In
October 1997, we acquired 97% of the outstanding common stock of Transian Technology Ltd.
Co. (Transian), a Taiwan corporation, for $512,000 to expand our design and
manufacturing capacity. In April 1998, we invested an additional $152,000 in cash,
increasing our ownership of Transian to 98.5%.

In
December 2000, we established a subsidiary, Alliance Fiber Optic Products, in the
Peoples Republic of China, which we have developed as a manufacturing facility. We
commenced production at this facility in the third quarter of 2003.

In
January 2004, we completed the purchase of the assets of Taiwan-based Ritek
Corporations photonics business. Under the terms of the agreement, AFOP acquired
substantially all of the assets of Riteks photonics business in exchange for 1.7
million shares of AFOP common stock for total consideration of $4.0 million. Additionally
AFOP received $1.5 million in cash from Ritek. This photonics business is located in Hsin
Chu Industrial Park, Taiwan, and we may continue to operate the business at this facility
rent-free until January 2006.

13

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# 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.

|                               | Years Ended December 31, |        
|------------------------------ | ------------------------ | -------
|                               | 2004                     |        
|Revenues                       |                          | 100.0% 
|                               |                          |        
|Cost of revenues:              |                          | 90.5   
|                               |                          |        
|Gross profit (loss)            |                          | 9.5    
|                               |                          |        
|Operating expenses:            |                          |        
|Research and development       |                          | 38.1   
|Sales and marketing            |                          | 14.1   
|General and administrative     |                          | 23.5   
|Excess facility charges        |                          | --     
|Asset impairment charge        |                          | 2.3    
|                               |                          |        
|Total operating expenses       |                          | 78.0   
|                               |                          |        
|Loss from operations           |                          | (68.5) 
|Interest and other income, net |                          | 4.3    
|                               |                          |        
|Loss before income taxes       |                          | (64.2) 
|Income tax benefit             |                          | --     
|                               |                          |        
|Net loss                       |                          | (64.2%)
|                               |                          |        

# Results of Operations

# Comparison of Fiscal
Year 2004 and Fiscal Year 2003

Revenues.Revenues were $14.6 million and $11.5 million for the years ended
          December 31, 2004 and 2003, respectively. OPMS revenues increased from $9.1
          million in 2003 to $10.6 million in 2004 primarily due to increased volume
          shipments of our products. DWDM revenues increased from $2.4 million in 2003 to
          $4.0 million in 2004 primarily due to the increased acceptance of our products
          by our customers which resulted in higher volume shipments partially offset by
          lower average selling prices.

Cost
of Revenues.Cost of revenues in fiscal year 2004 increased to $13.2 million from
approximately $9.7 million in fiscal year 2003. Cost of revenues as a percentage of net
revenues increased to 90.5% in fiscal year 2004 from 84.7% in fiscal year 2003. Cost of
revenues in 2004 were primarily impacted by provisions of $1.0 million for excess and
obsolete inventory related to older generations of our DWDM products and start-up costs
associated with the operation of the newly acquired photonics business from Ritek
Corporation. Management continues to closely monitor the Companys inventory levels.
Any decline in demand for our products would result in reduced sales, increased operating
losses and additional inventory provisions.

Gross
Profit. 2004 gross profit was $1.4 million, or 9.5% of revenues, compared with a 2003
gross profit of $1.7 million, or 15.3% of revenues.

The
gross loss in 2004 for DWDM products increased to $1.8 million from $1.4 million in 2003
primarily as a result of additional provisions for excess and obsolete inventory and
start-up costs associated with the operation of the newly acquired photonics business from
Ritek Corporation. The gross profit in 2004 for OPMS products increased to $3.2 from $3.1
million in 2003 as higher OPMS product revenues were mostly offset by lower average
selling prices.

14

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We
expect our gross margin as a percentage of revenues to improve in the near term due to
higher production volumes which will result in improved absorption of overhead expenses.
We believe that gross margins will continue to be negatively impacted by selling price
competition for our DWDM products which will partially offset the benefits from improved
overhead absorption. We had approximately $1.7 million in DWDM-related inventory and $2.3
million in OPMS-related inventory on hand at December 31, 2004. Although we continue to
take steps to attempt to manage future inventory levels, we may have to record inventory
provisions in future periods if a decrease in demand for our products occurs.

Research
and Development Expenses. Research and development expenses remained relatively flat
at $5.6 million in 2004 and 2003. As a percentage of revenues, research and development
expenses decreased to 38.1% in 2004 from 48.5% in 2003. We expect research and development
expenses 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 relatively flat at $2.0
million in 2004 and 2003. As a percentage of revenues, sales and marketing expenses
decreased to 14.1% in 2004 from 17.4% in 2003. We expect sales and marketing expenses will
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 remained relatively
flat at $3.4 million in 2004 and 2003. As a percentage of revenues, general and
administrative expenses decreased to 23.5% in 2004 from 29.7% in 2003. We expect to
maintain general and administrative expenses at the same level with the exception of
professional and legal services we expect will increase due to higher fees and costs
associated with compliance with new laws and regulations such as the Sarbanes-Oxley Act of
2002 and the regulations promulgated thereunder.

Asset
Impairment Charge. During the fourth quarter of 2004, we wrote off certain non
production-related transceiver equipment that was no longer being utilized resulting in an
asset impairment charge of $0.3 million.

Stock-Based
Compensation.Total stock-based compensation decreased to $0.3 million, or 2.0% of
revenues, in the year ended December 31, 2004 from $0.9 million, or 7.9% of revenues, in
the year ended December 31, 2003. This decrease was partially due to our accounting policy
which requires the amortization of a larger proportion of deferred compensation expense
during the early vesting periods of the option grants, and partially due to the reversal
of unamortized deferred compensation expense for unvested stock options of employees whose
employment was terminated during the year ended December 31, 2004.

Interest
and Other Income, Net.Interest and other income, net, was $0.6 million and $0.7
million for the years ended December 31, 2004 and 2003, respectively. These amounts
consisted primarily of interest income, which fluctuated based on cash balances and
changes in interest rates. The decrease in 2004 was due to lower average cash balances in
2004.

Income Taxes.There was no income tax benefit in the years ended December 31, 2004 and 2003, respectively.

As
of December 31, 2004, we had approximately $40.5 million and $22.2 million of net
operating loss carryforwards for federal and state tax purposes, respectively, which will
expire in 2021 for federal and in 2011 for state purposes, if not utilized. We have
provided a full valuation allowance against our net deferred tax assets because
realization of our deferred tax assets is uncertain due to lack of profitability.

# Comparison of Fiscal
Year 2003 and Fiscal Year 2002

Revenues.Revenues were $11.5 million and $13.1 million for the years ended
          December 31, 2003 and 2002, respectively. OPMS revenues decreased to $9.1
          million in 2003 from $12.0 million in 2002 primarily due to decreased volume
          shipments of our products as a result of continued poor market conditions. DWDM
          revenues increased to $2.4 million in 2003 from $1.1 million in 2002 primarily
          due to the increased acceptance of our products by our customers which resulted
          in higher volume shipments partially offset by lower ASPs.

Cost
of Revenues.Cost of revenues in fiscal year 2003 decreased to $9.7 million from
approximately $16.2 million in fiscal year 2002. Cost of revenues as a percentage of net
revenues decreased to 84.7% in fiscal year 2003 from 123.4% compared to fiscal year 2002.
Cost of revenues in 2003 benefited from the allocation of our fixed costs over increased
DWDM production volume and the decrease in provisions for excess and obsolete inventory
from $4.5 million to $0.2 million in 2003. Cost of revenues in 2002 were primarily
impacted by provisions for excess and obsolete inventory resulting from the slowdown in
telecommunications capital spending, the general downturn in the U.S. economy, and the
allocation of our fixed costs over decreased production volume.

15

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Gross
Profit (Loss). 2003 gross profit was $1.7 million, or 15.3% of revenues, compared with
a 2002 gross loss of $3.1 million, or 23.4% of revenues. The gross profit in 2003 was
mainly due to lower losses for our DWDM products as a result of the allocation of fixed
costs over increased DWDM production volume and lower inventory provisions. The gross loss
in 2002 was due to losses related to our DWDM products and decreasing profits on our OPMS
products.

The
gross loss in 2003 for DWDM products of $1.4 million was primarily caused by reduced
average selling prices as the market environment remained very price competitive. The
gross loss in 2002 for DWDM products of $5.1 million was primarily caused by reduced
revenue in 2002 and an inventory provision of $2.6 million for excess inventory which was
recorded in accordance with the Companys policy of establishing provisions for
inventory levels in excess of expected future demand.

Gross
profit for OPMS products increased to $3.1 million in 2003 from $2.0 million in 2002
primarily as a result of a lower inventory provision of $0.1 million for excess OPMS
inventory that was taken in 2003 as compared to the inventory provision of $1.9 million
that was taken in 2002 and the fixed assets write off of $1.0 million in 2002.

We
had approximately $1.4 million in DWDM-related inventory and $2.0 million in OPMS-related
inventory on hand at December 31, 2003.

Research
and Development Expenses. Research and development expenses decreased to
$5.6 million in 2003 from $7.3 million in 2002. The decrease in 2003 was
primarily due to lower general expenditures, as well as tighter controls over
discretionary spending. As a percentage of revenues, research and development expenses
decreased to 48.5% in 2003 from 55.7% in 2002.

Sales
and Marketing Expenses. Sales and marketing expenses decreased to $2.0 million in 2003
from $2.9 million in 2002. The decrease in 2003 was primarily due to lower sales
forces expenses resulting from tighter controls over discretionary spending. As a
percentage of revenues, sales and marketing expenses decreased to 17.4% in 2003 from 21.9%
in 2002.

General
and Administrative Expenses. General and administrative expenses decreased to $3.4
million in 2003 from $4.5 million in 2002. The decrease in 2003 was primarily due to
reduced general expenditures as well as tighter controls over discretionary spending. As a
percentage of revenues, general and administrative expenses decreased to 29.7% in 2003
from 34.3% in 2002.

Excess
Facility Charge. Due to the decline in business conditions and reduced headcount in
the United States, the Company consolidated its operations in the United States from three
buildings to two buildings in Sunnyvale, California in September 2002. As a consequence,
the Company recorded an excess facility charge of $1.8 million in the year ended December
31, 2002 comprising of $1.0 million of non-cancelable lease payments which were paid in
2003 and $0.6 million of future non-cancelable lease payments, which were paid in 2004,
and $0.2 million of fixed assets that were written-off.

Stock-Based
Compensation.Total stock-based compensation decreased to $0.9 million, or 7.9% of
revenues, in the year ended December 31, 2003 from $1.1 million, or 8.2% of revenues, in
the year ended December 31, 2002. This decrease was partially due to our accounting policy
which requires the amortization of a larger proportion of deferred compensation expense
during the early vesting periods of the option grants, and partially due to the reversal
of unamortized deferred compensation expense for unvested stock options of employees whose
employment was terminated during the year ended December 31, 2003.

Interest
and Other Income, Net.Interest and other income, net, was $0.7 million and $1.1
million for the years ended December 31, 2003 and 2002, respectively. These amounts
consisted primarily of interest income, which fluctuated based on cash balances. The
decrease to 2003 from 2002 was due to lower cash balances and lower interest rates.

Income
Taxes. There was no income tax benefit in the year ended December 31, 2003 and
there was a benefit of $0.2 million in the year ended December 31, 2002. The income tax
benefit in 2002 was primarily due to a federal income tax refund.

16

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As
of December 31, 2003, we had approximately $32.8 million and $14.9 million of net
operating loss carryforwards for federal and state tax purposes, respectively, which will
expire in 2021 for federal and in 2011 for state purposes, if not utilized. We have
provided a full valuation allowance against our net deferred tax assets because
realization of our deferred tax assets is uncertain due to lack of profitability.

# Liquidity and Capital
Resources

As
of December 31, 2004, we had cash and cash equivalents of $7.5 million and
short-term investments of $24.0 million.

Net
cash used in operating activities was $6.6 million in 2004, $7.9 million in
2003, and $6.7 million in 2002. Net cash used in 2004 was primarily the result of our net
loss, which was partially offset by non-cash compensation expenses of $0.3 million,
depreciation of $1.7 million, impairment write-off of property and equipment of $0.3
million, and inventory provision of $1.3 million. In 2003, our net loss of $8.5 million
included non-cash charges of $2.0 million, primarily related to non-cash compensation
expenses of $0.9 million and depreciation of $1.1 million. Accounts receivable increased
by $0.3 million and inventory increased by $1.6 million from 2003 to 2004 primarily due to
an upturn in business in the fourth quarter of 2004. Accrued expenses decreased by $0.4
million, offset by an increase in payables by $0.7 million. Net cash used in operating
activities in 2004 totaled $6.6 million, $1.3 million less than cash used in 2003 in
operating activities. In 2002, our net loss of $18.3 million included non-cash charges of
$10.1 million, primarily related to non-cash compensation expenses of $1.1 million,
depreciation of $1.7 million, impairment write-off of property and equipment of $1.0
million, an excess facility charge of $1.8 million, and an inventory provision of $4.5
million.

Cash
generated by investing activities was $9.6 million in 2004, $4.9 million in 2003, and
$5.6 million in 2002. In 2004, we received net $9.0 million from the sale of short-term
securities and $1.5 million from the asset acquisition from Ritek, and we used $0.9
million for property and equipment. In 2003, we spent $0.3 million on property and
equipment, and we received net $5.2 million from the sale of short-term securities. In
2002, we spent $0.8 million on property and equipment, and we received net $6.5 million
from the sale of short-term securities.

Cash
generated by financing activities was $1.6 million in 2004, $1.1 million in 2003, and
$0.4 million in 2002. Cash generated by financing activities in 2004, 2003 and 2002 was
comprised of proceeds from the exercise of options to purchase shares of our common stock,
common stock issued through our Employee Stock Purchase Plan, borrowing under mortgage and
other debt, and repayment of notes receivable.

We
have a letter of credit with a financial institution for $0.4 million. As of December 31,
2004, there were no amounts outstanding under the letter of credit. We pledged $0.4
million of our short-term investments as collateral for the letter of credit. In November
2004, we entered into a ten year loan of $0.5 million in Taiwan with a fixed interest rate
of 2.3% for the first two years. The loan is secured by the building we own in Taiwan.

Our
principal source of liquidity as of December 31, 2004 consisted of $31.5 million in cash
and cash equivalents and interest bearing marketable securities.

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, additional credit facilities, strategic
relationships or other arrangements. 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 our research and development and marketing
expenses. Strategic arrangements, if necessary to raise additional funds, may require us
to relinquish our rights to certain of our technologies or products. Our failure to raise
capital when needed could harm our business, financial condition and operating results.

17

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# Contractual Obligations

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 of 2002,
we consolidated our operations in California into two buildings and vacated the facility
with 10,600 square feet. As a result of the consolidation, we recorded an excess facility
charge of $1.6 million and wrote off fixed assets of $0.2 million in the year ended
December 31, 2002. In July 2004, we moved into a larger corporate headquarters in
Sunnyvale, California. The lease has a six-year term commencing on July 22, 2004, and the
facility is 34,800 square feet. The remaining costs for the leasehold improvements of the
previous facilities have been accelerated and were fully amortized by June 30, 2004.

Additionally,
in December 2000, we purchased approximately 8,200 square feet of space immediately
adjacent to our leased facility in Tu-Cheng City, Taiwan for $0.8 million. We had a lease
for a facility near the Shenzhen, China area totaling approximately 12,000 square feet
which expired in December 2002. In August 2002 we entered into a new lease for a 62,000
square foot facility near the same Shenzhen area which will expire in July 2007. The
future minimum lease payments are as follows (in thousands):

| |                           |                 
| | ------------------------- | ----------------
| | Years ending December 31, |                 
| | 2005                      | $            629
| | 2006                      | 649             
| | 2007                      | 435             
| | 2008                      | 409             
| | 2009                      | 422             
| | 2010 and after            | 238             
| |                           |                 
| | Total                     | $          2,782
| |                           |                 

We
had no other significant commitments as of December 31, 2004.

# Off-Balance Sheet
Arrangements

We
do not have any off-balance sheet arrangements, as such term is defined in rules
promulgated by the Securities and Exchange Commission, that have or are reasonably likely
to have a current or future effect on our financial condition, changes in financial
condition, revenues or expenses, results of operations, liquidity, capital expenditures or
capital resources that are material to investors.

# Supplementary Data
 Unaudited Quarterly Results

The following table contains selected
unaudited quarterly results of operations data for each of the eight quarters in the
period ended December 31, 2004. We believe that the historical quarterly information has
been prepared substantially on the same basis as the audited financial statements, and all
necessary adjustments, consisting only of normal recurring adjustments, have been included
in the amounts below to present fairly the unaudited quarterly results of operation data
(in thousands, except per share data):

|                           | Three Months Ended
|-------------------------- | ------------------
|                           |                   
|                           | Dec. 31, 2004     
|                           |                   
|Revenues                   |                   
|Gross profit (loss)        |                   
|Net loss attributable to   |                   
|common stockholders (1)    |                   
|Basic and diluted net loss |                   
|per share attributable to  |                   
|common stockholders(2)     |                   

|(1) |  | Net loss attributable to common stockholders in the quarters ended March 31,
               2004, June 30, 2004, September 30, 2004 and December 31, 2004 include charges
               for inventory provisions of $0.2 million, $0.3 million, $0.3 million and $0.5
               million, respectively. Net loss attributable to common stockholders in the
               quarter ended December 31, 2004 includes an asset impairment charge of $0.3
               million.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | Net loss per share is computed independently for each quarter presented.
               Therefore, the aggregate of the quarterly per share information may not equal
               the annual net loss per share.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

18

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# 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 $9.3 million, $8.5 million and $18.3 million in
fiscal year 2004, 2003 and 2002, 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 December 31, 2004, we had an accumulated deficit of approximately $69.8
million.

Although
we continue to experience fluctuating demand for our products, we are hopeful that demand
for our products will increase in the future. If this happens, we expect to incur
significant and increasing expenses for expansion of our manufacturing operations,
research and development, sales and marketing, and administration, and in developing
direct sales and distribution channels. Given the rate at which competition in our
industry intensifies and the significant fluctuations 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 and
establishing additional manufacturing lines and facilities, changes in manufacturing
volume, declining average selling prices of our products, the timing and extent of product
sales, the mix of domestic and international sales, the mix of sales channels through
which our products are sold, the mix of products sold and significant fluctuations 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 73% of our revenues in the fiscal year ended
December 31, 2004 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 demand for these products, or failure to increase their market acceptance, would
seriously harm our business. Declining average selling prices of our products during 2004
have negatively impacted our revenues. 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 has
fluctuated over the past few years, declining sharply starting in mid fiscal 2001 and then
increasing beginning in 2003. If demand does not continue to increase and our target
customers do not continue to adopt and purchase our DWDM-related products, our revenues
may decline and we may have to write-off additional inventory that is currently on our
books.

19

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We are experiencing fluctuations
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 significant
fluctuations in consumption and demand. During the past few years, telecommunication
companies have mostly 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 full 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:

|  |                                                                                                                                                              
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------
|o | customer unwillingness to implement our products;                                                                                                            
|  |                                                                                                                                                              
|o | any delays or  difficulties  that we may incur in completing  the  development  and  introduction  of our planned  products or
         product enhancements;
|  |                                                                                                                                                              
|o | the success of our customers;                                                                                                                                
|  |                                                                                                                                                              
|o | excess inventory in the telecommunications industry;                                                                                                         
|  |                                                                                                                                                              
|o | new product introductions by our competitors;                                                                                                                
|  |                                                                                                                                                              
|o | any failure of our products to perform as expected; or                                                                                                       
|  |                                                                                                                                                              
|o | any difficulty we may incur in meeting customers' delivery requirements or product specifications.                                                           

The
fluctuations in the economy have affected the telecommunications industry.
Telecommunications companies have cut back on their capital expenditure budgets, which has
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
Corp., DiCon Fiberoptics, Inc., JDS Uniphase Corp., Oplink Communications Inc., Stratos
International, Inc. and Tyco Electronics Corporation. 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, and we cannot 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.

20

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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 past history of 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 had to carefully manage and re-evaluate this expansion given the sudden and
dramatic downturn in demand for our products experienced in 2001 and 2002. Additionally,
we implemented a reduction in force to reduce employees during the second, third and
fourth quarters of 2002 to match our operations to this decreased demand for our products.
As of December 31, 2004, we had a total of 59 full-time employees in Sunnyvale,
California, 274 full-time employees in Taiwan, and 161 full-time employees in China.
Matching the scale of our operations with 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:

|  |                                                                                                                                                                 
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------
|o | improve existing and implement new operational, financial and management controls, reporting systems and procedures;                                            
|  |                                                                                                                                                                 
|o | hire,  train,  motivate and manage  additional  qualified  personnel,  especially if we  experience a significant  increase in
         demand for our products;
|  |                                                                                                                                                                 
|o | effectively expand or reduce our manufacturing capacity, attempting to adjust it to customer demand; and                                                        
|  |                                                                                                                                                                 
|o | 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 operations 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 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 $5.6 million, $5.6 million and $7.3 million for the fiscal years 2004, 2003
and 2002, respectively. We intend to continue to invest a substantial amount of funds,
comparable to our investment levels in 2004, in our research and product development
efforts, which could have a negative impact on our earnings in future periods.

21

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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 fluctuating 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 fluctuating demand for their products that has resulted in inconsistent
demand 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.

Inconsistent
spending by telecommunication companies over the past three years has resulted in
fluctuating 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 the past 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.

22

---

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, optical
filters 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. Nippon Sheet Glass is
the only known supplier of GRIN lenses.

Because we experience long lead
times for materials and components, we may not be able to effectively manage our inventory
levels and manufacturing capacity, 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 years ended December 31, 2004 and December 31, 2002, respectively. 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, and we may be required to record impairment charges
related to manufacturing assets.

While we believe that we currently
have adequate internal controls over financial reporting, we are exposed to risks from
recent legislation requiring companies to evaluate those internal controls.

Section
404 of the Sarbanes-Oxley Act of 2004 requires our management to report on, and our
independent auditors to attest to, the effectiveness of our internal controls over
financial reporting beginning with our year ending December 31, 2006. We have an ongoing
program to perform the system and process evaluation and testing necessary to comply with
these requirements. This legislation is relatively new and neither companies nor
accounting firms have significant experience in complying with its requirements. As a
result, we expect to incur increased expense and to devote additional management resources
to Section 404 compliance. In the event that our chief executive officer, chief financial
officer or independent registered public accounting firm determine that our internal
controls over financial reporting are not effective as defined under Section 404, investor
perceptions of our company may be adversely affected and could cause a decline in the
market price of our stock.

23

---

Changes to financial accounting
standards may affect our results of operations and cause us to change our business
practices.

We
prepare our financial statements to conform with generally accepted accounting principles,
or GAAP, in the United States. These accounting principles are subject to interpretation
by the American Institute of Certified Public Accountants, the Securities and Exchange
Commission and various bodies formed to interpret and create appropriate accounting
policies. A change in those policies can have a significant effect on our reported results
and may affect our reporting of transactions completed before a change is announced.
Changes to those rules or the questioning of current practices may adversely affect our
reported financial results or the way we conduct our business. For example, accounting
policies affecting many aspects of our business, including rules relating to employee
stock option grants, have recently been revised or are under review. The Financial
Accounting Standards Board and other agencies have finalized changes to U.S. generally
accepted accounting principles that will require us, starting in our third quarter of
2005, to record a charge to earnings for employee stock option grants and other equity
incentives. We may have significant and ongoing accounting charges resulting from option
grant and other equity incentive expensing that could reduce our overall net income. In
addition, since we historically have used equity-related compensation as a component of
our total employee compensation program, the accounting change could make the use of
equity-related compensation less attractive to us and therefore make it more difficult to
attract and retain employees.

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, 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.

24

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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:

|  |                                                               
|- | --------------------------------------------------------------
|o | loss of customers;                                            
|  |                                                               
|o | damage to our reputation;                                     
|  |                                                               
|o | failure to attract new customers or achieve market acceptance;
|  |                                                               
|o | diversion of development and engineering resources; and       
|  |                                                               
|o | legal actions by our customers.                               

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

25

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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
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:

|  |                                                                                                                        
|- | -----------------------------------------------------------------------------------------------------------------------
|o | the education of potential end-user customers and network service providers about the benefits of optical networks; and
|  |                                                                                                                        
|o | the continued growth of the 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.

We may be unable to successfully
integrate acquired businesses or assets, including our acquisition of the photonics
division of Ritek Corporation, with our business, which may disrupt our business, divert
managements attention and slow our ability to expand the range of our proprietary
technologies and products.

To
expand the range of our proprietary technologies and products, we may acquire
complementary businesses, technologies or products, if appropriate opportunities arise.
For example, in 2004 we acquired the photonics division of Ritek Corporation. We may be
unable to identify other suitable acquisitions at reasonable prices or on reasonable
terms, or consummate future acquisitions or other investments, any of which could slow our
growth strategy. We may have difficulty integrating the acquired products, personnel or
technologies of the photonics division of Ritek Corporation or of any other company or
acquisition that we may make. Similarly, we may not be able to attract or retain key
management, technical or sales personnel of any other companies that we acquire or from
which we acquire assets. These difficulties could disrupt our ongoing business, distract
our management and employees and increase our expenses.

If our common stock is not
relisted on the Nasdaq National Market, we will be subject to certain provisions of the
California General Corporation Law that may affect our charter documents and result in
additional expenses.

Beginning
at the commencement of trading on November 8, 2002, the listing of our common stock was
transferred from the Nasdaq National Market to the Nasdaq SmallCap Market. As a result, we
may become subject to certain sections of the California General Corporation Law that
would affect our charter documents if our common stock is not returned to being listed on
the Nasdaq National Market. For example, we may not be able to continue to have a
classified board or continue to eliminate cumulative voting by our stockholders. 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 dissenting
stockholder rights under both California and Delaware law. Any of these changes to our
charter documents would result in additional expense as we would have to comply with
certain provisions of the California General Corporation Law as well as the Delaware
General Corporation Law. We included these provisions in our charter documents in order to
delay or discourage a change of control or changes in our management. Because of the
California General Corporation Law, we may not be able to avail ourselves of these
provisions.

If we are unable to maintain our
listing on the Nasdaq SmallCap Market, the price and liquidity of our common stock may
decline.

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. If the closing bid price of our common stock falls
and remains below $1.00 for 30 consecutive days as it has for significant periods of time
in the past, our common stock may not remain listed on the Nasdaq SmallCap Market. If we
fail to maintain continued listing on the Nasdaq SmallCap Market and must move to a market
with less liquidity, our financial condition could be harmed and our stock price would
likely decline. If we are delisted, it could have a material adverse effect on the market
price of, and the liquidity of the trading market for our common stock.

26

---

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. We continue to consider the merits of
implementing a reverse split and to evaluate other courses of action.

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 and suppliers 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 have and we may continue to
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.

27

---

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 years ended December 31, 2004, 2003 and 2002, sales to customers located outside of
North America were 13.0%, 10.0%, and 9.6% 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.

Outbreaks of diseases
pose a risk to the Companys business.

In
the past, outbreaks of Severe Acute Respiratory Syndrome, or SARS, and of the bird flu
have developed into an international health concern, especially in Asia. We have
manufacturing facilities located in Taiwan and China. A new outbreak of disease such as
SARS or the bird flu 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 outbreaks, 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 outbreaks,
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 diseases
such as SARS or the bird flu 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.

Two
of 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.

28

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# Item 7. Financial
Statements

# INDEX TO CONSOLIDATED
FINANCIAL STATEMENTS

| |                                                                                                                   | Page
| | ----------------------------------------------------------------------------------------------------------------- | ----
| | Consolidated Financial Statements                                                                                 |     
| | Report of Independent Registered Public Accounting Firms                                                          | 30  
| | Consolidated Balance Sheet as of December 31, 2004 and 2003                                                       | 31  
| | Consolidated Statements of Operations for each of the three years in the period ended December 31, 2004           | 32  
| | Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2004           | 33  
| | Consolidated Statements of Stockholders' Equity for each of the three years in the period ended December 31, 2004 | 34  
| | Notes to Consolidated Financial Statements                                                                        | 35  

29

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# REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM

To the Board of Directors and
Stockholders of Alliance Fiber Optic Products, Inc.:

In our opinion, the accompanying
consolidated balance sheets and the related consolidated statements of operations, of
stockholders equity and of cash flows present fairly, in all material respects, the
financial position of Alliance Fiber Optic Products, Inc. and its subsidiaries at December
31, 2004 and 2003, and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 2004 in conformity with accounting
principles generally accepted in the United States of America. These financial statements
are the responsibility of the Companys management; our responsibility is to express
an opinion on these financial statements based on our audits. We conducted our audits of
these statements in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the accounting
principles used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

PricewaterhouseCoopers LLPSan
Jose, California

January 29, 2005

30

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

|                                                               |              |     
|-------------------------------------------------------------- | ------------ | ----
|                                                               | December 31,
|                                                               | 2004         | 2003
|Assets                                                         |              |     
|Current assets:                                                |              |     
|Cash and cash equivalents                                      |              |     
|Short-term investments                                         |              |     
|Accounts receivable, net                                       |              |     
|Inventories                                                    |              |     
|Prepaid expense and other current assets                       |              |     
|                                                               |              |     
|                                                               |              |     
|Total current assets                                           |              |     
|Property and equipment, net                                    |              |     
|Other assets                                                   |              |     
|                                                               |              |     
|                                                               |              |     
|Total assets                                                   |              |     
|                                                               |              |     
|                                                               |              |     
|Liabilities and Stockholders' Equity                           |              |     
|Current liabilities:                                           |              |     
|Accounts payable                                               |              |     
|Accrued expenses                                               |              |     
|Current portion of bank loan                                   |              |     
|Accrued excess facility charge                                 |              |     
|                                                               |              |     
|                                                               |              |     
|Total current liabilities                                      |              |     
|Long-term liabilities:                                         |              |     
|Bank loan                                                      |              |     
|Other long-term liabilities                                    |              |     
|                                                               |              |     
|                                                               |              |     
|Total long term liabilities                                    |              |     
|                                                               |              |     
|                                                               |              |     
|Total liabilities                                              |              |     
|                                                               |              |     
|                                                               |              |     
|Commitments and contingencies (Note 12)                        |              |     
|Stockholders' equity                                           |              |     
|Common stock, $0.001 par value: 250,000,000 shares authorized; |              |     
|38,999,196 and 36,504,356 shares issued and outstanding at     |              |     
|December 31, 2004 and 2003, respectively                       |              |     
|Additional paid-in-capital                                     |              |     
|Receivables from stockholders                                  |              |     
|Deferred stock-based compensation                              |              |     
|Accumulated deficit                                            |              |     
|Accumulated other comprehensive Income/(loss)                  |              |     
|                                                               |              |     
|                                                               |              |     
|Total stockholders' equity                                     |              |     
|                                                               |              |     
|                                                               |              |     
|Total liabilities and stockholders' equity                     |              |     
|                                                               |              |     

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

31

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

|                                             |                          |      |     
|-------------------------------------------- | ------------------------ | ---- | ----
|                                             | Years Ended December 31,
|                                             | 2004                     | 2003 | 2002
|Revenues                                     |                          |      | $   
|Cost of revenues                             |                          |      |     
|                                             |                          |      |     
|                                             |                          |      |     
|Gross profit (loss)                          |                          |      |     
|                                             |                          |      |     
|                                             |                          |      |     
|Operating expenses:                          |                          |     
|Research and development                     |                          |      |     
|Sales and marketing                          |                          |      |     
|General and administrative                   |                          |      |     
|Excess facility charges                      |                          |      |     
|Asset impairment charge                      |                          |      |     
|                                             |                          |      |     
|                                             |                          |      |     
|Total operating expenses                     |                          |      |     
|                                             |                          |      |     
|                                             |                          |      |     
|Loss from operations                         |                          |      |     
|Interest and other income, net               |                          |      |     
|                                             |                          |      |     
|                                             |                          |      |     
|Loss before income taxes                     |                          |      |     
|Income tax benefit                           |                          |      |     
|                                             |                          |      |     
|                                             |                          |      |     
|Net loss                                     |                          |      |     
|                                             |                          |      |     
|                                             |                          |      |     
|Net loss per share:                          |                          |     
|Basic and diluted                            |                          |      | $   
|                                             |                          |      |     
|                                             |                          |      |     
|Shares used in computing net loss per share: |                          |     
|Basic and diluted                            |                          |      |     
|                                             |                          |      |     
|                                             |                          |      |     
|Included in costs and expenses above:        |                          |     
|Stock based compensation charges             |                          |      |     
|Cost of revenues                             |                          |      | $   
|Research and development                     |                          |      |     
|Sales and marketing                          |                          |      |     
|General and administrative                   |                          |      |     
|                                             |                          |      |     
|                                             |                          |      |     
|Total                                        |                          |      | $   
|                                             |                          |      |     
|                                             |                          |      |     

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

32

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# ALLIANCE FIBER OPTIC
PRODUCTS, INC.Consolidated
Statements of Cash Flows(in
thousands)

|                                                             |                          |      |     
|------------------------------------------------------------ | ------------------------ | ---- | ----
|                                                             | Years Ended December 31,
|                                                             | 2004                     | 2003 | 2002
|Cash flows from operating activities:                        |                          |      |     
|Net loss                                                     |                          |      | $   
|Adjustments to reconcile net loss to net cash used           |                          |     
|in operating activities:                                     |                          |     
|Depreciation and amortization                                |                          |      |     
|Amortization of stock based compensation                     |                          |      |     
|Impairment of property and equipment                         |                          |      |     
|Provision for inventory valuation                            |                          |      |     
|Provision (credit) for doubtful accounts and sales returns   |                          |      |     
|Excess facility charge                                       |                          |      |     
|Interest income receivable                                   |                          |      |     
|Changes in assets and liabilities:                           |                          |     
|Accounts receivable                                          |                          |      |     
|Inventories                                                  |                          |      |     
|Prepaid expenses and other assets                            |                          |      |     
|Accounts payable                                             |                          |      |     
|Accrued expenses and facility charges                        |                          |      |     
|Other long-term liabilities                                  |                          |      |     
|                                                             |                          |      |     
|                                                             |                          |      |     
|Net cash used in operating activities                        |                          |      |     
|                                                             |                          |      |     
|                                                             |                          |      |     
|Cash flows from investing activities:                        |                          |     
|Purchase of short-term investments                           |                          |      |     
|Proceeds from sales and maturities of short-term investments |                          |      |     
|Cash from asset acquistion                                   |                          |      |     
|Purchase of property and equipment                           |                          |      |     
|                                                             |                          |      |     
|                                                             |                          |      |     
|Net cash provided by investing activities                    |                          |      |     
|                                                             |                          |      |     
|                                                             |                          |      |     
|Cash flows from financing activities:                        |                          |     
|Proceeds from issuance of common stock under ESPP            |                          |      |     
|Proceeds from the exercise of common stock options           |                          |      |     
|Proceeds from repayment of notes receivable                  |                          |      |     
|Net borrowing under bank loan                                |                          |      |     
|                                                             |                          |      |     
|                                                             |                          |      |     
|Net cash provided by financing activities                    |                          |      |     
|                                                             |                          |      |     
|                                                             |                          |      |     
|Effect of exchange rate changes on cash and cash equivalents |                          |      |     
|                                                             |                          |      |     
|                                                             |                          |      |     
|Net increase (decrease) in cash and cash equivalents         |                          |      |     
|Cash and cash equivalents at beginning of year               |                          |      |     
|                                                             |                          |      |     
|                                                             |                          |      |     
|Cash and cash equivalents at end of year                     |                          |      | $   
|                                                             |                          |      |     
|                                                             |                          |      |     
|Supplemental cash flow information:                          |                          |     
|Issuance of common stock in connection with asset            |                          |     
|acquisition                                                  |                          |      | $   
|Fair value of assets acquired                                |                          |      | $   
|Liability assumed                                            |                          |      | $   

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

33

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# ALLIANCE FIBER OPTIC
PRODUCTS, INC.Consolidated
Statements of Stockholders Equity(in
thousands)

|                                  | Common StockShares          Amount | AdditionalPaid-inCapital | ReceivablesFromStockholders | DeferredStock-basedCompensation | AccumulatedDeficit | AccumulatedOtherComprehensiveLoss | Total | ComprehensiveIncome/(Loss)
|--------------------------------- | ---------------------------------- | ------------------------ | --------------------------- | ------------------------------- | ------------------ | --------------------------------- | ----- | --------------------------
|Balance at December 31, 2001      |                                    |                          |                             | 35,409                          |                    | $                                 | 35    |                           
|Issuance of Common Stock          |                                    |                         
|upon exercise of options          |                                    |                          |                             | 80                              |                    |                                   | --    |                           
|Issuance of Common Stock upon     |                                    |                          |                             |                                 |                    |                                   |       |                           
|Purchase of ESPP                  |                                    |                          |                             | 254                             |                    |                                   | --    |                           
|Interest of notes receivable      |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Repayment of notes receivable     |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Stock repurchased                 |                                    |                          |                             | (163                            | )                  |                                   | --    |                           
|Deferred stock-based compensation |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Amortization of deferred          |                                    |                         
|stock-based compensation          |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Comprehensive Loss:               |                                    |                          |                             |                                 |                    |                                   |       |                           
|Net loss for the year             |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Unrealized loss on                |                                    |                          |                             |                                 |                    |                                   |       |                           
|short-term investments            |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Currency translation adjustments  |                                    |                          |                             | --                              |                    |                                   | --    |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           
|Comprehensive Loss                |                                    |                          |                             |                                 |                    |                                   |       |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           
|Balance at December 31, 2002      |                                    |                          |                             | 35,580                          |                    | $                                 | 35    |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           
|Issuance of Common Stock          |                                    |                          |                             |                                 |                    |                                   |       |                           
|upon exercise of options          |                                    |                          |                             | 219                             |                    |                                   | --    |                           
|Issuance of Common Stock upon     |                                    |                         
|purchase of ESPP                  |                                    |                          |                             | 705                             |                    |                                   | 1     |                           
|Interest of notes receivable      |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Repayment of notes receivable     |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Deferred stock-based compensation |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Amortization of deferred          |                                    |                         
|stock-based compensation          |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Comprehensive Loss:               |                                    |                          |                             |                                 |                    |                                   |       |                           
|Net loss for the year             |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Unrealized loss on                |                                    |                          |                             |                                 |                    |                                   |       |                           
|short-term investments            |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Currency translation adjustments  |                                    |                          |                             | --                              |                    |                                   | --    |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           
|Comprehensive Loss                |                                    |                          |                             |                                 |                    |                                   |       |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           
|Balance at December 31, 2003      |                                    |                          |                             | 36,504                          |                    | $                                 | 36    |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           
|Issuance of Common Stock          |                                    |                          |                             |                                 |                    |                                   |       |                           
|upon exercise of options          |                                    |                          |                             | 247                             |                    |                                   | 1     |                           
|Issuance of Common Stock upon     |                                    |                         
|purchase of ESPP                  |                                    |                          |                             | 1,078                           |                    |                                   | 2     |                           
|Issuance of Common Stock upon     |                                    |                          |                             |                                 |                    |                                   |       |                           
|assets acquisition                |                                    |                          |                             | 1,700                           |                    |                                   | 1     |                           
|Repayment of notes receivable     |                                    |                          |                             | (530                            | )                  |                                   | (1    | )                         
|Deferred stock-based compensation |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Amortization of deferred          |                                    |                         
|stock-based compensation          |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Comprehensive Loss:               |                                    |                          |                             |                                 |                    |                                   |       |                           
|Net loss for the year             |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Unrealized loss on                |                                    |                          |                             |                                 |                    |                                   |       |                           
|short-term investments            |                                    |                          |                             | --                              |                    |                                   | --    |                           
|Currency translation adjustments  |                                    |                          |                             | --                              |                    |                                   | --    |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           
|Comprehensive Loss                |                                    |                          |                             |                                 |                    |                                   |       |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           
|Balance at December 31, 2004      |                                    |                          |                             | 38,999                          |                    | $                                 | 39    |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           
|                                  |                                    |                          |                             |                                 |                    |                                   |       |                           

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

34

---

# ALLIANCE FIBER OPTIC
PRODUCTS, INC.

# Notes to Consolidated
Financial Statements

# 1. The Company and
Summary of Significant Accounting Policies

# 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 are located in Sunnyvale,
California, and it has operations in Taiwan and China.

# Use of estimates

The
preparation of financial statements in accordance with generally accepted accounting
principles in the United States of America requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual results could differ
from those estimates.

# Basis of presentation

The
consolidated financial statements include the accounts of the Company and its
subsidiaries. All material intercompany accounts and transactions have been eliminated in
consolidation.

# Foreign currency
translation

The
Companys operations through foreign subsidiaries use the local currency as their
functional currency. All assets and liabilities of the subsidiaries are translated at
rates of exchange on the balance sheet date. Revenues and expenses are translated at the
average rate of exchange for the period. Gains and losses resulting from foreign currency
translation are recorded as a separate component of other comprehensive income (loss) in
stockholders equity. Foreign currency transaction gains and losses are recorded in
interest and other income and have not been material.

# Cash, cash equivalents
and short-term investments

The
Company considers all highly liquid instruments with a maturity of three months or less
when purchased to be cash equivalents. Cash equivalents consist primarily of market rate
accounts, municipal bonds, and highly rated commercial paper that are stated at cost,
which approximates fair value. Investments include high-grade corporate debt obligations
that have maturities greater than three months but less than one year. As of December 31,
2003 and 2004, all investments are classified as short-term investments. Short-term
investments are classified as available-for-sale and are reported at fair value, with
unrealized gains and losses recorded in stockholders equity as a component of other
comprehensive income/loss. Realized gains and losses on sales of all investments are
reported in results of operations and computed using the specific identification method.

The
Companys financial instruments also include accounts receivable, accounts payable
and debts, and are carried at cost, which approximates their fair value because of the
short-term maturity of these instruments.

35

---

The
Company has reclassified certain auction rate securities, for which interest rates reset
in less than 90 days, but for which the maturity date is longer than 90 days, from cash
and cash equivalents to short-term investments. This resulted in a reclassification from
cash and cash equivalents to short-term investments of approximately $2.1 million on the
December 31, 2003 consolidated balance sheet. Similar reclassifications were made in prior
years which resulted in increases in net cash provided by investing activities of approximately $4.9 million and $4.6 million on the Consolidated Statements
of Cash Flows for the years ended December 31, 2003 and 2002, respectively.

# Allowance for Doubtful
Accounts

The
Company performs credit evaluations of customers financial condition. The Company
maintains allowances for doubtful accounts for estimated losses resulting from the
inability or unwillingness of customers to make required payments. When the Company
becomes aware that a specific customer is unable to meet its financial obligations, for
example, as a result of bankruptcy or deterioration in the customers operating
results or financial position, the Company records a specific allowance to reflect the
level of credit risk in the customers outstanding receivable balance. In addition,
the Company records additional allowances based on certain percentages of aged receivable
balances. These percentages are determined by a variety of factors including, but not
limited to, current economic trends, historical payment and bad debt write-off experience.
The Company is not able to predict changes in the financial condition of customers, and if
circumstances related to customers deteriorate, estimates of the recoverability of trade
receivables could be materially affected and the Company may be required to record
additional allowances. Alternatively, if the Company provides more allowances than the
Company needs, the Company may reverse a portion of such provisions in future periods
based on actual collection experience.

# Inventories

Inventories
are stated at the lower of cost or market, with cost being determined on a first-in,
first-out basis. Provisions are made for excess and obsolete inventory based on historical
usage and managements estimates of future demand.

# Property and equipment

Property
and equipment are stated at cost less accumulated depreciation and impairment charges.
Depreciation is computed using the straight-line method using estimated useful lives of
two to five years for machinery and equipment and five years for furniture and fixtures.
Amortization of leasehold improvements is computed using the straight-line method over the
shorter of the estimated life of the assets, generally two to four years, or the lease
term. Depreciation and amortization expense was $1.7 million in 2004, $1.1 million in 2003
and $1.7 million in 2002.

# Impairment of long-lived
assets

The
Company reviews long-lived assets for impairment whenever events or changes in
circumstances indicate the carrying amount of the assets may not be fully recoverable.
When such an event occurs, the Company estimates the future cash flows expected to result
from the use of the asset and its eventual disposition. If the undiscounted expected
future cash flows are less than the carrying amount of the asset, an impairment loss is
recognized to the extent the carrying amount of such assets exceeds its fair value, which
is determined based on discounted cash flows or appraised value, depending on the nature
of the asset.

36

---

# Revenue recognition

The
Company recognizes revenue upon shipment of its products to its customers, provided that
the Company has received a purchase order, the price is fixed, collection of the resulting
receivable is reasonably assured and transfer of title and risk of loss has occurred.
Subsequent to the sale of its products, the Company has no obligation to provide any
modification or customization upgrades, enhancements or post contract customer support.

Allowances
are provided for estimated returns. A provision for estimated sales return allowances is
recorded at the time revenue is recognized based on historical returns, current economic
trends and changes in customer demand. Such allowances are adjusted periodically to
reflect actual and anticipated experience. Such adjustments, which are recorded against
revenue in the period, could be material.

# Research and development
expenses

Research
and development costs are expensed as incurred.

# Advertising expenses

Advertising
costs are expensed as incurred and have not been material.

# Income taxes

The
Company accounts for deferred income taxes under the liability approach whereby the
expected future tax consequences of temporary differences between the book and tax basis
of assets and liabilities are recognized as deferred tax assets and liabilities. A
valuation allowance is established for any deferred tax assets for which realization is
uncertain.

# 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 and Financial Accounting Standards
Board (FASB) issued Interpretations (FIN) No. 44 Accounting
for Certain Transactions Involving Stock Compensation  An Interpretation of APB No.
25. Under APB Opinion No. 25 and FIN No. 44, compensation cost is, in general,
recognized based on the excess, if any, of the fair market value of the Companys
stock on the date of grant over the amount an employee must pay to acquire the stock. 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 Disclosure
Under SFAS No. 123

Pro
forma information regarding net loss and net 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. The Company calculated the
fair value of each stock-based award on the date of grant using the Black-Scholes model,
as prescribed by SFAS No. 123, using the following assumptions and dividend yields of
0% for all years presented:

37

---

|     | Options      | ESPP        
|---- | ------------ | ------------
|     | InterestRate | Term        
|2004 |              | 3.28 - 3.56%
|2003 |              | 1.91 - 2.77%
|2002 |              | 2.40 - 3.73%

The
weighted average fair value on the grant date of options in the years ended
December 31, 2004, 2003 and 2002 was $0.91, $0.65, and $0.39 respectively. The
weighted average fair value of the employee stock purchase rights granted under the 2000
Employee Stock Purchase Plan (ESPP) plan during 2004, 2003, and 2002 was $0.19, $1.66 and
$0.28, respectively. No employee stock purchase rights were granted in 2000.

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):

|                                                        | Years Ended December 31,
|------------------------------------------------------- | ------------------------
|                                                        | 2004                    
|Net loss, as reported                                   |                         
|                                                        |                         
|Add: Stock-based employee compensation expense included |                         
|in reported net loss                                    |                         
|Deduct: Total stock-based employee compensation expense |                         
|determined under fair value based method for all awards |                         
|                                                        |                         
|Pro forma net loss                                      |                         
|                                                        |                         
|Net loss per share attributable to common stockholders, |                         
|basic and diluted:                                      |                         
|As reported                                             |                         
|Pro forma                                               |                         

# 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 combination of dilutive common
share equivalents, comprised of shares issuable under the Companys stock-based
compensation plans, and the weighted average number of common shares outstanding during
the period. There were no incremental dilutive common share equivalents in the periods
presented.

# Comprehensive income
(loss)

Comprehensive
income (loss) is defined as the change in equity of a company from transactions and other
events and circumstances excluding transactions resulting from investments from owners and
distributions to owners. Comprehensive income (loss) consists of cumulative translation
adjustments and unrealized gain (loss) on short-term investments and is disclosed in the
consolidated statements of stockholders equity.

38

---

# 2. Balance Sheet
Components

|                                                        | December 31,
|------------------------------------------------------- | ------------
|                                                        | 2004        
|Cash and cash equivalents:                              |             
|Cash                                                    |             
|Government agencies' discount notes                     |             
|Money market instruments and funds                      |             
|                                                        |             
|                                                        |             
|                                                        |             
|                                                        |             
|Accounts receivable, net:                               |             
|Accounts receivable                                     |             
|Less: Allowance for doubtful accounts and sales returns |             
|                                                        |             
|                                                        |             
|                                                        |             
|                                                        |             
|Allowance for doubtful accounts and sales returns:      |             
|Balance at beginning of year                            |             
|Change                                                  |             
|Utilized                                                |             
|                                                        |             
|Balance at end of year                                  |             
|                                                        |             
|                                                        |             
|Inventories:                                            |             
|Finished goods                                          |             
|Work-in-process                                         |             
|Raw materials                                           |             
|                                                        |             
|                                                        |             
|                                                        |             
|                                                        |             
|Accrued expenses:                                       |             
|Accrued compensation costs                              |             
|Accrued professional fees                               |             
|Other accruals                                          |             
|                                                        |             
|                                                        |             
|                                                        |             
|                                                        |             
|Other long-term liabilities:                            |             
|Accrued pension liability                               |             
|Other liabilities                                       |             
|                                                        |             
|                                                        |             
|                                                        |             
|                                                        |             
|                                                        |             
|Accumulated other comprehensive Income/(Loss):          |             
|Cumulative translation adjustments                      |             
|Unrealized loss on short-term investments               |             
|                                                        |             
|                                                        |             
|                                                        |             
|                                                        |             

39

---

# 3. Marketable Securities

|                          | December 31, 2004             | December 31, 2003            
|------------------------- | ----------------------------- | -----------------------------
|                          |                               |                              
|                          | Available-for-Sale Securities | Available-for-Sale Securities
|                          |                               |                              
|(in thousands)            | Cost                          | GrossUnrealizedGains         
|Money market funds        |                               |                              
|Auction rate securities   |                               |                              
|US Treasury and Federal   |                               |                              
|Agency Securities         |                               |                              
|Corporate bonds           |                               |                              
|                          |                               |                              
|Total available-for-sale  |                               |                              
|securities                |                               |                              
|Included in:              |                               |                              
|Cash and cash equivalents |                               |                              
|Short-term investments    |                               |                              
|                          |                               |                              
|Total                     |                               |                              
|                          |                               |                              

Approximately
$0.4 million of the short term investments above are pledged as collateral for a stand-by
letter of credit issued by a commercial bank.

# 4. Property and
Equipment, Net:

|                                   | December 31,
|---------------------------------- | ------------
|(in thousands)                     | 2004        
|Machinery and equipment            |             
|Furniture and fixtures             |             
|Leasehold improvements             |             
|Building and equipment prepayments |             
|                                   |             
|                                   |             
|Less: Accumulated depreciation     |             
|                                   |             
|Total property and equipment, net  |             
|                                   |             
|                                   |             

During
the fourth quarter of 2004, the Company wrote off $0.3 million of certain non
production-related transceiver equipment that was no longer being utilized.

In
2002, certain of the Companys equipment and machinery located in Taiwan for the
production of its fused fiber products were determined to be non-functional or damaged.
Accordingly, the Company wrote off $1.0 million within cost of revenues in the year ended
December 31, 2002 for this equipment and machinery.

40

---

# 5. Excess Facility
Charges

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 to 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 non-cancelable lease payments and
$0.2 million of fixed assets written-off. Cash payments in 2004 and 2003 amounted to $0.6
million and $1.0 million respectively.

# 6. Income Taxes

The components of loss before income
taxes are as follows:

|                                           | Years Ended December 31, | 
|------------------------------------------ | ------------------------ | 
|(in thousands)                             | 2004                     | 
|Loss subject to domestic income taxes only |                          | 
|Loss subject to foreign income taxes only  |                          | 
|                                           |                          | 
|                                           |                          | 
|                                           |                          | 
|                                           |                          | 

The income tax provision (benefit) is
composed of the following:

|                          | Years Ended December 31, | 
|------------------------- | ------------------------ | 
|(in thousands)            | 2004                     | 
|Current                   |                          | 
|Federal                   |                          | 
|State                     |                          | 
|Foreign                   |                          | 
|                          |                          | 
|                          |                          | 
|Deferred                  |                          | 
|                          |                          | 
|Total provision (benefit) |                          | 
|                          |                          | 
|                          |                          | 

41

---

The following is a reconciliation of
the effective tax rates and the United States statutory federal income tax rate

|                                  | Years Ended December 31, | 
|--------------------------------- | ------------------------ | 
|                                  | 2004                     | 
|Statutory federal income tax rate |                          | 
|State income tax                  |                          | 
|Stock compensation                |                          | 
|Research and development credits  |                          | 
|Valuation allowance               |                          | 
|Other                             |                          | 
|                                  |                          | 
|Effective tax rate                |                          | 
|                                  |                          | 
|                                  |                          | 

Deferred tax assets consisted of the following:

|                                 | Years Ended December 31, | 
|-------------------------------- | ------------------------ | 
|(in thousands)                   | 2004                     | 
|Deferred tax assets:             |                          | 
|Net operating loss carryforwards |                          | 
|Credit carryforwards             |                          | 
|Depreciation                     |                          | 
|Accruals and allowances          |                          | 
|                                 |                          | 
|                                 |                          | 
|Less: valuation allowances       |                          | 
|                                 |                          | 
|Net deferred tax assets          |                          | 
|                                 |                          | 

|                                             | Years Ended December 31, | 
|-------------------------------------------- | ------------------------ | 
|(in thousands)                               | 2004                     | 
|Valuation allowances on deferred tax assets: |                          | 
|Balance at beginning of year                 |                          | 
|Addition                                     |                          | 
|Utilized                                     |                          | 
|                                             |                          | 
|Balance at end of year                       |                          | 
|                                             |                          | 
|                                             |                          | 

Based
upon the weight of available evidence, which includes the Companys historical
operating performance, lack of taxable income and the accumulated deficit, the Company
provided a full valuation allowance against the net deferred tax assets.

As
of December 31, 2004, the Company had net operating loss carryforwards of
approximately $40.5 million for federal and $22.2 million for state tax purposes. If not
utilized, these carryforwards will begin to expire in 2021 for federal and in 2011 for
state purposes.

42

---

As
of December 31, 2004, the Company had research credit carryforwards of approximately $1.1
million and $0.9 million for federal and state income tax purposes, respectively. If not
utilized, the federal carryforward will expire in various amounts beginning in 2021. The
California tax credit can be carried forward indefinitely.

Internal
Revenue Code Section 382 limits the use of net operating loss and tax credit carryforwards
in certain situations where changes occur in the stock ownership of a company. In the
event the Company has had a change in ownership, utilization of the carryforwards could be
restricted.

# 7. Net Loss Per Share

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

|                                                             | Years Ended December 31, | 
|------------------------------------------------------------ | ------------------------ | 
|                                                             | 2004                     | 
|Numerator:                                                   |                          | 
|Net loss attributable to common stockholders                 |                          | 
|                                                             |                          | 
|Denominator:                                                 |                          | 
|Shares used in computing net loss per share:                 |                          | 
|Weighted average of common shares outstanding                |                          | 
|Less: Weighted average of shares subject to repurchase right |                          | 
|                                                             |                          | 
|Basic and diluted                                            |                          | 
|                                                             |                          | 
|                                                             |                          | 
|Net loss per share attributable to common stockholders:      |                          | 
|Basic and diluted                                            |                          | 
|                                                             |                          | 
|                                                             |                          | 

The
following outstanding options were excluded from the computation of diluted net loss per
share (in thousands) as the effect would have been anti-dilutive:

|                                            | Years Ended December 31, | 
|------------------------------------------- | ------------------------ | 
|                                            | 2004                     | 
|Options to purchase common stock and shares |                          | 
|subject to repurchase                       |                          | 
|                                            |                          | 
|                                            |                          | 

43

---

# 8. Stock-based
Compensation Plans

# 1997 Stock Option Plan

In
May 1997, the Company adopted its 1997 Stock Plan under which 3,000,000 shares of common
stock were reserved for issuance to eligible employees, directors and consultants upon
exercise of stock options and stock purchase rights. During the year ended
December 31, 2000, an additional 5,200,000 shares were reserved for issuance under
the 1997 Stock Plan. Incentive stock options are granted at a price not less than 100% of
the fair market value of the Companys common stock and at a price of not less than
110% of the fair market value for grants to any person who owned more than 10% of the
voting power of all classes of stock on the date of grant. Nonstatutory stock options are
granted at a price not less than 85% of the fair market value of the common stock and at a
price not less than 110% of the fair market value for grants to a person who owned more
than 10% of the voting power of all classes of stock on the date of the grant. Options
granted under the 1997 Stock Plan generally vest over four years and are exercisable for
not more than ten years (five years for grants to any person who owned more than 10% of
the voting power of all classes of stock on the date of the grant). In November 2000, the
1997 Stock Plan was replaced by the 2000 Stock Incentive Plan.

# 2000 Stock Incentive Plan

In
November 2000, the Company adopted its 2000 Stock Incentive Plan under which 1,500,000
shares of common stock were reserved for issuance to eligible employees, directors and
consultants upon exercise of stock options and stock purchase rights. On January 1 of
each year, beginning on January 1, 2001, the number of shares available for grant will
automatically increase by the lesser of: (i) 1,700,000 shares; (ii) 5% of the
fully diluted outstanding shares of stock on that date; or (iii) a lesser amount as
may be determined by the Board of Directors. Incentive stock options are granted at a
price not less than 100% of the fair market value of the Companys common stock and
at a price of not less than 110% of the fair market value for grants to any person who
owned more than 10% of the voting power of all classes of stock on the date of grant.
Nonstatutory stock options are granted at a price not less than 85% of the fair market
value of the common stock and at a price not less than 110% of the fair market value for
grants to a person who owned more than 10% of the voting power of all classes of stock on
the date of the grant. Options granted under the 2000 Stock Incentive Plan generally vest
over four years and are exercisable for not more than ten years (five years for grants to
any person who owned more than 10% of the voting power of all classes of stock on the date
of the grant).

The following table summarizes option
activity under the Plans:

|                             |                    | Options Outstanding |                 | Weighted
Average |              
|---------------------------- | ------------------ | ------------------- | --------------- | ---------------- | -------------
|                             | Availablefor Grant |                     | Number ofShares |                  | ExercisePrice
|Balance at December 31, 2001 |                    |                     |                 | 2,360,050        |              
|                             |                    |                     |                 |                 
|Additional shares reserved   |                    |                     |                 | --               |              
|Granted                      |                    |                     |                 | (632,900         | )            
|Canceled                     |                    |                     |                 | 733,350          |              
|Exercised                    |                    |                     |                 | --               |              
|Balance at December 31, 2002 |                    |                     |                 | 2,460,500        |              
|                             |                    |                     |                 |                 
|Additional shares reserved   |                    |                     |                 | 1,700,000        |              
|Granted                      |                    |                     |                 | (1,356,300       | )            
|Canceled                     |                    |                     |                 | 290,850          |              
|Exercised                    |                    |                     |                 | --               |              
|Balance at December 31, 2003 |                    |                     |                 | 3,095,050        |              
|                             |                    |                     |                 |                 
|Additional shares reserved   |                    |                     |                 | 2,002,133        |              
|Granted                      |                    |                     |                 | (1,311,300       | )            
|Canceled                     |                    |                     |                 | 322,833          |              
|Exercised                    |                    |                     |                 | --               |              
|Balance at December 31, 2004 |                    |                     |                 | 4,108,716        |              

44

---

Information relating to stock options outstanding
at December 31, 2004 is as follows:

|Options Outstanding |             | Options Exercisable | 
|------------------- | ----------- | ------------------- | 
|ExercisePrice       |             | NumberOutstanding   | 
|$                   | 0.20        |                     | 
|$                   | 0.40 $0.63 |                     | 
|$                   | 0.70 $1.00 |                     | 
|$                   | 1.56 $2.50 |                     | 
|$                   | 4.00 $5.75 |                     | 
|$                   | 6.38        |                     | 
|                    |             |                     | 

Options
exercisable as of December 31, 2004, 2003, and 2002 were 1,895,723, 1,468,725, and 474,092
at an average exercise price of $1.32, $1.43, and $0.49 per share, respectively.

# Receivables from
Stockholders

On
various dates during the year ended December 31, 2000, 2,935,000 options were exercised
prior to being vested by certain officers of the Company for a total of $1.95 million in
notes payable to the Company. These exercised shares are subject to rights of repurchase
by the Company until such shares are vested. The notes are full recourse, have a four-year
term, and bear interest at rates ranging from 6.5% to 7.0% per annum. The number of shares
of common stock subject to repurchase was 570,833 and 170,833 as of December 31, 2002 and
2003, respectively. On August 25, 2004, the Company purchased an aggregate of 530,000
shares from two officers at the market price of $0.82 per share. The proceeds received by
the officers for the shares were applied against amounts owed to the Company by the
officers. All notes payable to the Company are paid in full.

# Employee Stock Purchase
Plan

In
November 2000, the Company adopted its 2000 Employee Stock Purchase Plan (the
Plan). The Company reserved 1,500,000 shares of common stock for issuance
under the Plan. On the first day of January each year beginning January 1, 2001,
additional shares of common stock are reserved for issuance under the Plan as determined
by the Board of Directors. The plan limits the annual increase to the lesser of 1% of the
Companys issued and outstanding common stock or 1,000,000 shares. The Plan provides
eligible employees with the opportunity to acquire shares of common stock at a price of
85% of the lower of the fair market value of the common stock on the first day of the
offering period or the last day of the offering period, whichever is lower. The Plan is
structured as a qualified employee stock purchase plan under Section 423 of the amended
Internal Revenue Code of 1986. However, the Plan is not intended to be a qualified
pension, profit sharing or stock bonus plan under Section 401(a) of the 1986 Code and is
not subject to the provisions of the Employee Retirement Security Act of 1974. The Board
may amend, suspend, or terminate the Plan at any time without notice. A total of
1,077,623, 705,185 and 253,647 shares were issued under the Plan in 2004, 2003 and 2002,
respectively.

45

---

There
were 703,092 shares available for future issuance under the Employee Stock Purchase Plan
as of December 31, 2004.

# Stock-based Compensation
under APB Opinion No. 25

During
the years ended December 31, 2004, 2003 and 2002, the Company recorded stock based
compensation expense of $0.3 million, $0.9 million and $1.1 million, respectively. This
compensation expense represents the difference between the exercise price of common stock
options and the deemed fair value for financial statement reporting purposes of the
Companys common stock on the option grant date. Deferred compensation is being
amortized using the graded vesting method, in accordance with FIN No. 28, over the
vesting period of each respective option, generally four years. Under the graded vesting
method, each option grant is separated into portions based on its vesting terms, which
results in acceleration of amortization expense for the overall award. The accelerated
amortization pattern results in expensing approximately 52% of the total award in year
one, 27% in year two, 15% in year three and 6% in year four.

# SFAS No. 123
Compensation to Consultants

The
Company did not grant any options or shares to consultants in the years ended
December 31, 2004 and 2003. In the year ended December 31, 2002, the Company granted
options to purchase 10,000 shares of common stock to an advisor at an exercise price of
$0.40 per share. These options were fully vested in 2004. The Company is required to
record the change in the fair value of these options at each reporting date prior to
vesting and then finally at the vesting date of the option. Amortization of the deferred
stock-based compensation balance amounted to $0.2 million for the year ended
December 31, 2002.

# 9. Concentrations of
Certain Risks

Financial
instruments that potentially subject the Company to significant concentrations of credit
risk consist primarily of cash, cash equivalents, short-term investments and accounts
receivable. The Company limits the amount of deposits in any one financial institution and
any one financial instrument. The Company invests its excess cash principally in
certificates of deposit, debt instruments issued by high-credit quality financial
institutions and corporations and money market accounts with financial institutions in the
United States.

The
Company performs ongoing credit evaluations of its customers financial condition,
and limits the amount of credit extended when deemed necessary, but generally does not
require collateral.

At
December 31, 2004, two customers accounted for 11% and 10% of the Companys accounts
receivable, respectively. At December 31, 2003, two customers accounted for 14% and
13% of the Companys accounts receivable, respectively.

One
customer accounted for 11% of our revenues in the years ended December 31, 2004 and 2003,
respectively. For the year ended December 31, 2002, no individual customer accounted
for 10% or more of the Companys revenues.

Certain
components used in manufacturing the Companys products have relatively few
alternative sources of supply, and establishing additional or replacement suppliers for
such components cannot be accomplished quickly.

46

---

# 10. Acquisition of Assets

In
January 2004, the Company acquired substantially all of the assets of Taiwan-based Ritek
Corporations photonics business unit. Through this transaction, the Company acquired
certain assets and assumed certain pension liabilities. The Company also received $1.5
million in cash from Ritek.

The
total purchase price was approximately $4.0 million, which consisted of the issuance of
1.7 million shares of the Companys common stock. The purchase price was allocated as
follows (in thousands):

|                          | 
|------------------------- | 
|Cash                      | 
|Fixed assets              | 
|Inventory                 | 
|Prepaid facilities rent   | 
|Pension liability assumed | 
|                          | 
|Total                     | 
|                          | 

Prepaid
facilities rent is being amortized over twenty-four months (length of the prepaid lease).

# 11. 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 by geographic segments,
revenues generated by product lines and identifiable assets located in these segments (in
thousands):

47

---

|              | Years Ended December 31, | 
|------------- | ------------------------ | 
|              | 2004                     | 
|Revenues      |                          | 
|United States |                          | 
|Taiwan        |                          | 
|              |                          | 
|              |                          | 
|              |                          | 
|              |                          | 

|                                   | Years Ended December 31, | 
|---------------------------------- | ------------------------ | 
|                                   | 2004                     | 
|Revenues                           |                          | 
|Optical path multiplexing solution |                          | 
|Dense wave division multiplexer    |                          | 
|                                   |                          | 
|                                   |                          | 
|                                   |                          | 

|                       | December 31,
|---------------------- | ------------
|                       | 2004        
|Property and Equipment |             
|United States          |             
|Taiwan                 |             
|China                  |             
|                       |             
|                       |             
|                       |             

# 12. Commitments and
Contingencies

Litigation: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.

Indemnification
and Product Warranty:The Company indemnifies certain customers, suppliers and
subcontractors for attorney fees and damages and costs awarded against these parties in
certain circumstances in which products are alleged to infringe third party intellectual
property rights, including patents, trade secrets, trademarks or copyrights. In all cases,
there are limits on and exceptions to the potential liability for indemnification relating
to intellectual property infringement claims. The Company cannot estimate the amount of
potential future payments, if any, that might be required to make as a result of these
agreements. To date, the Company has not paid any claim or been required to defend any
action related to indemnification obligations, and accordingly, the Company has not
accrued any amounts for such indemnification obligations. However, the Company may record
charges in the future as a result of these indemnification obligations.

The
Company generally warrants products against defects in materials and workmanship and
non-conformance to specifications for varying lengths of time. If there is a material
increase in customer claims compared with historical experience, or if costs of servicing
warranty claims are greater than expected, the Company may record a charge against cost of
revenues.

Operating
Leases:The Company leases certain office space under long-term operating leases
expiring at various dates through 2010. Total lease expenses under these operating leases
were approximately $1.0 million, $1.2 million and $1.8 million for the years ended
December 31, 2004, 2003, and 2002, respectively.

48

---

Total
future minimum lease payments under operating leases as of December 31, 2004 are
summarized below (in thousands):

|Years ending December 31, | 
|------------------------- | 
|2005                      | 
|2006                      | 
|2007                      | 
|2008                      | 
|2009                      | 
|2010 and after            | 
|                          | 
|Total                     | 
|                          | 

Letter
of Credit:The Company had a letter of credit of $0.4 million outstanding as of
December 31, 2004. The letter of credit is collateralized by short term investments of
$0.4 million.

# 13. Bank Loan

In
November 2004, the Company entered into a ten year loan of $0.5 million in Taiwan with a
fixed interest rate of 2.3% for the first two years. The loan is secured by the
Companys building in Taiwan. The net book value of the building was $0.8 million as
of December 31, 2004.

Payments due under the bank loan as
of December 31, 2004 are as follows (in thousands):

|Years ending December 31,               | 
|--------------------------------------- | 
|2005                                    | 
|2006                                    | 
|2007                                    | 
|2008                                    | 
|2009                                    | 
|2010 and after                          | 
|                                        | 
|Total payment                           | 
|Less: Amounts representing interest     | 
|                                        | 
|Present value of net remaining payments | 
|Less: current portion                   | 
|                                        | 
|Long-term portion                       | 
|                                        | 

# 14. Related Party
Transactions

As
of March 3, 2005, Foxconn Holding Limited was a holder of 20.5% of the Companys
common stock. The Company sells products and purchases raw materials from Hon Hai
Precision Company Limited, who is the parent company of Foxconn Holding Limited, in the
normal course of business. These transactions were made at prices and terms consistent
with those of unrelated third parties. Sales of products to Hon Hai Precision Industry
Company Limited were $0.3 million in the year ended December 31, 2004. Purchases of raw
materials from Hon Hai Precision Company Limited were $1.4 million in the year ended
December 31, 2004. Amounts due from Hon Hai Precision Company Limited were $0.3 million at
December 31, 2004. Amounts due to Hon Hai Precision Company Limited were $0.6 million at
December 31, 2004.

49

---

# 15. Recent Accounting
Pronouncements

In
March 2004, the Financial Accounting Standards Board (FASB) approved the consensus reached
on the Emerging Issues Task Force (EITF) Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments. 
EITF 03-1 provides guidance for identifying impaired investments and new disclosure
requirements for investments that are deemed to be temporarily impaired. On September 30,
2004, the FASB issued a final staff position EITF Issue No. 03-1-1 that delays the
effective date for the measurement and recognition guidance included in paragraphs 10
through 20 of EITF 03-1. Quantitative and qualitative disclosures required by EITF 03-1
remain effective and have been adopted for the Companys fiscal 2004 financial
statements. The Company will evaluate the effect, if any, of EITF Issue No. 03-1 when
formal guidance is released.

In
November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB
No. 43, Chapter 4". This statement amends the guidance in ARB No. 43, Chapter 4,
Inventory Pricing to clarify the accounting for abnormal amounts of
idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS 151
requires that those items be recognized as current-period charges. In addition, this
statement requires that allocation of fixed production overheads to costs of conversion be
based upon the normal capacity of the production facilities. The provisions of SFAS 151
are effective for inventory cost incurred in fiscal years beginning after June 15, 2005.
As such, the Company is required to adopt these provisions at the beginning of fiscal
2007. The Company is currently evaluating the impact of SFAS 151 on its consolidated
financial statements.

In
December 2004, the FASB issued SFAS No. 153, Exchanges of Non-monetary Assets, an
amendment of APB Opinion No. 29". SFAS 153 replaces the exception from fair value
measurement in APB Opinion No. 29 for non-monetary exchanges of similar productive assets
with a general exception from fair value measurement for exchanges of non-monetary assets
that do not have commercial substance. A non-monetary exchange has commercial substance if
the future cash flows of the entity are expected to change significantly as a result of
the exchange. SFAS 153 is to be applied prospectively, and is effective for non-monetary
asset exchanges occurring in fiscal periods after the date of issuance of SFAS 153. The
Company does not believe the impact of adoption of SFAS 153 will be significant to the
overall results of operations or financial position.

In
December 2004, the FASB issued SFAS No. 123R, Share-Based Payment (SFAS
123R), which requires companies to measure and recognize compensation expense for all
stock-based compensation to employees at fair value. SFAS 123R will be effective for all
interim fiscal periods beginning after June 15, 2005, and thus will be effective for the
Company beginning the third quarter of 2005. Retroactive application of the provisions of
SFAS 123R to the beginning of the fiscal year that includes the effective date is
permitted, but not required. The Company is currently evaluating the impact of SFAS 123R
on its financial statements.

50

---

# Item 8. Changes In and
Disagreements With Accountants on Accounting and Financial Disclosure

None.

# Item 8A. 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. Our disclosure controls and procedures have
          been designed to meet, and management believes that they meet, reasonable
          assurance standards. 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 Annual Report on Form
10-KSB, 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 Annual Report on Form 10-KSB 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 8A(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.

# Item 8B. Other
Information

Not
Applicable.

51

---

# PART III

# Item 9. Directors, Executive
Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act

The
information required by this item (with respect to Directors) is incorporated by reference
from the information under the caption Election of Directors contained in the
Companys Proxy Statement to be filed with the Securities and Exchange Commission in
connection with the solicitation of proxies for the Companys 2005 Annual Meeting of
Stockholders to be held on May 20, 2005 (the Proxy Statement). Certain
information required by this item concerning executive officers is set forth in Part I of
this Report under the caption Executive Officers of the Registrant.

Item 405
of Regulation S-B calls for disclosure of any known late filing or failure by an
insider to file a report required by Section 16(a) of the Exchange Act. This
disclosure is contained in the section entitled Section 16(a) Beneficial
Ownership Reporting Compliance in the Proxy Statement and is incorporated herein by
reference.

The
Company has a separately designated standing Audit Committee established in accordance
with Section 3(a)(58)(A) of the Exchange Act. The members of the Audit Committee are James
C. Yeh (Chairperson), Richard Black and Ray Sun, all of whom meet the independence
standards established by The Nasdaq Stock Market for serving on an audit committee. The
Board of Directors has determined that each of James Yeh, Richard Black and Ray Sun is an
audit committee financial expert as defined SEC regulations.

The
Companys Board of Directors adopted a Code of Ethics for all of its directors and
officers on March 24, 2004. The Companys Code of Ethics is available on the
Companys website at http://www.afop.com.To date, there have been no waivers
under the companys Code of Ethics. The Company will post any waivers, if and when
granted, under its Code of Ethics on the Companys website at http://www.afop.com.

# Item 10. Executive
Compensation

The
information required by this item is incorporated by reference from the information under
the captions Election of Directors  Director Compensation,
Executive Compensation, and Election of Directors  Compensation
Committee Interlocks and Insider Participation contained in the Proxy Statement.

# Item 11. Security
Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The
information required by this item is incorporated by reference from the information under
the caption Security Ownership of Certain Beneficial Owners and Management
contained in the Proxy Statement.

52

---

# Equity Compensation Plan
Information

Set
forth in the table below is certain information regarding the Companys equity
compensation plans as of December 31, 2004:

|                              |                                                                                                              | 
|----------------------------- | ------------------------------------------------------------------------------------------------------------ | 
|Plan category                 | Number of securitiesto be issued uponexercise ofoutstanding options,warrants and rights                  (a) | 
|Equity compensation plans     |                                                                                                              | 
|approved by security holders  |                                                                                                              | 
|Equity compensation plans not |                                                                                                              | 
|approved by security holders  |                                                                                                              | 
|                              |                                                                                                              | 
|Total                         |                                                                                                              | 
|                              |                                                                                                              | 

(1)    
          Includes shares to be issued upon exercise of outstanding options granted under
          the 1997 Stock Plan and the 2000 Stock Incentive Plan. Options to purchase
          shares of the Companys Common Stock are no longer granted under the 1997
          Stock Plan.

(2)    
          Includes:

(a)       
          4,108,716 of shares reserved for issuance under the Companys 2000 Stock
          Incentive Plan. The number of shares reserved for issuance under the
          Companys 2000 Stock Incentive Plan will be increased on the first day of
          the Companys fiscal year by the lesser of 1,700,000 shares, 5% of the
          fully diluted outstanding shares of the Companys common stock on that date
          or a lesser amount determined by the Companys Board of Directors. Stock
          options, restricted stock, restricted stock units or stock appreciation rights
          may be awarded under the 2000 Stock Incentive Plan.

(b)       
          703,092 shares reserved for issuance under the Companys 2000 Employee
          Stock Purchase Plan (the ESPP). The number of shares reserved for
          issuance under the ESPP increases on the first day of the Companys fiscal
          year by an amount as may be determined by the Board of Directors, or, if less,
          the lesser of 1,000,000 shares or 1.0% of the outstanding common stock on that
          date. The ESPP permits eligible employees to contribute up to 20% of cash
          compensation toward the semi-annual purchase of the Companys common stock.
          The purchase price per share is 85% of the fair market value on the last trading
          day prior to the beginning of the six-month period at which an eligible employee
          is enrolled; or the fair market value on the last trading day of the month in
          which the six-month period expired, whichever is lower.

# Item 12. Certain
Relationships and Related Transactions

The
information required by this item is incorporated by reference from the information
contained under the caption Certain Relationships and Related Party
Transactions contained in the Proxy Statement.

53

---

# Item 13. Exhibits

All financial statement schedules
have been omitted because they are not applicable or not required or because the
information is included elsewhere in the Consolidated Financial Statements or the Notes
thereto.

|ExhibitNumber | Description of Document                                                                                                                                                                                                                                                                                           
|------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3(i).1        | Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3(i).3 to
                   the Company's Registration Statement on Form S-1 (File No. 333-45482)).                                                                                                                      
|3(i).2        | Certificate of Designation of Series A Participating Preferred Stock (incorporated by reference to Exhibit 3(i).2 to the Company's Form 10-K for the year ended December 31, 2002).                                                                                                                               
|3(ii).1       | Restated Bylaws of the Registrant (incorporated by reference to Exhibit 3(ii).3 to the Company's
                   Registration Statement on Form S-1 (File No. 333-45482)).                                                                                                                                     
|4.1           | Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to the Company's
                   Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2002).                                                                                                                  
|4.2           | Amended and Restated Rights Agreement dated as of August 31, 2000 (incorporated by reference to
                   Exhibit 4.2 to the Company's Registration Statement on Form S-1 (File No. 333-45482)).                                                                                                         
|4.3           | Rights Agreement dated as of May 29, 2001 between the Company and Mellon Investor Services, LLC
                   (incorporated by reference to Exhibit 4.1 to the Company's Form 8-A (File No. 0-31857)).                                                                                                       
|10.1#         | 1997 Stock Plan and form of agreements thereunder (incorporated by reference to Exhibit 10.1 to
                   the Company's Registration Statement on Form S-1 (File No. 333-45482)).                                                                                                                        
|10.2#         | Form of Indemnification Agreement between the Company and its officers and directors
                   (incorporated by reference to Exhibit 10.2 to the Company's Registration Statement on Form S-1
                   (File No. 333-45482)).                                                                  
|10.3          | Lease Agreement dated April 6, 1999 by and between North Pastoria Partners and the Company
                   (incorporated by reference to Exhibit 10.3 to the Company's Registration Statement on Form S-1
                   (File No. 333-45482)).                                                            
|10.4          | Lease dated June 26, 2000 by and between Renault & Handley Employees Investment Co. and the
                   Company (incorporated by reference to Exhibit 10.4 to the Company's Registration Statement on
                   Form S-1 (File No. 333-45482)).                                                   
|10.5#         | Alliance Fiber Optic Products, Inc. 2000 Stock Incentive Plan (incorporated by reference to
                   Exhibit 10.5 to Amendment No. 3 to the Company's Registration Statement on Form S-1 (File
                   No. 333-45482)).                                                                      
|10.6#         | Alliance Fiber Optic Products, Inc. Amended and Restated 2000 Employee Stock Purchase Plan.                                                                                                                                                                                                                       
|10.7#         | Alliance Fiber Optic Products, Inc. 1997 Stock Plan Stock Option Agreement dated May 2, 2000
                   between Peter C. Chang and the Company (incorporated by reference to Exhibit 10.7 to Amendment
                   No. 1 to the Company's Registration Statement on Form S-1 (File No. 333-45482)).
|10.8#         | Form of Full Recourse Promissory Note (incorporated by reference to Exhibit 10.9 to Amendment
                   No. 1 to the Company's Registration Statement on Form S-1 (File No. 333-45482)).                                                                                                                 

54

---

|ExhibitNumber | Description of Document                                                                                                                                                                                                                                                                      
|------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.9#         | Full Recourse Promissory Note dated May 1, 2002 between the Company and Wei-Shin Tsay
                   (incorporated by reference to Exhibit 10.1 to the Company's quarterly report on Form 10-Q for the
                   quarterly period ended June 30, 2002).                         
|10.10#        | Lease  Agreement dated April 5, 2004 by and between Moffett Office Park Investors LLC and
                   Alliance Fiber Optic Products, Inc. (incorporated by reference to Exhibit 10.13 to Company's
                   Quarterly Report on Form 10-QSB for period ended June 30, 2004).
|21.1          | Subsidiaries of the Company (incorporated by reference to Exhibit 21.1 to the Company's Annual
                   Report on Form 10-K for the year ended December 31, 2000).                                                                                                                 
|23.1          | Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm.                                                                                                                                                                                                        
|24.1          | Power of Attorney (see page 56 of this Form 10-KSB)                                                                                                                                                                                                                                          
|31.1          | RRule 13a-14(a) certification of Chief Executive Officer.                                                                                                                                                                                                                                    
|31.2          | Rule 13a-14(a) certification of Acting Chief Financial Officer.                                                                                                                                                                                                                              
|32.1**        | Statement of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18
                   U.S.C.ss.1350).                                                                                                                                                              
|32.2**        | Statement of Acting Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002
                   (18 U.S.C.ss.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-KSB 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.
# Indicates management contract or compensatory plan or arrangement.

# Item 14. Principal
Accountant Fees and Services

The information  required by this item is incorporated by reference from the information  under the caption  "Ratification  of
Independent  Registered  Public Accounting Firm - Principal  Accountant Fees and Services" and  "Pre-Approval  Policies and Procedures"
contained in the Proxy Statement.

55

---

# SIGNATURES

In  accordance  with Section 13 or 15(d) of the  Securities  Exchange  Act of 1934,  the Company has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.

|                     | ALLIANCE FIBER OPTIC PRODUCTS, INC.  
|-------------------- | -------------------------------------
|                     |                                      
|Date: March 24, 2005 |                                      
|                     | By/s/ Peter C. Chang                 
|                     | Peter C. Chang                       
|                     | President and Chief Executive Officer

# POWER OF ATTORNEY

KNOW
ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and
appoints Peter C. Chang and Anita K. Ho, and each of them, his true and lawful
attorneys-in-fact, each with full power of substitution, for him or her in any and all
capacities, to sign any amendments to this report on Form 10-KSB and to file the same,
with exhibits thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each of said
attorneys-in-fact or their substitute or substitutes may do or cause to be done by virtue
hereof.

Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been signed
below by the following persons on behalf of the registrant and in the capacities and on
the dates indicated.

|Name               | Title                               | Date          
|------------------ | ----------------------------------- | --------------
|                   |                                     |               
|/s/ Peter C. Chang | President, Chief Executive Officer  | March 24, 2005
|Peter C. Chang     | (Principal Executive Officer) and   |               
|                   | Chairman                            |               
|/s/ Anita K. Ho    | Acting Chief Financial Officer      | March 24, 2005
|Anita K. Ho        | (Principal Financial and Accounting |               
|                   | Officer)                            |               
|/s/ Richard Black  | Director                            | March 24, 2005
|Richard Black      |                                     |               
|                   |                                     |               
|/s/ Gwong-Yih Lee  | Director                            | March 24, 2005
|Gwong-Yih Lee      |                                     |               
|                   |                                     |               
|/s/ Ray Sun        | Director                            | March 24, 2005
|Ray Sun            |                                     |               
|                   |                                     |               
|/s/ James C. Yeh   | Director                            | March 24, 2005
|James C. Yeh       |                                     |               
|                   |                                     |               

56

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# EXHIBIT INDEX

|ExhibitNumber | Description of Document                                                                                                                                                                                                                                                                                           
|------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3(i).1        | Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3(i).3 to
                   the Company's Registration Statement on Form S-1 (File No. 333-45482)).                                                                                                                      
|3(i).2        | Certificate of Designation of Series A Participating Preferred Stock (incorporated by reference
                   to Exhibit 3(i).2 to Company's 10-K for year ended December 31, 2002).                                                                                                                         
|3(ii).1       | Restated Bylaws of the Registrant (incorporated by reference to Exhibit 3(ii).3 to the Company's
                   Registration Statement on Form S-1 (File No. 333-45482)).                                                                                                                                     
|4.1           | Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to the Company's
                   Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2002).                                                                                                                  
|4.2           | Amended and Restated Rights Agreement dated as of August 31, 2000 (incorporated by reference to
                   Exhibit 4.2 to the Company's Registration Statement on Form S-1 (File No. 333-45482)).                                                                                                         
|4.3           | Rights Agreement dated as of May 29, 2001 between the Company and Mellon Investor Services, LLC
                   (incorporated by reference to Exhibit 4.1 to the Company's Form 8-A (File No. 0-31857)).                                                                                                       
|10.1#         | 1997 Stock Plan and form of agreements thereunder (incorporated by reference to Exhibit 10.1 to
                   the Company's Registration Statement on Form S-1 (File No. 333-45482)).                                                                                                                        
|10.2#         | Form of Indemnification Agreement between the Company and its officers and directors
                   (incorporated by reference to Exhibit 10.2 to the Company's Registration Statement on Form S-1
                   (File No. 333-45482)).                                                                  
|10.3          | Lease Agreement dated April 6, 1999 by and between North Pastoria Partners and the Company
                   (incorporated by reference to Exhibit 10.3 to the Company's Registration Statement on Form S-1
                   (File No. 333-45482)).                                                            
|10.4          | Lease dated June 26, 2000 by and between Renault & Handley Employees Investment Co. and the
                   Company (incorporated by reference to Exhibit 10.4 to the Company's Registration Statement on
                   Form S-1 (File No. 333-45482)).                                                   
|10.5#         | Alliance Fiber Optic Products, Inc. 2000 Stock Incentive Plan (incorporated by reference to
                   Exhibit 10.5 to Amendment No. 3 to the Company's Registration Statement on Form S-1 (File
                   No. 333-45482)).                                                                      
|10.6#         | Alliance Fiber Optic Products, Inc. Amended and Restated 2000 Employee Stock Purchase Plan.                                                                                                                                                                                                                       
|10.7#         | Alliance Fiber Optic Products, Inc. 1997 Stock Plan Stock Option Agreement dated May 2, 2000
                   between Peter C. Chang and the Company (incorporated by reference to Exhibit 10.7 to Amendment
                   No. 1 to the Company's Registration Statement on Form S-1 (File No. 333-45482)).
|10.8#         | Form of Full Recourse Promissory Note (incorporated by reference to Exhibit 10.9 to Amendment
                   No. 1 to the Company's Registration Statement on Form S-1 (File No. 333-45482)).                                                                                                                 

57

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|ExhibitNumber | Description of Document                                                                                                                                                                                                                                                                      
|------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.9#         | Full Recourse Promissory Note dated May 1, 2002 between the Company and Wei-Shin Tsay
                   (incorporated by reference to Exhibit 10.1 to the Company's quarterly report on Form 10-Q for the
                   quarterly period ended June 30, 2002).                         
|10.10#        | Lease  Agreement dated April 5, 2004 by and between Moffett Office Park Investors LLC and
                   Alliance Fiber Optic Products, Inc. (incorporated by reference to Exhibit 10.13 to Company's
                   Quarterly Report on Form 10-QSB for period ended June 30, 2004).
|21.1          | Subsidiaries of the Company (incorporated by reference to Exhibit 21.1 to the Company's Annual
                   Report on Form 10-K for the year ended December 31, 2000).                                                                                                                 
|23.1          | Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm.                                                                                                                                                                                                        
|24.1          | Power of Attorney (see page 56 of this Form 10-KSB)                                                                                                                                                                                                                                          
|31.1          | Rule 13a-14(a) certification of Chief Executive Officer.                                                                                                                                                                                                                                     
|31.2          | Rule 13a-14(a) certification of Acting Chief Financial Officer.                                                                                                                                                                                                                              
|32.1**        | Statement of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18
                   U.S.C.ss.1350).                                                                                                                                                              
|32.2**        | Statement of Acting Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002
                   (18 U.S.C.ss.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-KSB 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. # Indicates management contract or compensatory plan or arrangement.

58

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