# UNITED STATES

# SECURITIES AND
EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

_________________

# FORM 10-QSB

| |           
| | ----------
| | (Mark One)

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

| |                                              
| | ---------------------------------------------
| | For the quarterly period ended March 31, 2004

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

| |                                   
| | ----------------------------------
| | For the transition period from

to

| |                               
| | ------------------------------
| | Commission File Number 0-31857

|                                                                 
|-----------------------------------------------------------------
|ALLIANCE FIBER OPTIC PRODUCTS, INC.                              
|                                                                 
|(Exact name of small business issuer as specified in its charter)

| |                                 |  |                        | 
| | ------------------------------- |  | ---------------------- | 
| | Delaware                        |  | 77-0554122             | 
| |                                 |  |                        | 
| | (State or other jurisdiction of |  | (I.R.S. employer       | 
| | Incorporation or organization)  |  | identification number) | 

|                                                      
|------------------------------------------------------
|735 North Pastoria Avenue, Sunnyvale, California 94085
|                                                      
|(Address of Principal Executive Offices)              

|                           
|---------------------------
|(408) 736-6900             
|                           
|(Issuer's telephone number)

On May 4, 2004, 38,686,202
shares of the Registrants Common Stock, $0.001 par value per share, were
outstanding.

Transitional Small Business Disclosure Format (Check One):  Yes o   No þ



---

# ALLIANCE FIBER OPTIC
PRODUCTS, INC.

# FORM 10-QSB

# QUARTERLY PERIOD ENDED
MARCH 31, 2004

# INDEX

| |                                                                                                    | Page
| | -------------------------------------------------------------------------------------------------- | ----
| | Part I:  Financial Information                                                                     | 1   
| | Item 1:  Financial Statements - Unaudited                                                          | 1   
| | Condensed Consolidated Balance Sheets at December 31, 2003 and March 31, 2004                      | 1   
| | Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2003 and 2004 | 2   
| | Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2003 and 2004 | 3   
| | Notes to Consolidated Financial Statements                                                         | 4   
| | Item 2:  Management's Discussion and Analysis of Financial Condition and Results of Operations     | 8   
| | Item 3:  Controls and Procedures                                                                   | 24  
| | Part II:  Other Information                                                                        | 25  
| | Item 2:  Changes in Securities and Small Business Issuer Purchases of Equity Securities            | 25  
| | Item 6:  Exhibits and Reports on Form 8-K                                                          | 25  
| | Signature                                                                                          | 26  

i

---

PART I: FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

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

|                                                               | Mar. 31, | Dec. 31,
|-------------------------------------------------------------- | -------- | --------
|
|                                                               |          |         
|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                                               |          |         
|Income tax payable                                             |          |         
|Accrued expenses                                               |          |         
|Accrued excess facility charge-short term                      |          |         
|                                                               |          |         
|                                                               |          |         
|Total current liabilities                                      |          |         
|                                                               |          |         
|Other long-term liabilities                                    |          |         
|                                                               |          |         
|                                                               |          |         
|Total liabilities                                              |          |         
|                                                               |          |         
|                                                               |          |         
|Commitments and contingencies (Note 9)                         |          |         
|Stockholders' equity:                                          |          |         
|Common stock, $0.001 par value: 250,000,000 shares authorized; |          |         
|36,504,356 and 38,280,073 shares issued and outstanding at     |          |         
|December 31, 2003 and March 31, 2004, respectively             |          |         
|Additional paid-in-capital                                     |          |         
|Receivables from stockholders                                  |          |         
|Deferred stock-based compensation                              |          |         
|Accumulated deficit                                            |          |         
|Accumulated other comprehensive loss                           |          |         
|                                                               |          |         
|                                                               |          |         
|Stockholders' equity                                           |          |         
|                                                               |          |         
|                                                               |          |         
|Total liabilities and stockholders' equity                     |          |         
|                                                               |          |         

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

1

---

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

|                                             | Three Months Ended Mar. 31, | 
|-------------------------------------------- | --------------------------- | 
|                                             | 2004                        | 
|Revenues                                     |                             | 
|Cost of revenues                             |                             | 
|                                             |                             | 
|                                             |                             | 
|Gross profit (loss)                          |                             | 
|                                             |                             | 
|                                             |                             | 
|Operating expenses:                          |                             | 
|Research and development                     |                             | 
|Sales and marketing                          |                             | 
|General and administrative                   |                             | 
|                                             |                             | 
|                                             |                             | 
|Total operating expenses                     |                             | 
|                                             |                             | 
|                                             |                             | 
|Loss from operations                         |                             | 
|Interest and other income, net               |                             | 
|                                             |                             | 
|                                             |                             | 
|Loss before income taxes                     |                             | 
|Income tax provision                         |                             | 
|                                             |                             | 
|                                             |                             | 
|Net loss                                     |                             | 
|                                             |                             | 
|                                             |                             | 
|Net loss per share:                          |                             | 
|Basic and diluted                            |                             | 
|                                             |                             | 
|                                             |                             | 
|Shares used in computing net loss per share: |                             | 
|Basic and diluted                            |                             | 
|                                             |                             | 

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

2

---

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

|                                                           | Three Months Ended Mar. 31, | 
|---------------------------------------------------------- | --------------------------- | 
|                                                           | 2004                        | 
|Cash flows from operating activities:                      |                             | 
|Net loss                                                   |                             | 
|Adjustments to reconcile net loss to net cash used         |                             | 
|in operating activities:                                   |                             | 
|Depreciation                                               |                             | 
|Amortization of stock-based compensation                   |                             | 
|Provision for inventory                                    |                             | 
|Changes in assets and liabilities, net of amounts          |                             | 
|acquired:                                                  |                             | 
|Accounts receivable                                        |                             | 
|Inventories                                                |                             | 
|Prepaid expenses and other assets                          |                             | 
|Accounts payable                                           |                             | 
|Accrued expenses                                           |                             | 
|Other assets                                               |                             | 
|Other long-term liabilities                                |                             | 
|                                                           |                             | 
|                                                           |                             | 
|Net cash used in operating activities                      |                             | 
|                                                           |                             | 
|                                                           |                             | 
|Cash flows from investing activities:                      |                             | 
|Proceeds from sale or (purchase of) short-term investments |                             | 
|Cash acquired from acquisition                             |                             | 
|Purchase of property and equipment                         |                             | 
|                                                           |                             | 
|                                                           |                             | 
|Net cash provided by or used in investing                  |                             | 
|activities                                                 |                             | 
|                                                           |                             | 
|                                                           |                             | 
|Cash flows from financing activities:                      |                             | 
|Proceeds from the exercise of common stock options         |                             | 
|Proceeds from the repayment of notes receivable            |                             | 
|                                                           |                             | 
|                                                           |                             | 
|Net cash provided by financing activities                  |                             | 
|                                                           |                             | 
|                                                           |                             | 
|Net increase or (decrease) in cash and cash equivalents    |                             | 
|Cash and cash equivalents at beginning of period           |                             | 
|                                                           |                             | 
|                                                           |                             | 
|Cash and cash equivalents at end of period                 |                             | 
|                                                           |                             | 
|                                                           |                             | 
|Supplemental non 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 Condensed Consolidated Financial
Statements.

3

---

ALLIANCE
FIBER OPTIC PRODUCTS, INC.

# NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS

# (Unaudited)

# 1. The Company

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

# 2. Basis of presentation

The
condensed consolidated financial information as of March 31, 2004 included herein is
unaudited, has been prepared by the Company in accordance with generally accepted
accounting principles in the United States of America, and reflects all adjustments,
consisting only of normal recurring adjustments, which in the opinion of management are
necessary to state fairly the Companys consolidated financial position, results of
its consolidated operations, and consolidated cash flows for the periods presented.

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

These
financial statements should be read in conjunction with the Companys audited
consolidated financial statements included in the Companys Annual Report on Form
10-KSB for the year ended December 31, 2003. The results of operations for the three
months ended March 31, 2004 are not necessarily indicative of the results to be expected
for any future periods.

# 3. Recent Accounting
Pronouncements

In
January 2003, the Financial Accounting Standards Board (FASB) issued
Interpretation Number (FIN) 46, Consolidation of Variable Interest
Entities. In general, a variable interest entity is a corporation, partnership,
trust, or any other legal structure used for business purposes that either (a) does
not have equity investors with voting rights or (b) has equity investors that do not
provide sufficient financial resources for the entity to support its activities. FIN 46
requires certain variable interest entities to be consolidated by the primary beneficiary
of the entity if the investors do not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support from other parties. The consolidation
requirements of FIN 46 apply immediately to variable interest entities created after
January 31, 2003. Certain of the disclosure requirements apply to all financial
statements issued after January 31, 2003, regardless of when the variable interest
entity was established. The effective dates of certain elements of FIN 46 have been
deferred. We do not believe that the adoption of this standard will have a material impact
on our consolidated financial statements.

In
December 2003, the Securities and Exchange Commission (SEC) issued Staff Accounting
Bulletin (SAB) No. 104, Revenue Recognition (SAB 104).SAB 104 revises
or rescinds portions of the interpretive guidance included in Topic 13 of the codification
of staff accounting bulletins in order to make this interpretive guidance consistent with
current authoritative accounting and auditing guidance and SEC rules and regulations. The
adoption of SAB 104 had no effect on our results of operations or financial condition.

4

---

# 4. Stock-based
Compensation

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

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):

|                                                        | Quarters Ended March 31, | 
|------------------------------------------------------- | ------------------------ | 
|                                                        | 2004                     | 
|Net loss, as reported:                                  |                          | 
|Add: Stock-based employee compensation expense included |                          | 
|in reported net income                                  |                          | 
|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                                               |                          | 
|                                                        |                          | 
|Shares used in EPS calculation (basic and diluted)      |                          | 
|                                                        |                          | 

# 5. Inventories (in
thousands)

|                | Mar. 31,2004 |  | Dec. 31,2003 |      
|--------------- | ------------ |  | ------------ | -----
|Inventories     |              |  |              |      
|Finished goods  |              |  | $            | 545  
|Work-in-process |              |  |              | 1,488
|Raw materials   |              |  |              | 2,055
|                |              |  |              |      
|                |              | 
|                |              |  | $            | 4,088
|                |              |  |              |      

# 6. Impairment of
Property and Equipment

In
the third quarter of 2002, as a result of a general business decline and reduced headcount
in the United States, the Company consolidated its operations in the United States from
three leased buildings into two buildings in Sunnyvale, California. As a consequence, the
Company recorded excess facility charges of $1.8 million during 2002, comprised of $1.6
million of non-cancelable lease payments and $0.2 million of fixed asset write-off. Cash
payments in the quarter ended March 31, 2004 amounted to $0.2 million and $0.3 million
remains on the condensed consolidated balance sheet in accrued facility charges at March
31, 2004.

5

---

# 7. Net Loss Per Share

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

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

|                                                       | Three Months
Ended Mar. 31, | 
|------------------------------------------------------ | --------------------------- | 
|                                                       | 2004                        | 
|Numerator:                                             |                             | 
|Net loss                                               |                             | 
|                                                       |                             | 
|Denominator:                                           |                             | 
|Shares used in computing net loss per share:           |                             | 
|Weighted average of common shares outstanding          |                             | 
|Less: Weighted average of shares subject to repurchase |                             | 
|                                                       |                             | 
|Basic and diluted                                      |                             | 
|                                                       |                             | 
|Net loss per share:                                    |                             | 
|Basic and diluted                                      |                             | 
|                                                       |                             | 

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

|                                     | Three Months
Ended Mar. 31, | 
|------------------------------------ | --------------------------- | 
|                                     | 2004                        | 
|Options to purchase common stock and |                             | 
|shares subject to repurchase         |                             | 
|                                     |                             | 

6

---

# 8. Comprehensive Loss

Comprehensive
income (loss) is defined as the change in equity of a company during a period resulting
from transactions and other events and circumstances, excluding transactions resulting
from investments by owners and distributions to owners. The difference between net loss
and comprehensive loss for the Company is due to foreign exchange translations adjustments
and unrealized gain (loss) on available-for-sale securities.

The
components of comprehensive loss are as follows (in thousands):

|                                                 | Three Months
Ended Mar. 31, | 
|------------------------------------------------ | --------------------------- | 
|                                                 | 2004                        | 
|Net loss                                         |                             | 
|Cumulative translation adjustments               |                             | 
|Unrealized gain (loss) on short-term investments |                             | 
|                                                 |                             | 
|                                                 |                             | 
|Total comprehensive loss                         |                             | 
|                                                 |                             | 

# 9. Contingencies

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

# 10. Acquisition of Assets

In
January 2004, we acquired substantially all of the assets of Taiwan-based Ritek
Corporations photonic business unit. Through this transaction, we acquired certain
assets that we believe will enable us to complement our existing family of products and
assumed certain pension liabilities. In addition, AFOP received $1.5 million in cash from
Ritek. The assets were acquired by means of a purchase for shares of AFOP common stock

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

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

Prepaid
lease facilities will be amortized over twenty-four months (length of the prepaid lease).

7

---

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

When
used in this discussion, the words expects, anticipates,
believes, estimates, plans, and similar expressions
are intended to identify forward-looking statements. These statements, which include
statements as to critical accounting policies, sources of revenues, revenue levels,
profitability, the fluctuation of our cost of revenues as a percentage of revenues, our
net and operating losses, our net cash flow, the amount and mix of our anticipated
expenditures and expenses, expenditures required to remain competitive, increase or
decrease of our expenses in absolute dollars or as a percentage of revenue, market
conditions, the need for additional inventory reserves or provisions, gross margin as a
percentage of revenue, our reliance on our OPMS products sales levels, reliance on
the commercial success of our DWDM-related products, our success being tied to
relationships with key customers, our deferred stock-based compensation, the adequacy of
our capital resources, the impact of recent accounting pronouncements, period-to-period
comparisons of our operating results, our ability to obtain raw materials and components
and maintain and develop supplier relationships, our ability to establish and maintain
relationships with key customers, our anticipated use of resources, our ability to
maintain appropriate inventory, factors that affect a customers decision to choose a
supplier, our competitors, competition in our industry, our competitive advantage,
consolidation in our industry, our need for additional financing and investments of our
existing cash are subject to risks and uncertainties that could cause actual results to
differ materially from those projected. These risks and uncertainties include, but are not
limited to, those risks discussed below, further decreased demand for our products,
continued economic instability, as well as competition including the impact of competitive
products and pricing, timely design acceptance by our customers, our success attracting
new customers, loss of a key customer, our customers adopting our new products, timely
introduction of new technologies, our ability to ramp new products into volume production,
our ability to attract and retain highly skilled personnel, the accuracy of estimates,
loss of a key supplier, industry wide shifts in supply and demand for optical components
and modules, industry overcapacity, being delisted from the Nasdaq SmallCap Market,
integration of acquired businesses, financial stability in foreign markets and the matters
discussed in Factors That May Affect Results. These forward-looking statements
speak only as of the date hereof. The Company expressly disclaims any obligation or
undertaking to release publicly any updates or revisions to any forward-looking statements
contained herein to reflect any change in the Companys expectations with regard
thereto or any change in events, conditions or circumstances on which any such statement
is based.

This
Managements Discussion and Analysis of Financial Condition and Results of Operations
should be read in conjunction with the section entitled Managements Discussion
and Analysis of Financial Condition and Results of Operations in the Companys
Annual Report on Form 10-KSB, its Consolidated Financial Statement and the notes thereto,
for the year ended December 31, 2003.

8

---

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

# 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.

For
additional information regarding our critical accounting policies and estimates, see the
section entitled Managements Discussion and Analysis of Financial Condition
and Results of Operations in our Annual Report on Form 10-KSB, for the year ended
December 31, 2003.

# 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 started selling our dense wavelength division multiplexing, or DWDM,
and other wavelength management products in July 2000. Since introduction, sales of
DWDM-related products have fluctuated with the overall market for these products.

From
our inception through March 31, 2004, we derived substantially all of our revenues from
our OPMS product line. Our DWDM-related products contributed revenues of $0.4 million and
$0.7 million for the quarters ended March 31, 2003 and March 31, 2004, respectively. In
the quarters ended March 31, 2003 and March 31, 2004, our top 10 customers comprised
48.1% and 52.7% of our revenues, respectively. For the quarters ended March 31, 2003 and
March 31, 2004, no customer accounted for 10% or more of revenues.

We
market and sell our products predominantly through our direct sales force, which we began
building in early 1998.

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.

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

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

9

---

In
connection with the grant of stock options to employees and consultants, we recorded
deferred stock-based compensation of approximately $26.8 million in
stockholders equity prior to our initial public offering, representing the
difference between the estimated fair market value of our common stock and the exercise
price of these options at the date of grant. Deferred stock-based compensation is being
amortized using the graded vesting method, under which each option grant is separated into
portions based on its vesting terms which results in acceleration of amortization expense
for the overall award. The deferred stock-based compensation balance of $0.8 million as of
March 31, 2004 will be fully amortized on an accelerated basis by December 1, 2004.

In
January 2004, we completed the purchase of the assets of Taiwan-based Ritek
Corporations photonic business unit in exchange for 1.7 million shares of AFOP
common stock. The total purchase price was $4.0 million, including $1.5 million in cash
from Ritek. The unit is located in Hsin Chu Industrial Park, Taiwan.

# Results of Operations

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

|                               | Three Months
Ended Mar. 31,
|------------------------------ | ---------------------------
|                               | 2004                       
|Revenues                       |                            
|Cost of revenues:              |                            
|                               |                            
|                               |                            
|Gross profit (loss)            |                            
|Operating expenses:            |                            
|Research and development:      |                            
|Sales and marketing:           |                            
|General and administrative:    |                            
|                               |                            
|                               |                            
|Total operating expenses       |                            
|Loss from operations           |                            
|Interest and other income, net |                            
|                               |                            
|                               |                            
|Loss before income taxes       |                            
|Income tax provision           |                            
|                               |                            
|Net loss                       |                            
|                               |                            

Revenues.Revenues were $2.4 million and $3.0 million for the three months ended
          March 31, 2003 and 2004, respectively. Revenues increased 25.8% from the quarter
          ended March 31, 2003 to the same period in 2004 primarily due to increased
          volume shipments of our products as a result of improving market conditions
          which were somewhat offset by decreasing average selling prices. Revenues from
          our DWDM-related products were $0.4 million and $0.7 million for the three
          months ended March 31, 2003 and 2004, respectively.

Cost
of Revenues.Cost of revenues was $2.3 million and $3.1 million for the three months
ended March 31, 2003 and 2004, respectively. Cost of revenues as a percentage of net
revenues increased from 96.5% for the three months ended March 31, 2003 to 104.2% for the
three months ended March 31, 2004. Cost of revenues for the period ended March 31, 2004
was impacted by inventory charges to reflect lower of cost or market write downs due to
lower average sales prices and provision for excess and obsolete materials resulting from
a reduction in demand for one DWDM product line which resulted in a charge of $0.2
million.

10

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Gross
Profit (Loss).Gross profit (loss) changed from a gross profit of $0.1 million, or
3.5% of revenues, for the three months ended March 31, 2003 to a gross loss of
$0.1 million, or negative 4.2% of revenues, for the same period in 2004. The reasons
for the gross loss were due to lower average selling prices for our products, especially
for one DWDM product line, and additional inventory charges.

We
expect our gross profit as a percentage of revenues to continue to be negatively impacted
in the near term due to decreasing average selling prices. We had approximately $1.9
million in DWDM-related net inventory and $2.2 million in OPMS-related net inventory on
hand at March 31, 2004. Although we continue to take steps to attempt to manage future
inventory levels, we may have to record additional inventory provisions in future periods
if demand for our products decrease below our forecasted levels.

Research
and Development Expenses. Research and development expenses increased from $1.4
million for the three months ended March 31, 2003 to $1.5 million for the same period
in 2004. The increase was primarily due to the increased spending related to Ritek
Corporations photonic business unit which we acquired in January 2004. As a
percentage of revenues, research and development expenses decreased from 58.8% in the
three months ended March 31, 2003 to 51.2% for the same period in 2004. We expect research
and development expenses on our product development efforts to remain relatively flat due
to the uncertainty about customer demand for our products in the current economic
environment.

Sales
and Marketing Expenses. Sales and marketing expenses decreased from $0.6 million, or
24.0% of revenues, for the three months ended March 31, 2003 to $0.5 million, or 16.4% of
revenues, for the same period in 2004. The decrease was primarily due to tighter controls
over discretionary expenses. We expect sales and marketing expenses to remain relatively
flat due to uncertainty about customer demand for our products in the current economic
environment.

General
and Administrative Expenses. General and administrative expenses remained flat at $0.9
million for the three months ended March 31, 2003 and 2004, respectively. As a percentage
of revenues, general and administrative expenses decreased from 39.9% in the three months
ended March 31, 2003 to 30.1% for the same period in 2004. We expect to maintain general
and administrative expenses at the same level as the first three months of 2004 with the
exception of professional and legal services which may increase due to higher fees and
costs associated with compliance with the Sarbanes-Oxley Act and Nasdaq corporate
governance requirements.

Stock-Based
Compensation. Total stock based compensation decreased from $0.4 million for the three
months ended March 31, 2003 to $0.1 million for the same period in 2004. 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.

Interest
and Other Income, Net.Interest and other income, net, was $0.2 million for the three
months ended March 31, 2003 and 2004, respectively.

Income Taxes.  We had no income tax provision for the three months ended March 31, 2003 or 2004.

# Liquidity and Capital
Resources

Since
inception, we have financed our operations primarily through private sales of convertible
preferred stock and bank debt. Additionally, in November 2000, we completed our initial
public offering of common stock, raising approximately $44.4 million, net of costs
and expenses. At March 31, 2004, we had cash and cash equivalents of $13.1 million
and short-term investments of $22.0 million.

Net
cash used in operating activities was $2.4 million for the three months ended March 31,
2004 and was primarily due to our net loss of $2.8 million.

11

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Cash
generated in investing activities was $10.1 million for the three months ended March 31,
2004 and cash used in investing activities was $4.2 million for the three months ended
March 31, 2003. In the three months ended March 31, 2004, $8.9 million was generated from
the maturity of high-grade, short-term investments, $1.5 million was generated from the
asset acquisition from Ritek, and $0.3 million was used to acquire property and equipment.
In the three months ended March 31, 2003, $4.0 million was invested in high-grade,
short-term investments, while $0.1 million was used to acquire property and equipment.

Cash
generated by financing activities was $0.4 million and $0.3 million for the three months
ended March 31, 2004 and 2003, respectively, resulting from proceeds from exercise of
options to purchase common stock and repayment of notes receivable. For the three months
ended March 31, 2003 and 2004, proceeds from the repayment of notes receivable were at
$0.3 million each.

In
July and December 2000, we entered into leases for 10,500 and 10,600 square feet of space,
respectively, near our existing facility in Sunnyvale, California. In September 2002, we
consolidated our operations in California into two buildings and vacated the 10,600 square
foot facility. As a result of the consolidation, we recorded an excess facility charge of
$1.8 million in the year ended December 31, 2002. Additionally, in December 2000, the
Company purchased approximately 8,200 square feet of space immediately adjacent to our
leased facility in Tu-Cheng City, Taiwan for $0.8 million. In April 2001, we entered into
a lease in China but cancelled it, without penalty, in the third quarter of 2001. We had a
lease for a facility near the Shenzhen area of China totaling approximately 12,000 square
feet, which expired in December 2002. In August 2002, we entered into a new lease for
62,000 square foot facility near the same Shenzhen area which will expire in July 2007. In
April 2004, we entered into a new lease for 34,800 square feet of space near our existing
facility in Sunnyvale, California which we will occupy once our other existing leases in
Sunnyvale expire.

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 any potential
acquisitions, may require additional funding. If cash generated from operations is
insufficient to satisfy our long-term liquidity requirements, we may need to raise capital
through additional equity or debt financings or additional credit facilities. If
additional funds are raised through the issuance of securities, these securities could
have rights, preferences and privileges senior to holders of common stock, and the terms
of any debt facility could impose restrictions on our operations. The sale of additional
equity or debt securities could result in additional dilution to our stockholders, and
additional financing may not be available in amounts or on terms acceptable to us, if at
all. If we are unable to obtain additional financing, we may be required to reduce the
scope of our planned product development and marketing efforts, which could harm our
business, financial condition and operating results.

# Recent Accounting
Pronouncements

In
January 2003, the Financial Accounting Standards Board (FASB) issued
Interpretation Number (FIN) 46, Consolidation of Variable Interest
Entities. In general, a variable interest entity is a corporation, partnership,
trust, or any other legal structure used for business purposes that either (a) does
not have equity investors with voting rights or (b) has equity investors that do not
provide sufficient financial resources for the entity to support its activities. FIN 46
requires certain variable interest entities to be consolidated by the primary beneficiary
of the entity if the investors do not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support from other parties. The consolidation
requirements of FIN 46 apply immediately to variable interest entities created after
January 31, 2003. Certain of the disclosure requirements apply to all financial
statements issued after January 31, 2003, regardless of when the variable interest
entity was established. The effective dates of certain elements of FIN 46 have been
deferred. We do not believe that the adoption of this standard will have a material impact
on our consolidated financial statements.

In
December 2003, the Securities and Exchange Commission (SEC) issued Staff Accounting
Bulletin (SAB) No. 104, Revenue Recognition (SAB 104).SAB 104 revises
or rescinds portions of the interpretive guidance included in Topic 13 of the codification
of staff accounting bulletins in order to make this interpretive guidance consistent with
current authoritative accounting and auditing guidance and SEC rules and regulations. The
adoption of SAB 104 had no effect on our results of operations or financial condition.

12

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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 operating losses of approximately $2.7 million and $2.8 million in the first
quarter of fiscal 2003 and 2004, 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 March 31, 2004, we had an accumulated deficit of approximately $63.3
million.

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

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

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

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

Sales
of our OPMS products accounted for over 78% of our revenues in the quarter ended March 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 price of, or
demand for, these products, or failure to increase their market acceptance, would
seriously harm our business. In addition, we believe that our future growth and a
significant portion of our future revenues will depend on the commercial success of our
DWDM-related products, which we began shipping commercially in July 2000. Demand for these
products have fluctuated over the past few years as demand declined sharply starting in
mid fiscal 2001 and then increased beginning in 2003. In the quarter ended March 31, 2004,
we wrote off $0.2 million of DWDM-related inventory. If demand for these products does not
continue to increase and our target customers do not continue to adopt and purchase our
DWDM-related products, our revenues may decline further and we may have to write-off
additional inventory that is currently on our books.

13

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

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

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

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

|  |                                                                                                                                                              
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------
|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
downturn in the economy has 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,
DiCon Fiberoptics, Gould, JDS Uniphase, Lucent, Luminent (a subsidiary of MRV
Communications, Inc.), Oplink, Stratos Lightwave and Tyco Electronics. We believe that we
primarily compete with diversified suppliers for the majority of our product line and to a
lesser extent with niche companies that offer a more limited product line. Competitors in
any portion of our business may also rapidly become competitors in other portions of our
business. In addition, our industry has recently experienced significant consolidation,
and we anticipate that further consolidation will occur. This consolidation has further
increased competition.

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

14

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

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

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

We
rapidly expanded our operations domestically and internationally in the final two quarters
of 2000. We 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 March 31, 2004, we had a total of 76 full-time employees in Sunnyvale, California,
227 full-time employees in Taiwan, and 150 full-time employees in China. Matching the
scale of our operations with the recent demand fluctuations, combined with the challenges
of expanding and managing geographically dispersed operations, has placed, and will
continue to place, a significant strain on our management and resources. To manage the
expected fluctuations in our operations and personnel, we will be required to:

|  |                                                                                                                                              
|- | ---------------------------------------------------------------------------------------------------------------------------------------------
|o | improve existing and implement new operational, financial and management controls, reporting systems and procedures;                         
|  |                                                                                                                                              
|o | hire, train, motivate and manage additional qualified  personnel, 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 growth in an efficient and timely manner, our business will be
severely harmed.

Our
success also depends, to a large degree, on the efficient and uninterrupted operation of
our facilities. We have expanded our manufacturing facilities in Taiwan and manufacture
many of our products there. During the third quarter of 2002, we entered into a 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.

15

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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 $1.4 million and $1.5 million for the quarters ended March 31, 2003 and
2004, respectively. We intend to continue to invest a substantial amount of funds in our
research and product development efforts, which could have a negative impact on our
earnings in future periods.

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

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

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

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

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

The
communications industry is experiencing rapid consolidation and realignment, as industry
participants seek to capitalize on the rapidly changing competitive landscape developing
around the Internet and new communications technologies such as fiber optic networks. As
the communications industry consolidates and realigns to accommodate technological and
other developments, our customers may consolidate or align with other entities in a manner
that results in a decrease in demand for our products.

16

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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
contributed to a decline in our gross margins in the quarter and impacted our results of
operations.

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

Communications
service providers and optical systems manufacturers typically require that suppliers
commit to provide specified quantities of products over a given period of time. If we are
unable to commit to deliver quantities of our products to satisfy a customers
anticipated needs, we will lose the order and the opportunity for significant sales to
that customer for a lengthy period of time. In addition, we would be unable to fill large
orders if we do not have sufficient manufacturing capacity to enable us to commit to
provide customers with specified quantities of products. However, if we build our
manufacturing capacity and inventory in excess of demand, as we have done in the past, we
may produce excess inventory that may have to be reserved or written off. In the quarter
ended March 31, 2004, we wrote off $0.2 million of DWDM-related inventory.

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, 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. 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.

17

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

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

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

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

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

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

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

18

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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:

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|  |                                                               
|- | --------------------------------------------------------------
|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.

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

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

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

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

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, we recently 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 may 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 will
affect our charter documents if our common stock is not returned to being listed on the
Nasdaq National Market. For example, we will 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 will have dissenting stockholder rights under both California
and Delaware law. Any of these changes will result in additional expense as we will 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.

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

Beginning
at the commencement of trading on November 8, 2002, our common stock was listed on the
Nasdaq SmallCap Market. The transfer of our common stock to the Nasdaq SmallCap Market
will result in decreased liquidity of our common stock and may further decrease the price
per share of our common stock. 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. The minimum bid price
for our common stock has been below $1.00 since May 3, 2004. 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.

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

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

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

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

Our
industry is very competitive and is characterized by frequent intellectual property
litigation based on allegations of infringement of intellectual property rights. Numerous
patents in our industry have already been issued, and as the market further develops and
participants in our industry obtain additional intellectual property protection,
litigation is likely to become more frequent. From time to time, third parties may assert
patent, copyright, trademark and other intellectual property rights to technologies or
rights that are important to our business. In addition, we have and 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.

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

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

For
the year ended December 31, 2003 and the three months ended March 31, 2004, sales to
customers located outside of North America were 10.0% and 9.7% of our revenues,
respectively. In order to expand our business, we must increase our sales to customers
located outside of North America. We have limited experience in marketing and distributing
our products internationally and in developing versions of our products that comply with
local standards. Our international sales will be limited if we cannot establish
relationships with international distributors, establish additional foreign operations,
expand international sales channels, hire additional personnel and develop relationships
with international communications equipment manufacturers. Even if we are able to
successfully continue international operations, we may not be able to maintain or increase
international market demand for our products.

The outbreaks of Severe Acute
Respiratory Syndrome, or SARS, and of the Bird flu pose a risk to the Companys
business.

The
outbreaks of 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. An
outbreak of 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 SARS or the bird flu, we may not
be able to obtain the parts necessary to make our products which could negatively impact
our revenues. In addition, if any of our customers experiences a significant disruption in
their business as a result of SARS or the bird flu, they may delay or cancel purchases of
our products which could harm our business. Also, certain of our key employees travel to
Asia to oversee our Asian operations and to meet with our suppliers and customers. If any
of our key employees are infected with SARS 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.

22

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

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

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# ITEM 3: CONTROLS AND
PROCEDURES

(a)
          Evaluation of disclosure controls and procedures. We maintain
          disclosure controls and procedures, as such term is defined in Rule
          13a-15(e) under the Securities Exchange Act of 1934 (the Exchange
          Act), that are designed to ensure that information required to be
          disclosed by us in reports that we file or submit under the Exchange Act is
          recorded, processed, summarized, and reported within the time periods specified
          in Securities and Exchange Commission rules and forms, and that such information
          is accumulated and communicated to our management, including our Chief Executive
          Officer and Acting Chief Financial Officer, as appropriate, to allow timely
          decisions regarding required disclosure. In designing and evaluating our
          disclosure controls and procedures, management recognized that disclosure
          controls and procedures, no matter how well conceived and operated, can provide
          only reasonable, not absolute, assurance that the objectives of the disclosure
          controls and procedures are met. 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 Quarterly Report on Form
10-QSB, our Chief Executive Officer and Acting Chief Financial Officer have concluded
that, subject to the limitations noted above, our disclosure controls and procedures were
effective to ensure that material information relating to us, including our consolidated
subsidiaries, is made known to them by others within those entities, particularly during
the period in which this Quarterly Report on Form 10-QSB was being prepared.

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

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# PART II: OTHER
INFORMATION

# ITEM 2: CHANGES IN SECURITIES
AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES

(c)
          On January 16, 2004, we issued 1.7 million shares of our common stock in
          connection with our purchase of the photonics business unit of Ritek
          Corporation. The total purchase price was $4.0 million, comprised of cash and
          other assets. The issuance of the common stock was considered to be exempt from
          registration under the Securities Act in reliance on Section 4(2) of such Act or
          Regulation D promulgated thereunder.

# ITEM 6: EXHIBITS AND
REPORTS ON FORM 8-K

(a) Exhibits

|Exhibit |                                                                                                                                                                                                                                  
|------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
|10.6#   | Amended and Restated Alliance Fiber Optic Products, Inc. 2000 Employee Stock Purchase Plan
(incoporated by reference to Exhibit 10.6 to Amendment No. 4 to the Company's Registration
Statement on Form S-1 (File No. 333-45482))
|        |                                                                                                                                                                                                                                  
|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. § 1350).                                                                                                                     
|        |                                                                                                                                                                                                                                  
|32.2*   | Statement of Acting Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350).                                                                                                              

_________________

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

(b)
          Reports on Form 8-K.

On
April 29, 2004, we filed a current report on Form 8-K furnishing under Item 12 the
Companys press release relating to its financial results for the quarter ended March
31, 2004.

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# SIGNATURE

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

Dated:  May 10, 2004

| |                                     |                                                        
| | ----------------------------------- | -------------------------------------------------------
| | ALLIANCE FIBER OPTIC PRODUCTS, INC.
| |                                     |                                                        
| | By                                  | /s/ Anita K. Ho                                        
| |                                     | Anita K. Ho                                            
| |                                     | Acting Chief Financial Officer and Corporate Controller
| |                                     | (Principal Financial and Accounting Officer and Duly   
| |                                     | Authorized Signatory)                                  

26

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