# UNITED STATES

# SECURITIES AND
EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

_________________

# FORM 10-Q

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

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

| |                                                  
| | -------------------------------------------------
| | For the quarterly period ended September 30, 2006

| |   |                                                  
| | - | -------------------------------------------------
| | 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 registrant as specified in its charter)

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

|                                                
|------------------------------------------------
|275 Gibraltar Drive, Sunnyvale, California 94089
|                                                
|(Address of Principal Executive Offices)        

|                                                   
|---------------------------------------------------
|(408) 736-6900                                     
|                                                   
|(Registrant's telephone number including area code)

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

Indicate by check mark whether the registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See
definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act).
 Large Accelerated Filer  o Accelerated Filer  o   Non-Accelerated Filer  þ

Indicate by check mark whether the registrant is a shell company
(as defined in Rule 12b-2 of the Exchange Act).   Yes o   No þ

On November 3, 2006, 40,378,748 shares of the registrants Common Stock, $0.001 par value per share, were outstanding.



---

# ALLIANCE FIBER OPTIC
PRODUCTS, INC.

# FORM 10-Q

# QUARTERLY PERIOD ENDED
SEPTEMBER 30, 2006

# INDEX

|                                                                                              | Page
|--------------------------------------------------------------------------------------------- | ----
|                                                                                              |     
|PART I: FINANCIAL INFORMATION                                                                 | 1   
|                                                                                              |     
|ITEM 1: FINANCIAL STATEMENTS                                                                  | 1   
|                                                                                              |     
|Condensed Consolidated Balance Sheets at September 30, 2006 (Unaudited)                       |     
|and December 31, 2005                                                                         | 1   
|                                                                                              |     
|Condensed Consolidated Statements of Operations for the                                       |     
|Three and Nine Months Ended September 30, 2006 and 2005 (Unaudited)                           | 2   
|                                                                                              |     
|Condensed Consolidated Statements of Cash Flows for the                                       |     
|Nine Months Ended September 30, 2006 and 2005 (Unaudited)                                     | 3   
|                                                                                              |     
|NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                          | 4   
|                                                                                              |     
|ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 14  
|                                                                                              |     
|ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            | 20  
|                                                                                              |     
|ITEM 4: CONTROLS AND PROCEDURES                                                               | 21  
|                                                                                              |     
|PART II: OTHER INFORMATION                                                                    | 22  
|                                                                                              |     
|ITEM 1A: RISK FACTORS                                                                         | 22  
|                                                                                              |     
|ITEM 6: EXHIBITS                                                                              | 33  
|                                                                                              |     
|SIGNATURE                                                                                     | 33  

i

---

# PART I: FINANCIAL INFORMATION

# ITEM 1: FINANCIAL STATEMENTS

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

|                                                               | September 30,2006 | December 31,2005
|-------------------------------------------------------------- | ----------------- | ----------------
|Assets                                                         |                   |                 
|Current assets:                                                |                   |                 
|Cash and cash equivalents                                      |                   |                 
|Short-term investments                                         |                   |                 
|Accounts receivable, net                                       |                   |                 
|Inventories, net                                               |                   |                 
|Prepaid expense and other current assets                       |                   |                 
|                                                               |                   |                 
|                                                               |                   |                 
|Total current assets                                           |                   |                 
|                                                               |                   |                 
|Property and equipment, net                                    |                   |                 
|Other assets                                                   |                   |                 
|                                                               |                   |                 
|                                                               |                   |                 
|Total assets                                                   |                   |                 
|                                                               |                   |                 
|                                                               |                   |                 
|Liabilities and Stockholders' Equity                           |                   |                 
|Current liabilities:                                           |                   |                 
|Accounts payable                                               |                   |                 
|Accrued expenses                                               |                   |                 
|Current portion of bank loan                                   |                   |                 
|                                                               |                   |                 
|                                                               |                   |                 
|Total current liabilities                                      |                   |                 
|Other long-term liabilities                                    |                   |                 
|Bank loan                                                      |                   |                 
|Other long-term liabilities                                    |                   |                 
|                                                               |                   |                 
|                                                               |                   |                 
|Total long term liabilities                                    |                   |                 
|                                                               |                   |                 
|                                                               |                   |                 
|Total liabilities                                              |                   |                 
|                                                               |                   |                 
|                                                               |                   |                 
|Commitments and contingencies (Note 7)                         |                   |                 
|Stockholders' equity:                                          |                   |                 
|Common stock, $0.001 par value: 250,000,000 shares authorized; |                   |                 
|40,272,849 and 39,719,351 shares issued and outstanding at     |                   |                 
|September 30, 2006 and December 31, 2005, respectively         |                   |                 
|Additional paid-in-capital                                     |                   |                 
|Accumulated deficit                                            |                   |                 
|Accumulated other comprehensive income (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 September 30, |  | Nine Months Ended September 30, |       
|----------------------------------------------------- | -------------------------------- |  | ------------------------------- | ------
|                                                      | 2006                             |  | 2005                            |       
|Revenues                                              |                                  |  | $                               | 7,573 
|Cost of revenues                                      |                                  |  |                                 | 5,402 
|                                                      |                                  |  |                                 |       
|Gross profit                                          |                                  |  |                                 | 2,171 
|                                                      |                                  |  |                                 |       
|                                                      |                                  |  |                                 |       
|Operating expenses:                                   |                                  | 
|Research and development                              |                                  |  |                                 | 815   
|Sales and marketing                                   |                                  |  |                                 | 543   
|General and administrative                            |                                  |  |                                 | 789   
|                                                      |                                  |  |                                 |       
|Total operating expenses                              |                                  |  |                                 | 2,147 
|                                                      |                                  |  |                                 |       
|Income(loss) from operations                          |                                  |  |                                 | 24    
|Interest and other income, net                        |                                  |  |                                 | 334   
|                                                      |                                  |  |                                 |       
|Net income (loss)                                     |                                  |  |                                 | 358   
|                                                      |                                  |  |                                 |       
|Net income (loss) per share:                          |                                  | 
|Basic                                                 |                                  |  | $                               | 0.01  
|                                                      |                                  |  |                                 |       
|Diluted                                               |                                  |  | $                               | 0.01  
|                                                      |                                  |  |                                 |       
|Shares used in computing net income (loss) per share: |                                  | 
|Basic                                                 |                                  | 
|                                                      |                                  |  |                                 | 40,205
|                                                      |                                  |  |                                 |       
|Diluted                                               |                                  | 
|                                                      |                                  |  |                                 | 43,728
|                                                      |                                  |  |                                 |       
|                                                      |                                  |  |                                 |       

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, excpet share data)

|                                                             | Nine Months Ended September 30,
|------------------------------------------------------------ | -------------------------------
|
|Cash flows from operating activities:                        |                                
|Net Income(loss)                                             |                                
|Adjustments to reconcile net loss to net cash used           |                                
|in operating activities:                                     |                                
|Depreciation and amortization                                |                                
|Disposal of property and equipment                           |                                
|Amortization of stock-based compensation                     |                                
|Provision for inventory obsolescence                         |                                
|Changes in assets and liabilities:                           |                                
|Accounts receivable                                          |                                
|Inventories                                                  |                                
|Prepaid expenses and other current assets                    |                                
|Accounts payable                                             |                                
|Accrued expenses                                             |                                
|Other long-term liabilities                                  |                                
|                                                             |                                
|Net cash provided by (used in) operating activities          |                                
|                                                             |                                
|Cash flows from investing activities:                        |                                
|Purchase of short-term investments                           |                                
|Proceeds from sales and maturities of short-term investments |                                
|Purchase of of property and equipment                        |                                
|                                                             |                                
|Net cash provided by or (used in) investing activities       |                                
|                                                             |                                
|Cash flows from financing activities:                        |                                
|Proceeds from issuance of common stock under ESPP            |                                
|Proceeds from the exercise of common stock options           |                                
|Proceeds of bank borrowings                                  |                                
|Repayment of bank borrowings                                 |                                
|                                                             |                                
|Net cash provided by financing activities                    |                                
|                                                             |                                
|Effect of exchange rate changes on cash and cash equivalents |                                
|                                                             |                                
|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                   |                                
|                                                             |                                

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. Summary of
Significant Accounting Policies

The Company

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

Basis of presentation

The condensed consolidated financial
 information as of September 30, 2006 included herein is unaudited, has been prepared by the Company
in accordance with generally accepted accounting principles in the United States of America, and reflects all adjustments, consisting
only of normal recurring adjustments, which in the opinion of management are necessary to state fairly the Company's consolidated
financial position, results of its consolidated operations, and consolidated cash flows for the periods presented.

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

These financial statements should be
read in conjunction with the Company's audited consolidated financial statements included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2005. The results of operations for the three and nine months
ended September 30, 2006 are not necessarily indicative of the results to be expected for any future periods.

Revenue Recognition

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

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

Cash and Cash Equivalents

The
Company considers all highly liquid instruments with a maturity of three months or less
when purchased to be cash equivalents. Cash equivalents consist primarily of market rate
accounts, municipal bonds, and highly rated commercial paper that are stated at cost,
which approximates fair value.

4

---

Concentrations of Risk

The Company's dense
wavelength  division  multiplexing  ("DWDM")  related  products  contributed  revenues of $2.9
million and $7.0 million for the three and nine months ended  September  30,  2006,  respectively  and $1.4 million
and $5.1 million for the three and nine months ended  September  30, 2005,  respectively.  In the nine months ended
September  30, 2006 and  September  30,  2005,  the  Company's  top 10 customers  comprised  58.1% and 58.2% of its
revenues,  respectively.  For the nine months ended  September 30, 2006, one customer  accounted for 13.4% of total
revenues.  For the nine months ended  September  30, 2005,  one customers  accounted  for 11.0% of total  revenues,
respectively.

# 2. Recent Accounting
Pronouncements

In September 2006, the Financial Accounting Standards Board ("FASB") issued SFAS No. 157 ("FAS 157"), "Fair Value
Measurements." Among other requirements, FAS 157 defines fair value and establishes a framework for measuring
fair value and also expands disclosure about the use of fair value to measure assets and liabilities. FAS 157 is
effective beginning the first fiscal year that begins after November 15, 2007. The Company is currently
evaluating the impact of FAS 157 on our financial position and results of operations.


        In June 2006, the FASB issued  Interpretation  No. 48, "Accounting for Uncertainty in Income
Taxes an  interpretation of FASB Statement No. 109" ("FIN 48"). This interpretation  clarifies the accounting for uncertainty in income
taxes  recognized in an  enterprise's  financial  statements  in  accordance  with SFAS No. 109,  "Accounting  for Income  Taxes." This
interpretation  prescribes a recognition  threshold and measurement  attribute for the financial statement  recognition and measurement
of a tax  position  taken or  expected  to be taken in a tax return.  This  interpretation  also  provides  guidance on  derecognition,
classification,  interest and  penalties,  accounting in interim  periods,  disclosure and  transition.  FIN 48 is effective for fiscal
years  beginning  after  December  15,  2006.  The Company is currently  evaluating  the impact of adopting FIN 48 on the  Consolidated
Financial Statements.

In March 2006, the FASB issued
Statement of Financial  Accounting  Standard No. 156,  "Accounting for Servicing of Financial Assets  an
amendment of FASB  Statement  No. 140".  SFAS 156 amends SFAS  Statement  No.140,  "Accounting  for Transfers and Servicing of Financial
Assets and  Extinguishments of Liabilities",  with respect to the accounting for separately  recognized  servicing assets and servicing
liabilities.  The Statement  addresses the recognition and measurement of separately  recognized  servicing  assets and liabilities and
provides  an  approach  to  simplify  efforts to obtain  hedge-like  (offset)  accounting.  SFAS 56 will be adopted  January 1, 2007 as
required by the statement.  The Company does not believe  adoption of SFAS 156 will have a material  effect on its financial  position,
results of operations, or cash flows.

In  February 2006,  the FASB issued
SFAS No. 155,  "Accounting for Certain Hybrid  Financial  Instruments."  SFAS No. 155 permits fair
value  remeasurement  for any  hybrid  financial  instrument  that  contains  an  embedded  derivative  that  otherwise  would  require
bifurcation.  As of March 31,  2006, the Company did not have any hybrid financial instruments subject to the fair value election under
SFAS  No. 155.   The Company is  required to adopt SFAS  No. 155  effective  at the  beginning  of 2008.  The Company  does not believe
adoption of SFAS 155 will have a material effect on its financial position, results of operations, or cash flows.

        Other recent  accounting  pronouncements  issued by the FASB  (including  its Emerging
Issues Task Force),  the American  Institute of
Certified  Public  Accountants  ("AICPA")  and the SEC did not or are not  believed  by  management  to have a  material  impact on the
Company's present or future consolidated financial statements.

# 3. Stock-based
Compensation

Effective January 1,  2006,
the Company adopted the provisions of FASB Statement No. 123 (revised 2004),  "Share-Based Payment" and the
Securities  and Exchange  Commission  Staff  Accounting  Bulletin  No. 107  (collectively,  "Statement  No. 123(R)"),  which  establish
accounting for  share-based  payment  ("SBP") awards  exchanged for employee  services and requires  companies to expense the estimated
fair value of these awards over the requisite employee service period.

        Prior to January 1, 2006,  the Company  accounted  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 EITF Issue No. 96-18, which require the award to be recorded at its fair value.

5

---

Statement  No. 123(R)  requires
companies to record  compensation  expense for stock  options  measured at fair value,  on the date of
grant,  using an  option-pricing  model.  The fair value of stock options is determined using the Binomial Lattice Model instead of the
Black-Scholes Model previously  utilized under Statement No. 123.  The Company believes that the former represents a more likely
projection of actual outcomes.

        The Company  adopted the modified  prospective  transition  method provided for under
 Statement No. 123(R) and,  accordingly,  has not
restated prior period amounts.  Under this  transition  method,  compensation  expense for the three and nine months ended September 30, 2006
includes  compensation  expense for all SBP awards granted prior to, but not yet vested as of, January 1,  2006 based on the grant date
fair value estimated in accordance with the original  provisions of Statement  No. 123.  Stock-based  compensation  expense for all SBP
awards granted after  January 1,  2006 is based on the grant date fair value  estimated in accordance  with the provisions of Statement
No. 123(R).  Stock-based  compensation  expense  includes an estimate for  forfeitures  and is recognized over the expected term of the
award on a  straight-line  basis.  The Company  evaluated  the need to record a  cumulative  effect  adjustment  relating to  estimated
forfeitures for unvested previously issued awards, and the impact was not deemed to be material.

        As a result of adopting  Statement  No. 123(R),  on January 1, 2006, the Company's
 income before income tax and net
income for the three months ended  September  30, 2006 was  $358,000,  or $83,000 lower than if it had continued to
account for share-based  compensation  under APB Opinion 25. The Company's  income before income tax and net income
for the nine months ended  September  30, 2006 was $4,000,  or $192,000  lower than if it had  continued to account
for  share-based  compensation  under  Opinion 25. The  adoption of Statement  No.  123(R) did not impact basic and
diluted income and loss per share for the three and nine months ended September 30, 2006.


        Statement  No. 123(R)  requires  that the realized tax benefit  related to the excess
of the  deductible  amount over the  compensation
expense  recognized be reported as a financing cash flow rather than as an operating  cash flow, as required under previous  accounting
guidance. The Company does not recognize any tax benefit related to this based on Company's historical operating  performance,  lack of
taxable income and the accumulated deficit.

        As of September 30, 2006, there was $0.4 million of total  unrecognized  compensation
 cost related to non-vested  share-based  compensation
arrangements granted under the Company's various option plans. The cost is expected to be recognized over a period of 3.25 years.

        The  following  table  presents  the  Company's  pro forma net income and basic and
 diluted net income per share for the three and six
months ended September 30, 2005 had  compensation  expense been  determined  in  accordance  with the fair value method of accounting at the
grant dates for awards under the Company's various stock-based compensation plans:

6

---

|                                                   | Three Months Ended | Nine Months Ended
|-------------------------------------------------- | ------------------ | -----------------
|
|Net loss, as reported                              |                    | $   (558)        
|Deduct: Total stock-based employee compensation    |                    |                  
|expense determined under the fair value method for |                    |                  
|all awards, net of related taxes                   |                    | $   (116)        
|                                                   |                    |                  
|Pro forma net loss                                 |                    | $   (674)        
|                                                   |                    |                  
|Net loss per share                                 |                    |                  
|Basic and Diluted - as reported                    |                    | $   (0.01)       
|Basic and Diluted - pro forma                      |                    | $   (0.02)       
|                                                   |                    |                  
|Shares used in EPS calculation (basic and diluted) |                    | $   39,405       
|                                                   |                    |                  

For the three and nine months
ended September 30, 2005, the fair value of SBP awards was estimated using the  Black-Scholes  valuation model,
with the following weighted-average assumptions and fair values as follows:

|                                     | Three Months Ended | Nine Months Ended
|------------------------------------ | ------------------ | -----------------
|
|Volatility (percent)*                |                    | 46.2             
|Expected term (in years)**           |                    | 4                
|Risk-free interest rate (percent)*** |                    | 4.04             
|Expected dividend rate (percent)     |                    | --               
|Weighted-average fair value per      |                    |                  
|option granted                       |                    | N/A              

* Volatility is measured using historical daily price changes of the Company's common stock over the expected life of the option

** The expected term  represents the weighted  average period the option is expected to be  outstanding  and is based  primarily on the
historical exercise behavior of employees.

*** The risk free interest rate is based on the U.S.  Treasury  zero-coupon  yield with a maturity that  approximates the expected life
of the option.

N/A:  There were no options granted during the period.

        For the three and nine months ended Septemebr 30, 2006, the fair value of SBP awards
were estimated using the Binomial Lattice valuation
model, with the following weighted-average assumptions and fair values as follows:

7

---

|                                     | Three Months Ended | Nine Months Ended
|------------------------------------ | ------------------ | -----------------
|
|Volatility (percent)*                |                    | 36.7             
|Expected term (in years)**           |                    | 4                
|Risk-free interest rate (percent)*** |                    | 4.74             
|Expected dividend rate (percent)     |                    | --               
|Forfeiture rate (percent)****        |                    | 10               
|Weighted-average fair value per      |                    |                  
|granted                              |                    | $        0.71    

* Volatility is projected using Industry Analysis forecasts for earnings, earnings per share, and stock price, and the Company's earning forecast.

** The expected term  represents the weighted  average period the option is expected to be  outstanding  and is based  primarily on the
historical exercise behavior of employees.

*** The risk free interest rate is based on the U.S.  Treasury  zero-coupon  yield with a maturity that  approximates the expected life
of the option.

**** Forfeiture rate is the estimated percentage of options forfeited by employees by leaving or being terminated before vesting.

At September 30,  2006,  the  Company
had two  stock-based  compensation  plans.  They are:  (a) 1997 Stock  Option Plan and (b) 2000 Stock
Incentive Plan, which are described below.

(a) 1997 Stock Option Plan

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

(b) 2000 Stock Incentive Plan

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

        The following information relates to the stock option activity for the nine months ended September 30, 2006:

8

---

|                                                  | Nine Months EndedSeptember 30, 2006
|------------------------------------------------- | -----------------------------------
|
|Outstanding at December 31, 2005                  |                                    
|Granted                                           |                                    
|Exercised                                         |                                    
|Forfeited                                         |                                    
|Outstanding at September 30, 2006                 |                                    
|Vested and expected to vest at September 30, 2006 |                                    
|Exercisable at September 30, 2006                 |                                    

The aggregate  intrinsic  value in the table above  represents the total pre-tax
intrinsic  value (the  difference
between  the  Company's  closing  stock price on the last  trading day of the third  quarter of fiscal 2006 and the
exercise  price,  multiplied  by the number of  in-the-money  options)  that would have been received by the option
holders had all option  holders  exercised  their options on September 30, 2006.  This amount  changes based on the
fair market value of the  Company's  stock.  The total  intrinsic  value of options  exercised for the three months
ended  September  30, 2006 and 2005 was $25,000 and $82,000,  respectively.  The total  intrinsic  value of options
exercised for the nine months ended September 30, 2006 and 2005 was $327,000 and $161,000, respectively.


         No options were
granted during the quarter ended September 30, 2005.

        The expected dividend rate is 0% for both three month periods ended September 30, 2006
and 2005 respectively.

        Cash  received  from option  exercises  during the three and nine months ended
September  30, 2006 was $26,000 and
$194,000,  respectively,  and is included within the financing activities section in the accompanying  consolidated
statements of cash flows.


Employee Stock Purchase Plan

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

9

---

The following information relates to the plan:

|Additional Information About ESPP                                    |  |   |        
|-------------------------------------------------------------------- |  | - | -------
|Weighted average fair value per share of purchase                    |  | $ | 0.71   
|Total compensationn expense for ESPP                                 |  | $ | 22,975 
|Total amount of cash received from the puchase of stock through ESPP |  | $ | 200,374
|Total intrinsic value of ESPP stock purchased as September 30, 2006  |  | $ | 223,598

# 4. Inventories, net (in
thousands)

|                | September 30, 2006 | December 31, 2005
|--------------- | ------------------ | -----------------
|                |                    |                  
|Inventories     |                    |                  
|Finished goods  |                    | $   1,691        
|Work-in-process |                    | 1,872            
|Raw materials   |                    | 1,249            
|                |                    |                  
|                |                    | $   4,812        
|                |                    |                  
|                |                    |                  

# 5. 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 as the effect of potential  common shares
would be anti-dilutive.

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):

10

---

|                                                       | Three Months Ended September 30, |  | Nine Months Ended September 30, |       
|------------------------------------------------------ | -------------------------------- |  | ------------------------------- | ------
|                                                       | 2006                             |  | 2005                            |       
|Numerator                                              |                                  |  |                                 |       
|Net income (loss)                                      |                                  |  | $                               | 358   
|                                                       |                                  |  |                                 |       
|Denominator:                                           |                                  |  |                                 |       
|Shares used in computing net income (loss) per share:  |                                  |  |                                 |       
|Weighted average of common shares outstanding          |                                  |  |                                 | 40,205
|Less: Weighted average of shares subject to repurchase |                                  |  |                                 | -     
|                                                       |                                  |  |                                 |       
|Basic                                                  |                                  |  |                                 | 40,205
|                                                       |                                  |  |                                 |       
|Diluted                                                |                                  |  |                                 | 43,728
|                                                       |                                  |  |                                 |       
|Net income (loss) per share:                           |                                  |  |                                 |       
|Basic                                                  |                                  |  | $                               | 0.01  
|                                                       |                                  |  |                                 |       
|Diluted                                                |                                  |  | $                               | 0.01  
|                                                       |                                  |  |                                 |       

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

|                                     | Nine Months Ended September 30,
|------------------------------------ | -------------------------------
|
|Options to purchase common stock and |                                
|shares subject to repurchase         |                                
|                                     |                                
|                                     |                                

# 6. 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 income (loss) are as follows (in thousands):

|                                          | Three Months Ended September 30, |  | Nine Months Ended September 30, |    
|----------------------------------------- | -------------------------------- |  | ------------------------------- | ---
|                                          | 2006                             |  | 2005                            |    
|Net income (loss)                         |                                  |  | $                               | 358
|Cumulative translation adjustments        |                                  |  |                                 | 42 
|Unrealized gain on short-term investments |                                  |  |                                 | 9  
|                                          |                                  |  |                                 |    
|Total comprehensive income (loss)         |                                  |  | $                               | 409
|                                          |                                  |  |                                 |    

# 7. Commitments and
Contingencies

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

11

---

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

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

Operating
Leases:
        The Company leases certain office space under long-term operating leases
expiring at various dates through 2010.

The Companys aggregate future
minimum facility lease payments are as follows (in thousands):

|                                      | 
|------------------------------------- | 
|Three months ending December 31, 2006 | 
|Years ending December 31:             | 
|2007                                  | 
|2008                                  | 
|2009                                  | 
|2010                                  | 
|                                      | 
|Total                                 | 
|                                      | 
|                                      | 
|                                      | 

Letter
of Credit:
        The Company had a letter of credit of $0.4 million outstanding as of September 30, 2006.
 The letter of credit is collateralized by short-term investments of $0.4 million.

# 8. Bank Loan

In November
2004,  the Company  entered into a ten-year  loan of $0.5 million with a lender in Taiwan.  The loan has a fixed  interest
rate of 2.3% for the first year after  which the loan has a variable  interest  rate  equal to  Taiwan's  prime rate for the  remaining
years.  The loan is secured by the  Company's  building in Taiwan.  The net book value of the building was $0.6 million as of September 30,
2006.

Payments due under the bank loan as
of September 30, 2006 are as follows (in thousands):

12

---

|                                        | 
|--------------------------------------- | 
|Years ending December 31,               | 
|2006                                    | 
|2007                                    | 
|2008                                    | 
|2009                                    | 
|2010                                    | 
|2011 and after                          | 
|                                        | 
|Total payment                           | 
|Less: Amounts representing interest     | 
|                                        | 
|Present value of net remaining payments | 
|Less: current portion                   | 
|                                        | 
|Long-term portion                       | 
|                                        | 
|                                        | 

# 9. Related Party
Transactions

As of September 30, 2006,
 Foxconn  Holding Limited was a holder of 19.9% of the Company's  common stock,  based on
share  ownership  information  set forth in a Schedule 13G filed by Foxconn Holding Limited on January 4, 2002. The
Company  sells  products and purchases raw materials  from Hon Hai  Precision  Company  Limited,  who is the parent
company of Foxconn Holding Limited,  in the normal course of business.  These  transactions were made at prices and
terms  consistent  with those with  unrelated  third  parties.  Sales of  products  to Hon Hai  Precision  Industry
Company  Limited were $31,000 and $0.4 million for the three and nine months ended  September  30, 2006.  Purchases
of raw materials from Hon Hai Precision  Company  Limited were $0.6 million and $1.8 million for the three and nine
months ended September 30, 2006.  Amounts due from Hon Hai Precision  Company Limited were $49,000 at September 30,
2006. Amounts due to Hon Hai Precision Company Limited were $0.5 million at September 30, 2006.

# 10. Geographic Segment
Information

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

The  following is a
summary of the  Company's  revenues  generated by  geographic  segments,  revenues  generated by product  lines and
identifiable assets located in these segments (in thousands):

13

---

|              | Three Months Ended September 30, |  | Nine Months Ended September 30, |      
|------------- | -------------------------------- |  | ------------------------------- | -----
|              | 2006                             |  | 2005                            |      
|Revenues      |                                  |  |                                 |      
|North America |                                  |  | $                               | 5,393
|Asia          |                                  |  |                                 | 1,727
|Europe        |                                  |  |                                 | 453  
|              |                                  |  |                                 |      
|              |                                  |  | $                               | 7,573
|              |                                  |  |                                 |      

|                                   | Three Months Ended September 30, |  | Nine Months Ended September 30, |      
|---------------------------------- | -------------------------------- |  | ------------------------------- | -----
|                                   | 2006                             |  | 2005                            |      
|Revenues                           |                                  |  |                                 |      
|Optical path mulitplexing solution |                                  |  | $                               | 4,699
|Dense wave division multiplexer    |                                  |  |                                 | 2,874
|                                   |                                  |  |                                 |      
|                                   |                                  |  | $                               | 7,573
|                                   |                                  |  |                                 |      

|                       | September 30, 2006 |  | December 31,2005
|---------------------- | ------------------ |  | ----------------
|Property and Equipment |                    |  |                 
|United States          |                    |  | $               
|Taiwan                 |                    |  |                 
|China                  |                    |  |                 
|                       |                    |  |                 
|                       |                    |  | $               
|                       |                    |  |                 
|                       |                    | 
|                       |                    | 

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

When used in this Report, the
words "expects," "anticipates," "believes", "estimates," "plans," "intends," "could," "will," "may" and
similar expressions are intended to identify forward-looking statements.  These are statements that relate to future periods and
include statements as to our operating results, revenues, sources of revenues, cost of revenues, gross profit, net operating losses,
profitability, the amount and mix of anticipated investments, expenditures and expenses, our liquidity and the adequacy of our
capital resources, exposure to interest rate or currency fluctuation, anticipated working capital and capital expenditures, reliance
on our OPMS products, our cash flow, trends in average selling prices, our reliance on the commercial success of our DWDM-related
products, plans for future products and enhancements of existing products, features, benefits and uses of our products, demand for
our products, our success being tied to relationships with key customers, industry trends and market demand, acquisitions of
complementary businesses, products or technologies, our efforts to protect our intellectual property, potential indemnification
agreements, increases in the number of possible license offers and patent infringement claims, our competitive position, sources of
competition, consolidation in our industry, our international strategy, inventory management, our plans for a reverse stock split,
our employee relations, the adequacy of our internal controls, the effect of recent and changing accounting pronouncements and our critical
accounting policies, estimates, models and assumptions.  Forward-looking statements are subject to risks and uncertainties that could
cause actual results to differ materially from those projected.  These risks and uncertainties include, but are not limited to, those
risks discussed elsewhere in this report, as well as risks related to the development of the metropolitan, last mile access, and
enterprise networks, customer acceptance of our products, our ability to retain and obtain customers, industry-wide overcapacity and
shifts in supply and demand for optical components and modules, our ability to meet customer demand and manage inventory,
fluctuations in demand for our products, declines in average selling prices, development of new products by us and our competitors,
increased competition, inability to obtain sufficient quantities of a raw material product, loss of a key supplier, integration of
acquired businesses or technologies, financial stability in foreign markets, foreign currency exchange rates, interest rates, costs
associated with being a public company, delisting from the Nasdaq Capital Market, failure to meet customer requirements, our ability
to license intellectual property on commercially reasonable terms, economic stability, and the risks set forth below under Part II,
Item 1A, "Risk Factors."  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.

14

---

This Management's Discussion
 and Analysis of Financial Condition and Results of Operations should be read in conjunction with the
section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's Annual
Report on Form 10-K, its Consolidated Financial Statement and the notes thereto, for the year ended December 31, 2005.

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

# Critical Accounting
Policies and Estimates

Stock-based Compensation Expense

        On January 1, 2006, we adopted Statement of Financial  Accounting
Standards  No. 123 (revised 2004),  "Share-Based
Payment,"  ("SFAS  123(R)")  which  requires  the  measurement  and  recognition  of  compensation  expense for all
share-based  payment  awards made to our  employees  and directors  including  employee  stock options and employee
stock  purchases  related to the Employee Stock  Purchase Plan ("ESPP") based on estimated fair values.  We adopted
SFAS 123(R) using the modified  prospective  transition  method,  which requires the  application of the accounting
standard as of January 1,  2006, the first day of our fiscal year 2006. Our  Consolidated  Financial  Statements as
of and for the three and nine months ended  September  30, 2006 reflect the impact of SFAS  123(R).  In  accordance
with the modified prospective  transition method, our Consolidated  Financial Statements for prior periods have not
been  restated to reflect,  and do not include,  the impact of SFAS  123(R).  The value of the portion of the award
that  is  ultimately  expected  to vest is  recognized  as  expense  over  the  requisite  service  periods  in our
Consolidated  Statement of Operations.  Prior to the adoption of SFAS 123(R),  we accounted for stock-based  awards
to employees and directors  using the intrinsic  value method in accordance  with APB 25 as allowed under Statement
of Financial  Accounting  Standards  No. 123,  Accounting for Stock-Based  Compensation  (SFAS 123). As stock-based
compensation  expense  recognized in the Consolidated  Statement of Operations for the first quarter of fiscal 2006
is based on awards  ultimately  expected  to vest,  it has been  reduced  for  estimated  forfeitures.  SFAS 123(R)
requires  forfeitures  to be estimated at the time of grant and revised,  if necessary,  in  subsequent  periods if
actual  forfeitures  differ from those  estimates.  The estimated  average  forfeiture rates for the three and nine
months ended September 30, 2006, of approximately 10% were based on historical  forfeiture  experience.  In our pro
forma  information  required  under SFAS 123 for the  periods  prior to fiscal  2006,  the  Company  accounted  for
forfeitures as they occurred.

        Stock-based  compensation  expense  recognized  under SFAS 123(R) for
the three and nine months ended September 30,
2006 was $83,000 and $192,000,  respectively,  determined by the Binomial  Lattice  valuation model, and represents
stock-based   compensation   expense  related  to  employee  stock  options.   As  of  September  30,  2006,  total
unrecognized  compensation  costs  related to unnvested  stock  options was $0.4  million,  which is expected to be
recognized as an expense over a weighted  average period of  approximately  3.25 years.  Subsequent to the adoption
of SFAS 123(R),  we have not made any changes in the type of incentive equity  instruments or added any performance
conditions to the incentive options.

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

        For additional  information  regarding our critical  accounting
policies and estimates,  see the section  entitled
"Management's  Discussion  and Analysis of Financial  Condition and Results of  Operations" in our Annual Report on
Form 10-K, for the year ended December 31, 2005.

15

---

# 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  September  30, 2006,  we derived a  substantial  portion of our revenues from our OPMS
product line,  although  revenues from our DWDM product line have increased as a percentage of revenues in the last
few quarters.  Revenues from our DWDM products  represented  38.0% and 26.0% of total revenues for the three months
ended  September 30, 2006 and 2005,  respectively,  and 36.9% and 33.2% of total revenues for the nine months ended
September  30,  2006 and 2005,  respectively.  We market and sell our  products  predominantly  through  our direct
sales force.

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.

        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  was being amortized  using the graded vesting method,  under which each option grant was separated into portions based on
its  vesting  terms  which  resulted  in  acceleration  of  amortization  expense  for the  overall  award.  The  deferred  stock-based
compensation balance was 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 our 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.

16

---

# 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 September 30, |  | Nine Months Ended September 30, |       
|------------------------------ | -------------------------------- |  | ------------------------------- | ------
|                               | 2006                             |  | 2005                            |       
|Revenues                       |                                  |  |                                 | 100.0%
|Cost of revenues               |                                  |  |                                 | 71.3  
|                               |                                  |  |                                 |       
|Gross profit                   |                                  |  |                                 | 28.1  
|                               |                                  |  |                                 |       
|Operating expenses:            |                                  |  |                                 |       
|Research and development:      |                                  |  |                                 | 10.8  
|Sales and marketing:           |                                  |  |                                 | 7.2   
|General and administrative     |                                  |  |                                 | 10.4  
|                               |                                  |  |                                 |       
|Total operating expenses       |                                  |  |                                 | 28.4  
|                               |                                  |  |                                 |       
|Income(loss) from operations   |                                  |  |                                 | 0.3   
|Interest and other income, net |                                  |  |                                 | 4.4   
|                               |                                  |  |                                 |       
|Net income (loss)              |                                  |  |                                 | 4.7%  

Revenues.. . Revenues  were  $7.6  million  and   $5.3 million  for  the  three  months  ended  September  30,  2006  and  2005,
respectively.  Revenues  increased  43.7% in the  quarter  ended  September  30,  2006 from the same period in 2005
primarily due to increased  volume  shipments of our OPMS products for various  premise  cabling  applications  and
increased sales into Fiber to the Home (FTTH)  systems.  The FTTH sales increase  resulted from  production  demand
from a video system  customer.  Revenues were $19.0 million and  $15.5 million  for the nine months ended September
30, 2006 and 2005,  respectively.  Revenues  increased  23.3% in the nine months ended  September 30, 2006 from the
same  period in 2005,  primarily  due to  increased  volume  shipments  of our OPMS and DWDM  products  of  various
applications including FTTH.

17

---

Cost of  Revenues.  Cost of  revenues  was $5.4  million and $4.1
 million  for the three  months  ended  September  30, 2006 and 2005,
respectively.  Cost of  revenues  as a  percentage  of  revenues  decreased  to 71.3%  for the three  months  ended
September  30, 2006 from 78.6% for the three months ended  September  30, 2005.  Cost of revenues was $13.9 million
and $12.3  million for the nine months  ended  September  30,  2006 and 2005,  respectively.  Cost of revenues as a
percentage  of revenues  decreased  to 73.0% for the nine months ended  September  30, 2006 from 79.6% for the nine
months  ended  September  30,  2005.  Cost of revenues  for the period  ended  September  30, 2006  benefited  from
increased  factory  utilization  and improved  manufacturing  overhead  absorption as a result of increased  volume
shipments of our products.



        Gross  Profit.  Gross  profit  increased to $2.2  million,  or
28.7% of revenues,  for the three  months ended  September  30, 2006
from  $1.1 million,  or 21.4% of revenues,  for the same period in 2005.  Gross profit  increased to $5.1  million,
or 27.0% of revenues,  for the nine months ended September 30, 2006 from  $3.2 million,  or 20.5% of revenues,  for
the same period in 2005.  For the period  ended  September  30,  2006,  higher  utilization  of our  factories as a
result of increased  volume  shipments of our products  resulted in an improved  gross margin.  We expect our gross
profit as a  percentage  of  revenues to  continue  to improve in the near term due to higher  production  volumes,
which we anticipate will result in improved  absorption of overhead  expenses.  However,  we expect that decreasing
average  selling  prices  will  negatively  impact  our gross  profit and may offset  any  benefits  from  improved
absorption.  We had  approximately  $2.1 million in DWDM-related net inventory and $2.7 million in OPMS-related net
inventory  on hand at  September  30,  2006.  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  remained at $0.8 million for the three months ended September 30, 2006 and for
the same period in 2005.  Research  and  development  expenses  decreased to $2.3 million for the nine months ended
September  30,  2006 from  $2.6 million  for the same  period in 2005.  The  decrease  was  primarily  due to lower
headcount related expenses.  As a percentage of revenues,  research and development  expenses decreased to 10.8% in
the three  months ended  September  30, 2006 from 14.9% for the same period in 2005.  As a percentage  of revenues,
research and  development  expenses  decreased to 12.0% in the nine months ended  September 30, 2006 from 16.9% for
the same period in 2005.  We expect  research  and  development  expenses on our  product  development  efforts may
increase in the last  quarter of 2005 as we intend to continue to invest in our  research  and product  development
efforts.



        Sales and  Marketing  Expenses. Sales and  marketing  expenses
 remained at $0.5 million for the three months ended  September 30, 2006 and for the
same period in 2005.  Sales and  marketing  expenses  remained at $1.7 million for the nine months ended  September
30, 2006 and for the same period in 2005. As a percentage of revenues,  sales and marketing  expenses  decreased to
7.2% in the three  months  ended  September  30, 2006 from 9.9% for the same  period in 2005.  As a  percentage  of
revenues,  sales and marketing  expenses  decreased to 8.9% in the nine months ended  September 30, 2006 from 10.7%
for the same period in 2005.  We expect sales and marketing  expenses to decline  slightly in the next quarter as a
result of fewer trade show activities.



        General and Administrative  Expenses.  General and  administrative
 expenses  remained at $0.8 million for the three months ended  September  30, 2006 and
for the same period in 2005.  General and  administrative  expenses  increased  to $2.3 million for the nine months
ended  September 30, 2006 from $2.2 million for the same period in 2005.  As a percentage of revenues,  general and
administrative  expenses  decreased to 10.4% in the three months ended  September  30, 2006 from 14.3% for the same
period in 2005. As a percentage of revenues,  general and  administrative  expenses  decreased to 11.9% in the nine
months  ended  September  30, 2006 from 14.4% for the same  period in 2005.  We expect  general and  administrative
expenses will increase due to higher fees and costs  associated with compliance with new laws and regulations  such
as the Sarbanes-Oxley Act of 2002 and the regulations promulgated thereunder.



        Stock-Based  Compensation. Total stock based  compensation
increased to $83,000 for the three months ended September 30, 2006 from $0 for the
same period in 2005. Total stock based  compensation  increased to $192,000 for the nine months ended September 30,
2006 from $0 for the same period in 2005.  This  increase  was due to the  adoption  of SFAS No. 123R  ("Accounting
for Stock Based  Compensation")  as of January 2006.  In 2005,  the Company  accelerated  the vesting of options to
purchase up to approximately  1.9 million shares.  The Company's  accounting  policy requires the amortization of a
larger  proportion of deferred  compensation  expense during the early vesting  periods of the option  grants.  The
deferred  compensation  balance  was fully  amortized  as of  December  1, 2004.  This  resulted  in no stock based
compensation in the first quarter of 2005.



        Interest and Other  Income,  Net.  . Interest and other  income,
 net, was $0.3  million and $0.4  million for the three  months ended  September  30,
2006 and 2005,  respectively.  Interest  and other  income,  net,  was $1.1  million and $1.2  million for the nine
months ended September 30, 2006 and 2005, respectively.

18

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Liquidity and Capital Resources

        At  September  30,  2006,  we had  cash  and  cash  equivalents  of  $3.9 million
and  short-term  investments  of
$25.9 million.


        Net cash  provided by operating  activities  was $564,000 for the nine months
ended  September  30, 2006.  The cash
provided was primarily due to depreciation  expenses of $1.0 million and a $0.4 million inventory provision,  which
was partially  offset by $1.5 million  increase in  inventory.  Accounts  receivable  increased by $0.3 million and
prepaid  expenses and other assets  increased by $0.2 million offset by a $0.8 million increase in accounts payable
and a $0.2 million  increase in accrued  expenses.  Net cash used in operating  activities was $1.6 million for the
nine months ended September 30, 2005, and was primarily due to a net loss of $2.1 million.


        Net cash  provided by investing  activities  was $0.3 million for the nine months ended
 September  30, 2006.  This
resulted  from $0.8 million in net proceeds from sales of short-term  investments  offset by $0.5 million  spending
on  equipment.  Cash used in investing  activities  was $2.0 million for the nine months ended  September 30, 2005.
In the nine  months  ended  September  30,  2005,  we spent a net  $1.4  million  for the  purchase  of  short-term
securities, and we used $0.6 million for property and equipment.


        Cash  provided by financing  activities  was $0.3 million and $0.4 million for the
nine months ended  September 30,
2006 and 2005,  respectively,  and was comprised of proceeds from exercise of options to purchase  common stock and
common stock issued through our Employee Stock  Purchase  Plan.  Cash provided for the nine months ended  September
30, 2005 also included net proceeds from  borrowings  under an equipment  loan of $0.2 million  offset by repayment
of bank borrowings.


        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,   additional  credit   facilities,   strategic   relationships  or  other
arrangements.  If additional  funds are raised  through the issuance of  securities,  these  securities  could have
rights,  preferences  and  privileges  senior to holders of common stock,  and the terms of any debt facility could
impose  restrictions  on our  operations.  The  sale of  additional  equity  or debt  securities  could  result  in
additional  dilution to our  stockholders,  and  additional  financing  may not be available in amounts or on terms
acceptable  to us, if at all.  If we are unable to obtain  additional  financing,  we may be required to reduce the
scope of our planned  product  development and marketing  efforts.  Strategic  arrangements,  if necessary to raise
additional  funds,  may  require  us to  relinquish  our rights to certain of our  technologies  or  products.  Our
failure to raise capital when needed could harm our business, financial condition and operating results.

Contractual Obligations

|                            | Payments Due by Period
|--------------------------- | ----------------------
|
|                            |                       
|                            |                       
|Longterm debt obligations   |                       
|Operating lease obligations |                       
|                            |                       
|Total                       |                       
|                            |                       

In November  2004, the Company  entered into a ten-year loan of $0.5 million with a lender in Taiwan.  The loan has
a fixed  interest  rate of 2.3% for the first  year  after  which the loan has a  variable  interest  rate equal to
Taiwan's  prime rate for the  remaining  years.  The loan is secured by the Company's  building in Taiwan.  The net
book value of the building was $0.6 million as of September 30, 2006.

        Our corporate  headquarters  are in Sunnyvale,  California  where we lease the facilities  from a third party.  The
lease has a six-year term  commencing on July 22, 2004, the facility is 34,800 square feet and the current  monthly
rent is approximately $32,000.

        In  December  2000,  we  purchased  approximately  8,200  square feet of space  immediately  adjacent to our leased
facility in Tu-Cheng  City,  Taiwan for $0.8  million.  In August 2002,  we entered into a lease for 62,000  square
foot facility in the Shenzhen area of China, which will expire in July 2007.

        Additionally,  in February 2006, we entered into a new lease for a total of 21,600 square feet facility  located in
Hu-Kou, Taiwan. This lease will expire in January 2009.Off-balance Sheet Arrangements

As of September 30, 2006, we did not have any off-balance sheet arrangements.

19

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# ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Sensitivity

        We currently  maintain our funds  primarily in money market funds and highly liquid  marketable  securities.  We do
not have any derivative financial instruments.  As of September 30, 2006, $4.1 million,  or 15% of our investments,
had  maturities  of less than three months.  We will continue to invest a significant  portion of our existing cash
in interest  bearing,  investment grade  securities,  with maturities of less than 12 months pending their need for
other uses. We do not believe that our investments,  in the aggregate,  have significant  exposure to interest rate
risk and we do not believe that a 10% change in interest  rates will have a significant  impact on our  investments
or interest income.

Exchange Rate Sensitivity

        We currently have operations in the United States,  Taiwan and China.  The functional
currency of our subsidiaries in Taiwan and China
are the local currencies,  and we are subject to foreign currency exchange rate fluctuations  associated with the translation to United
States  dollars.  Though some  expenses are  incurred by our Taiwan and China  operations,  substantially  all of our sales are made in
United States dollars;  hence, we have minimal exposure to foreign currency rate  fluctuations  relating to sales  transactions.  We do
not believe that a hypothetical  change of 10% in the foreign  currency  exchange  rates would have a material  impact on our financial
results.

        While we expect our  international  revenues to continue to be  denominated  predominately
in United  States  dollars,  an  increasing
portion of our  international  revenues may be denominated  in foreign  currencies in the future.  In addition,  we plan to continue to
expand our overseas  operations.  As a result, our operating results may become subject to significant  fluctuations based upon changes
in  exchange  rates of certain  currencies  in  relation  to the United  States  dollar.  We will  analyze  our  exposure  to  currency
fluctuations  and may engage in  financial  hedging  techniques  in the future to attempt  to  minimize  the effect of these  potential
fluctuations; however, exchange rate fluctuations may adversely affect our financial results in the future.

20

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# ITEM 4:  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 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-Q, our Chief  Executive  Officer and Acting Chief  Financial  Officer have  concluded  that, as of such date, 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-Q 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.

21

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# PART II: OTHER INFORMATION

# ITEM 1A: RISK FACTORS

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 had net income of  approximately  $0.4 million in the third  quarter of fiscal
2006.  We incurred net losses of
approximately  $0.6 million in the third  quarter of fiscal 2005.  Although we generated a profit in the second and
third  quarters,  we may  not be  able  to  sustain  profitability  in the  future.  Although  our  cash  and  cash
equivalents  increased from previous two quarters,  we could find our cash flows to be negative again in the future
as we  continue  to  invest  in  our  business.  As of  September  30,  2006,  we  had an  accumulated  deficit  of
approximately $72.5 million.



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

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

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

        Our Optical Path Management  Solution (OPMS) products have historically  represented a
substantial portion 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 62.0% of our revenues in the quarter
ended  September 30, 2006 and a
substantial  portion 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. 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.

22

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

        The United States economy has  experienced and continues to experience  significant
 fluctuations in consumption and demand since 2001.
During the past few years,  telecommunication  companies  have  periodically  decreased  their  spending  which has  resulted in excess
inventory,  overcapacity  and a  decrease  in demand for our  products.  We may  experience  periodic  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  fluctuations in the economy have affected the  telecommunications  industry.
 Telecommunications  companies have cut back on their
capital  expenditure  budgets,  which has and may continue to further decrease demand for equipment and parts,  including our products.
This  decrease has had and may continue to have an adverse  effect on the demand for fiber optic  products  and  negatively  impact the
growth of our customer base.
        We are exposed to risks and  increased  expenses  and  business  risk as a result of new  Restriction  on Hazardous
Substances (RoHS) directives.

        Following the lead of the European Union, or EU, various  governmental  agencies have either already put into place
or are planning to introduce  regulations that regulate the permissible levels of hazardous  substances in products
sold in  various  regions  of the  world.  For  example,  the RoHS  directive  for EU took  effect on July 1, 2006.
Consequently,  many suppliers of products sold into the EU countries have required their  suppliers to be compliant
with the new  directive.  Many of our customers  have adopted this approach and have required our full  compliance.
Though we have devoted a  significant  amount of resources and effort  planning and executing our RoHS program,  it
is possible that some portion of our products  might be  incompatible  with such  regulations.  In such events,  we
could  experience  the  following  consequences:  loss of revenue,  damaged  reputation,  diversion  of  resources,
monetary penalties, and legal action.

23

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



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

        Several of our existing and potential  customers are also current and potential
competitors  of ours.  These  companies may develop or
acquire  additional  competitive  products or technologies in the future and  subsequently  reduce or cease their purchases from us. In
light of the  consolidation  in the optical  networking  industry,  we also believe that the size of suppliers will be an  increasingly
important part of a purchaser's  decision-making  criteria in the future.  We may not be able to compete  successfully with existing or
new  competitors,  and we cannot ensure that the competitive  pressures we face will not result in lower prices for our products,  loss
of market share, or reduced gross margins, any of which could harm our business.

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

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

        We rapidly expanded our operations  domestically and  internationally
in the final two quarters of 2000. We had to
carefully manage and re-evaluate  this expansion given the sudden and dramatic  downturn in demand for our products
experienced  in 2001 and 2002.  Additionally,  we implemented a reduction in force to reduce  employees  during the
second,  third and fourth  quarters of 2002 to match our operations to this decreased  demand for our products.  As
of September 30, 2006, we had a total of 44 full-time employees in Sunnyvale,  California,  363 full-time employees
in Taiwan,  and 260 full-time  employees in China.  Matching the scale of our operations with demand  fluctuations,
combined with the challenges of expanding and managing  geographically  dispersed operations,  has placed, and will
continue to place, a significant  strain on our management and resources.  To manage the expected  fluctuations  in
our operations and personnel, we will be required to:



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

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

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

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

24

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

        Our success also depends,  to a large degree,  on the efficient and  uninterrupted
operation of our  facilities.  We have expanded our
manufacturing  facilities  in Taiwan and  manufacture  many of our  products  there.  Our  facility in China also houses a  substantial
portion of our  manufacturing  operations.  There is significant  political  tension  between Taiwan and China. If there is an outbreak
of hostilities  between Taiwan and China, our  manufacturing  operations may be disrupted or we may have to relocate our  manufacturing
operations.  Tensions  between  Taiwan and China may also affect our  facility in China.  Relocating a portion of our  employees  could
cause temporary disruptions in our operations and divert management's attention.

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

        The  development  of new or enhanced  fiber optic  products is a complex
and uncertain  process.  We may experience
design, manufacturing,  marketing and other difficulties that could delay or prevent the development,  introduction
or  marketing  of new products and  enhancements.  Development  costs and expenses are incurred  before we generate
revenues from sales of products  resulting from these efforts.  Our total  research and  development  expenses were
approximately  $0.8  million  for the three  months  ended  September  30, 2006 and 2005,  respectively.  Our total
research  and  development  expenses  were  approximately  $2.3  million and $2.6 million for the nine months ended
September  30, 2006 and 2005,  respectively.  We expect that our research and  development  expense may increase in
the last quarter of 2006 as we intend to continue to invest in our research and product  development  efforts.  Any
such increase 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 fluctuating demand for fiber optic products.

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

25

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

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

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

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

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

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

        We depend on a limited number of third parties to supply key materials,  components
and equipment,  such as ferrules,  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,  is obtained from one supplier,  Nippon Sheet Glass.  Nippon Sheet Glass is the only known supplier of GRIN
lenses.

26

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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.  Both  situations  could cause our results of operations to be below the  expectations of
investors and public market  analysts,  which could,  in turn,  cause the price of our common stock to decline.  The time our customers
require to  incorporate  our products  into their own can vary  significantly  and  generally  exceeds  several  months,  which further
complicates our planning  processes and reduces the  predictability of our forecasts.  Even if we receive these orders,  the additional
manufacturing capacity that we add to meet our customer's requirements may be underutilized in a subsequent quarter.

        We are exposed to risks and increased expenses as a result of laws requiring
companies to evaluate internal controls
over financial reporting.

        Section 404 of the  Sarbanes-Oxley  Act of 2002 requires our  management to perform assessment
of control by December 31, 2007, and our
 independent  auditors to attest to the
effectiveness  of our  internal  controls  over  financial  reporting  beginning  with our  year  ending  December  31,  2008.  We have
implemented  an ongoing  program to perform the system and process  evaluation  and testing we believe to be  necessary  to comply with
these  requirements,  however,  we cannot assure you that we will be successful in our efforts.  This legislation is relatively new and
neither  companies nor accounting  firms have  significant  experience in complying with its  requirements.  As a result,  we expect to
incur  increased  expense  and to devote  additional  management  resources  to  Section  404  compliance.  In the event that our chief
executive  officer,  acting chief  financial  officer or  independent  registered  public  accounting  firm determine that our internal
controls  over  financial  reporting  are not  effective as defined  under  Section  404,  investor  perceptions  of our Company may be
adversely affected and could cause a decline in the market price of our stock.

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

        We prepare our financial  statements to conform to generally  accepted  accounting  principles,
 or GAAP, in the United  States.  These
accounting  principles are subject to  interpretation  by the American  Institute of Certified Public  Accountants,  the Securities and
Exchange Commission and various bodies formed to interpret and create appropriate  accounting  policies. A change in those policies can
have a  significant  effect on our  reported  results  and may  affect  our  reporting  of  transactions  completed  before a change is
announced.  Changes to those rules or the questioning of current  practices may adversely affect our reported  financial results or the
way we conduct our business.  For example,  accounting  policies  affecting many aspects of our business,  including  rules relating to
employee  stock option  grants,  have recently been revised or are under review.  The Financial  Accounting  Standards  Board and other
agencies have finalized  changes to U.S.  generally  accepted  accounting  principles that require us, starting in our first quarter of
2006,  to record a charge to earnings  for employee  stock  option  grants and other equity  incentives.  We may have  significant  and
ongoing accounting  charges resulting from option grant and other equity incentive  expensing that could reduce our overall net income.
While the implementation of this standard did not have material impact on the Company's  financial  statements at September 30, 2006, it may
in the  future.  In  addition,  since we  historically  have used  equity-related  compensation  as a component  of our total  employee
compensation  program,  the accounting  change could make the use of  equity-related  compensation  less attractive to us and therefore
make it more difficult to attract and retain employees.

27

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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,  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.

28

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

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

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

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

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

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

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

o           loss of customers;

     o           damage to our reputation;

     o           failure to attract new customers or achieve market acceptance;

     o           diversion of development and engineering resources; and

     o           legal actions by our customers.

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

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

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

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

     o           the continued growth of the metropolitan, last mile, and enterprise access
segments of the communications network.

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

        We may be unable to successfully  integrate  acquired  businesses or assets 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. 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 any 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 Global Market, we will be subject to
 certain  provisions of the California  General
Corporation Law that may affect our charter documents and result in additional expenses.

29

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Beginning  at the  commencement  of trading on  November  8, 2002,  the  listing of our
 common  stock was  transferred  from the Nasdaq
Global  Market to the Nasdaq  Capital  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  Global
Market. A recent Delaware  decision has called into question the  applicability of the California  General  Corporation Law to Delaware
corporations.  However,  if the California  General  Corporation Law applies to our Company,  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.

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

        There can be no assurance that we will be able to satisfy all of the  quantitative
 maintenance  criteria for continued  listing on the
Nasdaq  Capital  Market,  including a  continued  minimum  bid price of $1.00 per share.  If the closing bid price of our common  stock
falls and remains below $1.00 for 30 consecutive  days as it has for significant  periods of time in the past, our common stock may not
remain listed on the Nasdaq Capital Market.  If we fail to maintain  continued  listing on the Nasdaq Capital 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.


        Many  companies  that face delisting as a result of closing bid prices that are below
the Nasdaq  Capital  Market's  continued  listing
standards  seek to maintain the listing of their  securities by effecting  reverse stock splits.  However,  reverse stock splits do not
always result in a sustained  closing bid price per share.  We continue to consider the merits of  implementing  a reverse split and to
evaluate other courses of action.

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

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

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

30

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

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

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


        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 three and nine months ended  September 30, 2006,  sales to customers
located outside of North America were
28.7% and 28.4% of our  revenues,  respectively.  In order to expand our  business,  we must  increase our sales to
customers  located  outside of North  America.  We have  limited  experience  in  marketing  and  distributing  our
products  internationally  and in  developing  versions  of our  products  that comply  with local  standards.  Our
international  sales  will be  limited  if we  cannot  establish  relationships  with  international  distributors,
establish  additional  foreign  operations,  expand  international  sales channels,  hire additional  personnel and
develop  relationships  with  international  communications  equipment  manufacturers.  Even  if  we  are  able  to
successfully continue  international  operations,  we may not be able to maintain or increase  international market
demand for our products.



        Outbreaks of diseases pose a risk to the our business.

31

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

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

        Three of our primary  manufacturing  operations are located in Sunnyvale,  California,
Tu-Cheng City, Taiwan, and Hu-Kou City, Taiwan,
all 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.

32

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# ITEM 6: EXHIBITS

Exhibits

|Exhibit Number      | Title                                                                                                              
|------------------- | -------------------------------------------------------------------------------------------------------------------
|31.1                | Rule 13a-14(a) certification of Chief Executive Office                                                             
|                    |                                                                                                                    
|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-Q 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.

33

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# SIGNATURE

In
accordance with the requirements of the Exchange Act, the registrant caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.

Dated:
November 13, 2006

| |                                                              
| | -------------------------------------------------------------
| | 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)