# UNITED STATES

# SECURITIES AND
EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

_________________

# FORM 10-QSB

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

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

| |                                                  
| | -------------------------------------------------
| | For the quarterly period ended September 30, 2005

| |   |                                            
| | - | -------------------------------------------
| | o | TRANSITION REPORT UNDER SECTION 13 OR 15(d)
| |   | OF THE EXCHANGE ACT                        

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

to

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

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

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

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

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

_________________

Check whether the issuer (1) filed
all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the
past 12 months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ
No oIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act.) Yes oNo þOn November 8, 2005, 39,692,662
shares of the Registrants Common Stock, $0.001 par value per share, were
outstanding.

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



---

# ALLIANCE FIBER OPTIC
PRODUCTS, INC.

# FORM 10-QSB

# QUARTERLY PERIOD ENDED
SEPTEMBER 30, 2005

# INDEX

|                                                                     | Page
|-------------------------------------------------------------------- | ----
|                                                                     |     
|Part I: Financial Information                                        | 1   
|                                                                     |     
|Item 1: Finance Statements                                           | 1   
|                                                                     |     
|Condensed Consolidated Balance Sheets at September 30,               |     
|2005 Unaudited and December 31, 2004                                 | 1   
|                                                                     |     
|Condensed Consolidated Statements of Operations for the              |     
|Three and Nine Months Ended September 30, 2005 and 2004 Unaudited    | 2   
|                                                                     |     
|Condensed Consolidated Statements of Cash Flows for the Nine         |     
|Months Ended September 30, 2005 and 2004 Unaudited                   | 3   
|                                                                     |     
|Notes to Condensed Consolidated Financial Statements                 | 4   
|                                                                     |     
|Item 2: Management's Discussion and Analysis or Plan of Operation    | 12  
|                                                                     |     
|Item 3: Controls and Procedures                                      | 29  
|                                                                     |     
|Part II: Other Information                                           | 30  
|                                                                     |     
|Item 1:  Legal Proceedings                                           | 30  
|                                                                     |     
|Item 2:  Unregistered Sales of Equity Securities and Use of Proceeds | 30  
|                                                                     |     
|Item 3:  Defaults Upon Senior Securities                             | 30  
|                                                                     |     
|Item 4:  Submission of Matters to a Vote of Security Holders         | 30  
|                                                                     |     
|Item 5:  Other Events                                                | 30  
|                                                                     |     
|Item 6: Exhibits                                                     | 30  
|                                                                     |     
|Signature                                                            | 32  

i

---

# PART I: FINANCIAL INFORMATION

# ITEM 1: FINANCIAL STATEMENTS

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

|                                                               |  | 
|-------------------------------------------------------------- |  | 
|
|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 8)                         |  | 
|Stockholders' equity:                                          |  | 
|Common stock, $0.001 par value: 250,000,000 shares authorized; |  | 
|39,467,927 and 38,999,196 shares issued and outstanding at     |  | 
|September 30, 2005 and December 31, 2004, 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 Sept. 30, |  | Nine Months Ended Sept. 30, |       
|-------------------------------------------- | ---------------------------- |  | --------------------------- | ------
|                                             | 2005                         |  | 2004                        |       
|Revenues                                     |                              |  | $                           | 5,269 
|Cost of revenues                             |                              |  |                             | 4,141 
|                                             |                              |  |                             |       
|Gross profit                                 |                              |  |                             | 1,128 
|                                             |                              |  |                             |       
|Operating expenses:                          |                              | 
|Research and development                     |                              |  |                             | 784   
|Sales and marketing                          |                              |  |                             | 519   
|General and administrative                   |                              |  |                             | 756   
|                                             |                              |  |                             |       
|Total operating expenses                     |                              |  |                             | 2,059 
|                                             |                              |  |                             |       
|Loss from operations                         |                              |  |                             | (931  
|Interest and other income, net               |                              |  |                             | 373   
|                                             |                              |  |                             |       
|Net loss                                     |                              |  | $                           | (558  
|                                             |                              |  |                             |       
|Net loss per share:                          |                              | 
|Basic and diluted                            |                              |  | $                           | (0.01 
|                                             |                              |  |                             |       
|                                             |                              |  |                             |       
|Shares used in computing net loss per share: |                              | 
|Basic and diluted                            |                              |  |                             | 39,405
|                                             |                              |  |                             |       
|                                             |                              |  |                             |       

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

2

---

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

|                                                             | Nine Months Ended Sept. 30,
|------------------------------------------------------------ | ---------------------------
|
|Cash flows from operating activities:                        |                            
|Net 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                     |                            
|Impairment/write down in property and equipment              |                            
|Provision for inventory                                      |                            
|Changes in assets and liabilities:                           |                            
|Accounts receivable, net                                     |                            
|Inventories, net                                             |                            
|Prepaid expenses and other assets                            |                            
|Accounts payable                                             |                            
|Accrued expenses                                             |                            
|Income tax payable                                           |                            
|Other long-term liabilities                                  |                            
|                                                             |                            
|Net cash used in operating activities                        |                            
|                                                             |                            
|Cash flows from investing activities:                        |                            
|Purchase of short-term investments                           |                            
|Proceeds from sales and maturities of short-term investments |                            
|Purchase of property and equipment                           |                            
|Cash acquired from acquisition                               |                            
|                                                             |                            
|Net cash provided by (used in) investing activities          |                            
|                                                             |                            
|Cash flows from financing activities:                        |                            
|Proceeds from issurance of common stock under ESPP           |                            
|Proceeds from the exercise of common stock options           |                            
|Proceeds from the repayment of notes receivable              |                            
|Proceeds from bank borrowings                                |                            
|Repayment of bank borrowings                                 |                            
|                                                             |                            
|Net cash provided by financing activities                    |                            
|                                                             |                            
|Effect of exchange rate changes on cash and cash equivalents |                            
|                                                             |                            
|Net increase (decrease) in cash and cash equivalents         |                            
|Cash and cash equivalents at beginning of period             |                            
|                                                             |                            
|Cash and cash equivalents at end of period                   |                            
|                                                             |                            
|Supplemental non cash flow information:                      |                            
|Issuance of common stock in connection with asset            |                            
|acquisition                                                  |                            
|Fair value of assets acquired                                |                            
|Liability assumed                                            |                            
|                                                             |                            
|                                                             |                            

The
accompanying notes are an integral part of these 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
consolidated financial information as of September 30, 2005 included herein is unaudited
and 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 generally accepted accounting
principles in the United States of America requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the disclosure
of contingent assets and liabilities at the date of the financial statements as well as
the reported amounts of revenues and expenses during the reporting period. Actual results
could differ from those estimates, and such differences may be material to the financial
statements.

These
financial statements should be read in conjunction with the Companys audited
consolidated financial statements included in the Companys Annual Report on Form
10-KSB for the year ended December 31, 2004. The results of operations for the three and
nine months ended September 30, 2005 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.

Concentrations of Risk

OPMS-related
products contributed revenues of $10.3 million, or 67% of total revenues; and $7.6
million, or 77% of total revenues, for the nine months ended September 30, 2005 and
September 30, 2004, respectively. DWDM-related products contributed revenues of $5.1
million, or 33% of total revenues; and $2.3 million, or 23% of total revenues, for the
nine months ended September 30, 2005 and September 30, 2004, respectively.

4

---

In
the nine months ended September 30, 2005 and September 30, 2004, the Companys
top 10 customers comprised 58.2% and 49.7% of revenues, respectively. For the nine months
ended September 30, 2005, one customer accounted for 11.0% of our total revenues. For the
nine months ended September 30, 2004, one customer accounted for 10.3% of our total
revenues.

# 2. Recent Accounting
Pronouncements

On
March 29, 2005, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin No. 107 (SAB 107) regarding the Staffs interpretation of
SFAS 123(R). This interpretation expresses the views of the Staff regarding the
interaction between SFAS 123(R) and certain SEC rules and regulations and provides the
Staffs views regarding the valuation of share-based payment arrangements by public
companies. In particular, this SAB provides guidance related to share-based payment
transactions with nonemployees, the transition from nonpublic to public entity status,
valuation methods, the accounting for certain redeemable financial instruments issued
under share-based payment arrangements, the classification of compensation expense,
non-GAAP financial measures, first-time adoption of SFAS 123(R) in an interim period,
capitalization of compensation cost related to share-based payment arrangements, the
accounting for income tax effects of share-based payment arrangements upon adoption of
SFAS 123(R), the modification of employee share options prior to adoption of SFAS 123(R)
and disclosures in Managements Discussion and Analysis subsequent to adoption of
SFAS 123(R). The Company will adopt SAB 107 in connection with its adoption of SFAS
123(R), which could have a material impact on the Companys consolidated financial
position, results of operations and cash flows.

Other
recent accounting pronouncements issued by the FASB (including its Emerging Issues Task
Force), the American Institute of Certified Public Accountants (AICPA), Public
Company Accounting Oversight Board (PCAOB) 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.

On
March 30, 2005, FASB Interpretation (FIN) No. 47, Accounting for Conditional Asset
Retirement Obligations  An Interpretation of FASB Statement No. 143, was issued.
The FASB issued FIN 47 to address diverse accounting practices that developed with respect
to the timing of liability recognition for legal obligations associated with the
retirement of a tangible long-lived asset when the timing and (or) method of settlement of
the obligation are conditional on a future event. For example, some entities recognize the
fair value of the obligation prior to the retirement of the asset with the uncertainty
about the timing and (or) method of settlement incorporated into the fair value of the
liability. Other entities recognize the fair value of the obligation only when it is
probable the asset will be retired as of a specified date using a specified method or when
the asset is actually retired. FIN 47 concludes that an entity is required to recognize a
liability for the fair value of a conditional asset retirement obligation when incurred if
the liabilitys fair value can be reasonably estimated. Originally, the FASB proposed
guidance in FASB Staff Position (FSP) FAS FIN 47 143-x, Application of FASB
Statement No. 143, Accounting for Asset Retirement Obligations, to Legislative
Requirements on Property Owners to Remove and Dispose of Asbestos or Asbestos-Containing
Materials, but the FASB ultimately concluded there were additional issues that
required the FASBs attention. Accordingly, the FASB withdrew the proposed FSP and
issued an Exposure Draft, Accounting for Conditional Asset Retirement Obligations,which is the basis for FIN 47.

The
Company has not evaluated the impact of the new pronouncement on the financial statements.

On June 29, 2005, the FASB ratified the EITF Issue No. 05-06, Determining the
Amortization Period for Leasehold Improvements. Issue 05-06 provides that the
amortization period used for leasehold improvements acquired in a business combination or
purchased after the inception of a lease be the shorter of (a) the useful life of the
assets or (b) a term that includes required lease periods and renewals that are reasonably
assured upon the acquisition or the purchase. The provisions of Issue 05-06 are effective
on a prospective basis for leasehold improvements purchased or acquired beginning in our
second quarter of fiscal 2006. We do not believe the adoption of Issue 05-06 will have a
material effect on our consolidated financial position, results of operations or cash
flows.

The
Company has not evaluated the impact of the new pronouncement on the financial statements.

5

---

# 3. Stock-based
Compensation

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

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

|                                                        | Three Months Ended Sep. 30, | Nine Months Ended Sep. 30,
|------------------------------------------------------- | --------------------------- | --------------------------
|                                                        | 2005                        |                           
|Net loss, as reported:                                  |                             |                           
|Add: Stock-based employee compensation expense included |                             |                           
|in reported net loss                                    |                             |                           
|Deduct: Total stock-based employee compensation expense |                             |                           
|determined under fair value based method for all awards |                             |                           
|                                                        |                             |                           
|Pro forma net loss:                                     |                             |                           
|                                                        |                             |                           
|Net loss per share attributable to common stockholders, |                             |                           
|basic and diluted:                                      |                             |                           
|As reported                                             |                             |                           
|Pro forma                                               |                             |                           
|Shares used in EPS calculation (basic and diluted)      |                             |                           
|                                                        |                             |                           
|                                                        |                             |                           

* Restatement of Net loss, as reported for the nine months ended September 30, 2004.

A clerical error occurred in posting the nine months net loss figure on page 5, Note 3, of last years 10-QSB
report, and that error has been corrected.  The net loss as posted was $7,775 and should have been $7,755.

# 4. Marketable Securities

|                          | September 30, 2005            | December 31, 2004            
|------------------------- | ----------------------------- | -----------------------------
|                          |                               |                              
|                          | Available-for-Sale Securities | Available-for-Sale Securities
|                          |                               |                              
|(in thousands)            | Cost                          | GrossUnrealizedGains         
|Money market funds        |                               |                              
|Auction rate securities   |                               |                              
|US Treasury and Federal   |                               |                              
|Agency Securities         |                               |                              
|Corporate bonds           |                               |                              
|                          |                               |                              
|Total available-for-sale  |                               |                              
|securities                |                               |                              
|Included in:              |                               |                              
|Cash and cash equivalents |                               |                              
|Short-term investments    |                               |                              
|                          |                               |                              
|Total                     |                               |                              
|                          |                               |                              

6

---

# 5. Inventories, net (in thousands)

|                | Sept. 30, 2005 | Dec. 31, 2004
|--------------- | -------------- | -------------
|Inventories     |                |              
|Finished goods  |                |              
|Work-in-process |                |              
|Raw materials   |                |              
|                |                |              
|                |                |              
|                |                |              
|                |                |              

# 6. Net Loss Per Share

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

|                                                       | Three Months Ended Sep. 30, | Nine Months Ended Sep. 30,
|------------------------------------------------------ | --------------------------- | --------------------------
|                                                       | 2005                        |                           
|Numerator:                                             |                             |                           
|Net loss                                               |                             |                           
|                                                       |                             |                           
|Denominator:                                           |                             |                           
|Shares used in computing net loss per share:           |                             |                           
|Weighted average of common shares outstanding          |                             |                           
|Less: Weighted average of shares subject to repurchase |                             |                           
|                                                       |                             |                           
|Basic and diluted                                      |                             |                           
|                                                       |                             |                           
|Net loss per share:                                    |                             |                           
|Basic and diluted                                      |                             |                           
|                                                       |                             |                           
|                                                       |                             |                           
|                                                       |                             |                           

* Restatement of Net loss, as reported for the nine months ended September 30, 2004.

A clerical error occurred in posting the nine months net loss figure on page 6, Note 7, of last years 10-QSB
report, and that error has been corrected.  The net loss as posted was $7,775 and should have been $7,755.

7

---

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

|                                     | Three Months Ended Sep. 30, | Nine Months Ended Sep. 30,
|------------------------------------ | --------------------------- | --------------------------
|                                     | 2005                        |                           
|Options to purchase common stock and |                             |                           
|shares subject to repurchase         |                             |                           
|                                     |                             |                           
|                                     |                             |                           

# 7. Comprehensive Loss

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

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

|                                                 | Three Months Ended Sep. 30, | Nine Months Ended Sep. 30,
|------------------------------------------------ | --------------------------- | --------------------------
|                                                 | 2005                        |                           
|Net loss                                         |                             |                           
|Cumulative translation adjustments               |                             |                           
|Unrealized gain (loss) on short-term investments |                             |                           
|                                                 |                             |                           
|Total comprehensive loss                         |                             |                           
|                                                 |                             |                           

# 8. Commitments and
Contingencies

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

Indemnification
and Product Warranty:The Company indemnifies certain customers, suppliers and
subcontractors for attorney fees and damages and costs awarded against these parties in
certain circumstances in which products are alleged to infringe third party intellectual
property rights, including patents, trade secrets, trademarks or copyrights. In all cases,
there are limits on and exceptions to the potential liability for indemnification relating
to intellectual property infringement claims. The Company cannot estimate the amount of
potential future payments, if any, that 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.

8

---

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

Letter
of Credit:The Company had a letter of credit of $0.4 million outstanding as of
September 30, 2005. The letter of credit is collateralized by short term investments of
$0.4 million and there is currently no outstanding balance.

# 9. Bank Loans

In
November 2004, the Company entered into a ten year loan of $0.5 million with a lender in
Taiwan. The loan has an interest rate based upon the Certificate of Deposit rate plus 0.7%
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 $0.7 million as
of September 30, 2005. The outstanding balance of this loan was $0.4 million as of
September 30, 2005.

In
April 2005, the Company entered into a five year loan of $0.2 million with a lender in
Taiwan. The loan has an interest rate based upon the Certificate of Deposit rate plus 1.2%
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 equipment in Taiwan. The net book value of the secured equipment was $0.2
million as of September 30, 2005. The outstanding balance of this loan was $0.2 million as
of September 30, 2005.

Payments
due under the two bank loans as of September 30, 2005 are as follows (in thousands):

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

9

---

# 10. Related Party
Transactions

As
of September 30, 2005, Foxconn Holding Limited was a holder of 20.3% 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 Company Limited were $0.2 million in the three months ended September 30, 2005.
Sales of products to Hon Hai Precision Company Limited were $0.5 million in the nine
months ended September 30, 2005. Purchases of raw materials from Hon Hai Precision Company
Limited were $0.6 million in the three months ended September 30, 2005. Purchases of raw
materials from Hon Hai Precision Company Limited were $1.6 million in the nine months
ended September 30, 2005. Amounts due from Hon Hai Precision Company Limited were $0.2
million at September 30, 2005. Amounts due to Hon Hai Precision Company Limited were $0.5
million at September 30, 2005.

# 11. Acquisition of Assets

In
January 2004, we acquired substantially all of the assets of Taiwan-based Ritek
Corporations photonic business unit and assumed certain pension liabilities. In
addition, the Company received $1.5 million in cash from Ritek. The assets were acquired
by means of a purchase for shares of the Companys common stock. The results of
operation of Ritek are included in the accompanying statement of operations as of the date
of acquisition.

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

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

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

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

|              | Three Months Ended Sep. 30, | Nine Months Ended Sep. 30,
|------------- | --------------------------- | --------------------------
|              | 2005                        |                           
|Revenues      |                             |                           
|North America |                             |                           
|Europe        |                             |                           
|Asia          |                             |                           
|              |                             |                           
|              |                             |                           
|              |                             |                           
|              |                             |                           
|              |                             |                           

|                                       | Three Months Ended Sep. 30, | Nine Months Ended Sep. 30,
|-------------------------------------- | --------------------------- | --------------------------
|                                       | 2005                        |                           
|Revenues                               |                             |                           
|Optical path management solution       |                             |                           
|Dense wave length division multiplexer |                             |                           
|                                       |                             |                           
|                                       |                             |                           
|                                       |                             |                           
|                                       |                             |                           
|                                       |                             |                           

10

---

|                       | Sept. 30, 2005 | Dec. 31, 2004
|---------------------- | -------------- | -------------
|Property and Equipment |                |              
|United States          |                |              
|Taiwan                 |                |              
|China                  |                |              
|                       |                |              
|                       |                |              
|                       |                |              
|                       |                |              
|                       |                |              

11

---

# ITEM 2:
MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

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 and operating losses, profitability, the amount and mix of
anticipated investments, expenditures and expenses, our liquidity and the adequacy of our
capital resources, anticipated working capital and capital expenditures, reliance on our
OPMS products, our cash flow, trends in average selling prices, our reliance on the
commercial success of our DWDM-related products, plans for future products and
enhancements of existing products, features, benefits and uses of our products, demand for
our products, our success being tied to relationships with key customers, industry trends
and market demand, acquisitions of complementary businesses, products or technologies, our
efforts to protect our intellectual property, potential indemnification agreements,
increases in the number of possible license offers and patent infringement claims, our
competitive position, sources of competition, consolidation in our industry, our
international strategy, inventory management, our consideration of a reverse stock split,
our employee relations, the adequacy of our internal controls, the effect of recent
accounting pronouncements and our critical accounting policies and estimates.
Forward-looking statements are subject to risks and uncertainties that could cause actual
results to differ materially from those projected. These risks and uncertainties include,
but are not limited to, those risks discussed below, as well as risks related to the
development of the metropolitan, last mile access, and enterprise networks, customer
acceptance of our products, our ability to retain and obtain customers, industry-wide
overcapacity and shifts in supply and demand for optical components and modules, our
ability to meet customer demand and manage inventory, fluctuations in demand for our
products, declines in average selling prices, development of new products by us and our
competitors, increased competition, inability to obtain sufficient quantities of a raw
material product, loss of a key supplier, integration of acquired businesses or
technologies, financial stability in foreign markets, foreign currency exchange rates,
costs associated with being a public company, delisting from the Nasdaq 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
Item 2, Managements Discussion and Analysis or Plan of Operation.
These forward-looking statements speak only as of the date hereof. The Company expressly
disclaims any obligation or undertaking to release publicly any updates or revisions to
any forward-looking statements contained herein to reflect any change in the
Companys expectations with regard thereto or any change in events, conditions or
circumstances on which any such statement is based.

This
Managements Discussion and Analysis or Plan of Operation should be read in
conjunction with the section entitled Managements Discussion and Analysis of
Financial Condition and Results of Operations in the Companys Annual Report on
Form 10-KSB, its Consolidated Financial Statements and the Notes thereto, for the year
ended December 31, 2004.

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

# Critical Accounting
Policies and Estimates

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

12

---

For
additional information regarding our critical accounting policies and estimates, see the
section entitled Managements Discussion and Analysis of Financial Condition
and Results of Operations in our Annual Report on Form 10-KSB, for the year ended
December 31, 2004.

# Overview

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

Our
OPMS products contributed revenues of $10.3 million and $7.6 million for the nine months
ended September 30, 2005 and September 30, 2004, respectively. Our DWDM products
contributed revenues of $5.1 million and $2.3 million for the nine months ended September
30, 2005 and September 30, 2004, respectively. For the nine months ended September 30,
2005 and September 30, 2004, our top ten customers comprised 58.2% and 49.7% of our
revenues, respectively. For the nine months ended September 30, 2005, one customer
accounted for 11.0% of our total revenues. For the nine months ended September 30, 2004,
one customer accounted for 10.3% of our total revenues.

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, our expenditures may not 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.

13

---

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
amortized using the graded vesting method, under which each option grant is separated into
portions based on its vesting terms which results in acceleration of amortization expense
for the overall award. The deferred stock-based compensation balance was fully amortized
on an accelerated basis by December 1, 2004.

# Results of Operations

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

|                               | Three Months
Ended Sept. 30, | Nine Months
Ended Sept. 30,
|------------------------------ | ---------------------------- | ---------------------------
|                               | 2005                         | 2004                       
|Revenues                       |                              | 100                        
|Cost of revenues:              |                              | 78                         
|                               |                              |                            
|Gross profit                   |                              | 21                         
|Operating expenses:            |                             
|Research and development:      |                              | 14                         
|Sales and marketing:           |                              | 9                          
|General and administrative:    |                              | 14                         
|                               |                              |                            
|Total operating expenses       |                              | 39                         
|Loss from operations           |                              | (17                        
|Interest and other income, net |                              | 7                          
|                               |                              |                            
|Net loss                       |                              | (10                        
|                               |                              |                            

Revenues.Revenues were $5.3 million and $3.7 million for the three months ended
          September 30, 2005 and 2004, respectively. Revenues increased 43.8% from
          September 30, 2004 to September 30, 2005, primarily due to increased volume
          shipments of our Fiber to the Premise (FTTP) and Compact Coarse Wavelength
          Division Multiplexing (CCWDM) products which were somewhat offset by decreasing
          average selling prices in our older product lines. Revenues from our
          OPMS-related products were $3.9 million and $2.7 million for the three months
          ended September 30, 2005 and 2004, respectively and revenues from our
          DWDM-related products were $1.4 million and $0.9 million for the three months
          ended September 30, 2005 and 2004, respectively.

Revenues
were $15.5 million and $9.9 million for the nine months ended September 30, 2005
and 2004, respectively. Revenues from our OPMS-related products were $10.3 million and
$7.6 million for the nine months ended September 30, 2005 and 2004, respectively. Revenues
from our DWDM-related products were $5.1 million and $2.3 million for the nine months
ended September 30, 2005 and 2004, respectively. The DWDM revenue increase of 125.5% was
primarily due to increased volume shipments of and increased demand for our Spectramux
Coarse Wavelength Division Multiplexing and Fiber Array Unit products.

14

---

Cost
of Revenues.Cost of revenues was $4.1 million and $3.2 million for the three months
ended September 30, 2005 and 2004, respectively. Cost of revenues as a percentage of net
revenues decreased to 78.6% for the three months ended September 30, 2005 from 86.2% for
the three months ended September 30, 2004. Cost of revenues for the three months ended
September 30, 2005 benefited from increased absorption of manufacturing overhead costs due
to higher volume shipments while cost of revenues for the three months ended September 30,
2004 was primarily impacted by the increase in inventory provisions for excess and
obsolete inventory which resulted in a charge of $0.3 million.

Cost
of revenues was $12.3 million and $9.5 million for the nine months ended September 30,
2005 and 2004, respectively. Cost of revenues as a percentage of net revenues decreased to
79.5% for the nine months ended September 30, 2005 from 95.5% for the nine months ended
September 30, 2004. Cost of revenues for the nine months ended September 30, 2005
benefited from increased absorption of manufacturing overhead costs due to higher volume
shipments while cost of revenues for the nine months ended September 30, 2004 was
primarily impacted by inventory provisions for excess and obsolete inventory which
resulted in a charge of $0.8 million.

Gross
Profit.We earned a gross profit of $1.1 million and $0.5 million for the three month
periods ended September 30, 2005 and September 30, 2004, respectively. We earned a gross
profit of $3.2 million and $0.4 million for the nine months ended September 30, 2005 and
September 30, 2004, respectively. The improvement for the nine months ended September 30,
2005 when compared to the same period in 2004 was mainly due to increased absorption of
manufacturing overhead costs and reduced inventory provisions for excess and obsolete
inventory.

We
expect our gross profit as a percentage of revenues to improve in the near term due to
higher production volumes which we anticipate will result in improved absorption of
overhead expenses. However, decreasing average selling prices will negatively impact our
gross profit and may offset any benefits from improved absorption. We had approximately
$1.4 million in DWDM-related net inventory and $2.0 million in OPMS-related net inventory
on hand at September 30, 2005. Although we take steps to manage future inventory levels,
we may have to record additional inventory reserves in future periods if there is a
decrease in demand.

Research
and Development Expenses. Research and development expenses decreased to $0.8 million
for the three months ended September 30, 2005 from $1.5 million for the three months ended
September 30, 2004. As a percentage of revenues, research and development expenses
decreased to 14.9% for the three months ended September 30, 2005 from 40.2% for the same
period in 2004. Research and development expenses decreased to $2.6 million for the nine
months ended September 30, 2005 from $4.5 million for the nine months ended September 30,
2004. As a percentage of revenues, research and development expenses decreased to 16.9%
for the nine months ended September 30, 2005 from 45.2% for the same period in 2004. The
decrease in both the three month and nine month periods was primarily due to reduced
headcount in the United States and reduced material expenses. We expect research and development expenses on our product development
efforts to remain relatively flat in the near term as we continue to carefully monitor our
discretionary spending.

Sales
and Marketing Expenses. Sales and marketing expenses remained flat at $0.5 million for
the three months ended September 30, 2005 and September 30, 2004, respectively. As a
percentage of revenues, sales and marketing expenses decreased to 9.9% for the three
months ended September 30, 2005 from 12.8% for the three months ended September 30, 2004.
Sales and marketing expenses increased to $1.7 million for the nine months ended September
30, 2005 from $1.5 million for the nine months ended September 30, 2004. As a percentage
of revenues, sales and marketing expenses decreased to 10.7% for the nine months ended
September 30, 2005 from 15.0% for the nine months ended September 30, 2004. We expect
sales and marketing expenses to remain relatively flat in the near term as we continue to
carefully monitor our discretionary spending.

General
and Administrative Expenses.General and administrative expenses decreased to $0.8
million, or 14.3% of revenues, for the three months ended September 30, 2005 from $0.9
million, or 25.3% of revenues, for the same period in 2004. General and administrative
expenses decreased to $2.2 million for the nine months ended September 30, 2005 from $2.6
million for the nine months ended September 30, 2004. As a percentage of revenues, general
and administrative expenses decreased to 14.4% for the nine months ended September 30,
2005 from 26.2% for the same period in 2004. The decrease in expenses for both the three
month and nine month periods was primarily due to lower discretionary spending. We expect
to maintain general and administrative expenses at the same level as the first nine months
of 2005 with the exception of professional and legal services which we expect will
increase due to higher fees and costs associated with compliance with new laws and
regulations such as the Sarbanes-Oxley Act of 2002 and the regulations promulgated
thereunder.

15

---

Stock-Based
Compensation.Total stock-based compensation decreased to $0 for the three months
ended September 30, 2005 from $0.1 million, or 1.9% of revenues for the same period in
2004. Total stock-based compensation decreased to $0 for the nine months ended September
30, 2005 from $0.3 million, or 2.9% of revenues, for the same period in 2004. This
decrease was partially due to our accounting policy which requires the amortization of a
larger proportion of deferred compensation expense during the early vesting periods of the
option grants. The deferred compensation balance was fully amortized as of December 1,
2004.

Interest
and Other Income/(Expense), Net.Interest and other income (expense), net, was $0.4
million and ($26,000) for the three months ended September 30, 2005 and 2004,
respectively. Interest and other income(expense), net, was $1.2 million and $0.4 million
for the nine months ended September 30, 2005 and 2004, respectively.

# Liquidity and Capital
Resources

Since
inception, we have financed our operations primarily through sales of stock and bank
loans. Additionally, in November 2000, we completed our initial public offering of common
stock, raising approximately $44.4 million, net of costs and expenses. On September
30, 2005, we had cash and cash equivalents of $4.0 million and short-term investments of
$25.4 million.

Net
cash used in operating activities was $1.6 million and $6.8 million for the nine months
ended September 30, 2005 and 2004, respectively. For the nine months ended September 30,
2005, net cash used was primarily due to our net loss of $2.1 million. For the nine months
ended September 30, 2004, net cash used was primarily due to our net loss of $7.8 million.

Cash
used in investing activities was $2.0 million for the nine months ended September 30, 2005
and cash generated from investing activities was $13.5 million for the nine months
ended September 30, 2004. In the nine months ended September 30, 2005, we invested $1.4
million in high-grade, short-term investments, while $0.6 million was used to acquire
property and equipment. In the nine months ended September 30, 2004, $12.3 million was
generated in high-grade, short-term investments, $1.5 million was generated from the asset
acquisition from Ritek, and $0.3 million was used to acquire property and equipment.

Cash
generated by financing activities was $0.4 million and $1.0 million for the nine months
ended September 30, 2005 and 2004, respectively, resulting from proceeds from the exercise
of options to purchase shares of our common stock and common stock issued through our
employee stock purchase plan. Cash generated also included net proceeds from borrowings
under an equipment loan of $0.1 million and repayment of bank borrowings for the nine
months ended September 30, 2005. Cash generated also included net proceeds from the
repayment of notes receivable of $0.5 million for the nine months ended September 30,
2004.

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. In particular, if our common stock is
delisted from the Nasdaq Capital Market, it may make it more difficult for us to raise
capital in the future because our price per share could further decrease and the liquidity
of our common stock would be adversely impacted. 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.

16

---

# Contractual Obligations

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 that we pay is approximately $31,000.

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

# Recent Accounting
Pronouncements

On
March 29, 2005, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin No. 107 (SAB 107) regarding the Staffs interpretation of
SFAS 123(R). This interpretation expresses the views of the Staff regarding the
interaction between SFAS 123(R) and certain SEC rules and regulations and provides the
Staffs views regarding the valuation of share-based payment arrangements by public
companies. In particular, this SAB provides guidance related to share-based payment
transactions with nonemployees, the transition from nonpublic to public entity status,
valuation methods, the accounting for certain redeemable financial instruments issued
under share-based payment arrangements, the classification of compensation expense,
non-GAAP financial measures, first-time adoption of SFAS 123(R) in an interim period,
capitalization of compensation cost related to share-based payment arrangements, the
accounting for income tax effects of share-based payment arrangements upon adoption of
SFAS 123(R), the modification of employee share options prior to adoption of SFAS 123(R)
and disclosures in Managements Discussion and Analysis subsequent to adoption of
SFAS 123(R). We will adopt SAB 107 in connection with our adoption of SFAS 123(R), which
could have a material impact on our consolidated financial position, results of operations
and cash flows.

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

On
March 30, 2005, FASB Interpretation (FIN) No. 47, Accounting for Conditional Asset
Retirement Obligations  An Interpretation of FASB Statement No. 143, was issued.
The FASB issued FIN 47 to address diverse accounting practices that developed with respect
to the timing of liability recognition for legal obligations associated with the
retirement of a tangible long-lived asset when the timing and (or) method of settlement of
the obligation are conditional on a future event. For example, some entities recognize the
fair value of the obligation prior to the retirement of the asset with the uncertainty
about the timing and (or) method of settlement incorporated into the fair value of the
liability. Other entities recognize the fair value of the obligation only when it is
probable the asset will be retired as of a specified date using a specified method or when
the asset is actually retired. FIN 47 concludes that an entity is required to recognize a
liability for the fair value of a conditional asset retirement obligation when incurred if
the liabilitys fair value can be reasonably estimated. Originally, the FASB proposed
guidance in FASB Staff Position (FSP) FAS FIN 47 143-x, Application of FASB
Statement No. 143, Accounting for Asset Retirement Obligations, to Legislative
Requirements on Property Owners to Remove and Dispose of Asbestos or Asbestos-Containing
Materials, but the FASB ultimately concluded there were additional issues that
required the FASBs attention. Accordingly, the FASB withdrew the proposed FSP and
issued an Exposure Draft, Accounting for Conditional Asset Retirement Obligations,
which is the basis for FIN 47.

The
Company has not evaluated the impact of the new pronouncement on the financial statements.

17

---

On
June 29, 2005, the FASB ratified the EITF Issue No. 05-06, Determining the Amortization
Period for Leasehold Improvements. Issue 05-06 provides that the amortization period
used for leasehold improvements acquired in a business combination or purchased after the
inception of a lease be the shorter of (a) the useful life of the assets or (b) a term
that includes required lease periods and renewals that are reasonably assured upon the
acquisition or the purchase. The provisions of Issue 05-06 are effective on a prospective
basis for leasehold improvements purchased or acquired beginning in our second quarter of
fiscal 2006. We do not believe the adoption of Issue 05-06 will have a material effect on
our consolidated financial position, results of operations or cash flows.

The
Company has not evaluated the impact of the new pronouncement on the financial statements.

# FACTORS THAT MAY
AFFECT RESULTS

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

We
incurred net losses of approximately $7.8 million and $2.1 million in the first nine
months of fiscal 2004 and 2005, respectively, and expect that our net losses and negative
cash flows will continue for the foreseeable future as we continue to invest in our
business. As of September 30, 2005, we had an accumulated deficit of approximately $71.9
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.

18

---

Our Optical Path Management
Solution (OPMS) products have historically comprised a significant part 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 74% of our revenues in the the three months ended September
30, 2005, 77% of our revenues for the nine months ended September 30, 2004, and
substantially all of our historical revenues. We depend on these products for the majority
of 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 has 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.

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

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

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

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

o    customer unwillingness to implement our products;

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

o    the success of our customers;

o    excess inventory in the telecommunications industry;

o    new product introductions by our competitors;

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

o    any difficulty we may incur in meeting customers' delivery requirements or product specifications

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

19

---

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 historical fluctuations in demand for our products,
our operating results could be harmed.

We
rapidly expanded our operations domestically and internationally in the final two quarters
of 2000. We have had to carefully manage and re-evaluate this expansion given the sudden
and dramatic downturn in demand for our products 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, 2005, we had a total of 50 full-time employees in Sunnyvale,
California, 291 full-time employees in Taiwan, and 225 full-time employees in China.
Matching the scale of our operations with the recent demand fluctuations, combined with
the challenges of expanding and managing geographically dispersed operations, has placed,
and will continue to place, a significant strain on our management and resources. To
manage the expected fluctuations in our operations and personnel, we will be required to:

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

o    hire,  train,  motivate and manage  additional  qualified  personnel,  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.

20

---

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. We also have substantial manufacturing operations in China.
There is significant political tension between Taiwan and China. If there is an outbreak
of hostilities between Taiwan and China, our manufacturing operations may be disrupted or
we may have to relocate our manufacturing operations. Tensions between Taiwan and China
may also affect our facility in China. Relocating a portion of our employees could cause
temporary disruptions in our operations and divert managements attention.

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

The
development of new or enhanced fiber optic products is a complex and uncertain process. We
may experience design, manufacturing, marketing and other difficulties that could delay or
prevent the development, introduction or marketing of new products and enhancements.
Development costs and expenses are incurred before we generate revenues from sales of
products resulting from these efforts. Our total research and development expenses were
approximately $4.5 million and $2.6 million for the nine months ended September 30, 2004
and 2005, respectively. We intend to continue to invest a substantial amount of funds in
our research and product development efforts, which could have a negative impact on our
earnings in future periods.

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

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

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

21

---

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

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

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

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

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

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

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

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

22

---

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

Because
we experience long lead times for materials and components and are often required to
purchase significant amounts of materials and components far in advance of product
shipments, we may not effectively manage our inventory levels, which could harm our
operating results. Alternatively, if we underestimate our raw material requirements, we
may have inadequate inventory, which could result in delays in shipments and loss of
customers. If we purchase raw materials and increase production in anticipation of orders
that do not materialize or that shift to another quarter, we will, as we have in the past,
have to carry or write off excess inventory and our gross margins will decline. Either
situation could cause our results of operations to be below the expectations of investors
and public market analysts, which could, in turn, cause the price of our common stock to
decline. The time our customers require to incorporate our products into their own can
vary significantly and generally exceeds several months, which further complicates our
planning processes and reduces the predictability of our forecasts. Even if we receive
these orders, the additional manufacturing capacity that we add to meet our
customers requirements may be underutilized in a subsequent quarter.

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

Section
404 of the Sarbanes-Oxley Act of 2002 requires our management to report on, and our
independent auditors to attest to, the effectiveness of our internal controls over
financial reporting beginning with our fiscal year ending December 31, 2007. 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 with generally accepted accounting principles,
or GAAP, in the United States. These accounting principles are subject to interpretation
by the American Institute of Certified Public Accountants, the Securities and Exchange
Commission and various bodies formed to interpret and create appropriate accounting
policies. A change in those policies can have a significant effect on our reported results
and may affect our reporting of transactions completed before a change is announced.
Changes to those rules or the questioning of current practices may adversely affect our
reported financial results or the way we conduct our business. For example, accounting
policies affecting many aspects of our business, including rules relating to employee
stock option grants, have recently been revised or are under review. The Financial
Accounting Standards Board and other agencies have finalized changes to U.S. generally
accepted accounting principles that will require us, starting in our 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 increase our overall net loss or
negatively impact our potential to be profitable 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.

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.

23

---

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

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

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

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

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

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

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

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

24

---

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 long-haul,
metropolitan, last mile, and enterprise access segments of the networks, is critical to
our future success. Potential end-user customers who have invested substantial resources
in their existing copper lines or other systems may be reluctant or slow to adopt a new
approach, such as optical networks. Our success in generating revenues in this emerging
market will depend on:

25

---

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

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

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

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

Beginning
at the commencement of trading on November 8, 2002, the listing of our common stock was
transferred from the Nasdaq National Market to the Nasdaq 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 National 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. Although we were unable to comply with this criteria for at
least 10 consecutive trading days before May 12, 2005, Nasdaq granted us an additional 180
days, or until November 8, 2005, to comply with the minimum closing bid price requirement.
The Nasdaq has granted us another 180 day extension, or until May 8, 2006 to regain
compliance with this criteria. If we are unable to comply with this criteria for 10
consecutive trading days before May 8, 2006, our common stock will be delisted. If we are
unable to continue to meet any of the Nasdaq Capital Markets other initial listing
requirements during the grace period, we may be delisted from the Nasdaq Capital Market.
Delisting could further decrease the price per share and the liquidity of our common
stock, and make it more difficult for us to raise capital in the future

26

---

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 may independently develop similar technology, duplicate our
products, or design around any of our patents or other intellectual property. If we are
unable to adequately protect our proprietary technology rights, others may be able to use
our proprietary technology without having to compensate us, which could reduce our
revenues and negatively impact our ability to compete effectively.

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

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

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

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

27

---

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

For
the nine months ended September 30, 2004 and 2005, sales to customers located outside of
North America were 16.4% and 24.8% of our revenues, respectively. In order to expand our
business, we must increase our sales to customers located outside of North America. We
have limited experience in marketing and distributing our products internationally and in
developing versions of our products that comply with local standards. Our international
sales will be limited if we cannot establish relationships with international
distributors, establish additional foreign operations, expand international sales
channels, hire additional personnel and develop relationships with international
communications equipment manufacturers. Even if we are able to successfully continue
international operations, we may not be able to maintain or increase international market
demand for our products.

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

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

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

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

28

---

# ITEM 3: CONTROLS AND
PROCEDURES

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

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

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

29

---

# PART II: OTHER
INFORMATION

# ITEM 1: LEGAL PROCEEDINGS

None

# ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None

# ITEM 3: DEFAULTS UPON SENIOR SECURITIES

None

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

None

# ITEM 5: OTHER EVENTS

Our
2006 Annual Meeting of Stockholders will be held on May 19, 2006 at such place and
time as will be set forth in our proxy statement relating to that meeting. A stockholder
proposal not included in the proxy statement for the 2006 Annual Meeting will be
ineligible for presentation at the meeting unless the stockholder gives timely notice of
the proposal in writing to our Secretary at our principal executive offices and otherwise
complies with the provisions of our Bylaws. To be timely, the Companys Bylaws
provide that the Company must have received the stockholders notice not less than
60 days nor more than 90 days prior to the scheduled date of such meeting.
However, if notice or prior public disclosure of the date of the annual meeting is given
or made to stockholders less than 75 days prior to the meeting date, the Company must
receive the stockholders notice by the earlier of (i) the close of business on
the 15th day after the earlier of the day the Company mailed notice of the annual meeting
date or provided such public disclosure of the meeting date and (ii) two days prior
to the scheduled date of the annual meeting. For the Companys 2006 Annual Meeting of
Stockholders, stockholders must submit written notice to the Secretary in accordance with
the foregoing Bylaw provisions no later than March 20, 2006.

# ITEM 6: 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).
|               |                                                                                                                    
|               | ___________________                                                                                                

30

---

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

31

---

# 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 10, 2005

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

32

---