UNITED STATES




SECURITIES AND EXCHANGE COMMISSION




WASHINGTON, D.C. 20549









FORM 10-Q




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




For the quarterly period ended March 31, 2011




Commission File Number 0-31857




ALLIANCE FIBER OPTIC PRODUCTS, INC.(Exact name of registrant as specified in its charter)


Delaware

77-0554122(State or other jurisdiction of

(I.R.S. employerIncorporation or organization)

identification number)


275 Gibraltar Drive, Sunnyvale, California 94089(Address of Principal Executive Offices)(408) 736-6900(Issuer’s telephone number)


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




Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes o No þ




Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “accelerated filer”, ”large accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act). (Check one):




Large accelerated filer o
Accelerated Filer o
Non-accelerated filer o
Smaller reporting company þ(Do not check if a smaller reporting company)


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




On April 29, 2011, 8,835,786 shares of the registrant’s Common Stock, $0.001 par value per share, were outstanding.




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ALLIANCE FIBER OPTIC PRODUCTS, INC.




FORM 10-Q




QUARTERLY PERIOD ENDED MARCH 31, 2011




INDEX




PagePART I: FINANCIAL INFORMATION

1ITEM 1: FINANCIAL STATEMENTS

1Condensed Consolidated Balance Sheets at March 31, 2011 (unaudited) andDecember 31, 2010

1Condensed Consolidated Statements of Income for theThree Months Ended March 31, 2011 and 2010 (unaudited)

2Condensed Consolidated Statements of Cash Flows for theThree Months Ended March 31, 2011 and 2010 (unaudited)

3Notes to Condensed Consolidated Financial Statements (unaudited)

4ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS

11ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

15ITEM 4: CONTROLS AND PROCEDURES

16PART II: OTHER INFORMATION

17ITEM 1A: RISK FACTORS

17ITEM 6: EXHIBITS

26SIGNATURE

27


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PART I: FINANCIAL INFORMATION




ITEM 1: FINANCIAL STATEMENTS




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




March 31,

December 31,2011

2010(Unaudited)AssetsCurrent assets:Cash and cash equivalents

$
8,460


$
8,040Short-term investments


36,681



37,320Accounts receivable, net


6,514



7,224Inventories, net


7,977



7,439Prepaid expense and other current assets


684



733Total current assets


60,316



60,756Property and equipment, net


7,753



7,523Other assets


177



170Total assets

$
68,246


$
68,449Liabilities and Stockholders' EquityCurrent liabilities:Accounts payable

$
4,785


$
4,931Accrued expenses


3,230



4,633Current portion of bank loan


104



104Total current liabilities


8,119



9,668Other long-term liabilitiesBank loan


204



231Other long-term liabilities


557



546Total long term liabilities


761



777Total liabilities


8,880



10,445Commitments and contingencies (Note 8)Stockholders' equity:Common stock, $0.001 par value: 80,000,000 shares authorized;8,835,786 and 8,793,636 shares issued and outstanding atMarch 31, 2011 and December 31, 2010.


9



9Additional paid-in-capital


114,025



113,707Accumulated deficit


(56,763
)


(57,784
)Accumulated other comprehensive income


2,095



2,072Stockholders' equity


59,366



58,004Total liabilities and stockholders' equity

$
68,246


$
68,449


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




1




---




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




Three Months Ended March 31,2011

2010Revenues

$
9,450


$
8,406Cost of revenues


6,415



5,711Gross profit


3,035



2,695Operating expenses:Research and development


718



709Sales and marketing


550



561General and administrative


1,028



933Total operating expenses


2,296



2,203Income from operations


739



492Interest and other income, net


129



150Net income before tax


868



642Income tax


(153
)


1Net income

$
1,021


$
641Net income per share:Basic

$
0.12


$
0.08Diluted

$
0.11


$
0.07Shares used in computing net income per share:Basic


8,823



8,493Diluted


9,258



8,648


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




2




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ALLIANCE FIBER OPTIC PRODUCTS, INC. Condensed Consolidated Statements of Cash Flows 
(Unaudited, In thousands)




Three Months Ended March 31,2011

2010Cash flows from operating activities:Net income

$
1,021


$
641Adjustments to reconcile net income to net cash provided by(used in) operating activities:Depreciation


353



248Amortization of stock-based compensation


82



33Provision for inventory valuation


(105
)


(102
)Changes in assets and liabilities:Accounts receivable


710



(478
)Inventories


(433
)


(775
)Prepaid expenses and other current assets


49



(100
)Other assets


(7
)


106Accounts payable


(147
)


910Accrued expenses


(1,403
)


(1,122
)Other long-term liabilities


11



19Net cash provided by (used in) operating activities


131



(620
)Cash flows from investing activities:Purchase of short-term investments


(1,772
)


(2,583
)Proceeds from sales and maturities of short-term investments


2,400



2,155Purchase of property and equipment


(552
)


(576
)Net cash provided by (used in) investing activities


76



(1,004
)Cash flows from financing activities:Proceeds from the exercise of stock options


236



62Payment of bank loans


(28
)


(36
)Net cash provided by financing activities


208



26Effect of exchange rate changes on cash and cash equivalents


5



84Net increase (decrease) in cash and cash equivalents


420



(1,514
)Cash and cash equivalents at beginning of period


8,040



8,525Cash and cash equivalents at end of period

$
8,460


$
7,011Supplemental disclosure of cash flow information:Cash paid for interest

$
(2
)

$
(3
)


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




3




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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 accompanying condensed consolidated balance sheet as of December 31, 2010, which has been derived from audited financial statements, and the unaudited interim condensed consolidated financial statements as of March 31, 2011 have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) and include the accounts of Alliance Fiber Optic Products, Inc. and its wholly-owned subsidiaries. All inter-company accounts and transactions have been eliminated. Certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) have been condensed or omitted pursuant to such rules and regulations.




These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 as filed with the SEC on March 18, 2011. The unaudited condensed consolidated financial statements as of March 31, 2011, and for the three months ended March 31, 2011 and 2010, reflect, in the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary to state fairly the financial information set forth herein. The results of operations for the interim periods are not necessarily indicative of the results to be expected for any subsequent interim period or for an entire year. The December 31, 2010 balance sheet was derived from audited financial statements at that date, but does not include all disclosures required by U.S. GAAP.




There have been no significant changes in the Company’s critical accounting policies during the three months ended March 31, 2011 as compared to what was previously disclosed in the Company’s Form 10-K for the fiscal year ended December 31, 2010 as filed with the SEC.




Revenue Recognition




We recognize revenue upon shipment of our products to customers, provided that we have 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 our products, we have no obligation to provide any modification or customization upgrades, enhancements or post contract customer support.




Allowance for Doubtful Accounts




Allowances are provided for estimated returns and potential uncollectable trade receivables. Provisions for return allowances are recorded at the time revenue is recognized based on our historical returns, current economic trends and changes in customer demand. Such allowances are adjusted periodically to reflect actual and anticipated experience. We also identify specific accounts considered to have a high risk of uncollectibility and reserve the full amount. Material differences may result in the amount and timing of our revenue for any period if management made different judgments or utilized different estimates.




4




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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, corporate bonds, certificates of deposit, and commercial papers.




Concentrations of Risk




Our connectivity products (formerly named optical path multiplexing solution) contributed 77.2% and 66.9% of our revenues for the quarters ended March 31, 2011 and 2010, respectively. Our optical passive products (formerly named dense wavelength division multiplexing) contributed 22.8% and 33.1% of our revenues for the quarters ended March 31, 2011 and 2010, respectively.




In the quarters ended March 31, 2011 and 2010, our top 10 customers comprised 60.9% and 67.8% of our revenues, respectively. For the three months ended March 31, 2011, one customer accounted for 16.7% of our total revenues. Amounts due from this customer was $1.4 million at March 31, 2011. For the three months ended March 31, 2010, three customers accounted for 14.3%, 11.9% and 10.1% of our total revenues. Amounts due from these customers were $1.4 million $0.6 million, and $0.6 million at March 31, 2010, respectively.




2. Recent Accounting Pronouncements




In January 2010, the FASB issued Accounting Standards Update (ASU) No. 2010-06, Improving Disclosure about Fair Value Measurements . This ASU will add new requirements for disclosures into and out of Levels 1 and 2 fair value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. It also clarifies existing fair value disclosures about the level of disaggregation, inputs, and valuation techniques. The guidance in the ASU is effective for annual and interim reporting periods in fiscal years beginning after December 15, 2010. The Company does not anticipate the adoption of the new guidance will have a material effect on the Company’s consolidated financial statements or results of operations.




3. Stock-based Compensation




The Accounting Standards Council (“ASC”) 718 requires companies to record compensation expense for stock options measured at fair value, on the date of grant, using an option-pricing model. The fair value of stock options granted and stock purchased pursuant to the ESPP prior to June 30, 2010 was determined using the Binomial Lattice Model. The Company adopted the Black-Scholes valuation model for stock options granted and stock purchased pursuant to the ESPP after June 30, 2010. The Company believes that the newly adopted model is more appropriate in determining fair value of its stock-based compensation and does not differ materially from the previous valuation model used.




As of March 31, 2011, there were $0.6 million of total unrecognized compensation cost related to share-based compensation arrangements granted under the Company’s option plans. The compensation cost is expected to be realized over four years.




At March 31, 2011 the Company had two stock-based compensation plans. They are: (a) 1997 Stock Option Plan and (b) 2000 Stock Incentive Plan, which are described below.




(a) 1997 Stock Option Plan




In May 1997, the Company adopted its 1997 Stock Plan under which 3,000,000 shares of common stock were reserved for issuance to eligible employees, directors and consultants upon exercise of stock options and stock purchase rights. During the year ended December 31, 2000, an additional 5,200,000 shares were reserved for issuance under the 1997 Stock Plan. Incentive stock options are granted at a price not less than 100% of the fair market value of the Company’s common stock and at a price of not less than 110% of the fair market value for grants to any person who owned more than 10% of the voting power of all classes of stock on the date of grant. Nonstatutory stock options are granted at a price not less than 85% of the fair market value of the common stock and at a price not less than 110% of the fair market value for grants to a person who owned more than 10% of the voting power of all classes of stock on the date of the grant. Options granted under the 1997 Stock Plan generally vest over four years and are exercisable for not more than ten years (five years for grants to any person who owned more than 10% of the voting power of all classes of stock on the date of the grant). In November 2000, the 1997 Stock Plan was replaced by the 2000 Stock Incentive Plan. Options granted under the 1997 Stock Plan remained outstanding as of March 31, 2010.




5




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(b) 2000 Stock Incentive Plan




In November 2000, the Company adopted its 2000 Stock Incentive Plan under which 1,500,000 shares of common stock were reserved for issuance to eligible employees, directors and consultants upon exercise of stock options and stock purchase rights. The plan was amended and restated in 2010 to, among other things, extend the term under which awards may be granted under the plan until March 17, 2020, eliminate a 10 million share ceiling on the aggregate number of shares of common stock that may be issued under the plan, and to include certain qualifying performance criteria and annual award limits so that awards granted under the plan qualify as “performance-based compensation" under the requirements of Section 162(m) of the Internal Revenue Code of 1986, as amended.




Options granted under the 2000 Stock Incentive Plan generally vest over four years and are exercisable for not more than ten years. However, most options granted in the past four years have been fully vested at the time of grant. Options are exercisable for not more than ten years.




The following information relates to stock option activity for the three months ended March 31, 2011:




WeightedWeighted

AverageAverage

Remaining

AggregateExercise

Contractual

IntrinsicOptions

Shares

Price

Life

ValueOutstanding at December 31, 2010

920,040


$
7.27Granted

-



-Exercised

(42,160
)


5.59Forfeited

(7,600
)


25.87Outstanding at March 31, 2011

870,280


$
7.19

5.52 Years

$
3,474,131Vested and expected to vest at March 31, 2011

870,280


$
7.19

5.52 Years

$
3,474,131Exercisable at March 31, 2011

662,458


$
6.92

4.32 Years

$
2,827,190


The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the first quarter of fiscal 2011 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on March 31, 2011. This amount changes based on the fair market value of the Company’s stock. The total intrinsic value of options exercised for the three months ended March 31, 2011 and 2010 was $0.2 million and $0.04 million, respectively.




There were no options granted during the quarters ended March 31, 2011 or 2010, respectively.




Expected dividend rate is 0% for both three month periods ended March 31, 2011 and 2010, respectively.




Cash received from option exercises during the three months ended March 31, 2011 and 2010 were $236,000 and $62,000, respectively. Such amounts are included within the financing activities section in the accompanying condensed consolidated statements of cash flows.




6




---




The following table summarizes employee stock-based compensation expense resulting from stock options and the Company’s employee stock purchase plan (in thousands):




Three Months Ended Mar. 31,2011

2010Included in cost of revenue

$
23

$
12Included in operating expenses:Research and development


8


5Sales and marketing


15


4General and administrative


37


12Total


60


21Total stock-based compensation expense

$
83

$
33


4. Inventories, net (in thousands)




March 31,

December 31,2011

2010InventoriesFinished goods

$
2,392

$
2,211Work-in-process


3,100


2,713Raw materials


2,485


2,515$
7,977

$
7,439


5. Net Income Per Share




Basic net income per share is computed by dividing net income for the period by the weighted average number of shares of common stock outstanding during the period. Diluted net income per share is computed by dividing net income for the period by the combination of dilutive common share equivalents, comprised of shares issuable under the Company’s stock-based compensation plans, and the weighted average number of common shares outstanding during the period. There were no incremental dilutive common share equivalents in the periods presented.




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




Three Months Ended March 31,2011

2010Numerator:Net income

$
1,021

$
641Denominator:Shares used in computing net income per share:Basic


8,823


8,493Diluted


9,258


8,648Net income per share:Basic

$
0.12

$
0.08Diluted

$
0.11

$
0.07


The total number of shares excluded from the calculation of diluted net income per share is as follows (in thousands):




Three Months Ended March 31,2011

2010Options to purchase common stock

-

155


7




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6. Comprehensive Income




Comprehensive income 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 income and comprehensive income for the Company is due to foreign exchange translations adjustments and unrealized loss on available-for-sale securities.




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




Three Months Ended March 31,2011

2010Net income

$
1,021


$
641Cumulative translation adjustments


34



113Unrealized loss on investments


(11
)


(6
)Total comprehensive income

$
1,044


$
748


7. Income Taxes




The Company adopted ASC 740, Accounting for Uncertainty in Income Taxes on January 1, 2007. It is the Company's accounting policy to record income tax interest and penalties in the income tax provision. The Company did not have any material unrecognized tax benefits or uncertain tax positions at March 31, 2011.




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 might be required to make as a result of these agreements. As of March 31, 2011, 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 nonconformance 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. The Company accrued $0.02 million warranty reserves as of March 31, 2011 and 2010, respectively.




Operating Leases:




The Company leases certain office space under long-term operating leases expiring at various dates through 2016.




8




---




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




Years ending December 31:2011 (remaining nine months of the year)

$
4202012


6372013


3792014


3352015 and after


230Total

$
2,001


9. Bank Loans




In November 2004, the Company entered into a ten-year loan of $0.5 million in Taiwan with an interest rate of 2.3% for the first two years and 3.6% for the following years. In November 2006, the Company entered into a seven-year loan of $0.2 million in Taiwan with an interest rate of 2.8%. Both loans are secured by the Company’s building in Taiwan. In September 2007, the Company also entered a five-year equipment loan of $0.1 million with an interest rate of 3.68%.




Payments due under bank loans as of March 31, 2011 are as follows (in thousands):




Years ending December 31,2011


822012


1032013


822014


53Total payment


320Less: Amounts representing interest


(12
)Present value of net remaining payments


308Less: current portion


(104
)Long-term portion

$
204


10. Related Party Transactions




As of March 31, 2011, based on information filed with the SEC, Foxconn Holding Limited was a holder of 18.1% of the Company’s common stock. In the normal course of business, the Company sells products to and purchases raw materials from Hon Hai Precision Company Limited, who is the parent company of Foxconn Holding Limited. These transactions were made at prices and terms consistent with those of unrelated third parties. Sales of products to Hon Hai Precision Industry Company Limited were $6,500 and $0 in the quarters ended March 31, 2011 and 2010, respectively. Purchases of raw materials from Hon Hai Precision Company Limited were $0.3 million and $0.6 million in the quarters ended March 31, 2011 and 2010, respectively. Amounts due from Hon Hai Precision Company Limited were $6,500 and $0 at March 31, 2011 and 2010, respectively. Amounts due to Hon Hai Precision Company Limited were $0.3 million and $0.7 million at March 31, 2011 and 2010, respectively.




11. Fair Value of Financial instruments




Effective January 1, 2008, the Company adopted ASC 820 which provides a definition of fair value, establishes a hierarchy for measuring fair value under generally accepted accounting principles, and requires certain disclosures about fair values used in the financial statements. ASC 820 does not extend the use of fair value beyond what is currently required by other pronouncements, and it does not pertain to stock-based compensation under ASC 718, Share-Based Payments or to leases under ASC 840, Accounting for Leases .




In February 2008, FASB ASC 820 was issued. This FASB Staff Position provides a one year deferral of the effective date of ASC 820 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. Therefore, the Company has adopted the provisions of ASC 820 with respect to financial assets and liabilities only.




9




---




ASC 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value, which are the following:


- Level 1 – Inputs are based upon quoted prices in active markets for identical assets or liabilities.
- Level 2 – Are based upon inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
- Level 3 – Inputs are generally unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

The Company measures the following financial assets at fair value on a recurring basis. The fair value of these financial assets at March 31, 2011 (in thousands) was as follows:




Fair Value Measurements atReporting Date UsingQuoted Prices

Significantin Active

Other

SignificantBalance at

Markets for

Observable

UnobservableMarch 31,

Identical Assets

Inputs

Inputs2011

(Level 1)

(level 2)

(Level 3)Cash equivalents:Money market mutual funds
$
7,231

$
7,231

$
-

$
-Marketable Securities:Time deposits

23,467


23,467


-


-Commercial paper

2,998


-


2,998


-Corporate bonds

10,216


-


10,216


-Total
$
43,912

$
30,697

$
13,214

$
-


As of March 31, 2011, the Company held investments in corporate bonds, commercial paper, certificates of deposit, and money market securities. The Company’s cash and cash equivalents are comprised of investments with original maturities of 90 days or less from the date of purchase. The Company’s short-term investments are comprised of corporate bonds, commercial paper and certificates of deposit with original maturities of 91 days or more from the date of purchase.




12. Geographic Segment Information




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




10




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




Three Months Ended March 31,2011

2010RevenuesNorth America
$
5,082

$
4,235Europe

1,457


1,894Asia

2,911


2,277$
9,450

$
8,406Three Months Ended March 31,2011

2010RevenuesConnectivity Products
$
7,294

$
5,621Optical Passive Products

2,156


2,785$
9,450

$
8,406March 31,

December 31,2011

2010Property and EquipmentUnited States
$
76

$
79Taiwan

3,548


3,589China

4,129


3,855$
7,753

$
7,523


13. Subsequent Event




On April 29, 2011, the stockholders approved an amendment to the Amended and Restated Certificate of Incorporation to reduce the number of shares of Common Stock the Company is authorized to issue to 20,000,000.




We evaluated subsequent events through the time of the filing of this report on Form 10-Q. We are not aware of any significant events, other than those disclosed above, that occurred subsequent to the balance sheet date prior to the filing of this report that would have a material impact on our condensed consolidated financial statements.




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




When used in this Report, the words “expects,” “anticipates,” “believes”, “estimates,” “plans,” “intends,” “could,” “will,” “may” and similar expressions are intended to identify forward-looking statements. These are statements that relate to future periods and include statements as to our operating results, revenues, sources of revenues, cost of revenues, gross margin, profitability, the amount and mix of anticipated investments, expenditures and expenses, our liquidity and the adequacy of our capital resources, our uses of our cash, the impact of the economic environment on our business, exposure to interest rate or currency fluctuations, anticipated working capital and capital expenditures, reliance on our connectivity products, our cash flow, trends in average selling prices, our reliance on the commercial success of our optical passive 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, our efforts to protect our intellectual property, the potential benefit of 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 employee relations, the adequacy of our internal controls, and the effect of recent, future and changing accounting pronouncements and our critical accounting policies, estimates, models and assumptions on our financial results. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. These risks and uncertainties include, but are not limited to, those risks discussed elsewhere in this report, as well as risks related to the development of the metropolitan, last mile access, and enterprise networks, customer acceptance of our products, our ability to retain and obtain customers, industry-wide overcapacity and shifts in supply and demand for optical components and modules, our ability to meet customer demand and manage inventory, fluctuations in demand for our products, declines in average selling prices, development of new products by us and our competitors, increased competition, inability to obtain sufficient quantities of a raw material component, loss of a key supplier, integration of acquired businesses or technologies, financial stability in foreign markets, foreign currency exchange rates, interest rates, costs associated with being a public company, failure to remain listed on the Nasdaq Capital Market, failure to meet customer requirements, our ability to license intellectual property on commercially reasonable terms, the impact of the economic environment, and the risks set forth below under Part II, Item 1A, “Risk Factors.” These forward-looking statements speak only as of the date hereof. The Company expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in the Company’s expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.





11




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




For additional information regarding our critical accounting policies and estimates, see the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2010.




Overview




We were founded in December 1995 and commenced operations to design, manufacture and market fiber optic interconnect products, which we call our connectivity products. We started selling our optical passive products in July 2000. Since their introduction, sales of optical passive products have fluctuated with the overall market for these products.




Our connectivity products contributed revenues of $7.3 million and $5.6 million for the three months ended March 31, 2011 and 2010, respectively. Our optical passive products contributed revenues of $2.1 million and $2.8 million for the three months ended March 31, 2011 and 2010, respectively. Our connectivity products contributed 77.2% and 66.9% of our revenues for the three months ended March 31, 2011 and 2010, respectively. Our optical passive products contributed 22.8% and 33.1% of our revenues for the three months ended March 31, 2011 and 2010, respectively.




In the three months ended March 31, 2011 and 2010, our top 10 customers comprised 60.9% and 67.8% of our revenues, respectively. For the three months ended March 31, 2011, one customer accounted for 16.7% of our total revenues. For the three months ended March 31, 2010, three customers accounted for 14.3%, 11.9% and 10.1% of our total revenues, respectively. We market and sell our products predominantly through our direct sales force.




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


- changes in manufacturing volume;
- costs incurred in establishing additional manufacturing lines and facilities;

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- inventory write-downs and impairment charges related to manufacturing assets;
- mix of products sold;
- changes in our pricing and pricing from our competitors;
- mix of sales channels through which our products are sold; and
- mix of domestic and international sales.

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




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




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




Results of Operations




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




Three Months Ended Mar. 31,2011

2010Revenues
100.0
%

100.0
%Cost of revenues
67.9


67.9Gross profit
32.1


32.1Operating expenses:Research and development
7.6


8.4Sales and marketing
5.8


6.7General and administrative
10.9


11.1Total operating expenses
24.3


26.2Income from operations
7.8


5.9Interest and other income, net
1.4


1.7Net income before tax
9.2
%

7.6
%Income tax
(1.6
)

-Net income
10.8
%

7.6
%


Revenues. Revenues were $9.5 million and $8.4 million for the three months ended March 31, 2011 and 2010, respectively. Revenues increased 12.4% in the quarter ended March 31, 2011 from the same period in 2010, primarily due to increased volume shipments of telecom and enterprise applications related products.




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Cost of Revenues. Cost of revenues was $6.4 million and $5.7 million for the three months ended March 31, 2011 and 2010, respectively. Cost of revenues as a percentage of revenues was 67.9% in the three months ended March 31, 2011 and 2010, respectively. The higher cost of revenues was due to higher sales volume.




Gross Profit. Gross profit increased in dollars to $3.0 million, or 32.1% of revenues, for the three months ended March 31, 2011 from $2.7 million, or 32.1% of revenues, for the same period in 2010. The higher gross profit was due to higher sales volume. We expect our gross profit as a percentage of revenues to improve with higher production volumes, which we anticipate will result in improved absorption of overhead expenses. We believe this improved absorption will offset the negative impact of labor rate increases in China and modest declines in average selling price year over year.




Research and Development Expenses . Research and development expenses remained at $0.7 million for the three months ended March 31, 2011 and for the same period in 2010. As a percentage of revenues, research and development expenses decreased to 7.6% in the three months ended March 31, 2011 from 8.4% for the same period in 2010. We expect research and development expenses will increase as we intend to continue to invest in our research and product development efforts.




Sales and Marketing Expenses . Sales and marketing expenses remained at $0.6 million for the three months ended March 31, 2011 and for the same period in 2010. As a percentage of revenues, sales and marketing expenses decreased to 5.8% in the three months ended March 31, 2011 from 6.7% in the three months ended March 31, 2010. We expect sales and marketing expenses to decline slightly in the next few quarters as a result of fewer trade- show activities.




General and Administrative Expenses . General and administrative expenses increased to $1.0 million for the three months ended March 31, 2011 from $0.9 million for the same period in 2010. As a percentage of revenues, general and administrative expenses decreased to 10.9% in the three months ended March 31, 2011 from 11.1% in the three months ended march 31, 2010. We expect general and administrative expenses will remain relatively flat in the next quarter due in part to continued emphasis on expense control.




Stock-Based Compensation . Total stock based compensation increased to $0.08 million for the three months ended March 31, 2011 from $0.03 million for the same period in 2010. This increase was due to stock options granted in July 2010 and resulted in higher stock based compensation expenses.




Interest and Other Income, Net. Interest and other income, net, was $0.13 million and $0.15 million for the three months ended March 31, 2011 and 2010, respectively. These amounts consisted primarily of interest income which fluctuated based on cash balances and changes in interest rates.




Income tax expense. Income tax benefit was $0.15 million and income tax expense was $0.001 million for the three months ended March 31, 2011 and 2010, respectively. The credit for the three months ended March 31, 2011 was due to the reversal of over accrual for the California state tax in 2010. We did not incur income tax expense for the three months ended March 31, 2011 because we utilized tax credits due to our accumulated deficit.




Liquidity and Capital Resources




At March 31, 2011, we had cash and cash equivalents of $8.5 million and short-term investments of $36.7 million.




Net cash provided by operating activities was $0.1 million for the three months ended March 31, 2011. Net cash provided by operating activities was primarily due to net income of $1.0 million, a $0.7 million decrease in accounts receivable, and total depreciation and amortization expenses of $0.4 million, which was offset by a $0.5 million increase in inventory, and $1.4 million decrease in accrued expenses.




Net cash used in operating activities was $0.6 million for the three months ended March 31, 2010. Net cash used in operating activities was primarily due to a $0.5 million increase in accounts receivable, an $0.8 million increase in inventory, and a $1.1 million decrease in accrued expenses, which were offset by net income of $0.6 million, an increase in accounts payable of $0.9 million, and depreciation of $0.2 million.




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Cash provided by investing activities was $0.08 million for the three months ended March 31, 2011. In the three months ended March 31, 2011, we had a net of $0.6 million from the proceeds from sales and maturities of short-term securities, and we used $0.6 million to purchase equipment.




Net cash used in investing activities was $1.0 million for the three months ended March 31, 2010. In the three months ended March 31, 2010, we spent a net of $0.4 million for the purchase of short-term securities, and we used $0.6 million to purchase equipment.




Cash provided by financing activities was $0.2 million and $0.03 million for the three months ended March 31, 2011 and 2010, respectively. Net cash provided by financing activities was primarily due to proceeds from the exercise of options to purchase our common stock, which was offset in part by repayment of bank borrowings.




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




Off Balance Sheet Arrangements




We did not have any off-balance sheet arrangements at March 31, 2011.




Contractual Obligations




Our long-term debt obligations are for principal and interest on mortgage and equipment loans from financial institutions in Taiwan.




In July 2004, we moved into our corporate headquarters in Sunnyvale, California. The lease has a six-year term commencing on July 22, 2004. In June 2010, we renewed the lease for an 18,088 square foot facility in the same building, which lease will expire in January 2016.




In Taiwan, we lease a total of approximately 38,800 square feet in one facility located in Tu-Cheng City, Taiwan. This lease expires at various times from May 2011 to December 2011. In December 2000, The Company purchased approximately 8,200 square feet of space immediately adjacent to its leased facility for $0.8 million, bringing the total square footage to approximately 47,000 square feet.




We lease a 132,993 square foot facility in Shenzhen, China which lease will expire in October 2014.




Recent Accounting Pronouncements




See Note 2 of our Notes to Unaudited Condensed Consolidated Financial Statements included with this Quarterly Report on Form 10-Q for information on recent accounting pronouncements.




ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK




Not required.




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ITEM 4: CONTROLS AND PROCEDURES




(a)  Evaluation of disclosure controls and procedures. We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Acting Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Our disclosure controls and procedures have been designed to meet reasonable assurance standards. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit  relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Chief Executive Officer and Acting Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective to ensure that material information relating to us, including our consolidated subsidiaries, is made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared.




(b)  Changes in internal controls. There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with the evaluation described in Item 4(a) above that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.




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PART II: OTHER INFORMATION




ITEM 1A: RISK FACTORS




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




We had net income of approximately $1.0 million and $0.6 million in the first quarter of fiscal 2011 and 2010, respectively. Although we generated a profit in the first quarter of fiscal 2011 and 2010, we may not be able to sustain profitability in the future and our cash flows may be negative again in the future. As of March 31, 2011, we had an accumulated deficit of approximately $56.8 million.




We continue to experience fluctuating demand for our products. If demand for our products declines, we may not be able to decrease expenses on a timely basis, or at all, to offset the decrease in revenues. We also expect declining average selling prices may negatively impact our results of operations in future periods. If demand for our products increases in the future, we expect to incur significant and increasing expenses for expansion of our manufacturing operations, research and development, sales and marketing, and administration, and in expanding 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 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 sustain profitability on a quarterly or an annual basis.




Our connectivity products have historically represented a significant part of our revenues, and if we are unsuccessful in commercially selling our optical passive products, our business will be seriously harmed.




Sales of our connectivity products accounted for over 77% of our revenues in the quarter ended March 31, 2011 and a majority of our historical revenues. We expect to substantially depend on these products for the majority of our near-term revenues. We have experienced declines in average selling prices, and 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 optical passive products, which we began shipping commercially in July 2000. Demand for these products has fluctuated over the past few years, declining sharply starting in mid fiscal 2001 and then increasing beginning in 2003. If demand for these products does not continue to increase and our target customers do not continue to adopt and purchase our optical passive products, our revenues may decline and we may have to write-off additional inventory that is currently on our books.




Continuing weak general economic or business conditions may have a negative impact on our business.




Continuing concerns over inflation, deflation, energy costs, geopolitical issues, the availability and cost of credit, the Federal stimulus package and budget process, the U.S. mortgage market and an uncertain real estate market in the U.S. have contributed to increased volatility and diminished expectations for the global economy and expectations of slower global economic growth going forward. These factors, combined with volatile oil prices, declining business and consumer confidence, a volatile stock market and increased unemployment, have precipitated an economic slowdown and recession. If the economic climate in the U.S. and abroad does not improve or continues to deteriorate, our business, including our customers and our suppliers, could be negatively affected, resulting in a negative impact on our revenues.




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We depend on a small number of customers for a significant portion of our total revenues and the loss of, or a significant reduction in orders from, any of these customers, would significantly reduce our revenues and harm our operating results.





In the quarters ended March 31, 2011 and 2010, our top 10 customers comprised 60.9% and 67.8% of our revenues, respectively. For the three months ended March 31, 2011, one customer accounted for 16.7% of our total revenues. For the three months ended March 31, 2010, three customers accounted for 14.3%, 11.9%, and 10.1% of our total revenues, respectively.




We derive a significant portion of our revenues from a small number of customers, and we anticipate that we will continue to do so in the foreseeable future. These customers may decide not to purchase our products at all, to purchase fewer products than they did in the past, or to alter their purchasing patterns in some other way. The loss of any significant customer, a significant reduction in sales we make to them, or any problems collecting receivables from them would likely harm our financial condition and results of operations.




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.




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




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


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

The 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.




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We are exposed to risks and increased expenses and business risk as a result of Restriction on Hazardous Substances, or RoHS directives.




Following the lead of the European Union, or EU, various governmental agencies have either already put into place or are planning to introduce regulations that regulate the permissible levels of hazardous substances in products sold in various regions of the world. For example, the RoHS directive for EU took effect on July 1, 2006. The labeling provisions of similar legislation in China went into effect on March 1, 2007. Consequently, many suppliers of products sold into the EU have required their suppliers to be  compliant with the new directive. Many of our customers have adopted this approach and have required our full compliance. Though we have devoted a significant amount of resources and effort planning and executing our RoHS program, it is possible that some of our products might be incompatible with such regulations. In such event, we could experience the following consequences: loss of revenue, damaged reputation, diversion of resources, monetary penalties, and legal action.




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 Oclaro Inc. JDS Uniphase Corp., Oplink Communications 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.




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




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




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




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




As of March 31, 2011, we had a total of 34 full-time employees in Sunnyvale, California, 315 full-time employees in Taiwan, and 924 full-time employees in China. Matching the scale of our operations with demand fluctuations, combined with the challenges of expanding and managing geographically dispersed operations, has placed, and will continue to place, a significant strain on our management and resources. To manage the expected fluctuations in our operations and personnel, we will be required to:


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

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- hire, train, motivate and manage additional qualified personnel, especially if we experience a significant increase in demand for our products;
- effectively expand or reduce our manufacturing capacity, attempting to adjust it to customer demand; and
- effectively manage relationships with our customers, suppliers, representatives and other third parties.

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




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




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




The development of new or enhanced fiber optic products is a complex and uncertain process. We may experience difficulties in design, manufacturing, marketing and other areas that could delay or prevent the development, introduction or marketing of new products and enhancements. Development costs and expenses are incurred before we generate revenues from sales of products resulting from these efforts. Our total research and development expenses were approximately $0.7 million each for the quarters ended March 31, 2011 and 2010. We intend to continue to invest in our research and product development efforts and the amount of our investment may be substantial, which could have a negative impact on our earnings in future periods if we do not earn associated revenue from such efforts.




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 consolidation, realignment, and fluctuation in product inventory and 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 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.




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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 continued 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.




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




The United States economy has experienced and continues to experience significant fluctuations in consumption and demand. During the past several 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 recovery, the activity of the United States telecommunications industry may lag behind the recovery of the overall United States economy.




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.




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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. One component, GRIN lenses, are only available from one supplier. 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.




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




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




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




Section 404 of the Sarbanes-Oxley Act of 2002 requires our management to perform an assessment of our internal controls as of the end of each fiscal year, and may also require that our independent auditors to attest to the effectiveness of our internal controls over financial reporting in the future if we achieve a certain market capitalization levels. 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. We expect to incur increased expenses and to devote additional management resources to Section 404 compliance. In the event that our chief executive officer or acting chief financial officer determines that our internal controls over financial reporting are not effective as defined under Section 404, or our auditors are not able to provide us with an unqualified report as to the effectiveness of our internal control over financial reporting in the future, investor perceptions of our company may be negatively affected and this could cause a decline in our stock price.




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




Our success depends to a significant degree upon the continued contributions of the principal members of our technical sales, marketing, engineering and management personnel, many of whom perform important management functions and would be difficult to replace. We particularly depend upon the continued services of our executive officers, particularly Peter Chang, our President and Chief Executive Officer; David Hubbard, our Vice President, Sales and Marketing; Wei-shin Tsay, our senior Vice President of Product Development; Anita Ho, our Acting Chief Financial Officer; and 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 and at our facility in China. 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.




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




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




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




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




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




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




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




In addition, some of our customers require that our products be subject 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.




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




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




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




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


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

The occurrence of any one or more of the foregoing factors could negatively impact our revenues.




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


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




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




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




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




Beginning at the commencement of trading on November 8, 2002, the listing of our common stock was transferred from the Nasdaq Global Market to the Nasdaq Capital Market. As a result, we may become subject to certain sections of the California General Corporation Law that will affect our charter documents if our common stock is not returned to being listed on the Nasdaq Global Market. A recent Delaware decision has called into question the applicability of the California General Corporation Law to Delaware corporations. However, if the California General Corporation Law applies to our Company, we will not be able to continue to have a classified board or continue to eliminate cumulative voting by our stockholders. In addition, certain provisions of our Certificate of Incorporation that call for supermajority voting may need to be approved by stockholders every two years or be eliminated. Also, in the event of a reorganization, stockholders will have dissenting stockholder rights under both California and Delaware law. Any of these changes will result in additional expense as we will have to comply with certain provisions of the California General Corporation Law as well as the Delaware General Corporation Law. We included these provisions in our charter documents in order to delay or discourage a change of control or changes in our management. Because of the California General Corporation Law, we may not be able to avail ourselves of these provisions.




If we 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 it is difficult to police the unauthorized use of our products and we cannot be certain that the steps we have taken will prevent the misappropriation or unauthorized use of our technologies, particularly in foreign countries where the laws may not protect our proprietary rights as fully as United States laws. Our competitors and suppliers may independently develop similar technology, duplicate our products, or design around any of our patents or other intellectual property. If we are unable to adequately protect our proprietary technology rights, others may be able to use our proprietary technology without having to compensate us, which could reduce our revenues and negatively impact our ability to compete effectively.




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




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




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




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




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




Our manufacturing operations in Taiwan are located in active earthquake fault zones. This region has 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 of our manufacturing operations are located in Taiwan, a large earthquake or typhoon in Taiwan could disrupt our manufacturing operations for an extended period of time, which would limit our ability to supply our products to our customers in sufficient quantities on a timely basis, harming our customer relationships.




ITEM 6: EXHIBITS




Exhibits




Exhibit
Number

Title3(i).1

Integrated copy of the Amended and Restated Certificate of Incorporation of the Company.10.4#

Amended and Restated Alliance Fiber Optic Products, Inc. 2000 Employee Stock Purchase Plan (as amended as of February 15, 2011).31.1

Rule 13a-14(a) certification of Chief Executive Officer31.2

Rule 13a-14(a) certification of Acting Chief Financial Officer32.1**

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).




# Indicates management contract or compensatory plan or arrangement. ** In accordance with Item 601(b)(32)(ii) of Regulation S-K and SEC Release No. 34-47986, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed “filed” for purposes 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.




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SIGNATURE




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




Dated: May 12, 2011ALLIANCE FIBER OPTIC PRODUCTS, INC.By
/s/ Anita K. HoAnita K. HoActing Chief Financial Officer(Principal Financial and Accounting Officer and DulyAuthorized Signatory)


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