SECURITIES
AND EXCHANGE COMMISSION
 WASHINGTON,
DC 20549
 
 **FORM
10-K**
 **(Mark
One)**
 **x** **ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**
 **SECURITIES
EXCHANGE ACT OF 1934 [FEE REQUIRED]**
 
 **For
the fiscal year ended** **December
31, 2004**
 
 **oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE**
 **SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]**
 
 **For
the transition period from _______to_______**
 
 **Commission
file number** **1-8191**
 
 **PORTA
SYSTEMS CORP**.
 (Exact
name of registrant as specified in its charter)
 
 **Delaware**
    **11-2203988**(State
      or other jurisdiction
    (IRS
      Employerof
      incorporation or organization)
    Identification
      No.)**6851
      JerichoTurnpike, Syosset, New York**
    **11791**(Address
      of principal executive offices)
    (Zip
      Code)Registrant's
      telephone number, including area code: **(****516)
      364-9300**
 
 Securities
registered pursuant to Section 12(b) of the Act: None
 
 Securities
registered pursuant to Section 12(g) of the Act:
 
 Common
Stock, par value $.01 per share
 
 None
 
 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 x **** No o**.**
 
 Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10K or any amendment to this
Form 10K. o
 
 Indicate
by a check mark whether the registrant is an accelerated filer (as defined in
Rule 12b-2 of the Act). Yeso No x
 
 State
aggregate market value of the voting stock held by non-affiliates of the
registrant: $797,783 as of June 30, 2004.
 
 Indicate
the number of shares outstanding of each of the registrant's class of common
stock, as of the latest practicable date: 9,972,284 shares of Common Stock, par
value $.01 per share, as of March 15, 2005.
 
 **DOCUMENTS
INCORPORATED BY REFERENCE**
 
 None







**Part
I**
 
 **Item
1.** **** **Business**
 
 Porta
Systems Corp. develops designs, manufactures and markets a range of standard and
proprietary telecommunications equipment for sale domestically and
internationally. Our core products, focused on ensuring communications for
service providers worldwide, fall principally into two categories:
 
 Telecommunications
connection and protection equipment . These
systems are used to connect copper-wired telecommunications networks and to
protect telecommunications equipment from voltage surges. We market our copper
connection equipment and systems to telephone operating companies and customer
premise systems providers in the United States and foreign
countries.
 
 Signal
processing equipment . These
products, which we sell principally for use in defense and aerospace
applications, support copper wire-based communications systems.
 
 Through
2004, we offered a third category of products - operation support systems, which
we call OSS. During 2003 we began to scale back our OSS operations and we
continued to scale back these operations during 2004. We now limit our OSS
operations to the performance of maintenance on existing systems and the
performance of warranty services. We are also seeking to sell our existing OSS
inventory; however, such sales were not significant in 2004, and we do not plan
to add additional inventory. During 2004, we also completed installations of OSS
systems pursuant to contracts which we entered into in prior years. OSS systems
focus on the access loop and are components of telephone companies’ service
assurance and service delivery initiatives. The systems primarily focus on
trouble management, line testing, network provisioning, inventory and
assignment, and automatic activation, and most currently single ended line
qualification for the delivery of xDSL high bandwidth services.
 
 We are a
Delaware corporation incorporated in 1972 as the successor to a New York
corporation of the same name incorporated in 1969. Our principal offices are
located at 6851 Jericho Turnpike, Syosset, New York 11791; telephone number,
516-364-9300. References to “we,” “us,” “our,” and words of like import refer to
Porta Systems Corp. and its subsidiaries, unless the context indicates
otherwise.
 
 **Forward-Looking
Statements**
 
 Statements
in this Form 10-K annual report may be “forward-looking statements” within the
meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking
statements include, but are not limited to, statements that express our
intentions, beliefs, expectations, strategies, predictions or any other
statements relating to our future activities or other future events or
conditions. These statements are based on current expectations, estimates and
projections about our business based, in part, on assumptions made by
management. These statements are not guarantees of future performance and
involve risks, uncertainties and assumptions that are difficult to predict.
Therefore, actual outcomes and results may, and probably will, differ materially
from what is expressed or forecasted in the forward-looking statements due to
numerous factors, including those risks discussed from time to time in this Form
10-K annual report, including the risks described under “Risk Factors” and the
matters described under “Management’s Discussion and Analysis of Financial
Condition and Results of Operations,” and in other documents which we file with
the Securities and Exchange Commission. In addition, such statements could be
affected by risks and uncertainties related to our financial conditions, our
relationship with the holder of our senior debt, factors which affect the
telecommunications industry, market and customer acceptance, competition,
government regulations and requirements and pricing, as well as general industry
and market conditions and growth rates, and general economic conditions. Any
forward-looking statements speak only as of the date on which they are made, and
we do not undertake any obligation to update any forward-looking statement to
reflect events or circumstances after the date of this Form 10-K.
 
 
 **Risk
Factors**
 
 **We
require substantial financing to meet our working capital requirements and** **we
have no access to such** **financing.** We had a
working capital deficit at December 31, 2004 of
$34,150,000. As of December 31, 2004, our current liabilities included
$25,674,000 due to the
holder of our
senior debt. We do not have sufficient resources to pay the senior debt or to
pay principal and interest of $10,273,000 due at
December 31, 2004 on the outstanding subordinated notes that became due on July
3, 2001, and we do not expect to generate the necessary cash from our operations
to enable us to make those payments and we
have no other source of outside financing . The
holder of our senior debt is not advancing funds to us; and, at present our only
source of funds is from operations. To the extent that either our
operations do not generate sufficient funds to cover our expenses or the
holders of our debt demand payment which we are unable to make , it may
be necessary for us to seek protection under the Bankruptcy Code. See
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations.”
 
 **Our
independent auditors have included an explanatory paragraph relating to our
ability to** **continue
as a going concern in their report on our financial statements.** Because
we have suffered substantial recurring losses from operations in two of the last
three years, and because of our stockholders’ deficit of $30,661,000 and our
working capital deficit of $34,150,000 as of December 31, 2004, our auditors
included in their report an explanatory paragraph about our ability to
continue as a
going concern.
 
 **Our
increase in sales in our copper connection/protection segment is based on
specific market factors and the requirements of British Telecommunications,
which may not continue.** The
increase in our copper connection business during 2004 resulted primarily from
the requirements of British Telecommunications to provide increased DSL service.
Total sales for British Telecommunications, consisting of direct sales and sales
to systems integrators for British Telecommunications (including Fujitsu
Telecommunications Europe LTD) were $14,055,000 (48% of sales) for 2004,
$7,077,000 (36%) for 2003 and $5,128,000 (24%) for 2002. Almost all of such
sales were sales of copper connection products. To the extent that British
Telecommunications is no longer required to provide such service or no longer
requires products from us, we may be unable to operate profitably, and it may be
necessary for us to seek protection under the Bankruptcy Code.
 
 **We
are a defendant in a material arbitration proceeding which, if adversely
determined, would impair our ability to continue in business.** A vendor
has commenced an arbitration proceeding against us seeking $3 million for breach
of contract. Although terms of a settlement are being negotiated, if these
discussions do not result in an agreement and the claimant obtains a significant
judgment against us and the claimant seeks to enforce the judgment, it may be
necessary for us to seek protection under the Bankruptcy Code.
 
 **Our
sales have been impaired as a result of overbuilding by telecommunications
companies and the failure of a number of companies in the industry during the
past six years.** Since our
sales are dependent upon the growth of the telecommunications industry, our
ability to operate profitably will be impaired by any factors which affect the
telecommunications industries generally or to the extent that our customers’
needs change either as a result of regulatory conditions or changes in
technology.
 
 2
 **We
are heavily dependent on foreign sales.** Approximately 66% of our sales in 2004, 56% of our sales in 2003 and 54% of our
sales in 2002, were made to foreign telephone operating companies. In selling to
customers in foreign countries, we are exposed to inherent risks not normally
present in the case of our sales to United States customers, including risks
relating to political and economic changes ,
including the decline in the value of the dollar against other major
currencies .
Furthermore, our financial condition has impaired our ability to generate new
business in the international market as potential customers express concern
about our ability to perform.
 
 **We
have granted to British Telecommunications rights to our
technology.** Under
our agreement with British Telecommunications, we gave British
Telecommunications the right to use our connection/protection technology or have
products using our technology manufactured for it by others. As a result,
British Telecommunications may have the right to use our technology and purchase
products based on our technology from others, which may result in a significant
decline in our sales to British Telecommunications.
 
 **Because
of our small size and our financial problems, we may have difficulty competing
for business.** We
compete directly with a number of large and small domestic
and foreign telephone
equipment manufacturers , with
CommScope, Inc., which acquired the connection/protection business from Lucent
Technologies, continuing to be our principal United States competitor. Our
competitors have used our financial difficulties in successfully competing
against us. We anticipate that our working capital deficit and our historical
losses, combined with the absence of financing, may continue to place us in a
competitive disadvantage .
  **We
require access to current technological developments** . We rely
primarily on the performance and design characteristics of our products in
marketing our products, which requires access to state-of-the-art technology in
order to be competitive. Our business could be adversely affected if we cannot obtain
licenses for such updated technology or self develop state-of-the-art
technology. Because
of our financial problems, we were not able to devote any significant effort to
research and development, which could increase our difficulties in making sales
of our products.
  **We
rely on certain key employees.** We are
dependent upon the continued employment of certain key employees, including our
senior executive officers and our
operations and technical personnel . Our
failure to retain such employees may have a material adverse effect upon our
business. If we are unable to provide our customers with necessary service, our
ability to operate profitably could be impaired.
 
 **Because
our stock is subject to the penny stock rules, our stockholders may have
difficulty in selling our stock.** Because
our stock is traded on the OTC Bulletin Board and our stock price is very low,
our stock is subject to the Securities and Exchange Commission’s penny stock
rules, which impose additional sales practice requirements on broker-dealers
that sell our stock to persons other than established customers and
institutional accredited investors. These rules may affect the ability of
broker-dealers to sell our common stock and may affect the ability of our
stockholders to sell any common stock they may own.
 
 **We
do not pay dividends on common stock** . The
holder of our senior debt has prohibited us from paying any dividends on our
common stock.
 
 3
  **Products**
 
 Telecommunications
Connection Equipment . Our
copper connection/protection equipment is used by domestic and international
telephone operating companies, by owners of private telecommunications equipment
and manufacturers and suppliers of telephone central office and customer
premises equipment. Products of the types comprising our telecommunications
connection equipment are included as integral parts of all domestic and foreign
telephone and telecommunications systems.
  Our
connection equipment consists of connection/protection blocks, building entrance
terminals and protection modules. These products are used by telephone companies
and installers of communications and data transmission equipment to interconnect
copper-based subscriber lines to switching equipment lines. The protector
modules protect central office and customer premises personnel and equipment
from electrical surges. The need for protection products has increased as a
result of the worldwide move to digital technology, which is extremely sensitive
to damage by electrical overloads, and private owners of telecommunications
equipment now have the responsibility to protect their equipment, personnel and
buildings from damage caused by electrical surges. Line connection/protection
equipment usually incorporates protector modules to safeguard equipment and
personnel from injury due to power surges. Currently, these products include a
variety of connector blocks, protector modules, building entrance terminals and
frames used in telephone central switching offices, PBX installations, multiple
user facilities and customer premise applications.
 
 We also
have developed a range of frames for use in conjunction with our traditional
line of connecting/protecting products. Frames for the interconnection of copper
circuits are specially designed structures which, when equipped with connector
blocks and protectors, interconnect and protect telephone lines and distribute
them in an orderly fashion allowing access for repairs and changes in line
connections. One of our frame products, the CAM frame, is designed for the
optimum placement of connections for telephone lines and connector blocks
mounted on the frame.
 
 Our
copper connection/protection products are used by many of the regional Bell and
international operating companies as well as independent telephone operating
companies in the United States, owners of private telecommunications equipment
providing communications and data transmission facilities and equipment. These
products are also purchased by equipment manufacturers for integration with
their systems. In addition, our telecommunications connection products have been
sold to telephone operating companies in various foreign countries. This
equipment is compatible with existing telephone systems both within and outside
the United States and can generally be used without modification, although we do
custom-design modifications to accommodate the specific needs of our
customers.
  Signal
Processing Products . Our
signal processing products include data bus systems and wideband transformers.
Data bus systems, which are the communication standard for military and
aerospace systems, require an extremely high level of reliability and
performance. Wideband transformers are required for ground noise elimination in
video imaging systems and are used in the television and broadcast, medical
imaging and industrial process control industries.
 
 Operations
Support Systems . Through
2004, we sold our OSS
systems primarily to telephone operating companies in established and developing
countries in Asia, South and Central America and Europe. Because
of continuing losses in this division, combined with difficulties in marketing
OSS products in view of our financial condition, we limited our OSS activities
to the performance of maintenance and warranty services. In addition, we are
trying to sell our remaining OSS inventory, although such sales were not
significant and we can give no assurance that we will be able to sell the
remaining OSS inventory. Although we made modest efforts to generate new
business in selected markets, we were not successful in these efforts. We expect
our OSS business to continue to decline in future years.
 
 4
 The table
below shows, for the last three fiscal years, the contribution made to our sales
by each of our major categories of the telecommunications industry:
 
 Sales
by Product Category
 Years
Ended December 31,
 
 2004
    
    2003
    
    2002(Dollars
      in thousands)Line
      Connecting /Protecting Equipment
    
    $
    21,545
    
    
    74
    %
    $
    11,334
    
    
    58
    %
    $
    9,598
    
    
    45
    %Signal
      Processing
    
    
    5,551
    
    
    19
    %
    
    4,253
    
    
    21
    %
    
    4,523
    
    
    21
    %OSS
      Systems
    
    
    2,003
    
    
    7
    %
    
    3,249
    
    
    17
    %
    
    6,414
    
    
    30
    %Other
    
    
    69
    
    
    0
    %
    
    754
    
    
    4
    %
    
    882
    
    
    4
    %Total
    
    $
    29,168
    
    
    100
    %
    $
    19,590
    
    
    100
    %
    $
    21,417
    
    
    100
    %
  **Markets**
 
 As a
telephone company expands the number of its subscriber lines, it may require
additional connection equipment to interconnect and protect those lines in its
central offices. We provide a line of copper connection equipment for this
purpose. Recent trends towards the transmission of high frequency signals on
copper lines are sustaining this market. Less developed countries, such as those
with emerging telecommunications networks or those upgrading to digital
switching systems, provide a growing market for copper connection and protection
equipment.
 
 The
increased sensitivity of the newer digital switches to small amounts of voltage
requires the telephone company which is upgrading its systems to digital
switching systems to also upgrade its central office connection/protection
systems in order to meet these more stringent protection requirements. We supply
central office connection/protection systems to meet these needs.
 
 During
2004, approximately 74% of our sales were made to customers in this
category.
 
 Our line
of signal processing products is supplied to customers in the military and
aerospace industry as well as manufacturers of medical equipment and video
systems. The primary communication standard in new military and aerospace
systems is the MIL-STD-1553 Command Response Data Bus, an application which
requires an extremely high level of reliability and performance . Our
wideband transformers are required for ground noise elimination in video imaging
systems and are used in the television and broadcast, medical imaging and
industrial process control industries. If not eliminated, ground noise caused by
poor electrical system wiring or power supplies, results in significant
deterioration in system performance, including poor picture quality and process
failures in instrumentation. The wideband transformers provide a cost-effective
and quick solution to the problem without the need of redesign of the rest of
the system. Products
are designed to satisfy
the specific requirements of each military or aerospace customer.
 
 5
 During
2004, signal processing equipment accounted for approximately 19% of our
sales.
 
 During
2004, approximately 7% of our sales consisted principally of maintenance
services and, to a lesser extent, to the sale of our existing OSS inventory. We
do not expect to enter into new maintenance agreements which have a term that
extends beyond 2007. We anticipate that the OSS sales will represent a declining
percentage of total sales.
 
 **Marketing
and Sales**
 
 We
operate principally through two business units, which are organized by product
line, and with each having responsibility for the sales and marketing of its
products. We also continue to employ a modest staff of maintenance personnel to
perform maintenance and warranty services on OSS systems.
 
 When
appropriate to obtain sales in foreign countries, we may enter into business
arrangements and technology transfer agreements covering our products with local
manufacturers and participate in manufacturing and licensing arrangements with
local telephone equipment suppliers.
 
 In the
United States and throughout the world, we use independent distributors in the
marketing of all copper based products to the regional Bell operating companies
and the customer premises equipment market. All distributors marketing
copper-based products also market directly competing products. In addition, we
continue to promote the direct marketing relationships we developed in the past
with telephone operating companies.
 
 British
Telecommunications purchased line connecting/protecting products of $2,259,000
(8% of sales) in 2004, $867,000 (4% of sales) in 2003, and $689,000 (3% of
sales) in 2002. During these years, we also sold our products to unaffiliated
suppliers for resale to British Telecommunications, the most significant of
which was Fujitsu, a systems integrator for British Telecommunications, to whom
we sold $4,772,000 in 2004, $3,150,000 in 2003, and $1,585,000 in 2002. We have
a cross-licensing agreement with British Telecommunications which, in effect,
enables British Telecommunications to use certain of our proprietary information
to modify or enhance products provided to British Telecommunications and permits
British Telecommunications to manufacture or engage others to manufacture those
products.
  Our
signal processing products are sold primarily to United States military and
aerospace prime contractors, and domestic original equipment manufacturers and
end users.
  The
following table sets forth for the last three fiscal years our sales to
customers by geographic region:
 
 
 6
 Sales to
Customers By Geographic Region (1)
 
 Year
      Ended December 31,2004
    
    2003
    
    2002(Dollars
      in thousands)North
      America
    
    $
    12,948
    
    
    44
    %
    $
    9,647
    
    
    49
    %
    $
    10,442
    
    
    49
    %United
      Kingdom
    
    
    14,911
    
    
    51
    %
    
    7,523
    
    
    38
    %
    
    6,388
    
    
    30
    %Asia/Pacific
    
    
    694
    
    
    2
    %
    
    954
    
    
    6
    %
    
    2,729
    
    
    13
    %Other
      Europe
    
    
    457
    
    
    2
    %
    
    1,228
    
    
    6
    %
    
    1,600
    
    
    7
    %Latin
      America
    
    
    158
    
    
    1
    %
    
    238
    
    
    1
    %
    
    258
    
    
    1
    %Total
      Sales
    
    $
    29,168
    
    
    100
    %
    $
    19,590
    
    
    100
    %
    $
    21,417
    
    
    100
    %
 
 (1)
    For
      information regarding the amount of sales, operating profit or loss and
      identifiable assets attributable to each of our divisions and geographic
      areas, see Note 21 of Notes to the Consolidated Financial
      Statements.
 
 In
selling to customers in foreign countries, we face inherent risks not normally
present in the case of sales to United States customers, including risks
associated with currency devaluation, inability to convert local currency into
dollars, as well as local tax regulations and political
instability.
 
 **Manufacturing**
 
 At
present, our manufacturing operations are conducted at facilities located in
Syosset, New York and Matamoros, Mexico . From
time to time we also use subcontractors to augment various aspects of our
production activities and periodically explore the feasibility of conducting
operations at lower cost manufacturing facilities located abroad. We are no
longer manufacturing or purchasing new inventory for OSS products.
 
 **Source
and Availability of Components**
 
 We
generally purchase the standard components used in the manufacture of our
products from a number of suppliers. We attempt to assure ourselves that the
components are available from more than one source.
 
 **Significant
Customers**
 
 Our five
largest customers accounted for sales of $15,443,000, or approximately 53% of
sales, for 2004; $8,507,000, or approximately 43% of sales, for 2003; and $9,784,000,
or approximately 46% of sales, for
2002 . Fujitsu , a
system integrator for British Telecommunications, was our largest customer for
2004 and 2003, accounting for sales of $4,772,000, or approximately 16% for 2004
and $3,150,000, or approximately 16% for 2003. Direct
sales to British Telecommunications were
$2,652,000, or 9% of sales for 2004, which included line connecting/protecting
products of $2,259,000 and the balance OSS maintenance services, $1,480,000, or
8% of sales for 2003 and $2,306,000, or 11% of sales for 2002 . Total
sales for British Telecommunications, consisting of direct sales and sales to
systems integrators for British Telecommunications (including Fujitsu) were
$14,055,000 (48% of sales) for 2004, $7,077,000 (36%) for 2003 and $5,128,000
(24%) for 2002. During 2004, sales to Telmex accounted for $3,139,000, or
approximately 11% of sales. Philippine
Long Distance Telephone was our
largest customer for 2002, accounting for sales of $2,725,000, or approximately 13% of
sales. The revenue from Philippine Long Distance Telephone related to the sale
and installation of an OSS system, which was completed in 2004. No other
customers account for 10% or more of our sales in 2004, 2003 or 2002.
 
 7
 The
former Bell operating companies continue to be the ultimate purchasers of a
significant portion of our products sold in the United States, while sales to
foreign telephone operating companies constitute the major portion of our
foreign sales. Our contracts with these customers require no minimum purchases
by such customers. Significant customers for the signal processing products
include major United States aerospace companies, the Department of Defense and
original equipment manufacturers in the medical imaging and process control
equipment industries. We sell both catalog and custom designed products to these
customers. Some contracts are multi-year procurements.
 
 **Backlog**
 
 At
December 31, 2004, our backlog was approximately $5,300,000 compared with
approximately $6,000,000 at December 31, 2003. The decrease in the backlog
reflects our ability to manufacture and ship inventory during 2004 in a more
timely manner than in 2003 because of our improved cash flow. Of the December
31, 2004 backlog, approximately $2,800,000 represented orders from foreign
telephone operating companies. We expect to ship substantially all of our
December 31, 2004 backlog during 2005.
 
 **Intellectual
Property Rights**
 
 We own a
number of domestic utility and design patents and have pending patent
applications for these products. In addition, we have foreign patent protection
for a number of our products.
 
 From time
to time we enter into licensing and technical information agreements under which
we receive or grant rights to produce certain subcomponents used in our
products. These agreements are for varying terms and provide for the payment or
receipt of royalties or technical license fees.
 
 While we
consider patent protection important to the development of our business, we
believe that our success depends primarily upon our engineering, manufacturing
and marketing skills. Accordingly, we do not believe that a denial of any of our
pending patent applications, expiration of any of our patents, a determination
that any of the patents which have been granted to us are invalid or the
cancellation of any of our existing license agreements would have a material
adverse effect on our business.
 
 Under our
agreement with British Telecommunications, we gave British Telecommunications
the right to use our connection/protection technology or have products using our
technology manufactured for it by others .
 
 **Competition**
 
 The
telephone equipment market in which we do business is characterized by intense
competition, rapid technological change and a movement to consolidation and
private ownership of telecommunications networks. In competing for telephone
operating company business, the purchase price of equipment and associated
operating expenses have become significant factors, along with product design
and long-standing equipment supply relationships. In the customer premises
equipment market, we are functioning in a market characterized by distributors
and installers of equipment and by price competition.
 
 8
 We
compete directly with a number of large and small telephone equipment
manufacturers in the United States, with CommScope, Inc., which acquired the
business from Lucent Technologies, being our principal United States competitor.
CommScope’s greater resources, extensive research and development facilities,
long-standing equipment supply relationships with the operating companies of the
regional holding companies and history of manufacturing and marketing products
similar in function to those produced by us continue to be significant factors
in our competitive environment. Currently, CommScope and a number of companies
with greater financial resources than us produce, or have the design and
manufacturing capabilities to produce, products competitive with our products.
In meeting this competition, we rely primarily on the engineered performance and
design characteristics of our products to achieve comparable performance and we
endeavor to offer our products at prices that will make our products compete worldwide.
However, our ability to compete is hampered by our financial condition and our
history of losses.
 
 In
connection with overseas sales of our line connecting/protecting equipment, we
have met with significant competition from United States and foreign
manufacturers of comparable equipment and we expect this competition to
continue. In addition to CommScope, a number of our overseas competitors have
significantly greater resources than we do.
 
 **Research
and Development Activities**
 
 We spent
approximately $2,000,000 in 2004, $2,100,000 in 2003, and $2,500,000 in 2002 on
research and development activities. Most of
the research and development expenses in 2004 related to copper
connection/protection products , and was
oriented more toward modest enhancements on our existing products rather than
development of new technology.   All
research and development was Company sponsored and is expensed as incurred.
During 2004, we increased our research and development efforts in the
connection/protection business and, as part of our scale-back of our OSS
business, we terminated our research and development activities in that segment.
 
 **Employees**
 
 As of
December 31, 2004, we had 305 employees, of which 48 were employed in the United
States, 237 in Mexico, 12 in the United Kingdom, and 8 in China. We believe that
our relations with our employees are good, and we have never experienced a work
stoppage. Our employees are not covered by collective bargaining agreements,
except for our hourly employees in Mexico who are covered by two collective
bargaining agreements that expire on December 31, 2006 and May 20,
2006.
 
 **Item
2.** **** **Properties**
 
 We
currently lease approximately 14,500 square feet of executive, sales, marketing
and research and development space and 4,200 square feet of manufacturing space
in Syosset, New York. These facilities represent substantially all of our
office, plant and warehouse space in the United States. The Syosset, New York
leases expire February 2008 and May 2007, respectively. The annual rental
payable under these leases is approximately $285,000 and is subject to customary
escalation clauses.
 
 9
 Our
wholly-owned United Kingdom subsidiary leases an approximately 11,000 square
foot facility in Coventry, England, which facility comprises all of our office,
plant and warehouse space. The lease expires in 2019. The aggregate current
annual rental is approximately $375,000 and is subject to customary escalation
clauses. During 2002 and 2003, we subleased a portion of these facilities and
are currently seeking a new sublessee.
 
 Our
wholly-owned Mexican subsidiary owns an approximately 40,000 square foot
manufacturing facility, and approximately 50,000 square feet of adjacent land,
in Matamoros, Mexico.
 
 We
believe our properties are adequate for our needs.
 
 **Item
3.** **** **Legal
Proceedings** ****
 
 In June
2002, BMS Corp. commenced an arbitration proceeding against us in New York City
seeking damages of approximately $3,000,000 and alleging that we
breached our agreement to market and sell an update to our
OSS product
which BMS was to develop for
us . We
believe that we have defenses to the claims by BMS and we have
filed a counterclaim to recover the $350,000 we advanced to BMS under the
contract. As of
December 31, 2004, we have recorded a liability of $727,000, based on our
estimate of the present value of the Company's liability to BMS based upon the
terms of a proposed settlement with BMS. However, we can give no assurance that
we will be able to settle the action on such terms.
 
 In July
1996, an action was commenced against us and certain present and former
directors in the Supreme Court of the State of New York, New York County by
certain of the Company’s stockholders and warrant holders who acquired their
securities in connection with our acquisition of Aster Corporation. The
complaint alleged breach of contract against us and breach of fiduciary duty
against our directors arising out of an alleged failure to register certain
restricted shares and warrants owned by the plaintiffs. The complaint sought
damages of $413,000.  The case
has been administratively dismissed for failure to prosecute.
 
 In July
2001, the holder of a subordinated note in the principal amount of $500,000
commenced an action against us in the United States District Court for the
Southern District of New York seeking payment of the principal and accrued
interest on their subordinated notes which were payable in July 2001. The
payment of the note is subordinated to payment of our senior debt. The
plaintiff's motion for a summary judgment was denied by the court in January
2002, on the grounds that the terms of the note did not give them permission to
obtain a judgment while we remained in default to the senior debt holder. Since
that time, the action has remained inactive. Our obligations under the
subordinated notes are reflected as current liabilities on our balance sheet.
 
 **Item
4.** **** **Submission
of Matters to a Vote of Securities Holders**
 
 During
the fourth quarter of 2004, no matters were submitted to a vote of our security
holders.
 
 10
 
 **Part
II**
 
 **Item
5.** **** **Market
for Registrant's Common Equity and Related** **Stockholder
Matters**
 
 Our
common stock is traded on the OTC Bulletin Board under the symbol PYTM. The
following table sets forth, for 2004 and 2003, the quarterly high and low sales
prices for our common stock on the OTC Bulletin Board.
 
 High
    
    Low2004
    
    
    First
      Quarter
    
    $
    0.15
    
    $
    0.03Second
      Quarter
    
    
    0.23
    
    
    0.05Third Quarter
    
    
    0.23
    
    
    0.07Fourth Quarter
    
    
    0.21
    
    
    0.082003
    
    
    First
      Quarter
    
    $
    0.05
    
    $
    0.01Second
      Quarter
    
    
    0.05
    
    
    0.02Third
      Quarter
    
    
    0.04
    
    
    0.01Fourth
      Quarter
    
    
    0.04
    
    
    0.02
 
 We did
not declare or pay any cash dividends in 2004 or 2003, and we do not anticipate
paying cash dividends in the foreseeable future. Our agreement with the holder
of our senior debt prohibits us from paying cash dividends on our common stock.
 
 As of
March 15, 2005, we had approximately 798 stockholders of record, and the closing
price of our common stock was $0.19.
 
 We did
not issue any unregistered securities during 2004.
 
 **Equity
Compensation Plan Information**
 
 The
following table summarizes the equity compensation plans under which our
securities may be issued as of December 31, 2004.
  11
 Equity
Compensation Plan Information as of December 31, 2004
 
 Plan
      Category
    
    Number
      of securities to beissued upon exercise ofoutstanding options andwarrants
    
    Weighted-average
      exerciseprice of outstandingoptions
      and warrants
    
    Number
      of securitiesremaining available forfuture issuance
      underequity
      compensation plansEquity
      compensation plans approved by security holders
    
    565,280
    
    
    $1.60
    
    
    734,470Equity
      compensation plannot
      approved by security holders
    
    -0-
    
    
    -0-
    
    
    95,750565,280
    
    
    $1.60
    
    
    830,220
 
 The plan
that was not approved by security holders is a stock bonus plan that permits
issuance of stock to employees on a discretionary basis.
 
 **Item
6** **.** **Selected
Financial Data**
  The
following table sets forth certain selected consolidated financial information.
For further information, see the Consolidated Financial Statements and other
information set forth in Item 8 and Management's Discussion and Analysis of
Financial Condition and Results of Operations set forth in Item 7.
 
 12
 
 Year
      Ended December 31,2004
    
    2003
    
    2002
    
    2001
    
    2000(In
      thousands, except per share data)**Income
      Statement Data:**Sales
    
    $
    29,168
    
    $
    19,590
    
    $
    21,417
    
    $
    28,062
    
    $
    51,140Operating
      income (loss)
    
    
    4,153
    
    
    (2,352
    )
    
    (2,881
    )
    
    (11,453
    )
    
    (
      5,153
    )Net
      income (loss)
    
    
    2,675
    
    
    (3,357
    )
    
    (4,114
    )
    
    (14,774
    )
    
    (
      10,176
    )Basic
      and diluted net income (loss) per share
    
    $
    0.27
    
    $
    (0.34
    )
    $
    (0.41
    )
    $
    (1.50
    )
    $
    (1.04
    )Number
      of shares used in calculating net income (loss) per share:
      Basic
    
    
    9,972
    
    
    9,972
    
    
    9,972
    
    
    9,878
    
    
    9,763Diluted
    
    
    9,988
    
    
    9,972
    
    
    9,972
    
    
    9,878
    
    
    9,763**Balance
      Sheet Data:**Total
      assets
    
    $
    14,438
    
    $
    12,355
    
    $
    14,228
    
    $
    17,833
    
    $
    34,174Working
      capital (deficit)
    
    $
    (34,150
    )
    $
    (36,825
    )
    $
    (34,199
    )
    $
    (31,236
    )
    $
    (24,152
    )Current
      debt maturities, including accrued interest
    
    $
    36,736
    
    $
    35,479
    
    $
    34,238
    
    $
    30,124
    
    $
    27,656Long-term
      debt, excluding current maturities
    
    $
    -0-
    
    $
    -0-
    
    $
    -0-
    
    $
    -0-
    
    $
    $
      376Stockholders'
      deficit
    
    $
    (30,661
    )
    $
    (33,238
    )
    $
    (29,935
    )
    $
    (25,849
    )
    $
    (10,792
    )
 
 **Item
7** **.** **Management’s
Discussion and Analysis of Financial Condition and Results of
Operations** **.**
 
 **Critical
Accounting Policies and Estimates**
 
 The
discussion and analysis of our financial condition and results of operations are
based on our consolidated financial statements, which have been prepared in
conformity with accounting principles accepted in the United States. The
preparation of these financial statements requires us to make estimates and
assumptions that affect the reported amounts of assets, liabilities, revenues
and expenses reported in those financial statements. These judgments can be
complex and consequently actual results could differ from those estimates. Among
the more significant estimates included in these consolidated financial
statements are allowance for doubtful accounts receivable, inventory reserves,
goodwill valuation and the deferred tax asset valuation allowance. Because we have
suffered substantial recurring losses from operations in two of the last three
years, and
because of our stockholders’ deficit of $30,661,000 and working capital deficit
of $34,150,000 as of December 31, 2004, our independent auditors included in
their report an explanatory paragraph about our ability to continue as a going
concern. Further,
at December 31, 2004, we had outstanding senior debt of approximately $26
million and subordinated debt of approximately $10 million. Although we have
received an extension to July 1, 2005, if the note is called, we will be unable
to pay the note and it would be necessary for us to seek protection under the
Bankruptcy Act. Note 1 of
Notes to Consolidated Financial Statements, included elsewhere in this annual
report on Form 10-K, includes a summary of the significant accounting policies
and methods used in the preparation of our consolidated financial statements.
 
 13
 Allowance
for Doubtful Accounts Receivable
 
 We record
an allowance for doubtful accounts receivable based on specifically identified
amounts that we believe to be uncollectible. We also record additional
allowances based on certain percentages of our aged receivables, which are
determined based on historical experience and our assessment of the general
financial conditions affecting our customer base. If our actual collections
experience changes, revisions to our allowance may be required. We have a
limited number of customers with individually large amounts due at any given
balance sheet date. Any unanticipated change in one of those customers’ creditworthiness , or
other matters affecting the collectability of amounts due from such customers,
could have a material effect on our results of operations in the period in which
such changes or events occur. After all attempts to collect a receivable have
failed, the receivable is written off against the allowance.
 
 We established an allowance for doubtful accounts receivable of
$1,045,000 at December
31, 2004 and $ 1,091,000
at December 31, 2003. Our
allowance for doubtful accounts is a subjective critical estimate that has a
direct impact on reported net income (loss). This reserve is based upon the
evaluation of accounts receivable aging and specific exposures.
 
 Inventory
Reserves
 
 Inventories
are stated at the lower of cost (on the average or first-in, first-out methods)
or fair market value. Our stated inventory reflects an inventory obsolescence
reserve that represents the difference between the cost of the inventory and its
estimated market value. This reserve is calculated based on historical usage and
forecasted sales. Actual results may differ from our estimates .
 
 Goodwill
 
 Goodwill represents the difference
between the purchase price and the fair market value of net assets acquired in
business combinations treated as purchases. Commencing January 1, 2002, goodwill
is an indefinite lived asset and as such is not amortized. On an annual basis,
we test the goodwill for impairment. We determine the market value of the
reporting unit by considering the projected cash flows generated from the
reporting unit to which the goodwill relates. As of December 31, 2004 and 2003,
all of our goodwill related to our signal processing division. In 2002,
following the termination of negotiations to sell that division, we reduced
goodwill by $800,000. We cannot give assurances that further write-downs will
not be necessary, although management believes that no additional goodwill
impairment charges are necessary at this time.
 
 Deferred
Income Tax Valuation Allowance
 
 Deferred
taxes result from temporary differences between the tax bases of assets and
liabilities and their reported amounts in the financial statements. The
temporary differences result from costs required to be capitalized for tax
purposes by the United States Internal Revenue Code, and certain items accrued
for financial reporting purposes in the year incurred but not deductible for tax
purposes until paid. Due to our losses in 2003 and 2002, a valuation allowance
for the entire deferred tax asset was provided due to the uncertainty as to
future realization and uncertainties associated with projections of future
taxable income.
 
 14
 
 
 **Other
Matters**
 
 Senior
Debt
 
 Our
senior debt matures on July 1, 2005. During the fourth quarter of 2004, SHF IX
LLC, an affiliate of Minnesota-based Stonehill Financial, LLC, purchased the
Company’s senior debt of approximately $25,000,000 from Wells Fargo Foothill,
Inc. Although SHF IX has given us four extensions of the maturity of the debt,
in connection with the recent extensions, it has required us to make payments on
account of the debt. SHF IX has not made any advances to us. A t each
maturity date, the holder reviews our financial condition, business plan and
prospects, including our ability to make regular payments on account of the
senior debt. We cannot
assure you that SHF IX will continue to extend the maturity of the senior debt,
and its willingness to grant further extensions may be dependent upon its
perception of our ability to provide cash flow with respect to the debt, either
from operations or from the sale of one or more of our divisions. Further,
a ny
adverse event, including declines in business or attempts by creditors,
including judgment creditors, to realize on their claims or judgments could have
an effect on the decision of SHF IX to extend or demand payment on our notes. If
SHF IX demands payment, we would be unable to refinance the debt and it would be
necessary for us to seek protection under the Bankruptcy Code.
 
 Interest
 
 Under the
terms of our senior debt agreements, we have not paid or accrued interest on
$22,600,000 of senior debt since March 2002. As a result, our statement of
operations does not reflect any interest charges on the senior debt for 2004,
2003 and the last nine months of 2002. The holder of the senior debt has the
right at any time to require us to pay interest at a rate of 12%, and in the
case of default 14%; however, our obligation to pay interest will not require us
to pay interest on such senior debt for periods prior to the date that we were
required to commence interest payments. We continue to accrue interest on
obligations to the holder of our senior debt which were incurred subsequent to
March 2002.
 
 Continuation
of Our Businesses
 
 During
the past several years we have, on a number of occasions, engaged in
negotiations with respect to the sale of one or more of our divisions. None of
our discussions resulted in an agreement. We may continue to engage in such
negotiations in the future.
 
 Because
of the decline in sales volume and margins, we have determined that we cannot
operate our OSS business profitably. As a result, we currently perform
contractual maintenance and warranty services for our existing customers and we
are seeking to sell the balance of our OSS inventory to existing OSS users.
During 2004, we made modest sales of inventory and completed contracts for OSS
installations pursuant to contracts which we entered into in prior years.
 
 Recent
Increase in Copper Sales; Dependence on British
Telecommunications
 
 Since the
fourth quarter of 2003, we have experienced an increase in our copper connection
business primarily as a result of the requirements of British Telecommunications
to provide increased DSL service. We anticipate that British Telecommunications
will continue to require copper connection products while it is expanding its
DSL service. During the past three years, sales for British Telecommunications,
consisting of both direct sales and sales to systems integrators for British
Telecommunications (including Fujitsu), represented an increasing percentage of
our total sales, accounting for 48% of sales for 2004, 36% of sales for 2003 and
24% of sales for 2002. Almost all of such sales were sales of copper connection
products. We cannot predict how long British Telecommunications will continue to
place orders with us. If British Telecommunications and its systems integrators
cease or significantly reduce purchases from us, we may be unable to operate
profitably, and it may be necessary for us to seek protection under the
Bankruptcy Code.
 
 15
 **Results
of Operations**
 
 The
following table sets forth our consolidated statements of operations for the three years ended December 31,
2004, 2003 and 2002, as a
percentage of sales :
 
 Years
      Ended December 31,2004
    
    2003
    
    2002Sales
    
    
    100
    %
    
    100
    %
    
    100
    %Cost
      of sales
    
    
    61
    %
    
    72
    %
    
    68
    %Gross
      profit
    
    
    39
    %
    
    28
    %
    
    32
    %Selling,
      general andadministrative expenses
    
    
    18
    %
    
    29
    %
    
    30
    %Research
      and development expenses
    
    
    7
    %
    
    11
    %
    
    12
    %Goodwill
      impairment
    
    
    0
    %
    
    0
    %
    
    3
    %Operating
      income (loss)
    
    
    14
    %
    
    (12
    %)
    
    (13
    %)Interest
      expense
    
    
    (4
    )%
    
    (6
    %)
    
    (8
    %)Gain
      on sale of investment in joint venture
    
    
    -
    
    
    -
    
    
    2
    %Income
      (loss) before income taxes
    
    
    10
    %
    
    (18
    %)
    
    (19
    %)Income
      tax benefit (expense)
    
    
    (1
    %)
    
    1
    %
    
    -Net
      income (loss)
    
    
    9
    %
    
    (17
    %)
    
    (19
    %)
  **Results
of Operations**
 ***Years
Ended December 31, 2004 and 2003***
 
 Our sales
for 2004 were $29,168,000 compared to $19,590,000 in 2003, an increase of
$9,578,000 (49%). The increase in revenue is primarily attributed to the
increase in sales of DSL line products to British Telecommunications.
 
 Line
connection/protection equipment sales for 2004 increased approximately
$10,211,000 (90%) from $11,334,000 in 2003 to $21,545,000 in 2004. The increased
sales level resulted
primarily from an increased level of sales to British Telecommunications, and
systems integrators, as a result of British Telecommunications increasing the
availability of DSL lines in the United Kingdom. Direct sales to British
Telecommunications increased 161% from $867,000 to $2,259,000. Sales to systems
integrators increased from $5,597,000 to $11,403,000, or 104%, from 2003 to
2004. Sales also increased, to a lesser extent, in the U.S. and other
international markets. The direct sales to British Telecommunications do not
include sales to Fujitsu and other systems integrators for British
Telecommunications **** (see
“Significant Customers”). ****
 
 16
 Signal
processing revenue for 2004 compared to 2003 increased by $1,298,000 (31%) from
$4,253,000 to $5,551,000. The increase in sales primarily reflects increased
demand for our products and our ability to meet targeted shipment dates due to
our improved ability to secure materials.
 
 OSS sales
for 2004 were $2,003,000, compared to 2003 sales of $3,249,000, a decrease of
$1,246,000 (38%). The decline
in OSS sales in 2004 reflects our strategic business decision to scale back our
product offering and limit the markets we are servicing. During
2004, 91% of the OSS revenue resulted from maintenance services for existing OSS
installations. During 2003, 44% of the OSS revenue resulted from sales and 56%
from maintenance for existing OSS installations.
 
 Gross
margin increased from 28% in 2003 to 39% in 2004. **** The line
protection/connection and signal processing margins increased, but were offset
by lower OSS margins. The gains were the result of better absorption of
manufacturing overhead created by the increased copper connection and signal
processing levels of business
 
 Selling,
general and administrative expenses decreased by $475,000 (8%) from $5,729,000
in 2003 to $5,254,000 in 2004. This decrease relates primarily to our scale-back
in our OSS division.
  Research
and development expenses decreased by $145,000 (7%) from $2,066,000 in 2003 to
$1,921,000 in 2004. This decrease was primarily due to the scale-back of the OSS
division. Prior to 2004, a significant portion of our research and development
was dedicated to new and enhanced OSS products. The research and development for
our line and signal divisions is not substantial, and is oriented more toward
modest enhancements on our existing products rather than development of new
technology. Our absence of significant research and development could impair our
business over the long term.
 
 As a
result of the above, we had an operating income of $4,153,000 in 2004 versus an
operating loss of $2,352,000 in 2003.
 
 Interest
expense for 2004 increased by $39,000 from $1,278,000 for 2003 to $1,317,000 in
2004. Such interest excludes interest on our old term loan, in the principal
amount of approximately $23,000,000, as our related loan agreement provides that
no interest is due commencing March 1, 2002, until such time as the holder of
the debt, in its sole discretion, notifies us that interest, at a rate of 12%
or, in the case of default 14%, shall be payable.
 
 The tax
provision for 2004 is lower than the statutory rate principally as a result of
the utilization of available net operating loss carryforwards. The tax
benefit for 2003 resulted principally from the settlement of an outstanding tax
obligation of $274,000 of one of our subsidiaries for $30,000.
 
 As the
result of the foregoing, the 2004 net income was $2,675,000, $0.27 per share
(basic and diluted), compared with a net loss of $3,357,000, $0.34 per share
(basic and diluted) for 2003.
 
 Even
though we were profitable in 2004, we cannot assure you that we will be able to
operate profitably in the future. If we are unable to operate profitably, it may
be necessary for us to seek protection under the Bankruptcy Code.
 
 17
 
 
 **Results
of Operations**
 ***Years
Ended December 31, 2003 and 2002***
 
 Our sales
for 2003 were $19,590,000 compared to $21,417,000 in 2002, a decrease of
$1,827,000 (9%). The decrease in revenue is primarily attributed to the decline
in sales of OSS products which more than offset increases in sales from our line
connection/protection equipment.
 
 Line
connection/protection equipment sales for 2003 increased approximately
$1,736,000 (18%) from $9,598,000 in 2002 to $11,334,000 in 2003. The increased
sales level results
primarily from an increased level of sales to British Telecommunications
commencing in the third quarter of 2003 as a result of British
Telecommunications increasing the availability of DSL lines. These gains were
offset by a decrease in sales to other customers.
 
 Signal
processing revenue for 2003 compared to 2002 decreased by $270,000 (6%) from
$4,523,000 to $4,253,000. The decrease in sales primarily reflects delays in
shipments from the backlog due to shortages of materials due to our tight cash
situation.
  OSS sales
for 2003 were $3,249,000, compared to 2002 sales of $6,414,000, a decrease of
$3,165,000 (49%). The decline
in OSS sales in 2003 represented an accelerated decline in this line of business
which had sustained significant declines in previous years as well. OSS
contracts require performance over a relatively long term, and the customers are
generally national telephone companies in developing markets many of which are
operated or regulated by a government agency. As a result, our ability to
maintain OSS business has been impaired both by our financial condition, since
our financial condition may give customers concern about our ability to perform,
and the worldwide slowdown in this segment of the telecommunications industry.
In addition, our failure to provide a significant component for a major OSS
customer has resulted in a decision by that customer not to give us new OSS
contracts. Sales of
OSS systems are not made on a recurring basis to customers, but are the result
of extended negotiations that frequently cover many months and do not always
result in a contract. In addition, OSS contracts may include conditions
precedent, such as the customer obtaining financing or bank approval, and the
contracts are not effective until the conditions are satisfied.
 
 Gross
margin decreased from 32% in 2002 to 28% in 2003. **** The line
protection/connection and signal processing margins increased, but were offset
by lower OSS margins. The gains were the result of better absorption of
manufacturing overhead created by the increased copper/connection level of
business, particularly in the second half of 2003.
 
 Selling,
general and administrative expenses decreased by $654,000 (10%) from $6,383,000
in 2002 to $5,729,000 in 2003. This decrease relates primarily to reduced
salaries and benefits, consulting services and commissions reflecting our
current level of business.
 
 Research
and development expenses decreased by $450,000 (18%) from $2,516,000 in 2002 to
$2,066,000 in 2003. This decrease resulted from our efforts to reduce expenses
in all divisions to better match expense levels to sales levels.
 
 At
December 31, 2001, our goodwill was $3,761,000, all of which related to our
Signal division. We determined that this goodwill had been impaired as of June
30, 2002. We engaged in discussions with respect to the sale of that division
during the second quarter of 2002, and based on those discussions we estimated
that the impairment loss was approximately $800,000. This amount was charged to
operations in the quarter ended June 30, 2002. Furthermore, the negotiations
relating to the sale of the Signal division have been discontinued. There was no
impairment adjustment required in 2003. We cannot give any assurances that
further write-downs will not
be necessary in the future, although management believes that no additional
goodwill impairment charges are necessary at this time.
 
 18
 As a
result of the above, we had an operating loss of $2,352,000 in 2003 versus an
operating loss of $2,881,000 in 2002.
 
 Interest
expense for 2003 decreased by $520,000 from $1,798,000 for 2002 to $1,278,000 in
2003. The reduced level of interest expense is attributable to our amended
agreement with the holder of our senior debt whereby the old term loan, in the
principal amount of approximately $23,000,000, bears no interest commencing
March 1, 2002, until such time as the holder of the debt, in its sole
discretion, notifies us that interest, at a rate of 12%, shall be
payable.
 
 The tax
benefit for 2003 resulted principally from the settlement of an outstanding tax
obligation of $274,000 of one of our subsidiaries for $30,000.
 
 In April
2002, we sold our 50% interest in our Korean joint venture for $450,000 to our
joint venture partner. Payment was made by the forgiveness of commissions,
totaling $450,000, which we owed to our sales representation company owned by
our joint venture partner, with respect to sales made by the Korean joint
venture in Korea. There
were no sales in Korea in 2002 or 2003.
 
 As the
result of the foregoing, the 2003 net loss was $3,357,000, $0.34 per share
(basic and diluted), compared with a net loss of $4,114,000, $0.41 per share
(basic and diluted) for 2002.
 
 **Liquidity
and Capital Resources**
  At
December 31, 2004, we had cash and cash equivalents of $2,040,000 compared with
$469,000 at December 31, 2003. Our working capital deficit was $34,150,000 at
December 31, 2004, compared to a working capital deficit of $36,825,000 at
December 31, 2003, a
reduction of $2,675,000 in our working capital deficit. This improvement was a
result of our improved operating results for 2004. During the year ended
December 31, 2004 our operations generated net cash of $1,659,000, as compared
with the year ended December 31, 2003, in which we used cash of $525,000 in our
operations. Since
late 2003, neither our senior lender nor the present holder of our senior debt,
which acquired the senior debt in the fourth quarter of 2004, advanced us any
funds. As a result, our only source of funds was from operations. To the extent
that we are not able to generate sufficient funds to cover our expenses, we may
have to consider protection under the Bankruptcy Code.
 
 As of
December 31, 2004, our debt includes $25,674,000 of senior debt which matures on July 1,
2005 , and
$6,144,000 principal amount of subordinated debt which became due on July 3,
2001. We were unable to pay the interest payment on the subordinated notes of
approximately $4,129,000 which represents interest from July 2000 through
December 2004. As of
December 31, 2004, we also had
$385,000 outstanding of 6% Debentures which matured July 2, 2002. The interest
accrued at
December 31, 2004 was $104,000. At
December 31, 2004, we did not have sufficient resources to pay either the senior
debt or the subordinated debt and it is unlikely that we can generate such cash
from our operations in the foreseeable future. Further, the holder of our senior
debt has precluded us from making payments on the subordinated
debt.
 
 19
 Effective
April 1, 2005, the holder of our senior debt agreed to an extension of the
maturity date of our senior debt to July 1, 2005. As of December 31, 2004, we
did not have resources to pay the senior debt, and, in the event that the holder
of the senior debt does not grant an extension, it may be necessary for us to
seek protection under the Bankruptcy Code.
 
 We have
sought to
address our need for liquidity by exploring alternatives, including the possible
sale of one or more of our divisions. During 2003 and 2004, we were engaged in
discussions with respect to the possible sale of our divisions; however, those
negotiations were terminated without an agreement having been reached, and we
may not be able to sell those divisions on acceptable, if any, terms.
Furthermore, if we sell a division, we anticipate that a substantial
portion , if not
all, of the
net proceeds will be paid to the holder of our senior debt, and we will not
receive any significant amount of working capital from such a sale. We continue
our efforts to reduce costs while we seek additional business from new and
existing customers. The significant reduction in the operations of our OSS
division will impair our ability to sell that division, and such reduction, and
the dependence of our copper business on British Telecommunications and its
systems integrators, are major factors which may impair our ability to sell the
copper division or our business as a whole.
 
 Because
of our present stock price, we cannot raise funds through the sales of our
equity securities, and our financial condition prevents us from issuing debt
securities. In the event that we are unable to extend our debt obligations and
sell one or more of our divisions, we cannot assure you that we will be able to
continue in operations. Furthermore, we believe that our losses in two of the
last three years and our financial position are having, and will continue to
have, an adverse effect upon our ability to develop new business as competitors
and potential customers question our ability both to perform our obligations
under any agreements we may enter and to continue in business.
  As of
December 31, 2004, we did not have any material off-balance sheet arrangements
that have or are reasonably likely to have a material effect on our current or
future financial condition, results of operations, liquidity, or capital
resources.
 
 The
following table summarizes our principal contractual obligations as of December
31, 2004 and the effects such obligations are expected to have on our liquidity
and cash flow in future periods.
  Payments
Due by Period
 
 ContractualObligations
    
    
    2005
    
    2006-2007
    
    2008-2009
    
    Thereafter(in
      thousands)Long-term
      debt, including accrued interest
    
    
    $
    36,736
    
    
    -
    
    
    -
    
    
    -Operating
      leases
    
    
    
    594
    
    
    1,138
    
    
    584
    
    
    2,720Deferred
      compensation obligations
    
    
    
    109
    
    
    217
    
    
    218
    
    
    1,001Purchase
      obligations
    
    
    
    2,272
    
    
    -
    
    
    -
    
    
    -Total
    
    
    $
    39,711
    
    $
    1,355
    
    $
    802
    
    $
    3,721
  20
 **Recently
Issued Accounting Standards**
 
 On
December 31, 2004, the Financial Accounting Standards Board ("FASB") issued FASB
Staff Position No. FAS 109-1, "Application of FASB Statement No. 109, Accounting
for Income Taxes, to the Tax Deduction on Qualified Production Activities
Provided by the American Jobs Creation Act of 2004" ("FSP No. 109-1"), and FASB
Staff Position No. FAS 109-2, "Accounting and Disclosure Guidance for the
Foreign Earnings Repatriation Provision within the American Jobs Creation Act of
2004" ("FSP No. 109-2"). These staff positions provide accounting guidance on
how companies should account for the effects of the American Jobs Creation Act
of 2004 that was signed into law on October 22, 2004. FSP No. 109-1 states that
the tax relief (special tax deduction for domestic manufacturing) from this
legislation should be accounted for as a "special deduction" instead of a tax
rate reduction. FSP No. 109-2 gives a company additional time to evaluate the
effects of the legislation on any plan for reinvestment or repatriation of
foreign earnings for purposes of applying FASB Statement No. 109. We are
investigating the repatriation provision to determine whether it might
repatriate extraordinary dividends, as defined in the American Jobs Creation Act
of 2004 (“AJCA”). We are currently evaluating all available U.S. Treasury
guidance, as well as awaiting anticipated further guidance. We expect to
complete this evaluation within a reasonable amount of time after additional
guidance is published. We estimate the potential income tax effect of any such
repatriation would be to record a tax liability based on the effective 5.25%
rate provided by the AJCA. The actual income tax impact to us will become
determinable once further technical guidance has been issued.
 
 In
December 2004, the FASB issued Statement of Financial Accounting Standard
("SFAS") No. 123(R), "Share-Based Payment" ("SFAS No. 123(R)"). This statement
replaces SFAS No. 123, "Accounting for Stock-Based Compensation" and supersedes
APB No. 25, "Accounting for Stock Issued to Employees." SFAS 123(R) requires all
stock-based compensation to be recognized as an expense in the financial
statements and that such cost be measured according to the fair value of stock
options. SFAS 123(R) will be effective for quarterly periods beginning after
June 15, 2005, which is our third quarter of 2005. While we currently provide
the pro forma disclosures required by SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," on a quarterly basis (see "Note 1 -
Accounting for Stock-Based Compensation"), we are currently evaluating the
impact this statement will have on our consolidated financial
statements.
 
 In
November 2004, the FASB issued SFAS No. 151, "Inventory Costs - an amendment of
ARB No. 43, Chapter 4" ("SFAS No. 151"). SFAS No. 151 requires all companies to
recognize a current-period charge for abnormal amounts of idle facility expense,
freight, handling costs and wasted materials. This statement also requires that
the allocation of fixed production overhead to the costs of conversion be based
on the normal capacity of the production facilities. SFAS No. 151 will be
effective for fiscal years beginning after June 15, 2005. We are currently
evaluating the effect that this statement will have on our consolidated
financial statements, but do not expect it to be material.
 
 **Item
7A.**  **Quantitative
and Qualitative Disclosure About Market Risk.**
 
 We
conduct certain operations outside the United States. A substantial portion of
our revenue and expenses from our United Kingdom operations are denominated in
Sterling. Any Sterling-denominated receipts are promptly converted into United
States dollars. We do not engage in any hedging or other currency transactions.
For 2004, the currency translation adjustment was not significant in relation to
our total revenue.
 
 21
 
 
 **Item
8.** **** **Financial
Statements and Supplementary Data.**
 
 See
Exhibit I
 
 **Item
9** **.** **Changes
In and Disagreements With Accountants On Accounting and Financial
Disclosure.**
 
 Not
Applicable
 
 **Item
9A.** **** **Controls
and Procedures.**
  **Disclosure
Controls and Procedures**
  As of the
end of the period covered by this report, our Chief Executive Officer and Chief
Financial Officer evaluated the effectiveness of our disclosure controls and
procedures. Based on their evaluation, the Chief Executive Officer and the Chief
Financial Officer have concluded that our disclosure controls and procedures
are effective in alerting them to material information that is required to be
included in the reports that we file or submit under the Securities Exchange Act
of 1934.
  **Internal
Control Over Financial Reporting**
 
 There has
been no change in our internal control over financial reporting that occurred
during our last fiscal quarter that has materially affected, or is reasonably
likely to materially affect, our internal control over financial
reporting.
  **Item
9B.** **** **Other
Information.**
  None
  22
 **Part
III**
 
 **Item
10.** **** **Directors
and Executive Officers**
 
 Set forth
below is information concerning our directors:
 
 Name
    Principal
      Occupation or Employment
    Director
      Since
    AgeWilliam
      V. Carney1
    Chairman
      of the board and chief executive officer
    1970
    68Michael
      A. Tancredi
    Senior
      vice president, secretary and treasurer
    1970
    75Warren
      H. Esanu1,2
    Of
      counsel to Esanu Katsky Korins & Siger, LLP, attorneys at
      law
    1997
    62Herbert
      H. Feldman1,2
    President,
      Alpha Risk Management, Inc., independent risk management
      consultants
    1989
    71Marco
      M. Elser2
    Managing
      director of Advicorp, PLC., an investment advisory firm
    2000
    46
 _____________________
 1
    Member
      of the executive committee.2
    Member
      of the audit and compensation committees.
 
 Mr.
Carney has been chairman of the board and chief executive officer since October
1996. He was vice chairman from 1988 to October 1996, senior vice president from
1989 to October 1996, chief technical officer since 1990 and secretary from 1977
to October 1996. He also served as senior vice president-mechanical engineering
from 1988 to 1989, senior vice president-connector products from 1985 to 1988,
senior vice president-manufacturing from 1984 to 1985 and senior vice
president-operations from 1977 to 1984. Since December 2002, Mr. Carney has
worked for us on a part-time basis.
 
 Mr.
Tancredi has been senior vice president, secretary and treasurer since January
1997. He has been vice president-administration since 1995 and treasurer since
1978, having served as vice president-finance and administration from 1989 to
1995 and vice president-finance from 1984 to 1989.
 
 Mr. Esanu
has been a director since April 1997 and also served as a director from 1989 to
1996. He was also our chairman of the board from March 1996 to October 1996. He
has been of counsel to Esanu Katsky Korins & Siger, LLP, attorneys at law,
for more than the past five years. Mr. Esanu is also a founding partner and
chairman of Paul Reed Smith Guitars Limited Partnership (Maryland), a leading
manufacturer of premium-priced electrical guitars. He is also a senior officer
and director of a number of privately held real estate investment and management
companies.
 
 Mr. Elser
has been the managing director of Advicorp, PLC., an investment advisory firm,
for more than the past five years. He has also been associated with Northeast
Securities, a US-based broker dealer and is responsible for the Italian office,
which he founded in 1994.
 
 23
 Mr.
Feldman has been president of Alpha Risk Management, Inc., independent risk
management consultants, for more than the past five years.
 
 Set forth
is information concerning our executive officers:
 
 Name
      of Executive Officer
    Position
    AgeWilliam
      V. Carney
    Chairman
      of the board and chief executive officer
    68Michael
      A. Tancredi
    Senior
      vice president, secretary and treasurer
    75Edward
      B. Kornfeld
    President,
      chief operating officer and chief financial officer
    61
 
 All of
our officers serve at the pleasure of the board of directors. Messrs. Carney and
Tancredi are also members of the board of directors as stated above. There is no
family relationship between any of the executive officers listed
below.
 
 Mr.
Kornfeld, 61, has been president, chief operating and financial officer since
April 2004. He was senior vice president-operations since 1996 and chief
financial officer since October 1995. Since June 2002, Mr. Kornfeld has also
been a partner of the firm of Tatum CFO Partners, which provides chief financial
officer services to medium and large companies; however, he continues to devote
full time effort to our business. He was vice president-finance from October
1995 until 1996. For more than five years prior thereto, Mr. Kornfeld held
positions with several companies for more than five years, including Excel
Technology Inc. (Quantronix Corp.) and Anorad Corporation.
 
 We
maintain a code of ethics that applies to all of our executive officers,
including our principal executive, financial and accounting officers, our
directors, our financial managers and all employees. Any waiver of the code must
be approved by the Audit Committee and must be disclosed in accordance with SEC
rules. We also have a standard of conduct which is applicable to all
employees.
 
 
 Our board
of directors has determined that Mr. Marco Elser, based on his experience as a
financial investment advisor, is an audit committee financial expert, as defined
in Item 402(h) of Regulation S-K.
 
 **Section
16(a) Beneficial Ownership Reporting Compliance**
 
 Pursuant
to our stock option plans, our non-employee directors receive an automatic grant
of options to purchase 5,000 shares of common stock on May 1 of each year. The
exercise price of such shares is the average of closing price on the ten trading
days prior to May 1. Although the options were granted, we did not issue any
option grants to the non-employee directors for the options to purchase 5,000
shares for these options granted subsequent to 1999, and the directors did not
file a Form 4 for such grants. These non-employee directors are Mr. Esanu and
Mr. Feldman for 1999 through 2004 and Mr. Elser from 2001 through 2004. Mr.
Elser was elected as a director by the board of directors in 2000, and he was
delinquent in filing his Form 3.
 
 We had a
qualified employee stock purchase plan pursuant to which employees, including
officers, can purchase shares of common stock at a discount from market. During
2000 and 2001, our officers purchased shares of common stock pursuant to this
plan which were not reported on a Form 4. These officers are Mr. Carney, as to
54,749 shares, Mr. Kornfeld, as to 14,317 shares, and Mr. Tancredi, as to 17,581
shares.
 
 24
 We have
implemented a procedure designed to enable our officers and directors to file
their Form 4 in a timely manner with respect to options granted or shares issued
by us.
 
 **Item
11.** **** **Executive
Compensation**
 
 The
following table shows the compensation we paid to our chief executive officer
and the only executive officer, other than the chief executive officer, whose
salary and bonus earned exceeded $100,000 for the year ended December 31,
2004.
 
 **Summary
Compensation Table** ****
 AnnualCompensation
    
    Long-TermCompensation
      (Awards)Name
      and Principal Position
    
    Year
    
    Salary
    
    Bonus
    
    RestrictedStockAwards(Dollars)
    
    Options,SARs(Number)
    
    All
      otherCompensationWilliam
      V. Carney, Chairman
    
    
    2004
    
    $
    122,000
    
    $
    5,000
    
    
    --
    
    
    --
    
    $
    6,101of
      the board and chief
    
    
    2003
    
    
    133,000
    
    
    --
    
    
    --
    
    
    --
    
    
    7,734executive
      officer
    
    
    2002
    
    
    240,000
    
    
    --
    
    
    --
    
    
    --
    
    
    9,858Edward
      B. Kornfeld,
    
    
    2004
    
    
    206,000
    
    
    15,000
    
    
    --
    
    
    --
    
    
    6,639President,
      chief operating
    
    
    2003
    
    
    192,000
    
    
    --
    
    
    --
    
    
    --
    
    
    5,022officer
      and chief financial
    
    
    2002
    
    
    192,000
    
    
    --
    
    
    --
    
    
    --
    
    
    5,022officer
 ________________
 
 “All
Other Compensation” includes a payment to the executive’s account pursuant to
our 401(k) Plan, group life insurance in amounts greater than that available to
all employees and special long term disability coverage.
 
 Compensation
to Mr. Kornfeld does not include fees of $36,000 paid in both 2004 and 2003 to
Tatum CFO Partners, of which Mr. Kornfeld is a partner, for services rendered to
us by Mr. Kornfeld.
 
 Set forth
below is a chart that shows, for 2004, the components of “All Other
Compensation” listed in the Summary Compensation Table.
 
 Mr.Carney
    
    Mr.Kornfeld401(k)
      Match
    
    $
    1,910
    
    $
    3,075Supplemental
      Insurance
    
    
    4,191
    
    
    3,564
 
 During
2004, we did not grant Mr. Carney or Mr. Kornfeld any options, and neither of
them exercised any options to purchase shares of our common stock. As of
December 31, 2004, Mr.
Carney held options to purchase 86,250 shares of common stock and Mr. Kornfeld
held options to purchase 23,000 shares of common stock. All of these options are
currently exercisable and, because the exercise price is less than the
market price of the common stock, they were not in-the-money options and,
accordingly, their options had nominal value at December 31, 2004.
 
 25
 **Employment
Agreements** *.* During
2003, we amended our employment agreement with Mr. Carney whereby he is required
to work at a rate of two and one-half days per week, and half of his current
base pay is deferred until the termination of his amended employment agreement
on March 31, 2006. No further compensation shall be paid to Mr. Carney,
including the deferred amount, if we do not terminate Mr. Carney’s employment
prior to March 31, 2006.
 
 We
entered into a new employment agreement with Mr. Kornfeld, effective April 1,
2004. This agreement has a term which expires December 31, 2006 and continues on
a year-to-year basis thereafter unless terminated by either party on not less
than 90 days’ prior written notice. Salary is determined by the board, except
that the salary may not be reduced except as a part of a salary reduction
program applicable to all executive officers. Upon death or termination of
employment as a result of a disability, Mr.
Kornfeld or his
estate is to receive a payment equal to three months salary. Upon a termination
without cause, Mr. Kornfeld is entitled to receive his then current salary for
twelve months plus one month for each full year of service up to a maximum
aggregate of 36 months. In the event that Mr.
Kornfeld is
covered by an executive severance agreement, including the salary continuation
agreements (as described below), which provides for payments upon termination
subsequent to a “change of control,” the executive would be entitled to the
greater of the severance arrangements as described in this paragraph or the
severance payments under the executive severance agreements. We also have a
month-to-month agreement with Tatum CFO Partners of which Mr. Kornfeld is a
partner, pursuant to which we pay Tatum CFO Partners $3,000 per month for Mr.
Kornfeld’s services.
 
 **Salary
Continuation Agreement** *.* **** We are
party to a salary continuation agreement with Mr. Kornfeld. The salary
continuation agreement provides that, in the event that a change of control
occurs and Mr.
Kornfeld ’s
employment with us is subsequently terminated by us other than for cause, death
or disability, or is terminated by Mr.
Kornfeld as a
result of a substantial alteration in his duties,
compensation or other benefits, the executive shall be entitled to the payment
of an amount equal to his monthly salary at the rate in effect as of the date of
his termination (or, if higher, as in effect immediately prior to the change in
control) plus the pro rata monthly amount of his most recent annual bonus paid
immediately before the change of control multiplied by 36. For purposes of the
salary continuation agreement, a change of control is defined as one which would
be required to be reported in response to the proxy rules
under the Securities Exchange Act of 1934, as amended, the
acquisition of beneficial ownership, directly or indirectly, by a person or
group of persons of our securities representing 25% or more of the combined
voting power of our then outstanding securities, or, during any period of two
consecutive years, if individuals who at the beginning of such period
constituted the board cease for any reason to constitute at least a majority
thereof unless the election of each new director was nominated or ratified by at
least two-thirds of the directors then still in office who were directors at the
beginning of the period. The change of control must occur during the term of the
salary continuation agreement, which is currently through December 31, 2005  and is
renewed automatically unless we give timely notice prior to January 1 of any
year of our election not to renew the agreement. If such a change of control
occurs during the effectiveness of the salary continuation agreement, any
termination of Mr. Kornfeld during the 18 months following the change of control
will result in the payment of the compensation described above.
 
 26
 **Directors’
Fees.** On March
22, 2005, directors’ fees payable to the non-management directors were increased
from $4,250 per quarter to $6,250 per quarter, and meeting fees were increased
from $1,200 to $1,500.
  In 2000,
we authorized the issuance of an aggregate of 175,630 shares of common stock in
lieu of the cash payment of directors’ fees, based on the fair market value of
the shares on August 8, 2000. These shares have not been issued, and they will
be issued in the second quarter of 2005 to those individuals who were
non-employee directors in 2000.  Mr. Esanu and Mr. Feldman were directors
for all of 2000, and they will receive 35,938 and 39,630 shares,
respectively . Mr.
Elser was a director for a portion of 2000, and he will receive 5,784 shares.
The remaining shares will be issued to individuals who are no longer our
directors.
 
 **Item
12.** **** **Principal
Holders of Securities and Security Holdings of
Management**
 
 The
following table and discussion provides information as to the shares of common
stock beneficially owned on March 15, 2005 by:
 
 •
    each
      director;
 •
    each
      officer named in the summary compensation
table;
 •
    each
      person owning of record or known by us, based on information provided to
      us by the persons named below, to own beneficially at least 5% of our
      common stock; and
 •
    all
      directors and executive officers as a group.
  **Name******
    
    **Shares
      of Common****Stock
      Beneficially****Owned**
    
    **Percentage
      of Outstanding****Common
      Stock**William
      V. Carney
    
    
    209,272
    
    
    2.1%Michael
      A. Tancredi
    
    
    81,768
    
    
    *Warren
      H. Esanu
    
    
    99,000
    
    
    *Herbert
      H. Feldman
    
    
    71,000
    
    
    *Marco
      M. Elser
    
    
    330,592
    
    
    3.3%Edward
      B. Kornfeld
    
    
    49,317
    
    
    *All
      directors and executive officers as a group (6
individuals)
    
    
    840,949
    
    
    8.4%
 __________________
 * Less
than 1%
 
 Except as
otherwise indicated, each person has the sole power to vote and dispose of all
shares of common stock listed opposite his name.
 
 The
number of shares owned by our directors and officers named in the summary
compensation table includes shares of common stock which are issuable upon
exercise of options and warrants that are exercisable at March 15, 2005 or will
become exercisable within 60 days after that date. Set forth below is the number
of shares of common stock issuable upon exercise of those options and warrants
for each of these directors and officers.
  27
 
 **Name**
    
    **Shares**William
      V. Carney
    
    
    86,250Michael
      A. Tancredi
    
    
    42,530Warren
      H. Esanu
    
    
    49,000Herbert
      H. Feldman
    
    
    51,000Marco
      M. Elser
    
    
    20,000Edward
      B. Kornfeld
    
    
    23,000All
      officers and directors as a group
    
    
    271,780
 
 **Item
13.** **** **Certain
Relationships and Related Transactions**
 
 During
2004, Warren H. Esanu, a director, served as a member of our audit and
compensation committees. During 2004, the law firm of Esanu Katsky Korins &
Siger, LLP, to which Mr. Esanu is of counsel, provided legal services to us, for
which it received fees of $410,445. Esanu Katsky Korins & Siger, LLP is
continuing to render legal services to us during 2005.
 
 **Item
14.** **** **Principal
Accountant Fees and Services.**
 
 The
following is a summary of the fees for professional services rendered by our
independent accountants, BDO Seidman, LLP, for the years ended December 31,
2004 and December 31, 2003:
 
 **Fees****Fee
      Category**
    
    **2004**
    
    **2003**Audit
      fees
    
    $
    153,700
    
    $
    170,200Audit-related
      fees
    
    
    10,650
    
    
    10,000Tax
      fees
    
    
    12,490
    
    
    5,500Total
      Fees
    
    $
    176,840
    
    $
    185,700
  *Audit
fees.* Audit
fees represent fees for professional services performed by BDO Seidman, LLP for
the audit of our annual financial statements and the review of our quarterly
financial statements, as well as services that are normally provided in
connection with statutory and regulatory filings or engagements. **
  *Audit-related
fees.* Audit-related
fees represent fees for assurance and related services performed by BDO Seidman,
LLP that are reasonably related to the performance of the audit or review of our
financial statements. The specific service was the audit of our retirement plan.
  *Tax
Fees.* Tax fees
represent fees for tax compliance services performed by BDO Seidman,
LLP.
  28
 *All
other fees.* BDO
Seidman, LLP did not perform any services other than the services described
above.
  **Policy
on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of
Independent Auditors**
  The Audit
Committee’s policy is to pre-approve all audit and permissible non-audit
services provided by the independent auditors. These services may include audit
services, audit-related services, tax services and other services. The
independent auditors and management are required to periodically report to the
Audit Committee regarding the extent of services provided by the independent
auditors in accordance with this pre-approval, and the fees for the services
performed to date. The Audit Committee may also pre-approve particular services
on a case-by-case basis. All services were pre-approved by the Audit
Committee.
  29
  **Part
IV**
 
 **Item
15.** **** **Exhibits,
Financial Statements Schedules.**
 
 (a)
    Document
      filed as part of this Annual Report on Form 10-K:(i)
    Financial
      Statements.See
      Index to Consolidated Financial Statements under Item 8
      hereof.(ii)
    Financial
      Statement Schedules.None
 
 Schedules
not listed above have been omitted for the reasons that they were inapplicable
or not required or the information is given elsewhere in the financial
statements.
 
 Separate
financial statements of the registrant have been omitted since restricted net
assets of the consolidated subsidiaries do not exceed 25% of consolidated net
assets.
 
 (b)
    Exhibits
 
 Exhibit
      No.
    
    Description
      of Exhibit3.1
    
    Certificate
      of Incorporation of the Company, as amended to date, incorporated by
      reference to Exhibit 4 (a) of the Company’s Annual Report on Form 10-K for
      the year ended December 31, 1991.3.2
    
    Certificate
      of Designation of Series B Participating Convertible Preferred Stock,
      incorporated by reference to Exhibit 3.2 of the Company’s Annual Report on
      Form 10-K for the year ended December 31, 1995.3.3
    
    By-laws
      of the Company, as amended to date, incorporated by reference to Exhibit
      3.3 of the Company’s Annual Report on Form 10-K for the year ended
      December 31, 1995.4.1
    
    Amended
      and Restated Loan and Security Agreement dated as of November 28, 1994,
      between the Company and Foothill ("Foothill") Capital Corporation,
      incorporated by reference to Exhibit 2 to the Company’s Current Report on
      Form 8-K dated November 30, 1994.4.2
    
    Amended
      and Restated Secured Promissory Note dated February 13, 1995, incorporated
      by reference to Exhibit 4.9 of the Company’s Annual Report on Form 10K for
      the year ended December 31, 1995.4.3
    
    Warrant
      to Purchase Common Stock of the Company dated November 28, 1994 executed
      by the Company in favor of Foothill, incorporated by reference to Exhibit
      6 to the Company’s Current Report on Form 8-K dated November 30, 1994.
  30
  Exhibit
      No.
    
    Description
      of Exhibit4.4
    
    Lockbox
      Operating Procedural Agreement dated as of November 28, 1994 among
      Chemical Bank, the Company and Foothill, incorporated by reference to
      Exhibit 7 to the Company’s Current Report on Form 8-K dated November 30,
      1994.4.5
    
    Amendment
      Number Sixteen to the Amended and Restated Loan Security Agreement, dated
      February 1, 2005.4.6
    
    Amendment
      Number Seventeen to the Amended and Restated Loan and Security Agreement,
      dated April 1, 2005.10.1
    
    Form
      of Executive Salary Continuation Agreement, incorporated by reference to
      Exhibit 19 (cc) of the Company’s Quarterly Report on Form 10-Q for the
      quarter ended September 30, 1985.10.2
    
    Lease
      dated November 6, 2002 between the Company and Long Island Industrial
      Group LLC., incorporated by reference to Exhibit 10.2 of the Company’s
      Annual Report on Form 10K for the year ended December 31,
      2002.10.3
    
    Lease
      dated May 1, 2002 between the Company and Long Island Industrial Group
      LLC., incorporated by reference to Exhibit 10.3 of the Company’s Annual
      Report on Form 10K for the year ended December 31,
2002.10.4
    
    Employment
      Agreement between the Company and Edward B. Kornfeld dated April 1,
      2004.10.5
    
    Amendment
      to Employment Agreement between the Company and William V. Carney, dated
      July 21, 2003.14.1
    
    Code
      of Ethics of the Company, dated March 23, 2004, incorporated by reference
      to Exhibit 14.1 of the Company's Annual Report on Form 10K for the year
      ended December 31, 2003.14.2
    
    Standard
      of Conduct of the Company.22
    
    Subsidiaries
      of the Company, incorporated by reference to Exhibit 22.1 of the Company’s
      Annual Report on Form 10K for the year ended December 31,
      1995.23
    
    Consent
      of Independent Registered Public Accounting Firm.31.1
    
    Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.31.2
    
    Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.32.1
    
    Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to Section
      906 of the Sarbanes-Oxley Act of
2002.
 
 31
 
 
 **SIGNATURES**
 
 Pursuant
to the requirements of Section 13 or 15(b) of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.
  **PORTA SYSTEMS
      CORP.**Date: March 31,
2005
    By:
    /s/ William V.
    CarneyWilliam V. CarneyChairman
      of the Board andChief
      Executive Officer
  Pursuant
to the requirements of the Securities Exchange Act of 1934, as amended, the
report has been signed by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated. Each person whose signature
appears below hereby authorizes William V. Carney and Edward B. Kornfeld or
either of them acting in the absence of the others, as his true and lawful
attorney-in-fact and agent, with full power of substitution and resubstitution
for him and in his name, place and stead, in any and all capacities to sign any
and all amendments to this report, and to file the same, with all exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission.
 
 Signature
    
    Title
    
    Date/s/William
      V. Carney
    
    Chairman
      of the Board,
    
    March
      31, 2005William
      V. Carney
    
    Chief
      Executive Officer and Director (Principal Executive
      Officer)/s/Edward
      B. Kornfeld
    
    President
    
    March
      31, 2005Edward
      B. Kornfeld
    
    Chief
      Operating Officer and Chief Financial Officer (Principal Financial and
      Accounting Officer)/s/Warren
      H. Esanu
    
    Director
    
    March
      31, 2005Warren
      H. Esanu/s/Michael
      A. Tancredi
    
    Director
    
    March
      31, 2005Michael
      A. Tancredi/s/Herbert
      H. Feldman
    
    Director
    
    March
      31, 2005Herbert
      H. Feldman/s/Marco
      Elser
    
    Director
    
    March
      31, 2005Marco
      Elser
 
 32
 
  **Exhibit
I**
 
 **Item
8. Financial Statements and Supplementary Data**
 
 Index
    
    PageReport
      of Independent Registered Public Accounting Firm
    
    F-2Consolidated
      Financial Statements and Notes:Consolidated
      Balance Sheets, December 31, 2004 and 2003
    
    F-3Consolidated
      Statements of Operations and Comprehensive Income (Loss),Years Ended
      December 31, 2004, 2003 and 2002
    
    F-4Consolidated
      Statements of Stockholders’Deficit,
      Years Ended December 31, 2004, 2003 and 2002
    
    F-5Consolidated
      Statements of CashFlows
      forthe Years Ended December 31, 2004,2003 and2002
    
    F-6Notes
      to Consolidated Financial Statements
    
    F-7
 
 
 
 Report of Independent Registered Public Accounting
Firm
 
 The Board
of Directors and Stockholders
 Porta
Systems Corp.
 Syosset,
New York
 
 We have
audited the accompanying consolidated balance sheets of Porta Systems Corp. and
subsidiaries as of December 31, 2004 and 2003, and the related consolidated
statements of operations and comprehensive income (loss), stockholders’ deficit,
and cash flows for each of the three years in the period ended December 31,
2004. These financial statements are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our
audits included consideration of internal control over financial reporting as a
basis for designing audit procedures that are appropriate in the circumstances,
but not for the purpose of expressing an opinion on the effectiveness of the
Company’s internal control over financial reporting. Accordingly, we express no
such opinion. An audit
also includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
 
 In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Porta Systems Corp. and
subsidiaries as of December 31, 2004 and 2003, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2004, in conformity with accounting principles generally accepted
in the United States of America.
 
 The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern. As
discussed in Note 2 to the consolidated financial statements, the Company has
suffered substantial recurring losses from operations in two of the last three
years and, as of December 31, 2004, has a stockholders’ deficit of $30,661,000
and a working capital deficit of $34,150,000. These factors raise substantial
doubt about the Company ’ s ability
to continue as a going concern. Management’s plans in regard to these matters
are also described in Note 2. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
 
 
 /s/BDO
SEIDMAN, LLP
 BDO
SEIDMAN, LLP
 Melville,
New York
 March 25,
200 5
 
 
 F-2
 PORTA SYSTEMS CORP. AND SUBSIDIARIES
  Consolidated
Balance Sheets
 December
31, 2004 and 2003
 (in
thousands, except shares and par value)
 
 Assets
    
    2004
    
    2003Current
      assets:Cash
      and cash equivalents
    
    $
    2,040
    
    
    469Accounts
      receivable - trade, less allowance for doubtful accounts of $1,045in
      2004 and $1,091 in 2003
    
    
    3,076
    
    
    3,898Inventories
    
    
    4,576
    
    
    3,004Prepaid
      expenses and other current assets
    
    
    382
    
    
    472Total
      current assets
    
    
    10,074
    
    
    7,843Property,
      plant and equipment, net
    
    
    1,334
    
    
    1,466Goodwill
    
    
    2,961
    
    
    2,961Other
      assets
    
    
    69
    
    
    85Total
      assets
    
    $
    14,438
    
    
    12,355Liabilities
      and Stockholders’ DeficitCurrent
      liabilities:Senior
      debt, including accrued interest
    
    $
    25,674
    
    
    25,387Subordinated
      notes
    
    
    6,144
    
    
    6,1446%
      Convertible subordinated debentures
    
    
    385
    
    
    385Accounts
      payable
    
    
    4,728
    
    
    5,635Accrued
      expenses and other
    
    
    2,760
    
    
    3,554Other
      accrued interest payable
    
    
    4,533
    
    
    3,563Total
      current liabilities
    
    
    44,224
    
    
    44,668Deferred
      compensation
    
    
    875
    
    
    925Total
      long-term liabilities
    
    
    875
    
    
    925Total
      liabilities
    
    
    45,099
    
    
    45,593Commitments
      and contingenciesStockholders’
      deficit:Preferred
      stock, no par value; authorized 1,000,000 shares, none
    issued
    
    
    -
    
    
    -Common
      stock, par value $.01; authorized 20,000,000 shares, issued 10,003,224
      shares in both 2004 and 2003
    
    
    100
    
    
    100Additional
      paid-in capital
    
    
    76,059
    
    
    76,059Accumulated
      deficit
    
    
    (100,705
    )
    
    (103,380
    )Accumulated
      other comprehensive loss:Foreign
      currency translation adjustment
    
    
    (4,177
    )
    
    (4,079
    )(28,723
    )
    
    (31,300
    )Treasury
      stock, at cost, 30,940 shares
    
    
    (1,938
    )
    
    (1,938
    )Total
      stockholders’ deficit
    
    
    (30,661
    )
    
    (33,238
    )Total
      liabilities and stockholders’ deficit
    
    $
    14,438
    
    
    12,355
 
 See
accompanying notes to consolidated financial statements.
 
 F-3
 PORTA SYSTEMS CORP. AND SUBSIDIARIES
  Consolidated
Statements of Operations and Comprehensive Income (Loss)
 Years
ended December 31, 2004, 2003 and 2002
 (in
thousands, except per share amounts)
 
 2004
    
    2003
    
    2002Sales
    
    $
    29,168
    
    
    19,590
    
    
    21,417Cost
      of sales
    
    
    17,840
    
    
    14,147
    
    
    14,599Gross
      profit
    
    
    11,328
    
    
    5,443
    
    
    6,818Selling,
      general and administrative expenses
    
    
    5,254
    
    
    5,729
    
    
    6,383Research
      and development expenses
    
    
    1,921
    
    
    2,066
    
    
    2,516Goodwill
      impairment
    
    
    -
    
    
    -
    
    
    800Total
      expenses
    
    
    7,175
    
    
    7,795
    
    
    9,699Operating
      income (loss)
    
    
    4,153
    
    
    (2,352
    )
    
    (2,881
    )Interest
      expense
    
    
    (1,317
    )
    
    (1,278
    )
    
    (1,798
    )Interest
      income
    
    
    -
    
    
    1
    
    
    7Gain
      on sale of investment in joint venture
    
    
    -
    
    
    -
    
    
    450Other
      income, net
    
    
    8
    
    
    -
    
    
    119Income
      (loss) before income taxes
    
    
    2,844
    
    
    (3,629
    )
    
    (4,103
    )Income
      tax benefit (expense)
    
    
    (169
    )
    
    272
    
    
    (11
    )Net
      income (loss)
    
    $
    2,675
    
    
    (3,357
    )
    
    (4,114
    )Other
      comprehensive income (loss):Foreign
      currency translation adjustments
    
    
    (98
    )
    
    54
    
    
    24Comprehensive
      income (loss)
    
    $
    2,577
    
    
    (3,303
    )
    
    (4,090
    )Basic
      per share amounts:Net
      income (loss) per share of common stock
    
    $
    0.27
    
    
    (0.34
    )
    
    (0.41
    )Weighted
      average shares of common stock outstanding
    
    
    9,972
    
    
    9,972
    
    
    9,972Diluted
      per share amounts:Net
      income (loss) per share of common stock
    
    $
    0.27
    
    
    (0.34
    )
    
    (0.41
    )Weighted
      average shares of common stock outstanding
    
    
    9,988
    
    
    9,972
    
    
    9,972
 
 See
accompanying notes to consolidated financial statements.
 
 F-4
 PORTA SYSTEMS CORP. AND SUBSIDIARIES
  Consolidated
Statements of Stockholders’ Deficit
 Years
ended December 31, 2004, 2003 and 2002
 (In
thousands)
  Accumulated
    
    
    
    
    
    TotalCommon
      Stock
    
    Additional
    
    Other
    
    
    
    
    
    Stock-No.
      of
    
    Par
      Value
    
    Paid-in
    
    Comprehensive
    
    Accumulated
    
    Treasury
    
    holders’Shares
    
    Amount
    
    Capital
    
    (Loss)
    
    Deficit
    
    Stock
    
    DeficitBalance
      at December 31, 2001
    
    
    9,947
    
    $
    99
    
    $
    76,056
    
    $
    (4,157
    )
    $
    (95,909
    )
    $
    (1,938
    )
    $
    (25,849
    )Net
      loss 2002
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (4,114
    )
    
    -
    
    
    (4,114
    )Common
      stock issued
    
    
    56
    
    
    1
    
    
    3
    
    
    -
    
    
    -
    
    
    -
    
    
    4Foreign
      currency translation adjustment
    
    
    -
    
    
    -
    
    
    -
    
    
    24
    
    
    -
    
    
    -
    
    
    24Balance
      at December 31, 2002
    
    
    10,003
    
    
    100
    
    
    76,059
    
    
    (4,133
    )
    
    (100,023
    )
    
    (1,938
    )
    
    (29,935
    )Net
      loss 2003
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (3,357
    )
    
    -
    
    
    (3,357
    )Foreign
      currency translation adjustment
    
    
    -
    
    
    -
    
    
    -
    
    
    54
    
    
    -
    
    
    -
    
    
    54Balance
      at December 31, 2003
    
    
    10,003
    
    
    100
    
    
    76,059
    
    
    (4,079
    )
    
    (103,380
    )
    
    (1,938
    )
    
    (33,238
    )Net
      income 2004
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    2,675
    
    
    -
    
    
    2,675Foreign
      currency translation adjustment
    
    
    -
    
    
    -
    
    
    -
    
    
    (98
    )
    
    -
    
    
    -
    
    
    (98
    )Balance
      at December 31, 2004
    
    
    10,003
    
    $
    100
    
    $
    76,059
    
    $
    (4,177
    )
    $
    (100,705
    )
    $
    (1,938
    )
    $
    (30,661
    )
 
 
 See
accompanying notes to consolidated financial statements
 F-5
 PORTA SYSTEMS CORP. AND SUBSIDIARIES
  Consolidated
Statements of Cash Flows (Note 20)
 Years
ended December 31, 2004, 2003 and 2002
 (In
thousands)
 
 2004
    
    2003
    
    2002Cash
      flows from operating activities:Net
      income (loss)
    
    $
    2,675
    
    
    (3,357
    )
    
    (4,114
    )Adjustments
      to reconcile net income (loss) to net cashprovided by (used in)
      operating activities:Depreciation
      and amortization
    
    
    409
    
    
    483
    
    
    713Goodwill
      impairment
    
    
    -
    
    
    -
    
    
    800Amortization
      of debt discounts
    
    
    -
    
    
    -
    
    
    3Gain
      on sale of investment in joint venture
    
    
    -
    
    
    -
    
    
    (450
    )Changes
      in operating assets and liabilities:Accounts
      receivable
    
    
    822
    
    
    756
    
    
    (370
    )Inventories
    
    
    (1,572
    )
    
    359
    
    
    1843Prepaid
      expenses
    
    
    91
    
    
    (143
    )
    
    523Other
      assets
    
    
    17
    
    
    255
    
    
    (142
    )Accounts
      payable, accrued expenses and other liabilities
    
    
    (783
    )
    
    1,122
    
    
    (2,044
    )Net
      cash provided by (used in) operating activities
    
    
    1,659
    
    
    (525
    )
    
    (3,238
    )Cash
      flows from investing activities:Capital
      expenditures, net
    
    
    (259
    )
    
    (72
    )
    
    (124
    )Net
      cash used in investing activities
    
    
    (259
    )
    
    (72
    )
    
    (124
    )Cash
      flows from financing activities:Increase
      in senior debt
    
    
    357
    
    
    317
    
    
    2,975Repayments
      of senior debt
    
    
    (70
    )
    
    -
    
    
    -Proceeds
      from the issuance of common stock
    
    
    -
    
    
    -
    
    
    4Repayments
      of notes payable/short-term loans
    
    
    -
    
    
    (8
    )
    
    (3
    )Net
      cash provided by financing activities
    
    
    287
    
    
    309
    
    
    2,976Effect
      of exchange rate changes on cash and cash equivalents
    
    
    (116
    )
    
    (22
    )
    
    (39
    )Decrease
      in cash and cash equivalents
    
    
    1,571
    
    
    (310
    )
    
    (425
    )Cash
      and equivalents - beginning of year
    
    
    469
    
    
    779
    
    
    1,204Cash
      and equivalents - end of year
    
    $
    2,040
    
    
    469
    
    
    779
 
 See
accompanying notes to consolidated financial statements.
 F-6
 PORTA SYSTEMS CORP. AND SUBSIDIARIES
  Notes to
Consolidated Financial Statements
 December
31, 2004 and 2003
 
 (1) Summary
of Significant Accounting Policies
 
 Nature
of Operations and Principles of Consolidation
  Porta
Systems Corp. (“Porta” or the “Company”) designs, manufactures and markets
systems for the connection, protection, testing and administration of public and
private telecommunications lines and networks. The Company has various patents
for copper and software based products and systems that support voice, data,
image and video transmission. Porta’s principal customers are the U.S. regional
telephone operating companies and foreign telephone companies.
  The
accompanying consolidated financial statements include the accounts of Porta and
its majority-owned or controlled subsidiaries. All significant intercompany
transactions and balances have been eliminated in consolidation.
  Revenue
Recognition
  Revenue,
other than from long-term contracts for specialized products, is recognized when
a product is shipped. Revenues and earnings relating to long-term contracts for
specialized products are recognized on the percentage-of-completion basis
primarily measured by the attainment of milestones. Anticipated losses, if any,
are recognized in the period in which they are identified.
  Concentration
of Credit Risk
  Financial
instruments, which potentially subject Porta to concentrations of credit risk,
consist principally of cash and accounts receivable. At times such cash in banks
exceeds the FDIC insurance limit.
  Cash
Equivalents
  The
Company considers investments with original maturities of three months or less
at the time of purchase to be cash equivalents. Cash equivalents consist of
commercial paper.
  Accounts
Receivable
  Accounts
receivables are customer obligations due under normal trade terms. The Company
sells its products directly to customers, to distributors and original equipment
manufacturers involved in a variety of industries, principally telecommunications and military/aerospace. The Company performs continuing
credit evaluations of its customers ’ financial condition and although it generally does not require collateral,
letters of credit may be required from customers in certain
circumstances.
  
 F-7
  PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements, continued
 
 The
Company records an allowance for doubtful accounts receivable based on
specifically identified amounts that it believes to be uncollectible. The
Company also records additional allowances based on certain percentages of its
aged receivables, which are determined based on historical experience and its
assessment of the general financial conditions affecting its customer base. If
the Company’s actual collections experience changes, revisions to its allowance
may be required.
 
 The
Company has a limited number of customers with individually large amounts due at
any given balance sheet date.
  Inventories
 
 Inventories
are stated at the lower of cost (on the average or first-in, first-out methods)
or market.
 
 Property,
Plant and Equipment
 
 Property,
plant and equipment are carried at cost. Leasehold improvements are amortized
over the shorter of the term of the lease or the estimated lives of the related
assets. Depreciation is computed using the straight-line method over the related
assets’ estimated lives.
  
 Goodwill
 
 Goodwill
represents the difference between the purchase price and the fair market value
of net assets acquired in business combinations. Commencing January 1, 2002,
goodwill is an indefinite lived asset and as such is not amortized. On an annual
basis, or more frequently if certain events occur, the Company tests the
goodwill for impairment. The Company determines the estimated fair value of the
goodwill by considering the projected cash flows generated from the reporting
unit to which the goodwill relate s .
Goodwill at December 31, 2004 and 2003, related only to the Company’s signal
processing division.
 
 Income
Taxes
 
 Deferred
income taxes are recognized based on the differences between the tax bases of
assets and liabilities and their reported amounts in the financial statements
that will result in taxable or deductible amounts in future years, and tax
benefits of net operating loss carryforwards. Further, the effects of tax law or
rate changes are included in income as part of deferred tax expense or benefit
for the period that includes the enactment date. A valuation allowance is
recorded to reduce net deferred tax assets to amounts that are more likely than
not to be realized (note 14).
 
 Foreign
Currency Translation
 
 Assets
and liabilities of foreign subsidiaries are translated at year-end rates of
exchange, and revenues and expenses are translated at the average rates of
exchange for the year. Gains and losses resulting from translation are
accumulated in a separate component of stockholders’ equity. Gains and losses
resulting from foreign currency transactions (transactions denominated in a
currency other than the functional currency) are included in
operations.
 
 Shipping
and Handling Costs
 
 Shipping and
handling costs are included as a component of cost of sales.
 
 F-8
 PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements,
continued
 
 Net
Income (Loss) Per Share
 
 Basic net
income (loss) per share is based on the weighted average number of shares
outstanding. Diluted net income (loss) per share is based on the weighted
average number of shares outstanding plus the dilutive effect of potential
shares of common stock, as if such shares had been issued. For 2003 and 2002, no
dilutive potential shares of common stock were added to compute diluted loss per
share because the effect would be anti-dilutive.
  
 Reclassifications
 
 Certain
reclassifications have been made to conform prior years’ consolidated financial
statements to the 2004 presentation.
  
 Accounting
for Stock-Based Compensation
 
 The
Company applies the intrinsic value method as outlined in Accounting Principles
Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to
Employees , ” and
related Interpretations in accounting for stock options granted to employees.
Under the intrinsic value method, no compensation expense is recognized if the
exercise price of the Company’s employee stock options equals the market price
of the underlying stock on the date of the grant. Accordingly, no compensation
cost has been recognized. Statement of Financial Accounting Standard (“SFAS”)
No. 123, “Accounting for Stock-Based Compensation , ” requires
the Company to provide pro forma information regarding net income (loss) and net
income (loss) per common share as if compensation cost for the Company’s stock
option programs had been determined in accordance with the fair value method
prescribed therein. The following table illustrates the effect on net income
(loss) and income (loss) per share of common stock as if the fair value method
had been applied to all outstanding and unvested awards in each period
presented.
 
 **Year
      Ended**
      **December
      31****2004**
    
    **2003**
    
    **2002****(In
      thousands, except per share data)**Net
      income (loss),
      as reported
    
    $
    2,675
    
    $
    (3,357
    )
    $
    (4,114
    )Deduct:
      Total stock-based employee compensation expensedetermined under fair value method for all awards
    
    
    (1
    )
    
    (1
    )
    
    (1
    )Pro
      forma net income (loss)
    
    $
    2,674
    
    $
    (3,358
    )
    $
    (4,115
    )**Income
      (loss) per share of common stock:**Basic
      and diluted - as reported
    
    $
    0.27
    
    $
    (0.34
    )
    $
    (0.41
    )Basic
      and diluted - pro forma
    
    $
    0.27
    
    $
    (0.34
    )
    $
    (0.41
    )
 
 
 
 F-9


PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements,
continued




Accounting
for the Impairment of Long-Lived Assets





The
Company follows SFAS No. 144, “Accounting for the Impairment or Disposal of
Long-Lived Assets.” Long-lived assets other than goodwill are evaluated for
impairment when events or changes in circumstances indicate the carrying amount
of the assets may not be recoverable through the estimated undiscounted future
cash flows from the use of these assets.





Use of
Estimates





The
preparation of financial statements in accordance with generally accepted
accounting principles requires management to make estimates and assumptions that
affect reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Among the more
significant estimates included in these consolidated financial statements are
the estimated allowance for doubtful accounts receivable, inventory reserves,
percentage of completion for long-term contracts, accrued expenses, goodwill
valuation and the deferred tax asset valuation allowance. Actual results could
differ from those and other estimates.





New
Accounting Pronouncements







On
December 21, 2004, the Financial Accounting Standards Board ("FASB") issued FASB
Staff Position No. FAS 109-1, "Application of FASB Statement No. 109, Accounting
for Income Taxes, to the Tax Deduction on Qualified Production Activities
Provided by the American Jobs Creation Act of 2004" ("FSP No. 109-1"), and FASB
Staff Position No. FAS 109-2, "Accounting and Disclosure Guidance for the
Foreign Earnings Repatriation Provision within the American Jobs Creation Act of
2004" ("FSP No. 109-2"). These staff positions provide accounting guidance on
how companies should account for the effects of the American Jobs Creation Act
of 2004 that was signed into law on October 22, 2004. FSP No. 109-1 states that
the tax relief (special tax deduction for domestic manufacturing) from this
legislation should be accounted for as a "special deduction" instead of a tax
rate reduction. FSP No. 109-2 gives a company  additional
time to evaluate the effects of the legislation on any plan for reinvestment or
repatriation of foreign earnings for purposes of applying FASB Statement No.
109. The Company is investigating the repatriation provision to determine
whether it might repatriate extraordinary dividends, as defined in the American
Jobs Creation Act of 2004 (“AJCA”). The Company is currently evaluating all
available U.S. Treasury guidance, as well as awaiting anticipated further
guidance. The Company expects to complete this evaluation within a reasonable
amount of time after additional guidance is published. The Company estimates the
potential income tax effect of any such repatriation would be to record a tax
liability based on the effective 5.25% rate provided by the AJCA. The actual
income tax impact to us will become determinable once further technical guidance
has been issued.





In
December 2004, the FASB issued Statement of Financial Accounting Standard
("SFAS") No. 123(R), "Share-Based Payment" ("SFAS No. 123(R)"). This statement
replaces SFAS No. 123, "Accounting for Stock-Based Compensation" and supersedes
APB No. 25, "Accounting for Stock Issued to Employees." SFAS 123(R) requires all
stock-based compensation to be recognized as an expense in the financial
statements and that such cost be measured according to the fair value of stock
options. SFAS 123(R) will be effective for quarterly periods beginning after
June 15, 2005, which is the third quarter of 2005. While the Company currently
provides the pro forma disclosures required by SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure," on a quarterly basis (see
"Note 1 - Accounting for Stock-Based Compensation"), it is currently evaluating
the impact this statement will have on its consolidated financial
statements.





F-10


PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements, continued


In
November 2004, the FASB issued SFAS No. 151, "Inventory Costs - an amendment of
ARB No. 43, Chapter 4" ("SFAS No. 151"). SFAS No. 151 requires all companies to
recognize a current-period charge for abnormal amounts of idle facility expense,
freight, handling costs and wasted materials. This statement also requires that
the allocation of fixed production overhead to the costs of conversion be based
on the normal capacity of the production facilities. SFAS No. 151 will be
effective for fiscal years beginning after June 15, 2005. The Company is
currently evaluating the effect that this statement will have on its
consolidated financial statements, but presently anticipates that such effect
will be immaterial.





(2) Liquidity







As of
December 31, 2004, the Company ’ s debt
included (a) $25,674,000
of senior debt including principal and interest, which, as a result of
a n  extension
effective April 1, 2005, matures **** on July 1, 2005 ,
(b) $6,144,000 principal
amount of
subordinated debt, which matured on July 3, 2001, and
(c)  $385,000
of 6% Debentures which matured on July 2, 2002 . The
Company was unable to pay the principal ($6,144,000) or interest ($4,129,000) on
the subordinated notes or the
principal ($385,000) or interest ($104,000) on the 6% Debenture.  Accordingly,
all senior and subordinated debt are classified as current liabilities (notes 7,
8 and 9). In addition, the Company can not give any assurance that the senior
lender will extend the loan beyond July 1, 2005. If the senior lender does not
extent the maturity date of the obligations or demands payment of all or a
significant portion of the obligations due to the senior lender, the Company
will not be able to continue in business.





The
Company has suffered substantial losses from operations in two of the last three
years and, as of December 31, 2004, has a working capital deficit of
$34,150,000.





As a
result of its continuing financial difficulties:





•
    the
      Company is having and may continue to have difficulty performing its
      obligations under its contracts, which could result in the cancellation of
      contracts or the loss of future business and penalties for
      non-performance; and
 
 •
    the Company has significantly scaled back its
      Operating Support Systems (“OSS”) operations,so
      that the operations of that division are currently limited almost
      exclusively to performing warranty and maintenance services and the sale
      of existing inventory.




A vendor
has commenced an arbitration proceeding against the Company seeking $3 million
for breach of contract (see note 19). Based upon the terms of a proposed
settlement, the Company includes as a liability $727,000, representing the
present value of the proposed settlement. However, the Company can give no
assurance that it will be able to settle the proceeding on those terms. If the
claimant obtains a significant judgment against the Company and the claimant
seeks to enforce the judgment, or if one or more of the Company’s other
creditors obtain significant judgments against it and seeks to enforce the
judgments, the Company’s ability to continue in business
would be impaired and it may be necessary for the Company, or the holder of its
senior debt may require the Company, to seek protection under the Bankruptcy
Code.





F-11




PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements,
continued





The
Company is seeking to address its need for liquidity by exploring alternatives,
including the possible sale of one or more of its divisions. If the
Company sells any or all of its divisions , the
agreement with the holder of the Company’s senior debt requires it to pay the
net proceeds to the holder of its senior debt. As a result of this provision and
the Company’s obligations to the holders of subordinated debt, unless the
lenders consent to the Company retaining a portion of the net proceeds from any
sale for its operations, the Company will not receive any significant amount,
and may not receive any, of the net proceeds from any such sale for working
capital . During
2004, 2003 and 2002, the Company was engaged in discussions with respect to the
possible sale of its divisions; however, those negotiations were terminated
without an agreement having been reached .





During
2003 and 2004, the Company has taken steps to reduce overhead, including a
reduction in personnel and the hiring of lower wage personnel in its Mexico
facility. The Company will continue to look to reduce costs while it seeks
additional business from new and existing customers. Because of its present
stock price, the Company cannot raise funds through the sales of its equity
securities, and the Company’s financial condition prevents it from issuing debt
securities. In the event that the Company is unable to extend or restructure its
debt obligations and sell one or more of its divisions, it cannot be assured
that the Company will be able to continue in operations. Furthermore, the
Company believes that its losses in two out of the last three years, and its
financial position, are having an adverse effect upon its ability to develop new
business, as competitors and potential customers question its ability both to
perform obligations under any agreements it may enter and to continue in
business.





The
maturity date of the Company’s obligations to the holder of its senior debt has
been extended to July 1, 2005, at which time, the entire principal and interest
on the senior debt becomes due and payable. The
extension of the senior debt was granted by SHF IX LLC, an affiliate of
Stonehill Financial, LLC who purchased our senior debt from Wells Fargo
Foothill, Inc during the third quarter of 2004. At December 31, 2004, the
Company did not have sufficient resources to pay either the holder of its senior
debt or the subordinated lenders; and it is unlikely that it can generate such
cash from its operations, and the holder of its senior debt continues to
preclude the Company from making payments on any subordinated indebtedness,
other than accounts payable in the normal course of business. Accordingly, all
senior and subordinated debt are classified as current liabilities (note 7). The
holder of the Company’s senior debt has granted the Company extensions in the
past . However,
at each maturity date, the holder of our senior debt reviews the Company’s
financial condition, business plan and prospects. The Company cannot determine
whether the holder of its senior debt will continue to extend the loans. Any
adverse event, including continuing declines in business or attempts by
creditors, including judgment creditors, to realize on their claims or judgments
could have an effect on the decision of the holder of the Company’s senior debt
to extend or demand payment on the notes. In such event, it would be necessary
for the Company to seek protection under the Bankruptcy Code.





These
financial statements have been prepared assuming that the Company will continue
as a going concern and, accordingly, do not include any adjustments that might
result from the outcome of the uncertainties described above.





(3) Accounts
Receivable





Accounts
receivable are customer obligations due under normal trade terms. The Company
sells its products directly to customers, to distributors and original equipment
manufacturers involved in a variety of industries, principally telecommunications and military/aerospace. The Company performs continuing
credit evaluations of its customers ’
financial condition and although it generally does not require collateral,
letters of credit may be required from customers in certain circumstances.
Senior management reviews accounts receivable on a monthly basis to determine if
any receivables will potentially be uncollectible. Included are any accounts
receivable balances that are determined to be uncollectible, along with a
general reserve, in the overall allowance for doubtful accounts. After all
attempts to collect a receivable have failed, the receivable is written off
against the allowance. Based on the information available to the Company, it
believes the allowance for doubtful accounts as of December 31, 2004 is
adequate. However, actual write-offs might exceed the recorded allowance.





F-12


PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements,
continued





Accounts
receivable included approximately $56,000 and $1,213,000 at December 31, 2004
and 2003, respectively, of revenues earned but not yet contractually billable pursuant to
long-term contracts for specialized products. All such amounts at December 31,
2004 are expected to be billed in 2005. In addition, at December 31, 2003,
accounts receivable included approximately $224,000 of
retainage balances, representing amounts held back by customers to insure
performance by the Company of its obligations under various long-term
contracts.  There
were no such retainage amounts at December 31, 2004. The allowance for doubtful
accounts receivable was $ 1,045,000 and
$1,091,000 as of December 31, 2004 and 2003, respectively. The allowance for
doubtful accounts was increased by provisions of $ 34,000 ,
$210,000, and $23,000 and decreased by write-offs of $ 80,000 ,
$1,086,000, and $224,000 for the years ended December 31, 2004, 2003, and 2002,
respectively.







(4) Inventories





Inventories
consist of the following:





December
      31,2004
    
    2003Parts
      and components
    
    $
    2,650,000
    
    
    1,673,000Work-in-process
    
    
    654,000
    
    
    427,000Finished
      goods
    
    
    1,272,000
    
    
    904,000$
    4,576,000
    
    
    3,004,000




(5) Property,
Plant and Equipment





Property,
plant and equipment consists of the following:





December
      31
    
    Estimated2004
    
    2003
    
    useful
      livesLand
    
    $
    132,000
    
    
    132,000
    
    
    -Buildings
    
    
    1,119,000
    
    
    1,110,000
    
    
    20yearsMachinery
      and equipment
    
    
    8,190,000
    
    
    7,991,000
    
    
    3-8
      yearsFurniture
      and fixtures
    
    
    2,294,000
    
    
    2,295,000
    
    
    5-10
      yearsTransportation
      equipment
    
    
    55,000
    
    
    74,000
    
    
    4
      yearsTools
      and molds
    
    
    3,984,000
    
    
    3,833,000
    
    
    8
      yearsLeasehold
      improvements
    
    
    893,000
    
    
    882,000
    
    
    Lesser
      of term of leaseor estimated life of asset16,667,000
    
    
    16,317,000Less
      accumulated depreciation and amortization
    
    
    15,333,000
    
    
    14,851,000$
    1,334,000
    
    
    1,466,000




F-13


PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements,
continued





(6) Goodwill





The
Company measures the fair value of the acquired business at least annually,
instead of amortizing goodwill over a fixed period of time, to determine if
goodwill has been impaired. At January 1, 2003, the Company completed the first
step of the goodwill transitional impairment test, which required determining
the fair value of the reporting units as of January 1, 2003 and comparing it to
the carrying value of the reporting unit net assets. The Company determined that
there was no impairment loss resulting from the transitional impairment test as
of January 1, 2003.





As of
December 31, 2004 and 2003, goodwill was $2,961,000. At such
dates, all of the goodwill related to the Company’s Signal division. During
the second quarter of 2002, the Company was engaged in discussions with respect
to the sale of the Signal division. Based on those discussions the Company
determined that goodwill was impaired and it estimated that the amount of the
impairment was $800,000. This amount was charged to operations in the quarter
ended June 30, 2002. Furthermore, the Company cannot give assurances that further write-downs will
not be necessary, although management believes that no additional goodwill
impairment charges were necessary in 2003 or 2004.





(7) Senior
Debt





On
December 31, 2004 and 2003, Porta’s senior debt consisted of debt under its
credit facility in the amount of $25,674,000 and $25,387,000, respectively.
Substantially all of the Company’s assets are pledged as collateral for the
senior debt. The current agreement with the holder of the senior debt will
expire on July 1, 2005 and, accordingly, the senior debt has been classified as
a current liability (see note 2). The
extension of the senior debt was granted by SHF IX LLC, an affiliate of
Stonehill Financial, LLC, who purchased the Company’s senior debt from Wells
Fargo Foothill, Inc during the third quarter of 2004 .





In March
2002, the senior lender agreed to an amended and restated loan and security
agreement whereby a new term loan was established with a maximum principal
amount of $1,500,000 and subsequently increased in May 2002 to $2,250,000. The
agreement allowed the Company to draw monies subject to the senior lender’s
receipt and approval of a weekly disbursement budget. Any advances under this
agreement were at the discretion of the senior lender. Obligations under the new
term loan bear interest at 12%, which interest accrued monthly and was added to
the principal until September 1, 2002 when interest for the month of August 2002
became payable and current interest became payable. The agreement provides that
all indebtedness prior to March 1, 2002 is reflected as an old term loan in the
amount of $22,610,000, which includes the principal balance due at December 31,
2001 plus accrued interest though March 1, 2002. The old term loan bears no
interest until such time as the senior lender in its sole discretion notifies
the Company that interest shall be payable at a rate of 12% or a default rate of
14%. Additionally, the senior lender prohibited the Company from making any
payments on indebtedness to any subordinated creditors or from paying any
dividends on common stock, but the Company is not prohibited from paying
accounts payable in the ordinary course of business. Finally, the agreement
allowed for standby letters of credit not to exceed a maximum of $573,000. As of
December 31, 2004, the Company did not have any standby letters of credit
outstanding. As of December 31, 2004, the Company had borrowed
$2,250,000, the maximum principal amount under the new term loan, and the total
accrued interest on the new term loan was $814,000.





F-14


PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements,
continued





(8) 6%
Convertible Subordinated Debentures





As of
December 31, 2004 and 2003, the Company had outstanding $385,000 of its 6%
convertible subordinated debentures due July 1, 2002 (the “Debentures”). The
Company has not paid interest on these Debentures since July 2000, and the
holder of its senior debt prohibits it from making any  payments
of principal and interest (see note 7). At December 31, 2004 and 2003, accrued
interest on the debentures was $104,000 and
$81,000, respectively. The trustee of the Debentures gave notice to the Company
that the
non-payment caused an event of default. The convertibility feature associated
with the Debentures expired upon their maturity.







(9) Subordinated
Notes





As of
December 31, 2004 and 2003, $6,144,000 of Subordinated Notes were outstanding.
As of December 31, 2004, $6,144,000 of principal and $4,129,000 of accrued
interest were due and payable. However, the Company does not
have the resources to pay the $6,144,000 principal and $4,129,000 of interest
due on the subordinated debt. In addition, the
senior lender has precluded the Company from making payments on the subordinated
debt (note
7).





(10) Joint
Venture





In April
2002, the Company sold its 50% interest in its Korean joint venture company, for
$450,000 to its joint venture partner. Payment was made by the forgiveness of
commissions, totaling $450,000, which were owed by the
Company to its
sales representation company (which is owned by
the Company’s joint venture partner ) with
respect to sales made by the joint venture in Korea. The investment in the joint
venture had previously been written down to zero as the Company ’ s share
of the losses of the joint venture exceeded its investment. Therefore, the
transaction was reflected as a $450,000 reduction in accrued commissions and a
non-cash gain on sale of investment in joint venture.





(11) Warrants







At
December 31, 2004, the Company had outstanding (a) warrants issued to its senior
lender to purchase 100,000 shares of common stock, which are currently
exercisable at $0.25 per share and expire on June 6, 2005, (b) warrants issued
to a vendor to purchase 15,000 shares of common stock, which are currently exercisable at
$1.8125 per share and expire in May 2005 (c)
warrants issued to the holders of subordinated notes to purchase 127,500 shares
of Common Stock which are exercisable at $3.00 per share (which subsequently
expired unexercised on January 2, 2005).





(12) Employee
Benefit Plans





The
Company has deferred compensation agreements with certain present and former
officers and employees, with benefits commencing at retirement equal to 50% of
the employee’s base salary, as defined. Payments under the modified agreements
will be made for a period ranging from approximately 15 to approximately 25
years, although they may be accelerated under certain conditions. In 2003, under
the modified requirements, the accrued liability was reduced by approximately
$137,000. During 2002, the Company accrued approximately $122,000 under the
original agreements. Total
deferred compensation obligations as of December 31, 2004, before discounting at
a rate of 6.5%, were approximately $ 1,540,000.







F-15


PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements,
continued





The
Company maintains the Porta Systems Corp. 401(k) Savings Plan for the benefit of
eligible employees, as defined in the Savings Plan. Participants contribute a
specified percentage of their base salary up to a maximum of 15%. Porta will
match a participant’s contribution by an amount equal to 25% of the first 6%
contributed by the participant. A participant is 100% vested in all balances
credited to his account, including the Company’s contribution. For the years
ended December 31, 2004, 2003 and 2002, the Company’s contribution amounted to
$38,000, $37,000 and $47,000, respectively.




The
Company maintained the Employee Stock Purchase Plan for the benefit of eligible
employees, as defined in the Purchase Plan, which permitted employees to
purchase the Company’s common stock at discounts up to 10%. The Company had
reserved 1,000,000 shares of the Company’s stock for issuance under the plan.
During 2002, 55,803 shares were issued pursuant to the Purchase Plan. As of
March 18, 2002, the Plan was discontinued. Accordingly, no shares were issued in
2004 and 2003 pursuant to the Plan.





The
Company does not provide any other post-retirement benefits to any of its
employees.





(13) Incentive
Plans





During
1999, the Company established an Employee Stock Bonus Plan whereby stock may be
given to employees
who are not officers
or directors to recognize their contributions . A
maximum of 95,750 shares of common stock is reserved for issuance pursuant to
the Bonus Plan. No shares of common stock were issued pursuant to the Bonus Plan
during 2004, 2003 and 2002.





The
Company’s 1996 Stock Incentive Plan (“1996 Plan”) covers 450,000 shares of
common stock. Incentive stock options cannot be issued subsequent to ten years
from the date the 1996 Plan was approved. Options under the 1996 Plan may be
granted to key employees, including officers and directors of the Company and
its subsidiaries, except that members and alternate members of the stock option
committee are not eligible for options under the 1996 Plan. The exercise prices
for all options granted were equal to the fair market value at the date of grant
and vest as determined by the board of directors. In addition, the 1996 Plan
provides for the automatic grant to non-management directors of non-qualified
options to purchase 2,000 shares on May 1st of each year commencing May 1, 1996,
with an exercise price equal to the average closing price of the last ten
trading days of April of each year.





The
Company’s 1998 Non-Qualified Stock Option Plan (“1998 Plan”) covers 450,000
shares of common stock. Options under the 1998 Plan may be granted to key
employees, including officers and directors of the Company and its subsidiaries.
The exercise prices for all options granted were equal to the fair market value
at the date of grant and vest as determined by the board of
directors.





The
Company’s 1999 Incentive and Non-Qualified Stock Option Plan (“1999 Plan”)
covers 400,000 shares of common stock. Incentive stock options cannot be issued
subsequent to ten years from the date the 1999 Plan was approved. Options under
the 1999 Plan may be granted to key employees, including officers and directors
of the Company and its subsidiaries, except that members
and alternate members of the stock option committee are not eligible for options
under the 1999 Plan. The exercise prices for all options granted were equal to
the fair market value at the date of grant and vest as determined by the board
of directors. In addition, the 1999 Plan provides for the automatic grant to
non-management directors of non-qualified options to purchase 5,000 shares on
May 1st of each year commencing May 1, 1999, based upon the average closing
price of the last ten trading days of April of each year; provided, however,
that the non-management directors will not be granted non-qualified options
pursuant to the 1999 Plan for any year to the extent options are granted under
the 1996 Plan for such year.





F-16


PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements,
continued





The
weighted-average fair values of options granted were $0.05, $0.02 and $0.05 per
share for options granted in 2004, 2003 and 2002, respectively. The fair
value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following assumptions for 2004, 2003
and 2002:


2004
    2003
    2002Dividends:
    $0.00
      per share
    $0.00
      per share
    $0.00
      per shareVolatility:
    50%
    50%
    100%Risk-free
      interest:
    4.22%
    4.22%-5.48%
    4.22%-5.48%Expected
      term:
    5-9.6
      years
    5 -
      9.6 years
    5 -
      9.6 years


A summary
of the status of the Company’s stock option plans as of December 31, 2004, 2003,
and 2002, and changes during the years ending on those dates is presented below:




2004
    
    2003
    
    2002Shares
    
    Weighted
    
    Shares
    
    Weighted
    
    Shares
    
    WeightedUnder
    
    Average
    
    Under
    
    Average
    
    Under
    
    AverageOption
    
    Exercise
      Price
    
    Option
    
    Exercise
      Price
    
    Option
    
    Exercise
      PriceOutstanding
      beginning of year
    
    
    552,530
    
    $
    2.27
    
    
    601,530
    
    $
    2.43
    
    
    801,705
    
    $
    3.96Granted
    
    
    15,000
    
    
    0.07
    
    
    15,000
    
    
    0.03
    
    
    15,000
    
    
    0.07Exercised
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Forfeited
    
    
    (244,750
    )
    
    3.23
    
    
    (64,000
    )
    
    3.21
    
    
    (215,175
    )
    
    2.11Outstanding
      end of year
    
    
    322,780
    
    $
    1.45
    
    
    552,530
    
    $
    2.27
    
    
    601,530
    
    $
    2.43Options
      exercisable at year-end
    
    
    318,780
    
    
    
    
    
    542,530
    
    
    
    
    
    567,647







F-17


PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements,
continued





The
following table summarizes information about stock options outstanding under the
stock option plans at December 31, 2004:





Options
      Outstanding
    
    Options
      ExercisableWeighted-averageRange
      of
    
    Outstanding
    
    Remaining
    
    Weighted-average
    
    Exercisable
    
    Weighted-AverageExercise
      Prices
    
    at
      12/31/04
    
    Contractual
      Life
    
    Exercise
      Price
    
    at
      12/31/04
    
    Exercise
      Price<$1.00
    
    
    65,000
    
    
    7.3
      years
    
    
    $0.14
    
    
    65,000
    
    
    $0.14$1.00
      - 1.99
    
    
    213,780
    
    
    2.4
      years
    
    
    $1.51
    
    
    213,780
    
    
    $1.51$2.00
      - 2.99
    
    
    10,000
    
    
    5.3
      years
    
    
    $2.29
    
    
    10,000
    
    
    $2.29$3.00
      - 3.85
    
    
    34,000
    
    
    1.5
      years
    
    
    $3.38
    
    
    30,000
    
    
    $3.38322,780
    
    
    
    
    
    
    
    
    318,780










(14) Income
Taxes




The
provision (benefit) for income taxes consists of the following:





2004
    
    2003
    
    2002Current
    
    Deferred
    
    Current
    
    Deferred
    
    Current
    
    DeferredFederal
    
    $
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -State
      and foreign
    
    
    169,000
    
    
    -
    
    
    (272,000
    )
    
    -
    
    
    11,000
    
    
    -Total
    
    $
    169,000
    
    
    -
    
    
    (272,000
    )
    
    -
    
    
    11,000
    
    
    -





The
domestic and foreign components of income (loss) before provision (benefit) for
income taxes were as follows:







2004
    
    2003
    
    2002United
      States
    
    $
    732,000
    
    
    (2,989,000
    )
    
    (3,726,000
    )Foreign
    
    
    2,112,000
    
    
    (640,000
    )
    
    (376,000
    )Income
      (loss) before provision (benefit) for incometaxes
    
    $
    2,844,000
    
    
    (3,629,000
    )
    
    (4,102,000
    )





A
reconciliation of the Company’s income tax provision and the amount computed by
applying the statutory U.S. federal income tax rate of 34% to loss before income
taxes is as follows:







2004
    
    2003
    
    2002Tax
      benefit at statutory rate
    
    $
    967,000
    
    
    (1,234,000
    )
    
    (1,395,000
    )Increase
      (decrease) in income tax benefit resulting from:Increase
      (decrease)in valuation allowance
    
    
    (1,038,000
    )
    
    1,379,000
    
    
    1,094,000State
      and foreign taxes, less applicable federal benefits
    
    
    169,000
    
    
    (114,000
    )
    
    (98,000
    )Non-deductible
      goodwill impairment
    
    
    **-**
    
    
    -
    
    
    272,000Other
      expenses not deductible for tax purposes
    
    
    6,000
    
    
    8,000
    
    
    13,000Foreign
      (income) losses taxed at rates different from U.S. statutory
      rate
    
    
    26,000
    
    
    (16,000
    )
    
    (78,000
    )Reversal
      and adjustments of prior year’s accrual
    
    
    -
    
    
    (275,000
    )
    
    203,000Other
    
    
    39,000
    
    
    (20,000
    )
    
    -$
    169,000
    
    
    (272,000
    )
    
    11,000





F-18


PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements,
continued




Porta has
unused United States tax net operating loss (NOL) carryforwards of approximately
$51.2 million expiring at various dates between 2009 and 2023. Due to the 1997
change in ownership which resulted from the conversion of Porta’s Zero coupon
subordinated convertible notes to common stock, Porta’s usage of its NOL will be
limited in accordance with Internal Revenue Code section 382. Porta’s
carryforward utilization of the NOL is limited to $1,767,000 per year with
respect to approximately $23.9 million of the NOL, representing the portion that
arose prior to the change in control. The carryforward amounts are subject to
review by the Internal Revenue Service (IRS). In addition, Porta has foreign NOL
carryforwards of approximately $7,998,000 with indefinite expiration
dates.




The
components of the deferred tax assets, the net balance of which total zero after
the valuation allowance, as of December 31, 2004 and 2003 are as
follows:





2004
    
    2003Deferred
      tax assets:Inventory
    
    $
    1,413,000
    
    
    1,445,000Allowance
      for doubtful accounts receivable
    
    
    402,000
    
    
    420,000Benefits
      of tax loss carryforwards
    
    
    22,092,000
    
    
    23,656,000Benefit
      plans
    
    
    436,000
    
    
    468,000Accrued
      commissions
    
    
    105,000
    
    
    109,000Other
    
    
    2,489,000
    
    
    1,877,000Depreciation
    
    
    358,000
    
    
    358,00027,295,000
    
    
    28,333,000Valuation
      allowance
    
    
    (27,295,000
    )
    
    (28,333,000
    )$
    -
    
    
    -





Deferred
tax assets as of December 31, 2003 have been adjusted based on actual tax
returns filed.





Because
of Porta’s losses in 2003 and 2002 and
uncertainties associated with projections of future taxable income, a
valuation allowance for the entire deferred tax asset was provided due to the
uncertainty as to future realization.





In
January 2003,
Porta accepted an offer to pay $30,000 in full
settlement of a tax liability of its Puerto Rico subsidiary; accordingly the
related tax and accrued interest liability of $274,000 was reversed in 2003.





No
provision was made for U.S. income taxes on the undistributed earnings of
Porta’s foreign subsidiaries as it is management’s intention to utilize those
earnings in the foreign operations for an indefinite period of time or
repatriate such earnings only when tax effective to do so. **** At
December 31, 2004, undistributed earnings of the foreign subsidiaries amounted
to approximately $1,470,000. It is not practicable to determine the amount of
income or withholding tax that would be payable upon the remittance of those
earnings





(15) Leases





At
December 31, 2004, Porta and its subsidiaries leased manufacturing and
administrative facilities, equipment and automobiles under a number of operating
leases. Porta is required to pay increases in real estate taxes on the
facilities in addition to minimum rents. Total rent expense for 2004, 2003, and
2002 amounted to approximately $ 581,000 ,
$537,000 and $499,000, respectively. The Company also subleased a portion of one
of its facilities during 2003 and 2002; rent expense for such years was reduced
accordingly by $164,000 and $89,000, respectively. Minimum rental commitments,
exclusive of future escalation charges, for each of the next five years are as
follows:




F-19


PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements, continued


2005
    
    $
    594,0002006
    
    
    585,0002007
    
    
    553,0002008
    
    
    307,0002009
    
    
    277,000Thereafter
    
    
    2,720,000$
    5,036,000







(16) Major
Customers





Porta’s five
largest customers accounted for sales of $15,443,000, or approximately 53% of
sales, for 2004, $8,507,000,
or approximately 43% of sales, for 2003 and
$9,784,000, or approximately 46% of sales, for 2002. Fujitsu
Telecommunications Europe LTD was
Porta’s largest customer for 2004 and 2003, accounting for sales of $4,772,000,
or approximately 16% and  $3,150,000,
or approximately 16%,
respectively. A
significant amount of sales of the Company’s products for use by British
Telecommunications were sold to Fujitsu, a systems integrator for British
Telecommunications. As a result, most of the sales to Fujitsu Telecommunications
were for use by British Telecommunications. Direct sales to British
Telecommunications were $2,652,000, or  9% of
sales, for 2004, $1,480,000, or 8% of sales, for 2003 and $2,306,000, or 11% of
sales, for 2002.
Sales to Telmex in 2004 were $3,139,000, or approximately 11% of sales. Sales to
Philippine Long Distance Telephone in 2002 were $2,725,000, or approximately 13%
of sales. No other
customers account for 10% or more of the Company’s sales in 2004, 2003 or 2002.





(17) Fair
Values of Financial Instruments





Cash
equivalents, accounts receivable and accounts payable are reflected in the
consolidated financial statements at fair value because of the short term
maturity of these instruments.





The fair
value of the Company’s senior and subordinated debt and related interest cannot
be reasonably estimated due to the lack of marketability of such instruments.
Management understands that the senior debt was recently sold at a significant
discount from its face value.





(18) Net
Income (Loss) Per Share





In 2004,
the weighted average shares of common stock outstanding for purposes of
computing diluted net income per share include 16,000 dilutive potential common
shares related to stock options for which the options’ exercise price was less
than the weighted average market price of the Company’s common stock for the
year. Options to purchase 277,780, 552,530 and 601,530 shares of common stock
for 2004, 2003 and 2002, respectively, with exercise prices ranging from $0.30
to $3.85, $0.02 to $3.85 and $0.07 to $3.85 for 2004, 2003 and 2002,
respectively, were outstanding but not included in the computation of diluted
net income (loss) per share, because the effect of doing so would be
anti-dilutive.





Warrants
to purchase 242,500 shares of common stock, with exercise prices ranging from
$0.25 to $3.00, were outstanding as of December 31, 2004, 2003 and 2002 but not
included in the computation of diluted net income (loss) per share because the
exercise prices were greater than the average market price of common stock
during such years, and the effect of doing so would be
anti-dilutive.





F-20


PORTA SYSTEMS CORP. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements,
continued





(19) Legal
Matters





In June
2002, BMS Corp. commenced an arbitration proceeding against the Company in New
York City seeking damages of approximately $3,000,000 and alleging that Porta
breached its agreement to market and sell an update to an
OSS product
which BMS was to develop for the
Company. Porta believes that it has defenses
to the claims by BMS and has filed a
counterclaim to recover
the $350,000 the Company advanced
to BMS under the contract. As of December 31, 2004, the Company has recorded a
liability of $727,000, based on the Company's estimate of the present value of
the Company's liability to BMS, based upon the terms of a proposed
settlement with BMS.  However, the Company can give no assurance that the
Company will be able to settle the action on such terms.







In July
2001, the holder of a subordinated note in the principal amount of $500,000
commenced an action against the Company in the United States District Court for
the Southern District of New York seeking payment of the principal and accrued
interest on their subordinated notes which were payable in July 2001. The
payment of the note is subordinated to payment of Porta’s senior debt. The
plaintiff's motion for a summary judgment was denied by the court in January
2002 on the grounds that the terms of the note did not give them permission to
obtain a judgment while the Company remained in default to the senior debt
holder. Since that time, the action has remained inactive.







(20) Cash
Flow Information





Supplemental
cash flow information for the years ended December 31, is as
follows:




2004
    
    2003
    
    2002Cash
      paid for interest
    
    $
    116,000
    
    
    6,000
    
    
    10,000Cash
      paid for income taxes
    
    $
    69,000
    
    
    11,000
    
    
    2,000





(21) Segment
and Geographic Data





Porta has
three reportable segments: Line Connection and Protection Equipment (“Line”)
whose products interconnect copper telephone lines to switching equipment and
provides fuse elements that protect telephone equipment and personnel from
electrical surges; Signal Processing (“Signal”) whose products are used in data
communication devices that employ high frequency transformer technology; and
Operating Support Systems (“OSS”) whose products automate the testing,
provisioning, maintenance and administration of communication networks and the
management of support personnel and equipment. During 2004, the activity of the
OSS division was limited to the performance of warranty and maintenance
services, and the completion of installations of OSS systems pursuant to
contracts entered into in prior years.





The
factors used to determine the above segments focused primarily on the types of
products and services provided, and the type of customer served. Each of these
segments is managed separately from the others, and management evaluates segment
performance based on operating income.




F-21


PORTA SYSTEMS CORP. AND SUBSIDIARIESNotes to
Consolidated Financial Statements, continued




2004
    
    2003
    
    2002**Revenue:**Line
    
    $
    21,545,000
    
    
    11,334,000
    
    
    9,598,000Signal
    
    
    5,551,000
    
    
    4,253,000
    
    
    4,523,000OSS
    
    
    2,003,000
    
    
    3,249,000
    
    
    6,414,000$
    29,099,000
    
    
    18,836,000
    
    
    20,535,000**Segment
      profit (loss):**Line
    
    $
    5,784,000
    
    
    1,634,000
    
    
    (565,000
    )Signal
    
    
    2,124,000
    
    
    1,393,000
    
    
    286,000OSS
    
    
    (1,662,000
    )
    
    (3,072,000
    )
    
    226,000$
    6,246,000
    
    
    (45,000
    )
    
    (53,000
    )**Depreciation
      and amortization:**Line
    
    $
    218,000
    
    
    253,000
    
    
    245,000Signal
    
    
    27,000
    
    
    22,000
    
    
    25,000OSS
    
    
    95,000
    
    
    136,000
    
    
    350,000$
    340,000
    
    
    411,000
    
    
    620,000**Total
      identifiable assets:**Line
    
    $
    6,368,000
    
    
    4,099,000
    
    
    3,975,000Signal
    
    
    4,561,000
    
    
    4,293,000
    
    
    4,319,000OSS
    
    
    945,000
    
    
    2,932,000
    
    
    4,538,000$
    11,874,000
    
    
    11,324,000
    
    
    12,832,000**Capital
      expenditures:**Line
    
    $
    167,000
    
    
    46,000
    
    
    37,000Signal
    
    
    71,000
    
    
    4,000
    
    
    9,000OSS
    
    
    0
    
    
    0
    
    
    58000$
    238,000
    
    
    50,000
    
    
    104,000




F-22


PORTA SYSTEMS CORP. AND SUBSIDIARIESNotes to
Consolidated Financial Statements, continued


The
following table reconciles segment totals to consolidated totals:





2004
    
    2003
    
    2002**Revenue:**Total
      revenue for reportable segments
    
    $
    29,099,000
    
    
    18,836,000
    
    
    20,535,000Other
      revenue
    
    
    69,000
    
    
    754,000
    
    
    882,000Consolidated
      total revenue
    
    $
    29,168,000
    
    
    19,590,000
    
    
    21,417,000**Operating
      income (loss):**Total
      segment income (loss) for reportable segments
    
    $
    6,246,000
    
    
    (45,000
    )
    
    (53,000
    )Corporate
      and unallocated
    
    
    (2,093,000
    )
    
    (2,307,000
    )
    
    (2,828,000
    )Consolidated
      total operating income (loss)
    
    $
    4,153,000
    
    
    (2,352,000
    )
    
    (2,881,000
    )**Depreciation
      and amortization:**Total
      for reportable segments
    
    $
    340,000
    
    
    411,000
    
    
    620,000Corporate
      and unallocated
    
    
    69,000
    
    
    72,000
    
    
    93,000Consolidated
      total deprecation and amortization
    
    $
    409,000
    
    
    483,000
    
    
    713,000**Total
      assets:**Total
      for reportable segments
    
    $
    11,874,000
    
    
    11,324,000
    
    
    12,832,000Corporate
      and unallocated
    
    
    2,564,000
    
    
    1,031,000
    
    
    1,396,000Consolidated
      total assets
    
    $
    14,438,000
    
    
    12,355,000
    
    
    14,228,000**Capital
      expenditures:**Total
      for reportable segments
    
    $
    238,000
    
    
    50,000
    
    
    104,000Corporate
      and unallocated
    
    
    21,000
    
    
    22,000
    
    
    20,000Consolidated
      total capital expenditures
    
    $
    259,000
    
    
    72,000
    
    
    124,000





The
following table presents information about the Company by geographic
area:





2004
    
    2003
    
    2002**Revenue:**United
      States
    
    $
    9,809,000
    
    
    8,610,000
    
    
    9,877,000United
      Kingdom
    
    
    14,911,000
    
    
    7,523,000
    
    
    6,388,000Asia/Pacific
    
    
    128,000
    
    
    428,000
    
    
    2,725,000Other
      Europe
    
    
    457,000
    
    
    1,228,000
    
    
    1,600,000Latin
      America
    
    
    158,000
    
    
    238,000
    
    
    258,000Other
      North America
    
    
    3,139,000
    
    
    1,037,000
    
    
    565,000Other
    
    
    566,000
    
    
    526
    
    
    4,000Consolidated
      total revenue
    
    $
    29,168,000
    
    
    19,590,000
    
    
    21,417,000**Consolidated
      long-lived assets**:United
      States
    
    $
    3,843,000
    
    
    3,859,000
    
    
    4,274,000United
      Kingdom
    
    
    169,000
    
    
    255,000
    
    
    364,000Other
      North America
    
    
    352,000
    
    
    393,000
    
    
    455,000Asia/Pacific
    
    
    0
    
    
    0
    
    
    0Latin
      America
    
    
    0
    
    
    5,000
    
    
    7,000Other
    
    
    0
    
    
    0
    
    
    3,0004,364,000
    
    
    4,512,000
    
    
    5,103,000Current
      and other assets
    
    
    10,074,000
    
    
    7,843,000
    
    
    9,125,000Consolidated
      total assets
    
    $
    14,438,000
    
    
    12,355,000
    
    
    14,228,000










F-23
 
 PORTA
SYSTEMS CORP. AND SUBSIDIARIESNotes to
Consolidated Financial Statements, continued


(22) Quarterly
Information (Unaudited)





The
following presents certain unaudited quarterly financial data:





Quarter
      EndedMarch
      31, 2004
    
    June
      30, 2004
    
    September
      30, 2004
    
    December
      31, 2004Net
      sales
    
    $
    8,100,000
    
    $
    6,272,000
    
    $
    7,883,000
    
    $
    6,913,000Gross
      profit
    
    
    3,130,000
    
    
    2,367,000
    
    
    3,047,000
    
    
    2,783,000Net
      income
    
    
    828,000
    
    
    320,000
    
    
    1,058,000
    
    
    469,000Basic
      and diluted net income per share:$
    0.08
    
    $
    0.03
    
    $
    0.11
    
    $
    0.05








Quarter
      EndedMarch
      31, 2003
    
    June
      30, 2003
    
    September
      30, 2003
    
    December
      31, 2003Net
      sales
    
    $
    4,374,000
    
    $
    3,964,000
    
    $
    5,787,000
    
    $
    5,465,000Gross
      profit
    
    
    993,000
    
    
    1,068,000
    
    
    2,059,000
    
    
    1,324,000Netloss
    
    
    (1,426,000
    )
    
    (1,041,000
    )
    
    (214,000
    )
    
    (676,000
    )Basic
      and diluted net loss per share:
    
    $
    (0.14
    )
    $
    (0.10
    )
    $
    (0.02
    )
    $
    (0.07
    )








The net
loss for the quarter ended December 31, 2003 reflects a benefit of approximately
$214,000 resulting from a modification of deferred compensation agreements. In
addition, the Company recorded additional estimated costs to complete long-term
contracts in progress of $600,000 during that quarter.




F-24