**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

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FORM 10-K

**ANNUAL REPORT PURSUANT TO SECTION 13 OR15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

**Forthe Fiscal Year Ended December 31, 2004**

**CommissionFile Number**

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OPTELECOM, INC.

(Exact name of registrantas specified in its charter)

**DELAWARE**

(State or otherjurisdiction of incorporation or organization)

**52-1010850**

(IRS employeridentification number)

**12920 CLOVERLEAF CENTERDRIVE, GERMANTOWN, MARYLAND 20874**

(Address of principalexecutive offices)(Zip code)

Registrant’s telephonenumber, including area code: **(301) 444-2200.**

Securities registeredpursuant to Section 12(b) of the Act: **None.**

Securities registeredpursuant to Section 12(g) of the Act: **Common Stock$0.03 Par Value.**

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

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulations S-Kis not contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

Indicate by check markwhether the registrant is an accelerated filer (as defined by Rule 12b-2of the Act). Yes o  No x

At December 31, 2004,shares of the registrant’s Common Stock, $0.03 Par Value, held by persons otherthan “affiliates” of the registrant had an aggregate market value of$29,438,549 based on the average closing bid and asked prices as reported bythe National Association of Securities Dealers Automated Quotation System forsuch date.

At March 11,2005  the registrant had outstanding3,212,627 shares of Common Stock, $.03 Par Value.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the ProxyStatement for the 2005 Annual Meeting of Shareholders are incorporated byreference into Part III hereof.

 

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**OPTELECOM, INC.FISCAL YEAR 2004 FORM 10-K ANNUAL REPORTTABLE OF CONTENTS**
| Item          | ** ** | ** **                                                                                                                                 | ** ** | **Description** | ** ** | **Page  Number** |
|---------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|------------------|
| PART I   |       |                                                                                                                                       |       |            |
| Item 1        |       | Business                                                                                                                                   |       | 3               |       |
| Item 1A       |       | Risk Factors                                                                                                                               |       | 8               |       |
| Item 2        |       | Properties                                                                                                                                 |       | 11              |       |
| Item 3        |       | Legal  Proceedings                                                                                                                         |       | 11              |       |
| Item 4        |       | Submission  of Matters to a Vote of Security Holders                                                                                       |       | 11              |       |
| PART II  |       |                                                                                                                                       |       |            |       |
| Item 5        |       | Market  for Registrant’s Common Stock and Related Stockholder Matters                                                                 |       | 12              |       |
| Item 6        |       | Selected  Consolidated Financial Data                                                                                                      |       | 13              |       |
| Item 7        |       | Management’s  Discussion and Analysis of Financial Condition and  Results of Operations       |       | 14              |       |
| Item 7A       |       | Qualitative  and Quantitative Disclosures About Market Risk                                                                                |       | 23              |       |
| Item 8        |       | Financial  Statements and Supplementary Data                                                                                               |       | 24              |       |
| Item 9        |       | Changes  in and Disagreements with Accountants on Accounting and  Financial Disclosure                       |       | 44              |       |
| Item 9a       |       | Controls  and Procedures                                                                                                                   |       | 44              |       |
| PART III |       |                                                                                                                                       |       |            |       |
| Item 10       |       | Directors  and Executive Officers of the Registrant                                                                                        |       | 44              |       |
| Item 11       |       | Executive  Compensation                                                                                                                    |       | 45              |       |
| Item 12       |       | Security  Ownership of Certain Beneficial Owners and Management                                                                            |       | 45              |       |
| Item 13       |       | Certain  Relationships and Related Transactions                                                                                            |       | 45              |       |
| Item 14       |       | Principal  Accounting Fees and Services                                                                                                    |       | 45              |       |
| PART IV  |       |                                                                                                                                       |       |            |       |
| Item 15       |       | Exhibits,  Financial Statement Schedules and Reports on Form 8-K                                                                      |       | 45              |       |
| Signatures    |       | 47                                                                                                                                         |       |

 

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**PART I**

***Item 1.***                          BUSINESS

**GENERAL**

Optelecom, Inc. is aDelaware corporation whose business activities began in 1972. Optelecom’s earlybusiness commenced with the design and delivery of specialized laser systemsand fiber optic communications products for the defense arm of the Federalgovernment. During the mid-1990’s we successfully transitioned from having asignificant number of military customers to being an industry provider ofcopper and fiber optic based communications products for commercial and governmentcustomers. We have focused on providing integrated multi-media productsfor communicating video, audio, and other data over both copper wire andoptical network systems. 

Optelecom currentlymanages its operations under two business segments: the Communication ProductsDivision (CPD) and the Electro-optics Technology unit (EO). The CommunicationProducts Division is focused on the development, manufacture and sale ofoptical fiber-based data communication equipment to both commercial andGovernment clients. The Electro-optics Technology unit develops andmanufactures innovative optical devices under contract, primarily to governmentand defense industry customers. 

Fiber optic communicationsequipment is the main element of Optelecom’s product offerings. The marketplaceserved by Optelecom is experiencing a period of continuous growth and change asthe industry continues to grow. Technology development is constantly andrapidly improving the capability to transmit at increasing data rates over evengreater distances with fiber-based communication systems. 

In the Electro-opticsTechnology unit, emphasis has been placed on fabrication of precision-woundcoils of optical fiber used as the sensing elements of fiber optic gyroscopes.During the past decade, Optelecom has received U.S. Government contracts toinvestigate advanced manufacturing technology related to gyro coil winding.Optelecom currently pursues this tradition of business development andcontinues to seek out technology development opportunities with potential forproduction follow-on. The Electro-optics unit also producesprecision wound coils for applications ranging from optical fiber dispensersused in remote vehicle control systems to precision optical fiber coils forcommunications systems. Additionally, the group is currently engaged in aseries of contracts with the U. S. Air Force and prime contractors to developsystems for control of aircraft using optical fiber connections. 

Thetable below displays the Company’s three-year revenue and operatingincome (loss) by segment: 
| ** **              | ** ** | **2004**   | ** ** | **2003**    | ** ** | **2002**              | ** ** |
|-------------------------|------------|------------|------------|-------------|------------|-----------------------|------------|
| **Operating Unit** | ** ** | ** ** | ** ** | **Revenue** | ** ** | **Operating  Income** | ** ** | **Revenue** | ** ** | **Operating  Income** | ** ** | **Revenue** | ** ** | **Operating  Income** | ** ** |
| Communication  Products |       | $          | 17,952,578 |        | $          | 1,930,646             |       | $ | 15,327,411 |   | $ | 1,427,838 |   | $ | 13,665,771 |   | $ | 1,235,680 |   |
| Electro-Optics          |       | 1,442,569  |       | 339,329     |       | 1,792,247             |       | 544,497 |   | 1,242,783 |   | 376,439 |   |
| Company Totals          |       | $          | 19,395,147 |        | $          | 2,269,975             |       | $ | 17,119,658 |   | $ | 1,972,335 |   | $ | 14,908,554 |   | $ | 1,612,119 |   |
|                         |            |            |            |             |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**RECENT DEVELOPMENT**

On March 8, 2005 weacquired NKF Electronics B.V. (NKF), a wholly owned subsidiary of Draka HoldingN.V., pursuant to a definitive agreement entered into with Draka Holding N.V.We believe that this transaction establishes Optelecom as a leading globalindependent producer of comprehensive fiber optic-based communicationssolutions for video surveillance, traffic monitoring, and business videosystems. 

NKF Electronics wasfounded in 1981 and has accumulated extensive expertise in fiber optic andIP/Ethernet network technologies. This expertise has enabled NKF Electronics tobuild a broad range of 

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communicationsproducts, ranging from fiber optic video modems and multiplexers to completeVideo-Over-IP network solutions. All its products are designed and testedfor Local, Metropolitan and Wide Area Network (LAN, MAN and WAN) applications,especially those characterized by harsh environmental conditions and by largedistances between the individual transmission locations. 

The purchase price for theacquisition, subject to final purchase price adjustment, is between 17 and 20 millionEuro’s which consisted of a cash payment of 11 million Euro’s ($14.5 millionUSD) and a 6% subordinated note issued by Optelecom to Draka Holding N.V. forthe remainder, which will mature in 2010. The cash portion of the purchaseprice was funded by a $14.5 million senior term facility provided by M&TBank, which consists of a Euro based term loan and a US dollar based term loan.The purchase price is subject to post-closing adjustments for working capitaland fixed assets. The Optelecom-NKF combination creates a company employingover 150 people worldwide with increased financial resources to support globalgovernment and commercial end-users. 

The effect of ouracquisition of NKF Electronics is not reflected in our year end financialresults included in this Form 10-K since the transaction took placesubsequent to our year end. The results of NKF’s operations will be includedfrom the date of acquisition to March 31, 2005 in our first quarter 10-Qwe plan to file in May 2005. Optelecom filed a Form 8-K describingthe transaction and containing copies of the Purchase Agreement, theSubordinated Note and the Loan Agreement, which are hereby incorporated byreference to Exhibit 99.1, Exhibit 99.2, and Exhibit 99.3,respectively to our Form 8-K filed with the Securities and ExchangeCommission dated March 11, 2005. 

You can learn more aboutOptelecom at *www.optelecom.com* and about NKFElectronics at *www.nkfelectronics.com*

***PRODUCTS AND MARKETS***

**COMMUNICATIONPRODUCTS DIVISION (CPD)**

The Communication ProductsDivision addresses business opportunities in the worldwide opticalcommunication equipment marketplace, specializing in optical fiber transmissiontechnologies. The majority of CPD’s revenues are and will continue to bederived from several niche markets that apply the advantages of fiber optictelecommunications to their transmission requirements. Presently, the verticalmarkets we serve include communications systems for highway traffic monitoring,advanced air traffic control video monitor displays, security surveillance andcontrol systems, and manufacturing process and control communications. Verticalmarkets that offer future potential sources of revenue include videoteleconferencing, healthcare, and broadcasting. CPD offers many productsolutions to address our customers’ needs. Its products are classified into thefollowing categories: 

*Data Communications Products*

Data CommunicationsProducts include a comprehensive family of fiber optic modems that incorporatestandard telecommunications protocols. The market applications for theseproducts include specialty data and timing distribution modems for themilitary, aerospace and satellite earth station markets as well as commercial,industrial, traffic control and surveillance markets. 

*Uncompressed Digital Video Transmission Products*

Uncompressed digital videoproducts provide an extremely high quality video signal over long distances viaoptical fiber. The bandwidth required to achieve this performance isconsiderably greater than that needed for lower video quality systems, however,the enormous bandwidth capacity of fiber optic transmission media provides anobvious path for utilization of digital video technology. Additionally, sincethe video transmission format is strictly digital, it can be easily combinedwith digitized voice and digital data streams. This feature facilitatesswitching and multiplexing of a wide variety of signals. 

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Current products includeone, two, four, and eight channel digital video multiplexing and de-multiplexingunits offering near-broadcast quality performance, with many also combiningaudio and data with the digital video for transmission via one optical fiberusing one optical wavelength for each transmission direction. 

The totally modularapproach used in the digital system design architecture reduces the inventoryand logistical support investment required to address the increasing demand forthese products. Marketplace reception has been positive and new applicationsinvolving a combination of our other product offerings with the capabilities ofthe digital video equipment are being constantly proposed. 

*CWDM (Course Wavelength Division Multiplexer) Systems*

CWDM allows thetransmission and reception of multiple channels of light operating at differentwavelengths through a single optical fiber. With this technology, the user canconfigure systems that transport the video and data channel count transmittedby one wavelength (typically up to eight) multiplied by the wavelength channelcapacity of the CWDM. Optelecom offers CWDM systems with optical wavelengthchannel counts from two to seventeen, as well as single channel add/dropmultiplexers By using a two channel WDM (Wavelength Division Multiplexer) alongwith two eight channel digital video multiplexers transmitting at differentoptical wavelengths, sixteen channels of video along with data and audio may betransmitted via one optical fiber in one direction. Similarly, by using aseventeen channel CWDM (Course Wavelength Division Multiplexer) along with upto seventeen eight channel digital video multiplexers each transmitting atdifferent optical wavelengths, one hundred thirty six channels of very highquality digital video, along with audio and data, may be transmitted via oneoptical fiber in one direction. Alternately, by using the seventeenthwavelength for return path audio and data, one hundred twenty eight videochannels can be transmitted in one direction along with bi-directional audioand data. 

Combining Optelecom’s widevariety of transmission products with available CWDM components permits theuser to configure multiple variations of point-to-point or distributed linearoptical networks for the transmission of video, audio, and data. via a singleoptical fiber. 

*High Resolution RGB Video Transmission Products*

Red Green Blue (RGB) VideoTransmission Products include those used to remotely position a high-resolutiondisplay, such as a monitor or projector, from its video source. Because of thehigh bandwidth and fidelity required to transmit these signals, fiber optics isthe only available means to transmit them further than approximately 1,000feet. While VGA video, in the 1280 x 1024 pixel range, may be transmitted viacopper using active baluns (such as offered by the Copper Products unit) up todistances approaching 1,000 feet, the bandwidth required to transmit ultra highresolution 2048 x 2048 pixel RGB video limits the maximum transmission distancepossible over copper wire to less than 100 feet. Management is not aware of anyother fiber optic RGB video transmission system that meets the performancecharacteristics of the high-resolution RGB products that we offer.Applications for this technology include air traffic control, military controlrooms, remote conference rooms, financial trading desks and process control. 

*Compressed Digital Video Transmission Products*

Applying our expertise invideo communications, we have developed a low cost, high quality, compresseddigital video MPEG II product set that leverages the advantages of newmicroprocessor technology recently made available to the marketplace. MPEG IIhas become the defacto compression standard embraced by the consumer and otherelectronics marketplaces. The products we have developed will replace oldercompression products since their low cost, high performance characteristicsrender the previous family obsolete. 

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These products involve thedigitization and compression of National Television System Committee (NTSC) andPhase Alternation by Line (PAL) video signal sources, allowing transmissionusing T1, E1, or Ethernet, over IP (Internet Protocol). They are being offeredto the security and traffic markets as well as to other markets whose users areturning to video communications as a way to increase productivity. Theexplosive growth of the Internet facilitates the need for low cost, highquality compressed digital video for use over various private and public networks.

**ELECTROOPTICS TECHNOLOGY UNIT (EO)**

The Electro OpticsTechnology Unit focuses on Interferometric Fiber Optic Gyro (IFOG) coils, whichare components in rotation-sensing instruments that are beginning toreplace mechanical and laser gyros in aircraft, missiles, and other vehicles.Optelecom has used its expertise derived from prior Department of Defenseactivities to develop winding technology for IFOG coils and to manufacturethese coils. In 2003, continued improvements were incorporated to increaseproduction capacity in anticipation of increased requirements for these coils. 

Optelecom currentlysupports Boeing in a program for Wright-Patterson AFB which is devoted todevelopment of military aircraft photonic network systems. Optelecom is in theimplementation stage of an effort to demonstrate photonic vehicle controlfeedback components. Our photonic aerospace vehicle work provides anopportunity for Optelecom to apply its optical development and fabricationexpertise to an important military aircraft system application with subsequentpotential in commercial markets. 

***SALES AND MARKETING***

**COMMUNICATIONPRODUCTS DIVISION (CPD)**

The Communication ProductsDivision sells its products domestically through direct sales, selectcommercial integrators and resellers. In addition, several vendors incorporateOptelecom products in their product offerings. This enables Optelecom topenetrate markets we do not address directly. 

The Company continues tofocus it’s resources on developing additional sales and distribution channels.Specifically, in 2004 we added three representatives and thirty-nineintegrators domestically. Internationally, we added one new representative andthirteen new integrators. We expect this number to continue to grow in 2005 aswe further expand the market share of our fiber transmission products. 

The Company’s primarymethod of making new customer contacts has been through participation in anexpanded trade show schedule in both the Security and Traffic markets. Thesetrade shows have resulted in a significant increase in quotations and orderactivity. In addition, our web site (*www.optelecom.com*)has enabled the convenient and rapid dissemination of information required byour distribution channel personnel and other interested parties to gatherinformation necessary to select our equipment. 

**ELECTROOPTICS TECHNOLOGY UNIT (EO)**

The Electro-opticsunit sales are pursued independently of other corporate sales functions. Thisunit relies on established contacts, response to request for proposals (RFP’s)and participation in technical conferences to market precision wound coils andother contract services. 

***RESEARCH AND DEVELOPMENT***
| ** **                                                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expenditures on  Company sponsored research and development activities |       | $        | 1,155,000  |     | $          | 979,000  |       | $ | 847,000 |   |
|                                                                        |            |          |            |          |            |          |            |  |  |  |

 

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During 2004, the Companyinvested in the development of several new products. These products will permitus to increase our penetration of the present vertical markets we serve bypermitting our customers to increase information throughput at reduced pricepoints. It is anticipated that the new Digital Video (DV) products, bothcompressed and uncompressed, will gain significant market share due to theirextremely high reliability, increased bandwidth/channel capacities, and robustvideo compression techniques. 

A network softwaremanagement card incorporating an Ethernet capability was developed andintroduced in 2002. This unit allows remote access to, and management ofOptelecom equipment from a customers existing network. 

***MANUFACTURING PROCESSES***

**QUALITY ASSURANCE**

Optelecom has establishedand maintains a Quality Assurance system fully compliant with the requirementsof the 2000 version of ISO-9001 (an internationally recognized qualitysystem standard for companies that design and manufacture products). Alloperating segments have received certification to the standard. Thiscertification is re-validated every six months and the companysuccessfully passed audits in January and July of 2004. TheCorrective Action process and Quality Council meetings continue to beaggressively utilized to drive continuous improvements. 

**COMMUNICATIONPRODUCTS DIVISION**

The Communication ProductsDivision performs routine and specialized manufacturing, assembly, and producttesting functions in our corporate headquarters. We use equipment toautomatically assemble components onto printed circuit boards at high speed,thereby lowering manufacturing costs and reducing the time-to-marketfor new product designs. We also maintain a quality assurance function and testingarea that performs optical and electrical testing and quality control. Rawmaterials and supplies used in our business include optical materials, plasticproducts, and various electronic components, most of which are available fromnumerous sources. Although the number of companies from which we can obtainoptical emitters and detectors for use in our circuit assemblies is limited,availability is presently not a limiting factor. During 2004, manufacturingbasics continued to be an area of primary focus. This involved correcting,reassessing and improving many of the core manufacturing processes. 

**ELECTRO OPTICSTECHNOLOGY**

The Electro-Opticsunit uses custom facilities designed and fabricated by Optelecom for precisionwound coil production and contract research and development. Currently, sevencoil winding machines are employed in satisfying contract winding productionrequirements. 

***COMPETITION***

The two business segmentsof Optelecom compete in separate and distinct markets. 

**COMMUNICATION PRODUCTS DIVISION**

This Unit competes withother companies of roughly equal size that have similar resources. The majorityof our competitors are privately held companies. We estimate the total marketfor Optelecom transmission products to be approximately $200 million in 2004.The size of the traffic and security surveillance markets, which represents thelargest segment, is estimated to be approximately $75 million worldwide. Thecompetition in these markets has established mature sales channels that allowfor continued market penetration in both domestic and international markets. Weanticipate that the expansion of Optelecom’s sales and distribution channelsworldwide will be the basis for sustained growth. 

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TheCompany expects to increase its share of these expanding markets. In addition,our products contain two technologies that are in limited supply to thesemarkets: the compressed and uncompressed Digital Video products. We consideredNKF Electronics to be one of our primary competitors in this marketplace.

**ELECTRO OPTICSTECHNOLOGY**

Products offered byElectro-optics are sold to both small companies and large defense contractorswho tend to dominate the market. These companies have greater marketing,manufacturing, financial, research and personnel resources than Optelecom.Furthermore, as Department of Defense contracting activity has declined, thesecompanies have started to compete in markets that were primarily addressed bycompanies with resources similar to Optelecom’s. Our approach to thiscompetitive environment is to offer services and second source productioncapabilities which complement the capabilities and interests of our customers.

***SEASONALITY***

Optelecom’s products arebased on communications equipment technology. As such, seasonality affects ourrevenues to the extent that normal contracting activities are affected bycapital budget seasonality. 

***PATENTS***

Although Optelecom holdscertain patents which relate to optical sensor technology and optical fibernetworks, our business as a whole is not materially dependent upon ownership ofany one patent or group of patents. We do not license any patents from otherparties. 

***BACKLOG***

At the end of 2004, theestimated backlog for each business segment was $400,000 in the CommunicationProducts Division and $150,000 in the Electro Optics Products Unit. The Companyexpects to recognize a majority of the backlog as revenue in the first quarterof 2005.

***EMPLOYEES***

At December 31, 2004,a total of 78 full-time employees worldwide were employed at Optelecom,including 12 in research, development and engineering, 16 in sales andmarketing, 38 in manufacturing and 12 in general management, administration andfinance. The number of employees by operating segment is as follows:Communications Products—74; Electro Optics—4. We expect a slight increase inheadcount over the next 12 months, primarily in the areas of sales, marketingand manufacturing. Our future success will depend in part on our ability toattract, train, retain and motivate highly qualified employees. There can be noassurance that we will be successful in attracting and retaining suchpersonnel. Our employees are not represented by any collective bargainingorganization and we consider our employee relations to be good. 

In connection with ouracquisition of NKF Electronics in March 2005, our employee base increasedto approximately 150. The NKF Electronics employees located in the Netherlandsare part of a collective bargaining agreement.

***Item 1A.***                  RISKFACTORS 

The statements containedin this report on Form 10-K that are not purely historical are “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995 and Section 21E of the Securities Exchange Act of 1934, including,without limitations, statements regarding Optelecom’s expectations, hopes,beliefs, anticipations, commitments, intentions and strategies regarding thefuture. Forward-looking statements include, but are not limited to,statements contained in 

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“Item1-Business,” and “Item 7—Management’s Discussion and Analysis of FinancialCondition and Results of Operations” regarding Optelecom’s business andstrategies, product markets, sales, marketing, customer support and service,research and development, manufacturing, competition, backlog, employees,financial performance, revenue and expense levels in the future and thesufficiency of our existing assets to fund future operations and capitalspending needs. Actual results could differ from those projected in any forward-lookingstatements for the reasons, among others, detailed under “Risk Factors” in thisReport on Form 10-K. The fact that some of the risk factors may bethe same or similar to Optelecom’s past filings means only that the risks arepresent in multiple periods. We believe that many of the risks detailed hereare part of doing business in the industry in which we compete and will likelybe present in all periods reported. The fact that certain risks are endemic tothe industry does not lessen the significance of the risk. The forward-lookingstatements are made as of the date of this Form 10-K and we assumeno obligation to update the forward-looking statements, or to update thereasons why actual results could differ from those projected in the forward-lookingstatements. 

**FluctuationsIn Financial Performance**

Optelecom has experiencedand may, in the future, continue to experience fluctuations in our quarterlyand annual operating results. Factors that may cause operating results to varyinclude, but are not limited to, changing technology, new product transitions,delays in new product introductions, competition, shortages of systemcomponents, changes in the mix of products and services sold and timing ofinvestments in additional personnel, facilities and research and development.As a result of the impact of these and other factors, past financialperformance should not be considered to be a reliable indicator of the futureperformance in any particular fiscal period. We are somewhat limited in ourability to reduce expenses quickly in response to any revenue shortfalls. Therefore,Optelecom’s business, financial condition, and operating results could beadversely affected if increased revenues are not achieved. 

**Dependence On MajorCustomers**

For the twelve monthsended December 31, 2004 approximately 21% of our revenues were accountedfor by sales to five commercial customers. This is similar to the prior yearwhen five customers also represented 21% of our revenues. In the event of areduction, delay or cancellation of orders from one or more significantcustomers or if one or more significant customers selects products from one ofour competitors for inclusion in future product generations, our business,financial condition and operating results could be materially and adverselyaffected. There can be no assurance that Optelecom’s current customers willcontinue to place orders with us, that orders by existing customers willcontinue at current or historical levels or that we will be able to obtainorders from new customers. The loss of one or more of our current significantcustomers could materially and adversely affect Optelecom’s business, financialcondition and operating results. 

**TechnologicalChange**

Optelecom’s products aresold in markets that are subject to rapid technological change. Our futuresuccess will depend in part upon our ability to enhance our current productsand to develop and introduce new products that keep pace with technologicaldevelopments and emerging industry standards and that address the increasinglysophisticated needs of our customers. There can be no assurance that we will besuccessful in developing and marketing such products or producing enhancementsthat meet these changing demands, that Optelecom will not experiencedifficulties that could delay or prevent the successful development,introduction and marketing of these products or that our new products andproduct enhancements will adequately meet the demands of the marketplace andachieve market acceptance. Our inability to develop and introduce new productsor product enhancements in a timely manner or our failure to achieve marketacceptance of a new product could have a material adverse effect on Optelecom. 

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**Competition**

We face intense andincreasing competition from a large number of competitors, some of which arelarger than Optelecom and have larger product development, research and salesstaffs. We believe that the products developed in 2003 and 2004 and theproducts currently being developed will position us to compete effectivelythrough 2005 and well into 2006. There can be no assurance, however, that ourcompetitors will not develop products that are as, or possibly more, effectivethan ours. We continuously monitor our competitors’ product introductions toevaluate our ability to compete. 

**Acquisitions**

Optelecom has recentlycompleted the acquisition of NKF Electronics B.V. which is substantiallysimilar in size to Optelecom. The acquisition of the foreign subsidiaryinvolves increased risks relating to foreign currency risk exposure, increasedfinancing costs as a result of increased borrowings to effectuate thetransaction, increasing the debt of the Company and additional responsibilitiesimposed upon management involving post-acquisition assimilation activities endoversight of operations of the newly acquired subsidiary. All of these risksare magnified by the increase in size of the Company as a result of theacquisition.

While management believesthat the transaction will be accretive, if it is not, the Company may be requiredto pursue equity financing to refinance the acquisition debt and enter intoforeign currency hedges to reduce the exchange rate risk. Management believesthat the individuals that it retained at NKF Electronics will continue thesuccessful operations in the future and continue the effective management ofNKF.

The Company may also, inthe future, acquire additional subsidiaries. Any such additional acquisitionswould involve similar risks as discussed herein.

**FutureCapital Needs; Uncertainty Of Additional Funding**

Optelecom believes thatour existing capital resources, including an existing $5,000,000 bank line-of-creditand future operating cash flows, will generate the funds needed for our long-termcash requirements. 

If our growth rate shouldexceed expectations, or if we should fail to generate the anticipated operatingcash flows, Optelecom would be required to seek additional funding. In thosecircumstances, the Company would look to increase its line of credit and/orpursue equity financing. There can be no assurance that additional financingwill be available in a timely manner or on acceptable terms. If issuing equitysecurities raises additional funds, further dilution to existing stockholderswill result. If adequate funds are not available when needed, we may berequired to delay, scale back or eliminate product research and development andoverhead costs. 

**NeedTo Attract And Retain Key Employees**

Optelecom is substantiallydependent on the business and technical expertise of our senior management andon our ability to attract and retain key management and technical employees.The loss of members of senior management or of other key employees or ourinability to attract and retain other employees with necessary business ortechnical skills in the future would have a material adverse effect onOptelecom’s business. 

**PriceVolatility In Public Market**

Optelecom’s Common Stockcurrently trades on the NASDAQ Small Cap Market. The securities markets havefrom time-to-time experienced significant price and volumefluctuations that were unrelated to our operating performance. In addition, themarket prices of the common stock of many publicly traded 

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technologycompanies have in the past been, and can in the future be expected to be,especially volatile. Announcements of technological innovations or new productsof Optelecom or our competitors, developments or disputes concerningproprietary rights, publicity regarding products under development by Optelecomor our competitors, regulatory developments in both the United States andforeign countries, and economic and other external factors, as well as period-to-periodfluctuations in our operating and product development results, may have asignificant impact on the market price of Optelecom’s Common Stock. 

**Absence OfDividends; Dilution**

Optelecom has not paid anycash dividends since our inception and we do not anticipate paying any cashdividends in the foreseeable future. Dilution will occur upon the exercise ofoutstanding stock options and may occur upon future equity financing that couldbe required to fund operations. 

***Item 2.***                          PROPERTIES

TheCompany’s corporate office and manufacturing facility are located at12920 Cloverleaf Center Drive, Germantown, Maryland. This facility has 30,000square feet of space, 26,000 of which are occupied by Optelecom, with theremaining 4,000 square feet sub-leased. Our facility has been specificallydesigned and fitted to accommodate our current requirements and our anticipatednear-term growth needs.

Optelecom Europe Limitedhas its facilities in Thatcham, England, consisting of approximately 2,100square feet of office space. This lease expires in June 2006, and thepremises are in good repair, and are adequate for current requirements. 

NKF Electronics maintainsits corporate office and manufacturing facility in Gouda, the Netherlands, andhas sales offices in Spain, France and Singapore.

Management believes thatthe Company’s current facilities are sufficient to meets its current andforeseeable needs.

***Item 3.***                          LEGALPROCEEDINGS

From time to time,Optelecom is involved in legal proceedings and litigation arising in theordinary course of business. As of the date of this report Optelecom is not aparty to any litigation or other legal proceeding that, in the opinion ofmanagement, could have a material adverse effect on our business, financialcondition or results of operations. 

***Item 4.***                          SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

No matter was submittedfor a vote of our shareholders during the fourth quarter of 2004.

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**PART II**

***Item 5.***                          MARKETFOR REGISTRANT’S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

TheCompany’s Common Stock, representing its only class of publicly traded equitysecurities, is traded on the NASDAQ Small-Cap market under the symbol OPTC. Setforth below are the highest and lowest closing bid prices for the Common Stockas reported by the National Association of Securities Dealers AutomatedQuotation Service (NASDAQ) during each quarter for the two years ended December 31,2004 and 2003, respectively. Such quotations do not necessarily reflect actualtransactions: 
| ** **               | ** ** | **Bid Price** | ** ** |
|--------------------------|------------|--------------------|------------|
| ** **               | ** ** | **High**           | ** ** | **Low** | ** ** |
| *Quarter  Ended*         |       |               |       |   |   |
| December 31,  2004  |       | $                  | 9.50       |   | $ | 8.48 |   |
| September 30,  2004 |       | 10.79              |       | 7.90 |   |
| June 30,  2004      |       | 14.44              |       | 9.42 |   |
| March 31,  2004     |       | 12.65              |       | 8.91 |   |
| December 31, 2003   |       | 13.88              |       | 8.65 |   |
| September 30,  2003 |       | 15.99              |       | 10.24 |   |
| June 30,  2003      |       | 12.95              |       | 7.71 |   |
| March 31, 2003      |       | 8.67               |       | 4.23 |   |
|                          |            |                    |            |  |  |  |  |

 

There were 575 record holders of the Common Stock asof December 31, 2004. The Company has never declared or paid any cashdividends on its common stock and does not expect to do so in the foreseeablefuture. The Company intends to retain any future earnings to finance itsoperations and fund the growth of the business. Any payment of future dividendswill be at the discretion of the Board of Directors of the Company and willdepend upon, among other things, the Company’s earnings, financial condition,capital requirements, and other factors that the Company’s Board of Directorsdeems relevant.

Listedbelow is information on the Company’s equity compensation plans as of March 18,2005.
| **Plan Category**                                      | ** ** | ** ** | ** ** | **Number of securities to  be issued upon  exercise of outstanding  options  (a)** | ** ** | **Weighted  average  Exercise price of  outstanding  options  (b)** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in  Column (a)  (c)** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|-----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders     |       |       | 361,984    |                                                                                                                  |       |                                                                          | $          | 7.23                                                                                                                                                                                                             |       |   |   | 315,808 |   |   |
| Equity  compensation plans not approved by security holders |       |       | —     |                                                                                                                  |       |                                                                          | —     |                                                                                                                                                                                                             |       |   | — |   |   |
| Totals                                                      |       |       | 361,984    |                                                                                                                  |       |                                                                          | $          | 7.23                                                                                                                                                                                                             |       |   |   | 315,808 |   |   |

 

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***Item 6.***                          SELECTEDCONSOLIDATED FINANCIAL DATA

Thefollowing table sets forth selected historic consolidated financial data forthe periods and dates indicated that has been derived from the Company’s auditedconsolidated financial statements which have been audited by the Company’sindependent registered public accounting firm. The information set forth belowis qualified in its entirety by, and should be read in conjunction with, theconsolidated financial statements, the related notes thereto and Management’sDiscussion and Analysis of Financial Condition and Results of Operations.
| ** **                               | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**  | ** ** | **2000**   | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|------------|------------|-----------|------------|------------|------------|
| *Year ended December 31,*           |       |       |       |       |       |       |       |      |       |       |       |
| Revenues, net                            |       | $          | 19,395,147 |       | $          | 17,119,658 |       | $         | 14,908,554 |       | $          | 13,176,919 |   | $ | 10,676,829 |   |
| Net income (loss)                        |       | 1,594,612  |       | 3,553,266  |       | 1,644,120  |       | (933,585  | )          | (5,998,852 | )          |
| Basic earnings (loss) per common share   |       | 0.50       |       | 1.18       |       | 0.58       |       | (0.33     | )          | (2.53      | )          |
| Diluted earnings (loss) per common share |       | 0.49       |       | 1.11       |       | 0.56       |       | (0.33     | )          | (2.53      | )          |
| *As of December 31,*                |       |       |       |       |       |       |       |      |       |       |       |
| Total assets                             |       | 12,366,409 |       | 10,431,897 |       | 6,627,223  |       | 6,373,679 |       | 6,872,492  |       |
| Long-term obligations                    |       | 242,944    |       | 164,020    |       | —     |       | 69,111    |       | 663,642    |       |
| Stockholders’  equity               |       | 9,934,283  |       | 7,956,476  |       | 3,667,833  |       | 2,086,557 |       | 2,958,998  |       |
|                                          |            |            |            |            |            |            |            |           |            |            |            |  |  |  |  |  |

 

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***Item 7.***                          MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**ACQUISITION OF NKFELECTRONICS**

On March 8, 2005, theCompany completed the acquisition of NKF Electronics pursuant to the terms andconditions of the Share Purchase Agreement. The purchase of NKF shouldeffectively double the size of the Company’s operations and revenue, firmlyestablishing the Company’s position as the leading world-wide independentproducer of fiber optic-based communications solutions for video surveillance,traffic monitoring, and business video systems. The integration of thecompanies will result in expanded and diversified revenue streams, enhancedresearch and development capabilities, and a more extensive sales and serviceorganization, addressing the world-wide marketplace for the products of bothcompanies.

Through the acquisition ofNKF, we join two strong product lines and two sales units with littlegeographic overlap, and bring to market industry-leading, advancedcommunication solutions for mission critical video surveillance, intelligenttransportation, and business video systems. We believe that by combining ourresearch and development services and other resources, we can deliver excellentquality products to our customers at great values.

NKF’s primary marketposition and focus is centered in Europe, while Optelecom is an industry leaderin the U.S. marketplace. The Optelecom/NKF combination will create adiversified company that is a global leader in the video surveillance and intelligenttransportation markets. The Optelecom-NKF combination creates a companyemploying over 150 people worldwide with increased financial resources tosupport global government and commercial end-users.

Thefollowing table presents the summary financial results of NKF Electronics forthe years ended December 31, 2004 and 2003.
| ** **                        | ** ** | **2004**                                | ** ** | **2003** | ** ** |
|-----------------------------------|------------|-----------------------------------------|------------|----------|------------|
| ** **                        | ** ** | **(amounts in $000’s)*** | ** ** |
| Revenue                           |       | $                                       | 19,008     |     | $          | 15,501 |   |
| Cost of goods  sold               |       | 7,574                                   |       | 6,187    |       |
| Gross profit                      |       | 11,434                                  |       | 9,314    |       |
| Sales, general and administrative |       | 6,676                                   |       | 4,772    |       |
| Income from operations            |       | 4,758                                   |       | 4,542    |       |
| Other revenue and expenses        |       | (152                                    | )          | (85      | )          |
| Income taxes                      |       | 1,591                                   |       | 1,570    |       |
| Net income                        |       | $                                       | 3,015      |     | $          | 2,887 |   |

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*       amountsin USD 000’s, based on average annual exchange rates

The purchase price for theacquisition, subject to final purchase price adjustment is between 17 and 20 millionEuro’s, which consisted of a cash payment of 11 million Euro ($14.5 millionUSD) and a 6% subordinated note issued by Optelecom to Draka Holding N.V. forthe remainder. The cash portion of the purchase price was funded by a $14.5 millionsenior term facility provided by M&T Bank, which consists of a Euro basedterm loan and a US dollar based term loan. The Subordinated Note accruesinterest at a rate of 6% per annum and is due and payable in full on March 8,2010. The Acquisition Consideration is subject to post-closing adjustment inaccordance with the terms and conditions of the Purchase Agreement. The amountof consideration was determined on the basis of arm’s length negotiationsbetween the Company and Draka.

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The Company also replacedits current line of credit with a revolving credit facility in an amount not toexceed $5,000,000 to be made available to the Company and NKF for the purposeof obtaining letters of credit and financing the Company’s and NKF’s workingcapital needs.

**RESULTS OFOPERATIONS**

Optelecom designs,develops, manufactures and markets high-bandwidth fiber optic-basedcommunications systems for traffic monitoring, security / surveillance, andbusiness video systems. Over the past two years the Company has aggressivelypursued several operational objectives including: 1) the expansion of adistribution network both in the United States and abroad, 2) realization ofmanufacturing and process improvements, 3) implementation of a cost and assetmanagement program and 4) the comprehensive upgrade of our computer networks,operating systems and core financial, sales and manufacturing softwareplatforms.

The successful executionof these initiatives along with increased demand in our core markets hasenabled the Company to significantly improve its financial condition in 2003and 2004, as evidenced by increasing levels of profitability and positive cashflow. The Company will continue in 2005 to work at broadening its saleschannels, sustaining gross profit margins and controlling costs.

***2004 versus 2003***

2004 consolidated revenuesof $19.4 million were $2.3 million or 13% higher than 2003. Sales increased inthe Communication Products Division and decreased slightly in the Electro-OpticsUnit. Revenue for the Communication Products Division increased by $2.6 millionor 17%. This increase is attributed to the Company’s continued focus ofincreasing sales channels both domestically and internationally. Sales tointegrators and end users increased substantially over the prior year. Whileproduct pricing remained relatively stable between 2003 and 2004, the salesgrowth was attributable to increased sales orders and increased units sold. Electro-Opticsrevenues decreased to $1.4 million in 2004 from $1.8 million in 2003 as aresult of less activity in the contract services sector.

Gross profit was $11.1million in 2004 compared to $9.3 million in 2003. This 20% increase of $1.8million is primarily the result of a higher volume of sales of 9-bit and 10-bitdigital products in 2004, which had higher profit margins in 2004 compared to2003 as a result of continued improvements in manufacturing efficiencies andreductions in material costs over the prior year. As a percentage of sales, ourgross margin increased by 3% from 54% in 2003 to 57% in 2004. The Companyexpects margins in 2005 to be comparable to 2004.

Operating expenses were$8.9 million in 2004 compared to $7.3 million in 2003. This increase of $1.6million or 21% is primarily due to increases in spending for administrative,sales and engineering personnel, sales advertising and trade show costs andhigher occupancy costs. As a percentage of revenue our operating expensesincreased 3% from 43% in 2003 to 46% in 2004. In 2002 our operating expense asa percent of revenue was 44%.

The Company reported netincome in 2004 of $1.6 million or $0.49 per diluted share compared to netincome of $3.6 million or $1.11 per diluted share in 2003. The Company’s 2003net income included a $1.6 million tax benefit due to the reversal of thedeferred tax valuation allowance. The Company based its 2003 decision toreverse the deferred tax valuation allowance on its consistently strong profitperformance. The Company began to recognize tax expense in 2004.

***2003 versus 2002***

2003 consolidated revenuesof $17.1 million were $2.2 million or 15% higher than 2002. Sales increased inboth the Communication Products Division and Electro-Optics Unit. Revenuefor the 

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CommunicationProducts Division increased by $1.7 million or 12%. This increase is attributedto the Company’s continued focus of increasing sales channels both domesticallyand internationally. Sales to integrators, distributors and end users increasedsubstantially over the prior year. While product pricing remained relativelystable between 2002 and 2003, the sales growth was attributable to increasedsales orders and increased units sold. Electro-Optics revenues increasedto $1.8 million in 2003 from $1.2 million in 2002 as a result of expansion ofthe contract services and the coil winding businesses.

Gross profit was $9.3million in 2003 compared to $8.1 million in 2002. This 15% increase of $1.2million is primarily the result of a higher volume of sales of digital and datacommunications products in 2003, which had higher profit margins in 2003compared to 2002 as a result of continued improvements in manufacturingefficiencies and reductions in material costs over the prior year. As apercentage of sales, our 2003 gross margin remained constant with our 2002gross margin at 54%.

Operating expenses were$7.3 million in 2003 compared to $6.5 million in 2002. This increase of $0.8million or 13% is primarily due to increases in spending for engineeringpersonnel, sales advertising and trade show costs and higher occupancy costs asa result of the Company’s move to a larger and expanded facility early in 2003.As a percentage of revenue our operating expenses declined 1% from 44% in 2002to 43% in 2003. As our revenue increases we are experiencing a reduction in ouroperating expenses as a percentage of revenue. In 2001 our operating expense asa percent of revenue was 53%.

The Company reported netincome in 2003 of $3.6 million or $1.11 per diluted share compared to netincome of $1.6 million or $0.56 per diluted share in 2002. The Company’s 2003net income includes a $1.6 million tax benefit due to the reversal of thedeferred tax valuation allowance. The Company based its decision to reverse thedeferred tax valuation allowance on the consistently strong profit performanceover the last two and one-half years, along with our expectation of continuedfuture profitability.

*Operating Segments*

Optelecom’s products andservices are categorized into two operating segments: the CommunicationProducts Division and the Electro-Optics Technology Division. During 2003management decided to combine the Copper Products unit and the Optical Productsunit into the Communication Products Division in order to manage the businessmore effectively. The financial results for the two operating segments havebeen prepared on a basis that is consistent with the manner in which Optelecommanagement internally evaluates financial information for the purpose of assistingin making internal operating decisions. In this regard, certain common expenseshave been allocated among segments differently than would be required for standalone financial information prepared in accordance with accounting principlesgenerally accepted in the United States of America.

**COMMUNICATIONPRODUCTS DIVISION**
| **Communication Products Division** | ** ** | ** ** | ** ** | **2004**  | ** ** | **2003**   | ** ** | **2002** | ** ** |
|-----------------------------------------------|------------|------------|------------|-----------|------------|------------|------------|----------|------------|
| Net Sales                                     |       | $          | 17,952,579 |      | $          | 15,327,411 |       | $        | 13,665,771 |   |
| Gross Profit                                  |       | 10,553,077 |       | 8,438,028 |       | 7,500,348  |       |
| Total Operating  Expense                      |       | 8,622,432  |       | 7,023,204 |       | 6,264,668  |       |
| Operating Income (Loss)                       |       | 1,930,645  |       | 1,427,838 |       | 1,235,680  |       |
|                                               |            |            |            |           |            |            |            |          |            |  |  |  |

 

2004 sales for theCommunication Products Division of $18.0 million were 18% or $2.6 millionhigher than 2003’s sales of $15.3 million. This increase is attributed to theCompany’s focus of increasing sales channels both domestically andinternationally. Sales to integrators and end users increased substantiallyover the prior year.

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In 2004 the CommunicationProducts Division continued to experience the benefits of the expansion andre-alignment of its sales and marketing departments. The emphasis that wasplaced on developing new sales and distribution channels, both domestically andinternationally resulted in higher sales in 2004. During 2004, three independentsales representative organizations and thirty-nine integrators were addeddomestically and one independent sales representative organization and thirteenintegrators were added in the international marketplace. The Company expects tocontinue to add independent sales representative organizations and integratorsboth domestically and internationally in 2005.

Gross profit during 2004of $10.6 million, or 59% of sales, was higher than 2003’s gross profit of $8.4million or 55% of sales. The increase of $2.2 million is primarily the resultof the higher volume of sales of digital and data communications products in2004. The lower gross profit margin in 2003 is mainly attributable tosignificantly lower margins on a large installation for the Olympic Games inAthens, Greece. Management determined that the benefit of having our technologyshowcased at this premier venue provided exposure to a level of potentialcustomers that could not be easily reached otherwise. The Company expectsmargins in 2005 to be comparable to 2004.

Operating expenses were$8.5 million in 2004 compared to $7.0 million in 2003. Sales and marketingcosts increased $0.7 million over 2003, primarily due to higher employee costs,advertising and trade show costs. Engineering costs increased $0.2 million,primarily due to higher staff costs in 2004. General and administrative costsincreased $0.6 million from $3.1 million in 2003 to $3.7 million in 2004. Costincreases are primarily attributed to the increases in personnel and occupancycosts.

**ELECTRO-OPTICSTECHNOLOGY UNIT**
| ** **               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002**  | ** ** |
|--------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Net Sales                |       | $        | 1,442,568  |     | $          | 1,792,247 |       | $ | 1,242,783 |   |
| Gross Profit             |       | 575,247  |       | 845,253  |       | 598,189   |       |
| Total Operating  Expense |       | 235,917  |       | 300,756  |       | 221,750   |       |
| Operating Income         |       | 339,330  |       | 544,497  |       | 376,439   |       |
|                          |            |          |            |          |            |           |            |  |  |  |

 

Electro-Optics salesof $1.4 million in 2004 were $0.4 million lower than 2003. The decrease isprimarily attributable to the lower sales under the contract research anddevelopment portion of the business in 2004 when compared to 2003. There was aslight increase in the unit sales of the coil winding division from 2003 to2004. Operating income for 2004 decreased also as a result of lower contractresearch and development sales.

**OTHER INCOME(EXPENSE)**
| ** **                                     | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Interest expense—line  of credit          |       | $        | —     |     | $          | (11,483  | )          | $ | (77,442 | ) |
| Interest expense—long  term notes / other |       | (5,445   | )          | (3,465   | )          | (13,422  | )          |
| Interest / other  income                       |       | 25,760   |       | 4,602    |       | 139,540  |       |
| Total other  income (expense)                  |       | $        | 20,315     |     | $          | (10,346  | )          | $ | 48,676 |   |

 

Other income (expenses)totaled $20,315 in 2004 compared to ($10,346) in 2003. Total interest incomewas $25,760 in 2004 compared to $4,602 in 2003. Interest income for 2004increased as result of higher cash balances. Other income in 2002 represents arefund of federal income taxes paid in a prior year.

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**Impact of Inflation**

Inflation has not had asignificant effect on the operations of the Company during 2004, and we do notexpect it to have a significant effect during 2005.

**FINANCIAL CONDITION**

The Company’s Stockholders’equity increased from $8.0 million in 2003 to $9.9 million in 2004. The netincome of $1.6 million was accompanied by an increase of $0.3 million in commonstock and paid-in-capital, due to the exercise of stock options andpurchase of shares pursuant to the employee stock purchase plan.

Other key components ofOptelecom’s financial condition include accounts receivable, inventory, fixedassets and accounts payable. The Company’s current ratio has increased to 4.61at December 31, 2004 compared to 3.59 at December 31, 2003. This increaseis attributed primarily to the increase in cash from $1.4 million to $2.9million and the $0.3 million decrease in the Company’s balance in accountspayable. Accounts receivable increased this year from $2.8 million in 2003 to$3.0 million at December 31, 2004. A significant factor in this increasewas relatively large shipments late in 2004 compared to 2003.

Inventory increasedslightly from $2.7 million at December 31, 2003 to $2.9 million at December 31,2004 primarily due to increases in production materials and finished goodsinventories. These increases were due to the Company’s decision to increasestocking levels to meet customer requirements, primarily for the growingsecurity and surveillance market. As a result of the lessening of exposure tocomponent shortages, the Company has been able to focus on stocking material atsubassembly and finished good levels. This results in our ability to serviceour customer’s requirements in less time while benefiting from lower investmentin overall inventories.

Thefollowing chart shows the composition of inventory for the past three years,with Optelecom Europe Limited’s inventory included in finished goods:
| ** **                  | ** ** | **2004**  | ** ** | **2003** | ** ** | **2002**  | ** ** |
|-----------------------------|------------|-----------|------------|----------|------------|-----------|------------|
| Production  Materials       |       | $         | 1,604,605  |     | $          | 1,637,331 |       | $ | 1,367,886 |   |
| Work in Process             |       | 192,145   |       | 414,639  |       | 210,637   |       |
| Finished Goods              |       | 1,164,264 |       | 889,022  |       | 1,178,674 |       |
| Allowance for  Obsolescence |       | (93,132   | )          | (279,992 | )          | (303,996  | )          |
| TOTAL                       |       | $         | 2,867,882  |     | $          | 2,661,000 |       | $ | 2,453,201 |   |

 

In 2004, fixed assetadditions were $0.9 million, compared to $1.0 million in 2003 and $0.12 millionin 2002. During 2002 the Company had adopted a conservative policy on capitalpurchases in its effort to curtail spending and improve profitability. During2003 and 2004, as the Company’s profitability continued to improve, capitalspending was increased in order to improve and expand on engineering andfactory capabilities. While the Company does not currently have any capitalasset purchase commitments, we anticipate an investment in capital expendituresof approximately $1.0 million in 2005.

The Company’s currentliabilities decreased $0.1 million from $2.3 million in 2003 to $2.2 million in2004 primarily as a result of a decrease of $0.3 million in accounts payablewhich was offset by slight increases in accrued payroll and warranty reservetotaling $0.15 million. During 2003 the Company incurred short term noteindebtedness of $0.07 million as a result of purchasing new capital equipmentunder a financing arrangement.

Likewise, long-term debtwas increased in 2003 by $0.09 million as a result of purchasing new capitalequipment under a financing arrangement. In addition, the Company incurred adeferred rent liability in 

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2003 asa result of entering into a new lease term on the Company’s U.S. office space. Thisdeferred rent liability increased from $0.06 million in 2003 to $0.19 millionin 2004.

**LIQUIDITY ANDCAPITAL RESOURCES**

The Company’s operatingactivities have provided positive cash flows for 2004 and 2003. Cash providedby operating activities was $2.1 million in 2004 compared to $2.3 million in2003.

Cash used in investingactivities in 2004 decreased slightly to $0.9 million compared to $1.0 millionin 2003. The Company continued to be active in capital asset acquisition during2004 in an effort to improve and expand the manufacturing capabilities and thecomputer network infrastructure.

During 2004, financingactivities provided $0.4 million compared to $0.09 million provided byfinancing activities during 2003. Cash provided by financing activitiesresulted from the reclassification of a $0.14 million restricted certificate ofdeposit from non-current to current assets. Additionally, proceeds from theexercise of stock options and common stock issued from the employee stockpurchase plan totaled $0.35 million during 2004.

Under its current bankingfacility, the Company has the ability to borrow up to $3.5 million under itsexisting bank line-of-credit as of December 31, 2004, providedthere are sufficient accounts receivable and inventory. This facility consistsof two components: (a) a demandworking capital line of credit which will enable the Company to borrow up tothe lesser of $3.0 million or the borrowing base; and (b) a $500,000transaction specific revolving demand export line of credit for short-term financing.The amount available will be the lesser of $500,000 or the borrowing base. TheCompany’s borrowing base under the first facility equals the sum of 90% of eligible government billed accounts receivable,80% of the eligible commercial billed accounts receivable and 20% of eligiblerelated inventory capped at $500,000. The Company’s borrowing base under thesecond facility equals the sum of 80% of the eligible export-related inventoryand 90% of the eligible export-related accounts receivable. This facility isguaranteed 90% by the Export-Import Bank of the United States (“Ex-Im Bank”) under Ex-Im Bank’sWorking Capital Guarantee Program.

The first facility carriesinterest at the rate of LIBOR (3.10% at December 31, 2004) plus 3.5%. Thesecond facility carries interest at the rate of PRIME (5.25% at December 31,2004) plus 1.25%, floating.

Optelecom is required tocomply with certain financial ratios including maintaining a minimum currentratio, a maximum debt to worth ratio, a maximum funded debt to EBITDA ratio anda minimum tangible net worth ratio. The Company was in compliance with all ofthese covenants at December 31, 2004.

Optelecom’s future workingcapital needs will be financed by our operating cash flow and continued use ofthe line-of-credit. In the event that operating cash flows becomeinsufficient to meet funding needs, the Company may be required to scale backor eliminate product research and development and overhead costs. Additionally,the Company would look to increase its line of credit and/or pursue equityfinancing. The Company’s strategy will focus on identifying new products thatmeet the demands of our core markets, expanding our distribution channels andimplementing processes which will increase manufacturing efficiencies. Managementfully understands the costs required to execute this strategy and will pursuethese initiatives in a timely and fiscally prudent manner.

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Thefollowing are our contractual obligations as of December 31, 2004 are asfollows:
| ** **                      | ** ** | **Total** | ** ** | **Less Than  1 Year** | ** ** | **1–3 Years** | ** ** | **4-5 Years** | ** ** | **More Than  5 Years** | ** ** |
|---------------------------------|------------|-----------|------------|---------------------------------|------------|-------------------------|------------|--------------------|------------|----------------------------------|------------|
| Long-term debt  obligations     |       | $         | 90,000     |                            | $          | 45,000                  |       | $                  | 45,000     |                             | $          | — |   | $ | — |   |
| Capitalized lease  obligations  |       | —    |       | —                          |       | —                  |       | —             |       | —                           |       |
| Operating lease  obligations(1) |       | 4,738,428 |       | 519,031                         |       | 1,548,746               |       | 1,098,999          |       | 1,571,652                        |       |
| Purchase  obligations           |       | —    |       | —                          |       | —                  |       | —             |       | —                           |       |
| Totals                          |       | $         | 4,811,644  |                            | $          | 564,031                 |       | $                  | 1,593,746  |                             | $          | 1,098,999 |   | $ | 1,571,652 |   |

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(1)          Operatingleases include our office space in the U.S. and the U.K. Total rental expenseunder these leases for fiscal year 2004 was $565,731.

As described above, inconnection with the acquisition of NKF Electronics the Company entered in newacquisition related debt agreements.

**NEW ACCOUNTINGSTANDARDS**

In November of 2004,FASB issued Statement No 151, *InventoryCosts,* an amendment of Accounting Research Bulletin No. 43,Chapter 4 (SFAS 151). The amendments made by SFAS 151 clarify thatabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterials (spoilage) should be recognized as current period charges andrequire the allocation of fixed production overheads to inventory based on thenormal capacity of the production facilities. The FASB’s goal is to promoteconvergence of accounting standards internationally by adopting languagesimilar to that used in the International Accounting Standard 2, *Inventories*adopted by the InternationalAccounting Standards Board (IASB). The Boards noted that the wording of theoriginal standards were similar but were concerned that the differences wouldlead to inconsistent application of those similar requirements. The guidance iseffective for inventory costs incurred during the Company’s year beginning January 1,2006. The Company does not believe that the adoption of the new standard willhave a material impact on its financial position.

The FASB issued FSP No. 109-2,*Accounting and Disclosure Guidance for the ForeignEarnings Repatriation Provision within the American Jobs Creation Act of 2004*(FSP 109-2) to provide guidance under SFAS 109 regarding the AmericanJobs Creation Act of 2004 (the “Jobs Act”) enacted on October 22, 2004.The Jobs Act provides for a special one-time dividends received deduction onthe repatriation of certain foreign earnings to a US taxpayer. FSP 109-2contains provisions allowing companies to apply the provisions of FAS 109 afterthe period in which the Jobs Act was enacted. The Company is evaluating theeffect of the Jobs Act on its plan for reinvestment or repatriation of foreignearnings. The Company has not completed its evaluation and has not adjusted itstax calculations to reflect the repatriation provisions of the Jobs Act asallowed by FSP 109-2.

On December 16, 2004,the FASB issued Statement No. 123 (revised 2004), *Share-Based Payment*(SFAS 123R), which isa revision of SFAS 123. SFAS 123R supersedes APB 25 and amends FASB Statement No. 95,*Statement of Cash Flows*.Generally, the approach in SFAS 123R is similar to the approach described inSFAS 123. However, SFAS 123R requires all share-based payments to employees,including grants of employee stock options, to be recognized in the incomestatement based on their fair values. Pro forma disclosure is no longer analternative. SFAS 123R must be adopted no later than July 1, 2005. Earlyadoption will be permitted in periods in which financial statements have notyet been issued. The Company expects to adopt SFAS 123R on July 1, 2005.

SFAS 123R permits publiccompanies to adopt its requirement using one of two methods—(i) a “modifiedprospective” method in which compensation cost is recognized beginning with theeffective date 

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(a) basedon the requirements of SFAS 123R all share-based payments granted after theeffective date and (b) based on the requirements of SFAS 123 for allawards granted to employees prior to the effective date of SFAS 123R thatremain unvested on the effective date or (ii) a “modified retrospective”method which includes the requirements of the modified prospective methoddescribed above, but also permits entities to restate based on the amountspreviously recognized under SFAS 123 for purposes of pro forma disclosureseither (a) all prior periods presented or (b) prior interim periodsof the year of adoption. The Company is currently evaluating the method it willuse when it adopts SFAS 123 R

Both SFAS 123 and SFAS123R require measurement of fair value using an option-pricing model. Althoughthe Company currently uses the Black-Scholes model, the Company may determine thata lattice model provides a better estimate of fair value for its employee stockoptions. The Company has not determined which model it will use for new awardsissued and for awards modified, repurchased or cancelled on or after theeffective date, July 1, 2005. All awards granted prior to July 1,2005 will maintain their grant-date value as calculated under SFAS 123. Thefuture compensation cost for the portion of these awards that are unvested (theservice period continues after date of adoption) will be based on theirgrant-date value adjusted for estimated forfeitures. The Company currentlyadjusts the pro forma expense for forfeitures only as they occur.

As permitted by SFAS 123,the Company currently accounts for share-based payment to employees using APB25’s intrinsic value method and consequently recognizes no compensation costfor employee stock options. Accordingly, the adoption of SFAS 123R’s fair valuemethod will have an impact on the result of operations, although it will haveno impact on the Company’s overall financial position. The impact of adoptionof SFAS 123R cannot be predicted because it will depend on levels ofshare-based payments granted in the future. However, had adoption of SFAS 123Roccurred in prior periods, the impact of that standard would have approximatedthe impact of SFAS 123 as described in the disclosure of pro forma net incomeand earnings per share in Note 1 of the consolidated financial statements.

**CRITICAL ACCOUNTINGPOLICIES**

Optelecom’s discussion andanalysis of its financial condition and results of operations are based uponOptelecom’s consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America. The preparation of these financial statements requires Optelecom tomake estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities. On an on-going basis, Optelecom evaluates its estimates,including those related to product returns, bad debts, inventories, incometaxes, financing operations, warranty obligations, and contingencies andlitigation. Optelecom bases its estimates on historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates underdifferent assumptions or conditions.

We consider certainaccounting policies related to revenue recognition, valuation of accountsreceivable, inventory, stock-based compensation and income taxes to be criticalto our business operations and the understanding of our results of operations.The impact and any associated risks related to these policies on our businessoperations is discussed throughout Management’s Discussion and Analysis ofFinancial Condition and Results of Operations where such policies affect ourreported and expected financial results. For a detailed discussion on theapplication of these and other accounting policies, see Notes to theConsolidated Financial Statements in Item 14 of this Annual Report on Form 10-K.

*Revenue Recognition**—*Revenue from commercial sales isrecognized when product is shipped and accepted. Revenues from fixed-pricecontracts, such as contracts from the government, are recognized on thepercentage-of-completion method, which relies on estimates of total expectedcontract revenue and 

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costs. Optelecomfollows this method since reasonably dependable estimates of the revenue andcosts applicable to various stages of a contract can be made. Recognizedrevenues and profit are subject to revisions as the contract progresses tocompletion. Revenues from time-and-materials contracts are recorded at thecontract rates times the labor hours plus other direct costs as incurred. In the ordinary course of business, theCompany warrants its products against defect in design, materials, andworkmanship over various time periods. Warranty reserve and allowance forproduct returns is established based upon management’s best estimates ofamounts necessary to settle future and existing claims on products sold as of thebalance sheet date. Beginning December 2002, the Company established awarranty reserve for expenses associated with future warranty claims. Thisreserve is updated on a quarterly basis.

*Allowance for DoubtfulAccounts**—*Optelecommaintains allowances for doubtful accounts for estimated losses resulting fromthe inability of customers to make required payments. The Company regularlymonitors and assesses its risk of not collecting amounts owed to it by itscustomers. This evaluation is based upon an analysis of amounts currently andpast due along with relevant history and facts particular to the customer suchas collection history and the results of credit inquiries. If the financialcondition of Optelecom’s customers were to deteriorate, resulting in an impairmentof their ability to make payments, additional allowances may be required.

*Inventories**—*Production materials are valued at thelower of cost or market applied on a standard cost basis. Work-in-processrepresents direct labor, materials, and overhead incurred on products notdelivered to date. Finished goods inventories are valued at the lower of costor market, cost being determined using standards that approximate actual costson a specific identification basis. Optelecom writes down its inventory forestimated obsolescence or unmarketable inventory based upon assumptions aboutfuture demand and market conditions as well as historical inventory turnover.If actual market conditions are less favorable than those projected bymanagement, additional inventory write-downs may be required.

*Income Taxes**—*The company accounts for income taxes in accordance withSFAS No. 109, “Accounting for Income Taxes” which requires that deferredtax assets and liabilities be recognized using enacted tax rates for the effectof temporary differences between the book and tax bases of recorded assets andliabilities. SFAS No. 109 also requires that deferred tax assets bereduced by a valuation allowance if it is more likely than not that someportion or all of the deferred tax asset will not be realized.

At December 31, 2004and 2003, the company had deferred tax assets in excess of deferred taxliabilities of $1.2 million and $1.7 million, respectively. For the reasonscited below, at December 31, 2004 and 2003, management determined that itis more likely than not that $1.2 million and $1.7 million, respectively, ofsuch assets will be realized, resulting in a valuation allowance of $0.0million and $0.0 million, respectively.

The company evaluatesquarterly the realizability of its deferred tax assets by assessing itsvaluation allowance and by adjusting the amount of such allowance, ifnecessary. The factors used to assess the likelihood of realization are thecompany’s forecast of future taxable income and available tax planningstrategies that could be implemented to realize the net deferred tax assets.The company has used tax planning strategies to realize or renew net deferredtax assets in order to avoid the potential loss of future tax benefits.

Approximately $3.4 millionof future taxable income (predominately U.S.) ultimately is needed to realizethe net deferred tax assets at December 31, 2004. Failure to achieveforecasted taxable income might affect the ultimate realization of the netdeferred tax assets. Factors that may affect the company’s ability to achievesufficient forecasted taxable income include, but are not limited to, thefollowing: increased competition, a decline in sales or margins, loss of marketshare, delays in product availability or technological obsolescence.

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In addition, the companyoperates within multiple taxing jurisdictions and is subject to audit in thesejurisdictions. These audits can involve complex issues, which may require anextended period of time to resolve. In management’s opinion, adequateprovisions for income taxes have been made for all years.

***Item 7A.***                  QUANTITATIVEAND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS

Market risk is thepotential change in an instrument’s value caused by, for example, fluctuationsin interest and currency exchange rates. The Company has not purchased anyfutures contracts nor purchased or held any derivative financial instrumentsfor trading purposes during the twelve months ended December 31, 2004 and2003. The primary market risk exposure is the risk that interest rates on ouroutstanding borrowings may increase. Optelecom also faces market risk exposureas a result of foreign currency translation adjustments of the Company’sforeign subsidiaries, Optelecom Europe Limited and NKF Electronics B.V.. TheCompany believes this risk is immaterial.

Optelecom currently has noborrowings under its bank line-of-credit. Optelecom has not enteredinto any hedging arrangements with respect to any prior interest obligationsunder these lines of credit.

**CERTAINRISKS OF FOREIGN OPERATIONS**

The Company has twowholly-owned subsidiaries, Optelecom Europe Limited and NKF Electronics B.V.,which operate primarily in countries outside the United States and are subjectto certain risks such as currency exchange rates. There can be no assurancesthat these factors will not have an adverse impact on our future internationalsales or operating results. We do not currently enter into foreign currencyhedging transactions and therefore may be exposed to possible losses oninternational transactions.

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***Item 8.****                         *FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA

**Indexto the Consolidated Financial Statements**
|                                                                                                                       | ** ** | **Page** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report  of Independent Registered Public Accounting Firm                                                              |       | 25       |
| Independent  Auditors Report                                                                                          |       | 26       |
| Consolidated  Balance Sheets as of December 31, 2004 and 2003                                                    |       | 27       |
| Consolidated  Statements of Operations for the years ended December 31, 2004, 2003 and  2002                     |       | 28       |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and  2002                     |       | 29       |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2004, 2003 and 2002 |       | 30       |
| Notes to Consolidated Financial  Statements                                                                           |       | 31       |
| SCHEDULE OF VALUATION AND  QUALIFYING ACCOUNTS                                                                        |       | 48       |

 

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors andStockholders of Optelecom, Inc.

We have audited the accompanying consolidated balancesheet of Optelecom, Inc. and subsidiaries (the Company) as of December 31,2004 and 2003, and the related consolidated statements of operations,stockholders’ equity and cash flows for each of the two years ended December 31,2004 and 2003. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on the financialstatements and financial statement schedule based on our audit.

We conducted our audit in accordance with standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. The Companyis not required to have, nor were we engaged to perform an audit of itsinternal control over financial reporting. Our audit included consideration ofinternal control over financial reporting as a basis for designing auditprocedures that are appropriate in the circumstances, but not for the purposeof expressing an opinion on the effectiveness of the Company’s internal controlover financial reporting. Accordingly, we express no such opinion. An audit alsoincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, as well as evaluating theoverall financial statement presentation. We believe that our audit provides areasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the financial position ofOptelecom, Inc. as of December 31, 2004 and 2003, and the results oftheir operations and their cash flows for each of the two years ended December 31,2004 and 2003 in conformity with accounting principles generally accepted inthe United States of America.

We have also auditedSchedule II for each of the two years ended December 31, 2004 and 2003. Inour opinion, this schedule, when considered in relation to the basic financialstatements taken as a whole, presents fairly, in all material respects, theinformation therein.

GRANT THORNTON, LLP

Baltimore, MarylandFebruary 15, 2005 (except for Note 11, as to which the date is March 8,2005)

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**INDEPENDENT AUDITORS’ REPORT**

To the Board of Directors andStockholders of Optelecom, Inc.

We have audited the accompanying consolidatedstatements of operations and comprehensive income, stockholders’ equity andcash flows for the year ended December 31, 2002. Our audit also includedthe financial statement schedule for the year ended December 31, 2002listed in the index at Item 14. These financial statements and financialstatement schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on the financial statements andfinancial statement schedule based on our audit.

We conducted our audit in accordance with auditingstandards generally accepted in the United States of America. Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audit provides a reasonable basis for our opinion.

In our opinion, suchconsolidated financial statements present fairly, in all material respects, theresults of its operations and its cash flows for the year ended December 31,2002 in conformity with accounting principles generally accepted in the UnitedStates of America. Also, in our opinion, such financial statement schedule forthe year ended December 31, 2002, when considered in relation to the basicconsolidated financial statements taken as a whole, presents fairly, in allmaterial respects, the information set forth therein.

ERNST & YOUNG, LLP

McLean, VirginiaFebruary 14, 2003

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**OPTELECOM, INC.CONSOLIDATED BALANCE SHEETSAS OF DECEMBER 31,**
| ** **                                                                                                                                                  | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                                                                                                                                  |       |       |       |       |       |
| CURRENT ASSETS                                                                                                                                              |       |       |       |       |       |
| Cash and cash equivalents                                                                                                                                   |       | $          | 2,918,959  |       | $          | 1,387,866 |   |
| Accounts and contracts receivable, net                                                                                                                      |       | 3,015,588  |       | 2,834,956  |       |
| Inventories, net                                                                                                                                            |       | 2,867,882  |       | 2,661,000  |       |
| Deferred tax asset—current                                                                                                                             |       | 767,841    |       | 1,069,479  |       |
| Prepaid expenses and other current assets                                                                                                                   |       | 519,494    |       | 340,078    |       |
| Total current assets                                                                                                                                        |       | 10,089,764 |       | 8,293,379  |       |
| Property and equipment, net                                                                                                                                 |       | 1,870,039  |       | 1,350,366  |       |
| Restricted certificate of deposit                                                                                                                           |       | —     |       | 129,368    |       |
| Deferred tax asset—non-current                                                                                                                         |       | 406,606    |       | 658,784    |       |
| TOTAL ASSETS                                                                                                                                                |       | $          | 12,366,409 |       | $          | 10,431,897 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                              |       |       |       |       |       |
| CURRENT  LIABILITIES                                                                                                                                        |       |       |       |       |       |
| Accounts payable                                                                                                                                            |       | $          | 798,965    |       | $          | 1,052,410 |   |
| Accrued payroll                                                                                                                                             |       | 394,185    |       | 315,889    |       |
| Commissions payable                                                                                                                                         |       | 297,870    |       | 287,767    |       |
| Current portion of notes payable                                                                                                                            |       | 45,000     |       | 67,500     |       |
| Accrued warranty reserve                                                                                                                                    |       | 130,084    |       | 60,846     |       |
| Other current liabilities                                                                                                                                   |       | 523,078    |       | 526,989    |       |
| Total current liabilities                                                                                                                                   |       | 2,189,182  |       | 2,311,401  |       |
| Notes payable                                                                                                                                               |       | 45,000     |       | 90,000     |       |
| Security deposits payable                                                                                                                                   |       | 11,526     |       | 11,526     |       |
| Deferred rent liability                                                                                                                                     |       | 186,418    |       | 62,494     |       |
| Total liabilities                                                                                                                                           |       | 2,432,126  |       | 2,475,421  |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                              |       |       |       |       |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                 |       |       |       |       |       |
| Common stock, $.03 par value—shares authorized,  15,000,000; issued and outstanding, 3,179,109 and 3,114,898 shares as of 2004  and 2003, respectively |       | 95,373     |       | 93,446     |       |
| Additional paid-in capital                                                                                                                                  |       | 11,318,968 |       | 10,942,206 |       |
| Other comprehensive income                                                                                                                                  |       | (15,166    | )          | (19,672    | )          |
| Treasury stock, 162,672 shares, at cost                                                                                                                     |       | (1,265,047 | )          | (1,265,047 | )          |
| Accumulated deficit                                                                                                                                         |       | (199,845   | )          | (1,794,457 | )          |
| Total stockholders’ equity                                                                                                                             |       | 9,934,283  |       | 7,956,476  |       |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                            |       | $          | 12,366,409 |       | $          | 10,431,897 |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**OPTELECOM, INC.CONSOLIDATED STATEMENTS OFOPERATIONSFOR THE YEARS ENDED DECEMBER 31,**
| ** **                                              | ** ** | **2004**   | ** ** | **2003**  | ** ** | **2002**   | ** ** |
|---------------------------------------------------------|------------|------------|------------|-----------|------------|------------|------------|
| Revenues                                                |       | $          | 19,395,147 |      | $          | 17,119,658 |       | $ | 14,908,554 |   |
| Cost of goods  sold                                     |       | 8,266,823  |       | 7,836,377 |       | 6,810,017  |       |
| Gross profit                                            |       | 11,128,324 |       | 9,283,281 |       | 8,098,537  |       |
| Operating  expenses:                                    |       |       |       |      |       |       |       |
| Engineering                                             |       | 1,593,174  |       | 1,370,933 |       | 1,145,532  |       |
| Selling and marketing                                   |       | 3,522,709  |       | 2,817,327 |       | 2,605,130  |       |
| General and administrative                              |       | 3,742,466  |       | 3,122,686 |       | 2,735,756  |       |
| Total operating expenses                                |       | 8,858,349  |       | 7,310,946 |       | 6,486,418  |       |
| Income from operations                                  |       | 2,269,975  |       | 1,972,335 |       | 1,612,119  |       |
| Other income  (expense):                                |       |       |       |      |       |       |       |
| Interest income (expense), net                          |       | 20,315     |       | (10,346   | )          | (90,864    | )          |
| Other income                                            |       | —     |       | —    |       | 139,540    |       |
| Total other income (expense)                            |       | 20,315     |       | (10,346   | )          | 48,676     |       |
| Income (loss) before income taxes                       |       | 2,290,290  |       | 1,961,989 |       | 1,660,795  |       |
| (Provision)  benefit for income taxes                   |       | (695,678   | )          | 1,591,277 |       | (16,675    | )          |
| Net income                                              |       | $          | 1,594,612  |      | $          | 3,553,266  |       | $ | 1,644,120 |   |
| Basic earnings (loss) per share                         |       | $          | 0.50       |      | $          | 1.18       |       | $ | 0.58 |   |
| Diluted earnings (loss) per share                       |       | $          | 0.49       |      | $          | 1.11       |       | $ | 0.56 |   |
| Weighted average common shares outstanding—basic   |       | 3,159,285  |       | 3,019,279 |       | 2,850,587  |       |
| Weighted average common shares outstanding—diluted |       | 3,264,807  |       | 3,197,807 |       | 2,940,026  |       |
| Net income                                              |       | $          | 1,594,612  |      | $          | 3,553,266  |       | $ | 1,644,120 |   |
| Foreign currency  translation                           |       | 4,506      |       | (61,210   | )          | (185,591   | )          |
| Comprehensive income                                    |       | $          | 1,599,118  |      | $          | 3,492,056  |       | $ | 1,458,529 |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**OPTELECOM, INC.CONSOLIDATED STATEMENTS OFCASH FLOWSFOR THE YEARS ENDED DECEMBER 31,**
| ** **                                                                                               | ** ** | **2004**  | ** ** | **2003**   | ** ** | **2002**    | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-----------|------------|------------|------------|-------------|------------|
| Cash Flows From Operating Activities                                                                     |       |      |       |       |       |        |       |
| Net income                                                                                               |       | $         | 1,594,612  |       | $          | 3,553,266   |       | $ | 1,644,120 |   |
| Adjustments to reconcile net income (loss) to net cash  provided by (used in) operating activities: |       |      |       |       |       |        |       |
| Depreciation and  amortization                                                                           |       | 430,180   |       | 332,822    |       | 360,927     |       |
| Loss on disposal  of equipment                                                                           |       | —    |       | —     |       | 8,110       |       |
| Write off discount  on common stock                                                                      |       | —    |       | —     |       | 11,161      |       |
| Accounts  receivable provision                                                                           |       | 41,111    |       | (54,356    | )          | 54,697      |       |
| Inventory  provision                                                                                     |       | (186,859  | )          | (24,005    | )          | (48,704     | )          |
| Stock based  compensation                                                                                |       | 24,900    |       | —     |       | 6,432       |       |
| Deferred rent                                                                                            |       | 123,924   |       | 62,494     |       | (33,111     | )          |
| Deferred tax asset                                                                                       |       | 553,816   |       | (1,624,158 | )          | —      |       |
| Change in assets and  liabilities:                                                                       |       |      |       |       |       |        |       |
| Accounts and  contracts receivable                                                                       |       | (221,742  | )          | 384,120    |       | (741,373    | )          |
| Inventories                                                                                              |       | (20,023   | )          | (183,794   | )          | 391,151     |       |
| Prepaid expenses  and other assets                                                                       |       | (179,416  | )          | (157,178   | )          | (45,502     | )          |
| Other assets                                                                                             |       | —    |       | 126,062    |       | (126,062    | )          |
| Accounts payable                                                                                         |       | (253,445  | )          | 80,994     |       | (275,667    | )          |
| Other current  liabilities                                                                               |       | 153,726   |       | (219,399   | )          | 624,609     |       |
| Net cash provided  by operating activities                                                               |       | 2,060,784 |       | 2,276,868  |       | 1,830,788   |       |
| Cash Flows From Investing Activities                                                                     |       |      |       |       |       |        |       |
| Proceeds from sale  of equipment                                                                         |       | —    |       | —     |       | 5,841       |       |
| Security deposit                                                                                         |       | —    |       | 11,526     |       | —      |       |
| Capital  expenditures                                                                                    |       | (948,363  | )          | (980,205   | )          | (123,510    | )          |
| Net cash used in  investing activities                                                                   |       | (948,363  | )          | (968,679   | )          | (117,669    | )          |
| Cash Flows From Financing Activities                                                                     |       |      |       |       |       |        |       |
| Borrowings on bank  line-of-credit payable                                                               |       | —    |       | 2,020,551  |       | 11,406,756  |       |
| Payments on bank  line-of-credit payable                                                                 |       | —    |       | (2,596,630 | )          | (12,506,542 | )          |
| Payments on notes  payable and capital leases                                                            |       | (67,500   | )          | (23,506    | )          | (543,777    | )          |
| Decrease in  restricted certificate of deposit                                                           |       | 129,368   |       | —     |       | —      |       |
| Proceeds from  issuance of common stock                                                                  |       | 59,569    |       | 58,636     |       | 64,226      |       |
| Proceeds from  exercise of stock options                                                                 |       | 294,220   |       | 633,847    |       | 40,928      |       |
| Net cash provided  by (used in) financing activities                                                     |       | 415,657   |       | 92,898     |       | (1,538,409  | )          |
| Effect of exchange  rates on cash and cash equivalents                                                   |       | 3,015     |       | (61,210    | )          | (185,591    | )          |
| Net increase  (decrease) in cash and cash equivalents                                                    |       | 1,531,093 |       | 1,339,878  |       | (10,881     | )          |
| Cash and cash  equivalents—beginning of period                                                      |       | 1,387,866 |       | 47,988     |       | 58,869      |       |
| Cash and cash  equivalents—end of period                                                            |       | $         | 2,918,959  |       | $          | 1,387,866   |       | $ | 47,988 |   |
| Supplemental Disclosures of Cash Flow Information:                                                       |       |      |       |       |       |        |       |
| Cash paid during  the year for interest                                                                  |       | $         | 5,445      |       | $          | 15,436      |       | $ | 105,895 |   |
| Cash paid during  the year for income taxes                                                              |       | $         | 57,564     |       | $          | 36,374      |       | $ | — |   |
| Supplemental information on non-cash investing  and financing activities:                                |       |      |       |       |       |        |       |
| Notes and capital  lease obligations incurred for new equipment                                          |       | $         | —     |       | $          | 180,000     |       | $ | 4,800 |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**OPTELECOM, INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITYFOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000**
| ** **                                                 | ** ** | **Number  of Shares** | ** ** | **Common  Stock** | ** ** | **Discount  on  Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Deferred  Compensation** | ** ** | **Accumulated  Deficit** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Treasury  Stock** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|------------------------------------------------------------|------------|----------------------------|------------|-------------------|------------|---------------------------------|------------|----------------------------------|------------|----------------------------|------------|--------------------------|------------|-----------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|
| BALANCE, JANUARY 1,  2002                             |       | 2,833,321                  |       |              | 85,000     |                            |       | (11,161                          | )          | 10,048,911                 |       |                     | (6,432     | )                                             |       |                | (6,991,843 | )                                     |       |   | 227,129 |   |   | (1,265,047 | ) |   | 2,086,557 |   |   |
| Common stock issued from exercise of options               |       | 25,420                     |       |              | 761        |                            |       | —                           |       | 63,465                     |       |                     | —     |                                          |       |                | —     |                                  |       |   | — |   |   | — |   |   | 64,226 |   |   |
| Common stock issued from employee stock purchase plan      |       | 19,150                     |       |              | 575        |                            |       | —                           |       | 40,353                     |       |                     | —     |                                          |       |                | —     |                                  |       |   | — |   |   | — |   |   | 40,928 |   |   |
| Foreign currency translation                               |       | —                     |       |              | —     |                            |       | —                           |       | —                     |       |                     | —     |                                          |       |                | —     |                                  |       |   | (185,591 | ) |   | — |   |   | (185,591 | ) |   |
| Stock based compensation                                   |       | —                     |       |              | —     |                            |       | —                           |       | —                     |       |                     | 6,432      |                                          |       |                | —     |                                  |       |   | — |   |   | — |   |   | 6,432 |   |   |
| Write off discount on stock                                |       | —                     |       |              | —     |                            |       | 11,161                           |       | —                     |       |                     | —     |                                          |       |                | —     |                                  |       |   | — |   |   | — |   |   | 11,161 |   |   |
| Net income                                                 |       | —                     |       |              | —     |                            |       | —                           |       | —                     |       |                     | —     |                                          |       |                | 1,644,120  |                                  |       |   | — |   |   | — |   |   | 1,644,120 |   |   |
| BALANCE, DECEMBER 31, 2002                                 |       | 2,877,891                  |       |              | 86,336     |                            |       | —                           |       | 10,152,729                 |       |                     | —     |                                          |       |                | (5,347,723 | )                                     |       |   | 41,538 |   |   | (1,265,047 | ) |   | 3,667,833 |   |   |
| Common stock issued from exercise of options               |       | 224,014                    |       |              | 6,720      |                            |       | —                           |       | 627,126                    |       |                     | —     |                                          |       |                | —     |                                  |       |   | — |   |   | — |   |   | 633,846 |   |   |
| Common stock issued from employee stock purchase plan      |       | 10,993                     |       |              | 330        |                            |       | —                           |       | 52,181                     |       |                     | —     |                                          |       |                | —     |                                  |       |   | — |   |   | — |   |   | 52,511 |   |   |
| Stock awards                                               |       | 2,000                      |       |              | 60         |                            |       | —                           |       | 20,920                     |       |                     | (14,855    | )                                             |       |                | —     |                                  |       |   |   |   |   | — |   |   | 6,125 |   |   |
| Foreign currency translation                               |       | —                     |       |              | —     |                            |       | —                           |       | —                     |       |                     | —     |                                          |       |                | —     |                                  |       |   | (61,210 | ) |   | — |   |   | (61,210 | ) |   |
| Tax benefit from exercise of options                       |       | —                     |       |              | —     |                            |       | —                           |       | 104,105                    |       |                     | —     |                                          |       |                | —     |                                  |       |   | — |   |   | — |   |   | 104,105 |   |   |
| Net income                                                 |       | —                     |       |              | —     |                            |       | —                           |       | —                     |       |                     | —     |                                          |       |                | 3,553,266  |                                  |       |   | — |   |   | — |   |   | 3,553,266 |   |   |
| BALANCE, DECEMBER 31, 2003                            |       | 3,114,898                  |       |              | 93,446     |                            |       | —                           |       | 10,957,061                 |       |                     | (14,855    | )                                             |       |                | (1,794,457 | )                                     |       |   | (19,672 | ) |   | (1,265,047 | ) |   | 7,956,476 |   |   |
| Common stock issued from exercise of options and  warrants |       | 52,545                     |       |              | 1,577      |                            |       | —                           |       | 189,103                    |       |                     | —     |                                          |       |                | —     |                                  |       |   | — |   |   | — |   |   | 190,680 |   |   |
| Common stock issued from employee stock purchase plan      |       | 7,666                      |       |              | 230        |                            |       | —                           |       | 59,339                     |       |                     | —     |                                          |       |                | —     |                                  |       |   | — |   |   | — |   |   | 59,569 |   |   |
| Stock awards                                               |       | 4,000                      |       |              | 120        |                            |       | —                           |       | 43,040                     |       |                     | (43,160    | )                                             |       |                | —     |                                  |       |   |   |   |   | — |   |   | — |   |   |
| Stock based compensation                                   |       | —                     |       |              | —     |                            |       | —                           |       | —                     |       |                     | 24,900     |                                          |       |                | —     |                                  |       |   | — |   |   | — |   |   | 24,900 |   |   |
| Foreign currency translation                               |       | —                     |       |              | —     |                            |       | —                           |       | —                     |       |                     |       |                                          |       |                | —     |                                  |       |   | (10,246 | ) |   | — |   |   | (10,246 | ) |   |
| Tax benefit from exercise of options                       |       | —                     |       |              | —     |                            |       | —                           |       | 103,540                    |       |                     | —     |                                          |       |                | —     |                                  |       |   | 14,752 |   |   | — |   |   | 118,292 |   |   |
| Net income                                                 |       | —                     |       |              | —     |                            |       | —                           |       | —                     |       |                     | —     |                                          |       |                | 1,594,612  |                                  |       |   | — |   |   | — |   |   | 1,594,612 |   |   |
| BALANCE,  DECEMBER 31, 2004                           |       | 3,179,109                  |       |              | $          | 95,373                          |       |                             | $          | —                     |       | $                        | 11,352,083 |                                          |       | $                   | (33,115    | )                                     |       |   | $ | (199,845 | ) |   |   | $ | (15,166 | ) |   | $ | (1,265,047 | ) |   | $ | 9,934,283 |   |   |
|                                                            |            |                            |            |                   |            |                                 |            |                                  |            |                            |            |                          |            |                                               |            |                     |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**OPTELECOM, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002**

**1.   NATURE OFBUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

*Nature of Business**—*Optelecom, Inc. (the Company) is aDelaware corporation that was organized in 1972. The Company designs,manufactures and markets video communication products, specializing intransmission and distribution equipment for the delivery of real time video.

Optelecom’s products and services are categorized intotwo operating segments: the Communication Products Division and the Electro-OpticsTechnology Division. During 2003 management decided to combine the CopperProducts unit and the Optical Products unit into the Communication ProductsDivision in order to manage the business more effectively. The financialresults for these operating segments have been prepared on a basis that isconsistent with the manner in which Optelecom management internally evaluatesfinancial information for the purpose of assisting in making internal operatingdecisions. In this regard, certain common expenses have been allocated amongsegments differently than would be required for stand alone financialinformation prepared in accordance with accounting principles generallyaccepted in the United States of America.

*Principles of Consolidation—*Theconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries, Optelecom UK Limited (Optelecom UK), and OptelecomEurope Limited. All significant inter-company transactions and balanceshave been eliminated.

*Use of Estimates—*Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenue and expensesduring the reporting period. Actual results could differ from those estimates.

*Accounts Receivable*—Accountsreceivable potentially subject the Company to concentrations of credit risk. Creditis extended based on evaluation of a customer’s financial condition and,generally, collateral is not required. Accounts receivable are due within 30days and are stated at amounts due from the customers net of an allowance fordoubtful accounts. Accounts outstanding longer than the contractual paymentterms are considered past due. The Company determines its allowances consideringa number of factors, including the length of time trade accounts receivable arepast due, the Company’s previous loss history, the customer’s current abilityto pay its obligations to the Company, and the condition of the general economyand the industry as a whole. The Company believes that its allowance fordoubtful accounts is adequate to cover any potential losses on its credit riskexposure. The Company writes off accounts receivable when they becomeuncollectible, and payments subsequently received on such receivables arecredited to the allowances for doubtful accounts.

*Revenue Recognition—*Revenuefrom commercial sales is recognized when products are shipped. Revenues fromfixed-price contracts, such as contracts from the government, are recognizedon the percentage-of-completion method based on costs incurred inrelation to total estimated costs. Revenues from time-and-materialscontracts are recorded at the contract rates times the labor hours plus otherdirect costs as incurred. All shipping handling fees and related costs arerecorded as components of cost of goods sold.

*Product Warranty*—Inthe ordinary course of business, the Company warrants its products againstdefect in design, materials, and workmanship over various time periods. Beginningin July 2002 the 

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Company offers a lifetimewarranty on its products. Prior to 2002 the warranty period was limited to fouryears. Warranty reserve and allowance for product returns is established basedupon management’s best estimates of amounts necessary to settle future andexisting claims on products sold as of the balance sheet date.

Thefollowing is a summary of the Company’s continuing warranty obligation for theyears ended December 31:
| ** **                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|
| Balance,  beginning of year         |       | $        | 60,846     |     | $          | 44,512 |   |
| Provision for  warranty obligations |       | 152,558  |       | 52,446   |       |
| Charges of  warranty obligations    |       | (83,320  | )          | (36,112  | )          |
| Balance, end of  year               |       | $        | 130,084    |     | $          | 60,846 |   |

 

*Inventories—*Productionmaterials are valued at the lower of cost or market applied on a weightedaverage cost basis. Work-in-process represents direct labor,materials, and overhead incurred on products not delivered to date. Finishedgoods inventories are valued at the lower of cost or market, cost beingdetermined using standards that approximate actual costs on a specificidentification basis. Optelecom writes down its inventory for estimatedobsolescence or unmarketable inventory based upon assumptions about futuredemand and market conditions as well as historical inventory turnover. If actualmarket conditions are less favorable than those projected by management,additional inventory write-downs may be required.

*Property, Equipment, andDepreciation—*Property and equipment are recorded at cost andare depreciated using the straight-line method over the estimated usefullives of the assets, which range from 5 to 10 years. Leasehold improvements areamortized over the terms of the respective leases or the service lives of theassets, whichever is shorter. Expenditures for maintenance and repairs areexpensed as incurred.

*Impairment of Long-Lived Assets—*TheCompany periodically reviews the carrying value of long-lived assetsincluding property and equipment for impairment whenever events or changes incircumstances indicate that the carrying amount of assets may not berecoverable. Recovery of assets to be held and used is measured by comparingthe carrying value of these assets with the expected future cash flowsgenerated by the assets. If the assets are considered to be impaired, theimpairment is recognized by the amount which the carrying amount of the assetsexceeds their fair value. No impairment losses were recorded during 2004, 2003or 2002.

*Research and Development Costs—*Researchand development costs are expensed as incurred as a component of engineeringexpense in the consolidated statements of operations. The Company incurredresearch and development costs of $1,155,000, $979,000 and $847,000 for theyears ended December 31, 2004, 2003 and 2002, respectively.

*Income Taxes—*TheCompany accounts for income taxes using the asset and liability approach asdefined by FASB No. 109, “Accounting for Income Taxes.” Under this method,deferred tax assets and liabilities are determined based on the differencebetween financial reporting and tax basis of assets and liabilities based onexpected tax rates at the point the items are expected to reverse. Deferred taxassets are reduced by a valuation allowance when, in the opinion of management,it is more likely than not that some portion or all of the deferred tax assetswill not be realized*.*

*Stock-BasedCompensation—*The Company has elected to follow AccountingPrinciples Board (APB) Opinion No. 25, “*Accountingfor Stock Issued to Employees*,” (APB 25) and relatedinterpretations, in accounting for its employee stock options and complies withthe disclosure requirements of SFAS No. 123, “*Accounting for Stock-Based Compensation*” (FAS 123). APB 25provides that the compensation expense 

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relative to the Company’semployee stock options is measured based on the intrinsic value of the stockoption. FAS 123 requires companies that continue to follow APB 25 to provide apro forma disclosure of the impact of applying the fair value method of FAS123.

In December 2002, the FASB issued SFAS No. 148,Accounting for Stock-Based Compensation-Transition and Disclosure (FAS 148).FAS 148 amends FAS 123, to provide alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation. In addition, this Statement amends the disclosurerequirements of FAS 123 to require prominent disclosures in both annual andinterim financial statements about the method of accounting for stock-basedemployee compensation and the effect of the method used on reported results.The provisions of this Standard are effective for fiscal years ending after December 15,2002, and have been incorporated into these financial statements andaccompanying footnotes.

Stock-based compensation related to options granted tonon-employees is accounted for using the fair value method in accordance withthe SFAS No. 123 and EITF 96-18, *Accountingfor Equity Instruments That Are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods or Service*s.

Thefollowing table illustrates the effect on net income (loss) and net income(loss) per common share if the Company had applied the fair value recognitionprovisions of SFAS No. 123 to stock-based compensation.
| ** **                                                                                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002**  | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Net income as  reported                                                                                      |       | $        | 1,594,612  |     | $          | 3,553,266 |       | $ | 1,644,120 |   |
| Less: Stock-based  employee compensation costs, net of income tax, as if fair value method had  been applied |       | (657,538 | )          | (279,865 | )          | (121,052  | )          |
| Net income pro  forma                                                                                        |       | $        | 937,074    |     | $          | 3,273,401 |       | $ | 1,523,068 |   |
| Basic income per  share:                                                                                     |       |     |       |     |       |      |       |
| As reported                                                                                                  |       | $        | 0.50       |     | $          | 1.18      |       | $ | 0.58 |   |
| Pro forma                                                                                                    |       | $        | 0.30       |     | $          | 1.08      |       | $ | 0.53 |   |
| Diluted income per share:                                                                                    |       |     |       |     |       |      |       |
| As reported                                                                                                  |       | $        | 0.49       |     | $          | 1.11      |       | $ | 0.56 |   |
| Pro forma                                                                                                    |       | $        | 0.29       |     | $          | 1.02      |       | $ | 0.52 |   |

 

The effect of applying SFAS No. 123 on a proforma net loss as stated above is not necessarily representative of the effectson reported net loss for future years due to, among other things, the vestingperiod of the stock options and the fair value of additional options to begranted in the future years.

Theweighted-average fair value of options granted during 2004, 2003, and 2002 was$9.44, $5.89 and $3.15, respectively. The fair value of each option isestimated on the date of grant using the Black Scholes option-pricing modelwith the following assumptions used for grants issued during the years ended December 31,2004, 2003, and 2002:
| ** **                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected dividend  yield         |       | 0        | %          | 0        | %          | 0        | %          |
| Expected stock  price volatility |       | 87       | %          | 122      | %          | 129      | %          |
| Risk-free  interest rate         |       | 3.60     | %          | 2.27     | %          | 2.39     | %          |
| Average expected life            |       | 4 years  |       | 4 years  |       | 4 years  |       |

 

*Foreign Currency Translation—*TheCompany translates the assets and liabilities of its foreign subsidiaries intoU.S. dollars at the current exchange rate in effect at the end of the year. Thegains and losses that result from this process, and gains and losses on inter-companytransactions that are long-term in nature and that the Company does notintend to repatriate, are shown in the foreign currency 

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translation adjustmentbalance in the stockholder’s equity section of the balance sheet. The revenueand expense accounts of the foreign subsidiaries are translated into U.S.dollars at the average rates that prevailed during the year.

*Cash and Cash Equivalents—*TheCompany considers all liquid investments with original maturities of threemonths or less at the time of purchase to be cash equivalents.

*Restricted Certificate of Deposit—*TheCompany has provided a performance bond in relation to a contract which issecured by a letter of credit in the amount of $129,368 at December 31,2003. This letter of credit was fully collateralized by a certificate ofdeposit. The certificate of deposit was redeemable by the Company upon thesatisfactory completion of the contract in 2004.

*Fair Value of Financial Instruments—*Thecarrying amounts of the Company’s financial instruments, which include cashequivalents, trade receivables, accounts payables and accrued expenses, and therevolving credit agreement approximate their fair values due to the shortmaturities.

*Earnings Per Share*—Basicearnings per share is computed by dividing net income (loss) by weightedaverage shares outstanding. No dilution for any potentially dilutive securitiesis included in basic earnings per share. Diluted earnings per share is computedby dividing net income (loss) by weighted average shares and common equivalentshares outstanding.

Thecomputation of weighted average shares outstanding for the years ended December 31,2004, 2003 and 2002 is as follows:
| ** **                                 | ** ** | **2004**  | ** ** | **2003**  | ** ** | **2002**  | ** ** |
|--------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Basic Earnings Per  Share:                 |       |      |       |      |       |      |       |
| Earning available to common stockholders   |       | $         | 1,594,612  |      | $          | 3,553,266 |       | $ | 1,644,120 |   |
| Weighted average common shares outstanding |       | 3,159,285 |       | 3,019,279 |       | 2,850,587 |       |
| Basic earnings per share                   |       | $         | 0.50       |      | $          | 1.18      |       | $ | 0.58 |   |
| Diluted Earnings Per  Share:               |       |      |       |      |       |      |       |
| Earning available to common stockholders   |       | $         | 1,594,612  |      | $          | 3,553,266 |       | $ | 1,644,120 |   |
| Weighted average common shares outstanding |       | 3,159,285 |       | 3,019,279 |       | 2,850,587 |       |
| Effect of stock options and warrants       |       | 105,522   |       | 178,528   |       | 89,439    |       |
| Diluted Shares                             |       | 3,264,807 |       | 3,197,807 |       | 2,940,026 |       |
| Diluted earnings  per share                |       | $         | 0.49       |      | $          | 1.11      |       | $ | 0.56 |   |

 

*RecentAccounting Pronouncements—*In November of 2004, FASBissued Statement No 151, *Inventory Costs,*an amendment of Accounting Research Bulletin No. 43, Chapter 4 (SFAS151). The amendments made by SFAS 151 clarify that abnormal amounts of idlefacility expense, freight, handling costs, and wasted materials(spoilage) should be recognized as current period charges and require theallocation of fixed production overheads to inventory based on the normalcapacity of the production facilities. The FASB’s goal is to promoteconvergence of accounting standards internationally by adopting languagesimilar to that used in the International Accounting Standard 2, *Inventories*adopted by the InternationalAccounting Standards Board (IASB). The Boards noted that the wording of theoriginal standards were similar but were concerned that the differences wouldlead to inconsistent application of those similar requirements. The guidance iseffective for inventory costs incurred during the Company’s year beginning January 1,2006. The Company does not believe that the adoption of the new standard willhave a material impact on its financial position.

On December 16, 2004, the FASB issued Statement No. 123(revised 2004), *Share-Based Payment*(SFAS123R), which is a revision of SFAS 123. SFAS 123R supersedes APB 25 and amendsFASB Statement No. 95, *Statement ofCash Flows*. Generally, the approach in SFAS 123R is similar to the 

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approach described in SFAS123. However, SFAS 123R requires all share-based payments to employees,including grants of employee stock options, to be recognized in the incomestatement based on their fair values. Pro forma disclosure is no longer analternative. SFAS 123R must be adopted no later than July 1, 2005. Earlyadoption will be permitted in periods in which financial statements have notyet been issued. The Company expects to adopt SFAS 123R on July 1, 2005.

SFAS 123R permits public companies to adopt itsrequirement using one of two methods—(i) a “modified prospective” methodin which compensation cost is recognized beginning with the effective date (a) basedon the requirements of SFAS 123R all share-based payments granted after theeffective date and (b) based on the requirements of SFAS 123 for allawards granted to employees prior to the effective date of SFAS 123R thatremain unvested on the effective date or (ii) a “modified retrospective”method which includes the requirements of the modified prospective methoddescribed above, but also permits entities to restate based on the amountspreviously recognized under SFAS 123 for purposes of pro forma disclosureseither (a) all prior periods presented or (b) prior interim periodsof the year of adoption. The Company is currently evaluating the method it willuse when it adopts SFAS 123 R

Both SFAS 123 and SFAS 123R require measurement offair value using an option-pricing model. Although the Company currently usesthe Black-Scholes model, the Company may determine that a lattice modelprovides a better estimate of fair value for its employee stock options. TheCompany has not determined which model it will use for new awards issued andfor awards modified, repurchased or cancelled on or after the effective date, July 1,2005. All awards granted prior to July 1, 2005 will maintain theirgrant-date value as calculated under SFAS 123. The future compensation cost forthe portion of these awards that are unvested (the service period continuesafter date of adoption) will be based on their grant-date value adjusted forestimated forfeitures. The Company currently adjusts the pro forma expense forforfeitures only as they occur.

As permitted by SFAS 123,the Company currently accounts for share-based payment to employees using APB25’s intrinsic value method and consequently recognizes no compensation costfor employee stock options. Accordingly, the adoption of SFAS 123R’s fair valuemethod will have an impact on the result of operations, although it will haveno impact on the Company’s overall financial position. The impact of adoptionof SFAS 123R cannot be predicted because it will depend on levels ofshare-based payments granted in the future. However, had adoption of SFAS 123Roccurred in prior periods, the impact of that standard would have approximatedthe impact of SFAS 123 as described in the disclosure of pro forma net incomeand earnings per share in *Stock-BasedCompensation*above.

**2.   ACCOUNTSAND CONTRACTS RECEIVABLE**

Accounts and contractsreceivable consisted of the following at December 31:
| ** **                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|
| Accounts and  contracts receivable     |       | $        | 3,158,782  |     | $          | 2,937,040 |   |
| Less: Allowance  for doubtful accounts |       | (143,194 | )          | (102,084 | )          |
|                                   |       | $        | 3,015,588  |     | $          | 2,834,956 |   |

 

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**3.   INVENTORIES**

Inventoriesconsisted of the following at December 31:
| ** **                  | ** ** | **2004**  | ** ** | **2003** | ** ** |
|-----------------------------|------------|-----------|------------|----------|------------|
| Production  materials       |       | $         | 1,604,605  |     | $          | 1,637,331 |   |
| Work in process             |       | 192,145   |       | 414,639  |       |
| Finished goods              |       | 1,164,264 |       | 889,022  |       |
| Allowance for  obsolescence |       | (93,132   | )          | (279,992 | )          |
| Net                         |       | $         | 2,867,882  |     | $          | 2,661,000 |   |

 

**4.   PROPERTYAND EQUIPMENT**

Propertyand equipment consisted of the following at December 31:
| ** **                                      | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
| Laboratory  equipment                           |       | $          | 2,133,285  |       | $          | 1,695,428 |   |
| Office equipment                                |       | 2,092,922  |       | 1,998,705  |       |
| Furniture and  fixtures                         |       | 90,083     |       | 83,159     |       |
| Leasehold  improvements                         |       | 526,890    |       | 500,199    |       |
| Computer hardware  and software                 |       | 402,286    |       | 99,806     |       |
|                                            |       | 5,245,466  |       | 4,377,297  |       |
| Less accumulated  depreciation and amortization |       | (3,375,427 | )          | (3,026,931 | )          |
| Net property and  equipment                     |       | $          | 1,870,039  |       | $          | 1,350,366 |   |

 

Assetsunder capital leases are included in the above categories and consisted of thefollowing:
| ** **                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
| Laboratory  equipment            |       | $        | 85,171     |     | $          | 85,171 |   |
| Office equipment                 |       | 52,389   |       | 52,389   |       |
|                             |       | 137,560  |       | 137,560  |       |
| Less accumulated  amortization   |       | (101,912 | )          | (92,915  | )          |
| Net assets under capital  leases |       | $        | 35,648     |     | $          | 44,645 |   |

 

Depreciation expense was$430,180, $332,822 and $360,927 for the years ended December 31, 2004,2003 and 2002, respectively.

**5.   INCOMETAXES**

Thecomponents of income before income taxes consisted of the following for theyears ended December 31:
| ** **           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002**  | ** ** |
|----------------------|------------|----------|------------|----------|------------|-----------|------------|
| U.S. Operations      |       | $        | 2,111,653  |     | $          | 1,621,094 |       | $ | 1,909,945 |   |
| Non-U.S.  Operations |       | 178,637  |       | 340,895  |       | (249,150  | )          |
|                 |       | $        | 2,290,290  |     | $          | 1,961,989 |       | $ | 1,660,795 |   |

 

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Thecomponents of the expense (benefit) provision for income taxes for the yearsended December 31 are summarized as follows:
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Current  expense (benefit)** |       |     |       |     |       |     |       |
| U.S. Operations                |       | $        | 29,299     |     | $          | 27,153   |       | $ | 16,675 |   |
| Non-U.S.  Operations           |       | —   |       | —   |       | —   |       |
|                           |       | $        | 29,299     |     | $          | 27,153   |       | $ | 16,675 |   |

 
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** | **2002**   | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|------------|------------|
| **Deferred expense (benefit)** |       |     |       |     |       |       |       |
| U.S. Operations                |       | $        | 605,189    |     | $          | (1,324,455 | )          | $ | — |   |
| Non-U.S.  Operations           |       | 61,190   |       | (293,975 | )          | —     |       |
|                           |       | $        | 666,379    |     | $          | (1,618,430 | )          | $ | — |   |
| Total                          |       | $        | 695,678    |     | $          | (1,591,277 | )          | $ | 16,675 |   |

 

Thedifference between the federal income tax expense (benefit) and the amountcomputed applying the statutory federal income tax rate are summarized asfollows for the years ended December 31:
| ** **                                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| United States  Federal tax at statutory rates           |       | 34.0     | %          | 34.0     | %          | 34.0     | %          |
| (Reduction) increase of  taxes:                         |       |     |       |     |       |     |       |
| State taxes, net of federal benefit                     |       | 3.3      |       | 1.9      |       | 3.3      |       |
| Valuation allowance related to net deferred tax  assets |       | —   |       | (116.8   | )          | (45.1    | )          |
| Income from foreign subsidiary                          |       | —   |       | —   |       | 7.8      |       |
| Business tax credits                                    |       | (6.9     | )          | —   |       | —   |       |
| Other                                                   |       | (0.1     | )          | (0.2     | )          | (1.1     | )          |
| Effective income  tax rate                              |       | 30.3     | %          | (81.1    | )%         | (1.1     | )%         |

 

Deferredincome taxes reflect the net tax effects of temporary differences between theamount of assets and liabilities for income tax and financial reportingpurposes. The components of deferred income tax liabilities and assets as of December 31are as follows:
| ** **                       | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|----------------------------------|------------|-----------|------------|-----------|------------|
| Gross deferred tax  assets:      |       |      |       |      |       |
| Excess book depreciation         |       | $         | —     |      | $          | 97,215 |   |
| Inventory                        |       | 142,346   |       | 199,256   |       |
| Accrued vacation                 |       | 76,611    |       | 60,329    |       |
| Deferral of rent expense         |       | 68,304    |       | 22,898    |       |
| Bad debt reserve                 |       | 51,507    |       | 41,676    |       |
| Accrued warranty reserve         |       | 47,663    |       | 22,294    |       |
| Tax credits                      |       | 484,830   |       | 311,792   |       |
| Other                            |       | 25,924    |       | 1,979     |       |
| Net operating  loss—non-US  |       | 140,743   |       | 191,818   |       |
| Net operating loss               |       | 338,008   |       | 779,006   |       |
| Deferred tax assets              |       | 1,375,936 |       | 1,728,263 |       |
| Gross deferred tax  liabilities: |       |      |       |      |       |
| Excess tax depreciation          |       | (134,394  | )          | —    |       |
| Other                            |       | (67,093   | )          | —    |       |
| Net deferred tax assets          |       | $         | 1,174,449  |      | $          | 1,728,263 |   |

 

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As of December 31, 2004, Optelecom had taxeffected net operating loss and business tax credit carryforwards ofapproximately $338,000 and $425,000, respectively, for US income tax purposes. Thesecarryforwards begin to expire in the year 2020. The Company also had tax creditcarryforwards available for alternative minimum tax purposes of approximately$45,000, which do not expire. The use of these net operating loss and taxcredit carryforwards may be subject to limitation under the rules regardinga change of ownership as determined by the Internal Revenue Service. Theeffects of potential ownership changes, if any, have not been analyzed by theCompany. Additionally, as of December 31, 2004, Optelecom had tax effectednet operating loss carryforwards in jurisdictions outside the United States ofapproximately $141,000, which carry forward indefinitely.

In evaluating the Company’sability to recover its deferred tax assets, we considered all availablepositive and negative evidence, including past operating results, the reversalof temporary differences, the forecasts of future taxable income and theimplementation of feasible and prudent tax planning strategies. Theseassumptions require significant judgment about the forecasts of future taxableincome and are consistent with estimates being used to manage the business. Basedon the weight of the positive and negative evidence and the informationavailable, Optelecom believes that it is more likely than not that its deferredtax assets will be realized.

**6.   NOTESPAYABLE TO BANK**

Under its current banking facility, the Company hasthe ability to borrow up to $3.5 million under its existing bank line-of-creditas of December 31, 2004, provided there are sufficient accounts receivableand inventory,. This facility consists of two components: (a) a demand working capital line of credit whichwill enable the Company to borrow up to the lesser of $3.0 million or theborrowing base; and (b) a $500,000 transaction specific revolving demandexport line of credit for short-term financing. The amount available will bethe lesser of $500,000 or the borrowing base. The Company’s borrowingbase under the first facility equalsthe sum of 90% of eligible government billed accounts receivable, 80% of theeligible commercial billed accounts receivable and 20% of eligible relatedinventory capped at $500,000. The Company’s borrowing base under the secondfacility equals the sum of 75% of the eligible export-related inventory and 90%of the eligible export-related accounts receivable. This facility is guaranteed90% by the Export-Import Bank of the United States (“Ex-Im Bank”) under Ex-ImBank’s Working Capital Guarantee Program.

The first facility carries interest at the rate ofLIBOR (3.10% at December 31, 2004) plus 3.5%. The second facility carriesinterest at the rate of PRIME (5.25% at December 31, 2004) plus 1.25%,floating.

Optelecom is required to comply with certain financialratios including maintaining a minimum current ratio, a maximum debt to worthratio, a maximum funded debt to EBITDA ratio and a minimum tangible net worthratio. The Company was in compliance with all of these covenants at December 31,2004.

The Company had a promissory note agreement with abank that was collateralized by substantially all the assets and contracts ofthe Company. The original note principal was $2,500,000 and was payable inmonthly installments of $62,500 through August 2002, with interest payablemonthly at the rate of prime plus 1%. The principal balance was repaid during2002.

The Company took delivery of major capital equipmentfor its manufacturing operations in March 2003 and incurred a promissorynote with the vendor. The note principal was $180,000 and is payable insemi-annual installments of $22,500 beginning June 2003 through December 2006,with interest payable at the rate of 4.40%.

On March 8, 2005, inconnection with the Company’s acquisition of NKF Electronics the Companyexecuted acquisition related debt agreements which are described in Note 11.

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**7.   COMMITMENTS AND CONTINGENCIES**

*OperatingLeases**—*InMarch 2003, the Company began to occupy its corporate office andmanufacturing facility located in Germantown, Maryland. As an inducement toenter this operating lease, the Company received certain incentives such asrent abatement. Additionally, the lease provides for scheduled rent increases.These lease incentives will be amortized over the lease period. Rent expense isbeing recognized on a straight-line basis.

Optelecom Europe, Ltd. has leases for office and salesfacilities, which expire in June, 2006.

As of December 31,2004, future net minimum rental payments required under operating leases thathave initial or remaining non-cancelable terms in excess of one year areas follows:
| **Year Ended  December 31:** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| 2005                                   |       | $          | 519,031    |       |
| 2006                                   |       | 512,105    |       |
| 2007                                   |       | 511,024    |       |
| 2008                                   |       | 525,617    |       |
| 2009                                   |       | 541,383    |       |
| Thereafter                             |       | 2,129,268  |       |
|                                   |       | $4,738,428 |       |
|                                        |            |            |            |            |            |  |

 

Rent expense was $565,733, $530,478 and $263,642 in2004, 2003 and 2002, respectively.

During 2004 and 2003, Optelecom leased office andlaboratory equipment and a motor vehicle. These leases have terms ranging fromone to five years and were recorded as operating and capital leases. The futureminimum payments under these leases are $28,892.

*Legal Proceedings*—Fromtime to time, Optelecom is involved in legal proceedings and litigation arisingin the ordinary course of business. As of the date of this report Optelecom isnot a party to any litigation or other legal proceeding that, in the opinion ofmanagement, could have a material adverse effect on our business, financialcondition or results of operations.

**8.   STOCKHOLDERS’ EQUITY**

*CommonStock**—*During2003 and 2004, proceeds from the exercise of stock options were $633,847 and$294,220, respectively.

*Director’sStock Compensation**—*Eachnon-employee Director receives stock options to purchase 1,000 shares of commonstock for each board meeting attended either in person or by telephone. Additionally,each non-employee Director is granted 1,000 shares of restricted common stockat the closing price on the date of the annual shareholders’ meeting.

*StockOptions**—*The2000 Nonqualified Employee Stock Option Plan was terminated and rolled into the2002 Incentive Stock Option Plan. The Company issued 23,400 options under the2000 Plan. The exercise price of each option was the fair market value of thestock at the grant date. Options are exercisable after one year from the dateof grant and in equal increments over four years. Options expire five yearsfrom the date of grant and, in most cases, upon termination of employment.

The 2002 Incentive Stock Option Plan provides for upto 476,600 shares available for grant. The options may be granted to officers(including officers who are directors), other key employees of, and consultantsto the Company. There were 205,308 options available for future grant at December 31,2004. The exercise price of each option is the fair market value of the stockat the grant date. Options are 25% exercisable at the grant date, 75%exercisable one year from the grant date and fully exercisable two years 

39

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from the grant date. Optionsexpire five years from the date of grant and, in most cases, upon terminationof employment.

Asummary of stock option activity for the Non-qualified Employee andIncentive Stock Option Plans during the years ended December 31 is asfollows:
| ** **                             | ** ** | **2004**   | ** ** | **2003**     | ** ** | **2002**   | ** ** |
|----------------------------------------|------------|------------|------------|--------------|------------|------------|------------|
| ** **                             | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                             | ** ** | ** ** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                             | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                             | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Shares** | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| Outstanding,  January 1           |       | 187,550    |       |         | $          | 4.51       |       |   | 164,938 |   |   | $ | 3.72 |   |   | 176,801 |   |   | $ | 4.37 |   |   |
| Granted                                |       | 138,091    |       |         | 9.35       |       |       | 103,851 |   |   | 5.30 |   |   | 39,700 |   |   | 3.95 |   |   |
| Exercised                              |       | 33,295     |       |         | 3.74       |       |       | 72,764 |   |   | 3.73 |   |   | 16,169 |   |   | 2.36 |   |   |
| Canceled                               |       | 612        |       |         | 2.93       |       |       | 8,475 |   |   | 5.45 |   |   | 35,394 |   |   | 7.79 |   |   |
| Outstanding, end  of year              |       | 291,734    |       |         | $          | 6.89       |       |   | 187,550 |   |   | $ | 4.51 |   |   | 164,938 |   |   | $ | 3.72 |   |   |
| Exercisable options,  December 31 |       | 148,786    |       |         | $          | 5.86       |       |   | 72,915 |   |   | $ | 4.31 |   |   | 82,971 |   |   | $ | 4.05 |   |   |

 

Thefollowing table summarizes information about stock options outstanding at December 31,2004:
| ** **                                 | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                 | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                 | ** ** | ** **                   | ** ** | **average**                  | ** ** | **average** | ** ** | ** ** | ** ** | **average** | ** ** |
| ** **                                 | ** ** | **Number**                   | ** ** | **remaining**                | ** ** | **exercise** | ** ** | **Number** | ** ** | **exercise** | ** ** |
| **Range of exercise price** | ** ** | ** **                   | ** ** | **outstanding**              | ** ** | **life in years** | ** ** | **price** | ** ** | **exercisable** | ** ** | **price** | ** ** |
| $1.44 to $4.66                             |       |                         | 119,768    |                         |       |   | 2.45 |   |   |   | $ | 3.89 |   |   |   | 83,608 |   |   |   | $ | 3.91 |   |   |
| $4.77 to $9.17                             |       |                         | 28,875     |                         |       |   | 2.25 |   |   |   | 6.01 |   |   |   | 24,800 |   |   |   | 5.70 |   |   |
| $9.19 to $9.19                             |       |                         | 118,166    |                         |       |   | 4.02 |   |   |   | 9.19 |   |   |   | 28,928 |   |   |   | 9.19 |   |   |
| $9.22 and above                            |       |                         | 24,925     |                         |       |   | 3.86 |   |   |   | 11.45 |   |   |   | 11,450 |   |   |   | 12.00 |   |   |
|                                       |       |                         | 291,734    |                         |       |   | 3.19 |   |   |   | $ | 6.89 |   |   |   | 148,786 |   |   |   | $ | 5.86 |   |   |
|                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The 2001 Nonqualified Director Stock Option Planprovides for up to 200,000 shares available for grant. Under this plan, eachnon-employee director who attends a Board of Directors meeting is grantedan option to purchase 1,000 shares of common stock at fair market value on thedate of such Board meeting. The options are exercisable upon grant and expirefive years thereafter. There were 110,500 options available for future grant atDecember 31, 2004.

Asummary of stock option activity for the Non-qualified Director Planduring the year ended December 31 is as follows:
| ** **                             | ** ** | **2004**   | ** ** | **2003**                               | ** ** | **2002**   | ** ** |
|----------------------------------------|------------|------------|------------|----------------------------------------|------------|------------|------------|
| ** **                             | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding,  January 1           |       | 55,500     |       |                                   | $          | 6.14       |       |   | 91,250 |   |   | $ | 3.85 |   |   | 83,000 |   |   | $ | 3.68 |   |   |
| Granted                                |       | 34,000     |       |                                   | 9.78       |       |       | 15,500 |   |   | 9.81 |   |   | 17,000 |   |   | 3.74 |   |   |
| Exercised                              |       | 19,250     |       |                                   | 3.43       |       |       | 51,250 |   |   | 3.18 |   |   | 8,750 |   |   | 2.98 |   |   |
| Canceled                               |       | —     |       |                                   | —     |       |       | — |   |   | — |   |   | — |   |   | — |   |   |
| Outstanding, end  of year              |       | 70,250     |       |                                   | $          | 8.65       |       |   | 55,500 |   |   | $ | 6.14 |   |   | 91,250 |   |   | $ | 3.85 |   |   |
| Exercisable options,  December 31 |       | 70,250     |       |                                   | $          | 8.65       |       |   | 55,500 |   |   | $ | 6.14 |   |   | 91,250 |   |   | $ | 3.85 |   |   |

 

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Thefollowing table summarizes information about stock options outstanding at December 31,2004:
| ** **                                 | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of exercise price** | ** ** | ** **                   | ** ** | **Number  outstanding**      | ** ** | **Weighted  average  remaining  life in years** | ** ** | **Weighted  average  exercise  price** | ** ** | **Number  exercisable** | ** ** | **Weighted  average  exercise  price** | ** ** |
| $1.75 to $5.23                             |       |                         | 18,250     |                         |       |   | 1.51 |   |   |   | $ | 3.49 |   |   |   | 18,250 |   |   |   | $ | 3.49 |   |   |
| $5.87 to $9.20                             |       |                         | 19,500     |                         |       |   | 4.30 |   |   |   | 8.72 |   |   |   | 19,500 |   |   |   | 8.72 |   |   |
| $9.71 to $10.79                            |       |                         | 19,000     |                         |       |   | 4.16 |   |   |   | 10.25 |   |   |   | 19,000 |   |   |   | 10.25 |   |   |
| $10.82 and above                           |       |                         | 13,500     |                         |       |   | 2.68 |   |   |   | 13.25 |   |   |   | 13,500 |   |   |   | 13.25 |   |   |
|                                       |       |                         | 70,250     |                         |       |   | 3.23 |   |   |   | $ | 8.65 |   |   |   | 70,250 |   |   |   | $ | 8.65 |   |   |
|                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**9.   EMPLOYEE BENEFIT PLANS**

The Company has a noncontributory Profit-SharingRetirement Plan covering substantially all employees. Vesting occurs over aperiod of four years from the date of entry into the plan (date of employment).Under the plan, the Company’s contribution is determined annually by the Boardof Directors and is funded as accrued. There was no profit-sharingexpense for 2004, 2003 and 2002.

The Company also has acontributory cash and deferred profit sharing plan qualified under Section 401(k) ofthe Internal Revenue Code for all of the Company’s full-time employees.The Company matches employee contributions to the plan up to a maximum of 2.5%.Total matching contributions were $111,241, $84,318 and $59,036 in 2004, 2003and 2002, respectively.

**10.   BUSINESS SEGMENT INFORMATION**

**Descriptionof the Types of Products from which each Segment Derives its Revenues**

The Company manages itsoperations in two segments: the Communication Products Division which develops,manufactures, and sells optical fiber-based data communication equipmentto both commercial and government clients, and the Electro-OpticsDivision which is focused on Interferometric Fiber Optic Gyro coils.

**Measurementof Segment Profit of Loss and Segment Assets**

The Company evaluates performanceand allocates resources based on profit or loss from operations before incometaxes. The accounting policies of the reportable segments are the same asdescribed in the summary of significant accounting policies. Inter-segmentsales at current market prices.

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**FactorsManagement Used to Identify the Company’s Reportable Segments**

TheCompany’s reportable segments are business units that manufacture and marketseparate and distinct products and are managed separately because each businessrequires different processes, technologies, and market strategies. Thefollowing table summarizes revenues, depreciation and amortization, operatingincome, total assets, and capital expenditures by business segment for fiscal2004, 2003, and 2002:
| ** **                     | ** ** | **Year ended December 31, 2004** | ** ** |
|--------------------------------|------------|------------------------------------------------------|------------|
| ** **                     | ** ** | **Communication  Products Division**            | ** ** | **Electro-  Optics  Division** | ** ** | **Total** | ** ** |
| Revenues                       |       |                                                 | $          | 17,952,579 |   |   | $ | 1,442,568 |   | $ | 19,395,147 |   |
| Depreciation and  amortization |       |                                                 | 430,180    |   |   | — |   | 430,180 |   |
| Income from  operations        |       |                                                 | 1,930,645  |   |   | 339,330 |   | 2,269,975 |   |
| Assets                         |       |                                                 | 12,157,605 |   |   | 208,804 |   | 12,366,409 |   |
| Capital expenditures           |       |                                                 | 948,363    |   |   | — |   | 948,363 |   |
|                                |            |                                                      |            |  |  |  |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Year ended December 31, 2003** | ** ** |
|--------------------------------|------------|------------------------------------------------------|------------|
| ** **                     | ** ** | **Communication  Products Division**            | ** ** | **Electro-  Optics  Division** | ** ** | **Total** | ** ** |
| Revenues                       |       |                                                 | $          | 15,327,411 |   |   | $ | 1,792,247 |   | $ | 17,119,658 |   |
| Depreciation and  amortization |       |                                                 | 332,822    |   |   | — |   | 332,822 |   |
| Income from  operations        |       |                                                 | 1,427,838  |   |   | 544,497 |   | 1,972,335 |   |
| Assets                         |       |                                                 | 10,125,473 |   |   | 306,424 |   | 10,431,897 |   |
| Capital expenditures           |       |                                                 | 1,160,205  |   |   | — |   | 1,160,205 |   |
|                                |            |                                                      |            |  |  |  |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Year ended December 31, 2002** | ** ** |
|--------------------------------|------------|------------------------------------------------------|------------|
| ** **                     | ** ** | **Communication  Products Division**            | ** ** | **Electro-  Optics  Division** | ** ** | **Total** | ** ** |
| Revenues                       |       |                                                 | $          | 13,665,771 |   |   | $ | 1,242,783 |   | $ | 14,908,554 |   |
| Depreciation and  amortization |       |                                                 | 360,927    |   |   | — |   | 360,927 |   |
| Income from  operations        |       |                                                 | 1,235,680  |   |   | 376,439 |   | 1,612,119 |   |
| Assets                         |       |                                                 | 6,312,719  |   |   | 314,504 |   | 6,627,223 |   |
| Capital expenditures           |       |                                                 | 123,510    |   |   | — |   | 123,510 |   |
|                                |            |                                                      |            |  |  |  |  |  |  |  |  |  |

 

Reconciliationof operating profit by segment to net income before benefit (provision) forincome taxes:
| ** **                                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002**  | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Operating income  (loss) by segment              |       | $        | 2,269,975  |     | $          | 1,972,335 |       | $ | 1,612,119 |   |
| Interest expense—line of credit             |       | —   |       | (11,483  | )          | (77,442   | )          |
| Interest  expense—long term notes           |       | (5,445   | )          | (3,465   | )          | (13,422   | )          |
| Other income  (expense)                          |       | 25,760   |       | 4,602    |       | 139,540   |       |
| Total other  income (expense)                    |       | 20,315   |       | (10,346  | )          | 48,676    |       |
| Income (loss)  before provision for income taxes |       | $        | 2,290,290  |     | $          | 1,961,989 |       | $ | 1,660,795 |   |

 

Optelecom is engagedprimarily in the development, manufacture, and sale of optical fibercommunications products and laser systems. Revenue represents shipments andservices provided to third parties. Contract costs and operating expensesdirectly traceable to individual segments were deducted 

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fromrevenue to arrive at operating income. Identifiable assets by segment are thoseassets that are used in the Company’s operations in each segment.

**SignificantCustomers and Foreign Exports**

Optelecom does most of its business with commercialcustomers with some sales to the U.S. Government and its prime contractors. In2004, five commercial customers accounted for a total of 21% of sales with noone customer accounting for more than 10% of sales. In 2003, five commercialcustomers accounted for a total of 21% of sales with no one customer accountingfor more than 10% of sales. In 2002, five commercial customers accounted for atotal of 22% of sales with one customer accounting for more than 10% of sales.

Included in theCommunication Products’ revenues are export sales of $1,709,360, $1,462,967 and$3,260,000 for 2004, 2003, and 2002, respectively. Additionally, theCommunication Products Division has operations in Europe through its OptelecomEurope, Ltd. subsidiary and it recorded sales of $2,688,221, $3,224,158 and$1,881,219 for 2004, 2003 and 2002, respectively. Long-lived assetsreported for the Optelecom Europe, Ltd. are located in the United Kingdom. Alllong-lived assets for the Communication Products segment are located inthe United States.

**11.   SUBSEQUENT EVENT**

On March 8, 2005, Optelecom, Inc. (the “Company”)completed the acquisition of NKF Electronics, B.V. a private company withlimited liability, incorporated in the Netherlands (“NKF”), pursuant to theterms and conditions of the Share Purchase Agreement dated March 8, 2005(the “Purchase Agreement”)

Pursuant to the PurchaseAgreement, the Company acquired all of the outstanding stock of NKF for thefollowing consideration (the “Acquisition Consideration”): (a) eleven millionEuro (€11,000,000)paid in cash; and (b) a Subordinated Promissory Note in the principalamount of up to Nine Million Euro (€9,000,000) (the “SubordinatedNote”), subject to final purchase price adjustments. The Subordinated Noteaccrues interest at a rate of 6% per annum and is due and payable in full on March 8,2010. The Acquisition Consideration is subject to post-closing adjustment inaccordance with the terms and conditions of the Purchase Agreement. The amountof consideration was determined on the basis of arm’s length negotiationsbetween the Company and Draka.

The Company also replacedits current line of credit with a revolving credit facility in an amount not toexceed $5,000,000 to be made available to the Company and NKF for the purposeof obtaining letters of credit and financing the Company’s and NKF’s workingcapital needs.

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**12.   QUARTERLYINFORMATION (UNAUDITED)**

Thefollowing unaudited information sets forth our results of operations on aquarterly basis for the two years ended December 31, 2004 and 2003:
| ** **                       | ** ** | **March 31**                                                              | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|----------------------------------|------------|--------------------------------------------------------------------------------|------------|------------------|------------|-----------------------|------------|----------------------|------------|
| ** **                       | ** ** | **(amounts in thousands except per share data)** | ** ** |
| **2004:**                        |       |                                                                           |       |             |       |                  |       |                 |       |   |   |   |   |   |   |
| Revenues, net                    |       |                                                                           | $          | 4,180            |       |                  | $          | 4,265                |       |   | $ | 5,530 |   |   |   | $ | 5,420 |   |   |
| Gross profit                     |       |                                                                           | 2,411      |             |       | 2,433                 |       |                 | 3,143      |   |   |   | 3,141 |   |   |
| Operating income                 |       |                                                                           | 441        |             |       | 449                   |       |                 | 755        |   |   |   | 625 |   |   |
| Net income                       |       |                                                                           | 303        |             |       | 303                   |       |                 | 569        |   |   |   | 420 |   |   |
| Earnings per share—basic    |       |                                                                           | $          | 0.10             |       |                  | $          | 0.10                 |       |   | $ | 0.18 |   |   |   | $ | 0.13 |   |   |
| Earnings per share—diluted  |       |                                                                           | $          | 0.09             |       |                  | $          | 0.09                 |       |   | $ | 0.17 |   |   |   | $ | 0.13 |   |   |
| **2003:**                        |       |                                                                           |       |             |       |                  |       |                 |       |   |   |   |   |   |   |
| Revenues, net                    |       |                                                                           | $          | 3,488            |       |                  | $          | 4,176                |       |   | $ | 4,499 |   |   |   | $ | 4,957 |   |   |
| Gross profit                     |       |                                                                           | 1,966      |             |       | 2,490                 |       |                 | 2,507      |   |   |   | 2,320 |   |   |
| Operating income                 |       |                                                                           | 376        |             |       | 544                   |       |                 | 660        |   |   |   | 392 |   |   |
| Net income                       |       |                                                                           | 369        |             |       | 536                   |       |                 | 645        |   |   |   | 2,003 |   |   |
| Earnings per share—basic    |       |                                                                           | $          | 0.13             |       |                  | $          | 0.18                 |       |   | $ | 0.21 |   |   |   | $ | 0.64 |   |   |
| Earnings per  share—diluted |       |                                                                           | $          | 0.12             |       |                  | $          | 0.17                 |       |   | $ | 0.20 |   |   |   | $ | 0.62 |   |   |

 

***Item 9.***                          CHANGESIN AND DISAGREEMENT WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

**None**

***Item 9A.***                  CONTROLSAND PROCEDURES

Under the direction and with the participation of theCompany’s management, including the Company’s Chief Executive Officer and ChiefFinancial Officer, the Company carried out an evaluation of the effectivenessof the design and operation of its disclosure controls and procedures pursuantto Exchange Act Rule 13a-15 as of the end of the period covered bythe report. Based on that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that the Company’s disclosure controls andprocedures are effective to ensure that information required to be disclosed bythe Company in reports that it files or submits under the Exchange Act of 1934 (i) isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms and (ii) isaccumulated and communicated to the Company’s senior management to allow timelydecisions regarding required disclosure.

There have been nosignificant changes in our internal controls over financial reporting or, toour knowledge, in other factors that could significantly affect our internalcontrol over financial reporting subsequent to the date we conducted theabove-described evaluation. The Company is currently reviewing the new internalcontrols documentation and attestation requirements regarding Rule 404 ofthe Sarbanes Oxley Act of 2002 and is confident that it will fully comply withsuch requirements.

**PART III**

***Item 10.****                  *DIRECTORS AND EXECUTIVE OFFICERSOF THE REGISTRANT

The information called for by this Item regardingdirectors and executive officers is set forth in the Company’s Proxy Statementfor the 2005 Annual Meeting in the Sections entitled “Election of Directors,” “Management”and “Section 16(a) Beneficial Ownership Reporting Compliance” and isincorporated herein by reference.

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We have adopted a Code ofEthics that applies to all of our directors and employees including, ourprincipal executive officer and principal financial officer and all of ouremployees performing financial and accounting functions. Our Code of Ethics isposted to our website *www.optelecom.com*and may be found under the “Corporate Governance” section. We intend to satisfythe disclosure requirement under Item 10 of Form 8-K regarding anamendment to, or waiver from, a provision of our Code of Ethics by posting suchinformation on our website at the location specified above.

***Item 11.***                   EXECUTIVECOMPENSATION

The information called forby this Item is set forth in the Company’s Proxy Statement for the 2005 AnnualMeeting in the Section entitled “Executive Compensation” and isincorporated herein by reference.

***Item 12.***                   SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information called forby this Item is set forth in the Company’s Proxy Statement for the 2005 AnnualMeeting in the Section entitled “Security Ownership of Certain BeneficialOwners and Management” and is incorporated herein by reference.

***Item 13.****                  *CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

No response is required tothis item.

***Item 14.***                   PRINCIPALACCOUNTANT FEES AND SERVICES

The information called forby this Item is set forth in the Company’s Proxy Statement for the 2005 AnnualMeeting in the Section entitled “Selection of the Auditor” and isincorporated herein by reference.

**PART IV**

***Item 15.****                  *EXHIBITS,FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
| Number | ** **                                                                                                                                                                                                                                                                                                                                                                                       | ** **                                                                                                           | **Description** |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------|-----------------|
| (a)    | The following documents are filed as a part of this  report:                                                                                                                                                                                                                                                                                                                                     |
| (1)    | All financial  statements;                                                                                                                                                                                                                                                                                                                                                                       |
|   | The consolidated  financial statements of the Company and its subsidiaries on pages 27 through  30 hereof, and the reports thereon of Grant Thornton LLP and Ernst &  Young LLP appearing on pages 25 and 26 hereof.                                                                                                                                                          |
| (2)    | Financial Statement  Schedule                                                                                                                                                                                                                                                                                                                                                                    |
|   | Schedule II for the years  ended December 31, 2004, 2003 and 2002 and the report thereon of Grant  Thornton LLP and Ernst & Young LLP appearing on pages 25 and 26  hereof. All other schedules have been omitted because they are not applicable  or are not required. All other required schedules are included in the  Consolidated Financial Statements or notes therein. |
| (3)    | Exhibits                                                                                                                                                                                                                                                                                                                                                                                         |
|   | 3.1                                                                                                                                                                                                                                                                                                                                                                                              | Certificate of  Incorporation, as amended (Incorporated by reference from Form 10-K  filed March 31, 1998) |
|   | 3.2                                                                                                                                                                                                                                                                                                                                                                                              | By-Laws (Incorporated by reference from Form 10-K  filed March 31, 1998)                                   |
|   | 21                                                                                                                                                                                                                                                                                                                                                                                               | List of Subsidiaries                                                                                                 |
|   | 23.1                                                                                                                                                                                                                                                                                                                                                                                             | Consent of Grant Thornton LLP—Independent Certified  Public Accountants                                         |
|   | 23.2                                                                                                                                                                                                                                                                                                                                                                                             | Consent of Ernst & Young LLP—Independent  Certified Public Accountants                                 |

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|        | 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                        | Certification Pursuant to 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |
| (b)    | Reports on Form 8-K: |
|   | None                      |

 

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|                            | **OPTELECOM, INC.** |
|----------------------------|---------------------|
| Date: March 24,  2005 | By                  | /s/ EDMUND LUDWIG |
|                       |                | Edmund Ludwig |
|                       |                | *Director and President and CEO* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.
|                            | **OPTELECOM, INC.** |
|----------------------------|---------------------|
| Date: March 24,  2005 | By                  | /s/ CARL RUBBO, JR. |
|                       |                | Carl Rubbo, Jr. |
|                       |                | *Director* |
| Date: March 24,  2005 | By                  | /s/ DAVID R. LIPINSKI |
|                       |                | David R. Lipinski |
|                       |                | *Director* |
| Date: March 24,  2005 | By                  | /s/ ROBERT URSO |
|                       |                | Robert Urso |
|                       |                | *Director* |
| Date: March 24,  2005 | By                  | /s/ WALTER R. FATZINGER, JR. |
|                       |                | Walter R. Fatzinger, Jr. |
|                       |                | *Director* |
| Date: March 24,  2005 | By                  | /s/ JAMES ARMSTRONG |
|                       |                | James Armstrong |
|                       |                | *Director and Chief Financial Officer* |

 

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**SCHEDULEII**

**OPTELECOM, INC.**

**SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTSFOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002**
| ** **                                             | ** ** | **Balance  at**               | ** ** | **Charged to**          | ** ** | **Balance**    | ** ** |
|--------------------------------------------------------|------------|-------------------------------|------------|------------------------------|------------|----------------|------------|
| ** **                                             | ** ** | **Beginning  of Period** | ** ** | **Costs and  Expenses** | ** ** | **Deductions** | ** ** | **at End  of Period** | ** ** |
| *Year Ended December 31,  2004:*                  |       |                          |       |                         |       |           |       |   |   |
| Reserves and  allowances deducted from asset accounts: |       |                          |       |                         |       |           |       |   |   |
| Obsolescence reserve for inventory                     |       | $                             | 279,991    |                         | $          | 120,079        |       | $ | (306,938 | ) | $ | 93,132 |   |
| Allowance for uncollectible accounts receivable        |       | 102,084                       |       | 41,111                       |       | —         |       | 143,195 |   |
| Valuation allowance for deferred tax assets            |       | —                        |       | —                       |       | —         |       | — |   |
| *Year  Ended December 31, 2003:*                  |       |                          |       |                         |       |           |       |   |   |
| Reserves and  allowances deducted from asset accounts: |       |                          |       |                         |       |           |       |   |   |
| Obsolescence reserve for inventory                     |       | 303,996                       |       | 266,412                      |       | (290,417       | )          | 279,991 |   |
| Allowance for uncollectible accounts receivable        |       | 156,439                       |       | 77,350                       |       | (131,705       | )          | 102,084 |   |
| Valuation allowance for deferred tax assets            |       | 1,449,630                     |       | —                       |       | (1,449,630     | )          | — |   |
| *Year  Ended December 31, 2002:*                  |       |                          |       |                         |       |           |       |   |   |
| Reserves and  allowances deducted from asset accounts: |       |                          |       |                         |       |           |       |   |   |
| Obsolescence reserve for inventory                     |       | 352,700                       |       | 150,434                      |       | (199,138       | )          | 303,996 |   |
| Allowance for uncollectible accounts receivable        |       | 101,742                       |       | 104,481                      |       | (49,784        | )          | 156,439 |   |
| Valuation  allowance for deferred tax assets           |       | 2,760,817                     |       | —                       |       | (1,311,187     | )          | 1,449,630 |   |
|                                                        |            |                               |            |                              |            |                |            |  |  |  |  |  |  |

 

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