**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, 2003**

**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’stelephone number,including area code: **(301) 444-2200**.

Securitiesregistered pursuant to Section 12(b) of the Act: **None**.

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

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

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulations S-K is not contained herein,and will not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. x

At September 30, 2003, shares of the registrant’sCommon Stock, $0.03 Par Value, held by persons other than “affiliates” of theregistrant had an aggregate market value of $37,728,445 based on the averageclosing bid and asked prices as reported by the National Association ofSecurities Dealers Automated Quotation System for such date.

At March 26, 2004, the registrant had outstanding3,151,243 shares of Common Stock, $.03 Par Value.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portionsof the Proxy Statement for the 2004 Annual Meeting of Shareholders areincorporated by reference into Part III hereof.

 

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**OPTELECOM, INC.FISCAL YEAR 2003 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         |
| PART II  |       |                                                                                                   |       |       |
| Item  4       |       | Submission  of Matters to a Vote of Security Holders                                                   |       | 11         |
| Item  5       |       | Market  for Registrant’s Common Stock and Related Stockholder Matters                             |       | 11         |
| Item 6        |       | Selected  Consolidated Financial Data                                                                  |       | 12         |
| Item  7       |       | Management’s  Discussion and Analysis of Financial Condition and  Results of Operations |       | 12         |
| Item  7A      |       | Qualitative  and Quantitative Disclosures About Market Risk                                            |       | 20         |
| Item  8       |       | Financial  Statements and Supplementary Data                                                           |       | 21         |
| Item  9       |       | Changes  in and Disagreements with Accountants on Accounting and  Financial Disclosure            |       | 42         |
| Item 9a       |       | Controls and  Procedures                                                                               |       | 42         |
| PART III |       |                                                                                                   |       |       |
| Item  10      |       | Directors  and Executive Officers of the Registrant                                                    |       | 43         |
| Item 11       |       | Executive  Compensation                                                                                |       | 43         |
| Item  12      |       | Security  Ownership of Certain Beneficial Owners and Management                                        |       | 43         |
| Item  13      |       | Certain  Relationships and Related Transactions                                                        |       | 43         |
| Item  14      |       | Principal  Accounting Fees and Services                                                                |       | 43         |
| PART IV  |       |                                                                                                   |       |       |
| Item  15      |       | Exhibits, Financial Statement Schedules and  Reports on Form 8-K.                                 |       | 44         |
| Signatures    |       | 45                                                                                                     |

 

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**PART I**

***Item 1*.   BUSINESS**

**GENERAL**

Optelecom, Inc. is a Delaware corporation whosebusiness activities began in 1972. Optelecom’s early business commenced withthe design and delivery of specialized laser systems and fiber opticcommunications products for the defense arm of the Federal government. Duringthe mid-1990’s we successfully transitioned from having a significant number ofmilitary customers to being an industry provider of copper and fiber opticbased communications products for commercial and government customers. We havefocused on providing integrated multi-media products for communicatingvideo, audio, and other data over both copper wire and optical network systems.

Optelecom currently manages its operations under twobusiness segments: the Communication Products Division (CPD)  and the Electro-optics Technology unit (EO). TheCommunication Products Division is focused on the development, manufacture andsale of optical fiber-based data communication equipment to bothcommercial and Government clients. The Electro-optics Technology unitdevelops and manufactures innovative optical devices under contract, primarilyto government and defense industry customers. Prior to 2003, the Companymanaged its operations under three business segments: the Optical Productsunit, the Electro-optics Technology unit and the Copper Products Unit.  During 2003 the Optical Products unit andCopper Products unit were combined into the current Communication ProductsDivision. As a result of this integration, the Copper Products unit, formerlyoperating under the name Paragon Audio Visual, was renamed Optelecom EuropeLimited (OEL). As a result, OEL will support the full range of Optelecom’sfiber optic product line in Europe, the Middle East and Africa.  Segment information for all prior periodspresented has been restated to conform to the current presentation.

During 2003 the Company established a new businessunit called Integrated Systems. This unit will focus on delivering videocontent management solutions to both new and existing customers. Initialproduct offerings will include rich media communications and networked securitysystems. While the Company incurred insignificant costs in developing theIntegrated Systems unit during 2003, management expects the unit to begingenerating revenue in 2004 when it intends to report it as a separate operatingunit.

Fiber optic communications equipment is the mainelement of Optelecom’s sales. The marketplace served by Optelecom isexperiencing a period of continuous growth and change as the industry continuesto grow. Technology development is constantly and rapidly improving thecapability to transmit at increasing data rates over even greater distanceswith fiber-based communication systems.

In the Electro-optics Technology unit, emphasishas been placed on fabrication of precision-wound coils of optical fiberused as the sensing elements of fiber optic gyroscopes. During the past decade,Optelecom has received U.S. Government contracts to investigate advancedmanufacturing technology related to gyro coil winding. Optelecom currentlypursues this tradition of business development and continues to seek outtechnology development opportunities with potential for production follow-on.The Electro-optics unit also produces precision wound coils forapplications ranging from optical fiber dispensers used in remote vehiclecontrol systems to precision optical fiber coils for communications systems. Additionally,the group is currently engaged in a series of contracts with the U. S. AirForce and prime contractors to develop elements of a fiber optic data busnetwork for a new air vehicle.

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Thetable below displays the Company’s three-year revenue and operatingincome (loss) by segment:
| ** **              | ** ** | **2003**   | ** ** | **2002**    | ** ** | **2001**              | ** ** |
|-------------------------|------------|------------|------------|-------------|------------|-----------------------|------------|
| **Operating Unit** | ** ** | ** ** | ** ** | **Revenue** | ** ** | **Operating  Income** | ** ** | **Revenue** | ** ** | **Operating  Income** | ** ** | **Revenue** | ** ** | **Operating  Income  (Loss)** | ** ** |
| Communication  Products |       | $          | 15,327,411 |        | $          | 1,427,838             |       | $ | 13,665,771 |   | $ | 1,235,680 |   | $ | 12,124,288 |   | $ | (980,252 | ) |
| Electro-Optics          |       | 1,792,247  |       | 544,497     |       | 1,242,783             |       | 376,439 |   | 1,052,631 |   | 236,195 |   |
| Company Totals          |       | $          | 17,119,658 |        | $          | 1,972,335             |       | $ | 14,908,554 |   | $ | 1,612,119 |   | $ | 13,176,919 |   | $ | (744,057 | ) |
|                         |            |            |            |             |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***PRODUCTS AND MARKETS***

**COMMUNICATION PRODUCTS DIVISION (CPD)**

The Communication ProductsDivision addresses business opportunities in the worldwide opticalcommunication equipment marketplace, specializing in optical fiber transmissiontechnologies. The majority of its current and future revenues are and will 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 CommunicationsProducts*

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.

*UncompressedDigital 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.

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. During 2003, weintroduced a new line of 9 bit single and dual channel video transmitterspriced competitively for the security market.

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.

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*CWDM (CourseWavelength Division Multiplexer) Systems*

CWDM allows the transmission and reception of multiplechannels of light operating at different wavelengths through a single opticalfiber. With this technology, the user can configure systems which transport thevideo and data channel count transmitted by one wavelength (typically up toeight) multiplied by the wavelength channel capacity of the CWDM. Optelecomoffers CWDM systems with optical wavelength channel counts of from two toseventeen, as well as single channel add/drop multiplexers   By using a two channel WDM (WavelengthDivision Multiplexer) along with two eight channel digital video multiplexerstransmitting at different optical wavelengths, sixteen channels of video alongwith data and audio may be transmitted via one optical fiber in one direction. Similarly,by using a seventeen channel CWDM (Course Wavelength Division Multiplexer)along with up to seventeen eight channel digital video multiplexers eachtransmitting at different optical wavelengths, one hundred thirty six channelsof very high quality digital video, along with audio and data, may betransmitted via one optical fiber in one direction. Alternately, by using theseventeenth wavelength for return path audio and data, one hundred twenty eightvideo channels 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 RGBVideo 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 DigitalVideo Transmission Products*

Applying our expertise in video communications, wehave developed a low cost, high quality, compressed digital video MPEG IIproduct set that leverages the advantages of new microprocessor technologyrecently made available to the marketplace. MPEG II has become the defactocompression standard embraced by the consumer and other electronicsmarketplaces. The products we have developed will replace older compressionproducts since their low cost, high performance characteristics render theprevious family obsolete.

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 publicnetworks.

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**ELECTRO OPTICS 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. Optelecomcurrently supports Boeing in a program for Wright-Patterson AFB which isdevoted to development of military aircraft photonic network systems. Optelecomis in the implementation stage of an effort to develop a demonstration ofphotonic vehicle control feedback components. Under a related Small BusinessInnovation Research (SBIR) contract completed in 2003, Optelecom investigatedphotonics systems optimized for aerospace vehicles, which culminated in thedesign of an optical subsystem prototype. Our photonic aerospace vehicle workprovides an opportunity for Optelecom to apply its optical development andfabrication expertise to an important aircraft system application withpotential application to commercial markets.

***SALES AND MARKETING***

**COMMUNICATIONPRODUCTS DIVISION**

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 2003 we added seven representatives and forty-seven integratorsdomestically. Internationally, we added seven new integrators. We expect thisnumber to continue to grow in 2004 as we further expand the market share of ourfiber 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 updated web site (www.optelecom.com) has enabled theconvenient and rapid dissemination of information required by our distributionchannel personnel and other interested parties to gather information necessaryto select our equipment.

**ELECTRO OPTICS TECHNOLOGY UNIT**

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 ANDDEVELOPMENT***
| ** **                                                             | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expenditures on Company  sponsored research and development activities |       | $979,000 |       | $847,000 |       | $958,000 |       |

 

During 2003, the Company invested in the developmentof several new products. These products will permit us to increase ourpenetration of the present vertical markets we serve by permitting ourcustomers to increase information throughput at reduced price points. It isanticipated that the new Digital Video (DV) products, both compressed anduncompressed, will gain significant market share due to their 

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extremely highreliability, increased bandwidth/channel capacities, and robust videocompression 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***

**QUALITYASSURANCE**

Optelecom has establishedand maintains a Quality Assurance system fully compliant with the requirementsof ISO-9001 (an internationally recognized quality system standard forcompanies that design and manufacture products). All operating segments havereceived registration to the standard. This registration is re-validatedevery six months by an independent third party audit. The company successfullypassed audits in January and July of 2003. During the successful January auditOptelecom was updated from the 1994 version of ISO-9001 to the 2000version; Optelecom was compliant to the updated standard throughout 2003 (ayear ahead of the deadline). The Corrective Action and feedback process alongwith Quality Council meetings continue to be aggressively utilized to drivecontinuous improvements.

**COMMUNICATION PRODUCTS 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 andtesting area that performs optical and electrical testing and quality control.Raw materials and supplies used in our business include optical materials,plastic products, and various electronic components, most of which areavailable from numerous sources. Although the number of companies from which wecan obtain optical emitters and detectors for use in our circuit assemblies islimited, availability is presently not a limiting factor. During 2003,manufacturing basics continued to be an area of primary focus. This involvedcorrecting, reassessing and improving many of the core manufacturing processes.

**ELECTRO OPTICS TECHNOLOGY**

The Electro-Opticsunit uses custom facilities designed and fabricated by Optelecom for precisionwound coil production and contract research and development. Currently, fivecoil 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 $180 million in 2003.The size of the traffic and security surveillance markets, which represents thelargest segment, is estimated to be approximately $60 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. The Company expects toincrease its share of these expanding markets. In addition, our productscontain 

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twotechnologies that are in limited supply to these markets: the compressed anduncompressed Digital Video products.

**ELECTROOPTICS TECHNOLOGY**

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 modulator 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 2003, theestimated backlog for each business segment was $1,100,000 in the CommunicationProducts Division and $705,000 in the Electro Optics Products Unit. The Companyexpects to recognize a majority of the backlog as revenue in the first quarterof 2004.

***EMPLOYEES***

At December 31, 2003,a total of 69 full-time employees worldwide were employed at Optelecom,including 13 in research, development and engineering, 13 in sales andmarketing, 31 in manufacturing and 12 in general management, administration andfinance. The number of employees by operating segment is as follows: OpticalProducts Unit—64;  Electro Optics—5. Weexpect a slight increase in headcount over the next 12 months, primarily in theareas of sales, marketing and manufacturing. Our future success will depend inpart on our ability to attract, train, retain and motivate highly qualifiedemployees. There can be no assurance that we will be successful in attractingand retaining such personnel. Our employees are not represented by anycollective bargaining organization and we consider our employee relations to begood.

***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 “Item 1. Business,” and “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations”regarding Optelecom’s business and strategies, product markets, sales,marketing, customer support and service, research and development,manufacturing, competition, backlog, employees, financial performance, revenueand expense levels in the future and the sufficiency of our 

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existingassets to fund future operations and capital spending needs. Actual resultscould differ from those projected in any forward-looking statements forthe reasons, among others, detailed under “Risk Factors” in this Report on Form 10-K.The fact that some of the risk factors may be the same or similar to Optelecom’spast filings means only that the risks are present in multiple periods. Webelieve that many of the risks detailed here are part of doing business in theindustry in which we compete and will likely be present in all periodsreported. The fact that certain risks are endemic to the industry does notlessen the significance of the risk. The forward-looking statements aremade as of the date of this Form 10-K and we assume no obligation toupdate the forward-looking statements, or to update the reasons whyactual results could differ from those projected in the forward-lookingstatements.

**Fluctuations In 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 Major Customers**

For the twelve monthsended December 31, 2003 approximately 21% of our revenues were accountedfor by sales to five commercial customers. This is a decline from the prioryear when five customers represented 22% 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.

**Technological Change**

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 2002 and 2003 and the productscurrently being developed will position us to compete effectively through 2004and well into 2005. There can be no assurance, however, that our competitorswill not develop products that are as, or possibly more, effective than ours.We continuously monitor our competitors’ product introductions to evaluate ourability to compete.

**Future Capital Needs; Uncertainty Of AdditionalFunding**

Optelecom believes that our existing capitalresources, including an existing $3,500,000 bank line-of-credit andfuture 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.

**Need To 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.

**Price Volatility 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 technology companieshave in the past been, and can in the future be expected to be, especiallyvolatile. Announcements of technological innovations or new products ofOptelecom or our competitors, developments or disputes concerning proprietaryrights, publicity regarding products under development by Optelecom or ourcompetitors, regulatory developments in both the United States and foreigncountries, 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 Of Dividends; 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.

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***Item 2.  *PROPERTIES**

The Company’s corporateoffice and manufacturing facility are located at 12920 Cloverleaf CenterDrive, Germantown, Maryland. This facility has 30,000 square feet of space,26,000 of which are occupied by Optelecom, with the remaining 4,000 square feetsub-leased. Our move in 2003 to this facility which has been specificallydesigned and fitted to accommodate our current requirements and our anticipatednear-term growth needs is expected to improve our ability to serve ourcustomers.

As part of the 2001restructuring of Optelecom Europe Limited, its facilities were consolidated ina smaller, but superior, facility in Thatcham, England, consisting ofapproximately 2,100 square feet of office space. This lease expires in June 2006,and the premises are in good repair, and are adequate for current requirements.

***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 2003.

**PART II**

***Item5.  *MARKET FOR REGISTRANT’S COMMON STOCK AND RELATEDSTOCKHOLDER 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 31,2003 and 2002, respectively. Such quotations do not necessarily reflect actualtransactions:
| ** **                | ** ** | **Bid Price** | ** ** |
|---------------------------|------------|--------------------|------------|
| ** **                | ** ** | **High**           | ** ** | **Low** | ** ** |
| *Quarter Ended*           |       |               |       |   |   |
| 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 |   |
| December 31, 2002    |       | 6.50               |       | 4.49 |   |
| September 30,  2002  |       | 6.04               |       | 2.25 |   |
| June 30,  2002       |       | 3.40               |       | 2.30 |   |
| March 31, 2002       |       | 3.40               |       | 2.50 |   |
|                           |            |                    |            |  |  |  |  |

 

There were 584 record holders of the Common Stock asof December 31, 2003. The Company has never declared or paid any cash dividendson its common stock and does not expect to do so in the foreseeable future. TheCompany intends to retain any future earnings to finance its operations andfund the growth of the business. Any payment of future dividends will be at thediscretion of the Board of Directors of the Company and will depend upon, amongother things, the Company’s earnings, financial condition, capitalrequirements, and other factors that the Company’s Board of Directors deemsrelevant.

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Listedbelow is information on the Company’s equity compensation plans as of March 8,2004.
| **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     |       |       | 243,050    |                                                                                                                        |       |                                                                              | $          | 4.88                                                                                                                                                                                                        |       |   |   | 287,899 |   |   |
| Equity  compensation plans not approved by security holders |       |       | —     |                                                                                                                        |       |                                                                              | —     |                                                                                                                                                                                                        |       |   | — |   |   |
| Totals                                                      |       |       | 243,050    |                                                                                                                        |       |                                                                              | $          | 4.88                                                                                                                                                                                                        |       |   |   | 287,899 |   |   |

 

***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’saudited consolidated financial statements which have been audited by theCompany’s independent public accountants. The information set forth below isqualified 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
| ** **                               | ** ** | **2003**   | ** ** | **2002**  | ** ** | **2001**   | ** ** | **2000**   | ** ** | **1999**  | ** ** |
|------------------------------------------|------------|------------|------------|-----------|------------|------------|------------|------------|------------|-----------|------------|
| *Year ended December 31,*           |       |       |       |      |       |       |       |       |       |      |       |
| Revenues, net                            |       | $          | 17,119,658 |      | $          | 14,908,554 |       | $          | 13,176,919 |      | $          | 10,676,829 |   | $ | 12,636,892 |   |
| Net income (loss)                        |       | 3,553,266  |       | 1,644,120 |       | (933,585   | )          | (5,998,852 | )          | (211,359  | )          |
| Basic earnings (loss) per common share   |       | 1.18       |       | 0.58      |       | (0.33      | )          | (2.53      | )          | (0.10     | )          |
| Diluted earnings (loss) per common share |       | 1.11       |       | 0.56      |       | (0.33      | )          | (2.53      | )          | (0.10     | )          |
| *As of December 31,*                |       |       |       |      |       |       |       |       |       |      |       |
| Total assets                             |       | 10,431,897 |       | 6,627,223 |       | 6,373,679  |       | 6,872,492  |       | 8,615,614 |       |
| Long-term obligations                    |       | 164,020    |       | —    |       | 69,111     |       | 663,642    |       | 1,380,575 |       |
| Stockholders’  equity               |       | 7,956,476  |       | 3,667,833 |       | 2,086,557  |       | 2,958,998  |       | 2,896,620 |       |
|                                          |            |            |            |           |            |            |            |            |            |           |            |  |  |  |  |  |

 

***Item 7.  *MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**RESULTS OF OPERATIONS**

Optelecom, Inc. designs, develops, manufacturesand markets high-bandwidth fiber optic-based communications systems for trafficmonitoring, security / surveillance, and business video systems. Over the pasttwo years the company has aggressively pursued several operational objectivesincluding: 1) the expansion of a distribution network both in the UnitedStates and abroad, 2) realization of manufacturing and processimprovements and 3) implementation of a cost and asset management program.

The successful execution of these initiatives alongwith increased demand in our core markets has enabled the Company tosignificantly improve its financial condition in 2002 and 2003, as evidenced byincreasing levels of profitability and positive cash flow.

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In the fourth quarter of 2003 the Company determinedthat its deferred tax assets, comprised mainly of net operating losscarryforwards and tax credits, were more likely to be realized than not. As aresult, the Company reversed its deferred tax valuation allowance andrecognized a one-time non-cash tax benefit of $1.6 million. The Company willbegin recognizing tax provisions in 2004.

The Company will continuein 2004 to work at broadening its sales channels, sustaining gross profitmargins and controlling costs. To supplement the growth expected in its corebusiness, the Company in 2003 established a new business unit called IntegratedSystems. This unit will focus on delivering video content management solutionsto both existing and new customers and is expected to start generating revenuein 2004.

***2003 versus 2002***

2003 consolidated revenues of $17.1 million were $2.2million or 15% higher than 2002. Sales increased in both the CommunicationProducts Division and Electro-Optics Unit. Revenue for the 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 $9.3 million in 2003 compared to $8.1million in 2002. This 15% increase of $1.2 million is primarily the result of ahigher volume of sales of digital and data communications products in 2003,which had higher profit margins in 2003 compared to 2002 as a result ofcontinued improvements in manufacturing efficiencies and reductions in materialcosts over the prior year. As a percentage of sales, our 2003 gross marginremained constant with our 2002 gross margin at 54%. The Company expectsmargins in 2004 to be comparable to 2003.

Operating expenses were $7.3 million in 2003 comparedto $6.5 million in 2002. This increase of $0.8 million or 13% is primarily dueto increases in spending for engineering personnel, sales advertising and tradeshow costs and higher occupancy costs as a result of the Company’s move to alarger and expanded facility early in 2003. As a percentage of revenue ouroperating expenses declined 1% from 44% in 2002 to 43% in 2003. As our revenueincreases we are experiencing a reduction in our operating expenses as apercentage of revenue. In 2001 our operating expense as a percent of revenuewas 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. The Company will begin to recognize tax expense in 2004.

***2002 versus 2001***

2002 consolidated revenues of $14.9 million were $1.7million or 13% higher than 2001. Sales increased in the Optical Products andElectro-Optics Units and were lower in the Copper Products Unit. Revenuefor the Optical Products Unit increased by $1.9 million or 19%. This increaseis attributed to the Company’s focus of increasing sales channels bothdomestically and internationally. Sales to integrators and distributorsincreased substantially as a result of market penetration and the continuingavailability of existing products and new products. Electro-Opticsrevenues increased to $1.2 million in 2002 from $1.1 million in 2001 as aresult of expansion of the contract research and development services and thecoil 

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winding business. Revenuefor the Copper Products Unit decreased by $0.4 million or 17% as the Companybegan to shift its sales focus from copper-based products to fiber-basedproducts.

Gross profit was $8.1 million in 2002 compared to $6.3million in 2001. This increase of $1.8 million is primarily the result of ahigher volume of sales of digital and high resolution products in 2002, whichhave higher profit margins. Additionally, there was a higher level of sales oflower margin copper products in the year ended December 31, 2001. As a percentage of sales, our 2002 grossmargin improved to 54% from our 2001 gross margin of 48%.

Operating expenses were $6.5 million in 2002 comparedto $7.0 million in 2001. This decrease of $0.5 million or 7.6% is primarily dueto reductions in spending for engineering personnel, engineering consultantsand lower corporate staff expense as a result of the 2002 restructuring of theCopper Products Unit. The principal purpose of this restructuring was torelocate key administrative functionality from Europe to the US operations. Thesereductions in 2002 spending were partially offset by higher selling personnelcosts and the increased commissions necessary to support higher sales levels.

The Company reported netincome in 2002 of $1.6 million or $0.56 per diluted share compared to a netloss of $0.9 million or ($0.33) per share in 2001. There was a modest provisionfor state income tax in 2002 compared to no provision in 2001. The company iscurrently not paying federal income tax due to the net operating losscarryforwards from prior years.

*Operating Segments*

Optelecom’s products andservices are categorized into two operating segments: the CommunicationProducts Division and the Electro-Optics Technology unit. Prior to 2003, theCompany had been reporting the revenues and expenses of the Copper Productsunit separately. During 2003 management decided to combine the Copper Productsunit and the Optical Products into the Communication Products Division in orderto manage the business more effectively. The financial results for the twooperating segments have been prepared on a basis that is consistent with themanner in which Optelecom management internally evaluates financial informationfor the purpose of assisting in making internal operating decisions. In thisregard, certain common expenses have been allocated among segments differentlythan would be required for stand alone financial information prepared inaccordance with accounting principles generally accepted in the United Statesof America.

**COMMUNICATIONPRODUCTS DIVISION**
| **Communication Products Division** | ** ** | ** ** | ** ** | **2003**  | ** ** | **2002**   | ** ** | **2001** | ** ** |
|-----------------------------------------------|------------|------------|------------|-----------|------------|------------|------------|----------|------------|
| Net Sales                                     |       | $          | 15,237,411 |      | $          | 13,665,771 |       | $        | 12,124,288 |   |
| Gross Profit                                  |       | 8,438,028  |       | 7,500,348 |       | 5,845,946  |       |
| Total Operating  Expense                      |       | 7,023,204  |       | 6,264,668 |       | 6,826,198  |       |
| Operating Income (Loss)                       |       | 1,427,838  |       | 1,235,680 |       | (980,252   | )          |
|                                               |            |            |            |           |            |            |            |          |            |  |  |  |

 

2003 Sales for Communication Products Division of$15.2 million were 14% or $1.8 million higher than 2002’s sales of $13.4million. This increase is attributed to the Company’s focus of increasing saleschannels both domestically and internationally. Sales to integrators anddistributors increased substantially over the prior year.

In 2003 the Communication Products Division continuedto experience the benefits of the expansion and re-alignment of its sales andmarketing departments. The emphasis that was placed on developing new sales anddistribution channels, both domestically and internationally resulted in highersales in 2003. During 2003, seven independent sales representativeorganizations and forty seven integrators were added domestically and sevenintegrators were added in the international marketplace.  The Company expects to 

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continue to addindependent sales representative organizations and integrators both domesticallyand internationally in 2004.

Gross profit during 2003 of $8.4 million, or 55% ofsales, was higher than 2002’s gross profit of $7.5 million or 56% of sales. Theincrease of $0.9 million is primarily the result of the higher volume of salesof digital and data communications products in 2003. The slight decline ingross profit margin in 2003 is mainly attributable to significantly lowermargins on a large installation for the upcoming Olympics in Athens. Managementdetermined that the benefit of having our technology showcased at this premiervenue provided exposure to a level of potential customers that could not beeasily reached otherwise.  The Company expects margins in 2004 to becomparable to 2003.

Operating expenses were$7.0 million in 2003 compared to $6.3 million in 2002. Sales and marketingcosts increased $0.2 million over 2002, primarily due to higher advertising andtrade show costs. Engineering costs increased $0.2 million, primarily due tohigher staff costs in 2003. General and administrative costs increased $0.4million from $2.7 million in 2002 to $3.1 million in 2003. Cost increases areprimarily attributed to the increases in personnel and occupancy costs as aresult of locating to larger facilities early in 2003 and increased sales levels.

**ELECTRO-OPTICSTECHNOLOGY UNIT**
| ** **               | ** ** | **2003** | ** ** | **2002** | ** ** | **2001**  | ** ** |
|--------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Net Sales                |       | $        | 1,792,247  |     | $          | 1,242,783 |       | $ | 1,052,631 |   |
| Gross Profit             |       | 845,253  |       | 598,189  |       | 427,587   |       |
| Total Operating  Expense |       | 300,756  |       | 221,750  |       | 191,392   |       |
| Operating Income         |       | 544,497  |       | 376,439  |       | 236,195   |       |
|                          |            |          |            |          |            |           |            |  |  |  |

 

Electro-Optics salesof $1.8 million in 2003 were $0.6 million higher than 2002. The increase isprimarily attributable to the increased unit sales of the coil winding divisionand higher sales under the contract research and development portion of thebusiness in 2003 when compared to 2002. Operating income for 2003 improvedslightly as compared to 2002 primarily due to higher sales levels.

**OTHER INCOME (EXPENSE)**
| ** **                                     | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Interest expense—line of  credit          |       | $        | (11,483    | )        | $          | (77,442  | )          | $ | (109,019 | ) |
| Interest expense—long term  notes / other |       | (3,465   | )          | (13,422  | )          | (80,509  | )          |
| Other income  (expense)                        |       | 4,602    |       | 139,540  |       | —   |       |
| Total other  income (expense)                  |       | $        | (10,346    | )        | $          | 48,676   |       | $ | (189,528 | ) |

 

Other income (expenses)totaled ($0.01) million in 2003 compared to $0.05 million in 2002. Totalinterest expense was $0.01 million in 2003 compared to $0.09 million in 2002. Interestexpense for 2003 decreased as result of paying down the principal on the line-of-credit.The average borrowing under the line-of-credit was $0.6 million in 2003 and $1.18million in 2002. The interest rate averaged 5.5% in 2003. Other income in 2003relates to interest income while other income in 2002 represents a refund offederal income taxes paid in a prior year.

**Impactof Inflation**

Inflation has not had asignificant effect on the operations of the Company during 2003, and we do notexpect it to have a significant effect during 2004.

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**FINANCIALCONDITION**

The Company’s Stockholders’ equity increased from $3.7million in 2002 to $8.0 million in 2003. The net income and consequent decreasein accumulated deficit of $3.6 million was accompanied by an increase of $0.8million in common stock and paid-in-capital, due to the exercise ofstock options and purchase of shares pursuant to the employee stock purchaseplan.

Other key components of Optelecom’s financialcondition include accounts receivable, inventory, fixed assets and accountspayable. The Company’s current ratio has increased to 3.59 at December 31,2003 compared to 1.98 at December 31, 2002. This increase is attributedprimarily to the increase in cash from $0.05 million to $1.4 million, theincrease in the current deferred tax asset to $1.1 million and the $0.6 milliondecrease in the Company’s bank line of credit. Accounts receivable decreasedthis year from $3.2 million in 2002 to $2.8 million at December 31, 2003.A significant factor in this decrease was relatively large shipments late in2002.

Inventory increased slightly from $2.5 million at December 31,2002 to $2.7 million at December 31, 2003 primarily due to increases inproduction materials and work in process inventories. These increases were dueto the Company’s decision to increase stocking levels to meet customerrequirements, primarily for the growing security and surveillance market. Duringthe year ended December 31, 2002, as a result of the lessening of exposureto component shortages, we were able to focus on stocking material atsubassembly and finished good levels. This resulted 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:
| ** **                  | ** ** | **2003** | ** ** | **2002**  | ** ** | **2001**  | ** ** |
|-----------------------------|------------|----------|------------|-----------|------------|-----------|------------|
| Production  Materials       |       | $        | 1,637,331  |      | $          | 1,367,886 |       | $ | 2,065,350 |   |
| Work in Process             |       | 414,639  |       | 210,637   |       | 278,731   |       |
| Finished Goods              |       | 889,022  |       | 1,178,674 |       | 804,267   |       |
| Allowance for  Obsolescence |       | (279,992 | )          | (303,996  | )          | (352,700  | )          |
| TOTAL                       |       | $        | 2,661,000  |      | $          | 2,453,201 |       | $ | 2,795,648 |   |

 

In 2003, fixed asset additions were $1.2 million,compared to $0.12 million in 2002 and $0.09 million in 2001. During 2001 and2002 the Company had adopted a conservative policy on capital purchases in itseffort to curtail spending and improve profitability. During 2003, as theCompany’s profitability continued to improve, capital spending was increased inorder to improve and expand on engineering and factory capabilities. While theCompany does not currently have any capital asset purchase commitments, weanticipate an investment in capital expenditures of approximately $0.5 millionin 2004.

The Company’s current liabilities decreased $0.7million from $3.0 million in 2002 to $2.3 million in 2003 primarily as a resultof a decrease of $0.6 million in the bank line-of-credit payableand $0.2 million in other current liabilities. Accounts payable increased onlyslightly by $0.08 million from 2002 to 2003. During 2003 the Company incurredshort term note indebtedness of $0.07 million as a result of purchasing newcapital equipment under a financing arrangement.

Likewise, long-term debtwas increased by $0.09 million as a result of purchasing new capital equipmentunder a financing arrangement. In addition, the Company incurred a deferredrent liability as a result of entering into a new lease term on the Company’sU.S. office space.

**LIQUIDITY AND CAPITAL RESOURCES**

The Company’s operating activities have providedpositive cash flows for 2003 and 2002. Cash provided by operating activitieswas $2.3 million in 2003 compared to $1.8 million in 2002.

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Cash used in investing activities in 2003 increased to$1.0 million compared to $0.1 million in 2002. The Company was more active incapital asset acquisition during 2003 in an effort to improve and expandmanufacturing capabilities as well as increased leasehold improvementsassociated with moving into a new corporate facility.

During 2003, financing activities provided $0.09million compared to $1.5 million used by financing activities during 2002.  Cash provided by financing activities resultedfrom the elimination of the bank line-of-credit of $0.6 millioncompared to the prior years net decrease in borrowings on the bankline-of-credit of $1.1 million. Additionally, proceeds from the exercise ofstock options and common stock issued from the employee stock purchase plantotaled $0.7 million during 2003.

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, 2003, provided there are sufficient accounts receivableand inventory. This facility consists of two components:  (a) a demand working capital line of credit which will enable the Company toborrow up to the lesser of $3.0 million or the borrowing base; and (b) a$500,000 transaction specific revolving demand export line of credit forshort-term financing. The amount available will be the lesser of $500,000 orthe borrowing base. The Company’s borrowing base under the firstfacility equals the sum of 90% ofeligible government billed accounts receivable, 80% of the eligible commercialbilled accounts receivable and 20% of eligible related inventory capped at$500,000. The Company’s borrowing base under the second facility equals the sumof 75% of the eligible export-related inventory and 90% of the eligibleexport-related accounts receivable. This facility is guaranteed 90% by theExport-Import Bank of the United States (“Ex-Im Bank”) under Ex-Im Bank’sWorking Capital Guarantee Program.

The first facility carries interest at the rate ofLIBOR (1.46% at December 31, 2003) plus 3.5%. The second facility carriesinterest at the rate of PRIME (4.0% at December 31, 2003) 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 31,2003.

Optelecom’s future working capital needs will befinanced by our operating cash flow and continued use of the line-of-credit.In the event that operating cash flows become insufficient to meet fundingneeds, the Company may be required to scale back or eliminate product researchand development and overhead costs. Additionally, the Company would look toincrease its line of credit and/or pursue equity financing. The Company’sstrategy will focus on identifying new products that meet the demands of ourcore markets, expanding our distribution channels and implementing processeswhich will increase manufacturing efficiencies. Management fully understandsthe costs required to execute this strategy and will pursue these initiativesin a timely and fiscally prudent manner.

Thefollowing are our contractual obligations as of December 31, 2003 are asfollows:
| ** **                      | ** ** | **Total** | ** ** | **Less Than 1  Year** | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **More Than 5  Years** | ** ** |
|---------------------------------|------------|-----------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|----------------------------------|------------|
| Long-term debt  obligations     |       | $         | 157,500    |                            | $          | 67,500             |       | $                  | 90,000     |                             | $          | — |   | $ | — |   |
| Capitalized lease  obligations  |       | —    |       | —                          |       | —             |       | —             |       | —                           |       |
| Operating lease  obligations(1) |       | 5,240,307 |       | 504,508                         |       | 1,539,531          |       | 1,067,000          |       | 2,129,268                        |       |
| Purchase  obligations           |       | —    |       | —                          |       | —             |       | —             |       | —                           |       |
| Totals                          |       | $         | 5,397,807  |                            | $          | 572,008            |       | $                  | 1,629,531  |                             | $          | 1,067,000 |   | $ | 2,129,268 |   |

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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 2002 was $263,342.

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**NEW ACCOUNTING STANDARDS**

In January 2003, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 46 (FIN 46), “Consolidation ofVariable Interest Entities.” This Interpretation clarifies the application ofAccounting Research Bulletin No. 51, “Consolidated Financial Statements,” tocertain entities in which equity investors do not have the characteristics of acontrolling financial interest or do not have sufficient equity at risk for theentity to finance its activities without additional subordinated financialsupport from other parties. FIN 46 requires an enterprise to consolidate avariable interest entity if that enterprise will absorb a majority of theentity’s expected losses, is entitled to receive a majority of the entity’sexpected residual returns, or both. FIN 46 also requires disclosures aboutunconsolidated variable interest entities in which an enterprise holds asignificant variable interest. Application of FIN 46, as revised in December2003, is required for financial statements of public entities that haveinterest in variable interest entities, or potential variable interest entitiescommonly referred to as special-purpose entities for periods ending afterDecember 15, 2003. Application by public companies for all other types ofentities is required in financial statements for periods ending after March 15,2004. The Company does not expect the adoption of FIN 46 to have a materialeffect on its financial statements.

In May 2003, the FASB issued Statement ofAccounting Standards No. 150 “Accounting for Certain Financial Instrumentswith Characteristics of both Liabilities and Equity” which changes the accountingfor mandatorily redeemable shares, put options, forward purchase contracts andobligations that can be settled with shares effective for financial instrumentsentered into or modified after May 31, 2003. As the Company does not haveany of these types of instruments outstanding, the adoption of this statementdid not have any impact upon the Company’s Consolidated Financial Statements.

In December 2003, theFASB issued Staff Position (FSP) FAS 106-1, “Accounting and DisclosureRequirements Related to the Medicare Prescription Drug, Improvement andModernization Act of 2003” (the “Act”). The Act expands Medicare, primarily byadding a prescription drug benefit for Medicare-eligibles starting in 2006. TheAct provides employers currently sponsoring prescription drug programs forMedicare-eligibles with a range of options for coordinating with the newgovernment-sponsored program to potentially reduce program cost. The FSPconcludes that companies will be permitted to recognize that amount foryear-end 2003 financial statements pursuant to FAS 106 or to delay having toreport the effects of the Act until remaining questions are resolved. Managementdoes not believe the adoption of this statement will have any impact upon theCompany’s Consolidated Financial Statements.

**CRITICAL ACCOUNTING POLICIES**

Optelecom’s discussion and analysis of its financialcondition and results of operations are based upon Optelecom’s consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States of America. The preparationof these financial statements requires Optelecom to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenues andexpenses, and related disclosure of contingent assets and liabilities. On anon-going basis, Optelecom evaluates its estimates, including those related toproduct returns, bad debts, inventories, income taxes, financing operations,warranty obligations, and contingencies and litigation. Optelecom bases itsestimates on historical experience and on various other assumptions that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions.

We consider certain accounting policies related torevenue recognition, valuation of accounts receivable, inventory,  stock-based compensation and income taxes tobe critical to our business operations and the understanding of our results ofoperations. The impact and any associated risks related to these policies onour business operations is discussed throughout Management’s Discussion andAnalysis of 

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Financial Condition andResults of Operations where such policies affect our reported and expectedfinancial results. For a detailed discussion on the application of these andother accounting policies, see Notes to the Consolidated Financial Statementsin Item 14 of this Annual Report on Form 10-K.

*RevenueRecognition**—*Revenuefrom commercial sales is recognized when product is shipped and accepted.Revenues from fixed-price contracts, such as contracts from thegovernment, are recognized on the percentage-of-completion method, which relieson estimates of total expected contract revenue and costs. Optelecom followsthis method since reasonably dependable estimates of the revenue and costsapplicable to various stages of a contract can be made. Recognized revenues andprofit are subject to revisions as the contract progresses to completion.Revenues from time-and-materials contracts are recorded at the contract ratestimes 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 ofthe balance sheet date. Beginning December 2002, the Company established awarranty reserve for expenses associated with future warranty claims. Thisreserve is updated on a quarterly basis.

*Allowancefor Doubtful Accounts**—*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 animpairment of their ability to make payments, additional allowances may berequired.

*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.

*IncomeTaxes**—*The companyaccounts for income taxes in accordance with SFAS No. 109, “Accounting forIncome Taxes” which requires that deferred tax assets and liabilities berecognized using enacted tax rates for the effect of temporary differencesbetween the book and tax bases of recorded assets and liabilities. SFAS No. 109also requires that deferred tax assets be reduced by a valuation allowance ifit is more likely than not that some portion or all of the deferred tax assetwill not be realized.

At December 31, 2003 and 2002,  the company had deferred tax assets in excessof deferred tax liabilities of $1.7 million and $1.6 million, respectively. Forthe reasons cited below, at December 31, 2003 and 2002, managementdetermined that it is more likely than not that $1.7 million and $0.0 million,respectively, of such assets will be realized, resulting in a valuationallowance of $0.0 million and $1.6 million, respectively.

The company evaluates quarterly the realizability ofits deferred tax assets by assessing its valuation allowance and by adjustingthe amount of such allowance, if necessary. The factors used to assess thelikelihood of realization are the company’s forecast of future taxable incomeand available tax planning strategies that could be implemented to realize thenet deferred tax assets. The company has used tax planning strategies torealize or renew net deferred tax assets in order to avoid the potential lossof future tax benefits.

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Approximately $4.8 million of future taxable income(predominately U.S.) ultimately is needed to realize the net deferred taxassets at December 31, 2003. Failure to achieve forecasted taxable incomemight affect the ultimate realization of the net deferred tax assets. Factorsthat may affect the company’s ability to achieve sufficient forecasted taxableincome include, but are not limited to, the following: increased competition, adecline in sales or margins, loss of market share, delays in productavailability or technological obsolescence.

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 the potential change in an instrument’svalue caused by, for example, fluctuations in interest and currency exchangerates. The Company has not purchased any futures contracts nor purchased orheld any derivative financial instruments for trading purposes during thetwelve months ended December 31, 2003 and 2002. The primary market riskexposure is the risk that interest rates on our outstanding borrowings mayincrease. Optelecom also faces market risk exposure as a result of foreigncurrency translation adjustments of the Company’s foreign subsidiary, Paragon.The Company believes this risk is immaterial.

Optelecom currently has nobank line-of-credit with aggregate maximum borrowings. Optelecomhas not entered into any hedging arrangements with respect to any priorinterest obligations under these lines of credit.

**CERTAIN RISKS OF FOREIGN OPERATIONS**

In December 1997, Optelecom purchased OEL(formerly Paragon Audio Visual), which operates primarily in countries outsidethe United States and is subject to certain risks such as currency exchangerates. There can be no assurances that these factors will not have an adverseimpact on our future international sales or operating results. We do notcurrently enter into foreign currency hedging transactions and therefore may beexposed to possible losses on international transactions.

20

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***Item 8.  *FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

**Index to theConsolidated Financial Statements**
| ** **                                                                                                       | ** ** | ** ** | **Page** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------|----------|------------|
| Independent Auditors  Reports                                                                                    |       | 22         |
| Consolidated  Balance Sheets as of December 31, 2003 and 2002                                               |       | 25         |
| Consolidated  Statements of Operations for the years ended December 31, 2003, 2002 and  2001                |       | 26         |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2003, 2002 and  2001                |       | 27         |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2003, 2002 and 2001 |       | 28         |
| Notes to  Consolidated Financial Statements                                                                      |       | 29         |
| SCHEDULE  OF VALUATION AND QUALIFYING ACCOUNTS                                                                   |       | 46         |

 

21

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**INDEPENDENTAUDITORS’ REPORT**

**To the Board of Directors and**Stockholders of Optelecom, Inc.Gaithersburg, Maryland

We have audited the accompanying consolidated balancesheet of Optelecom, Inc. and subsidiaries (the Company) as of December 31,2003, and the related consolidated statements of operations, stockholders’equity and cash flows for the year ended December 31, 2003. Thesefinancial statements 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, the financial statements referred toabove present fairly, in all material respects, the financial position ofOptelecom, Inc. as of December 31, 2003, and the results of theiroperations and their cash flows for the year ended December 31, 2003 inconformity with accounting principles generally accepted in the United Statesof America.

We have also auditedSchedule II for the year ended December 31, 2003. In our opinion, thisschedule, when considered in relation to the basic financial statements takenas a whole, presents fairly, in all material respects, the information therein.

**GRANTTHORNTON, LLP**

**Baltimore, MarylandFebruary 20, 2004**

22

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**INDEPENDENTAUDITORS’ REPORT**

**To the Board of Directors andStockholders of Optelecom, Inc.Gaithersburg, Maryland**

We have audited theaccompanying consolidated balance sheets of Optelecom, Inc. andsubsidiaries (the Company) as of December 31, 2002 and the relatedconsolidated statements of operations and comprehensive income, stockholders’equity and cash flows for the year ended December 31, 2002. Our audit alsoincluded the financial statement schedule for the  year ended December 31, 2002 listed inthe index at Item 14. These financial statements and financial statementschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on the financial statements and financial statementschedule based on our audits.

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, thefinancial position of the Company as of December 31, 2002 and the resultsof its operations and its cash flows for the year ended December 31, 2002in 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**

23

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**INDEPENDENTAUDITORS’ OPINION**

To the Board of DirectorsandStockholders of Optelecom, Inc.Gaithersburg, Maryland

We have audited the accompanying consolidatedstatements of operations, stockholders’ equity and cash flows of Optelecom, Inc.and subsidiaries (“the Company”) for the year ended December 31, 2001. Ouraudit also included the consolidated financial statement schedule of valuationand qualifying accounts as of and for the year ended December 31, 2001.These consolidated financial statements and the consolidated financialstatement schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on the consolidated financialstatements and consolidated financial statement schedule based on our audit.

We conducted our audit in accordance with auditingstandards generally accepted in the United States of America. Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudit 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 31,2001 in conformity with accounting principles generally accepted in the UnitedStates of America. Also, in our opinion, such consolidated financial statementschedule, when considered in relation to the basic consolidated financialstatements taken as a whole, presents fairly, in all material respects, theinformation set forth therein.

DELOITTE & TOUCHELLP

McLean, VirginiaMarch 8, 2002

 

24

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**OPTELECOM,INC.CONSOLIDATED BALANCE SHEETSAS OF DECEMBER 31,**
| ** **                                                                                                                                                  | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                                                                                                                                  |       |       |       |       |       |
| CURRENT ASSETS                                                                                                                                              |       |       |       |       |       |
| Cash and cash equivalents                                                                                                                                   |       | $          | 1,387,866  |       | $          | 47,988 |   |
| Accounts and contracts receivable, net                                                                                                                      |       | 2,834,956  |       | 3,164,721  |       |
| Inventories, net                                                                                                                                            |       | 2,661,000  |       | 2,453,201  |       |
| Deferred tax asset—current                                                                                                                             |       | 1,069,479  |       | —     |       |
| Prepaid expenses and other current assets                                                                                                                   |       | 340,078    |       | 182,900    |       |
| Total current assets                                                                                                                                        |       | 8,293,379  |       | 5,848,810  |       |
| Property and equipment, net                                                                                                                                 |       | 1,350,366  |       | 522,983    |       |
| Restricted certificate of deposit                                                                                                                           |       | 129,368    |       | 129,368    |       |
| Deferred tax asset—non-current                                                                                                                         |       | 658,784    |       | —     |       |
| Other assets                                                                                                                                                |       | —     |       | 126,062    |       |
| TOTAL ASSETS                                                                                                                                                |       | $          | 10,431,897 |       | $          | 6,627,223 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                              |       |       |       |       |       |
| CURRENT  LIABILITIES                                                                                                                                        |       |       |       |       |       |
| Accounts payable                                                                                                                                            |       | $          | 1,052,410  |       | $          | 971,416 |   |
| Accrued payroll                                                                                                                                             |       | 315,889    |       | 255,096    |       |
| Commissions payable                                                                                                                                         |       | 287,767    |       | 369,197    |       |
| Bank line-of-credit payable                                                                                                                                 |       | —     |       | 576,079    |       |
| Current portion of leases payable                                                                                                                           |       | —     |       | 1,006      |       |
| Current portion of notes payable                                                                                                                            |       | 67,500     |       | —     |       |
| Other current liabilities                                                                                                                                   |       | 587,835    |       | 786,596    |       |
| Total current liabilities                                                                                                                                   |       | 2,311,401  |       | 2,959,390  |       |
| Notes and leases payable                                                                                                                                    |       | 90,000     |       | —     |       |
| Security deposits payable                                                                                                                                   |       | 11,526     |       |       |       |
| Deferred rent liability                                                                                                                                     |       | 62,494     |       | —     |       |
| Total liabilities                                                                                                                                           |       | 2,475,421  |       | 2,959,390  |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                              |       |       |       |       |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                 |       |       |       |       |       |
| Common stock, $.03 par value—shares authorized,  15,000,000; issued and outstanding, 3,114,898 and 2,877,891 shares as of 2003  and 2002, respectively |       | 93,446     |       | 86,336     |       |
| Additional paid-in capital                                                                                                                                  |       | 10,942,206 |       | 10,152,729 |       |
| Other comprehensive income                                                                                                                                  |       | (19,672    | )          | 41,538     |       |
| Treasury stock, 162,672 shares, at cost                                                                                                                     |       | (1,265,047 | )          | (1,265,047 | )          |
| Accumulated deficit                                                                                                                                         |       | (1,794,457 | )          | (5,347,723 | )          |
| Total stockholders’ equity                                                                                                                             |       | 7,956,476  |       | 3,667,833  |       |
| TOTAL LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                                                            |       | $          | 10,431,897 |       | $          | 6,627,223 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

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**OPTELECOM, INC.CONSOLIDATED STATEMENTS OF OPERATIONSFOR THE YEARS ENDED DECEMBER 31,**
| ** **                                              | ** ** | **2003**  | ** ** | **2002**  | ** ** | **2001**   | ** ** |
|---------------------------------------------------------|------------|-----------|------------|-----------|------------|------------|------------|
| Revenues                                                |       | $         | 17,119,658 |      | $          | 14,908,554 |       | $ | 13,176,919 |   |
| Cost of goods  sold                                     |       | 7,836,377 |       | 6,810,017 |       | 6,903,386  |       |
| Gross profit                                            |       | 9,283,281 |       | 8,098,537 |       | 6,273,533  |       |
| Operating  expenses:                                    |       |      |       |      |       |       |       |
| Engineering                                             |       | 1,370,933 |       | 1,145,532 |       | 1,451,913  |       |
| Selling and marketing                                   |       | 2,817,327 |       | 2,605,130 |       | 2,423,415  |       |
| General and administrative                              |       | 3,122,686 |       | 2,735,756 |       | 3,142,262  |       |
| Total operating expenses                                |       | 7,310,946 |       | 6,486,418 |       | 7,017,590  |       |
| Income (loss) from operations                           |       | 1,972,335 |       | 1,612,119 |       | (744,057   | )          |
| Other income  (expense):                                |       |      |       |      |       |       |       |
| Interest expense, net                                   |       | (10,346   | )          | (90,864   | )          | (189,528   | )          |
| Other income                                            |       | —    |       | 139,540   |       | —     |       |
| Total other income (expense)                            |       | (10,346   | )          | 48,676    |       | (189,528   | )          |
| Income (loss) before income taxes                       |       | 1,961,989 |       | 1,660,795 |       | (933,585   | )          |
| Benefit  (provision) for income taxes                   |       | 1,591,277 |       | (16,675   | )          | —     |       |
| Net income (loss)                                       |       | $         | 3,553,266  |      | $          | 1,644,120  |       | $ | (933,585 | ) |
| Basic earnings (loss) per share                         |       | $         | 1.18       |      | $          | 0.58       |       | $ | (0.33 | ) |
| Diluted earnings (loss) per share                       |       | $         | 1.11       |      | $          | 0.56       |       | $ | (0.33 | ) |
| Weighted average common shares outstanding—basic   |       | 3,019,279 |       | 2,850,587 |       | 2,825,651  |       |
| Weighted average common shares outstanding—diluted |       | 3,197,807 |       | 2,940,026 |       | 2,825,651  |       |
| Net income (loss)                                       |       | $         | 3,553,266  |      | $          | 1,644,120  |       | $ | (933,585 | ) |
| Foreign currency  translation                           |       | (61,210   | )          | (185,591  | )          | 24,233     |       |
| Comprehensive income  (loss)                            |       | $         | 3,492,056  |      | $          | 1,458,529  |       | $ | (909,352 | ) |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

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**OPTELECOM, INC.CONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE YEARS ENDED DECEMBER 31,**
| ** **                                                                                          | ** ** | **2003**   | ** ** | **2002**    | ** ** | **2001**    | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------|------------|-------------|------------|-------------|------------|
| Cash Flows From Operating  Activities                                                               |       |       |       |        |       |        |       |
| Net income (loss)                                                                                   |       | $          | 3,553,266  |        | $          | 1,644,120   |       | $ | (933,585 | ) |
| Adjustments to reconcile  net income (loss) to net cash provided by (used in) operating activities: |       |       |       |        |       |        |       |
| Depreciation and amortization                                                                       |       | 332,822    |       | 360,927     |       | 425,125     |       |
| Loss (gain) on disposal of equipment                                                                |       | —     |       | 8,110       |       | (294        | )          |
| Write off discount on common stock                                                                  |       | —     |       | 11,161      |       | —      |       |
| Accounts receivable provision                                                                       |       | (54,356    | )          | 54,697      |       | 49,982      |       |
| Inventory provision                                                                                 |       | (24,005    | )          | (48,704     | )          | 92,833      |       |
| Stock based compensation                                                                            |       | —     |       | 6,432       |       | 2,102       |       |
| Deferred rent                                                                                       |       | 62,494     |       | (33,111     | )          | (44,568     | )          |
| Deferred tax asset                                                                                  |       | (1,624,158 | )          | —      |       | —      |       |
| Change in assets and  liabilities:                                                                  |       |       |       |        |       |        |       |
| Accounts and contracts receivable                                                                   |       | 384,120    |       | (741,373    | )          | 943,740     |       |
| Inventories                                                                                         |       | (183,794   | )          | 391,151     |       | (1,085,789  | )          |
| Prepaid expenses and other assets                                                                   |       | (157,178   | )          | (45,502     | )          | (26,317     | )          |
| Restricted certificates of deposit                                                                  |       | —     |       | —      |       | (129,368    | )          |
| Other assets                                                                                        |       | 126,062    |       | (126,062    | )          | 144,691     |       |
| Accounts payable                                                                                    |       | 80,994     |       | (275,667    | )          | 189,788     |       |
| Other current liabilities                                                                           |       | (219,399   | )          | 624,609     |       | 58,589      |       |
| Net cash provided by (used in) operating activities                                                 |       | 2,276,868  |       | 1,830,788   |       | (313,071    | )          |
| Cash Flows From  Investing Activities                                                               |       |       |       |        |       |        |       |
| Proceeds from sale of equipment                                                                     |       | —     |       | 5,841       |       | —      |       |
| Security deposit                                                                                    |       | 11,526     |       | —      |       | —      |       |
| Capital expenditures                                                                                |       | (980,205   | )          | (123,510    | )          | (90,849     | )          |
| Net cash used in investing activities                                                               |       | (968,679   | )          | (117,669    | )          | (90,849     | )          |
| Cash Flows From  Financing Activities                                                               |       |       |       |        |       |        |       |
| Borrowings on bank line-of-credit payable                                                           |       | 2,020,551  |       | 11,406,756  |       | 12,406,384  |       |
| Payments on bank line-of-credit payable                                                             |       | (2,596,630 | )          | (12,506,542 | )          | (11,399,055 | )          |
| Payments on notes payable and capital leases                                                        |       | (23,506    | )          | (543,777    | )          | (837,510    | )          |
| Proceeds from issuance of common stock                                                              |       | 58,636     |       | 64,226      |       | 33,809      |       |
| Proceeds from exercise of stock options                                                             |       | 633,847    |       | 40,928      |       | 1,000       |       |
| Net cash provided by (used in) financing activities                                                 |       | 92,898     |       | (1,538,409  | )          | 204,628     |       |
| Effect of exchange rates on cash and cash equivalents                                               |       | (61,210    | )          | (185,591    | )          | 24,233      |       |
| Net increase (decrease) in cash and cash equivalents                                                |       | 1,339,878  |       | (10,881     | )          | (175,059    | )          |
| Cash and cash equivalents—beginning of period                                                  |       | 47,988     |       | 58,869      |       | 233,928     |       |
| Cash and cash equivalents—end of period                                                        |       | $          | 1,387,866  |        | $          | 47,988      |       | $ | 58,869 |   |
| Supplemental  Disclosures of Cash Flow Information:                                                 |       |       |       |        |       |        |       |
| Cash paid during the year for interest                                                              |       | $          | 15,436     |        | $          | 105,895     |       | $ | 186,287 |   |
| Cash paid during the year for income taxes                                                          |       | $          | 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 consolidatedfinancial statements.

27

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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, 2001                              |       | 2,809,725                  |       | $                 | 84,292     |                            | $          | (11,161                          | )          | $                          | 10,033,138 |                     |       | $                                             | (26,862    | )                   |       | $                                     | (6,058,258 | ) |   | $ | 202,896 |   |   | $ | (1,265,047 | ) |   | $ | 2,958,998 |   |   |
| Common stock issued from exercise of options               |       | 500                        |       | 15                |       | —                          |       | 985                              |       |                       | —     |                     |       | —                                        |       |                | —     |                                  |       | — |   |   | 1,000 |   |   |
| Common stock issued from employee stock purchase plan      |       | 23,096                     |       | 693               |       |                            |       | 33,116                           |       |                       | —     |                     |       | —                                        |       |                | —     |                                  |       | — |   |   | 33,809 |   |   |
| Foreign currency translation                               |       | —                     |       | —            |       | —                          |       | —                           |       |                       | —     |                     |       | —                                        |       |                | 24,233     |                                  |       | — |   |   | 24,233 |   |   |
| Stock based compensation                                   |       | —                     |       | —            |       | —                          |       | —                           |       |                       | 14,682     |                     |       | —                                        |       |                | —     |                                  |       | — |   |   | 14,682 |   |   |
| Forfeiture of stock options                                |       | —                     |       | —            |       | —                          |       | (18,328                          | )          |                       | 5,748      |                     |       | —                                        |       |                | —     |                                  |       | — |   |   | (12,580 | ) |   |
| Net loss                                                   |       | —                     |       | —            |       | —                          |       | —                           |       |                       | —     |                     |       | (933,585                                      | )          |                | —     |                                  |       | — |   |   | (933,585 | ) |   |
| BALANCE, DECEMBER 31, 2001                                 |       | 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 issed 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 and  warrants |       | 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 |   |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

28

 

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**OPTELECOM, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001**

**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 reorganized its operations during 2003 intotwo operating segments: the Communication Products Division  (CPD) and the Electro-optics Technology Unit(EO). CPD develops, manufactures, and sells optical fiber based datacommunication equipment to both commercial and government clients. EOfabricates precision-wound coils of optical fiber used in fiber opticgyroscopes and manufactures innovative optical devices under contract,primarily to government and defense industry customers. Segment information forall prior periods has been restated to conform to the current presentation.

*Principles of Consolidation**—*The consolidated financial statementsinclude the accounts of the Company and its wholly owned subsidiaries,Optelecom UK Limited (Optelecom UK), and Optelecom Europe Limited. Allsignificant inter-company transactions and balances have been eliminated.

*Use of Estimates**—*The preparation of financial statementsin conformity with accounting principles generally accepted in the UnitedStates of America requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenue and expenses during the reporting period.Actual results could differ from those estimates.

*Accounts Receivable**—*Accounts receivable potentially subjectthe Company to concentrations of credit risk. Credit is extended based onevaluation of a customer’s financial condition and, generally, collateral isnot required. Accounts receivable are due within 30 days and are stated atamounts due from the customers net of an allowance for doubtful accounts. Accountsoutstanding longer than the contractual payment terms are considered past due. TheCompany determines its allowances considering a number of factors, includingthe length of time trade accounts receivable are past due, the Company’sprevious loss history, the customer’s current ability to pay its obligations tothe Company, and the condition of the general economy and the industry as awhole. The Company believes that its allowance for doubtful accounts isadequate to cover any potential losses on its credit risk exposure. The Companywrites off accounts receivable when they become uncollectible, and paymentssubsequently received on such receivables are credited to the allowances fordoubtful accounts.

*Revenue Recognition**—*Revenue from commercial sales isrecognized when product is shipped. Revenues from fixed-price contracts,such as contracts from the government, are recognized on the percentage-of-completionmethod based on costs incurred in relation to total estimated costs. Revenuesfrom time-and-materials contracts are recorded at the contractrates times the labor hours plus other direct costs as incurred. Shipping andhandling fees and the related costs are recorded as components of cost of goodssold.

***Product Warranty***—In the ordinary course of business, the Company warrants itsproducts against defect in design, materials, and workmanship over various timeperiods. Beginning in July 2002 the Company offers a lifetime warranty onits products. Prior to 2002 the warranty period was limited to four years. Warrantyreserve and allowance for product returns is established based upon management’sbest estimates of amounts necessary to settle future and existing claims onproducts sold as of the balance sheet date.

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*Inventories**—*Production materials are valued at thelower of cost or market applied on a weighted average 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.

*Property, Equipment, and Depreciation**—*Property and equipment are recorded atcost and are depreciated using the straight-line method over theestimated useful lives of the assets, which range from 5 to 10 years. Leaseholdimprovements are amortized over the terms of the respective leases or theservice lives of the assets, whichever is shorter. Expenditures for maintenanceand repairs are expensed as incurred.

*Impairment of Long-Lived Assets**—*The Company periodically reviews thecarrying value of long-lived assets including property and equipment forimpairment whenever events or changes in circumstances indicate that thecarrying amount of assets may not be recoverable.  Recovery of assets to be held and used ismeasured by comparing the carrying value of these assets with the expectedfuture cash flows generated by the assets. If the assets are considered to beimpaired, the impairment is recognized by the amount which the carrying amountof the assets exceeds their fair value. No such impairment losses were recordedduring 2003, 2002 or 2001.

*Research and Development Costs**—*Research and development costs areexpensed as incurred as a component of engineering expense in the consolidatedstatements of operations. The Company incurred research and development costsof $979,000, $847,000 and $958,000 for the years ended December 31, 2003,2002 and 2001, respectively.

*Income Taxes*—The Company accounts for incometaxes using the asset and liability approach as defined by FASB No. 109, “Accountingfor 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-Based Compensation**—*The Company haselected to follow Accounting Principles Board (APB) Opinion No. 25, “*Accounting for Stock Issued to Employees*,”(APB 25) and related interpretations, in accounting for its employee stockoptions and complies with the disclosure requirements of SFAS No. 123, “*Accounting for Stock-Based Compensation*”(FAS 123). APB 25 provides that the compensation expense relative to theCompany’s employee stock options is measured based on the intrinsic value ofthe stock option. FAS 123 requires companies that continue to follow APB 25 toprovide a pro forma disclosure of the impact of applying the fair value methodof FAS 123.

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.

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Stock-based compensation related to options granted tononemployees 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.
| ** **                                                                                                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001**  | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Net income  (loss), as reported                                                                              |       | $        | 3,553,266  |     | $          | 1,644,120 |       | $ | (933,585 | ) |
| Less: Stock-based  employee compensation costs, net of income tax, as if fair value method had  been applied |       | (405,601 | )          | (175,438 | )          | (142,056  | )          |
| Net income (loss)  pro forma                                                                                 |       | $        | 3,147,665  |     | $          | 1,468,682 |       | $ | (1,075,641 | ) |
| Basic income (loss) per  share:                                                                              |       |     |       |     |       |      |       |
| As reported                                                                                                  |       | $        | 1.18       |     | $          | 0.58      |       | $ | (0.33 | ) |
| Pro forma                                                                                                    |       | $        | 1.04       |     | $          | 0.52      |       | $ | (0.38 | ) |
| Diluted income  (loss) per share:                                                                            |       |     |       |     |       |      |       |
| As reported                                                                                                  |       | $        | 1.11       |     | $          | 0.56      |       | $ | (0.33 | ) |
| Pro forma.                                                                                                   |       | $        | 0.98       |     | $          | 0.50      |       | $ | (0.38 | ) |

 

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 2003, 2002, and 2001 was$5.89, $3.15 and $1.67 respectively. The fair value of each option is estimatedon the date of grant using the Black Scholes option-pricing model with thefollowing assumptions used for grants issued during the years ended December 31,2003, 2002, and 2001:
| ** **                       | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected dividend  yield         |       | 0        | %          | 0        | %          | 0        | %          |
| Expected stock  price volatility |       | 122      | %          | 129      | %          | 118      | %          |
| Risk-free  interest rate         |       | 2.27     | %          | 2.39     | %          | 3.99     | %          |
| Average expected life            |       | 4 years  |       | 4 years  |       | 4 years  |       |

* *

*Foreign Currency Translation**—*The Company translates the assets andliabilities of its foreign subsidiaries into U.S. dollars at the currentexchange rate in effect at the end of the year. The gains and losses thatresult 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 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**—*The Company considers all liquidinvestments with original maturities of three months or less at the time ofpurchase to be cash equivalents.

*Restricted Certificate of Deposit**—*The Company has provided a performancebond in relation to a contract which is secured by a letter of credit in theamount of $129,368. This letter of credit is fully collateralized by acertificate of deposit. The certificate of deposit is redeemable by the Companyupon the satisfactory completion of the contract in 2005.

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*Fair Value of Financial Instruments**—*The carrying amounts of the Company’sfinancial instruments, which include cash equivalents, trade receivables,accounts payables and accrued expenses, and the revolving credit agreementapproximate their fair values due to the short maturities.

*Earnings Per Share**—*Basic earnings per share is computed bydividing net income (loss) by weighted average shares outstanding. No dilutionfor any potentially dilutive securities is included in basic earnings per share.Diluted earnings per share is computed by dividing net income (loss) byweighted average shares and common equivalent shares outstanding.

Thecomputation of weighted average shares outstanding for the years ended December 31,2003, 2002 and 2001 is as follows:
| ** **                                      | ** ** | **2003**  | ** ** | **2002**  | ** ** | **2001**  | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Basic Earnings  (Loss) Per Share:               |       |      |       |      |       |      |       |
| Earning (loss) available to common stockholders |       | $         | 3,553,266  |      | $          | 1,644,120 |       | $ | (933,585 | ) |
| Weighted average common shares outstanding      |       | 3,019,279 |       | 2,850,587 |       | 2,825,651 |       |
| Basic earnings (loss) per share                 |       | $         | 1.18       |      | $          | 0.58      |       | $ | (0.33 | ) |
| Diluted Earnings  (Loss) Per Share:             |       |      |       |      |       |      |       |
| Earning (loss) available to common stockholders |       | $         | 3,553,266  |      | $          | 1,644,120 |       | $ | (933,585 | ) |
| Weighted average common shares outstanding      |       | 3,019,279 |       | 2,850,587 |       | 2,825,651 |       |
| Effect of stock options and warrants            |       | 178,528   |       | 89,439    |       | —    |       |
| Diluted Shares                                  |       | 3,197,807 |       | 2,940,026 |       | 2,825,651 |       |
| Diluted earnings (loss)  per share              |       | $         | 1.11       |      | $          | 0.56      |       | $ | (0.33 | ) |

 

Options outstanding for 5,486 shares for 2001 areexcluded from the calculation of weighted average common shares—dilutivebecause they are anti-dilutive as a result of the Company’s net loss in2001.

*Recent Accounting Pronouncements**—*In January 2003, theFinancial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46(FIN 46), “Consolidation of Variable Interest Entities.” This Interpretationclarifies the application of Accounting Research Bulletin No. 51, “ConsolidatedFinancial Statements,” to certain entities in which equity investors do nothave the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties. FIN 46 requiresan enterprise to consolidate a variable interest entity if that enterprise willabsorb a majority of the entity’s expected losses, is entitled to receive amajority of the entity’s expected residual returns, or both. FIN 46 alsorequires disclosures about unconsolidated variable interest entities in whichan enterprise holds a significant variable interest. Application of FIN 46, asrevised in December 2003, is required for financial statements of publicentities that have interest in variable interest entities, or potentialvariable interest entities commonly referred to as special-purpose entities forperiods ending after December 15, 2003. Application by public companies for allother types of entities is required in financial statements for periods endingafter March 15, 2004. The Company does not expect the adoption of FIN 46 tohave a material effect on its financial statements.

In May 2003, the FASB issued Statement ofAccounting Standards No. 150 “Accounting for Certain Financial Instrumentswith Characteristics of both Liabilities and Equity” which changes theaccounting for mandatorily redeemable shares, put options, forward purchasecontracts and obligations that can be settled with shares effective forfinancial instruments entered into or modified after May 31, 2003. As theCompany does not have any of these types of instruments outstanding, theadoption of this statement did not have any impact upon the Company’sConsolidated Financial Statements.

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In December 2003, theFASB issued Staff Position (FSP) FAS 106-1, “Accounting and DisclosureRequirements Related to the Medicare Prescription Drug, Improvement andModernization Act of 2003” (the “Act”). The Act expands Medicare, primarily byadding a prescription drug benefit for Medicare-eligibles starting in 2006. TheAct provides employers currently sponsoring prescription drug programs forMedicare-eligibles with a range of options for coordinating with the newgovernment-sponsored program to potentially reduce program cost. The FSPconcludes that companies will be permitted to recognize that amount foryear-end 2003 financial statements pursuant to FAS 106 or to delay having toreport the effects of the Act until remaining questions are resolved. Managementdoes not believe the adoption of this statement will have any impact upon theCompany’s Consolidated Financial Statements.

**2. ACCOUNTS ANDCONTRACTS RECEIVABLE**

Accountsand contracts receivable consisted of the following at December 31:
| ** **                             | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|
| Accounts and  contracts receivable     |       | $        | 2,937,040  |     | $          | 3,321,160 |   |
| Less: Allowance  for doubtful accounts |       | (102,084 | )          | (156,439 | )          |
|                                   |       | $        | 2,834,956  |     | $          | 3,164,721 |   |

 

**3. INVENTORIES**

Inventoriesconsisted of the following at December 31:
| ** **                  | ** ** | **2003** | ** ** | **2002**  | ** ** |
|-----------------------------|------------|----------|------------|-----------|------------|
| Production  materials       |       | $        | 1,637,331  |      | $          | 1,367,886 |   |
| Work in process             |       | 414,639  |       | 210,637   |       |
| Finished goods              |       | 889,022  |       | 1,178,674 |       |
| Allowance for  obsolescence |       | (279,992 | )          | (303,996  | )          |
| Net                         |       | $        | 2,661,000  |      | $          | 2,453,201 |   |

 

**4.  PROPERTY AND EQUIPMENT**

Propertyand equipment consisted of the following at December 31:
| ** **                                      | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
| Laboratory  equipment                           |       | $          | 1,695,428  |       | $          | 1,362,570 |   |
| Office equipment                                |       | 1,998,705  |       | 1,894,916  |       |
| Furniture and  fixtures                         |       | 83,159     |       | 75,018     |       |
| Leasehold  improvements                         |       | 500,199    |       | 572,449    |       |
| Computer hardware  and software                 |       | 99,806     |       | —     |       |
|                                            |       | 4,377,297  |       | 3,904,953  |       |
| Less accumulated  depreciation and amortization |       | (3,026,931 | )          | (3,381,970 | )          |
| Net property and  equipment                     |       | $          | 1,350,366  |       | $          | 522,983 |   |

 

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Assetsunder capital leases are included in the above categories and consisted of thefollowing:
| ** **                       | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
| Laboratory  equipment            |       | $        | 85,171     |     | $          | 85,171 |   |
| Office equipment                 |       | 52,389   |       | 63,437   |       |
|                             |       | 137,560  |       | 148,608  |       |
| Less accumulated  amortization   |       | (92,915  | )          | (95,273  | )          |
| Net assets under capital  leases |       | $        | 44,645     |     | $          | 53,335 |   |

 

Depreciation expense was$332,822, $360,927 and $425,125 for the years ended December 31, 2003,2002 and 2001, respectively.

**5. OTHER CURRENTLIABILITIES**

Othercurrent liabilities consisted of the following at December 31:
| ** **                 | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|
| Accrued expenses           |       | $        | 400,568    |     | $          | 339,087 |   |
| Income taxes  payable      |       | 20,782   |       | 16,675   |       |
| Other current  liabilities |       | 166,485  |       | 430,834  |       |
| Other current  liabilities |       | $        | 587,835    |     | $          | 786,596 |   |

 

**6.  INCOME TAXES**

The components of income from continuing operationsbefore income taxes consisted of the following for the years ended December 31:
| ** **          | ** ** | **2003** | ** ** | **2002** | ** ** | **2001**  | ** ** |
|---------------------|------------|----------|------------|----------|------------|-----------|------------|
| U.S. Operations     |       | $        | 1,621,094  |     | $          | 1,910,125 |       | $ | (508,363 | ) |
| Non-U.S. Operations |       | 340,895  |       | (249,150 | )          | (425,222  | )          |
|                |       | $        | 1,961,989  |     | $          | 1,660,975 |       | $ | (933,585 | ) |

 

Thecomponents of the expense (benefit) provision for income taxes for the yearsended December 31 are summarized as follows:
| **Current expense (benefit)** | ** ** | ** ** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|-----------------------------------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|
| U.S. Operations                         |       | $          | 27,153     |     | $          | 16,675   |       | $        | —     |   |
| Non-U.S.  Operations                    |       | —     |       | —   |       | —   |       |
|                                    |       | $          | 27,153     |     | $          | 16,675   |       | $        | —     |   |

 
| **Deferred expense (benefit)** | ** ** | ** ** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|------------------------------------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|
| U.S. Operations                          |       | $          | (1,324,455 | )        | $          | —   |       | $        | —     |   |
| Non-U.S.  Operations                     |       | (293,975   | )          | —   |       | —   |       |
|                                     |       | $          | (1,618,430 | )        | $          | —   |       | $        | —     |   |
| **Total**                                |       | $          | (1,591,277 | )        | $          | 16,675   |       | $        | —     |   |

 

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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:
| ** **                                              | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| United States  Federal tax at statutory rates           |       | 34.0     | %          | 34.0     | %          | 34.0     | %          |
| (Reduction)  increase of taxes:                         |       |     |       |     |       |     |       |
| State taxes, net of federal benefit                     |       | 1.9      |       | 3.3      |       | 2.6      |       |
| Valuation allowance related to net deferred tax  assets |       | (116.8   | )          | (45.1    | )          | (17.1    | )          |
| Income from foreign subsidiary                          |       | —   |       | 7.8      |       | (15.5    | )          |
| Life insurance                                          |       | —   |       | —   |       | (4.2     | )          |
| Other                                                   |       | (0.2     | )          | (1.1     | )          | 0.2      |       |
| Effective income  tax rate                              |       | (81.1    | )%         | (1.1     | )%         | 0.0      | %          |

 

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:
| ** **                      | ** ** | **2003**  | ** ** | **2002**   | ** ** |
|---------------------------------|------------|-----------|------------|------------|------------|
| Gross deferred tax assets:      |       |      |       |       |       |
| Excess book depreciation        |       | $         | 97,215     |       | $          | 100,120 |   |
| Inventory                       |       | 199,256   |       | 92,905     |       |
| Accrued vacation                |       | 60,329    |       | 50,321     |       |
| Deferral of rent expense        |       | 22,898    |       | —     |       |
| Bad debt reserve                |       | 41,676    |       | 57,319     |       |
| Accrued warranty reserve        |       | 22,294    |       | —     |       |
| Tax credits                     |       | 311,792   |       | —     |       |
| Other                           |       | 1,979     |       | 121,501    |       |
| Net operating loss—non-US  |       | 191,818   |       | —     |       |
| Net operating loss              |       | 779,006   |       | 1,193,802  |       |
| Gross deferred tax assets       |       | 1,728,263 |       | 1,615,968  |       |
| Less: valuation allowance       |       | —    |       | (1,615,968 | )          |
| Net deferred tax assets         |       | 1,728,263 |       | —     |       |
| Gross deferred tax liabilities: |       |      |       |       |       |
| Other                           |       | (5,730    | )          | —     |       |
| Net deferred tax  assets        |       | $         | 1,722,533  |       | $          | — |   |

 

As of December 31, 2003, Optelecom had taxeffected net operating loss and business tax credit carryforwards ofapproximately $779,000 and $267,000, 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, 2003, Optelecom had tax effectednet operating loss carryforwards in jurisdictions outside the United States ofapproximately $192,000, which carry forward indefinitely.

In evaluating the Company’sability to recover its deferred tax assets, we considered all available positiveand negative evidence, including past operating results, the reversal oftemporary 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 

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consistentwith estimates being used to manage the business. Based on the weight of thepositive and negative evidence and the information available, Optelecombelieves that it is more likely than not that its deferred tax assets will berealized.

**7.  NOTES PAYABLE 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, 2003, provided there are sufficient accounts receivableand inventory,. This facility consists of two components:  (a) a demand working capital line of credit which will enable the Company toborrow up to the lesser of $3.0 million or the borrowing base; and (b) a$500,000 transaction specific revolving demand export line of credit forshort-term financing. The amount available will be the lesser of $500,000 orthe borrowing base. The Company’s borrowing base under the firstfacility equals the sum of 90% ofeligible government billed accounts receivable, 80% of the eligible commercialbilled accounts receivable and 20% of eligible related inventory capped at$500,000. The Company’s borrowing base under the second facility equals the sumof 75% of the eligible export-related inventory and 90% of the eligibleexport-related accounts receivable. This facility is guaranteed 90% by theExport-Import Bank of the United States (“Ex-Im Bank”) under Ex-Im Bank’sWorking Capital Guarantee Program.

The first facility carries interest at the rate ofLIBOR (1.46% at December 31, 2003) plus 3.5%. The second facility carriesinterest at the rate of PRIME (4.0% at December 31, 2003) 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 31,2003.

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.

In December 1998, the Company received a loan of$60,000 from the Economic Development Fund of Montgomery County, Maryland tomaintain or establish jobs and an economic presence in Montgomery County,Maryland. The entire principal balance of $60,000 was paid during 2002,resulting in no future obligations.

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

**8.  COMMITMENTS AND CONTINGENCIES**

*Operating Leases**—*The Company’s operating lease for the corporateoffice and manufacturing facilities expired August 31, 2002 and theCompany negotiated a lease extension through March, 2003. In November 2002,the Company entered into a lease to occupy a new facility located inGermantown, Maryland. As an inducement to enter the new lease, the Companyreceived certain incentives such as rent abatement. Additionally, the leaseprovides for scheduled rent increases. These lease incentives will be amortizedover the lease period. Rent expense is being recognized on a straight-linebasis.

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

 

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As of December 31,2003, 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:** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|------------|------------|------------|------------|
| 2004                                       |       | $          | 504,508    |       |
| 2005                                       |       | 517,175    |       |
| 2006                                       |       | 511,332    |       |
| 2007                                       |       | 511,024    |       |
| 2008                                       |       | 525,617    |       |
| Thereafter                                 |       | 2,670,651  |       |
|                                       |       | $          | 5,240,307  |       |

 

Rental expense was $530,478, $263,642 and $261,627 in2003, 2002 and 2001, respectively.

During 2003 and 2002, 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.

**9.  STOCKHOLDERS’ EQUITY**

*Common Stock**—*During 2002 and 2003, proceeds from theexercise of stock options were $40,928 and $633,847, respectively.

*Director’s Stock Compensation**—*Each non-employee Director receives stockoptions to purchase 1,000 shares of common stock for each board meetingattended either in person or by telephone. Additionally, each non-employeeDirector is granted 1,000 shares of restricted common stock at the closingprice on the date of the annual shareholders’ meeting.

*Stock Options**—*The 2000 Nonqualified Employee StockOption Plan was terminated and rolled into the 2002 Incentive Stock Option Plan.The Company issued 23,400 options under the 2000 Plan. The exercise price ofeach option was the fair market value of the stock at the grant date. Optionsare exercisable after one year from the date of grant and in equal incrementsover four years. Options expire five years from the date of grant and, in mostcases, upon termination of employment.

The 2002 Incentive Stock Option Plan provides for upto 276,600 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 143,399 options available for future grant at December 31,2003. 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 fromthe grant date. Options expire five years from the date of grant and, in mostcases, upon termination of employment.

37

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Asummary of stock option activity for the Non-qualified Employee andIncentive Stock Option Plans during the years ended December 31 is asfollows:
| ** **                             | ** ** | **2003**   | ** ** | **2002**                               | ** ** | **2001**   | ** ** |
|----------------------------------------|------------|------------|------------|----------------------------------------|------------|------------|------------|
| ** **                             | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding,  January 1           |       | 164,938    |       |                                   | $          | 3.72       |       |   | 176,801 |   |   | $ | 4.37 |   |   | 293,937 |   |   | $ | 4.55 |   |   |
| Granted                                |       | 103,851    |       |                                   | 5.30       |       |       | 39,700 |   |   | 3.95 |   |   | 42,800 |   |   | 2.06 |   |   |
| Exercised                              |       | 72,764     |       |                                   | 3.73       |       |       | 16,169 |   |   | 2.36 |   |   | 500 |   |   | 2.00 |   |   |
| Canceled                               |       | 8,475      |       |                                   | 5.45       |       |       | 35,394 |   |   | 7.79 |   |   | 159,436 |   |   | 4.17 |   |   |
| Outstanding, end of year               |       | 187,550    |       |                                   | $          | 4.51       |       |   | 164,938 |   |   | $ | 3.72 |   |   | 176,801 |   |   | $ | 4.37 |   |   |
| Exercisable  options, December 31 |       | 72,915     |       |                                   | $          | 4.31       |       |   | 82,971 |   |   | $ | 4.05 |   |   | 84,641 |   |   | $ | 5.45 |   |   |

 

Thefollowing table summarizes information about stock options outstanding at December 31,2003:
| ** **                                 | ** ** | **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** | ** ** |
| $1.44 to $3.25                             |       |                         | 48,781     |                         |       |   | 2.28 |   |   |   | $ | 2.37 |   |   |   | 26,557 |   |   |   | $ | 2.44 |   |   |
| $3.38 to $4.65                             |       |                         | 18,012     |                         |       |   | 1.89 |   |   |   | 3.55 |   |   |   | 9,212 |   |   |   | 3.58 |   |   |
| $4.66 to $4.66                             |       |                         | 83,207     |                         |       |   | 4.02 |   |   |   | 4.66 |   |   |   | 15,821 |   |   |   | 4.66 |   |   |
| $4.77 and above                            |       |                         | 37,550     |                         |       |   | 3.26 |   |   |   | 7.40 |   |   |   | 21,325 |   |   |   | 6.69 |   |   |
|                                       |       |                         | 187,550    |                         |       |   | 3.21 |   |   |   | $ | 4.51 |   |   |   | 72,915 |   |   |   | $ | 4.31 |   |   |
|                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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 144,500 options available for future grant atDecember 31, 2003.

Asummary of stock option activity for the Non-qualified Director Planduring the year ended December 31 is as follows:
| ** **                             | ** ** | **2003**   | ** ** | **2002**                               | ** ** | **2001**   | ** ** |
|----------------------------------------|------------|------------|------------|----------------------------------------|------------|------------|------------|
| ** **                             | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding,  January 1           |       | 91,250     |       |                                   | $          | 3.85       |       |   | 83,000 |   |   | $ | 3.68 |   |   | 57,750 |   |   | $ | 4.55 |   |   |
| Granted                                |       | 15,500     |       |                                   | 9.81       |       |       | 17,000 |   |   | 3.74 |   |   | 26,750 |   |   | 2.32 |   |   |
| Exercised                              |       | 51,250     |       |                                   | 3.18       |       |       | 8,750 |   |   | 2.98 |   |   | — |   |   | — |   |   |
| Canceled                               |       | —     |       |                                   | —     |       |       | — |   |   | — |   |   | 1,500 |   |   | 3.50 |   |   |
| Outstanding, end  of year              |       | 55,500     |       |                                   | $          | 6.14       |       |   | 91,250 |   |   | $ | 3.85 |   |   | 83,000 |   |   | $ | 3.68 |   |   |
| Exercisable options,  December 31 |       | 55,500     |       |                                   | $          | 6.14       |       |   | 91,250 |   |   | $ | 3.85 |   |   | 83,000 |   |   | $ | 3.68 |   |   |

 

38

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Thefollowing table summarizes information about stock options outstanding at December 31,2003:
| ** **                                 | ** ** | **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 $2.61                             |       |                         | 15,000     |                         |       |   | 2.64 |   |   |   | $ | 2.34 |   |   |   | 15,000 |   |   |   | $ | 2.34 |   |   |
| $2.74 to $4.88                             |       |                         | 15,250     |                         |       |   | 1.95 |   |   |   | 3.73 |   |   |   | 15,250 |   |   |   | 3.73 |   |   |
| $5.00 to $10.49                            |       |                         | 14,750     |                         |       |   | 3.40 |   |   |   | 7.08 |   |   |   | 14,750 |   |   |   | 7.08 |   |   |
| $10.82 and above                           |       |                         | 10,500     |                         |       |   | 3.25 |   |   |   | 13.75 |   |   |   | 10,500 |   |   |   | 13.75 |   |   |
|                                       |       |                         | 55,500     |                         |       |   | 2.77 |   |   |   | $ | 6.14 |   |   |   | 55,500 |   |   |   | $ | 6.14 |   |   |
|                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**10.  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 2003, 2002 and 2001.

The Company also has acontributory cash and deferred profit sharing plan qualified under Section 401(k)of the Internal Revenue Code for all of the Company’s full-timeemployees. The Company matches employee contributions to the plan up to amaximum of 2.5%. Total matching contributions were $84,318, $59,036 and $69,127in 2003, 2002 and 2001, respectively.

**11.  BUSINESS SEGMENT INFORMATION**

**Description of the Types of Products from which each SegmentDerives 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.

**Measurement of Segment Profit of Loss and SegmentAssets**

The Company evaluatesperformance and allocates resources based on profit or loss from operationsbefore income taxes. The accounting policies of the reportable segments are thesame as described in the summary of significant accounting policies. Inter-segmentsales at current market prices.

39

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**Factors Management Used to Identify the Company’sReportable 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 fiscal2003, 2002, and 2001:
| ** **                     | ** ** | **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                         |       |                                                 | 9,190,104  |   |   | 306,424 |   | 9,496,528 |   |
| 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           |       |                                                 | 123,511    |   |   | — |   | 123,511 |   |
|                                |            |                                                      |            |  |  |  |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Year ended December 31, 2001** | ** ** |
|--------------------------------|------------|------------------------------------------------------|------------|
| ** **                     | ** ** | **Communication  Products Division**            | ** ** | **Electro-  Optics  Division** | ** ** | **Total** | ** ** |
| Revenues                       |       |                                                 | $          | 12,124,288 |   |   | $ | 1,052,631 |   | $ | 13,176,919 |   |
| Depreciation and  amortization |       |                                                 | 425,125    |   |   | — |   | 425,125 |   |
| Income from  operations        |       |                                                 | (980,252   | ) |   | 236,195 |   | (744,057 | ) |
| Assets                         |       |                                                 | 6,076,513  |   |   | 297,166 |   | 6,373,679 |   |
| Capital expenditures           |       |                                                 | 90,849     |   |   | — |   | 90,849 |   |
|                                |            |                                                      |            |  |  |  |  |  |  |  |  |  |

 

Reconciliationof operating profit by segment to net income before benefit (provision) forincome taxes:
| ** **                                       | ** ** | **2003** | ** ** | **2002** | ** ** | **2001**  | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Operating income (loss) by segment               |       | $        | 1,972,335  |     | $          | 1,612,119 |       | $ | (744,057 | ) |
| Interest expense—line of credit             |       | (11,483  | )          | (77,442  | )          | (109,019  | )          |
| Interest expense—long  term notes           |       | (3,465   | )          | (13,422  | )          | (80,509   | )          |
| Other income  (expense)                          |       | 4,602    |       | 139,540  |       | —    |       |
| Total other  income (expense)                    |       | (10,346  | )          | 48,676   |       | (189,528  | )          |
| Income (loss)  before provision for income taxes |       | $        | 1,961,989  |     | $          | 1,660,795 |       | $ | (933,585 | ) |

 

40

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Optelecom is engaged primarilyin the development, manufacture, and sale of optical fiber communicationsproducts and laser systems. Revenue represents shipments and services providedto third parties. Contract costs and operating expenses directly traceable toindividual segments were deducted from revenue to arrive at operating income.Identifiable assets by segment are those assets that are used in the Company’soperations in each segment.

**Significant Customers and Foreign Exports**

Optelecom does most of its business with commercialcustomers with some sales to the U.S. Government and its prime contractors. In2003, five commercial customers accounted for a total of 21% of sales with noone customer accounting for more than 10% of sales. In 2002, five commercialcustomers accounted for a total of 22% of sales with no one customer accountingfor more than 10% of sales. In 2001, five commercial customers accounted for atotal of 29% of sales with one customer accounting for more than 10% of sales.

Included in theCommunication Products’ revenues are export sales of $1,462,967, $3,260,000 and$3,407,000 for 2003, 2002, and 2001, respectively. Additionally, theCommunication Products Division has operations in Europe through its OptelecomEurope, Ltd. subsidiary and it had sales of $3,224,158, $1,881,219 and$2,258,452 for 2003, 2002 and 2001, 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.

**12.  QUARTERLY INFORMATION (UNAUDITED)**

Thefollowing unaudited information sets forth our results of operations on aquarterly basis for the two years ended December 31, 2003 and 2002:
| ** **                       | ** ** | **March 31**                                                              | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|----------------------------------|------------|--------------------------------------------------------------------------------|------------|------------------|------------|-----------------------|------------|----------------------|------------|
| ** **                       | ** ** | **(amounts in thousands except per share data)** | ** ** |
| **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 |   |   |
| **2002:**                        |       |                                                                           |       |             |       |                  |       |                 |       |   |   |   |   |   |   |
| Revenues, net                    |       |                                                                           | $          | 3,306            |       |                  | $          | 3,328                |       |   | $ | 3,726 |   |   |   | $ | 4,549 |   |   |
| Gross profit                     |       |                                                                           | 1,750      |             |       | 1,856                 |       |                 | 2,169      |   |   |   | 2,324 |   |   |
| Operating (loss) income          |       |                                                                           | 232        |             |       | 251                   |       |                 | 533        |   |   |   | 596 |   |   |
| Net (loss) income                |       |                                                                           | 204        |             |       | 225                   |       |                 | 515        |   |   |   | 700 |   |   |
| Earnings per share—basic    |       |                                                                           | $          | 0.07             |       |                  | $          | 0.08                 |       |   | $ | 0.18 |   |   |   | $ | 0.25 |   |   |
| Earnings per  share—diluted |       |                                                                           | $          | 0.07             |       |                  | $          | 0.08                 |       |   | $ | 0.18 |   |   |   | $ | 0.23 |   |   |

* *

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***Item 9.****  *CHANGES IN ANDDISAGREEMENT WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

**None**

***Item 9A.****  *CONTROLS ANDPROCEDURES

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 with suchrequirements.

42

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**PART III**

***Item 10.****  **DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT*

The informationcalled for by this Item regarding directors and executive officers is set forthin the Company’s Proxy Statement for the 2004 Annual Meeting in the Sectionsentitled “Election of Directors,” “Management” and “Section 16(a) BeneficialOwnership Reporting Compliance” and is incorporated herein by reference.

Wehave adopted a Code of Ethics that applies to all of our directors andemployees including, our principal executive officer and principal financialofficer and all of our employees performing financial and accounting functions.Our Code of Ethics is posted 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****.**  ****EXECUTIVE COMPENSATION***

Theinformation called for by this Item is set forth in the Company’s ProxyStatement for the 2004 Annual Meeting in the Section entitled “ExecutiveCompensation” and is incorporated herein by reference.

***Item 12.***   SECURITY OWNERSHIPOF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Theinformation called for by this Item is set forth in the Company’s ProxyStatement for the 2004 Annual Meeting in the Section entitled “SecurityOwnership of Certain Beneficial Owners and Management” and is incorporatedherein by reference.

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

Noresponse is required to this item.

***Item 14****.**  ****PRINCIPAL ACCOUNTANT FEES AND SERVICES***

The information called forby this Item is set forth in the Company’s Proxy Statement for the 2004 AnnualMeeting in the Section entitled “Selection of the Auditor” and isincorporated herein by reference.

43

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**PART IV**

***Item 15******.******  ******EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTSON 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 22  through 25 hereof and the reports thereon of Grant Thornton LLP,  Ernst & Young LLP and Deloitte & Touche LLP appearing on  pages 19, 20 and 21 hereof.                                                                                                                                            |
| (2)        |       | Financial  Statement Schedule                                                                                                                                                                                                                                                                                                                                                                                          |
|       |       | Schedule II for  the year ended December 31, 2003 and the report thereon of Grant  Thornton LLP, Ernst & Young LLP and Deloitte & Touche LLP  appearing on pages  19, 20 and 21 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                                               |
|       |       | 23.3                                                                                                                                                                                                                                                                                                                                                                                                                   | Consent of  Deloitte & Touche LLP—Independent Certified Public Accountants                                           |
|       |       | 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 29, 2004 | 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 29, 2004  | By                  | /s/ Carl  Rubbo, Jr. |
|                       |                | Carl Rubbo, Jr. |
|                       |                | *Director* |
| Date: March 29,  2004 | By                  | /s/ David R. Lipinski |
|                       |                | David R. Lipinski |
|                       |                | *Director* |
| Date: March 29,  2004 | 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, 2003, 2002 AND 2001**
| ** **                                             | ** ** | ** **                                     | ** ** | **Charged to**          | ** ** | ** **     | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------|------------|----------------|------------|
| ** **                                             | ** ** | **Balance at  Beginning  of Period** | ** ** | **Costs and  Expenses** | ** ** | **Deductions** | ** ** | **Balance at  End  of Period** | ** ** |
| *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                       |       | (131,706       | )          | 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 |   |
| *Year  Ended December 31, 2001:*                  |       |                                           |       |                         |       |           |       |   |   |
| Reserves and  allowances deducted from asset accounts: |       |                                           |       |                         |       |           |       |   |   |
| Obsolescence reserve for inventory                     |       | 259,867                                        |       | 92,833                       |       | —         |       | 352,700 |   |
| Allowance for uncollectible accounts receivable        |       | 51,760                                         |       | 211,087                      |       | (161,105       | )          | 101,742 |   |
| Valuation  allowance for deferred tax assets           |       | 2,760,817                                      |       | —                       |       | —         |       | 2,760,817 |   |
|                                                        |            |                                                |            |                              |            |                |            |  |  |  |  |  |  |

 

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