UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, DC 20549

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934For the Fiscal Year Ended December 31, 2007

Commission file number 0-8828

OPTELECOM-NKF, INC.(Exact name of registrant as specified in its charter)

|DELAWARE(State or other jurisdiction of
incorporation or organization) |  | 52-1010850(IRS employer
identification number)
|---------------------------------------------------------------------- |  | ----------------------------------------------

12920 CLOVERLEAF CENTER DRIVE, GERMANTOWN, MARYLAND 20874(Address of principal executive offices)(Zip code)

Registrant's
telephone number, including area code: (301) 444-2200.

Securities registered pursuant to Section 12(b) of the Act: None.

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

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act. Yes o    No ý

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act. Yes o    No ý

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulations S-K (§ 229.405 of this
chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. o

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

|Large accelerated filer o |  | Accelerated filer o |  | Non-accelerated filer o |  | Smaller Reporting Company ý
|------------------------- |  | ------------------- |  | ----------------------- |  | ---------------------------

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

At June 29, 2007, shares of the registrant's Common Stock, $0.03 Par Value, held by persons other than "affiliates" of the registrant had an aggregate
market value of $25,838,932 based on the average closing bid and asked prices as reported by the National Association of Securities Dealers Automated Quotation System for such date.

At
March 11, 2008, the registrant had outstanding 3,636,730 shares of Common Stock, $.03 Par Value.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2008 Annual Meeting of Shareholders are incorporated by reference into Part III.



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OPTELECOM-NKF, INC.  FISCAL YEAR 2007 FORM 10-K ANNUAL REPORT    TABLE OF CONTENTS

|Item        |  | Description                                                                                    |  | Page
Number
|----------- |  | ---------------------------------------------------------------------------------------------- |  | -----------
|            |  | PART I                                                                                         |  |            
|Item 1      |  | Business                                                                                       |  | 3          
|Item 1A     |  | Risk Factors                                                                                   |  | 8          
|Item 1B     |  | Unresolved Staff Comments                                                                      |  | 12         
|Item 2      |  | Properties                                                                                     |  | 12         
|Item 3      |  | Legal Proceedings                                                                              |  | 12         
|Item 4      |  | Submission of Matters to a Vote of Security Holders                                            |  | 12         
|            |  | PART II                                                                                        |  |            
|Item 5      |  | Market for Registrant's Common Stock and Related Stockholder Matters                           |  | 13         
|Item 6      |  | Selected Consolidated Financial Data                                                           |  | 14         
|Item 7      |  | Management's Discussion and Analysis of Financial Condition and Results of Operations          |  | 15         
|Item 7A     |  | Quantitative and Qualitative Disclosures About Market Risk                                     |  | 23         
|Item 8      |  | Financial Statements and Supplementary Data                                                    |  | 24         
|Item 9      |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure           |  | 49         
|Item 9A (T) |  | Controls and Procedures                                                                        |  | 49         
|Item 9B     |  | Other Information                                                                              |  | 50         
|            |  | PART III                                                                                       |  |            
|Item 10     |  | Directors, Executive Officers and Corporate Governance                                         |  | 51         
|Item 11     |  | Executive Compensation                                                                         |  | 51         
|Item 12     |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |  | 51         
|Item 13     |  | Certain Relationships and Related Transactions and Director Independence                       |  | 51         
|Item 14     |  | Principal Accountant Fees and Services                                                         |  | 51         
|            |  | PART IV                                                                                        |  |            
|Item 15     |  | Exhibits and Financial Statement Schedules                                                     |  | 52         
|Signatures  |  | 54                                                                                            

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PART I

FORWARD LOOKING STATEMENTS

Statements in this Form 10-K that are in the future tense, and all statements accompanied by terms such as "believe," "project," "expect,"
"estimate," "assume," "intend," "anticipate," and variations or similar terms are intended to be "forward-looking statements" as defined by federal securities law. Forward-looking statements are based
upon assumptions, expectations, plans and projections that are believed valid when made, but that are subject to the risks and uncertainties identified below and under the Risk Factors identified in
Item 1A of this Form 10-K, that may cause actual results to differ materially from those expressed or implied in the forward-looking statements.

The
Company intends that all forward-looking statements made will be subject to safe harbor protection of the federal securities laws pursuant to Section 27A of the Securities Act
of 1933 and Section 21E of the Securities Exchange Act of 1934.

Forward-looking
statements are based upon, among other things, the Company's assumptions with respect to:



You
should consider the limitations on, and risks associated with, forward-looking statements and not unduly rely on the accuracy of predictions contained in forward-looking statements.
These forward-looking statements speak only as of the date when they are made. The Company does not undertake any obligation to update forward-looking statements to reflect events, circumstances,
changes in expectations, or the occurrence of unanticipated events after the date of those statements. In the future, the Company and its senior management may make forward-looking statements that
involve the risk factors and other matters described in this Form 10-K as well as other risk factors
subsequently identified, including those in the Company's filings with the Securities and Exchange Commission on Form 10-Q and Form 8-K.

Item 1.BUSINESS

Optelecom-NKF, Inc. (NASDAQ: OPTC), is a global supplier of Internet Protocol (IP) video and fiber transmission equipment, including IP
cameras, video servers, network video recorders, video management and video analytics software. We deliver complete solutions for traffic management and security of airports, seaports, casinos,
prisons, utilities, public transport, city centers, hospitals, and corporate campuses.

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Optelecom-NKF, Inc.
(Optelecom-NKF or the Company) is committed to providing its customers with expert technical advice and support in addition to products
that are developed and tested for professional and mission critical applications. All Optelecom-NKF IP surveillance solutions are marketed under the Siqura® name.

The
Optelecom-NKF corporate headquarters is in Germantown, Maryland, USA, with European corporate offices in Gouda, the Netherlands, and sales offices in France, Spain, the
UK, Dubai and Singapore.

HISTORY

Optelecom-NKF is a Delaware corporation whose business activities began in 1972 under the name Optelecom, Inc. The Company's early business
commenced with the design and delivery of specialized laser systems and fiber optic communications products for the Department of Defense and other defense related agencies of the Federal government.

During
the mid-1990's we successfully transitioned from having a significant number of military customers to being an industry provider of copper and fiber optic based
communications
products for both commercial and government customers. We focused on providing integrated multi-media products for communicating video, audio, and other data over both copper wire and optical network
systems.

On
March 8, 2005, we acquired NKF Electronics B.V. (NKF), a wholly owned subsidiary of Draka Holding N.V. (Draka). NKF was founded in 1981 and had accumulated
extensive expertise in fiber optic and IP/Ethernet network technologies. This expertise enabled NKF to build a broad range of communications products, ranging from fiber optic video modems and
multiplexers to Video-Over-IP network solutions.

On
April 17, 2005, the Company's name was changed from Optelecom, Inc. to Optelecom-NKF, Inc. to reflect the importance of this acquisition and new
corporate structure. The results of NKF's operations are included in our financial results beginning on March 8, 2005, when we acquired NKF.

ORGANIZATION, MARKETS AND PRODUCTS

The Company currently maintains its corporate headquarters in Germantown, Maryland. In March 2007, we updated our corporate structure to globally integrate the
management functions into one group. The Company was previously established as individually and separately-managed units at our U.S. and European operating facilities. We maintain operating centers in
both the United States and the Netherlands under this integrated management structure, which includes research and development (R&D), production, sales and logistics in each location.

See
Note 11 to the consolidated financial statements for information concerning the geographic areas of the Company.

We
are a global supplier of network video equipment, including video codecs and servers, fiber optic systems, network video recorders, Ethernet switches and video management software. We
are a customer and product focused company with a flexible philosophy based on providing companies and governments across the world with top quality solutions for traffic management and security
surveillance.

Optelecom-NKF
is committed to providing its customers with competitively priced, highly reliable, quality equipment and solutions, along with outstanding technical advice and
support. All products are developed and tested for real applications, particularly those that need to operate in challenging environmental conditions and across large distances between individual
transmission sites. We are

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ISO 9001:2000
certified and dedicated to the ongoing improvement of our products and processes, applying a high level of quality monitoring to increase customer satisfaction.

We
sell our products worldwide through direct sales, commercial integrators and resellers. Management expects the primary sales channel to continue to be the commercial integrator. In
addition, several vendors incorporate the Company's products in their product offerings allowing the Company to penetrate markets we do not address directly.

The
Company continues to focus its resources on developing additional IP products, sales and distribution channels. Service and technical support programs are in place to attract and
maintain a large network of integration companies. The Company primarily attracts new customer contacts through participation in trade shows in both the security and traffic markets. Our web site
(www.optelecom-nkf.com) has enabled the convenient and rapid dissemination of information required by our distribution channel personnel and other interested parties to gather information
necessary to select our equipment.

The
Company has expanded its focus to identify prospects that have a requirement for complete IP-video solutions including the Company's video codecs, Ethernet network
equipment, network video recorders and video management software as well as a broad range of pre and post sales services such as design, detailed engineering and training. Internal training programs
have been implemented and additional personnel hired to expand the in-depth knowledge of our worldwide sales and support offices.

We
strive to continue improving our position as a leading producer and supplier of powerful, intelligent network video solutions by providing reliable and profitable products and
services that enable customers around the world to reduce their total cost of ownership and enhance the effectiveness of their applications. Products for these markets are classified into the two
broad categories of IP Video and Fiber Optic.

IP Video Products

The Company offers complete IP surveillance solutions for small to large size Closed Circuit TV (CCTV) applications. IP Video related products represent 24% of
our total sales in 2007. These products involve the digitization and compression of National Television System Committee (NTSC) and Phase Alternation by Line (PAL) video signal sources, thereby
allowing transmission of video using Ethernet and IP. They are offered to the security and traffic markets as well as to other markets whose users are looking for cost-effective, high
quality video solutions over private and public networks. These solutions are optimized to address specific customer requirements by offering a broad range of products for each network building block.
These products provide compatibility between network components, high efficiency through modularity and scalability, improved effectiveness with the aid of powerful intelligent software tools, and
reliability and availability of network services.

Video
over IP solutions are represented by the Siqura® product line. The Siqura product line includes video servers/codecs, IP cameras, Ethernet switches, recording and
storage equipment. Also, to bring together all these hardware components, Siqura software solutions, Operator Office and the Optelecom-NKF Software Development Kit (SDK), help
the user consolidate a complete video network under one, easy-to-use management platform.

Fiber Optic Products

The Video over Fiber product line is comprised of the MC Series and the 9000 Series. The MC Series is designed for most common fiber applications and is
recognized for its exceptional price-performance ratio. The 9000 Series is designed for the more complex and demanding Video over Fiber applications. The availability of 18 different wavelengths and
the unique concept of using "option

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modules"
are the core elements behind the versatility of the 9000 Series. Fiber Optic related products represent 73% of our total sales in 2007 and include the following:

Data Communications Products

Data Communications Products traditionally include a comprehensive family of fiber optic modems that incorporate standard telecommunications protocols. The market
applications for these products include specialty data and timing distribution modems for the military, aerospace and satellite earth station markets as well as commercial, industrial, traffic control
and surveillance markets. This product set also
includes a comprehensive line of Ethernet media converters and Ethernet switches. These products can be applied to a wide variety of Local and Wide Area Network applications within our vertical
markets.

Digital Video Transmission Products

Digital video transmission products provide a high quality video signal over long distances via optical fiber. The bandwidth required to achieve this performance
is considerably greater than that needed for lower video quality systems, however, the enormous bandwidth capacity of fiber optic transmission media provides an obvious path for utilization of digital
video technology. The video transmission format is strictly digital and can easily be combined with digitized voice and digital data streams. This feature facilitates switching and multiplexing of a
wide variety of signals.

Coarse Wavelength Division Multiplexer (CWDM) Systems

CWDM allows the transmission and reception of multiple channels of light operating at different wavelengths through a single optical fiber. With this technology,
the user can configure systems that transport the video and data channel count transmitted by one wavelength (typically up to eight) multiplied by the wavelength channel capacity of the CWDM. The
Company offers CWDM systems with optical wavelength channel counts from two to seventeen, as well as single channel optical add/drop multiplexers.

High Resolution Video Transmission Products

High Resolution Video Transmission Products include those used to remotely position a high-resolution display, such as a monitor or projector, from
its video source. Because of the high bandwidth and fidelity required to transmit these signals, fiber optics is the only available means to transmit them further than approximately 1,000 feet. While
VGA video, in the 1280 × 1024 pixel range, may be transmitted via copper using active baluns up to distances approaching 1,000 feet, the bandwidth required to transmit ultra
high resolution 2048 × 2048 pixel RGB video limits the maximum transmission distance possible over copper wire to less than 100 feet.

Electro Optics Products

In addition to our two primary product categories of IP and Fiber Optics the Company operates an Electro Optics (EO) group focused on Interferometric Fiber Optic
Gyro coils and manufacturing innovative optical devices under contract, primarily to government and defense industry customers. In EO, emphasis has been placed on fabrication of precision-wound coils
of optical fiber used as the sensing elements of fiber optic gyroscopes. EO also produces precision wound coils for applications ranging from optical fiber dispensers used in remote vehicle control
systems to precision optical fiber coils for communications systems. EO represents 3% of the Company's revenue in 2007 and sales are expected to decline in 2008.

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RESEARCH AND DEVELOPMENT

In recent years the Company has increased its investments and focused on the development of products being applied to the IP Video marketplace. These products
will permit us to increase our penetration of the markets we serve and expand into new markets. The Company has increased its research and development staffing and is utilizing these additional
resources to continue expanding its existing IP product lines. Our research and development expense is classified as Engineering in our financial statements and for the years ended 2007, 2006 and 2005
were $4.3 million, $3.6 million and $2.7 million respectively.

Although
the Company holds a limited number of patents relating to optical sensor technology and optical fiber networks, our business is not materially dependent upon ownership of any
one patent or group of patents. We do not license any patents from third parties and we assign no value to patents in our financial statements.

QUALITY MANAGEMENT SYSTEM

The Company maintains a Quality Management System fully compliant with ISO9001:2000 and maintains an ongoing certification to this standard. In keeping with our
continuous improvement objectives, we continually implement enhancements to our quality performance metrics which track internal product defects, out-of-box failures, customer
concerns, product repairs and new product introduction issues. With the goal of increasing customer satisfaction, management has continued to stress the importance of the Quality Management System and
continues to utilize numerous quality tools, including a corrective action process, internal quality control audits and senior management reviews. Additionally, the Quality Management System provides
for proper controls, conducts material review meetings, performs Mean Time Between Failure calculations to determine product reliability and works closely with suppliers to reduce incoming material
defects. The U.S. and Netherlands-based facilities are in the process of comparing, improving, and synchronizing quality processes by standardizing many company-wide procedures.

In
keeping with our Company's commitment to quality products and services we adhere to the following corporate quality policy: Quality is the responsibility of every
Optelecom-NKF
employee and focuses on everything we do to maintain our competitive edge. Our commitment to quality includes a customer focus, individual ownership for quality, measurement and feedback systems,
maintaining an ISO 9001:2000 compliant quality management system, and continual review of our quality objectives.

MANUFACTURING

Both the US and the Netherlands-based facilities perform routine and specialized manufacturing, assembly, and product testing functions. We use equipment to
automatically assemble components onto printed circuit boards at high speed, thereby lowering manufacturing costs and reducing the time-to-market for new product designs. We
also maintain a quality assurance function and testing area that performs quality inspections along with optical and electrical testing. Raw materials and supplies used in our business include sheet
metal, optical materials, plastic products, and various electronic components, most of which are available from numerous sources. Although the number of companies from which we can obtain optical
emitters and detectors for use in our circuit assemblies is limited, availability is presently not a significant factor in our ability to provide products. In 2007, we continued to focus on decreasing
the manufacturing defect rate, making throughput cycle-time improvements, and striving toward work-in-progress (WIP) reductions as the result of embracing lean
concepts. This progress is all part of continuous, long-term improvement efforts.

To
remove potential barriers to international sales, we have an aggressive program to comply with Directive 2002/95/EC. This is often referred to as the ROHS directive (or
Lead-Free legislation). This directive applies to the restriction on the use of certain hazardous substances in electrical and

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electronic
equipment. In order to comply with the European Union ROHS legislation all of these substances are being removed, or reduced to within maximum permitted concentrations for products to be
sold within the European Union.

COMPETITION

We compete with other companies of roughly equal size that have similar resources as well as with much larger companies with greater resources. Our competitors
include many privately held companies and some public corporations. The Company historically competes in two primary market segments, traffic monitoring and security surveillance. The competition in
these markets often has established mature sales channels that allow for continued market penetration in both domestic and international markets. We anticipate that the expansion of the Company's IP
product offering and increased sales
and distribution channels worldwide will be the basis for sustained growth. We also will consider strategic acquisitions to enhance our planned internal growth.

SEASONALITY

The Company's products are based on communications equipment technology. As such, seasonality affects our revenues to the extent that normal contracting
activities are affected by capital budgets. We are also impacted in areas with colder climates as some outdoor projects are planned to avoid the winter months. This seasonality has resulted in
generally lower levels of revenue in the first half of the year when compared to revenue in the second half of the year.

EMPLOYEES

At December 31, 2007, the Company had 177 full time equivalent employees worldwide, including 57 in manufacturing, 55 in sales and marketing, 38 in
research, development and engineering, 5 in Electro Optics, and 22 in general management, quality management, finance and administration. We expect a modest increase in headcount over the next
12 months.

Our
U.S. employees are not represented by any collective bargaining organization. The European employees based in the Netherlands are part of a collective bargaining agreement. We
consider our employee relations at both locations to be good.

CORPORATE

The Company's principal executive offices are located at 12920 Cloverleaf Center Drive, Germantown, MD 20874. The Company's telephone number is
(301) 444-2200. Our home page on the Internet is www.optelecom-nkf.com. The Company makes web site content available for informational purposes, which is not
incorporated by reference into this Form 10-K.

Item 1A.RISK FACTORS

Fluctuations in financial performance could harm our long-term growth strategy.

We have experienced and may continue to experience fluctuations in our quarterly and annual operating results. Factors that may cause operating results to vary
include, but are not limited to, changing technology, new product transitions, delays in new product introductions, competition, shortages of system components, changes in the mix of products and
services sold and timing of investments in additional personnel, facilities and research and development. As a result of the impact of these and other factors, past financial performance should not be
considered to be a reliable indicator of the future performance in any particular fiscal period. We are somewhat limited in our ability to reduce expenses quickly in response to any revenue
shortfalls. Therefore, our business,

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financial
condition, and operating results could be adversely affected if increased revenues are not achieved. If we fail to manage or anticipate future growth effectively our business will suffer.

The loss of one or more of our major customers could adversely affect our business, financial condition and operating results.

For the twelve months ended December 31, 2007, approximately 16% of our revenues were accounted for by sales to five commercial customers. This is similar
to the prior year when five customers represented 15% of our revenues. In the event of a reduction, delay or cancellation of orders from one or more significant customers or if one or more significant
customers selects products from one of our competitors for inclusion in future projects, our business, financial condition and operating results could be materially and adversely affected. There can
be no assurance that current customers will continue to place orders with us, that orders by existing customers will continue at current or historical levels or that we will be able to obtain orders
from new customers. The loss of one or more of our current significant customers could materially and adversely affect our business, financial condition and operating results.

We face significant competition for our products and any failure to remain competitive would harm our operating results.

The markets in which we sell our products are highly competitive and characterized by rapidly changing technologies. We face significant competition from a large
number of domestic and international competitors, some of which are larger and have larger product development, research and sales staffs. To remain competitive in both the current and future business
climates, we believe we must maintain a substantial commitment to research and development. Our future success will depend in part upon our ability to enhance our current products and to develop and
introduce new products that keep pace with technological developments and emerging industry standards that address the increasingly sophisticated needs of our customers. There can be no assurance that
we will be successful in developing and marketing such products or producing enhancements that meet these changing demands, or that we will not experience difficulties that could delay or prevent the
successful development, introduction and marketing of these products or that our new products and product enhancements will adequately meet the demands of the marketplace and achieve market
acceptance. Our inability to develop and introduce new products or product enhancements in a timely manner or our failure to achieve market acceptance of new products could have a material adverse
effect on our business, financial condition and operating results and our efforts to remain competitive.

We continue to integrate our global management structure.

In March 2007, we updated our corporate structure to globally integrate the management functions into one group to address the continually changing technology
trends within the industry. The Company was previously established as individually and separately-managed units at our U.S. global headquarters and European operating facilities. We continue the
integration process, including product development, manufacturing, sales processes, finance and information technology. The challenges involved in this integration include the following:



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Also,
we cannot assure you that the growth rate of the Company will equal the historical growth rates.

Optelecom borrowed $23.1 million of senior and subordinated notes in connection with its acquisition of NKF.

In connection with the acquisition of NKF, we borrowed $23.1 million of senior and subordinated notes. The issuance of these notes substantially increased
our principal payment obligations and we may not have enough cash to repay the notes when due. By incurring indebtedness, the related risks that we face intensify. The degree to which we are leveraged
could materially and adversely affect our ability to successfully obtain financing for working capital, acquisitions or other purposes and could make us more vulnerable to industry downturns and
competitive pressures. While management believes that the transaction will continue to be accretive, if it is not, we may be required to pursue equity or other financing to refinance the acquisition
debt. At December 31, 2007, we have an outstanding balance of $17.0 million on this debt. Final maturity of the senior and subordinated notes is March 2009 and March 2010, respectively.

Future Capital Needs; Uncertainty of Additional Funding.

We believe that our current capital resources, including an existing bank line-of-credit and future operating cash flows, will generate
the funds needed for our long-term cash requirements. However, if our growth rate does not meet
expectations, or if we should fail to generate the anticipated operating cash flows, we would be required to seek additional funding. In those circumstances, we would look to increase our line of
credit and/or pursue equity financing. There can be no assurance that additional financing will be available in a timely manner or on acceptable terms. If issuing equity securities raises additional
funds, further dilution to existing stockholders will result. If adequate funds are not available when needed, we may be required to delay, scale back or eliminate product development, sales and
marketing, and overhead costs.

If we fail to attract and retain key personnel, our business could suffer.

Our future depends, in part, on our ability to attract and retain key personnel. We may not be able to hire and retain personnel at levels consistent with our
existing compensation and salary structure. Our future also depends on the continued contributions of our executive management team and other key management, and technical personnel, many of whom
could be difficult to replace. The loss of service from these or other executive officers or key personnel or the inability to attract qualified personnel could have a material adverse effect on our
business.

Our common stock price is volatile, we have never paid dividends and our stock is subject to future dilution.

Our Common Stock currently trades on the NASDAQ Global Market. The securities markets have from time-to-time experienced significant price
and volume fluctuations that were unrelated to our operating performance. In addition, the market prices of the common stock of many publicly traded technology companies have in the past been, and may
in the future be, especially volatile. Announcements of technological innovations or new products of the Company or our competitors, developments or disputes concerning proprietary rights, publicity
regarding products under development by the Company or our competitors, regulatory developments in both the United States and foreign countries, and economic and other external factors, as well as
period-to-period fluctuations in our operating and product development results, may have a significant impact on the market price of our Common Stock.

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We
have not paid any cash dividends since our inception and we do not anticipate paying any cash dividends in the foreseeable future. In addition, dilution will occur upon the exercise
of outstanding stock options or issuance of additional stock. Further dilution could be significant if we experience additional requirements to fund operations and decide to complete a future equity
financing.

We face risks related to our international operations and revenue.

Our customers are located throughout the world. In addition, with the acquisition of NKF, we have significant international operations including manufacturing,
product development, sales and customer support operations. Our operations outside North America are primarily located in the Netherlands. Our international presence exposes us to certain risks,
including the following:



Net
revenue from customers outside the United States accounted for 65%, 64%, and 59% of the Company's total revenue in 2007, 2006, and 2005, respectively. We expect that revenue from
customers outside the United States will continue to account for a significant portion of our total net revenue. In addition, sales to many of our customers depend on international sales and
consequently further expose us to the risks associated with such international sales.

If we fail to manage our exposure to worldwide financial markets successfully, our operating results could suffer.

We are exposed to financial market risks, including changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments
to manage these risks. A portion of our net revenue, expense and capital purchasing activities are transacted in U.S. dollars. However, a substantial portion of our activities are conducted in other
currencies, primarily Euros. A significant change in interest rates or movement in the Euro compared to the U.S. Dollar impacts our operations and financial position. At December 31, 2007, our
stockholder's equity includes a $1.0 million accumulated unrealized foreign exchange loss on the 7.3 million Euro denominated subordinated note to the seller of NKF.

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We may be required to establish a valuation allowance on certain deferred tax assets if we are unable to obtain sufficient future profitability in our
U.S. operations.

The Company has net operating loss and business tax credit carryforwards for U.S. income tax purposes that begin to expire in 2019. In evaluating the Company's
ability to realize the deferred tax assets recorded as a result of these items, we consider all available positive and negative evidence, including past operating results, the reversal of temporary
differences, the forecasts of future taxable income and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about future taxable income
which has a substantial amount of inherent subjectivity. If we are unable to obtain sufficient future profitability in the U.S. operations and/or implement appropriate tax planning strategies the
Company may be required to provide a valuation allowance related to its deferred tax assets. While recording a valuation allowance would not have an immediate cash flow impact it could have a material
negative impact on the earnings and net assets of the Company.

If we are unable to generate new sales and maintain profitability, our business and our financial condition and results of operations will be adversely
impacted.

Our lack of profitability in certain periods may impact our ability to attract customers, employees, investors and creditors. Our ability to sustain profitability
in future periods will depend in large part on our ability to maintain current customers and generate new sales, to maintain or improve our rate of manufacturing utilization, and to manage sales,
product development, and general and administrative expenses in proportion to our revenue. We cannot be certain that we will generate profits in the future and a failure to do so would have a material
adverse effect on our business. Our profitability and cash flow constraints are particularly emphasized in our U.S. operations where our recent sales levels underscore the need to succeed with the
implementation of product advancements, sales improvements and maintain cost controls.

Item 1B.UNRESOLVED STAFF COMMENTS

The Company has no unresolved comments from the Securities and Exchange Commission.

Item 2.PROPERTIES

The Company's corporate headquarters and domestic manufacturing facility is located at 12920 Cloverleaf Center Drive, Germantown, Maryland, where it leases 30,000
square feet of space, all of which is occupied by the Company. The lease expires in August of 2013. We maintain a corporate office and manufacturing facility in Gouda, the Netherlands where we lease
approximately 36,000 feet of space, all of which we fully occupy. This lease expires in March of 2015.

The
Company also maintains office space in England, Spain, France, Singapore and Dubai. Management believes that our facilities, which have been specifically designed and fitted to
accommodate our requirements, are sufficient to meet our current and anticipated near-term growth needs.

Item 3.LEGAL PROCEEDINGS

None.

Item 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matter was submitted for a vote of our shareholders during the fourth quarter of 2007.

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PART II

Item 5.MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

The Company's Common Stock, representing its only class of publicly traded securities, is traded on the NASDAQ Global Market under the symbol OPTC. The following
are the highest and lowest closing bid prices for the Common Stock as reported by NASDAQ during each quarter for the two years ended December 31, 2007 and 2006, respectively. These quotations
may not necessarily reflect actual transactions:

Bid PriceQuarter EndedHigh

LowDecember 31, 2007

$
9.20

6.46September 30, 2007


8.42

6.05June 30, 2007


9.10

5.90March 31, 2007


12.60

7.90December 31, 2006


11.24

9.84September 30, 2006


13.66

7.90June 30, 2006


29.16

13.33March 31, 2006


25.34

13.36


At
March 11, 2008, the closing price of our Common Stock was $6.77.

There
were 3,636,730 shares of Common Stock outstanding as of March 11, 2008, and 518 record holders as of such date. The Company has never declared or paid any cash dividends on
its Common Stock and does not expect to do so in the foreseeable future. The Company intends to use any future earnings to finance its operations, repay its debt obligations and fund growth of the
business.

The
following is information on the Company's equity compensation plans as of December 31, 2007.

|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     |  | 423,289                                                                    |  | 10.27                                                      |  | 130,247                                                                                                                                        
|Equity compensation plans not approved by security holders |  |                                                                           |  |                                                           |  |                                                                                                                                               
|                                                           |  |                                                                            |  |                                                            |  |                                                                                                                                                
|Totals                                                     |  | 423,289                                                                    |  | 10.27                                                      |  | 130,247                                                                                                                                        
|                                                           |  |                                                                            |  |                                                            |  |                                                                                                                                                

STOCK PRICE PERFORMANCE GRAPH

Set forth in this section is a line graph comparing the cumulative total stockholder return on Optelecom-NKF common stock against the cumulative total
return of the NASDAQ US Index, the NASDAQ Telecommunications Stocks Index and the NASDAQ Electronic Components Stocks Index for the period of five fiscal years commencing December 31, 2002 and
ending December 31, 2007. The Electronic Components Stocks Index was added in the current year to provide a closer comparison to our Company then the Telecommunications Stocks Index. The graph
and table assume that $100 was invested on December 31, 2002 in each of Optelecom-NKF Common Stock, the NASDAQ US Index,

13

---



the
NASDAQ Telecommunications Stocks Index and the NASDAQ Electronic Components Stocks Index and that all dividends were reinvested. This data was furnished by NASDAQ.

|                                          |  | 2002 |     | 2003 |   | 2004 |  | 2005 |     | 2006 |   | 2007
|----------------------------------------- |  | ---- | --- | ---- | - | ---- |  | ---- | --- | ---- | - | ----
|Optelecom-NKF                             |  | $    | 100 |      | $ | 196  |  | $    | 200 |      | $ | 289 
|Nasdaq US Index                           |  | $    | 100 |      | $ | 150  |  | $    | 163 |      | $ | 166 
|Nasdaq Telecommunications Stocks Index    |  | $    | 100 |      | $ | 112  |  | $    | 85  |      | $ | 90  
|Nasdaq Electronic Components Stocks Index |  | $    | 100 |      | $ | 192  |  | $    | 152 |      | $ | 151 

GRAPHIC

Item 6.SELECTED CONSOLIDATED FINANCIAL DATA

The following table sets forth selected historic consolidated financial data for the periods and dates indicated. This information is derived from the Company's
audited consolidated financial statements, which have been audited by the Company's independent registered public accounting firm. The information set forth below is qualified in its entirety by, and
should be read in conjunction with, the consolidated financial statements, the related notes, and Management's Discussion and Analysis of Financial Condition and Results of Operations.

(Dollars in Thousands, Except Share Amounts)

|Year Ended December 31,           |  | 2007(a) |        | 2006(a) |   | 2005(a) |  | 2004 |        | 2003
|--------------------------------- |  | ------- | ------ | ------- | - | ------- |  | ---- | ------ | ----
|Revenues, net                     |  | $       | 42,503 |         | $ | 39,484  |  | $    | 33,865 |     
|Net income                        |  |         | 1,281  |         |   | 1,554   |  |      | 2,682  |     
|Basic earnings per common share   |  |         | 0.37   |         |   | 0.45    |  |      | 0.83   |     
|Diluted earnings per common share |  |         | 0.37   |         |   | 0.44    |  |      | 0.80   |     
|As of December 31,                |  |         |        |         |   |         |  |      |        |     
|Total assets                      |  |         | 49,963 |         |   | 46,274  |  |      | 38,868 |     
|Long-term obligations             |  |         | 17,749 |         |   | 17,833  |  |      | 18,787 |     
|Stockholders' equity              |  |         | 23,101 |         |   | 17,943  |  |      | 11,754 |     

---

14

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Item 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Optelecom-NKF is a global supplier of IP video and fiber transmission equipment, including IP cameras, video servers, network video recorders, video
management and video analytics software. We deliver complete solutions for traffic management and security of airports, seaports, casinos, prisons, utilities, public transport, city centers,
hospitals, and corporate campuses.

Optelecom-NKF
is committed to providing its customers with expert technical advice and support in addition to products that are developed and tested for professional and
mission critical applications. All Optelecom-NKF IP surveillance solutions are marketed under the Siqura® name.

The
Optelecom-NKF corporate headquarters is in Germantown, Maryland, USA, with European corporate offices in Gouda, the Netherlands, and sales offices in France, Spain, the
UK, Dubai and Singapore.

Optelecom-NKF
provides competitively priced, highly reliable, top quality equipment and solutions, along with technical advice and support. All products are developed and
tested for real applications, particularly those that need to operate in challenging environmental conditions and across large distances between individual transmission sites. We are
ISO 9001:2000 certified and dedicated to the ongoing improvement of our products and processes, applying a high level of quality monitoring to increase customer satisfaction.

We
sell our products worldwide through direct sales, commercial integrators and resellers. Management expects the primary sales channel to continue to be commercial integrators. In
addition, several vendors incorporate the Company's products in their product offerings allowing the Company to penetrate markets we do not address directly.

The
Company continues to focus its resources on developing additional IP products, sales and distribution channels. Service and technical support programs are in place to attract and
maintain a large network of integration companies. The Company primarily attracts new customer contacts through participation in trade shows in both the security and traffic markets. Our web site
(www.optelecom-nkf.com) has enabled the convenient and rapid dissemination of information required by our distribution channel personnel and
other interested parties to gather information necessary to select our equipment.

The
Company has expanded its focus to identify prospects that have a requirement for complete IP-video solutions including the Company's video codecs, Ethernet network
equipment, network video recorders and video management software as well as a broad range of pre and post sales services such as design, detailed engineering and training. Internal training programs
have been implemented and additional personnel hired to expand the in-depth knowledge of our worldwide sales and support offices.

We
strive to continue improving our position as a leading producer and supplier of powerful, intelligent network video solutions by providing reliable and profitable products and
services that enable customers around the world to reduce their total cost of ownership and enhance the effectiveness of their applications. Products for these markets are classified into two broad
categories: IP Video and Fiber Optic.

Video
over IP solutions are represented by the Siqura® product line. The Siqura product line includes video servers/codecs, IP cameras, Ethernet switches, recording and
storage equipment. Also, to bring together all these hardware components, Siqura software solutions, Operator Office and the Optelecom-NKF SDK, help the user consolidate a
complete video network under one, easy-to-use management platform.

15

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The
Video over Fiber product line is comprised of the MC Series and the 9000 Series. The MC Series is designed for most common fiber applications and is recognized for its exceptional
price-performance ratio. The 9000 Series is designed for the more complex and demanding Video over Fiber applications. The availability of 18 different wavelengths and the unique concept of using
"option modules" are the core elements behind the versatility of the 9000 Series.

In
addition to our two primary product categories of IP and Fiber Optics the Company operates an Electro Optics (EO) group focused on Interferometric Fiber Optic Gyro coils and
manufacturing innovative optical devices under contract, primarily to government and defense industry customers.

RESULTS OF OPERATIONS

The Company is in a transition to accommodate an industry-wide shift from video transmission over fiber optics to IP/Ethernet based solutions. In
March 2005 the Company acquired NKF as a means of obtaining a robust IP product line and global sales capability with IP products and solutions. In March 2007, the Company restructured its operations
to globally align all operating areas of the business to address the continually changing technology trends within the industry.

During
2007 we increased revenue 8%, maintained margins at 59%, and contained operating expenses to an increase of 8%. Management believes we made progress this past year in moving the
Company toward a stronger position in sales of advanced IP network video technologies.

Overall,
2007 revenue and profits were driven by our international business, including foreign currency exchange. Revenue in our European based operations increased 13% to
$27.1 million and accounted for all of the Company's income from operations. Revenue in our U.S. based operations was flat at $15.4 million in 2007 but we were able to reduce U.S. losses
during the year with improvements in gross margin and reduction in certain operating expenses.

The
Company was impacted by foreign exchange rates in 2007 as the U.S. dollar continued to weaken against the Euro. The Company had an overall increase of 8% in 2007 compared to 2006 in
both its revenue and operating expenses. After considering the impact of foreign exchange rates these increases would have each been 3%. Overall the company's income from operations, excluding the
impact of foreign exchange rates, would have been flat in 2007 compared to 2006.

Revenue
by product category in the recent three year period was:

(Dollars in thousands)

2007

2006

2005Fiber Optic

$
31,107

$
31,628

$
28,294IP Video


10,305


6,852


4,601Electro Optics


1,091


1,004


970Total Revenue

$
42,503

$
39,484

$
33,865


2007
sales of Fiber Optic products were $31.1 million representing a 2% decline from 2006 sales of $31.6 million. This small decline is attributed to the market shift away
from Fiber Optic and toward IP Video products. In recent years the Company has invested heavily in IP Video products. The result is an increase of 50% or $3.5 million in IP related revenue in
2007 over 2006. The IP product growth is primarily in our international operations. In 2007, the Company began introducing a new line of IP products to address this market shift within the U.S. The
Company also continued to add sales staff, sales representative organizations and integrators both domestically and internationally over the past three years. The total revenue increase of almost
$5.6 million in 2006 compared to 2005 is primarily the result of the acquisition of NKF in March 2005.

Gross
profit in 2007 was $25.0 million and 59% of sales. This is an increase of $1.6 million versus 2006 when gross profit margins were also 59%. The current year increase
is directly attributable to the

16

---



growth
in revenues in our international operations. Gross profit during 2006 totaled $23.4 million which was an increase of $3.0 million compared to 2005. The increase during 2006 was
primarily the result of the acquisition of NKF.

The
level of operating expense increased during 2007 to $22.1 million from $20.5 million in 2006. The current year increase compared to 2006 is from additional personnel
and costs in the sales and marketing function of $1.5 million. This increase is part of the Company's effort to transition its products and related sales effort toward the IP Video market.
Personnel and other costs increased in the Company's sales and marketing function as the Company hired additional Regional Sales Managers and continued to support the development of IP products,
specifically the Siqura product suite.

Operating
expenses increased to $20.5 million in 2006 compared to the $15.8 million in 2005, an increase of 30%. All expense comparisons in 2006 reflect the results of
incorporating NKF operating expenses for the entire twelve-month period of 2006 as compared to slightly less than ten months in 2005 when it was acquired. The 2006 increase compared to 2005 is
primarily from additional personnel and costs in the sales and engineering functions of $2.7 million and stock compensation of approximately $1.0 million. The Company's management
expects operating expenses to increase as revenues continue to grow and the Company develops and delivers new IP products to the marketplace.

OTHER INCOME (EXPENSE)

Other expense totaled $1.2 million in both 2007 and 2006 compared to $1.1 million in 2005. Substantially all of our Other Income (Expense) is from
interest expense. The interest expense on long term notes was $1.1 million this year and $1.2 million in 2006 as we paid down our bank term debt from our NKF acquisition. The interest
expense on our line of credit is $110 thousand in 2007 and $26 thousand in 2006. The line is used in our U.S. operation where we continue to supplement cash flow from operations. The
average balance outstanding on this line increased in 2007 when compared to 2006.

INCOME TAXES

The effective tax rates for 2007, 2006 and 2005 were 23%, 10% and 24%, respectively. The lower tax rate in 2006 was attributed primarily to the reduction of the
statutory income tax rate in the Netherlands from 29.6% to 25.5% in the fourth quarter that year. The Company evaluates the realizability of its deferred tax assets each quarter. The factors used to
assess the likelihood of realization are the Company's forecast of future taxable income, reversal of temporary differences and available tax planning strategies that could be implemented to realize
the net deferred tax assets.

The
U.S. legal entity continues to accumulate tax credits for net operating losses and R&D credits. While the resulting deferred tax assets have not increased significantly in the
current year they total $1.7 million on our balance sheet at year-end. There is a risk that performance of the U.S. business will not allow for utilization of these net operating
losses and tax credits in the future. If this were the case, we would need to consider a charge against earnings. Management continues to
believe that it is more likely than not that the Company will be able to use its net operating losses and tax credit carry forwards prior to their expiration.

Impact of Inflation

Inflation did not have a significant effect on the operations of the Company during 2007 or 2006, and we do not expect it to have a significant effect during
2008.

17

---



FINANCIAL CONDITION

Total assets were $50.0 million at December 31, 2007, an increase of $3.7 million from year-end 2006. The $3.7 million
increase results primarily from increases in cash and cash equivalents, deferred tax assets and goodwill. The increase in cash was $1.5 million during 2007 as international operations generated
positive cash flow from operations. Deferred tax assets increased by $1.0 million due to additions to non-current items related to foreign exchange, stock compensation and inventory
reserves. Goodwill was $1.6 million higher at year-end 2007 as the balance increased in line with the increase in the Euro versus the U.S. dollar.

Inventory
balances declined slightly during 2007 with a reduction in our fiber optic product line. Also, the Company kept additional inventory on hand in 2006 which was used to provide
greater in-stock items to meet the delivery needs of our customers. The following chart shows the composition of inventory for the past three years:

(Dollars in thousands)

2007

2006

2005Production Materials

$
3,187

$
3,431

$
2,574Work in Process


801


785


499Finished Goods


1,976


2,050


1,574Allowance for Obsolescence


(750
)

(507
)

(434
)TOTAL

$
5,214

$
5,759

$
4,213


Total
liabilities at year-end 2007 were $26.9 million, a $1.5 million decline from year-end 2006. The decline includes reductions in accounts
payable, taxes payable and notes payable. The decline in accounts payable is from the timing of payments on capital equipment purchased in late 2006 and paid for in early 2007. The reduction in taxes
payable is due to tax payments in our European operations that were accrued at year-end 2006 but paid in 2007. Notes payables declined as we continued to make monthly principal payments
during the year on our bank term debt. These decreases are partially offset by increased use on our line of credit in the U.S. business and increased interest payable for the accrual of deferred
interest on our subordinated note due in 2010. Accrued interest on the subordinated note totaled $1.2 million at December 31, 2007. The Subordinated Note is denominated in Euros and the
liability also increased $1.1 million due to the impact of exchange rate changes during 2007. The impact of foreign exchange rates on this Subordinated Note is currently accounted for as a
component of other comprehensive income and will be recognized as other income (expense) upon payment of the note.

The
Company's stockholders' equity increased from $17.9 million at December 31, 2006 to $23.1 million at December 31, 2007, an increase of
$5.2 million. This increase is from net income in the current year of $1.3 million, $859 thousand related to the recognition of stock compensation expense, and additional
comprehensive income from the unrecognized foreign exchange gain between the Euro and U.S. Dollar totaling $2.8 million during 2007.

LIQUIDITY AND CAPITAL RESOURCES

The Company's operating activities provided positive cash flow of $2.8 million in 2007. This is primarily the result of $1.3 million in net income
combined with the previously discussed reductions in accounts receivable and a lower inventory balance at year-end 2007. This compared to cash flow from operating activities of
$358 thousand in 2006 and $7.8 million in 2005. The 2006 amount was reduced by increases in accounts receivable and inventory during the prior year.

18

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Cash used in investing activities increased to $1.0 million in 2007 compared to $494 thousand used in 2006 and $16.7 million used in 2005. In 2007 the Company
increased its capital expenditures as it worked toward upgrading technology systems, expanding product capabilities and improving infrastructure. The higher level of cash used in investment activities
in 2005 were due to the acquisition of NKF in March 2005.

During
2007, cash used in financing activities was $1.3 million compared to $210 thousand used in 2006. The current year increase is from payments on long-term
debt with a $200 thousand offset from increased borrowing on the line of credit in the U.S. Additionally, proceeds from the exercise of stock options and issuance of common stock to employees
totaled $1.3 million in 2006 compared with only $99 thousand in 2007 due to a decline in our stock price. In 2005 financing activities provided $9.1 million due to net borrowings
for the NKF acquisition.

Under
its current banking facility, the Company has the ability to borrow up to $5.0 million, provided there are sufficient accounts receivable and inventory. This facility allows
the Company to borrow in either U.S. Dollars or Euros with a maximum amount not to exceed $5.0 million USD. The borrowing base under the facility is between 60%-85% of the eligible commercial
billed accounts receivable and 30% of eligible related inventory.

The
revolving line of credit carries interest at the rate of LIBOR plus a margin that can range from 1.75% to 2.75% depending on the Company's leverage position with an effective
interest rate of 7.60% at the recent year-end. As of December 31, 2007, the Company had $1.0 million of outstanding borrowings on its bank
line-of-credit which is a $200 thousand increase from the prior year-end. The line of credit is used by the U.S. operation to provide necessary working
capital. At December 31, 2007, the Company had $1.0 million of additional borrowing capability in the U.S. and $2.3 million on our Euro line of credit through our subsidiary based
in the Netherlands.

The
Company is required by the bank to comply with certain financial covenants including maintaining a maximum senior debt coverage ratio and a minimum fixed charge coverage ratio. The
Company was in compliance with the financial covenants at December 31, 2007.

We
plan to finance our future working capital needs with our operating cash flow and continued use of our line-of-credit as needed. In the event these sources
become
insufficient to meet funding needs, the Company may be required to scale back sales and marketing expenses, product research and development costs, and overhead costs. Additionally, the Company would
pursue an increase in its line of credit, additional debt or equity financing, and/or make dividend payments from its European operations. Dividends from international operations could result in an
increased tax liability and tax expense to the Company.

The
Company experienced a net loss in the first half of 2007 with a return to profitability in the second half of the year. If losses were to recur, the liquidity of our business would
be adversely impacted. This may result in a reduction in our ability to secure additional financing opportunities. If we are able to secure additional financing under these circumstances the cost
could be prohibitive. Our net losses were primarily from U.S. operations which has experienced decreased operating cash flow in certain recent periods. From time to time in 2007 our U.S. operation was
near the maximum amount allowable on its line of credit.

19

---



Our
contractual obligations as of December 31, 2007 are as follows:

|(dollars in thousands)         |  | Total |        | Less Than
1 Year |       | 1-3 Years |        | 4-5 Years |       | More Than
5 Years
|------------------------------ |  | ----- | ------ | ---------------- | ----- | --------- | ------ | --------- | ----- | -----------------
|Long-term debt obligations(1)  |  | $     | 16,980 |                  | 1,525 |           | 15,455 |           |      |                  
|Capitalized lease obligations  |  |       | 45     |                  | 45    |           |       |           |      |                  
|Operating lease obligations(2) |  |       | 7,839  |                  | 1,361 |           | 2,469  |           | 2,333 |                  
|                               |  |       |        |                  |       |           |        |           |       |                  
|Totals                         |  | $     | 24,864 |                  | 2,931 |           | 17,924 |           | 2,333 |                  
|                               |  |       |        |                  |       |           |        |           |       |                  

---

NEW ACCOUNTING STANDARDS

In December 2007, the Financial Accounting Standards Board issued Statement 141 (revised 2007), "Business Combinations" (Statement 141R), to change how an entity
accounts for the acquisition of a business. When effective, Statement 141R will replace existing Statement 141 in its entirety. Statement 141R carries forward the existing requirements to account for
all business combinations using the acquisition method (formerly called the purchase method). In general, Statement 141R will require acquisition-date fair value measurement of
identifiable assets acquired, liabilities assumed, and noncontrolling interests in the acquiree. Statement 141R will eliminate the current costbased purchase method under Statement 141.

The
new measurement requirements will result in the recognition of the full amount of acquisition-date goodwill, which includes amounts attributable to noncontrolling
interests. The acquirer will recognize in income any gain or loss on the remeasurement to acquisition-date fair value of consideration transferred or of previously acquired equity
interests in the acquiree. Neither the direct costs incurred to effect a business combination nor the costs the acquirer expects to incur under a plan to restructure an acquired business will be
included as part of the business combination accounting. As a result, those costs will be charged to expense when incurred, except for debt or equity issuance costs, which will be accounted for in
accordance with other generally accepted accounting principles.

Statement
141R will also change the accounting for contingent consideration, in process research and development, contingencies, and restructuring costs. In addition, changes in deferred
tax asset valuation allowances and acquired income tax uncertainties in a business combination that occur after the measurement period will impact income taxes under Statement 141R.

Statement
141R is effective for fiscal years and interim periods within those fiscal years beginning on or after December 15, 2008. Early adoption is prohibited. The Company
intends to adopt Statement 141R effective January 1, 2009 and apply its provisions prospectively. The Company is evaluating the impact that the adoption of Statement 141R will have on its
financial statements.

Statement
141R amends the goodwill impairment test requirements in Statement 142. For a goodwill impairment test as of a date after the effective date of Statement 141R, the value of the
reporting unit and the amount of implied goodwill, calculated in the second step of the test, will be determined in accordance with the measurement and recognition guidance on accounting for business

20

---



combinations
under Statement 141R. This change could effect the determination of what amount, if any, should be recognized as an impairment loss for goodwill recorded before the effective date of
Statement 141R. This accounting will be required when Statement 141R becomes effective (January 1, 2009 for the Company) and applies to goodwill related to acquisitions accounted for originally
under Statement 141 as well as those accounted for under Statement 141R.

The
Company has $15,259,000 of goodwill at December 31, 2007 related to a previous business combination. The Company has not determined what effect, if any, Statement 141R will
have on the results of its impairment testing subsequent to December 31, 2008.

In
September 2006, the FASB issued SFAS 157, "Fair Value Measurements". SFAS No. 157 defines fair value, establishes a framework and gives guidance regarding the methods
used for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after
November 15, 2007, and interim periods within those
fiscal years. The Company is currently evaluating the impact of SFAS No. 157 on its results of operations and financial position.

In
February 2007, the FASB issued SFAS 159, "The Fair Value Option for Financial Assets and Financial Liabilities," which allows companies the option to measure certain financial
assets or liabilities at fair value and include unrealized gains and losses in net income rather than equity. Subsequent measurements for the financial instruments and liabilities an entity elects to
measure at fair value will be recognized in earnings. SFAS 159 also established additional disclosure requirements. SFAS 159 is effective for fiscal years beginning after
November 15, 2007, with early adoption permitted provided that the entity also adopts SFAS 157. The Company is currently evaluating the effect, if any, the adoption of SFAS 159
will have on its consolidated results of operations, financial position and cash flows.

CRITICAL ACCOUNTING POLICIES

The Company's discussion and analysis of its financial condition and results of operations are based upon the Company's consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company
evaluates its estimates, including those related to product returns, bad debts, inventories, income taxes, financing operations, warranty obligations, and contingencies and litigation. The Company
bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We
consider certain accounting policies related to revenue recognition, impairment of long lived assets, valuation of accounts receivable, inventory and income taxes to be critical to
our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout
Management's Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. For a detailed discussion on the
application of these and other accounting policies, see Notes to the Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K.

Revenue RecognitionRevenue from commercial sales is recognized when products are shipped and title passes pursuant to the
terms of the agreement with the customer, the amount from the customer is fixed, and collectability is reasonably assured. Revenues from fixed-price contracts, such as

21

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contracts
from the government, are recognized on the percentage-of-completion method, which relies on estimates of total expected contract revenue and costs. The Company
follows this method since reasonably dependable estimates of the revenue and costs applicable to various stages of a contract can be made. Recognized revenues and profit are subject to revisions as
the contract progresses to completion. Revenues from time-and-materials contracts are recorded at the contract rates times the labor hours plus other direct costs as incurred.
In the ordinary course of business, the Company warrants its products against defect in design, materials, and workmanship over various time periods. Warranty reserve and allowance for product returns
is established based upon management's best estimates of amounts necessary to settle future and existing claims on products sold as of the balance sheet date. Management evaluates the warranty reserve
on at least a quarterly basis.

Impairment of Long Lived AssetsIn connection with our acquisition of NKF during 2005, the Company's long-lived
assets increased significantly primarily related to acquired goodwill and other intangibles. With respect to acquired goodwill and intangibles with indefinite lives that are not amortized, we are
required to perform an impairment test annually under SFAS 142, "Goodwill and Other Intangible Assets." SFAS 142 requires us to make certain difficult, subjective and complex judgments
on a number of matters, including assumptions and estimates used to determine the fair value of our reporting units. We measure fair value on the basis of discounted expected future cash flows. Our
estimates are based upon our historical experience, our current knowledge from our commercial relationships, and available external information about future trends. For long-lived assets
with definite lives that are subject to amortization, SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," requires us to exercise judgment in assessing
whether an event of impairment has occurred by comparing the carrying value of these assets with the expected future cash flows generated by the assets. As of December 31, 2007, no such
impairments have occurred.

Allowance for Doubtful AccountsThe Company maintains allowances for doubtful accounts for estimated losses resulting from the
inability of customers to make required payments. The Company regularly monitors and assesses its risk of not collecting amounts owed by its customers. This evaluation is based upon an analysis of
amounts current and past due along with relevant history and facts particular to the customer such as collection history and the results of credit inquiries. If the financial condition of the
Company's customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

InventoriesProduction materials are valued at the lower of cost or market applied on a standard cost basis.
Work-in-process represents direct labor, materials, and overhead incurred on products not delivered to date. Finished goods inventories are valued at the lower of cost or
market, cost being determined using standards that approximate actual costs on a specific identification basis. The Company writes down its inventory for estimated obsolescence or
unmarketable inventory based upon assumptions about future demand and market conditions as well as historical inventory turnover. If actual market conditions are less favorable than those projected by
management, additional inventory write-downs may be required.

Income TaxesThe Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes" which
requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS
No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized.

Foreign Currency Effect on Cash FlowsThe Company prepares its statement of cash flows in accordance with SFAS 95, "Statement
of Cash Flows". As such the Company computes the foreign currency impact on cash flows by first computing the statement of cash flows for its foreign subsidiaries using the functional currency for
that subsidiary followed by a translation of these foreign currency cash

22

---



flows,
using the current exchange rate at the time of the cash flows into U.S. dollars. The effect of exchange rate changes on these cash flows is reported as a separate item in the reconciliation of
the beginning and ending balances of cash and cash equivalents.

Item 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS

Market Risk

Market risk is the risk of loss to future earnings, to fair values or to future cash flows that may result from changes in the price of financial instruments. We
are exposed to financial market risks, primarily related to changes in foreign currency exchange rates. We currently do not have any derivative financial instruments to protect against adverse
currency movements. We manage our exposure to market risks related to operations through regular operating and financing activities. All of the potential impacts noted below are based on a sensitivity
analysis performed as of December 31, 2007. Actual results may differ materially.

Foreign Currency Risk

We are exposed to the fluctuations in foreign currency exchange rates. Such fluctuations impact the recorded values of our investments in foreign subsidiaries in
our consolidated balance sheet, and our foreign currency translation adjustment, a component of other comprehensive income. For the year ended December 31, 2007, a 10% change in average
exchange rates would have changed our reported currency translation adjustment of $3.4 million by approximately $1.5 million. We currently do not have any derivative financial
instruments to protect against adverse currency movements. We manage our exposure to market risks related to operations through regular operating and financing activities. All of the potential impacts
noted above are based on a sensitivity analysis performed as of December 31, 2007. Actual results may differ materially.

Interest Rate Risk

At December 31, 2007, we have interest rate risk to the extent that interest rate changes expose our fixed rate long-term debt to changes in
fair value. As of December 31, 2007, we had $10.8 million of fixed rate long-term debt. In addition, the Company accrues deferred interest on the fixed rate debt which totals
$1.2 million at December 31, 2007. This debt is denominated in Euros and results from our acquisition of NKF in March 2005.

The
long-term debt is based on current rates at which the Company could borrow funds with similar remaining maturities. The carrying value of the Company's senior note
payable and subordinated note payable approximates fair value.

23

---





Item 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to the Consolidated Financial Statements

|                                                                                                                         |  | Page
|------------------------------------------------------------------------------------------------------------------------ |  | ----
|Report of Independent Registered Public Accounting Firm                                                                  |  | 25  
|Consolidated Balance Sheets as of December 31, 2007 and 2006                                                             |  | 26  
|Consolidated Statements of Operations and Comprehensive Income for the three years in the period ended December 31, 2007 |  | 27  
|Consolidated Statements of Stockholders' Equity for the three years in the period ended December 31, 2007                |  | 28  
|Consolidated Statements of Cash Flows for the three years in the period ended December 31, 2007                          |  | 29  
|Notes to Consolidated Financial Statements                                                                               |  | 30  
|SCHEDULE IISchedule of Valuation and Qualifying Accounts                                                                |  | 56  

24

---





REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To
the Board of Directors and
    Stockholders of Optelecom-NKF, Inc.

We
have audited the accompanying consolidated balance sheet of Optelecom-NKF, Inc. and subsidiaries (the Company) as of December 31, 2007 and 2006, and the
related consolidated statements of operations and comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2007. Our audit of the
basic financial statements included the financial schedule listed in the index appearing under Item 8. These financial statements and financial statement schedule are the responsibility of the
Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.

We
conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over
financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the
purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In
our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Optelecom-NKF, Inc. as of
December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting
principles generally accepted in the United States of
America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the
information set forth therein.

/s/
GRANT THORNTON, LLP

Baltimore,
Maryland
March 27, 2008

25

---





OPTELECOM-NKF, INC.        CONSOLIDATED BALANCE SHEETS        AS OF DECEMBER 31        (Dollars in Thousands, Except Share Amounts)

|                                     |                                                                           | 2007                                                                                                                                                                           |                            | 2006   |       
|------------------------------------ | ------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | -------------------------- | ------ | ------
|ASSETS                               |                                                                           |                                                                                                                                                                                |                            |        |       
|                                     | CURRENT ASSETS                                                            |                                                                                                                                                                                |                            |        |       
|                                     |                                                                           | Cash and cash equivalents                                                                                                                                                      |                            | $      | 5,043 
|                                     |                                                                           | Accounts and contracts receivable, net of allowance for doubtful accounts of $249 and $625                                                                                     |                            |        | 9,575 
|                                     |                                                                           | Inventories, net                                                                                                                                                               |                            |        | 5,214 
|                                     |                                                                           | Deferred tax assetcurrent                                                                                                                                                     |                            |        | 732   
|                                     |                                                                           | Prepaid expenses and other current assets                                                                                                                                      |                            |        | 816   
|                                     |                                                                           |                                                                                                                                                                                |                            |        |       
|                                     | Total current assets                                                      |                                                                                                                                                                                |                            | 21,380 |       
|                                     | Property and equipment, less accumulated depreciation of$7,634 and $6,377 |                                                                                                                                                                                |                            | 2,594  |       
|                                     | Deferred tax assetnon-current                                            |                                                                                                                                                                                |                            | 2,284  |       
|                                     | Intangible assets, net of accumulated amortization of $2,259 and $1,288   |                                                                                                                                                                                |                            | 8,241  |       
|                                     | Goodwill                                                                  |                                                                                                                                                                                |                            | 15,259 |       
|                                     | Other assets                                                              |                                                                                                                                                                                |                            | 205    |       
|                                     |                                                                           |                                                                                                                                                                                |                            |        |       
|                                     | TOTAL ASSETS                                                              |                                                                                                                                                                                | $                          | 49,963 |       
|                                     |                                                                           |                                                                                                                                                                                |                            |        |       
|LIABILITIES AND STOCKHOLDERS' EQUITY |                                                                           |                                                                                                                                                                                |                            |        |       
|                                     | CURRENT LIABILITIES                                                       |                                                                                                                                                                                |                            |        |       
|                                     |                                                                           | Accounts payable                                                                                                                                                               |                            | $      | 2,623 
|                                     |                                                                           | Accrued payroll                                                                                                                                                                |                            |        | 2,165 
|                                     |                                                                           | Commissions payable                                                                                                                                                            |                            |        | 198   
|                                     |                                                                           | Current portion of capitalized leases                                                                                                                                          |                            |        | 45    
|                                     |                                                                           | Bank line of credit                                                                                                                                                            |                            |        | 1,000 
|                                     |                                                                           | Current portion of notes payable                                                                                                                                               |                            |        | 1,525 
|                                     |                                                                           | Accrued warranty reserve                                                                                                                                                       |                            |        | 418   
|                                     |                                                                           | Taxes payable                                                                                                                                                                  |                            |        | 49    
|                                     |                                                                           | Other current liabilities                                                                                                                                                      |                            |        | 1,090 
|                                     |                                                                           |                                                                                                                                                                                |                            |        |       
|                                     |                                                                           |                                                                                                                                                                                | Total current liabilities  |        |       
|                                     | Notes payable                                                             |                                                                                                                                                                                |                            | 14,245 |       
|                                     | Deferred tax liability                                                    |                                                                                                                                                                                |                            | 2,037  |       
|                                     | Interest payable                                                          |                                                                                                                                                                                |                            | 1,210  |       
|                                     | Capitalized leases                                                        |                                                                                                                                                                                |                            |       |       
|                                     | Other liabilities                                                         |                                                                                                                                                                                |                            | 257    |       
|                                     |                                                                           |                                                                                                                                                                                |                            |        |       
|                                     |                                                                           | Total liabilities                                                                                                                                                              |                            |        | 26,862
|                                     |                                                                           |                                                                                                                                                                                |                            |        |       
|                                     | STOCKHOLDERS' EQUITY                                                      |                                                                                                                                                                                |                            |        |       
|                                     |                                                                           | Common stock, $.03 par valueshares authorized, 15,000,000; issued and outstanding, 3,632,083 and 3,495,382 shares as of December 31, 2007 and December 31, 2006, respectively |                            |        | 109   
|                                     |                                                                           | Additional paid-in capital                                                                                                                                                     |                            |        | 15,534
|                                     |                                                                           | Accumulated other comprehensive gain                                                                                                                                           |                            |        | 3,406 
|                                     |                                                                           | Treasury stock, 162,672 shares, at cost                                                                                                                                        |                            |        | (1,265
|                                     |                                                                           | Retained earnings                                                                                                                                                              |                            |        | 5,317 
|                                     |                                                                           |                                                                                                                                                                                |                            |        |       
|                                     |                                                                           |                                                                                                                                                                                | Total stockholders' equity |        |       
|                                     |                                                                           |                                                                                                                                                                                |                            |        |       
|                                     | TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                                |                                                                                                                                                                                | $                          | 49,963 |       
|                                     |                                                                           |                                                                                                                                                                                |                            |        |       

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

26

---





OPTELECOM-NKF, INC.        CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME        FOR THE YEARS ENDED DECEMBER 31,        (Dollars in Thousands, Except Share Amounts)

|                                                   |                            | 2007                     |           | 2006   |        | 2005      |       
|-------------------------------------------------- | -------------------------- | ------------------------ | --------- | ------ | ------ | --------- | ------
|Revenues                                           |                            | $                        | 42,503    |        | $      | 39,484    |       
|Cost of goods sold                                 |                            |                          | 17,452    |        |        | 16,051    |       
|                                                   |                            |                          |           |        |        |           |       
|                                                   | Gross profit               |                          |           | 25,051 |        |           | 23,433
|Operating expenses:                                |                            |                          |           |        |        |           |       
|                                                   | Selling and marketing      |                          |           | 9,794  |        |           | 8,269 
|                                                   | Engineering                |                          |           | 5,150  |        |           | 4,606 
|                                                   | General and administrative |                          |           | 6,437  |        |           | 7,006 
|Amortization of intangible assets                  |                            |                          | 765       |        |        | 630       |       
|                                                   |                            |                          |           |        |        |           |       
|                                                   |                            | Total operating expenses |           |        | 22,146 |           |       
|                                                   |                            |                          |           |        |        |           |       
|Income from operations                             |                            |                          | 2,905     |        |        | 2,922     |       
|Other (expense) income:                            |                            |                          |           |        |        |           |       
|                                                   | Interest (expense)         |                          |           | (1,236 | )      |           | (1,187
|                                                   |                            |                          |           |        |        |           |       
|Income before income taxes                         |                            |                          | 1,669     |        |        | 1,735     |       
|Provision for income taxes                         |                            |                          | 388       |        |        | 181       |       
|                                                   |                            |                          |           |        |        |           |       
|Net income                                         |                            | $                        | 1,281     |        | $      | 1,554     |       
|                                                   |                            |                          |           |        |        |           |       
|Basic earnings per share                           |                            | $                        | 0.37      |        | $      | 0.45      |       
|                                                   |                            |                          |           |        |        |           |       
|Diluted earnings per share                         |                            | $                        | 0.37      |        | $      | 0.44      |       
|                                                   |                            |                          |           |        |        |           |       
|Weighted average common shares outstandingbasic   |                            |                          | 3,497,430 |        |        | 3,436,696 |       
|                                                   |                            |                          |           |        |        |           |       
|Weighted average common shares outstandingdiluted |                            |                          | 3,502,765 |        |        | 3,561,635 |       
|                                                   |                            |                          |           |        |        |           |       
|Net income                                         |                            | $                        | 1,281     |        | $      | 1,554     |       
|Foreign currency translation                       |                            |                          | 2,836     |        |        | 2,388     |       
|                                                   |                            |                          |           |        |        |           |       
|Comprehensive income                               |                            | $                        | 4,117     |        | $      | 3,942     |       
|                                                   |                            |                          |           |        |        |           |       

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

27

---





OPTELECOM-NKF, INC        CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY        FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005        (Dollars in Thousands, Except Share Amounts)

|                           |                                                       | Number
of Shares |         | Common
Stock |     | Additional
Paid-in
Capital |   | Deferred
Compen-
sation |       | Accumu-
lated
Other
Compre-
hensive
Income |     | Treasury
Stock |   | Retained
Earnings |        | Total
Stock-
holders'
Equity |       
|-------------------------- | ----------------------------------------------------- | ---------------- | ------- | ------------ | --- | -------------------------- | - | ----------------------- | ----- | ------------------------------------------ | --- | -------------- | - | ----------------- | ------ | ---------------------------- | ------
|BALANCE JANUARY 1, 2005    |                                                       | 3,179,109        |         | $            | 95  |                            | $ | 11,352                  |       | $                                          | (33 | )              | $ | (15               | )      | $                            | (1,265
|                           |                                                       |                  |         |              |     |                            |   |                         |       |                                            |     |                |   |                   |        |                              |       
|                           | Common stock issued from exercise of options          |                  | 83,199  |              |     | 3                          |   |                         | 450   |                                            |     |                |   |                   |        |                              |       
|                           | Common stock issued from employee stock purchase plan |                  | 8,679   |              |     |                            |   |                         | 66    |                                            |     |                |   |                   |        |                              |       
|                           | Stock Awards                                          |                  | 30,427  |              |     | 1                          |   |                         | 253   |                                            |     | (40            | ) |                   |        |                              |       
|                           | Stock based compensation                              |                  |         |              |     |                            |   |                         |       |                                            |     | 39             |   |                   |        |                              |       
|                           | Foreign currency translation                          |                  |         |              |     |                            |   |                         |       |                                            |     |                |   |                   | (1,803 | )                            |       
|                           | Tax benefit from exercise of options                  |                  |         |              |     |                            |   |                         | 169   |                                            |     |                |   |                   |        |                              |       
|                           | Net income                                            |                  |         |              |     |                            |   |                         |       |                                            |     |                |   |                   |        |                              |       
|                           |                                                       |                  |         |              |     |                            |   |                         |       |                                            |     |                |   |                   |        |                              |       
|BALANCE DECEMBER 31, 2005  |                                                       | 3,301,414        |         |              | 99  |                            |   | 12,290                  |       |                                            | (34 | )              |   | (1,818            | )      |                              | (1,265
|                           |                                                       |                  |         |              |     |                            |   |                         |       |                                            |     |                |   |                   |        |                              |       
|                           | Common stock issued from exercise of options          |                  | 180,691 |              |     | 5                          |   |                         | 1,243 |                                            |     |                |   |                   |        |                              |       
|                           | Common stock issued from employee stock purchase plan |                  | 4,277   |              |     |                            |   |                         | 49    |                                            |     |                |   |                   |        |                              |       
|                           | Reclassification of unamortized deferred compensation |                  |         |              |     |                            |   |                         | (34   | )                                          |     | 34             |   |                   |        |                              |       
|                           | Stock awards                                          |                  | 9,000   |              |     | 1                          |   |                         | 388   |                                            |     |                |   |                   |        |                              |       
|                           | Stock based compensation                              |                  |         |              |     |                            |   |                         | 561   |                                            |     |                |   |                   |        |                              |       
|                           | Foreign currency translation                          |                  |         |              |     |                            |   |                         |       |                                            |     |                |   |                   | 2,388  |                              |       
|                           | Net income                                            |                  |         |              |     |                            |   |                         |       |                                            |     |                |   |                   |        |                              |       
|                           |                                                       |                  |         |              |     |                            |   |                         |       |                                            |     |                |   |                   |        |                              |       
|BALANCE, DECEMBER 31, 2006 |                                                       | 3,495,382        |         |              | 105 |                            |   | 14,497                  |       |                                            |    |                |   | 570               |        |                              | (1,265
|                           | Common stock issued from exercise of options          |                  | 12,300  |              |     |                            |   |                         | 57    |                                            |     |                |   |                   |        |                              |       
|                           | Common stock issued from employee stock purchase plan |                  | 5,006   |              |     |                            |   |                         | 42    |                                            |     |                |   |                   |        |                              |       
|                           | Stock Awards                                          |                  | 10,000  |              |     | 1                          |   |                         | 82    |                                            |     |                |   |                   |        |                              |       
|                           | Vested portion of restricted stock                    |                  | 109,395 |              |     | 3                          |   |                         | (3    | )                                          |     |                |   |                   |        |                              |       
|                           | Stock based compensation                              |                  |         |              |     |                            |   |                         | 859   |                                            |     |                |   |                   |        |                              |       
|                           | Foreign exchange translation                          |                  |         |              |     |                            |   |                         |       |                                            |     |                |   |                   | 2,836  |                              |       
|                           | Net income                                            |                  |         |              |     |                            |   |                         |       |                                            |     |                |   |                   |        |                              |       
|                           |                                                       |                  |         |              |     |                            |   |                         |       |                                            |     |                |   |                   |        |                              |       
|BALANCE DECEMBER 31, 2007  |                                                       | 3,632,083        |         | $            | 109 |                            | $ | 15,534                  |       | $                                          |    |                | $ | 3,406             |        | $                            | (1,265
|                           |                                                       |                  |         |              |     |                            |   |                         |       |                                            |     |                |   |                   |        |                              |       

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

28

---





OPTELECOM-NKF, INC.        CONSOLIDATED STATEMENTS OF CASH FLOWS        FOR THE YEARS ENDED DECEMBER 31,        (Dollars in Thousands)

|                                                                                  |                                                                | 2007 |        | 2006   |   | 2005  |       
|--------------------------------------------------------------------------------- | -------------------------------------------------------------- | ---- | ------ | ------ | - | ----- | ------
|Cash Flows from Operating Activities                                              |                                                                |      |        |        |   |       |       
|Net income                                                                        |                                                                | $    | 1,281  |        | $ | 1,554 |       
|Adjustments to reconcile net income to net cash provided by operating activities: |                                                                |      |        |        |   |       |       
|                                                                                  | Depreciation and amortization                                  |      |        | 1,830  |   |       | 1,395 
|                                                                                  | Accounts receivable provision                                  |      |        | (434   | ) |       | (45   
|                                                                                  | Inventory provision                                            |      |        | 207    |   |       | 42    
|                                                                                  | Stock based compensation                                       |      |        | 942    |   |       | 949   
|                                                                                  | Stock issued for payment of interest                           |      |        |       |   |       |      
|                                                                                  | Deferred rent                                                  |      |        | 9      |   |       | 23    
|                                                                                  | Deferred tax asset                                             |      |        | (804   | ) |       | (1,213
|                                                                                  | Other                                                          |      |        |       |   |       | 98    
|Change in assets and liabilities:                                                 |                                                                |      |        |        |   |       |       
|                                                                                  | Accounts and contracts receivable                              |      |        | 827    |   |       | (3,539
|                                                                                  | Inventories                                                    |      |        | 667    |   |       | (1,348
|                                                                                  | Prepaid expenses and other assets                              |      |        | 301    |   |       | (354  
|                                                                                  | Other assets                                                   |      |        | 17     |   |       | (186  
|                                                                                  | Accounts payable                                               |      |        | (979   | ) |       | 952   
|                                                                                  | Other current liabilities                                      |      |        | (1,055 | ) |       | 2,030 
|                                                                                  |                                                                |      |        |        |   |       |       
|                                                                                  | Net cash provided by operating activities                      |      |        | 2,809  |   |       | 358   
|                                                                                  |                                                                |      |        |        |   |       |       
|Cash Flows (used in) Investing Activities                                         |                                                                |      |        |        |   |       |       
|                                                                                  | Investment in NKF Electronics B.V., net cash acquired          |      |        |       |   |       |      
|                                                                                  | Capital expenditures                                           |      |        | (1,010 | ) |       | (494  
|                                                                                  |                                                                |      |        |        |   |       |       
|                                                                                  | Net cash used in investing activities                          |      |        | (1,010 | ) |       | (494  
|                                                                                  |                                                                |      |        |        |   |       |       
|Cash Flows (used in) from Financing Activities                                    |                                                                |      |        |        |   |       |       
|                                                                                  | Borrowings on bank line-of-credit payable                      |      |        | 200    |   |       | 800   
|                                                                                  | Proceeds from notes payable                                    |      |        |       |   |       |      
|                                                                                  | Payments on notes payable and capital leases                   |      |        | (1,619 | ) |       | (2,308
|                                                                                  | Proceeds from issuance of common stock                         |      |        | 42     |   |       | 50    
|                                                                                  | Proceeds from exercise of stock options                        |      |        | 57     |   |       | 1,248 
|                                                                                  |                                                                |      |        |        |   |       |       
|Net cash (used in) provided by financing activities                               |                                                                |      | (1,320 | )      |   | (210  | )     
|                                                                                  |                                                                |      |        |        |   |       |       
|Effect of exchange rates on cash and cash equivalents                             |                                                                |      | 993    |        |   | 871   |       
|Net increase in cash and cash equivalents                                         |                                                                |      | 1,472  |        |   | 525   |       
|Cash and cash equivalentsbeginning of period                                     |                                                                |      | 3,571  |        |   | 3,046 |       
|                                                                                  |                                                                |      |        |        |   |       |       
|Cash and cash equivalentsend of period                                           |                                                                | $    | 5,043  |        | $ | 3,571 |       
|                                                                                  |                                                                |      |        |        |   |       |       
|Supplemental Disclosures of Cash Flow Information:                                |                                                                |      |        |        |   |       |       
|                                                                                  | Cash paid during the year for interest                         |      | $      | 630    |   | $     | 1,186 
|                                                                                  |                                                                |      |        |        |   |       |       
|                                                                                  | Cash paid during the year for income taxes                     |      | $      | 1,707  |   | $     | 1,122 
|                                                                                  |                                                                |      |        |        |   |       |       
|Supplemental information on non-cash investing and financing activities:          |                                                                |      |        |        |   |       |       
|                                                                                  | Notes and capital lease obligations incurred for new equipment |      | $      |       |   | $     |      
|                                                                                  |                                                                |      |        |        |   |       |       

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

29

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

1. Nature of Business and Summary of Significant Accounting Policies

Nature of BusinessOptelecom-NKF, Inc. (the Company) is a Delaware corporation that
was organized in 1972. The Company is a global supplier of Internet Protocol (IP) video and fiber transmission equipment, including IP cameras, video servers, network video recorders, video management
and video analytics software. We deliver complete solutions for traffic management and security of airports, seaports, casinos, prisons, utilities, public transport, city centers, hospitals, and
corporate campuses.

Principles of ConsolidationThe consolidated financial statements include the accounts of the Company and its subsidiaries.
All significant inter-company transactions and balances have been eliminated.

Use of EstimatesThe preparation of financial statements in conformity with accounting principles generally accepted in the
United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Accounts ReceivableAccounts receivable potentially subjects the Company to concentrations of credit risk. Credit is extended
based on evaluation of a customer's financial condition and, generally, collateral is not required. Accounts receivable are due within 30 days and are stated at amounts due from the customers
net of an allowance for doubtful accounts. Accounts outstanding longer than the contractual payment terms are considered past due. The Company maintains allowances for doubtful accounts for estimated
losses resulting from the inability of customers to make required payments. The Company regularly monitors and assesses its risk of not collecting amounts owed by its customers. This evaluation is
based upon an analysis of amounts current and past due along with relevant history and facts particular to the customer such as collection history and the results of credit inquiries. The Company
believes that its allowance for doubtful accounts is adequate to cover any potential losses on its credit risk exposure. The Company writes off accounts receivable when they become uncollectible, and
payments subsequently received on such receivables are credited to the allowances for doubtful accounts.

Revenue RecognitionRevenue from commercial sales is recognized when products are shipped and title passes pursuant to the
terms of the agreement with the customer, the amount from
the customer is fixed, and collectability is reasonably assured. Revenues from fixed-price contracts, such as contracts from the government, are recognized on the
percentage-of-completion method, which relies on estimates of total expected contract revenue and costs. The Company follows this method since reasonably dependable estimates
of the revenue and costs applicable to various stages of a contract can be made. Recognized revenues and profit are subject to revisions as the contract progresses to completion. Revenues from
time-and-materials contracts are recorded at the contract rates times the labor hours plus other direct costs as incurred.

Product WarrantyIn the ordinary course of business, the Company warrants its products against defect in design, materials,
and workmanship over various time periods generally ranging from two to five years. Warranty reserve and allowance for product returns is established based upon management's best estimates of amounts
necessary to settle future and existing claims on products sold as of the

30

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

1. Nature of Business and Summary of Significant Accounting Policies (Continued)

balance
sheet date. The following is a summary of the Company's continuing warranty obligation for the years ended December 31:

(Dollars in thousands)

2007

2006Balance, beginning of year

$
431

$
309Provision for warranty obligations


144


182Charges against warranty obligations


(157
)

(60
)Balance, end of year

$
418

$
431


InventoriesProduction materials are valued at the lower of cost or market applied on a standard cost basis.
Work-in-process represents direct labor, materials, and overhead incurred on products not completed to date. Finished goods inventories are valued at the lower of cost or
market, cost being determined using standards that approximate actual costs on a specific identification basis. The Company writes down its inventory for estimated obsolescence or unmarketable
inventory based upon assumptions about future demand and market conditions as well as historical inventory turnover. If actual market conditions are less favorable than those projected by management,
additional inventory write-downs may be required.

Property, Equipment, and DepreciationProperty and equipment are recorded at cost and are depreciated using the
straight-line method over the estimated useful lives of the assets, which range from 3 to 10 years. Leasehold improvements are amortized over the terms of the respective leases or
the service lives of the assets, whichever is shorter. Expenditures for maintenance and repairs are expensed as incurred.

Intangibles and GoodwillIntangibles and goodwill acquired in connection with business acquisitions are stated at their fair
value on the date of purchase. The costs of intangibles which are subject to amortization are amortized on a straight-line basis over their expected lives of three to eleven years. The
recoverability of carrying values of amortizable intangible assets is evaluated on a recurring basis whenever events or changes in circumstances indicate that the carrying amount of assets may not be
recoverable. Recovery of assets to be held and used is measured by comparing the carrying value of these assets with the expected future cash flows generated by the assets. If the assets are
considered to be impaired, the impairment is recognized by the amount which the carrying amount of the assets exceeds their fair value. Goodwill and intangibles with indefinite lives are not
amortized, but are subject to an annual impairment test, pursuant to the provision of FAS No. 142: Goodwill and Other Intangible Assets. The primary indicators are current and forecasted
profitability and cash flow of the related business. There have been no adjustments to the carrying values of goodwill or intangible assets resulting from these impairment tests during 2007.

Research and Development CostsResearch and development costs are expensed as incurred and included as a component of
engineering expense in the consolidated statements of operations. The Company incurred research and development costs of $4.3 million, $3.6 million and $2.7 million for the years
ended December 31, 2007, 2006 and 2005, respectively.

Income TaxesThe Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes" which
requires that deferred tax assets and liabilities be recognized

31

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

1. Nature of Business and Summary of Significant Accounting Policies (Continued)

using
enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS No. 109 also requires that deferred tax assets be reduced
by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized.

The
Company adopted FASB Interpretation 48, "Accounting for Uncertainty in Income Taxes, an interpretation of SFAS 109" ("FIN 48"), on January 1, 2007. The Company
had no financial statement impact from the adoption of FIN 48. The Company's policy is that it would recognize interest and penalties accrued on any unrecognized tax benefits as a component of
income tax expense.

Stock-Based CompensationOn January 1, 2006, the Company adopted Statement of Financial Accounting Standards
No. 123 (revised 2001),Share-based Payments("SFAS 123R"), which requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors using a fair value based option pricing model, and eliminates the alternative to use the intrinsic value method of accounting for share-based
payments. SFAS 123R is effective for our fiscal year beginning January 1, 2006. Adoption of the expense provision of SFAS 123R had a material impact on our result of operations.
We have applied the modified prospective transition method; accordingly, compensation expense is reflected in the financial statements beginning January 1, 2006, with no restatement of prior
periods. Compensation expense is recognized for awards that are granted, modified, repurchased or cancelled on or after January 1, 2006, as well as for the portion of awards previously granted
that have not vested as of January 1, 2006. Share-based tax-affected compensation expense recognized under SFAS 123R for the year ending December 31, 2007 and 2006 was
$0.9 million and $0.8 million respectively. This resulted in a $0.26 and $0.22 decrease in both basic and diluted earnings per share for the years ended December 31, 2007 and 2006
respectively. As of December 31, 2007, total unamortized compensation expense related to non-vested share-based compensation was $1.0 million and is expected to be recognized
over a period of 1.08 years. At December 31, 2006, unamortized compensation expense related to non-vested share-based compensation was $0.8 million and was expected to
be recognized over a period of 1.7 years.

Prior
to the adoption of SFAS 123R, the Company accounted for share-based awards in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees(APB 25)
and related interpretations which provided that the compensation expense relative to the
Company's employee stock options be measured based on the intrinsic value of the stock option. Under the intrinsic value method, no share-based compensation expense had been recognized in the
Company's operating results because the exercise price of the Company's stock options granted to employees and directors equaled the fair market value of the underlying stock at the date of grant. In
accordance with Statement of Financials Accounting Standards No. 123,Accounting for Stock-Based Compensation(SFAS 123) and Statement of
Financials Standards No. 148,Accounting for Stock-Based Compensation-Transition and Disclosure(SFAS 148), the Company provided pro forma
information regarding net earnings and net earnings per share as if compensation costs for the Company's share-based awards had been determined in accordance with the fair value method.

32

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

1. Nature of Business and Summary of Significant Accounting Policies (Continued)

The
following table illustrates the effect on net income and net income per common share if the Company had applied the fair value recognition provisions of SFAS 123R to
stock-based compensation for the year ending December 31, 2005.

(Dollars in thousands)

December 31
2005Net Income

$
2,682Less Stock-based compensation costs, net of income tax, as if fair value method had been applied


(683
)Net income, pro forma

$
1,999Basic earnings per share:As reported

$
0.83Pro forma

$
0.62Diluted Earnings per Share:As reported

$
0.80Pro forma

$
0.59


Foreign Currency Translation/TransactionsThe functional currency of the Company's international operations is the local
currency. The Company translates the assets and liabilities of its foreign subsidiaries into U.S. dollars at the exchange rates in effect at the end of the year and revenue and expense accounts are
translated into U.S. dollars using the weighted average rates for the year. The related translation adjustments are reported as foreign currency translation in the statement of stockholders' equity.
Transaction gains and losses arising from transactions denominated in a currency other than the functional currency of the entity involved are included in the results of operations.

Cash and Cash EquivalentsThe Company considers all liquid investments with original maturities of three months or less at the
time of purchase to be cash equivalents.

Fair Value of Financial InstrumentsThe carrying amounts approximate fair value of the Company's cash and
short-term financial instruments. The fair value of long-term debt is based on current rates at which the Company could borrow funds with
similar remaining maturities. The Company believes the carrying value of its notes payable approximate fair value.

Advertising and Promotion ExpensesCosts of advertising are expensed as incurred. Advertising and promotion expenses for the
years ended December 31, 2007, 2006, and 2005 were $288 thousand, $437 thousand and $239 thousand, respectively.

Sales TaxIn June 2006, the FASB ratified a consensus opinion reached by the Emerging Issues Task Force (EITF) on EITF Issue
06-3, "How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)."The Company
presents all non-income government-assessed taxes (sales, use, and value added taxes) collected from its customers and remitted to governmental agencies on a net basis (excluded from
revenue) in its financial statements. The consensus in EITF Issue 06-3 does not require the Company to reevaluate its existing accounting policies for income statement presentation. The
Company applied the guidance in EITF Issue 06-3 effective January 1, 2007 which resulted in

33

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

1. Nature of Business and Summary of Significant Accounting Policies (Continued)

additional
disclosure but did not change the method in which the Company accounts for taxes collected.

Earnings Per ShareBasic earnings per share is computed by dividing net income by weighted average shares outstanding. No
dilution for any potentially dilutive securities is included in basic earnings per share. Diluted earnings per share is computed by dividing net income by weighted average shares and common equivalent
shares outstanding.

The
computation of basic and diluted earnings per share for the years ended December 31, 2007, 2006 and 2005 is as follows:

(Dollars in thousands except share amounts)

2007

2006

2005Basic Earnings Per Share:Net income

$
1,281

$
1,554

$
2,682Weighted average common shares outstanding


3,497,430


3,436,696


3,250,097Basic earnings per share

$
0.37

$
0.45

$
0.83Diluted Earnings Per Share:Net income

$
1,281

$
1,554

$
2,682Weighted average common shares outstanding, basic


3,497,430


3,436,696


3,250,097Effect of stock options


5,335


124,939


105,526Weighted average common shares outstanding, diluted


3,502,765


3,561,635


3,355,623Diluted earnings per share

$
0.37

$
0.44

$
0.80


Recent Accounting PronouncementsIn December 2007, the Financial Accounting Standards Board issued Statement 141 (revised
2007), Business Combinations (Statement 141R) to change how an entity accounts for the acquisition of a business. When effective, Statement 141R will replace existing
Statement 141 in its entirety. Statement 141R carries forward the existing requirements to account for all business combinations using the acquisition method (formerly called the
purchase method). In general, Statement 141R will require acquisition-date fair value measurement of identifiable assets acquired, liabilities assumed, and noncontrolling interests
in the acquiree. Statement 141R will eliminate the current costbased purchase method under Statement 141.

34

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

1. Nature of business and summary of significant accounting policies

The new measurement requirements will result in the recognition of the full amount of acquisition-date goodwill, which includes amounts attributable
to noncontrolling interests. The acquirer will recognize in income any gain or loss on the remeasurement to acquisition-date fair value of consideration transferred or of previously
acquired equity interests in the acquiree. Neither the direct costs incurred to effect a business combination nor the costs the acquirer expects to incur under a plan to restructure an acquired
business will be included as part of the business combination accounting. As a result, those costs will be charged to expense when incurred, except for debt or equity issuance costs, which will be
accounted for in accordance with other generally accepted accounting principles.

Statement
141R will also change the accounting for contingent consideration, in process research and development, contingencies, and restructuring costs. In addition, changes in deferred
tax asset valuation allowances and acquired income tax uncertainties in a business combination that occur after the measurement period will impact income taxes under Statement 141R.

Statement
141R is effective for fiscal years and interim periods within those fiscal years beginning on or after December 15, 2008. Early adoption is prohibited. The Company
intends to adopt Statement 141R effective January 1, 2009 and apply its provisions prospectively.

The
Company is evaluating the impact that the adoption of Statement 141R will have on its financial statements.

Statement
141R amends the goodwill impairment test requirements in Statement 142. For a goodwill impairment test as of a date after the effective date of Statement 141R,
the value of the reporting unit and the amount of implied goodwill, calculated in the second step of the test, will be determined in accordance with the measurement and recognition guidance on
accounting for business combinations under Statement 141R. This change could effect the determination of what amount, if any, should be recognized as an impairment loss for goodwill recorded
before the effective date of Statement 141R. This accounting will be required when Statement 141R becomes effective (January 1, 2009 for the Company) and applies to goodwill
related to acquisitions accounted for originally under Statement 141 as well as those accounted for under Statement 141R.

The
Company has $15,259,000 of goodwill at December 31, 2007 related to a previous business combination. The Company has not determined what effect, if any, Statement 141R
will have on the results of its impairment testing subsequent to December 31, 2008.

In
September 2006, the FASB issued SFAS 157, "Fair Value Measurements". SFAS No. 157 defines fair value, establishes a framework and gives guidance regarding the methods
used for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after
November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating the impact of SFAS No. 157 on its results of operations and financial position.

In
February 2007, the FASB issued SFAS 159, "The Fair Value Option for Financial Assets and Financial Liabilities," which allows companies the option to measure certain financial
assets or liabilities at fair value and include unrealized gains and losses in net income rather than equity. Subsequent measurements for the financial instruments and liabilities an entity elects to
measure at fair value will be recognized in earnings. SFAS 159 also established additional disclosure requirements. SFAS 159 is effective for fiscal years beginning after
November 15, 2007, with early adoption permitted

35

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

1. Nature of business and summary of significant accounting policies (Continued)

provided
that the entity also adopts SFAS 157. The Company is currently evaluating the effect, if any, the adoption of SFAS 159 will have on its consolidated results of operations,
financial position and cash flows.

2. Acquisition of NKF Electronics

On March 8, 2005,the Company completed the acquisition of NKF Electronics, B.V. a private company with limited liability, incorporated in the
Netherlands ("NKF"), pursuant to the terms and conditions of the Share Purchase Agreement dated March 8, 2005 (the "Purchase Agreement") by and among the Company, NKF, Draka
Holding, N.V., a limited liability company, incorporated in the Netherlands ("Draka"), and NKF Vastgoed B.V., a private company with limited liability, incorporated in the Netherlands, a
direct wholly-owned subsidiary of Draka ("Vastgoed" together with Drakathe "Sellers"). NKF focuses on business opportunities in the worldwide optical communication equipment marketplace.
The acquisition was undertaken to give the Company a strong
position in this market through expanded and diversified revenue streams, enhanced research and development capabilities, and a more extensive sales and service organization, addressing the
world-wide marketplace for the products of both companies.

Pursuant
to the Purchase Agreement, the Company acquired from the Sellers and the Sellers sold, all of the outstanding stock of NKF for the following consideration (the "Acquisition
Consideration"): (a) $9.2 million in cash; (b) $5.5 million paid in cash to retire NKF's inter-company debt owed to the Seller; and (c) a Euro denominated
Subordinated Promissory Note in the principal amount of $9.8 million (7.3 million Euros), and (d) closing costs of $2.0 million. The amount of consideration was determined
on the basis of arm's length negotiations between the Company and the Sellers. The results from NKF operations have been consolidated since its acquisition on March 8, 2005.

The
acquisition was accounted for using the purchase method of accounting, as required by Statement of Financial Accounting Standard No. 141, "Business Combinations." Under this
method of accounting, the Company allocated the purchase price to the fair value of the net assets acquired,

36

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

2. Acquisition of NKF Electronics (Continued)

including
identified intangible assets and goodwill. The following table summarizes the total purchase price and estimated fair values of the assets acquired and liabilities assumed (dollars in
thousands).

Cash paid at closing to Seller

$
14,607Note tendered at closing to Seller


9,795Direct acquisition costs


2,028Total purchase price

$
26,430Fair value of identified assets acquired and liabilities assumed:Cash

$
368Accounts receivable, net


4,176Inventory


2,707Other current assets


171Fixed assets


1,109Intangible assets


9,512Goodwill


13,921Total Assets Acquired


31,964Liabilities assumed


(2,515
)Deferred tax liability


(3,019
)Net Assets Acquired

$
26,430


The
changes in goodwill and intangibles from the date of acquisition to December 31, 2007 is a result of foreign exchange fluctuations. Goodwill is not expected to be tax
deductible. The acquired intangible assets were as follows:

(dollars in thousands)

Estimated
Fair Value

Weighted Average
Amortization
Period (Year)Customer Relationships

$
7,071

11.0Employment Agreement


306

3.0Total Intangibles subject to amortization


7,377

10.7Tradename and trademarknot subject to amortization


2,135

N/ATotal

$
9,512

10.7


37

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

2. Acquisition of NKF Electronics (Continued)

For
the year ended December 31, 2007 and 2006, amortization expense for customer relationships and the employment agreement totaled $765 thousand and $630 thousand
respectively. Estimated future aggregate annual amortization expense for intangible assets is as follows (dollars in thousands):

Year

Amount2008

$
6852009


6752010


6752011


675Thereafter


2,755


Unaudited
pro forma results of operations are as follows. The amounts are shown as if the acquisition had occurred at the beginning of the year ended December 31, 2005:

(Dollars in thousands except share amounts)

December 31,
2005Pro forma revenues

$
36,599Pro forma net income


2,924Pro forma earnings per sharebasic

$
0.89Pro forma earning per sharediluted


0.87


The
pro forma information is not necessarily indicative of the operational results that would have occurred if the acquisition had been consummated on the dates indicated nor is it
necessarily indicative of future operating results or financial position of the combined enterprise. The unaudited pro forma combined condensed financial information does not reflect any adjustments
to conform accounting practices or to reflect any cost savings or other synergies anticipated as a result of the acquisition.

3. Accounts and Contracts Receivable

Accounts and contracts receivable consisted of the following at December 31:

(Dollars in thousands)

2007

2006Accounts and contracts receivable

$
9,824

$
9,847Less: Allowance for doubtful accounts


(249
)

(625
)$
9,575

$
9,222


38

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

4. Inventories

Inventories consisted of the following at December 31:

(Dollars in thousands)

2007

2006Production materials

$
3,187

$
3,431Work in process


801


785Finished goods


1,976


2,050Allowance for obsolescence


(750
)

(507
)Net

$
5,214

$
5,759


5. Property and Equipment

Property and equipment consisted of the following at December 31:

(Dollars in thousands)

2007

2006Laboratory equipment

$
3,551

$
3,485Office equipment


2,163


2,569Furniture and fixtures


252


226Leasehold improvements


1,620


1,459Computer hardware and software


2,642


1,12610,228


8,865Less accumulated depreciation and amortization


(7,634
)

(6,377
)Net property and equipment

$
2,594

$
2,488


Assets
under capital leases are included in the above categories and consisted of the following:

(Dollars in thousands)

2007

2006Laboratory equipment

$
85

$
85Office equipment


269


269354


354Less accumulated amortization


(231
)

(178
)Net assets under capital leases

$
123

$
176


Depreciation
expense was $1.0 million, $800 thousand and $735 thousand for the years ended December 31, 2007, 2006 and 2005 respectively.

39

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

6. Income Taxes

The components of income before income taxes consisted of the following for the years ended December 31:

(Dollars in thousands)

2007

2006

2005U.S. Operations

$
(991
)
$
(1,839
)
$
(609
)Non-U.S. Operations


2,660


3,574


4,129$
1,669

$
1,735

$
3,520


The
components of the expense (benefit) provision for income taxes for the years ended December 31 are summarized as follows:

(Dollars in thousands)

2007

2006

2005Current Expense (Benefit)U.S. Operations

$
(15
)
$
2

$
(3
)Non-U.S. Operations


1,025


1,067


1,569$
1,010

$
1,069

$
1,566Deferred Expense (Benefit)U.S. Operations

$
(430
)
$
(587
)
$
(323
)Non-U.S. Operations


(192
)

(301
)

(405
)$
(622
)
$
(888
)
$
(728
)Total

$
388

$
181

$
838


The
difference between the federal income tax expense (benefit) and the amount computed applying the statutory federal income tax rate are summarized as follows for the years ended
December 31:

2007

2006

2005United States Federal tax at statutory rates

34.0
%
34.0
%
34.0
%(Reduction) increase of taxes:State taxes, net of federal benefit

(2.3
)
(2.1
)
(0.3
)Valuation allowance related to net deferred tax assets





Foreign rate differential

(12.8
)
(8.5
)
(2.7
)Business tax credits

(3.3
)
(4.7
)
(2.0
)Change in tax rates



(17.4
)
(4.8
)Permanent differences

8.7

7.3Other

(0.9
)
1.9

(0.4
)Effective income tax rate

23.4
%
10.5
%
23.8
%


40

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

6. Income Taxes (Continued)

Deferred income taxes reflect the net tax effects of temporary differences between the amount of assets and liabilities for income tax and financial reporting
purposes. The components of deferred income tax liabilities and assets as of December 31 are as follows (dollars in thousands):

2007

2006Gross deferred tax assets:Excess book depreciation

$
7

$
Inventory


173


264Accrued vacation


124


73Deferral of rent expense


96


91Bad debt reserve


36


101Tax credits


627


624Deferred Compensation


252


11Unrealized foreign exchange loss


383


Other


210


202Net operating loss


1,108


995Deferred tax assets


3,016


2,361Gross deferred tax liabilities:Intangibles


(2,037
)

(2,072
)Excess tax depreciation





(109
)Unrealized foreign exchange gain





(37
)Other





(56
)Deferred tax liabilities


(2,037
)

(2,274
)Net deferred tax assets

$
979

$
87


During
2007, 12,300 stock options were exercised for the purchase of shares of common stock. The exercise of these stock options generated an income tax deduction equal to the excess of
the fair market value over the exercise price. In accordance with SFAS 123(R) the Company will not recognize a deferred tax asset with respect to the excess stock compensation deductions until
those deductions actually reduce our income tax liability. As such, the Company has not recorded a deferred tax asset related to the net operating losses resulting from the exercise of these stock
options in the accompanying financial statements. At such time as the Company utilizes these net operating losses to reduce income tax payable, the tax benefit will be recorded as an increase in
additional paid in capital.

As
of December 31, 2007 and 2006, the Company had tax affected net operating loss and business tax credit carryforwards of approximately $1.7 million and
$1.6 million, respectively, for U.S. income tax purposes. These carryforwards and credits begin to expire in the year 2019. The use of these net operating loss and tax credit carryforwards may
be subject to limitation under the rules regarding a change of ownership as determined by the Internal Revenue Service. The effects of potential ownership changes, if any, have not been analyzed by
the Company.

In
evaluating the Company's ability to recover its deferred tax assets, we considered all available positive and negative evidence, including past operating results, the reversal of
temporary differences, the forecasts of future taxable income and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts
of future taxable income

41

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

6. Income Taxes (Continued)

and
are consistent with estimates being used to manage the business. Based on the weight of the positive and negative evidence and the information available, the Company believes that it is more
likely than not that its deferred tax assets will be realized.

The
Company files tax returns in the U.S. federal jurisdiction, as well as various state and foreign tax jurisdictions in which it has a subsidiary or branch operation. The tax years
2003 to 2007 remain open to examination by U.S. and state tax authorities, and the tax years 2005 to 2007 remain open to examination by the foreign tax authorities.

7. Notes Payable

Notes payable consist of the following at December 31:

(Dollars in thousands)

2007

2006Senior term facility with a bank due February 2009

$
4,958

$
6,483Subordinated note due March 2010(1)


12,022


10,480Other





2316,980


16,986Less Current Portion


(1,525
)

(1,548
)$
15,455

$
15,438




On
March 8, 2005, the Company completed the acquisition of NKF Electronics B.V. pursuant to the terms and conditions of the Share Purchase Agreement. The purchase price for
the acquisition following the final purchase price adjustment was approximately 18.3 million Euros ($24.4 million USD), which consisted of a cash payment of 11 million Euros
($14.6 million USD) and a 6% Euro denominated subordinated note for 7.3 million Euros issued by the Company to Draka for the remainder.

The
cash portion of the purchase price was funded by a $14.6 million senior term facility provided by a Bank, consisting of a 4.1 million Euro based term loan
($5.4 million USD) and a $9.2 million USD based term loan. Both term loans carry interest at the rate of LIBOR plus a margin that can range from 2.25% to 3.25%. The variability in the
margin is a function of the Company's leverage position that is calculated as Total Senior Debt divided by EBITDA. As of December 31, 2007, the interest rate on this facility was 8.60%. The
term loans are subject to a seventy-two month amortization which is payable over four years via a balloon payment in month 48. Principal and interest are payable on a monthly basis. The
Company made approximately $1.5 million and $2.2 million USD payments on this loan during 2007 and 2006 respectively.

The
Subordinated Note accrues interest at a rate of 6% per annum and is due and payable in full on March 8, 2010. $1.2 million of deferred interest payable has been accrued
on the Subordinated Note as of December 31, 2007. The Subordinated Note is denominated in Euros and the liability increased $1.1 million due to the impact of exchange rate changes during
2007. The impact of foreign exchange

42

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

7. Notes Payable (Continued)

rates
on this Subordinated Note will be recognized as other income (expense) upon payment of the note.

Under
its current banking facility, the Company has the ability to borrow up to $5.0 million under its existing bank line-of-credit as of
December 31, 2007, provided there are sufficient accounts receivable and inventory. This facility allows the Company to borrow in either USD or Euros with a maximum amount not to exceed
$5.0 million USD. The borrowing base under the facility is equal to between 60%85% of the eligible commercial billed accounts receivable and 30% of eligible related inventory.

The
revolving line of credit carries interest at the rate of LIBOR plus a margin that can range from 1.75% to 2.75% depending on the Company's leverage position. As of
December 31, 2007, the Company had $1.0 million outstanding on its bank line-of-credit with an effective interest rate of 8.60%. At December 31, 2007, the
Company had $1.0 million of additional borrowing capability in the U.S. and $2.3 million on our Euro line of credit through our subsidiary based in the Netherlands.

The
Company is required by the bank to comply with certain financial covenants including maintaining a minimum fixed charge coverage ratio and a maximum senior debt coverage ratio. The
Company was in compliance with the financial covenants at December 31, 2007.

The
Company took delivery of capital equipment for its manufacturing operations in March 2003 and incurred a promissory note with the vendor. The note principal was $180 thousand
and is payable in semi-annual installments of $22 thousand beginning June 2003 through December 2007, with interest payable at the rate of 4.40%.

Schedule
maturities on notes payable are as follows for each of the next five years:

Year Ended December 31, (Dollars in thousands):2008

$
1,5252009


3,4332010(1)


12,0222011


2012


$
16,980




8. Commitments and Contingencies

Operating LeasesIn March 2003, the Company began to occupy its corporate office and manufacturing
facility located in Germantown, Maryland. As an inducement to enter this operating lease, the Company received certain incentives such as rent abatement. Additionally, the lease provides for scheduled
rent increases. These lease incentives are being amortized over the lease period. Rent expense is being recognized on a straight-line basis.

43

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

8. Commitments and Contingencies (Continued)

In Europe we have leases for office and sales facilities located in the Netherlands that expires in March 2015, in France that expires in June 2009, and Spain
which expires in April 2009. In the U.K. we have a monthly lease for office and sales facilities.

As
of December 31, 2007, future net minimum rental payments required under capital and operating leases that have initial or remaining non-cancelable terms in excess
of one year are as follows:

Year Ended December 31 (Dollars in thousands):

Operating

Capital

Total2008

$
1,361

$
46

$
1,4072009


1,271





1,2712010


1,198





1,1982011


1,175





1,175Thereafter


2,834





2,834Gross Payments

$
7,839

$
46

$
7,885Less Amounts Representing Interest





1


1Net Minimum Rental Payments

$
7,839

$
45

$
7,884


Rent
expense was $1.1 million, $1.0 million, and $1.0 million for the years ended December 31, 2007, 2006, and 2005, respectively.

Legal ProceedingsFrom time to time, Optelecom-NKF is involved in legal proceedings and litigation arising in the
ordinary course of business. In management's opinion, the ultimate resolution of any such actions will not materially affect the Company's financial position or results of operations.

9. Stockholders' Equity

Common StockDuring 2007, 2006 and 2005, proceeds from the exercise of stock options for the purchase
of 12 thousand, 181 thousand, and 83 thousand shares of common stock were $57 thousand, $1.2 million and $453 thousand respectively.

Stock Purchase PlanThe Company's Stock Purchase Plan is intended to give employees a convenient means of purchasing shares of
Common Stock through payroll deductions. Each
participating employee's contributions will be used to purchase shares for the employee's share account as promptly as practicable after each calendar quarter. The cost per share will be 15% of the
lower of the closing price of the Company's Common Stock as reported by NASDAQ on the first or the last day of the calendar quarter. The Company has reserved 200,000 shares of Common Stock for
issuance under the Stock Purchase Plan. As of December 31, 2007, 79,000 shares have been issued under the Stock Purchase Plan.

Director's Stock CompensationPrior to July 1, 2006, each non-employee Director received stock options to
purchase 1,000 shares of common stock for each board meeting attended either in person or by telephone. Additionally, each non-employee Director was granted 1,000 shares of restricted
common stock at the closing price on the date of the annual shareholders' meeting. As of July 1, 2006, each non-employee Director is granted 625 shares of restricted common stock at
the closing price on the first day of each calendar quarter. The Company issued 10,000, 9,000, and 4,000 shares of common stock to directors in 2007, 2006 and 2005, respectively.

44

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

9. Stockholders' Equity (Continued)

Stock OptionsThe Company has two stock-based compensation plans. It is the practice of the Company to satisfy awards and
options granted under these plans through the issuance of new shares. During the years ended December 31, 2007, 2006 and 2005, the Company recognized compensation expense of
$942 thousand, $949 thousand and $39 thousand respectively. In each of the periods described above, compensation expense related to these plans was recorded in the Consolidated
Statements of Operations. The Company did not capitalize any stock-based compensation cost during the years ended December 31, 2007, 2006 and 2005, respectively. The Company did not realize any
income tax benefits from stock-based payment plans during the year ended December 31, 2007, as discussed in Note 6.

The
2002 Incentive Stock Option Plan provides for up to 776,600 shares available for grant. The options may be granted to officers (including officers who are directors), other key
employees of, and consultants to the Company. There were 130,247 options available for future grant at December 31, 2007. The exercise price of each option is the fair market value of the stock
at the grant date. Options granted prior to 2007 are 25% exercisable at the grant date, 75% exercisable one year from the grant date and are fully exercisable two years from the grant date. Options
granted in 2007 are fully exercisable two years from the grant date. Options expire five years from the date of grant and, in most cases, upon termination of employment.

The
2001 Nonqualified Director Stock Option Plan provides for up to 178,500 shares available for grant. Options under this plan are granted to non-employee directors at fair
market value on the date of the grant are exercisable upon grant and expire five years thereafter. There were 43,000 awards available for future grant at December 31, 2007.

The
fair value of each stock option award was estimated on the date of grant using a Black Scholes option-pricing model based on the following weighted average assumptions:

Years Ended December 31,2007

2006

2005Expected Dividend yield

0
%
0
%
0
%Expected volatility

54.67
%
55.75
%
56.28
%Risk-free interest rate

4.48
%
4.60
%
4.39
%Expected term

3

3

3


45

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

9. Stockholders' Equity (Continued)

A
summary of the status of the Company's aggregate stock option awards under its Plans during the years ended December 31, 2007, 2006 and 2005, is presented below:

|                                               |  | Shares
(in thousands) |   | Weighted-Average
Exercise Price |       | Weighted-Average
Remaining
Contractual Term
(Years) |      | Aggregate Intrinsic
Value
(in thousands)
|---------------------------------------------- |  | --------------------- | - | ------------------------------- | ----- | --------------------------------------------------- | ---- | ----------------------------------------
|Outstanding, January 1, 2005                   |  | 357                   |   | $                               | 7.17  |                                                     | 2.85 |                                         
|Granted                                        |  | 203                   |   |                                 | 9.73  |                                                     |      |                                         
|Exercised                                      |  | (82                   | ) |                                 | 5.43  |                                                     |      |                                         
|Forfeited, cancelled or expired                |  | (13                   | ) |                                 | 11.87 |                                                     |      |                                         
|                                               |  |                       |   |                                 |       |                                                     |      |                                         
|Outstanding December 31, 2005                  |  | 465                   |   |                                 | 8.48  |                                                     | 2.98 |                                         
|Granted                                        |  | 71                    |   |                                 | 14.25 |                                                     |      |                                         
|Exercised                                      |  | (181                  | ) |                                 | 6.91  |                                                     |      |                                         
|Forfeited, cancelled or expired                |  | (5                    | ) |                                 | 8.36  |                                                     |      |                                         
|                                               |  |                       |   |                                 |       |                                                     |      |                                         
|Outstanding December 31, 2006                  |  | 350                   |   |                                 | 10.45 |                                                     | 3.01 |                                         
|Granted                                        |  | 113                   |   |                                 | 9.12  |                                                     |      |                                         
|Exercised                                      |  | (12                   | ) |                                 | 4.63  |                                                     |      |                                         
|Forfeited, cancelled or expired                |  | (28                   | ) |                                 | 10.18 |                                                     |      |                                         
|                                               |  |                       |   |                                 |       |                                                     |      |                                         
|Outstanding, December 31, 2007                 |  | 423                   |   |                                 | 10.27 |                                                     | 2.61 |                                         
|                                               |  |                       |   |                                 |       |                                                     |      |                                         
|Vested and expected to vest, December 31, 2007 |  | 411                   |   |                                 | 10.29 |                                                     | 2.57 |                                         
|                                               |  |                       |   |                                 |       |                                                     |      |                                         
|Exercisable, December 31, 2007                 |  | 306                   |   | $                               | 10.52 |                                                     | 2.06 |                                         

The
following table summarizes information about all stock options outstanding at December 31, 2007.

|                 |  | Options Outstanding |  | Options Exercisable
|---------------- |  | ------------------- |  | -------------------
|
|$4.66 to $9.05   |  | 86                  |  | 2.09               
|$9.06 to $9.48   |  | 213                 |  | 2.89               
|$9.49 to $13.87  |  | 92                  |  | 2.23               
|$13.88 to $27.77 |  | 32                  |  | 3.31               
|                 |  |                     |  |                    
|                 |  | 423                 |  | 2.61               
|                 |  |                     |  |                    

The
per share weighted-average fair value of stock option awards granted during the years ended December 31, 2007, 2006 and 2005 was $9.12, $14.25, and $9.73, respectively, on the
date of grant. The total intrinsic value on the date of exercise of stock option awards exercised during the years ended December 31, 2007, 2006 and 2005 was $57 thousand,
$464 thousand and $910 thousand, respectively. As of December 31, 2007, there was $650 thousand of total unrecognized compensation cost related to

46

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

9. Stockholders' Equity (Continued)

stock
option awards granted under the plans. The weighted-average period over which the compensation expense for these awards is expected to be recognized is 1.08 years.

10. Employee Benefit Plans

The Company sponsors a 401(k) defined contribution plan in which most U.S. employees are eligible to participate. The Company matches employee contributions to
the plan up to a maximum of 2.5%. Total matching contributions were $84 thousand, $116 thousand, and $119 thousand for the years ended December 31, 2007, 2006, and 2005,
respectively.

In
December 2007 the Company amended the Employment Agreement with its Chief Executive Officer. The amended employment agreement increased the amount the CEO receives if he terminates
his employment by retirement in accordance with the Employment Agreement. The current agreement provides for a retirement benefit of three weeks of his annual base salary times the number of full
years that he has been employed by the Company. The cash payment is estimated at $672 thousand and is being accrued through the end of the current contract period on December 31, 2009.

11. Geographical Information

During the first quarter of 2007, the Company implemented a corporate restructuring. As part of the restructuring, management concluded that the Company operates
as one primary business segment, the Communication Products Division (CPD) which develops, manufactures and sells optical fiber-based data communications equipment to both commercial and government
customers. The Company derives more than 95% of its revenue from CPD.

Information
regarding the Company's domestic and foreign revenue and long lived assets is as follows (dollars in thousands):

|              |  | 2007 |        | 2006 |   | 2005  
|------------- |  | ---- | ------ | ---- | - | ------
|
|Europe        |  | $    | 21,731 |      |   | 24,747
|United States |  |      | 14,700 |      |   | 3,807 
|Middle East   |  |      | 1,908  |      |   |      
|Asia          |  |      | 2,704  |      |   | 29    
|Other         |  |      | 1,460  |      |   |      
|              |  |      |        |      |   |       
|              |  | $    | 42,503 |      | $ | 28,583
|              |  |      |        |      |   |       

Significant Customers and Foreign Exports

The Company conducts most of its business with commercial customers with some sales to the U.S. Government and its prime contractors. In 2007, five commercial
customers accounted for a total of 16% of sales with no one customer accounting for more than 10% of sales. In 2006, five commercial customers accounted for a total of 15% of sales with no one
customer accounting for more than 10% of sales. In 2005, five commercial customers accounted for a total of 16% of sales with no one customer accounting for more than 10% of sales.

47

---



OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

12. Quarterly Information (Unaudited)

The following unaudited information sets forth our results of operations on a quarterly basis for the two years ended December 31, 2007 and 2006:

|      |                                   | March 31 |   | June 30 |   | September 30 |       | December 31
|----- | --------------------------------- | -------- | - | ------- | - | ------------ | ----- | -----------
|
|2007: |                                   |          |   |         |   |              |       |            
|      | Revenues, net                     |          | $ | 8,836   |   | $            | 9,191 |            
|      | Gross profit                      |          |   | 4,914   |   |              | 5,548 |            
|      | Operating (loss) income           |          |   | (50     | ) |              | (26   | )          
|      | Net (loss) income                 |          |   | (257    | ) |              | (217  | )          
|      | (Loss) earnings per sharebasic   |          | $ | (0.07   | ) | $            | (0.06 | )          
|      | (Loss) earnings per sharediluted |          | $ | (0.07   | ) | $            | (0.06 | )          
|2006: |                                   |          |   |         |   |              |       |            
|      | Revenues, net                     |          | $ | 9,515   |   | $            | 8,987 |            
|      | Gross profit                      |          |   | 5,651   |   |              | 4,828 |            
|      | Operating income                  |          |   | 1,169   |   |              | 14    |            
|      | Net income (loss)                 |          |   | 564     |   |              | (176  | )          
|      | Earnings (loss) per sharebasic   |          | $ | 0.17    |   | $            | (0.05 | )          
|      | Earnings (loss) per sharediluted |          | $ | 0.16    |   | $            | (0.05 | )          

48

---





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

None.

Item 9A(T).CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed with the objective of providing reasonable assurance that information required to be disclosed in
our reports filed under the Securities and Exchange Act of 1934, or the Exchange Act, such as this Annual Report on Form 10-K is recorded, processed, summarized and reported within
the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer,
as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognizes that any controls and procedures,
no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management is required to apply its judgment in evaluating the
cost-benefit relationship of possible controls and procedures.

As
of December 31, 2007, the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including
our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure
controls and procedures pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e). This type of evaluation is performed on a quarterly basis so that conclusions of
management, including our Chief Executive Officer and Chief Financial Officer, concerning the effectiveness of the disclosure controls can be reported in our periodic reports on
Form 10-Q and Form 10-K. The overall goals of these evaluation activities are to monitor our disclosure controls and to modify them as necessary. We intend to
maintain the disclosure controls as dynamic systems that we adjust as circumstances merit. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure
controls and procedures were effective at the reasonable assurance level as of the end of the period covered by this report.

Management's Report on Internal Control over Financial Reporting

Internal control over financial reporting refers to the process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer,
and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for
external purposes in accordance with U.S. generally accepted accounting principles, and includes those policies and procedures that:



49

---





Internal
control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over
financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial
reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely
basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process
safeguards to reduce, though not eliminate, this risk. Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company.

Management
has used the framework set forth in the report entitled "Internal ControlIntegrated Framework" published by the Committee of Sponsoring Organizations of the
Treadway Commission to evaluate the effectiveness of the Company's internal control over financial reporting. Management has concluded that the Company's internal control over financial reporting was
effective as of the end of the most recent fiscal year.

This
annual report does not include an attestation report of the Company's registered public accounting firm regarding internal control over financial reporting. Management's report was
not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management's
report in this annual report.

Changes in Internal Control over Financial Reporting

There has been no change in our internal controls over financial reporting during our most recently completed fiscal quarter that has materially affected, or is
reasonably likely to materially affect, our internal controls over financial reporting.

Item 9B.OTHER INFORMATION

None.

50

---





PART III

Item 10.DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information called for by this Item is set forth in the Company's Proxy Statement for the 2008 Annual Meeting in the Sections entitled "Election of
Directors", "Security Ownership of Beneficial Owners, Management, and Directors" and "The Board of Directors and its Committees" and is incorporated herein by reference.

We
have adopted a Code of Ethics that applies to all of our directors and employees including, our principal executive officer and principal financial officer and all of our employees
performing financial and accounting functions. Our Code of Ethics is posted to our websitewww.optelecom-nkf.comunder the "Corporate
Governance" section. We intend to satisfy the disclosure requirement under Item 10 of Form 8-K regarding an amendment to, or waiver from, a provision of our Code of Ethics by
posting such information on our website at the location specified above as necessary.

Item 11.EXECUTIVE COMPENSATION

The information called for by this Item is set forth in the Company's Proxy Statement for the 2008 Annual Meeting in the Section titled "Executive Compensation"
and is incorporated herein by reference.

Item 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information called for by this Item is set forth in the Company's Proxy Statement for the 2008 Annual Meeting in the Section entitled "Security Ownership of
Beneficial Owners, Management and Directors" and is incorporated herein by reference.

Item 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE

The information called for by this Item is set forth in the Company's Proxy Statement for the 2008 Annual Meeting in the Sections titled "Certain Relationships
and Related Transactions" and "The Board of Directors and its Committees" and is incorporated by reference herein.

Item 14.PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information called for by this Item is set forth in the Company's Proxy Statement for the 2008 Annual Meeting in the Section entitled "Independent Public
Accountants' Fees" and is incorporated herein by reference.

51

---



PART IV

Item 15.EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

|Number |  | Description                                                                                                                                                                                                                                                                                                                               
|------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|       |  | 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 26 through 29 hereof, and the report thereon of Grant Thornton LLP appearing on page 25 hereof.                                                                                                                                                        
|(2)    |  | Financial Statement Schedule                                                                                                                                                                                                                                                                                                              
|       |  | Schedule II for the years ended December 31, 2007, 2006 and 2005 and the report thereon of Grant Thornton LLP appearing on page 56 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                                                                                                                                                                                                                                                                                                                                       
|       |  | 3.2                                                                                                                                                                                                                                                                                                                                       
|       |  | 10.1                                                                                                                                                                                                                                                                                                                                      
|       |  | 10.2                                                                                                                                                                                                                                                                                                                                      
|       |  | 10.3                                                                                                                                                                                                                                                                                                                                      
|       |  | 10.4                                                                                                                                                                                                                                                                                                                                      
|       |  | 10.5                                                                                                                                                                                                                                                                                                                                      
|       |  | 10.6                                                                                                                                                                                                                                                                                                                                      
|       |  | 10.7                                                                                                                                                                                                                                                                                                                                      
|       |  | 10.8                                                                                                                                                                                                                                                                                                                                      
|       |  | 10.9                                                                                                                                                                                                                                                                                                                                      
|       |  | 10.10                                                                                                                                                                                                                                                                                                                                     
|       |  | 10.11                                                                                                                                                                                                                                                                                                                                     

52

---



| |  | 10.12 |  | Facility lease by and among OptelecomNKF Inc., and Guardian Realty Mgt (incorporated by reference from Form 10-Q filed May 15, 2006) 
| |  | ----- |  | --------------------------------------------------------------------------------------------------------------------------------------
| |  | 21    |  | List of Subsidiaries, filed herewith                                                                                                  
| |  | 23.1  |  | Consent of Grant Thornton LLPIndependent Registered Public Accounting Firm, filed herewith                                           
| |  | 31.1  |  | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith                    
| |  | 31.2  |  | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith                    
| |  | 32    |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith

53

---





SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

| |  | OPTELECOM-NKF, INC.
| |  | -------------------
| |  | By:                

Date:
March 27, 2008

54

---



Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on
the dates indicated.

OPTELECOM-NKF, INC.By

/s/EDMUND LUDWIGEdmund Ludwig Director and President and CEO

Date: March 27, 2008By

/s/JAMES ARMSTRONGJames Armstrong Director and Executive VP, Federal Systems/Business
Development

Date: March 27, 2008By

/s/THOMAS OVERWIJNThomas Overwijn Director and Executive VP, Chief Operating Officer

Date: March 27, 2008By

/s/STEVEN TAMBUROSteven Tamburo Chief Financial Officer

Date: March 27, 2008By

/s/CARL RUBBO, JRCarl Rubbo, Jr. Director

Date: March 27, 2008By

/s/DAVID R. LIPINSKIDavid R. Lipinski Director

Date: March 27, 2008By

/s/ROBERT URSORobert Urso Director

Date: March 27, 2008By

/s/WALTER R. FATZINGER, JR.Walter R. Fatzinger, Jr. Director

Date: March 27, 2008


55

---





SCHEDULE II

OPTELECOM-NKF, INC.  SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTS  FOR THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005

|(Dollars in thousands)        |                                                       | Balance at
Beginning
of Period |   | Charges to
Costs and
Expenses |  | Deductions |     | Balance
at End
of Period
|----------------------------- | ----------------------------------------------------- | ------------------------------ | - | ----------------------------- |  | ---------- | --- | ------------------------
|Year Ended December 31, 2007: |                                                       |                                |   |                               |  |            |     |                         
|                              | Reserves and allowances deducted from asset accounts: |                                |   |                               |  |            |     |                         
|                              | Obsolescence reserve for inventory                    |                                | $ | 507                           |  | $          | 243 |                         
|                              | Allowance for uncollectible accounts receivable       |                                |   | 625                           |  |            |    |                         
|Year Ended December 31, 2006: |                                                       |                                |   |                               |  |            |     |                         
|                              | Reserves and allowances deducted from asset accounts: |                                |   |                               |  |            |     |                         
|                              | Obsolescence reserve for inventory                    |                                | $ | 434                           |  | $          | 73  |                         
|                              | Allowance for uncollectible accounts receivable       |                                |   | 554                           |  |            | 71  |                         
|Year Ended December 31, 2005: |                                                       |                                |   |                               |  |            |     |                         
|                              | Reserves and allowances deducted from asset accounts: |                                |   |                               |  |            |     |                         
|                              | Obsolescence reserve for inventory                    |                                | $ | 93                            |  | $          | 341 |                         
|                              | Allowance for uncollectible accounts receivable       |                                |   | 143                           |  |            | 411 |                         

56

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