UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D. C. 20549




FORM
10-K




(Mark
      One)ý
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the fiscal year ended: December 31, 2008ORo
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the transition period from
                     
      toCommission
      file number: 0-11668




Photonic
Products Group, Inc.


(Exact
name of registrant as specified in its charter)




New
      Jersey
            
            22-2003247State
      or other jurisdiction of incorporation or organization
            
            (I.
      R. S. Employer Identification No.)181
      Legrand Avenue, Northvale, NJ
            
            07647(Address
      of principal executive offices)
            
            (Zip
      Code)




Registrant’s
telephone number, including area code 201-767-1910




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




Name
      of each exchangeTitle
      of each class
                    
                    on
      which
registered




Securities
registered pursuant to section 12(g) of the Act:


Common
stock, par value $.01 Per Share




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.




Note –
Checking the box above will not relieve any registrant required to file reports
pursuant to Section 13 or 15(d) of the Exchange Act from their obligations under
those Sections.




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
Regulation 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 file, or a smaller reporting
company.  See definition of large accelerated filer, accelerated filer
and smaller reporting company in Rule 12b2 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




State the
aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the price at which the common equity was
last sold, or the average bid and asked price of such common equity, as of the
last business day of the registrant’s most recently completed second fiscal
quarter. $10,740,074.  (For
purposes of determining this amount, only directors, executive officers and 10%
or greater shareholders have been deemed affiliates.)




Note.If a
determination as to whether a particular person or entity is an affiliate cannot
be made without involving unreasonable effort and expense, the aggregate market
value of the common stock held by non-affiliates may be calculated on the basis
of assumptions reasonable under the circumstances, provided that the assumptions
are set forth in this Form




Indicate
the number of shares outstanding of each of the registrant’s classes of common
stock, as of the latest practicable date.




Common
Shares outstanding as of March 31, 2009


11,235,997


Documents
Incorporated by Reference




Portions
of the registrant's definitive proxy statement to be filed not later than 120
days after the end of the fiscal year covered by this report are incorporated by
reference in Part III.





Photonic
Products Group, Inc.





INDEX


Part IItem 1.
                
                Business
                3Item 1A.
                
                Risk Factors
                7Item 1B.
                
                Unresolved Staff Comments
                9Item 2.
                
                Properties
                9Item 3.
                
                Legal Proceedings
                9Item 4.
                
                Submission of Matters to a Vote of Security
      Holders
                9Part IIItem 5.
                
                Market for Registrant’s Common Equity and Related
      Stockholder Matters and Issuer Purchases of Equity
      Securities
                10Item 6.
                
                Selected Financial Data
                11Item 7.
                
                Management’s Discussion and Analysis of Financial
      Condition and Results of Operation
                11Item 7A.
                
                Quantitative and Qualitative Disclosures about
      Market Risk
                18Item 8.
                
                Financial Statements and Supplementary
      Data
                18Item 9.
                
                Changes in and Disagreements with Accountants on
      Accounting and Financial Disclosure
                18Item 9A
                
                Controls and Procedures
                19Item 9B
                
                Other Information
                19Part IIIItem 10.
                
                Directors, Executive Officers and Corporate
      Governance
                20Item 11.
                
                Executive Compensation
                20Item 12.
                
                Security Ownership of Certain Beneficial Owners
      and Management and Related Stockholder Matters
                20Item 13.
                
                Certain Relationships and Related Transactions,
      and Director Independence
                20Item 14.
                
                Principal Accounting Fees and
      Services
                20Part IVItem 15
                
                Exhibits and Financial Statement
      Schedules
                21Signatures
                23


2




PART
1




Caution Regarding Forward
Looking Statements




This
Annual Report contains forward-looking statements as that term is defined in the
federal securities laws.  The Company wishes to insure that any
forward-looking statements are accompanied by meaningful cautionary statements
in order to comply with the terms of the safe harbor provided by the Private
Securities Litigation Reform Act of 1995.  The events described in the
forward-looking statements contained in this Annual Report may not
occur.  Generally, these statements relate to business plans or
strategies, projected or anticipated benefits or other consequences of the
Company’s plans or strategies, projected or anticipated benefits of acquisitions
made by the Company, projections involving anticipated revenues, earnings, or
other aspects of the Company’s operating results.  The words “may”,
“will”, “expect”, “believe”, “anticipate”, “project”, “plan”, “intend”,
“estimate”, and “continue”, and their opposites and similar expressions are
intended to identify forward-looking statements.  The Company cautions
you that these statements are not guarantees of future performance or events and
are subject to a number of uncertainties, risks, and other influences, many of
which are beyond the Company’s control, that may influence the accuracy of the
statements and the projections upon which the statements are
based.  Factors which may affect the Company’s results include, but
are not limited to, the risks and uncertainties discussed in Items 1A, 7 and
7A.  Any one or more of these uncertainties, risks, and other
influences could materially affect the Company’s results of operations and
whether forward-looking statements made by the Company ultimately prove to be
accurate.  Readers are further cautioned that the Company’s financial
results can vary from quarter to quarter, and the financial results for any
period may not necessarily be indicative of future results.  The
foregoing is not intended to be an exhaustive list of all factors that could
cause actual results to differ materially from those expressed in
forward-looking statements made by the Company.  The Company’s actual
results, performance and achievements could differ materially from those
expressed or implied in these forward-looking statements.  The Company
undertakes no obligation to publicly update or revise any forward looking
statements, whether from new information, future events, or
otherwise.




Item
      1.
            Business




Photonic
Products Group, Inc. (the “Company” or “PPGI”), incorporated in 1973, develops,
manufactures and markets products and services for use in diverse Photonics
industry sectors via its multiple business units.




Prior to
September, 2003, PPGI was named and did business solely as Inrad,
Inc.  Company management, the Board of Directors, and shareholders
approved the name change in 2003, supporting the transformation of the Company’s
business model into that of a portfolio of business units serving the Photonics
industry.




In
November 2003, the Company concluded its first acquisition, with the purchase of
the assets and certain liabilities of Laser Optics, Inc. of Bethel,
CT.  Laser Optics, Inc. was a custom optics and optical coating
services provider, in business since 1966.  PPGI integrated the Bethel
team and their operations into the Company’s Northvale, NJ operations in
mid-2004, combining them with Inrad’s custom optics and optical coating product
lines under the Laser Optics name.




In
October 2004, the Company completed its second acquisition of a complementary
business when it acquired 100% of the stock of MRC Precision Metal Optics, Inc.
(“MRC”) of Sarasota, FL.  MRC, now a wholly-owned subsidiary of PPGI,
is a fully integrated precision metal optics and diamond-turned aspheric optics
manufacturer, specializing in CNC and single point diamond machining, optical
polishing, nickel plating, aluminum, albemet and beryllium
machining.  MRC also provides opto-mechanical assembly
services.




PPGI’s
business unit products fall into two product categories: optical components
(which include standard and custom optical components, optical assemblies,
single crystals, and crystal components), and laser system accessories (which
include wavelength conversion products and Pockel’s cells that use nonlinear
crystals for laser wavelength conversion).




The
Company is an optical component, subassembly, and sub-system supplier to OEM,
research institutes and researchers in the Photonics industry.




Administrative,
engineering and manufacturing operations are in a 42,000 square foot building
located in Northvale, New Jersey, about 15 miles northwest of New York City, and
in a 25,000 square foot building located in Sarasota, FL.  The
headquarters of the Company are located in the Northvale facility.




Custom
optic manufacturing is a major product area for PPGI.  The Company
specializes in high-end precision components.  It develops,
manufactures and delivers precision custom optics and thin film optical coating
services through its Laser Optics and MRC business units.  Glass,
metal, and crystal substrates are processed using modern manufacturing
equipment, complex processes and techniques to manufacture components, deposit
optical thin films, and assemble sub-components used in advanced Photonic
systems.  The majority of custom optical components and optical
coating services supplied are used in inspection, process control systems,
defense and aerospace electro-optical systems, laser system applications,
industrial scanners, and medical system applications.


3




The
Company also develops and manufactures synthetic optical crystals, optical
crystal components, and laser accessories through the INRAD business
unit.  It grows synthetic crystals with electro-optic (EO), non-linear
and optical properties for use in both its standard and custom
products.  The majority of crystals, crystal components and laser
accessories manufactured are used in laser systems, defense EO systems, and
R&D applications by engineers within corporations, universities and national
laboratories.




The
following table summarizes the Company’s product sales by product categories
during the past three years.  The methodology for categorizing the
products comprising “laser accessories” has been revised to include all
non-linear and electro-optical crystal components.  The prior year
figures in the following table have been revised to reflect this new
methodology:





Years
      Ended December 31,2008
                      
                      
                      2007
                      
                      
                      2006Category
                      
                      Sales
                      
                      
                      %
                      
                      
                      Sales
                      
                      
                      %
                      
                      
                      Sales
                      
                      
                      %Optical
      Components
                      
                      $
                      14,750,000
                      
                      
                      
                      90
                      
                      
                      $
                      13,410,000
                      
                      
                      
                      89
                      
                      
                      $
                      12,274,000
                      
                      
                      
                      88Laser
      Accessories
                      
                      
                      1,551,000
                      
                      
                      
                      10
                      
                      
                      
                      1,690,000
                      
                      
                      
                      11
                      
                      
                      
                      1,647,000
                      
                      
                      
                      12TOTAL
                      
                      $
                      16,301,000
                      
                      
                      
                      100
                      
                      
                      $
                      15,100,000
                      
                      
                      
                      100
                      
                      
                      $
                      13,921,000
                      
                      
                      
                      100




Products Manufactured by the
Company




Optical
Components




a)           Custom Optics and Optical
Coating Services




Manufacturing
of high-performance custom optics is at present a major product area for PPGI,
and is addressed in the marketplace by all three business units.




The Laser
Optics business unit was formed in 2003 with the combination of INRAD’s custom
optics and optical coating services and those of Laser Optics, Inc. which the
Company acquired.  The Company had been active in the field since
1973, and Laser Optics, Inc. since 1966.




The Laser
Optics business unit produces custom products manufactured to its customer’s
requirements.  It specializes in the manufacture of optical
components, optical coatings (ultra-violet wavelengths through infra-red
wavelengths) and subassemblies for military, aerospace, industrial and medical
marketplace.  Planar, prismatic and spherical components are
fabricated from glass and synthetic crystals, including fused silica, quartz,
infra-red materials (including germanium, zinc selenide and zinc sulfide),
calcite, magnesium fluoride and silicon.  Components consist of
mirrors, lenses, prisms, waveplates, polarizing optics, monochrometers, x-ray
mirrors, and cavity optics for lasers.




Most
optical components and sub-assemblies require thin film coatings on their
surfaces.  Depending on the design, optical coatings can refract,
reflect, or transmit specific wavelengths.  Laser Optics optical
coating specialties include high laser damage resistance, polarizing, high
reflective, anti-reflective, infra-red, and coating to complex custom
multi-wavelength requirements on a wide range of substrate
materials.  Laser Optics coating capability is mainly directed towards
optical components it manufactures, as well as customer furnished
components.  Coating deposition process technologies employed included
electron beam, thermal, and ion assist.




MRC
Optics, established in 1983, is a fully integrated precision metal optics and
optical assembly manufacturer.  The Company employs high precision CNC
and diamond machining, polishing, plating, aluminum, albemet, beryllium and
stainless steel opto-mechanical design, component manufacturing and assembly
services in the manufacture of custom optics.  MRC has developed
custom processes to support prototyping through medium to high rates
of  production for large and small metal mirrors, thermally stable
optical mirrors, low RMS surface finish polished mirrors, diamond machined
precision aspheric and planar mirrors, reflective porro prisms, and arc-second
accuracy polygons and motor assemblies.  Plating specialties include
void-free gold and electroless nickel.




2.
            UV Filter Optical
      Components




The INRAD
crystals and crystal components product lines include crystalline filter
materials, including both patented and proprietary materials, that have unique
transmission and absorption characteristics that enable them to be used in
critical applications in defense systems such as missile warning
sensors.  Such materials include nickel sulphate, and proprietary
materials such as UVC-7 and LAC.




Laser
Accessories




The INRAD
business unit manufactures crystal-based products that are used in laser
systems. These products include wavelength conversion crystals, Pockel’s cells,
and wavelength conversion instruments.


4




1.
            Crystal
      Components




Certain
synthetic crystals, because of their internal structure, have unique optical,
non-linear, or electro-optical properties that are essential to application in
or with laser systems.  Electro-optic and nonlinear crystal devices
can alter the intensity, polarization or wavelength of a laser
beam.  Developing growth processes for high quality synthetic crystals
and manufacturing and design processes for crystal components lies at the heart
of the INRAD laser accessory product lines.  Other crystal components,
both standard and custom, are used in laser research and in commercial laser
systems to change the wavelength of laser light.  Synthetic crystals
currently in production include Lithium Niobate, Beta Barium Borate, Alpha
Barium Borate, KDP, deuterated KDP and Zinc Germanium Phosphide and other
crystal formulations.




2.
            Pockel’s
      Cells




INRAD
manufactures a line of Pockel’s Cells and associated
electronics.  Pockel’s cells are used in applications that require
fast switching of the polarization direction of a beam of
light.  These uses include Q-switching of laser cavities to generate
pulsed laser light, coupling light into and out from regenerative amplifiers,
and light intensity modulation.  These devices are sold on an OEM
basis to laser manufacturers, researcher institutes and laser system design
engineers.




3.
            Harmonic Generation
      Systems




PPGI’s
Inrad business unit designs and manufactures harmonic generation laser
accessories.  Harmonic generation systems enable the users of lasers
to convert the fundamental frequency of the laser to another frequency required
for specific applications.  Harmonic generators are used in
spectroscopy, semiconductor processing, medical lasers, optical data storage and
scientific research.




Many
commercial lasers have automatic tuning features, allowing them to produce a
range of frequencies.  The INRAD Autotracker product, when used in
conjunction with these lasers, automatically generates tunable ultraviolet light
or infrared light for use in spectroscopic applications.




Markets




In 2008,
2007 and 2006 the Company’s product sales were made to customers in the
following market areas:





Market  (In
      thousands)
                                                                        
                                                                        2008
                                                                        
                                                                        
                                                                        2007
                                                                        
                                                                        
                                                                        2006Defense/Aerospace
                                                                        
                                                                        $
                                                                        10,329
                                                                        
                                                                        
                                                                        
                                                                        (63
                                                                        )%
                                                                        
                                                                        $
                                                                        9,456
                                                                        
                                                                        
                                                                        
                                                                        (63
                                                                        )%
                                                                        
                                                                        $
                                                                        9,048
                                                                        
                                                                        
                                                                        
                                                                        (65
                                                                        )%Process
      control & metrology
                                                                        
                                                                        
                                                                        4,692
                                                                        
                                                                        
                                                                        
                                                                        (29
                                                                        )%
                                                                        
                                                                        
                                                                        3,760
                                                                        
                                                                        
                                                                        
                                                                        (25
                                                                        )%
                                                                        
                                                                        
                                                                        2,862
                                                                        
                                                                        
                                                                        
                                                                        (20
                                                                        )%Laser
      systems (non-military)
                                                                        
                                                                        
                                                                        463
                                                                        
                                                                        
                                                                        
                                                                        (3
                                                                        )%
                                                                        
                                                                        
                                                                        932
                                                                        
                                                                        
                                                                        
                                                                        (6
                                                                        )%
                                                                        
                                                                        
                                                                        1,001
                                                                        
                                                                        
                                                                        
                                                                        (7
                                                                        )%Universities
      & National laboratories
                                                                        
                                                                        
                                                                        203
                                                                        
                                                                        
                                                                        
                                                                        (1
                                                                        )%
                                                                        
                                                                        
                                                                        352
                                                                        
                                                                        
                                                                        
                                                                        (2
                                                                        )%
                                                                        
                                                                        
                                                                        502
                                                                        
                                                                        
                                                                        
                                                                        (4
                                                                        )%Other
                                                                        
                                                                        
                                                                        614
                                                                        
                                                                        
                                                                        
                                                                        (4
                                                                        )%
                                                                        
                                                                        
                                                                        600
                                                                        
                                                                        
                                                                        
                                                                        (4
                                                                        )%
                                                                        
                                                                        
                                                                        508
                                                                        
                                                                        
                                                                        
                                                                        (4
                                                                        )%Total
                                                                        
                                                                        $
                                                                        16,301
                                                                        
                                                                        
                                                                        
                                                                        (100
                                                                        )%
                                                                        
                                                                        $
                                                                        15,100
                                                                        
                                                                        
                                                                        
                                                                        (100
                                                                        )%
                                                                        
                                                                        $
                                                                        13,921
                                                                        
                                                                        
                                                                        
                                                                        (100
                                                                        )%




Major
market sectors served by the Company include defense and aerospace, process
control & metrology, laser systems (non-military), telecom, universities and
national laboratories, and various other markets not separately
classified.  The “defense and aerospace” area consists of sales to OEM
defense electro-optical systems and subsystems manufacturers, manufacturers of
non-military satellite-based electro-optical systems and subsystems, and direct
sales to governments where the products have the same end-use.  The
“process control and metrology” area consists of customers who are OEM
manufacturers of capital equipment used in manufacturing process implementation
and control, optics-based metrology and quality assurance, and inventory and
product control equipment.  Examples of applications for such
equipment include semiconductor (i.e., chip) fabrication and testing and
inventory management and distribution control.  The “laser systems”
market area consists principally of customers who are OEM manufacturers of
industrial, medical, and R&D lasers.  “Universities and National
Laboratories” consists of product sales to researchers at such
institutions.  The “Other” category represents sales to market areas
that, while they may be the object of penetration plans by the Company, are not
currently large enough to list individually (example: bio-medical), and sales
through third parties for whom the end-use sector is not known.




The
Company is a provider of optical components, both specialty crystal components
and high precision custom optical components for customers in the aerospace and
defense electro-optical systems sector.  End-use applications include
military laser systems, military electro-optical systems, satellite-based
systems, and missile warning sensors and systems that protect
aircraft.  The dollar volume of shipments of product within this
sector depends in large measure on the U.S. Defense Department budget and its
priorities, that of foreign governments, the timing of their release of
contracts to their prime equipment and systems contractors, and the timing of
competitive awards from this customer community to the Company.  The
Company’s sales of products to this customer sector continued their upward trend
in sales dollars, but remained relatively constant as a percentage of total
sales dollars.  This represented approximately 63% of sales in 2008
and 2007 and 65% of sales in 2006.  In dollar terms, sales to
customers in this sector increased by 9.2% in 2008 over 2007 levels, and 4.5% in
2007 as compared to 2006.  The Company believes that the defense and
aerospace sector offers continued growth opportunities for the Company’s
capabilities in specialty crystal, glass and metal precision
optics.


5




Demand in
the Process Control and Metrology market sector increased in
2008.  Sales in 2008 were $4,692,000 or 29% of total
sales.  Sales in 2007 of $3,760,000 represented 25% of total sales
compared to $2,862,000 and 20% of total sales in 2006.  In dollar
terms, sales to customers in this sector were up 24.8% and 31.4%, in 2008 and
2007, respectively.  In 2006, sales to this sector were down 12% from
the previous year.  The Company believes that the optical and x-ray
inspection segment of the semiconductor industry offers continued opportunities
which match its capabilities in precision optics, crystal products, and
monochrometers.




The
Company serves the non-military laser industry as an OEM supplier of standard
and custom optical components and laser accessories.  In this sector,
2008 sales were $463,000 or 3% of total sales compared with sales in 2007 of
$932,000 or 6% of total sales.  Non-military laser industry sales in
2006 were $1,001,000 or 7% of the sales mix.  The continued sales
decline reflects the maturation of certain OEM products and consequent reduction
in demand for these types of legacy systems.




Sales to
customers within the University and National Laboratories market sector declined
in 2008 to $203,000 from $352,000 in 2007 and represented approximately 1% of
total revenues.  This compares to approximately 4% of total revenues
in 2007 and 2006.




Other
sector sales have been in the $500,000 to $700,000 range historically and growth
remained relatively flat at $614,000 in 2008.




The
Company’s export sales are primarily to customers in countries within Europe,
the Near East and Japan, and amounted to 5.2%, 9.5%, and 8.7% of product sales
in 2008, 2007 and 2006, respectively. In 2008, sales to these markets, which are
mainly through independent distributors, declined from the two prior
years.




In 2008,
the Company had sales to two major domestic customers which accounted for 21.6%
and 13.0% of sales.  One customer is an electro-optical systems
division of a major U.S. defense corporation who manufactures systems for U.S.
and allied foreign governments.  The second customer is in the process
control and metrology industry.  In 2007, two domestic customers
accounted for 19.0% and 13.5% of sales.  Both customers were
electro-optical systems divisions of major U.S defense industry
corporations.  In 2006, the same two domestic customers accounted for
15%, 16% of sales.  One customer in the Defense/Aerospace sector has
represented the highest percentage of sales for the past three
years.  Given the concentration of sales within a small number of
customers, the loss of any of these customers would have a significant negative
impact on the Company and its business units.




Long-Term
Contracts




Certain
of the Company’s orders from customers provide for periodic deliveries at fixed
prices over a long period of time.  In such cases, as in most other
cases as well, the Company attempts to obtain firm price commitments, as well
as,  cash advances from these suppliers for the purchase of the
materials necessary to fulfill the order.




Marketing and Business
Development




The
Company’s two Northvale, NJ-based business units and its MRC Optics subsidiary
market their products domestically through their sales, marketing and customer
service teams, located in Northvale and Sarasota, respectively, led by the
Corporate Vice President–Sales and Marketing.  The Company has been
moving towards a strategy of utilizing these combined sales and marketing
resources for cross-selling all products, across all business
lines.




Independent
sales agents are used in countries in major non-U.S. markets, including Canada,
UK, EU, Israel, and Japan.




Trade
show participation, Internet-based marketing, media and non-media advertising
and promotion, and international sales representative and distributor
relationships are coordinated at the corporate level under the auspices of the
corporate Vice President – Marketing and Sales.




Backlog




The
Company’s order backlog at December 31, 2008 was $6,102,000, essentially all of
which is expected to be shipped in 2009.  The Company’s order backlog
as of December 31, 2007 and 2006 was $9,432,000 and $6,969,000,
respectively.




Competition




Within
each product category in which the Company’s business units are active, there is
competition.




Changes
in the Photonics industry have had an effect on suppliers of custom
optics.  As end users have introduced products requiring large volumes
of optical components, suppliers have responded either by staying small and
carving out niche product areas or by ramping up their own manufacturing
capacity and modernizing their manufacturing methods to meet higher volume
production rates.  Many custom optics manufacturers lack in-house thin
film coating capability.  As a result, there are fewer well-rounded
competitors in the custom optics arena, and many are equipped with modern
facilities and manufacturing methods.  The Company has and continues
to judiciously deploy capital towards modernizing its facilities, and has
staffed its manufacturing groups with individuals with comprehensive experience
in manufacturing management, manufacturing engineering, advanced finishing
processes and optical coating processes.  The Company competes on the
basis of providing consistently high quality products delivered on time,
developing and maintaining strong customer relationships, and continuously
improving its capabilities, labor productivity, cost structure, and product
cycle times.


6




Competition
for the Company’s laser accessories is limited, but competitors’ products are
generally lower priced.  The Company’s laser accessories are
considered to be high end and generally offer a combination of features not
available elsewhere.  Because of the Company’s in-house crystal growth
capability, the Company’s staff is knowledgeable about matching appropriate
crystals to given applications for its laser accessories.




For the
crystal product area, price, quality, delivery, and customer service are market
drivers.  With advancing globalization, many of the Company’s
competitors supplying non-linear optical crystals are overseas and can offer
significantly reduced pricing for some crystal species.  Sales in this
arena are declining, but the Company has been able to retain a base by providing
the quality and customer service needed by certain OEM customers not readily
available from others, and by offering proprietary crystal components for which
the Company is either sole source or one of few available sources.  On
many occasions, the quality of the crystal component drives the ultimate
performance of the component or instrument into which it is
installed.  Thus, quality and technical support are considered to be
valuable attributes for a crystal supplier by some, but not all, OEM
customers.




Although
price is a principal factor in many product categories, competition is also
based on product design, product performance, customer confidence, quality,
delivery, and customer service.  The Company is a sole-source supplier
of products to several major customers who are leaders in their
industries.  Based on its performance to date, the Company believes
that it can continue to compete successfully in its niches, although no
assurances can be given in this regard.




Employees




As of the
close of business on December 31, 2008, the Company had 101 full-time
employees.




Patents and
Licenses




The
Company relies on its manufacturing and technological expertise, rather than on
patents, to maintain its competitive position in the industry.  The
Company takes precautionary and protective measures to safeguard its design and
technical and manufacturing data, and relies on nondisclosure agreements with
its employees to protect its proprietary information.




Regulation




Foreign
sales of certain of the Company’s products may require export licenses from the
United States Department of Commerce or Department of State.  Such
licenses are generally available to all but a limited number of countries and
are obtained when necessary.  Company sales in 2008, 2007 and 2006,
requiring U.S. State Department export approval represented less than 1.0% of
total sales.  In all cases, the required export approvals were
granted.




There are
no other federal regulations or any unusual state regulations that directly
affect the sale of the Company’s products other than those environmental
compliance regulations that generally affect companies engaged in manufacturing
operations in New Jersey and Florida.




Item
1A.                Risk
Factors




The
Company cautions investors that its performance (and, therefore, any forward
looking statement) is subject to risks and uncertainties.  Various
important factors, including but not limited to the following, may cause the
Company’s future results to differ materially from those projected in any
forward looking statement.




a)
            As general economic
      conditions deteriorate, the Company’s financial results may
      suffer




Significant
economic downturns or recessions in the United States or Europe such as the
current economic environment in which the Company operates, could adversely
affect the Company’s business, by causing a temporary or longer term decline in
demand for the Company’s goods and services and thus its
revenues.  The economic uncertainty has resulted in our key customers
delaying orders due to decreased demand by the end users of their products and
their difficulty in assessing and projecting end-user
needs.   Additionally, the Company’s revenues and earnings may
also be affected by general economic factors, such as excessive inflation,
currency fluctuations and employment levels.




b)
            The Company has
      exposure to Government
Markets




Sales to
customers in the defense industry have increased in the recent
past.  These customers in turn generally contract with a governmental
entity, typically the U.S. government.  Most governmental programs are
subject to funding approval and can be modified or terminated with no warning
upon the determination of a legislative or administrative body.  The
current economic crisis is having significant effects on government spending and
it is particularly difficult, at this time, to assess how this will impact our
defense industry customers and the timing and volume of business we do with
them. The loss or failure to obtain certain contracts or a loss of a major
government customer could have a material adverse effect on our business,
results of operations or financial condition.


7




c)
            The Company’s revenues
      are concentrated in its largest customer
  accounts




For the
year ended December 31, 2008, seven customer accounts represented in the
aggregate 68% of total revenues, and three customers accounted for 44% of
revenues.  These three customers each represented 22%, 13% and 10.0%
of sales, respectively.  Since we are a supplier of custom
manufactured components to OEM customers, the relative size and identity of our
largest customer accounts changes somewhat from year to year.  In the
short term, the loss of any of these large customer accounts could have a
material adverse effect on business, our results of operations, and our
financial condition.




d)
            The Company depends
      on, but may not succeed in, developing and acquiring new products and
      processes




In order
to meet the Company’s strategic objectives, the Company needs to continue to
develop new processes, to improve existing processes, and to manufacture and
market new products.  As a result, the Company may continue to make
investments in the future in process development and additions to its product
portfolio.  There can be no assurance that the Company will be able to
develop and introduce new products or enhancements to its existing products and
processes in a way that achieves market acceptance or other pertinent targeted
results.  The Company also cannot be sure that it will be successful
in acquiring complementary products or technologies or that it will have the
human or financial resources to pursue or succeed in such
activities.




e)
            The Company’s business
      success depends on its ability to recruit and retain key
      personnel




The
Company depends on the expertise, experience, and continuing services of certain
scientists, engineers, production and management personnel, and on the Company’s
ability to recruit additional personnel.  There is competition for the
services of these personnel, and there is no assurance that the Company will be
able to retain or attract the personnel necessary for its success, despite the
Company’s effort to do so.  The loss of the services of the Company’s
key personnel could have a material adverse affect on its business, on its
results of operations, or on its financial condition.




f)
            The Company may not be
      able to fully protect its intellectual
  property




The
Company currently holds one material patent applicable to an important product,
but does not in general rely on patents to protect its products or manufacturing
processes.  The Company generally relies on a combination of trade
secret and employee non-competition and nondisclosure agreements to protect its
intellectual property rights.  There can be no assurance that the
steps the Company takes will be adequate to prevent misappropriation of the
Company’s technology.  In addition, there can be no assurance that, in
the future, third parties will not assert infringement claims against the
Company.  Asserting the Company’s rights or defending against
third-party claims could involve substantial expense, thus materially and
adversely affecting the Company’s business, results of operations or financial
condition.




g)
            Many of the Company’s
      customer’s industries are
cyclical




The
Company’s business is significantly dependent on the demand its customers
experience for their products.  Many of their end users are in
industries that historically have experienced a cyclical demand for their
products.  The industries include but are not limited to, the defense
electro-optics industry and the manufacturers of process control capital
equipment for the semiconductor tools industry.  As a result, demand
for the Company’s products are subject to cyclical fluctuations, and this could
have a material adverse effect on our business, results of operations, or
financial condition.




h)
            The Company’s stock
      price may fluctuate widely




The
Company’s stock is thinly traded.  Many factors, including, but not
limited to, future announcements concerning the Company, its competitors or
customers, as well as quarterly variations in operating results, announcements
of technological innovations, seasonal or other variations in anticipated or
actual results of operations, changes in earnings estimates by analysts or
reports regarding the Company’s industries in the financial press or investment
advisory publications, could cause the market price of the Company’s stock to
fluctuate substantially.  In addition, the Company’s stock price may
fluctuate widely for reasons which may be unrelated to operating
results.  These fluctuations, as well as general economic, political
and market conditions such as recessions, military conflicts, or market or
market-sector declines, may materially and adversely affect the market price of
the Company’s Common Stock.  In addition, any information concerning
the Company, including projections of future operating results, appearing in
investment advisory publications or on-line bulletin boards or otherwise
emanating from a source other than the Company could in the future contribute to
volatility in the market price of the Company’s Common Stock.




i)
            The Company’s
      manufacturing processes require products from limited sources of
      supply




The
Company utilizes many relatively uncommon materials and compounds to manufacture
its products.  Examples include optical grade quartz, specialty
optical glasses, scarce natural and manmade crystals, beryllium and its alloys,
and high purity chemical compounds.  Failure of the Company’s
suppliers to deliver sufficient quantities of these necessary materials on a
timely basis, or to deliver contaminated or inferior quality materials, or to
markedly increase their prices could have an adverse effect on the Company’s
business, despite its efforts to secure long term commitments from the Company’s
suppliers.  Adverse results might include reducing the Company’s
ability to meet commitments to its customers, compromising the Company’s
relationship with its customers, adversely affecting the Company’s ability to
meet expanding demand for its products, or causing the Company’s financial
results to deteriorate.


8




j)
            The
      Company faces competition




The
Company encounters substantial competition from other companies positioned to
serve the same market sectors that the Company serves.  Some
competitors may have financial, technical, capacity, marketing or other
resources more extensive than ours, or may be able to respond more quickly than
the Company can to new or emerging technologies and other competitive
pressures.  Some competitors have manufacturing operations in low-cost
labor regions such as the Far East and Eastern Europe and can offer products at
lower price than the Company.  The Company may not be successful in
winning orders against the Company’s present or future competitors, and
competition may have a material adverse effect on our business, results of
operations or financial condition.




Item
1B.                Unresolved Staff
Comments




Not
applicable




Item
      2.
            Properties




Administrative,
engineering and manufacturing operations are housed in a 42,000 square foot
building located in Northvale, New Jersey and in a 25,000 square foot building
located in Sarasota, FL.  The headquarters of the Company are in its
Northvale facility.  On November 1, 2008, the Company signed an
extension of its Northvale lease for two years to October 31,
2010.  The Company has an option for renewing the lease for two
additional two year periods, at fixed terms, through October 31,
2012.




Photonic
Products Group, Inc’s subsidiary, MRC Precision Metal Optics, is located in
Sarasota, FL pursuant to a net lease expiring on August 31, 2010.  MRC
Optics has the option of extending the lease for three additional two year
periods through August 31, 2016, at fixed terms.




The
facilities are adequate to meet current and future projected production
requirements.




The total
rent in 2008 for these leases was approximately $588,000 compared to $570,000 in
2007.  The Company also paid real estate taxes and insurance premiums
that totaled approximately $179,000 in 2008 and $189,000 in 2007.




Item
      3.
            Legal
      Proceedings




There are
no legal proceedings involving the Company as of the date hereof.




Item
      4.
            Submission of Matters
      to a Vote of Security
Holders




None


9





PART
II




Item
      5.
            Market for
      Registrant’s Common Equity and Related Stockholder
      Matters




a)           Market
Information




The
Company’s Common Stock, with a par value of $0.01 per share, is traded on the
OTC Bulletin Board under the symbol PHPG.




The
following table sets forth the range of high and low closing prices for the
Company’s Common Stock in each fiscal quarter from the quarter ended March 31,
2007 through the quarter ended December 31, 2008, as reported by the National
Association of Securities Dealers NASDAQ System.  Such
over-the-counter quotations reflect inter-dealer prices, without retail mark-up,
mark-down or commission and may not necessarily represent actual
transactions.





PriceHigh
                  
                  
                  LowQuarter
      ended December 31, 2008
                  
                  
                  2.80
                  
                  
                  
                  1.40Quarter
      ended September 30, 2008
                  
                  
                  3.25
                  
                  
                  
                  1.45Quarter
      ended June 30, 2008
                  
                  
                  4.20
                  
                  
                  
                  2.90Quarter
      ended March 31, 2008
                  
                  
                  4.60
                  
                  
                  
                  3.51Quarter
      ended December 31, 2007
                  
                  
                  4.49
                  
                  
                  
                  2.50Quarter
      ended September 30, 2007
                  
                  
                  2.87
                  
                  
                  
                  2.00Quarter
      ended June 30, 2007
                  
                  
                  2.30
                  
                  
                  
                  1.55Quarter
      ended March 31, 2007
                  
                  
                  1.75
                  
                  
                  
                  1.30




As of
March 27, 2009 the Company’s closing stock price was $ 1.50 per
share.




b)           Shareholders




As of
March 27, 2009, there were approximately 170 shareholders of record of Common
Stock.  The number of shareholders of record of common stock was
approximated based upon the Shareholders’ Listing provided by the Company’s
Transfer Agent.  As of the same date, the Company estimates that there
are an additional 585 beneficial shareholders.




c)           Dividends




There was
no common stock dividend paid in 2008.  In 2007 and 2006, the Company
paid an annual dividend of 134,000 shares of Common Stock on its outstanding
Series A and Series B convertible preferred stock, valued at the closing price
on the dividend date.  The value of the dividend was $238,167 in 2007
and in $234,500 in 2006.




The
Series A convertible preferred stock consisting of 500 shares at a stated value
of $1,000 per share and convertible into common shares at the rate of $1.00 per
share was converted into 500,000 common shares of the Company’s stock in April
2007.  A total of 2,032 shares of the Series B convertible preferred
stock consisting of 2,082 shares at a stated value of $1,000 per share and
convertible into common shares at the rate of $2.50 per share were converted in
October and November of 2007.  The remaining 50 shares of Series B
preferred stock were redeemed by the Company for a cash payment of $50,000 and
an accrued stock dividend of 1,332 common shares.




The
Company historically has not historically paid cash
dividends.  Payment of cash dividends is at the discretion of the
Company’s Board of Directors and depends, among other factors, upon the
earnings, capital requirements, operations and financial condition of the
Company.  The Company does not anticipate paying cash dividends in the
immediate future.




d)           Recent Sales of Unregistered
Securities




There
were no sales of unregistered securities during 2008.


10




Item
      6.
            Selected Financial
      Data




The
following data is qualified in its entirety by the financial statements
presented elsewhere in this Annual Report on Form 10-K.




As
      of December 31, orFor
      the Year Ended December 31,2008
                                      
                                      
                                      2007
                                      
                                      
                                      2006
                                      
                                      
                                      2005
                                      
                                      
                                      2004Revenues
                                      
                                      $
                                      16,301,209
                                      
                                      
                                      $
                                      15,099,878
                                      
                                      
                                      $
                                      13,921,127
                                      
                                      
                                      $
                                      13,785,057
                                      
                                      
                                      $
                                      9,221,857Net
      income (loss)
                                      
                                      
                                      1,098,421
                                      
                                      
                                      
                                      1,880,081
                                      
                                      
                                      
                                      772,266
                                      
                                      
                                      
                                      (11,398
                                      )
                                      
                                      
                                      (672,937
                                      )Net
      income (loss) applicable to common shareholders
                                      
                                      $
                                      1,098,421
                                      
                                      
                                      $
                                      1,641,914
                                      
                                      
                                      $
                                      537,766
                                      
                                      
                                      $
                                      (145,398
                                      )
                                      
                                      $
                                      (837,757
                                      )Earnings
      per shareBasic
      earnings (loss) per share
                                      
                                      
                                      0.10
                                      
                                      
                                      
                                      0.19
                                      
                                      
                                      
                                      0.07
                                      
                                      
                                      
                                      (0.02
                                      )
                                      
                                      
                                      (0.15
                                      )Diluted
      earnings (loss) per share
                                      
                                      
                                      0.08
                                      
                                      
                                      
                                      0.13
                                      
                                      
                                      
                                      0.06
                                      
                                      
                                      
                                      (0.02
                                      )
                                      
                                      
                                      (0.15
                                      )Weighted
      average sharesBasic
                                      
                                      
                                      10,902,061
                                      
                                      
                                      
                                      8,609,822
                                      
                                      
                                      
                                      7,572,637
                                      
                                      
                                      
                                      7,218,244
                                      
                                      
                                      
                                      5,710,354Diluted
                                      
                                      
                                      15,619,304
                                      
                                      
                                      
                                      13,777,114
                                      
                                      
                                      
                                      11,915,090
                                      
                                      
                                      
                                      7,218,244
                                      
                                      
                                      
                                      5,710,354Common
      stock dividends on Preferred shares
                                      
                                      
                                      —
                                      
                                      
                                      
                                      238,167
                                      
                                      
                                      
                                      234,500
                                      
                                      
                                      
                                      134,000
                                      
                                      
                                      
                                      164,820Total
      assets
                                      
                                      
                                      15,732,149
                                      
                                      
                                      
                                      16,077,947
                                      
                                      
                                      
                                      15,316,260
                                      
                                      
                                      
                                      13,481,021
                                      
                                      
                                      
                                      13,526,634Long-term
      obligations
                                      
                                      
                                      2,853,663
                                      
                                      
                                      
                                      2,990,730
                                      
                                      
                                      
                                      6,299,767
                                      
                                      
                                      
                                      5,963,411
                                      
                                      
                                      
                                      6,459,088Shareholders’
      equity
                                      
                                      
                                      10,124,175
                                      
                                      
                                      
                                      7,712,799
                                      
                                      
                                      
                                      5,236,703
                                      
                                      
                                      
                                      3,929,407
                                      
                                      
                                      
                                      3,965,129




The
Company completed the acquisition of the stock of MRC Precision Metal Optics,
Inc. in mid-October 2004.




Item
      7.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operation




The
following discussion and analysis should be read in conjunction with the
Company’s consolidated financial statements and the notes thereto presented
elsewhere herein.  The discussion of results should not be construed
to imply any conclusion that such results will necessarily continue in the
future.




Critical Accounting
Policies




The
Company’s significant accounting polices are described in Note 1 of the
Consolidated Financial Statements that were prepared in accordance with
accounting principles generally accepted in the United States of
America.  In preparing the Company’s financial statements, the Company
made estimates and judgments that affect the results of its operations and the
value of assets and liabilities the Company reports.  The Company’s
actual results may differ from these estimates.




The
Company believes that the following summarizes critical accounting polices that
require significant judgments and estimates in the preparation of the Company’s
consolidated financial statements.




Revenue
Recognition




The
Company records revenue in accordance with Securities and Exchange Commission
Staff Accounting Bulletin No. 104, “Revenue Recognition” (“SAB
104”).  Under SAB 104, revenues are recorded when all four of the
following criteria are met:  persuasive evidence of an arrangement
exists; delivery has occurred or services have been rendered; the sales price is
fixed or determinable; and collectability is reasonably
assured.    Losses on contracts are recorded when
identified.




Accounts
Receivable




Accounts
receivable are stated at the historical carrying amount, net of write-offs and
allowances.  The Company establishes an allowance for doubtful
accounts based on estimates as to the collectibility of accounts
receivable.  Management specifically analyzes past-due accounts
receivable balances and, additionally, considers bad debts history, customer
credit-worthiness, current economic trends and changes in customer payment terms
when evaluating the adequacy of the allowance for doubtful
accounts.  Uncollectible accounts receivable are written-off when it
is determined that the balance will not be collected.  Historically,
the Company has experienced very few instances of uncollectible receivables and
related bad debt write-offs.  For each of the past three years, the
Company’s allowance for doubtful accounts has remained at
$15,000.


11




Inventory




Inventories
are stated at the lower of cost (first-in, first-out method) or
market.  Cost of manufactured goods includes material, labor and
overhead.




The
Company records a reserve for slow moving inventory as a charge against earnings
for all products identified as surplus, slow moving or
discontinued.  Excess work-in-process costs are charged against
earnings whenever estimated costs-of-completion exceed unbilled
revenues.




Goodwill and Intangible
assets




Intangible
assets with finite lives are amortized on a straight-line basis over the assets’
estimated useful life up to 14 years.  The Company periodically
evaluates on an annual basis, or more frequently when conditions require,
whether events or circumstances have occurred indicating the carrying amount of
intangible assets may not be recoverable.  When factors indicate that
intangible assets should be evaluated for possible impairment, the Company uses
an estimate of the associated undiscounted future cash flows compared to the
related carrying amount of assets to determine if an impairment loss should be
recognized.




Goodwill
and intangible assets not subject to amortization are tested in December of each
year for impairment, or more frequently if events and circumstances indicate
that the assets might have become impaired.  An impairment loss is
recognized to the extent that the carrying amount exceeds the asset’s fair
value.




Share-based
compensation




The
Company accounts for stock-based compensation in accordance with the recognition
and measurement provisions of Statement of Financial Accounting Standards
("SFAS") No. 123 (revised 2004), Share-Based Payment ("SFAS
123(R)").




Under the
fair value recognition provision of SFAS 123(R), stock based compensation cost
is estimated at the grant date based on the fair value of the
award.  The Company estimates the fair value of stock options granted
using the Black-Scholes option pricing model.  The fair value of
restricted stock units granted is based on the closing market price of the
Company’s common stock on the date of the grant.  The fair value of
these awards, adjusted for estimated forfeitures is amortized over the requisite
service period of the award, which is generally the vesting period.




Results of
Operations




The
following table summarizes the Company’s product sales by product categories
during the past three years:




Years
      Ended December 31,2008
                
                
                2007
                
                
                2006Category
                
                Sales
                
                
                %
                
                
                Sales
                
                
                %
                
                
                Sales
                
                
                %(In
      thousands)Optical
      Components
                
                $
                14,750
                
                
                
                90
                
                
                $
                13,410
                
                
                
                89
                
                
                $
                12,274
                
                
                
                89Laser
      Accessories
                
                
                1,551
                
                
                
                10
                
                
                
                1,690
                
                
                
                11
                
                
                
                1,647
                
                
                
                11TOTAL
                
                $
                16,301
                
                
                
                100
                
                
                $
                15,100
                
                
                
                100
                
                
                $
                13,921
                
                
                
                100




The
following table provides information on the Company’s sales to its major
business sectors:





Market
                                                                                                                
                                                                                                                2008
                                                                                                                
                                                                                                                
                                                                                                                2007
                                                                                                                
                                                                                                                
                                                                                                                2006(In
      thousands)Defense/Aerospace
                                                                                                                
                                                                                                                $
                                                                                                                10,329
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (63
                                                                                                                )%
                                                                                                                
                                                                                                                $
                                                                                                                9,456
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (63
                                                                                                                )%
                                                                                                                
                                                                                                                $
                                                                                                                9,048
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (65
                                                                                                                )%Process
      control & metrology
                                                                                                                
                                                                                                                
                                                                                                                4,692
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (29
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                3,760
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (25
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                2,862
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (20
                                                                                                                )%Laser
      systems (non-military)
                                                                                                                
                                                                                                                
                                                                                                                463
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (3
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                932
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (6
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                1,001
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (7
                                                                                                                )%Universities
      & National laboratories
                                                                                                                
                                                                                                                
                                                                                                                203
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (1
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                352
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (2
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                502
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (4
                                                                                                                )%Other
                                                                                                                
                                                                                                                
                                                                                                                614
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (4
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                600
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (4
                                                                                                                )%
                                                                                                                
                                                                                                                
                                                                                                                508
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (4
                                                                                                                )%Total
                                                                                                                
                                                                                                                $
                                                                                                                16,301
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (100
                                                                                                                )%
                                                                                                                
                                                                                                                $
                                                                                                                15,100
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (100
                                                                                                                )%
                                                                                                                
                                                                                                                $
                                                                                                                13,921
                                                                                                                
                                                                                                                
                                                                                                                
                                                                                                                (100
                                                                                                                )%


12




The
following table sets forth, for the past three years, the percentage
relationship of statement of operations categories to total
revenues.





Years ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Revenues:Product
      sales
                    
                    
                    100.0
                    %
                    
                    
                    100.0
                    %
                    
                    
                    100.0
                    %Costs
      and expenses:Cost
      of goods sold
                    
                    
                    70.5
                    %
                    
                    
                    60.5
                    %
                    
                    
                    67.4
                    %Gross
      profit margin
                    
                    
                    29.5
                    %
                    
                    
                    39.5
                    %
                    
                    
                    32.6
                    %Selling,
      general and administrative expenses
                    
                    
                    23.7
                    %
                    
                    
                    23.6
                    %
                    
                    
                    26.1
                    %Income
      from operations
                    
                    
                    5.9
                    %
                    
                    
                    15.9
                    %
                    
                    
                    6.6
                    %Net
      income
                    
                    
                    6.7
                    %
                    
                    
                    12.5
                    %
                    
                    
                    5.5
                    %




Revenues




Total
revenues were $16,301,000 in 2008, $15,100,000 in 2007 and $13,921,000 in 2006
reflecting the consolidated results from all three business
units.  Revenues increased, by 8% in 2008 and 8.5% in 2007 while
revenue growth in 2006 was relatively flat year over year.




Examining
these results by customer industry sector:




Sales to
the Defense/Aerospace sector continued its upward trend in 2008, increasing by
9.2% in dollar terms to $10,329,000 from $9,456,000 in 2007, although the
percentage to total sales was approximately 63% for both years.  In
2007, sales rose 4.5% over sales of $9,048,000 in 2006.  In 2006,
about 65% of total sales came from this industry sector.  In general,
increased military spending on electro-optical systems and R&D over the last
few years has boosted demand for the Company’s services in manufacturing custom
products for its OEM customers.




Process
Control and Metrology revenues were $4,692,000 in 2008, and related primarily to
shipments for OEM customers involved in the manufacture of semiconductor tools,
instruments, inventory management equipment and related products and
markets.  This represented an increase of 24.8% over 2007 mainly
reflecting increased shipments to one large OEM customer and increased sales
resulting from the development of a new product, to another OEM
customer.   In 2007, revenues for this sector showed an increase
of 31.4% to $3,760,000, reflecting the addition of one new large OEM account
during the year.  The optical and x-ray inspection segment of the
semiconductor industry offers continued opportunities for expanding the
Company’s capabilities in precision optics, crystal products, and X-ray
monochrometers.




Revenues
of $463,000 in the non-military Laser Systems sector fell by approximately 50%
in 2008 from $932,000, following a 6.9% drop in 2007.  The decreases
reflect the ongoing maturation of certain of the Company’s OEM
products.  Sales in 2006 were $1,001,000.  Sales to this
sector accounted for 3%, 6%, and 7% of total sales in 2008, 2007, and 2006,
respectively.




Customers
within the University and National Laboratories market sector accounted for less
than 5% of total revenues in 2008, 2007 and 2006.  Sales to this
sector have slowly trended lower over the last few years, reflecting the
commoditization of certain crystal component categories that has taken place in
the industry, as well as, increased internet buying by University researchers
from Asian sources, and the maturation of certain legacy
instruments.




Sales to
customers in “Other” (i.e. non-separately classified) sectors were $614,000 in
2008, $600,000 in 2007 and $508,000 in 2006.  Sales in these sectors
have accounted for approximately 4% of total sales in each of the past three
years.




Bookings




The
Company booked new orders totaling $13.0 million in 2008, down from $17.8
million in 2007 and $13.3 million in 2006.  The decline in 2008 was
partly attributable to lower orders for legacy INRAD laser accessories and
decreased demand for crystal components from one large
customer.   Additionally, bookings in our MRC Optics business
decreased from 2007 levels.  MRC had two large bookings near the end
of 2007 which were scheduled to carry through 2008 and into 2009.  In
the second half of 2008, MRC orders decreased as the impact of the economic
downturn affected our commercial customer’s and they experienced a slowdown in
their business activities and demand for our products.  This has
carried over into the first quarter of 2009.




Bookings
in 2008 for optical components in our Laser Optics business were comparable to
2007, in total.  However, the mix of 2008 bookings shifted as a large
defense order from one OEM customer was partially offset by a decrease in our
commercial business during the year.  New orders in 2007 increased
significantly from 2006 due to increased demand for optical components, mainly
in our Laser Optics and MRC Optics business units.  In particular,
orders from one large INRAD customer in the Process Control and Metrology sector
and one large Laser Optics OEM customer in the Defense/Aerospace sector
contributed significantly to the increase in 2007 from 2006.  One
large new Defense/Aerospace OEM was added in 2007 while orders from another
declined by 50%.  Additionally, a large new OEM customer in the
Process Control and Metrology sector was added in 2007.


13




The
decline in new orders along with increased sales levels affected the Company’s
backlog as of December 31, 2008 which decreased to $6.1 million, down from
$9.4 million at December 31, 2007.  The 2007 year-end backlog, by
comparison, was up around 35% from $7.0 million in 2006.




Cost of Goods Sold and Gross
Profit Margin




Cost of
goods sold was 70.5%, 60.5% and 67.4%, for the years ended December 31,
2008, 2007 and 2006, respectively.  In dollar terms, 2008 cost of
goods sold was $11,487,000 up 25.7% from $9,141,000 in 2007.




Although
approximately 8% of the increase is attributable to higher sales volumes, the
major part of the increase is due to a number of other factors.  In
particular material cost as a percentage of sales increased in 2008 due
principally to a change in product/sales mix, including several new OEM products
which were weighted towards a higher cost material content than in
2007.  Contributing to this was the conclusion of an agreement with
one large OEM customer which included customer supplied materials in 2007 and
early 2008 and the subsequent requirement for the Company to purchase material
for ongoing orders, over the last nine months of 2008.  In addition,
production problems during the year in our Florida operation resulted in higher
than expected material costs from rework requirements.




Production
labor costs, in dollar terms, rose by approximately 32% from
2007.  Increases in employment levels of production personnel to
support higher sales volumes, contributed to the higher costs.  Also,
as noted above, production issues in our MRC business unit, which affected
material costs, also resulted in inefficiencies and excessive rework that
negatively impacted labor and overhead costs throughout most of the
year.  This also resulted in direct inventory write-offs and increased
reserves against work in process during the year which totaled approximately
$48,000 and $161,000, respectively.




In 2007,
the cost of goods sold percent and the gross profit margin percentages improved
with increasing sales levels, as fixed costs represent a major component of our
total cost structure.  In addition, the cost of materials and outside
services as a percentage of sales, increasing labor productivity, and decreasing
fixed expenses contributed to improved profitability levels.  The cost
of goods sold improved to 60.5% of sales compared to 67.4% in
2006.  Cost of goods sold was $9,141,000 compared with $9,377,000 in
2006, down $236,000 or 2.5%, while revenues increased 8.5%.  The
reduction in the cost of goods sold percentage in 2007 was primarily a
reflection of lower material costs as a percentage of revenues in 2007, and
increased labor productivity on higher sales volume, while other manufacturing
expenses as a percentage of sales improved by approximately 6%, reflecting
continual expense control vigilance and the leveraging impact of increased
volumes over certain fixed costs.




Material
costs as a percentage of revenues decreased in 2007 by approximately 19% in
comparison to the prior year, caused principally by an increase in shipments in
the second half of custom products with customer furnished materials which carry
no related material costs in cost-of-goods sold.  The lower material
cost as a percentage of revenues in 2007 should not be viewed as a trend; rather
it reflects the impact of a one-time contractual arrangement with an OEM
customer for the second half of 2007 and the first quarter of
2008.  Total labor costs in 2007 were down 4.2% on the higher sales
volume, resulting in a labor productivity improvement of 12%.




Gross
margin in 2008 was $4,815,000 or 29.5% down from 2007 gross margin of $5,959,000
or 39.5%.  This compares with a gross margin of $4,544,000 or 32.6% in
2006.




Selling, General and
Administrative Expenses




Selling,
general and administrative expenses (“SG&A”) as a percentage of sales were
$3,858,000 in 2008, up $296,000 or 8.3% from 2007 and represented 23.7% of sales
in 2008 and 23.6% of sales in 2007. The increase resulted mainly from higher
wage, recruitment and relocation costs related to new personnel during the year.
In addition, higher sales travel and trade show expenses related to increased
business development activity during the year. Travel expenses also rose as a
result of more frequent travel by corporate staff between our operation centers
in New Jersey and Florida.  Stock-based compensation expenses rose due
to sign-on grants to new employees and the expense associated with fully vested
stock option awards to the Company’s former CEO.  These were offset by
reductions in commission expenses to independent sales agents and lower
consulting costs.  Increases in SG&A salaries and wages reflected
both annual SG&A pay increases as well as one-time living allowances paid to
replacement sales staff brought on at the end of 2007.




Selling,
general and administrative expenses in 2007 decreased in dollar terms from those
in 2006 by $66,000, or 1.8%, while sales increased by 8.5%, resulting in a
decrease in the 2007 SG&A cost as a percentage of sales.  SG&A
expenditures in 2006 included non-recurring expenses that were incurred in
connection with the investigation into misappropriation of Company funds for
personal use by its former CFO, as we reported in our Form 8-K filed on June 26,
2006, and the resolution of this matter.  These included additional
costs for legal advice, forensic consulting, temporary accounting assistance,
and special meetings of the Audit Committee of the Board of
Directors.  Increased expenses also resulted from recruitment costs
incurred in connection with the Company’s search for its new CFO and assistant
controller, and higher legal and accounting expenses related to day-to-day
corporate matters.  The Company did not incur expenses of this nature
in 2007, resulting in the decrease in overall SG&A expenses by
comparison.


14




Operating
Income




Operating
income of $957,000 declined in 2008 from $2,397,000 in the previous year as a
result of the increases in the Company’s cost of sales and lower margins related
to production inefficiencies and increased labor and overhead costs in our MRC
business unit, as well as a less profitable sales mix and higher selling,
general and administrative costs.




Operating
income in 2007 was $2,397,000, or 15.9% of sales, and in dollar terms up
$1,481,000 or 161% from the prior year.  This compares favorably with
a profit of $917,000, or 6.6% of sales in 2006, (up 156% over 2005), and
operating income of $358,000, or 2.6% of sales in 2005.




Management
believes that its efforts to increase profitability and to resolve production
issues at MRC are having positive effects and remains focused on improving
productivity throughout its operations.




Other Income and
Expenses




Net
interest expense of $170,000 in 2008 was down 34.8% from $261,000 in
2007.  Interest expense was $236,000 compared to $424,000 in
2007.  The reduction in net interest expense reflects the positive
impact of the Company’s continued reduction in debt and long term notes and
capital lease balances due to both scheduled amortization and accelerated
principal re-payments, including the $1,700,000 subordinated convertible debt in
the first quarter of 2008.  Interest income for 2008 was $66,000, down
from $163,000 in 2007 as the result of lower cash balances available for
investment during the year and reductions in bank interest rates on invested
cash balances.




In 2007,
interest income was $163,000 and $52,000 in 2006, respectively while interest
expense was $424,000 in 2007, compared to $454,000 in the previous
year.  The Company’s focus on pro-actively reducing debt levels
resulted in a decrease of approximately $1,844,000 in debt principal during
2007.




In 2006,
the Company received an insurance settlement for $300,000 from a claim under its
employee dishonesty insurance policy and the Company reported the recovery as
other income (expense) for the period.  These proceeds were largely
offset by the additional general and administrative costs related to the
investigation of the employee involved and costs associated with remediation of
the Company’s internal controls.




The
Company also incurred costs of $13,000 during 2006 to liquidate liabilities for
property tax and unemployment and disability tax that were incurred as part of
its acquisition in December 2003 of the assets and certain liabilities of the
former Laser Optics, Inc.




Income
Taxes




In 2008,
the company recorded a current provision for state tax and federal alternative
minimum tax of $100,000 and $5,000, respectively after the application of net
operating losses of $523,000 against federal tax.  In 2007, the
Company recorded income tax expense in the amount of $250,000 after utilizing
net operating losses of approximately $2,700,000 to offset federal taxes
payable.  In 2006, the Company recorded income tax expense of $21,000
after utilizing net operating losses of approximately $1,400,000 to offset
federal income tax payable and $678,000 against state income tax
payable.




In
accordance with the provisions of Statement of Financial Accounting Standards
No. 109, “Accounting for Income Taxes” (“SFAS 109”), the Company recognizes
deferred tax liabilities and assets for the expected future tax consequences of
events that have been recognized in the Company’s financial statements or tax
returns.  Deferred tax liabilities and assets are determined based on
the difference between the financial statements carrying amounts and the tax
basis of assets and liabilities using enacted tax rates in effect in the years
in which the differences are expected to reverse.




At
December 31, 2007, the Company had a net deferred tax asset of approximately
$2,041,000, the primary component of which was net operating loss carry
forwards.  Through December 31, 2007, the Company had established a
valuation allowance to fully offset this deferred tax asset in the event the tax
asset will not be realized in the future.  In accordance with SFAS
109, the Company has determined that based on a recent history of consistent
earnings and future income projections, a full valuation allowance was no longer
required.  Accordingly, during the year ended December 31, 2008, the
Company reduced the valuation allowance and recognized a deferred tax benefit
available from the Company’s net operating loss carry forward position of
$408,000 based on the effective federal tax rate of 34%.  This
resulted in the Company recording a net benefit from income taxes of $303,000
after offsetting the deferred tax benefit against the current tax
provision.  At December 31, 2008, the Company had net deferred tax
asset balance of $2,141,000 offset by a valuation allowance of
$1,733,000.




Net
Income




Net
income in 2008 was $1,098,000, down $782,000 from net income of
$1,880,000.  In 2007 net income was $1,880,000, in up
144%  or $1,108,000 from the prior year’s net income of
$772,000.


15




Net Income Applicable to
Common Shareholders and Earnings per Common Share




Net
income applicable to common shareholders, is arrived at after deducting the
value of the stock dividends issued by the Company to the holders of its Series
A and Series B convertible preferred stock. The dividend value is calculated by
reference to the market price of the common shares on the dividend distribution
date.  The number of common shares issued in settlement of the
dividend is determined based on the coupon rate of the preferred shares, the
total shares outstanding, and the conversion price of each series of preferred
shares.




In 2008,
the Company did not pay common stock dividends as all Preferred Series A and B
stock had been redeemed in the prior year.  In April of 2007 and 2006,
the Company distributed common stock dividends valued at $238,200 and $234,500,
respectively to the holders of its Series A and B convertible preferred
stock.




In 2007,
all of the shares of the Series A convertible preferred stock and approximately
98% of the shares of the Series B convertible preferred stock were converted by
the preferred shareholders into 812,800 shares of the Company’s common
stock.  The stock of the remaining holder of 50 shares of Series B
convertible preferred stock was redeemed by the Company on the payment of
$50,000, the liquidation value, plus an accrued stock dividend of
$5,000.




As a
result, net income applicable to common shareholders in 2008 was $1,098,000 or
$0.10 per share basic and $0.08 per share diluted, compared to 2007 which was
$1,642,000, or $0.19 per share basic and $0.13 per share diluted.  Net
income applicable to common shareholders for the same period in 2006 was
$538,000, and earnings per share were $0.07 basic and $0.06
diluted.




Liquidity and Capital
Resources




The
Company’s primary source of cash in recent years has been from operating cash
flows.  Other sources of cash include proceeds received from the
exercise of stock options, short-term borrowing, and issuance of common
stock.  The Company’s major uses of cash in the past three years have
been for capital expenditures and for repayment and servicing of outstanding
debt.




Supplemental
information pertaining to our source and use of cash is presented
below:





Selected
      Sources (uses) of cash
                    
                    Years ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006(In
      thousands)Net
      cash provided by operations
                    
                    $
                    548
                    
                    
                    $
                    3,001
                    
                    
                    $
                    2,672Net
      Proceeds from issuance of common stock,exercise
      of stock options and warrants
                    
                    
                    1,064
                    
                    
                    
                    395
                    
                    
                    
                    113Capital
      Expenditures
                    
                    
                    (785
                    )
                    
                    
                    (247
                    )
                    
                    
                    (987
                    )Principal
      payments on lease obligations
                    
                    
                    (47
                    )
                    
                    
                    (196
                    )
                    
                    
                    (250
                    )Net
      borrowing (payment) on debt obligations
                    
                    
                    (1,715
                    )
                    
                    
                    (1,647
                    )
                    
                    
                    373




In 2008
and 2007, the Company used excess cash in accelerating the repayment of debt,
and focused on retiring its convertible preferred shares.  This
initiative was undertaken to strengthen its balance sheet, and to have a
positive impact on the Company’s financial position, financial flexibility, and
financial results.




In March
2009, the maturity date of a $1,000,000 Subordinated Convertible Promissory Note
to Clarex Limited (“Clarex”), a major shareholder and debt holder, was extended
to April 1, 2011.  The note bears interest at 6% and was originally
due in January 2006, extended to December 31, 2008 and subsequently
again to April 1, 2009.  Interest accrues yearly and along with
principal may be converted into common stock, (and/or securities
convertible into common shares).  The Note is convertible into
1,000,000 Units consisting of 1,000,000 shares of common stock and
warrants.  The warrants had an original expiration date of August 2009
and allowed the holder to acquire 750,000 shares of common stock at a price of
$1.35 per share.  The expiration date of the warrants under the
conversion terms have been extended to April 1, 2014.




In
March of 2009, the maturity date of a $1,500,000 Subordinated Convertible
Promissory Note bearing interest at 6% was extended to April 1,
2011.  The note was originally due in January 2006 and was
subsequently extended to April 1, 2009.  Interest accrues yearly and
along with principal may be converted into Common Stock, and/or securities
convertible into Common Stock.  The note is convertible into 1,500,000
Units consisting of 1,500,000 shares of Common Stock and Warrants to acquire
1,125,000 shares of Common stock at a price of $1.35 per share up to August
2009. The original expiration date of warrants of August 2009 was extended to
April 1, 2014. The holder of the note is a major shareholder of the
Company.


16




On
January 29, 2008, the Board of Directors authorized the repayment in full of a
$1,700,000 Secured Promissory Note held by Clarex, including accrued interest of
$477,444.  The note was originally issued in June 2003 for a period of
18 months at an interest rate of 6% per annum and was secured by all assets
of the Company.  As additional consideration for the note, the Company
issued 200,000 warrants to Clarex.  In 2004, the note was extended for
an additional 36 months and the Company approved the issuance of 200,000
additional warrants to Clarex.  The initial and subsequent warrants
were exercisable at $0.425 per share and $1.08 per share, respectively, and had
an expiry date of March 31, 2008 and May 18, 2008.  The note
was extended again, to December 31, 2008, without issuance of warrants or
any other further consideration.




In March,
2008, Clarex elected to exercise the 200,000 warrants expiring on March 31, 2008
and the Company issued 200,000 shares of its commons stock for proceeds of
$85,000.




In May,
2008, Clarex exercised the remaining 200,000 warrants set to expire on May 18,
2008 for $216,000 and the Company issued 200,000 shares of its common
stock.




In
December 2007, the Company repaid the outstanding balance of $554,600 principal
and accrued interest of $1,740 of the original $700,000 loan from Clarex,
retiring this debt.  The loan was originally issued in February 2006
to provide the Company with financing to fund the acquisition of certain capital
assets required for expanded capabilities to meet customer demand. The terms
called for repayment in equal monthly installments, including
interest & principal, commencing March 2006, until maturity in
March 2013 at an annual interest rate of 6.75% and allowed for early
repayment.




On June
28, 2007, the Company accelerated payment of $500,000 on the outstanding balance
of a $1,000,000 Subordinated Convertible Promissory Note and subsequently, on
September 17, 2007, paid the remaining balance of principal and interest on this
note, in full, in the amount of $697,000, consisting of $500,000 in remaining
principal and $197,000 in accrued interest.  The Company originally
received $1,000,000 in proceeds from the issuance of a Subordinated Convertible
Promissory Note in 2004.  The note had an interest rate of 6% and was
initially due on March 31, 2007, but its term was extended in early 2007 to
March 31, 2008.  Interest accrued yearly and along with principal was
convertible into Common Stock, (and/or securities convertible into common
shares).  The note was convertible into 1,000,000 Units consisting of
1,000,000 shares of Common Stock and Warrants, exercisable through July 2009, to
acquire 750,000 shares of Common Stock at a price of $1.35 per
share.  The note holder was a major shareholder of the
Company.




On April
16, 2007, the Company called for the full redemption of its $500,000 Series A
10% Convertible Preferred Stock (the “Series A”).  On April 30, 2007,
Clarex Limited, the holder of all the shares of the Series A, notified the
Company that it had decided to convert all 500 preferred shares into 500,000
shares of the Company’s common stock, in accordance with the Series A
agreement.




On
October 25, 2007, two principal holders, two outside Directors, and the
Company’s CEO, notified the Company they were exercising their right to convert
their shares of the Company’s $2,082,000 Series B 10% Convertible Preferred
Stock (the “Series B”) into common stock at the specified conversion price of
$2.50 per share.  In the aggregate, these holder’s shares of the
Series B represented 1,560 shares or 75% of the total of 2,082 issued and
outstanding Series B shares.  Subsequently, on October 29, the Company
issued a call for the redemption of the remaining balance of 522 issued and
outstanding Series B shares on November 29, 2007.  The 10 holders of
these shares had the option of converting their shares into common stock prior
to the redemption date.  Nine holders elected to convert, and the
remaining holder elected to the preferred shares for cash and a final stock
dividend accrued to the redemption date.  In all, the Series B was
converted into 812,800 shares of common stock through conversion, and through
redemption into a cash payment of $50,000 and an accrued final stock dividend of
1,332 shares of common stock.




During
2004, the Company entered into an agreement with an investment banking firm to
raise equity via a private placement of the Company’s common
stock.  In July 2004, the Company issued 1,581,000 Units
consisting of 1,581,000 shares and warrants, exercisable through August 2009, to
acquire an additional 1,185,750 shares at $1.35 per share.  In
addition, 276,675 Warrants were issued to Casimir Capital, LP, who was the
placement agent for the private placement.  Casimir Capital earned
commissions of $142,391 as the underwriter of this private
placement.  This private placement resulted in net proceeds to the
Company of approximately $1,173,000.  The funds were utilized in
furtherance of the company’s M&A program, capital equipment purchases and to
meet general working capital requirements.  The issued shares and
shares underlying warrants were subsequently registered under an S-1
Registration filing.




During
2008, a total of 518,635 warrants pursuant to the private placement were
exercised by warrant holders.  A total of 375,520 warrants with a
total exercise price of $507,000 were surrendered to the Company in exchange for
the issuance of 375,250 shares of the Company’s common stock.  An
additional 142,385 placement agent warrants were exercised using a cashless
feature available for these warrants, in exchange for 89,702 shares of the
Company’s common stock.




Capital
expenditures for the year ended December 31, 2008 were $784,000 and
included planned expenditures primarily for increased production capacity and
capability in both our Sarasota, Florida and Northvale, New Jersey
locations.  Offsetting the impact of capital expenditures on cash
flows was the receipt of $10,000 from the sale of surplus manufacturing
equipment during the second quarter of 2008.


17




This
compares to capital expenditures in 2007 and 2006 of approximately $247,000 and
$987,000, respectively.  In 2007, capital expenditures were primarily
for replacement or refurbishment of manufacturing equipment and facility heating
and ventilating equipment at the end of its useful life.  Capital
expenditures in 2006 were used for the acquisition of manufacturing and test
equipment and the build-up of tooling for new customer
requirements.  In 2006, the major portion of capital additions
represented a major purchase of manufacturing equipment required in the
performance of certain specific contracts and to provide an increased capability
and a stronger competitive position for the Company in high precision spherical
and aspherical lens production.




During
2008, 182,000 stock options were exercised for proceeds of $285,000 and a
weighted exercise price of $1.42 per share and converted into an equivalent
number of shares of the Company’s common stock.  This compares with
proceeds from the exercise of stock options of $445,000 in 2007, with 651,100
stock options exercised at a weighted average exercise price of approximately
$0.68 per share.  By comparison, in 2006, proceeds from the exercise
of stock options were $113,000 with 145,000 stock options exercised at a
weighted average exercise price of $0.78 each and converted an equivalent number
of shares of common stock.




For 2008,
cash and cash equivalents decreased by $1,724,000 reflecting lower cash provided
from operations and after cash used in investing activities for capital
expenditures and increased cash used in financing activities related to the
Company’s repayment of Convertible debt.  The company had certificates
of deposit with terms greater than three months and showed these separately from
cash and cash equivalents on the balance sheet.  For 2007, cash and
cash equivalents increased by $1,318,000 to $4,396,000, after net cash outlays
for debt repayments and redemptions of $1,697,000.  In 2006, cash and
cash equivalents increased by $1,922,000, including net borrowing of
$373,000.




A summary
of the Company’s contractual cash obligations at December 31, 2008 is as
follows:


Contractual Obligations
                  
                  Total
                  
                  
                  Less than
                    1 Year
                  
                  
                  1-3 Years
                  
                  
                  4-5
                    Years
                  
                  
                  Greater
                    Than 5
                    Years(In
      thousands)Convertible
      notes payable
                  
                  
                  2,500
                  
                  
                  
                  —
                  
                  
                  
                  2,500
                  
                  
                  
                  —
                  
                  
                  
                  —Notes
      payable-other, including interest
                  
                  
                  667
                  
                  
                  
                  154
                  
                  
                  
                  69
                  
                  
                  
                  46
                  
                  
                  
                  398Operating
      leases (1)
                  
                  
                  931
                  
                  
                  
                  526
                  
                  
                  
                  406
                  
                  
                  
                  —
                  
                  
                  
                  —Total
      contractual cash obligations
                  
                  $
                  4,098
                  
                  
                  $
                  680
                  
                  
                  $
                  2,975
                  
                  
                  $
                  46
                  
                  
                  $
                  397





(1)  Excludes
all future lease renewal options available to Company and which have not yet
been exercised.




Overview of Financial
Condition




As shown
in the accompanying financial statements, the Company reported net income of
$1,098,000 in 2008, $1,880,000 in 2007, and $772,000 in 2006.  During
2008, 2007 and 2006, the Company’s working capital requirements were provided by
positive cash flow from its operations.




Net cash
provided by operations was $548,000 in 2008 as compared to $3,001,000 in 2007
and $2,672,000 in 2006.  Lower net income, after adjusting for
non-cash deferred tax benefit of $408,000, increases in working capital
requirements including higher accounts receivable (up $629,000), inventory (up
$104,000 excluding reserves) and reductions in both accounts payable (down
$581,000 primarily as a result of accrued interest paid on settlement of the
convertible promissory note during the year) and customer advance reductions
(down $414,000).   The Company’s management expects that future
cash flow from operations and its existing cash reserves will provide adequate
liquidity for the Company’s operations and working capital requirements in
2009.




Item
7A.                Quantitative and Qualitative
Disclosures about Market Risk




The
Company believes that it has limited exposure to changes in interest rates from
investments in certain money market accounts.  The Company does not
utilize derivative instruments or other market risk sensitive instruments to
manage exposure to interest rate changes.




Item
      8.
            Financial
      Statements and Supplementary
Data




The
financial statements and supplementary financial information required to be
filed under this Item are presented commencing on page 24 of the Annual Report
on Form 10-K, and are incorporated herein by reference.




Item
      9.
            Changes
      In and Disagreements with Accountants on Accounting and Financial
      Disclosure




None


18




Item
9A.                Controls
and Procedures




a)  Evaluation of Disclosure
Controls and Procedures




The
Company’s management, including the Chief Executive Officer and Chief Financial
Officer, has evaluated the effectiveness of the design and operation of the
Company’s disclosure controls and procedures (as defined in Exchange Act Rules
13a-15(e) and 15d-15(e)) as of the end of the period covered by this Annual
Report on Form 10-K.  Based upon that evaluation, the Company’s Chief
Executive Officer and Chief Financial Officer have concluded that the disclosure
controls and procedures as of December 31, 2008 are effective to ensure that
information required to be disclosed in the reports the Company files or submits
under the Exchange Act 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 the Company's management,
including the Chief Executive Officer and Chief Financial Officer, to allow
timely decisions regarding disclosure.




b)  Management’s Annual Report
on Internal Control over Financial Reporting




Our
management is responsible for establishing and maintaining an adequate system of
internal control over financial reporting.  Our internal control over
financial reporting includes those policies and procedures that:




·
            pertain
      to the maintenance of records that, in reasonable detail, accurately and
      fairly reflect the transactions and dispositions of our
      assets;




·
            provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of our financial statements in accordance with generally
      accepted accounting principles in the United States, and that our receipts
      and expenditures are being made only in accordance with authorizations of
      our management and directors; and




·
            provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of our assets that could have
      a material effect on the financial
statements.




Due to
its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.  All internal control
systems, no matter how well designed, have inherent
limitations.  Therefore, even those systems determined to be effective
can provide only reasonable assurance with respect to financial statement
preparation and presentation.  Because of the inherent limitations of
internal control, 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.




Our
management assessed the effectiveness of our system of internal control over
financial reporting as of December 31, 2008.  In making this
assessment, management used the framework in Internal Control — Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (“COSO”).  Based on our assessment and the criteria set
forth by COSO, management believes that the Company maintained effective
internal control over financial reporting as of December 31,
2008.




Our
annual report on Form 10-K 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.




There
have been no significant changes in the Company’s internal control over
financial reporting identified in connection with the evaluation that occurred
during the Company’s last fiscal quarter that have materially affected, or that
are reasonably likely to materially affect, the Company’s internal controls over
financial reporting.




Item
      9B
            Other
      Information




None


19





PART
III




Item
      10.
            Directors and
      Executive Officers of the Registrant and Corporate
      Governance




The
information required under this item is incorporated by reference to the
Company’s Proxy Statement for the 2009 Annual Meeting of
Stockholders.




Item
      11.
            Executive
      Compensation




The
information required under this item is incorporated by reference to the
Company’s Proxy Statement for the 2009 Annual Meeting of
Stockholders.




Item
      12.
            Security
      Ownership of Certain Beneficial Owners and
    Management




The
information required under this item is incorporated by reference to the
Company’s Proxy Statement for the 2009 Annual Meeting of
Stockholders.




Item
13.                 Certain
Relationships and Related Transactions




The
information required under this item is incorporated by reference to the
Company’s Proxy Statement for the 2009 Annual Meeting of
Stockholders.




Item
      14.
            Principal
      Accounting Fees and Services




The
information required under this item is incorporated by reference to the
Company’s Proxy Statement for the 2009 Annual Meeting of
Stockholders.


20




PART
IV




Item
      15.
            Exhibits
      and Financial Statement
Schedules




(a) (1)
            Financial
      Statements.




Reference
is made to the Index to Financial Statements and Financial Statement Schedule
commencing on Page 24.




(a) (2)
            Financial Statement
      Schedule.




Reference
is made to the Index to Financial Statements and Financial Statement
Schedule on Page 24..  All other schedules have been omitted
because the required information is not present or is not present in amounts
sufficient to require submission of the schedule, or because the information
required is included in the Financial Statements or Notes thereto.




(a) (3)
            Exhibits.


Exhibit No.
              
              Description
      of Exhibit2.1
              
              Stock
      Purchase Agreement between Photonic Products Group, Inc., MRC
      Precision Metal Optics and Frank E. Montone (incorporated by
      reference to Exhibit 2.1 to the Company’s Current Report on
      Form 8-K filed with the Securities and Exchange Commission on
      October 25, 2004)3.1
              
              Restated
      Certificate of Incorporation of Photonics Products Group, Inc.
      (incorporated by reference to Exhibit 3.1 to the Company’s
      Registration Statement on Form S-1 filed with the Securities and
      Exchange Commission on August 25, 2004)3.2
              
              By-Laws
      of Photonic Products Group, Inc. (incorporated by reference to
      Exhibit 3.2 to the Company’s Registration Statement on Form S-1
      filed with the Securities and Exchange Commission on August 25,
      2004)4.1
              
              Specimen
      Common Stock Certificate (incorporated by reference to Exhibit 4.1 to
      the Company’s Registration Statement on Form S-1 filed with the
      Securities and Exchange Commission on August 25,
  2004)4.2
              
              Form of
      Warrants issued pursuant to June 2004 Private Placement (incorporated
      by reference to Exhibit 4.2 to the Company’s Registration Statement
      on Form S-1 filed with the Securities and Exchange Commission on
      August 25, 2004)4.3
              
              Form of
      Placement Agent Warrants issued pursuant to June 2004 Private
      Placement (incorporated by reference to Exhibit 4.3 to the Company’s
      Registration Statement on Form S-1 filed with the Securities and
      Exchange Commission on August 25, 2004)4.4
              
              Promissory
      Note Dated June 30, 2003 held by Clarex, Ltd. (incorporated by
      reference to Exhibit 4.4 to the Company’s Registration Statement on
      Form S-1 filed with the Securities and Exchange Commission on
      August 25, 2004)4.5
              
              Subordinated
      Convertible Promissory Note dated April 1, 2004 held by Clarex, Ltd.
      (incorporated by reference to Exhibit 4.5 to the Company’s
      Registration Statement on Form S-1 filed with the Securities and
      Exchange Commission on August 25, 2004)4.6
              
              Subordinated
      Convertible Promissory Note dated October 31, 2003 held by Clarex,
      Ltd. (incorporated by reference to Exhibit 4.6 to the Company’s
      Registration Statement on Form S-1 filed with the Securities and
      Exchange Commission on August 25, 2004)4.7
              
              Subordinated
      Convertible Promissory Note dated December 31, 2002 held by Welland,
      Ltd. (incorporated by reference to Exhibit 4.7 to the Company’s
      Registration Statement on Form S-1 filed with the Securities and
      Exchange Commission on August 25, 2004)4.8
              
              Warrant
      dated March 31, 2004 issued to Clarex, Ltd. (incorporated by
      reference to Exhibit 10.2 to the Company’s Registration Statement on
      Form S-1 filed with the Securities and Exchange Commission on
      August 25, 2004)4.9
              
              Warrant
      dated May 19, 2004 issued to Clarex, Ltd. (incorporated by reference
      to Exhibit 10.3 to the Company’s Registration Statement on
      Form S-1 filed with the Securities and Exchange Commission on
      August 25, 2004)4.10
              
              Extension
      of Promissory Note dated February 15, 2008 originally issued to Clarex,
      Ltd. on October 31, 2003 (incorporated by reference to the Company’s
      Annual Report on Form 10-K filed with the Securities and Exchange
      Commission on March 28, 2008)4.11
              
              Extension
      of Promissory Note dated February 15, 2008 originally issued to Welland,
      Ltd. on December 31, 2002 (incorporated by reference to the Company’s
      Annual Report on Form 10-K filed with the Securities and Exchange
      Commission on March 28, 2008)4.12
              
              Subordinated
      Convertible Promissory Note dated April 1, 2009 held by Clarex,
      Ltd4.13
              
              Subordinated
      Convertible Promissory Note dated April 1, 2009 held by Welland,
      Ltd10.1
              
              2000
      Equity Compensation Program (incorporated by reference to
      Exhibit 10.1 to the Company’s Registration Statement on Form S-1
      filed with the Securities and Exchange Commission on August 25,
      2004)10.2
              
              Daniel
      Lehrfeld Employment Contract, dated October 20, 1999 (incorporated by
      reference to Exhibit 10.4 to the Company’s Registration Statement on
      Form S-1 filed with the Securities and Exchange Commission on
      August 25, 2004)14.1
              
              Code
      of Ethics (incorporated by reference to the Company’s Annual Report on
      Form 10-K filed with the Securities and Exchange Commission on March
      31, 2006)21.1
              
              List
      of Subsidiaries (incorporated by reference to the Company’s Annual Report
      on Form 10-K filed with the Securities and Exchange Commission on
      March 31, 2006)23.1
              
              Consent
      of Holtz Rubenstein Reminick LLP Independent Registered Public Accounting
      Firm


21





31.1
            
            Certification
      of Chief Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200231.2
            
            Certification
      of Chief Financial Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200232.1
            
            Certification
      of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      200232.2
            
            Certification
      of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002


22




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.





PHOTONIC
      PRODUCTS GROUP, INC.By:
            /s/
      Joseph J. RutherfordJoseph
      J. RutherfordChief
      Executive OfficerDated:
      March 31, 2009




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.


Signature
            
            Title
            
            Date/s/
      John C. Rich
            
            Chairman
      of the Board
            
            March
      31, 2009John
      C. Rich
            
            of
      Directors/s/
      Luke P. LaValle, Jr.
            
            Director
            
            March
      31, 2009Luke
      P. LaValle, Jr./s/
      Thomas H. Lenagh
            
            Director
            
            March
      31, 2009Thomas
      H. Lenagh/s/
      N.E. Rick Strandlund
            
            Director
            
            March
      31, 2009N.E.
      Rick Strandlund/s/
      Jan M. Winston
            
            Director
            
            March
      31, 2009Jan
      M. Winston/s/
      Joseph J. Rutherford
            
            President,
      Chief
            
            March
      31, 2009Joseph
      J. Rutherford
            
            Executive
      Officerand
      Director/s/
      William J. Foote
            
            Vice-President,
      Chief Financial Officer
            
            March
      31, 2009William
      J. Foote
            
            and
      Secretary


23


PHOTONIC PRODUCTS GROUP,
INC. AND SUBSIDIARIES





INDEX TO THE CONSOLIDATED
FINANCIAL STATEMENTS





THREE YEARS ENDED DECEMBER
31, 2008





CONTENTS




Report
      of Independent Registered Public Accounting FirmConsolidated
      balance sheets as of December 31, 2008 and 2007Consolidated
      statements of income for each of the three years in the period ended
      December 31, 2008Consolidated
      statements of shareholders’ equity for each of the three years in the
      period ended December 31, 2008Consolidated
      statements of cash flows for each of the three years in the
      period ended December 31, 2008Notes
      to consolidated financial statementsReport
      of Independent Registered Public Accounting Firm on Supplemental
      InformationSchedule
      II – Valuation and Qualifying Accounts


24





Report
of Independent Registered Public Accounting Firm





Board of
Directors and Shareholders


Photonic
Products Group, Inc.


and
Subsidiaries


Northvale,
New Jersey





We have
audited the accompanying consolidated balance sheets of Photonic Products Group,
Inc. and Subsidiaries as of December 31, 2008 and 2007, and the related
consolidated statements of income, shareholders' equity and cash flows for each
of the three years in the period ended December 31, 2008.  These
consolidated financial statements are the responsibility of the Company's
management.  Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.





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





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Photonic Products Group,
Inc. and Subsidiaries as of December 31, 2008 and 2007, and the results of their
operations and their cash flows for each of the three years in the
period ended December 31, 2008, in conformity with accounting principles
generally accepted in the United States of America.





/s/Holtz
Rubenstein Reminick LLP





Melville,
New York


March 30,
2009




25


PHOTONIC
PRODUCTS GROUP, INC AND SUBSIDIARIES





CONSOLIDATED
BALANCE SHEETS





December
      31,2008
                      
                      
                      2007AssetsCurrent
      assets:Cash
      and cash equivalents
                      
                      $
                      2,672,087
                      
                      
                      $
                      4,395,945Certificates
      of deposit
                      
                      
                      800,000
                      
                      
                      
                      —Accounts
      receivable (after allowance for doubtful accounts of $15,000 in 2008 and
      2007)
                      
                      
                      2,810,602
                      
                      
                      
                      2,181,859Inventories,
      net
                      
                      
                      2,732,336
                      
                      
                      
                      2,931,080Other
      current assets
                      
                      
                      188,084
                      
                      
                      
                      164,065Total
      Current Assets
                      
                      
                      9,203,109
                      
                      
                      
                      9,672,949Plant
      and equipment:Plant
      and equipment at cost
                      
                      
                      14,445,027
                      
                      
                      
                      13,690,229Less:
      Accumulated depreciation and amortization
                      
                      
                      (11,139,771
                      )
                      
                      
                      (10,189,853
                      )Total
      plant and equipment
                      
                      
                      3,305,256
                      
                      
                      
                      3,500,376Precious
      Metals
                      
                      
                      112,851
                      
                      
                      
                      112,851Deferred
      Income Taxes
                      
                      
                      408,000
                      
                      
                      
                      —Goodwill
                      
                      
                      1,869,646
                      
                      
                      
                      1,869,646Intangible
      Assets, net of accumulated amortization
                      
                      
                      751,580
                      
                      
                      
                      830,144Other
      Assets
                      
                      
                      81,707
                      
                      
                      
                      91,981Total
      Assets
                      
                      $
                      15,732,149
                      
                      
                      $
                      16,077,947Liabilities and Shareholders’
      EquityCurrent
      Liabilities:Current
      portion of notes payable -other
                      
                      $
                      136,892
                      
                      
                      $
                      14,814Accounts
      payable and accrued liabilities
                      
                      
                      2,160,665
                      
                      
                      
                      2,741,966Customer
      advances
                      
                      
                      456,754
                      
                      
                      
                      870,550Current
      obligations under capital leases
                      
                      
                      —
                      
                      
                      
                      47,088Related
      party secured note due within one year
                      
                      
                      —
                      
                      
                      
                      1,700,000Total
      Current Liabilities
                      
                      
                      2,754,311
                      
                      
                      
                      5,374,418Related
      Party Convertible Notes Payable
                      
                      
                      2,500,000
                      
                      
                      
                      2,500,000Notes
      Payable – Other, net of current portion
                      
                      
                      353,663
                      
                      
                      
                      490,730Total
      Liabilities
                      
                      
                      5,607,974
                      
                      
                      
                      8,365,148Commitments
      and Contingencies
                      
                      
                      —
                      
                      
                      
                      —Shareholders’
      equity:Common
      stock: $.01 par value; 60,000,000 authorized shares 11,230,678 issued at
      December 31, 2008 and 10,104,719 issued at December 31,
    2007
                      
                      
                      112,306
                      
                      
                      
                      101,046Capital
      in excess of par value
                      
                      
                      16,622,466
                      
                      
                      
                      15,320,771Accumulated
      deficit
                      
                      
                      (6,595,647
                      )
                      
                      
                      (7,694,068
                      )10,139,125
                      
                      
                      
                      7,727,749Less
      - Common stock in treasury, at cost (4,600 shares)
                      
                      
                      (14,950
                      )
                      
                      
                      (14,950
                      )Total
      Shareholders’ Equity
                      
                      
                      10,124,175
                      
                      
                      
                      7,712,799Total
      Liabilities and Shareholders’ Equity
                      
                      $
                      15,732,149
                      
                      
                      $
                      16,077,947





See notes
to consolidated financial statements


26





PHOTONIC
PRODUCTS GROUP, INC AND SUBSIDIARIES





CONSOLIDATED
STATEMENTS OF INCOME





Years
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006RevenuesNet
      sales
                  
                  $
                  16,301,209
                  
                  
                  $
                  15,099,878
                  
                  
                  $
                  13,921,127Cost
      and expensesCost
      of goods sold
                  
                  
                  11,486,620
                  
                  
                  
                  9,141,049
                  
                  
                  
                  9,377,313Selling,
      general and administrative expense
                  
                  
                  3,857,805
                  
                  
                  
                  3,561,570
                  
                  
                  
                  3,627,24415,344,425
                  
                  
                  
                  12,702,619
                  
                  
                  
                  13,004,557Operating
      income
                  
                  
                  956,784
                  
                  
                  
                  2,397,259
                  
                  
                  
                  916,570Other
      income (expense)Interest
      expense, net
                  
                  
                  (170,476
                  )
                  
                  
                  (261,327
                  )
                  
                  
                  (402,154
                  )Gain
      on sale of fixed asset
                  
                  
                  9,113
                  
                  
                  
                  —
                  
                  
                  
                  —Loss
      on sale of precious metals
                  
                  
                  —
                  
                  
                  
                  (5,851
                  )
                  
                  
                  —Settlement
      of insurance claim
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  300,000Other
      expense
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (21,150
                  )(161,363
                  )
                  
                  
                  (267,178
                  )
                  
                  
                  (123,304
                  )Income
      before income tax provision and preferred stock dividends
                  
                  
                  795,421
                  
                  
                  
                  2,130,081
                  
                  
                  
                  793,266Income
      tax benefit (provision)
                  
                  
                  303,000
                  
                  
                  
                  (250,000
                  )
                  
                  
                  (21,000
                  )Net
      income
                  
                  
                  1,098,421
                  
                  
                  
                  1,880,081
                  
                  
                  
                  772,266Preferred
      stock dividends
                  
                  
                  —
                  
                  
                  
                  (238,167
                  )
                  
                  
                  (234,500
                  )Net
      income applicable to common shareholders
                  
                  $
                  1,098,421
                  
                  
                  $
                  1,641,914
                  
                  
                  $
                  537,766Net
      income per share - basic
                  
                  $
                  0.10
                  
                  
                  $
                  0.19
                  
                  
                  $
                  0.07Net
      income per share - diluted
                  
                  $
                  0.08
                  
                  
                  $
                  0.13
                  
                  
                  $
                  0.06Weighted
      average shares outstanding - basic
                  
                  
                  10,902,061
                  
                  
                  
                  8,609,822
                  
                  
                  
                  7,572,637Weighted
      average shares outstanding – diluted
                  
                  
                  15,619,304
                  
                  
                  
                  13,777,114
                  
                  
                  
                  11,915,090





See notes
to consolidated financial statements


27


PHOTONIC PRODUCTS GROUP,
INC. AND SUBSIDIARIES





CONSOLIDATED STATEMENT OF
SHAREHOLDERS’ EQUITY




Preferred
      Stock
                                              
                                              
                                              Preferred
      Stock
                                              
                                              
                                              Capital
      in
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              TotalCommon
      Stock
                                              
                                              
                                              (Series
      A)
                                              
                                              
                                              (Series
      B)
                                              
                                              
                                              excess
      of
                                              
                                              
                                              
                                              
                                              
                                              Treasury
                                              
                                              
                                              Shareholders’Shares
                                              
                                              
                                              Amount
                                              
                                              
                                              Shares
                                              
                                              
                                              Amount
                                              
                                              
                                              Shares
                                              
                                              
                                              Amount
                                              
                                              
                                              par
      value
                                              
                                              
                                              Deficit
                                              
                                              
                                              Stock
                                              
                                              
                                              EquityBalance,
      December 31, 2005
                                              
                                              
                                              7,287,398
                                              
                                              
                                              $
                                              72,862
                                              
                                              
                                              
                                              500
                                              
                                              
                                              $
                                              500,000
                                              
                                              
                                              
                                              2,100
                                              
                                              
                                              $
                                              2,100,000
                                              
                                              
                                              $
                                              11,145,243
                                              
                                              
                                              $
                                              (
      9,873,748
                                              )
                                              
                                              $
                                              (14,950
                                              )
                                              
                                              $
                                              3,929,407401K
      contribution
                                              
                                              
                                              144,836
                                              
                                              
                                              
                                              1,448
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              149,053
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              150,501Dividend
      on Preferred Stock
                                              
                                              
                                              134,000
                                              
                                              
                                              
                                              1,340
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              233,160
                                              
                                              
                                              
                                              (234,500
                                              )
                                              
                                              
                                              —
                                              
                                              
                                              
                                              ---Issuance
      of common stock payable
                                              
                                              
                                              174,800
                                              
                                              
                                              
                                              1,760
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              152,252
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              154,012Exercise
      of stock options
                                              
                                              
                                              145,000
                                              
                                              
                                              
                                              1,450
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              111,380
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              112,830Cancellation
      of common stock
                                              
                                              
                                              (3,960
                                              )
                                              
                                              
                                              (40
                                              )
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              40
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Cancellation
      of preferred stock
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              (18
                                              )
                                              
                                              
                                              (18,000
                                              )
                                              
                                              
                                              18,000
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Share-based
      compensation expense
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              117,687
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              117,687Net
      income for the year
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              772,266
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              772,266Balance,
      December 31, 2006
                                              
                                              
                                              7,882,074
                                              
                                              
                                              
                                              78,820
                                              
                                              
                                              
                                              500
                                              
                                              
                                              
                                              500,000
                                              
                                              
                                              
                                              2,082
                                              
                                              
                                              
                                              2,082,000
                                              
                                              
                                              $
                                              11,926,815
                                              
                                              
                                              
                                              (9,335,982
                                              )
                                              
                                              
                                              (14,950
                                              )
                                              
                                              
                                              5,236,703401K
      contribution
                                              
                                              
                                              124,133
                                              
                                              
                                              
                                              1,241
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              165,453
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              166,694Dividend
      on preferred stock
                                              
                                              
                                              134,612
                                              
                                              
                                              
                                              1,346
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              236,821
                                              
                                              
                                              
                                              (238,167
                                              )
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Common
      stock issued on conversion of Series A Preferred stock
                                              
                                              
                                              500,000
                                              
                                              
                                              
                                              5,000
                                              
                                              
                                              
                                              (500
                                              )
                                              
                                              
                                              (500,000
                                              )
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              495,000
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              ---Common
      stock issued on exercise of options
                                              
                                              
                                              651,100
                                              
                                              
                                              
                                              6,511
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              438,736
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              445,247Share-based
      compensation expense
                                              
                                              
                                              —
                                              
                                              
                                              
                                              ---
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              34,074
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              34,074Common
      stock issued on conversion of Series B Preferred Stock
                                              
                                              
                                              812,800
                                              
                                              
                                              
                                              8,128
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              (2,032
                                              )
                                              
                                              
                                              (2,032,000
                                              )
                                              
                                              
                                              2,023,872
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Redemption
      of Series B Preferred Stock
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              (50
                                              )
                                              
                                              
                                              (50,000
                                              )
                                              
                                              
                                              ---
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              (50,000
                                              )Net
      income for the year
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              1,880,081
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              1,880,081Balance,
      December 31, 2007
                                              
                                              
                                              10,104,719
                                              
                                              
                                              $
                                              101,046
                                              
                                              
                                              
                                              —
                                              
                                              
                                              $
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              $
                                              
                                              
                                              
                                              $
                                              15,320,771
                                              
                                              
                                              $
                                              (7,694,068
                                              )
                                              
                                              $
                                              (14,950
                                              )
                                              
                                              $
                                              7,712,799401K
      contribution
                                              
                                              
                                              75,907
                                              
                                              
                                              
                                              759
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              159,422
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              160,181Common
      stock issued on exercise of options
                                              
                                              
                                              185,100
                                              
                                              
                                              
                                              1,851
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              254,919
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              256,770Common
      stock issued on conversion of warrants
                                              
                                              
                                              864,952
                                              
                                              
                                              
                                              8,650
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              798,937
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              807,587Share-based
      compensation expense
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              88,417
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              88,417Net
      income for the year
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              1,098,421
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              1,098,421Balance,
      December 31, 2008
                                              
                                              
                                              11,230,678
                                              
                                              
                                              $
                                              112,306
                                              
                                              
                                              
                                              —
                                              
                                              
                                              $
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              $
                                              —
                                              
                                              
                                              $
                                              16,622,466
                                              
                                              
                                              $
                                              (6,595,647
                                              )
                                              
                                              $
                                              (14,950
                                              )
                                              
                                              $
                                              10,124,175


See notes
to consolidated financial statements


28


PHOTONIC
PRODUCTS GROUP, INC AND SUBSIDIARIES
 
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 
 Years
      Ended December 31,2008
                                    
                                    
                                    2007
                                    
                                    
                                    2006Cash
      flows from operating activities:Net
      income
                                    
                                    $
                                    1,098,421
                                    
                                    
                                    $
                                    1,880,081
                                    
                                    
                                    $
                                    772,266Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
                                    
                                    
                                    1,059,741
                                    
                                    
                                    
                                    1,119,887
                                    
                                    
                                    
                                    1,099,003Deferred
      income taxes
                                    
                                    
                                    (408,000
                                    )
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —401K
      common stock contribution
                                    
                                    
                                    160,180
                                    
                                    
                                    
                                    166,694
                                    
                                    
                                    
                                    150,501Gain
      on sale of fixed asset
                                    
                                    
                                    (9,113
                                    )
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —Loss
      on sale of precious metal
                                    
                                    
                                    —
                                    
                                    
                                    
                                    5,851
                                    
                                    
                                    
                                    —Stock-based
      compensation expense
                                    
                                    
                                    88,417
                                    
                                    
                                    
                                    34,074
                                    
                                    
                                    
                                    117,687Change
      in inventory reserve
                                    
                                    
                                    302,511
                                    
                                    
                                    
                                    163,391
                                    
                                    
                                    
                                    102,817Changes
      in operating assets and liabilities:Accounts
      receivable
                                    
                                    
                                    (628,743
                                    )
                                    
                                    
                                    214,627
                                    
                                    
                                    
                                    (130,552
                                    )Inventories
                                    
                                    
                                    (103,767
                                    )
                                    
                                    
                                    (758,438
                                    )
                                    
                                    
                                    (14,971
                                    )Other
      current assets
                                    
                                    
                                    (24,019
                                    )
                                    
                                    
                                    12,522
                                    
                                    
                                    
                                    (22,864
                                    )Other
      assets
                                    
                                    
                                    7,865
                                    
                                    
                                    
                                    32,854
                                    
                                    
                                    
                                    39,549Accounts
      payable and accrued liabilities
                                    
                                    
                                    (581,301
                                    )
                                    
                                    
                                    246,568
                                    
                                    
                                    
                                    222,718Customer
      advances
                                    
                                    
                                    (413,796
                                    )
                                    
                                    
                                    (117,413
                                    )
                                    
                                    
                                    335,699Total
      adjustments
                                    
                                    
                                    (550,025
                                    )
                                    
                                    
                                    1,120,617
                                    
                                    
                                    
                                    1,899,587Net
      cash provided by operating activities
                                    
                                    
                                    548,396
                                    
                                    
                                    
                                    3,000,698
                                    
                                    
                                    
                                    2,671,853Cash
      flows from investing activities:Purchase
      of certificates of deposit, net
                                    
                                    
                                    (800,000
                                    )
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —Capital
      expenditures
                                    
                                    
                                    (784,534
                                    )
                                    
                                    
                                    (246,518
                                    )
                                    
                                    
                                    (986,732
                                    )Proceeds
      from sale of fixed assets
                                    
                                    
                                    10,000
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —Proceeds
      from sale of precious metals
                                    
                                    
                                    —
                                    
                                    
                                    
                                    12,030
                                    
                                    
                                    
                                    —Net
      cash used in investing activities
                                    
                                    
                                    (1,574,534
                                    )
                                    
                                    
                                    (234,488
                                    )
                                    
                                    
                                    (986,732
                                    )Cash
      flows from financing activities:Net
      proceeds from issuance of common stock
                                    
                                    
                                    1,064,357
                                    
                                    
                                    
                                    445,247
                                    
                                    
                                    
                                    112,830Proceeds
      from secured notes payable
                                    
                                    
                                    —
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    700,000Redemption
      of Series B Preferred shares
                                    
                                    
                                    —
                                    
                                    
                                    
                                    (50,000
                                    )
                                    
                                    
                                    —Principal
      payments of notes payable
                                    
                                    
                                    (14,989
                                    )
                                    
                                    
                                    (647,215
                                    )
                                    
                                    
                                    (326,724
                                    )Principal
      payments of convertible promissory notes
                                    
                                    
                                    (1,700,000
                                    )
                                    
                                    
                                    (1,000,000
                                    )
                                    
                                    
                                    —Principal
      payments of capital lease obligations
                                    
                                    
                                    (47,088
                                    )
                                    
                                    
                                    (196,349
                                    )
                                    
                                    
                                    (249,738
                                    )Net
      cash (used in) provided by financing activities
                                    
                                    
                                    (697,720
                                    )
                                    
                                    
                                    (1,448,317
                                    )
                                    
                                    
                                    236,368Net
      (decrease) increase in cash and cash equivalents
                                    
                                    
                                    (1,723,859
                                    )
                                    
                                    
                                    1,317,893
                                    
                                    
                                    
                                    1,921,489Cash
      and cash equivalents at beginning of the year
                                    
                                    
                                    4,395,945
                                    
                                    
                                    
                                    3,078,052
                                    
                                    
                                    
                                    1,156,563Cash
      and cash equivalents at end of the year
                                    
                                    $
                                    2,672,087
                                    
                                    
                                    $
                                    4,395,945
                                    
                                    
                                    $
                                    3,078,052
 
 See notes
to consolidated financial statements
  29
  PHOTONIC PRODUCTS GROUP,
INC. AND SUBSIDIARIES
 
 NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
 
 THREE YEARS ENDED DECEMBER
31, 2008
  1.
              Nature
      of Business and Summary of Significant Accounting Policies and
      Estimates
  a.
              Nature of
      Operations
  Photonic
Products Group, Inc. and Subsidiaries (the “Company”, formerly known as Inrad,
Inc.) is a manufacturer of crystals, crystal devices, electro-optic and optical
components, and sophisticated laser subsystems and instruments.  The
Company’s principal customers include commercial instrumentation companies and
OEM laser manufacturers, research laboratories, government agencies, and defense
contractors.  The Company’s products are sold domestically using its
own sales staff, and in major overseas markets, principally Europe and the Far
East, using independent sales agents.
  b.
              Principles of
      consolidation
  The
accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned Subsidiaries.  Upon consolidation, all
inter-company accounts and transactions are eliminated.
  c.
              Cash and cash
      equivalents
  The
Company considers cash-on-hand and highly liquid investments with original
maturity dates of three months or less at the date of purchase to be cash and
cash equivalents. Investments with original maturity dates exceeding three
months are separately disclosed on the Consolidate Balance Sheets and as cash
flows from investing activities on the Consolidated Statements of Cash
Flows.
  d.
              Accounts
      receivable
  Accounts
receivable are stated at the historical carrying amount, net of write-offs and
allowances.  The Company establishes an allowance for doubtful
accounts based on estimates as to the collectibility of accounts
receivable.  Management specifically analyzes past-due accounts
receivable balances and, additionally, considers bad debt history, customer
credit-worthiness, current economic trends and changes in customer payment terms
when evaluating the adequacy of the allowance for doubtful
accounts.  Uncollectible accounts receivable are written-off when it
is determined that the balance will not be collected.
  e.
              Inventories
  Inventories
are stated at the lower of cost (first-in, first-out method) or
market.  Cost of manufactured goods includes material, labor and
overhead.
  The
Company records a reserve for slow moving inventory as a charge against earnings
for all products identified as surplus, slow moving or
discontinued.  Excess work-in-process costs are charged against
earnings whenever estimated costs-of-completion exceed unbilled
revenues.
  f.
              Plant and
      Equipment
  Plant and
equipment are depreciated using the straight-line method over the estimated
useful lives of the related assets which range between 5 and 7
years.  Amortization of leasehold improvements is computed using the
straight-line method over the lesser of 10 years or the remaining term of the
lease including optional renewal periods.  Maintenance and repairs of
property and equipment are charged to operations and major improvements are
capitalized.  Upon retirement, sale or other disposition of property
and equipment, the cost and accumulated depreciation are eliminated from the
accounts and a gain or loss is recorded.
  g.
              Income
      taxes
  The
Company accounts for income taxes under Statement of Financial Accounting
Standards (“SFAS”) No, 109, “Accounting for Income Taxes.”  Deferred
tax assets and liabilities are determined based on differences between financial
reporting and tax bases of assets and liabilities, and are measured using the
enacted tax rates and laws that will be in effect when the differences are
expected to reverse.  Effective January 1, 2007, the Company adopted
the Financial Accounting Standards Board (“FASB”) Interpretation No. 48,
“Accounting for Uncertainty in Income Taxes, and interpretation of SFAS No. 109”
(“FIN 48”).  FIN 48 clarifies the accounting for uncertainty in income
taxes recognized in the financial statements and requires that a tax position
must be more likely than not to be sustained before being recognized in the
financial statements.  The tax benefits recognized in the financial
statements from such a position are measured based on the largest benefit that
has a greater than 50% likelihood of being realized upon ultimate
resolution.  Under FIN 48, the Company must also assess whether
uncertain tax positions, as filed, could result in the recognition of a
liability for possible interest and penalties which the Company would include as
a component of income tax expense.  For the years ended December 31,
2008 and 2007, the Company did not recognize any tax liabilities related to
uncertain tax positions.
  30
  h.
              Impairment
      of long-lived assets
  In
accordance with SFAS No. 144, long-lived assets, such as property, plant and
equipment, and purchased intangibles subject to amortization, are reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable.  Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of
an asset to estimate undiscounted future cash flows expected to be generated by
the asset.  If the carrying amount of an asset exceeds its estimated
future cash flows, an impairment charge is recognized by the amount by which the
carrying amount of the asset exceeds the fair value of the
assets.  Assets to be disposed of would be separately presented in the
balance sheet and reported at the lower of the carrying amount or fair value
less costs to sell and are no longer depreciated.  The assets and
liabilities of a disposed group classified as held for sale would be presented
separately in the appropriate asset and liability sections of the balance
sheet.
  i.
              Goodwill and
      Intangible assets
  Acquired
goodwill and intangible assets consist of goodwill of $1,870,000 and other
acquired intangible assets with finite lives, consisting principally of
non-contractual customer relationships, completed technology and trademarks that
approximated $1,100,000.  Intangible assets with finite lives are
amortized on a straight-line basis over the assets’ estimated useful life up to
14 years.  The Company evaluates whether events or circumstances have
occurred indicating the carrying amount of intangible assets may not be
recoverable.  When factors indicate that intangible assets should be
evaluated for possible impairment, the Company uses an estimate of the
associated undiscounted future cash flows compared to the related carrying
amount of assets to determine if an impairment loss should be
recognized.  Goodwill and intangible assets not subject to
amortization are tested in December of each year for impairment, or more
frequently if events and circumstances indicate that the assets might be
impaired.  An impairment loss is recognized to the extent that the
carrying amount exceeds the asset’s fair value.
  The gross
carrying amount of intangible assets as of December 31, 2008 and 2007 was
$1,100,000, respectively.  Accumulated amortization related to
intangible assets was $348,000 as of December 31, 2008 and $270,000 as of
December 31, 2007.  Amortization expense was approximately $79,000 for
the years ended December 31, 2008 and December 31, 2007,
respectively.  Aggregate amortization for the five succeeding years
from January 1, 2009 through December 31, 2013 is expected to be $395,000,
accumulating at the rate of $79,000 per year.  The weighted average
remaining life of the Company’s intangible assets is approximately 9.5
years.
  There
were no changes in the carrying amounts of goodwill, by acquisition, for the
year ended December 31, 2008, which remained at $1,870,000
  The
following schedule details the Company’s intangible asset balance by major asset
class.
 
 At
      December 31, 2008(In
      thousands)
                    
                    Gross
      Carrying
                      Amount
                    
                    
                    Accumulated
                      Amortization
                    
                    
                    Net
      Carrying
                      AmountCustomer-related
                    
                    $
                    550
                    
                    
                    $
                    (174
                    )
                    
                    $
                    376Completed
      technology
                    
                    
                    363
                    
                    
                    
                    (115
                    )
                    
                    
                    248Trademarks
                    
                    
                    187
                    
                    
                    
                    (59
                    )
                    
                    
                    128Total
                    
                    $
                    1,100
                    
                    
                    $
                    (348
                    )
                    
                    $
                    752
 
 At
      December 31, 2007(In
      thousands)
                    
                    Gross
      Carrying
                      Amount
                    
                    
                    Accumulated
                      Amortization
                    
                    
                    Net
      Carrying
                      AmountCustomer-related
                    
                    $
                    550
                    
                    
                    $
                    (135
                    )
                    
                    $
                    415Completed
      technology
                    
                    
                    363
                    
                    
                    
                    (89
                    )
                    
                    
                    274Trademarks
                    
                    
                    187
                    
                    
                    
                    (46
                    )
                    
                    
                    141Total
                    
                    $
                    1,100
                    
                    
                    $
                    (270
                    )
                    
                    $
                    830
  j.
                  Stock-based
      compensation
  The
Company accounts for stock-based compensation in accordance with the recognition
and measurement provisions of Statement of Financial Accounting Standards
("SFAS") No. 123 (revised 2004), Share-Based Payment ("SFAS
123(R)").
  31
  Under the
fair value recognition provision of SFAS 123(R), stock based compensation cost
is estimated at the grant date based on the fair value of the
award.  The Company estimates the fair value of stock options granted
using the Black-Scholes option pricing model.  The fair value of
restricted stock units granted is based on the closing market price of the
Company’s common stock on the date of the grant.  The fair value of
these awards, adjusted for estimated forfeitures is amortized over the requisite
service period of the award, which is generally the vesting period.
  k.
              Revenue
      recognition
  The
Company records revenue in accordance with Securities and Exchange Commission
Staff Accounting Bulletin No. 104, “Revenue Recognition” (“SAB
104”).  Under SAB 104, revenues are recorded when all four of the
following criteria are met:  persuasive evidence of an arrangement
exists; delivery has occurred or services have been rendered; the sales price is
fixed or determinable; and collectability is reasonably
assured.  Losses on contracts are recorded when
identified.
  l.
              Internal research and
      development costs
  Internal
research and development costs are charged to expense as incurred.
  m.
              Precious
      metals
  Precious
metals consist of various fixtures used in the high temperature crystal growth
manufacturing process.  They are valued at the lower of cost or net
realizable value, on a first-in, first-out basis.
  n.
              Use of
      estimates
  The
preparation of financial statements in conformity with generally accepted
accounting principles 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 revenues and expenses during the reporting
period.  Actual amounts could differ from those
estimates.
  o.
              Advertising
      costs
  Advertising
costs included in selling, general and administrative expenses were $26,000,
$29,000 and $27,000 for the years ended December 31, 2008, 2007 and 2006,
respectively.  Advertising costs are charged to expense when the
related services are incurred or related events take place.
  p.
              Statements of cash
      flows and non-cash
transactions
  For
purposes of the consolidated statements of cash flows, the Company considers all
highly liquid debt instruments purchased with a maturity of three months, or
less, to be cash equivalents.
  Interest
paid during the years ended December 31, 2008, 2007 and 2006 was $508,000,
$298,000 and $116,000, respectively.
  Income
taxes paid were$ 408,000 in 2008, $69,000 in 2007 and $7,000 in
2006.
  In 2007,
non-cash financing transactions resulting from the exchange of Series A
convertible preferred stock in exchange for common shares amounted to $500,000
and the exchange of Series B convertible preferred stock for common stock
amounted to $2,032,000.
  There
were no adjustments to goodwill in 2008, 2007 or 2006.
  q.
              Concentration of
      risk
  The
Company invests its excess cash in certificates of deposits with major financial
institutions.  Generally, the investments range over a variety of
maturity dates usually, within three to nine months, and therefore, are subject
to little risk. The Company has not experienced losses related to these
investments.
  The
concentration of credit risk in the Company’s accounts receivable is mitigated
by the Company’s credit evaluation process, familiarity with its small base of
recurring customers and reasonably short collection terms and the geographical
dispersion of revenue.  The Company generally does not require
collateral but, in some cases, the Company negotiates cash advances prior to the
undertaking of the work.  These cash advances are recorded as current
liabilities on the balance sheet until corresponding revenues are
realized.
  The
Company utilizes many relatively uncommon materials and compounds to manufacture
its products.  Therefore, any failure by its suppliers to deliver
materials of an adequate quality and quantity could have an adverse effect on
the Company’s ability to meet the commitments of its customers.
  For the
year ended December 31, 2008, seven customer accounts represented in the
aggregate 68% of total revenues, and three customers accounted for 44% of
revenues.  These three customers each represented 22%, 13% and 10.0%
of sales, respectively.  Since we are a supplier of custom
manufactured components to OEM customers, the relative size and identity of our
largest customer accounts changes somewhat from year to year.  In the
short term, the loss of any of these large customer accounts could have a
material adverse effect on business, our results of operations, and our
financial condition.
  32
  r.
              Net income per common
      share
  The basic
net income per share is computed using the weighted average number of common
shares outstanding for the applicable period.  The diluted income per
share is computed using the weighted average number of common shares plus
potential common equivalent shares outstanding, including the additional
dilution related to the conversion of stock options, warrants, convertible
preferred shares, and potential common shares issuable upon conversion of
outstanding convertible notes, except if the effect on the per share amounts is
anti-dilutive.  For the year ended December 31, 2006, there were
1,332,800 shares on the conversion of convertible preferred shares that have not
been included in dilutive shares as the effect would be
anti-dilutive.
  The
following is the reconciliation of the basic and diluted earnings per share
computations required by Statement of Financial Standards (“SFAS”) No. 128
(“Earnings per Share’)
 
 Years ended December 31,2008
                        
                        
                        2007
                        
                        
                        2006NumeratorsNet
      income applicable to common shareholders - basic
                        
                        $
                        1,098,421
                        
                        
                        $
                        1,641,914
                        
                        
                        $
                        537,766Interest
      on Convertible Debt
                        
                        
                        150,000
                        
                        
                        
                        188,096
                        
                        
                        
                        210,000Net
      income applicable to common shareholders - diluted
                        
                        $
                        1,248,421
                        
                        
                        $
                        1,830,010
                        
                        
                        $
                        747,766DenominatorsWeighed
      average shares outstanding-Basic
                        
                        
                        10,902,061
                        
                        
                        
                        8,609,822
                        
                        
                        
                        7,572,637Convertible
      Debt
                        
                        
                        2,500,000
                        
                        
                        
                        3,102,740
                        
                        
                        
                        3,500,000Warrants
                        
                        
                        1,615,417
                        
                        
                        
                        1,585,206
                        
                        
                        
                        287,353Stock
      options
                        
                        
                        594,972
                        
                        
                        
                        479,346
                        
                        
                        
                        555,100Restricted
      stock units
                        
                        
                        6,854
                        
                        
                        
                        —
                        
                        
                        
                        —Weighted
      average shares outstanding - diluted
                        
                        
                        15,619,304
                        
                        
                        
                        13,777,114
                        
                        
                        
                        11,915,090Net
      income per common share – basic
                        
                        $
                        0.10
                        
                        
                        $
                        0.19
                        
                        
                        $
                        0.07Net
      income per common share — diluted
                        
                        $
                        0.08
                        
                        
                        $
                        0.13
                        
                        
                        $
                        0.06
  s.
              Shipping and handling
      costs
  The
Company has included net of freight charge recovered from customers as a
component of selling, general and administrative expenses that amounted to
$27,000 in 2008, $36,000 in 2007 and $27,000 in 2006.  When applicable
the Company bills its customers for freight costs.
  t.
              Recently issued
      accounting pronouncements
  In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This
Statement defines fair value, establishes a framework for measuring fair value
and requires expanded disclosures about fair value measurements. SFAS
No. 157 applies only to fair-value measurements that are already required
or permitted by other accounting standards and is expected to increase the
consistency of those measurements. The Company prospectively adopted the
effective provisions of SFAS No. 157 on January 1, 2008, as required
for financial assets and liabilities. The adoption has not had a material impact
on the Company’s 2008 consolidated financial statements.
  In
February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial
Assets and Financial Liabilities,” (“SFAS 159”).  SFAS 159 provides
companies with an option to report selected financial assets and financial
liabilities at fair value.  Unrealized gains and losses on items for
which the fair value option has been elected are reported in earnings at each
subsequent reporting date.  SFAS 159 is effective for fiscal years
beginning after November 15, 2007, the year beginning January 1, 2008 for
the Company.  The Company did not make a fair value election pursuant
to this standard at the effective date and, as such, the adoption of SFAS No.
had no effect on its financial statements.
  In
December 2007, the FASB issued FASB Statement No. 141 (Revised 2007), “Business
Combinations” (“SFAS 141(R)”).  SFAS 141(R) will significantly change
the accounting for business combinations.  Under SFAS 141(R), an
acquiring entity will be required to recognize all the assets acquired and
liabilities assumed in a transaction at the acquisition-date fair value with
limited exceptions.  SFAS 141(R) will change the accounting treatment
for certain specific items, including:
  ·
              Non-controlling
      interests (formerly known as “minority interests”) will be recorded at
      fair value at the acquisition
date;
  33
  ·
              Acquired contingent liabilities
      will be recorded at fair value at the acquisition date and subsequently
      measured at either the higher of such amount or the amount determined
      under existing guidance for non-acquired
    contingencies;
  ·
              In-process research and
      development will be recorded at fair value as an indefinite-lived
      intangible asset at the acquisition
date;
  ·
              Restructuring costs associated
      with a business combination will generally be expensed subsequent to the
      acquisition date; and
  ·
              Changes in deferred tax asset
      valuation allowances and income tax uncertainties after the acquisition
      date generally will affect income tax
  expense.
  SFAS
141(R) also includes a substantial number of new disclosure
requirements.  The statement applies to the Company prospectively for
business combinations for which the acquisition date is on or after January 1,
2009.  Earlier adoption is prohibited.  The Company is
currently assessing the impact of adopting SFAS 141(R) on its financial
statements.
  The FASB
issued FASB Statement No. 160, “Non-controlling Interests in Consolidated
Financial Statements - An Amendment of ARB No. 51” in December 2007 (“SFAS
160”).  SFAS 160 establishes new accounting and reporting standards
for the non-controlling interest in a subsidiary and for the deconsolidation of
a subsidiary.  Specifically, this statement requires the recognition
of a non-controlling interest (minority interest) as equity in the consolidated
financial statements.  The amount of net income attributable to the
non-controlling interest will be included in consolidated net income on the face
of the income statement.  Statement 160 clarifies that changes in a
parent’s ownership interest in a subsidiary that do not result in
deconsolidation are equity transactions if the parent retains its controlling
financial interest.  In addition, this statement requires that a
parent recognize a gain or loss in net income when a subsidiary is
deconsolidated.  Such gain or loss will be measured using the fair
value of the non-controlling equity investment on the deconsolidation
date.  Statement 160 also includes expanded disclosure requirements
regarding the interests of the parent and its non-controlling
interest.  Statement 160 is effective for the Company for fiscal
years, and interim periods within those fiscal years, beginning with the year
ended December 31, 2009.  Earlier adoption is
prohibited.  The Company does not expect the adoption of SFAS No. 160
to have a significant impact on its financial statements.
  In
February 2008, the FASB issued FSP No. 157-1, Application of FASB Statement
No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements
That Address Fair Value Measurements for Purposes of Lease Classification or
Measurement under Statement 13,and FSP No. 157-2, Effective Date of FASB Statement
No. 157. FSP No. 157-1 amends SFAS No. 157 to exclude SFAS
No. 13, Accounting for
Leases, and its related interpretive accounting pronouncements that
address leasing transactions. FSP No. 157-2 delays the effective date of
SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities,
except those that are recognized or disclosed at fair value in the financial
statements on a recurring basis (at least annually), until the beginning of the
first quarter of 2009 for the Company. The implementation of SFAS No. 157
for the Company’s nonfinancial assets and nonfinancial liabilities is not
expected to have a material impact on the Company’s 2009 consolidated financial
statements. However, the determination of fair value for purposes of accounting
for business combinations and for conducting  periodic assessments of
goodwill and other long-lived assets for impairment will be made using the
definition of fair value prescribed by SFAS No. 157.
  In
March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities-An Amendment of SFAS No. 133. The
new standard is intended to improve financial reporting about derivative
instruments and hedging activities by requiring enhanced disclosures to enable
investors to better understand their effects on an entity’s financial position,
financial performance and cash flows. It is effective for periods beginning
after November 15, 2008, with early application encouraged. The Company’s
adoption of SFAS No. 161 is not expected to have a material impact on its
2009 consolidated financial statements.
  In
April 2008, the FASB issued FSP No. 142-3, Determination of the Useful Life of
Intangible Assets. FSP No. 142-3 amends the factors that should be
considered in developing renewal or extension assumptions used to determine the
useful life of a recognizable intangible asset under SFAS No. 142, Goodwill and Other Intangible
Assets. The intent of FSP No. 142-3 is to improve the consistency
between the useful life of a recognizable intangible asset under SFAS
No. 142 and the period of expected cash flows used to measure the fair
value of the asset under SFAS No. 141(R), and other U.S. generally accepted
accounting principles. FSP No. 142-3 is effective for financial statements
issued for fiscal years beginning after December 15, 2008, and interim
periods within those fiscal years. Useful lives assigned to intangible assets
acquired after this date will be based on the guidance contained in FSP
No. 142-3. The Company’s adoption of FSP No. 142-3 is not expected to
have a material impact on its 2009 consolidated financial
statements.
  34
   2.         Inventories,
net
  Inventories
are comprised of the following and are shown net of inventory reserves of
$1,315,000 for 2008 and $1,012,000 for 2007, respectively:
 December
      31,2008
                      
                      
                      2007(In
      thousands)Raw
      materials
                      
                      $
                      1,169
                      
                      
                      $
                      1,216Work
      in process, including manufactured parts and components
                      
                      
                      1,117
                      
                      
                      
                      1,082Finished
      goods
                      
                      
                      446
                      
                      
                      
                      633$
                      2,732
                      
                      
                      $
                      2,931
  The December 31, 2007 inventory
balances have been reclassified to conform to the basis of presentation adopted
this year.
  3.         Property
and Equipment
  Property
and equipment are comprised of the following:
 
 December
      31,2008
                          
                          
                          2007(In
      thousands)Office
      and computer equipment
                          
                          $
                          1,274
                          
                          
                          $
                          1,164Machinery
      and equipment
                          
                          
                          11,127
                          
                          
                          
                          10,550Leasehold
      improvements
                          
                          
                          2,044
                          
                          
                          
                          1,97614,445
                          
                          
                          
                          13,690Less
      accumulated depreciation and amortization
                          
                          
                          11,140
                          
                          
                          
                          10,190$
                          3,305
                          
                          
                          $
                          3,500
  4.         Related Party
Transactions
  In March
2009, the maturity date of a $1,500,000 Subordinated Convertible Promissory Note
to Clarex Limited (“Clarex”), a major shareholder and debt holder, was extended
to April 1, 2011.  The note bears interest at 6% and was originally
due in January 2006, extended to December 31, 2008 and subsequently
again to April 1, 2009.  Interest accrues yearly and along with
principal may be converted into securities of the Company as
follows:  The Note is convertible in the aggregate into 1,500,000
Units with each unit consisting of one share of common stock and one
warrant.  The warrants had an original expiration date of August 2009
and each warrant allowed the holder to acquire 0.75 shares of common stock at a
price of $1.35 per share.  The expiration date of the warrants under
the conversion terms has been extended to April 1, 2014.
  In March
2009, the maturity date of a $1,000,000 Subordinated Convertible Promissory Note
bearing interest at 6% was extended to April 1, 2011.  The note was
originally due in January 2006 and was subsequently extended to April 1,
2009.  Interest accrues yearly and along with principal may be
converted into securities of the Company as follows:  The Note is
convertible in the aggregate into 1,000,000 Units with each unit consisting of
one share of common stock and one warrant.  The warrants had an
original expiration date of August 2009 and each warrant allowed the holder to
acquire 0.75 shares of common stock at a price of $1.35 per
share.  The expiration date of the warrants under the conversion terms
has been extended to April 1, 2014.  The holder of the note is an
affiliate of Clarex.
  In
January 2008, the Company repaid in full a $1,700,000 Secured Promissory Note
held by Clarex, including accrued interest of $477,444.
  In March,
2008, Clarex elected to exercise the 200,000 warrants expiring on March 31, 2008
and the Company issued 200,000 shares of its commons stock for proceeds of
$85,000.
  In May,
2008, Clarex exercised the remaining 200,000 warrants set to expire on May 18,
2008 for $216,000 and the Company issued 200,000 shares of its common
stock.
  During
2007, the Company accelerated repayment of the outstanding balance of a secured
promissory note dated February 13, 2006 for $700,000 due to
Clarex.  The payment consisted of $554,607 in principal plus accrued
interest of $1,744.  The note was pursuant to a financing arrangement
with Clarex to fund the Company’s acquisition of capital assets needed to
capture new business opportunities.  The funds were originally
received in February 2006 and the Company issued the secured note which called
for monthly installments over a term of seven years with interest at
6.75%.
  During
2007, the Company repaid prior to maturity, a 6% Subordinated Convertible
Promissory Note in the amount of $1,000,000 due to Clarex.  The note
was originally dated April 1, 2004 and due on March 31, 2008 and was convertible
into 1,000,000 Units consisting of 1,000,000 shares of common stock and warrants
to acquire 750,000 shares of common stock at a price of $1.35 per
share.  An initial payment of $500,000 was made on June 28, 2007 and a
final payment of $500,000 plus accrued interest of $196,520 was made on
September 17, 2007.
  35
  In April
2007, Clarex exercised its right to convert its holdings of 500 shares of Series
A 10% Convertible Preferred Stock (the “Series A”) with a liquidation value of
$500,000 into common shares of the Company.  The preferred shares were
convertible at a conversion price of $1.00 per share and the Company issued
500,000 common shares in exchange.
  In
October 2007, Clarex exercised its right to convert its holdings of 1,000 shares
of the Company’s Series B 10% Convertible Stock (the “Series B”) with a
liquidation value of $1,000,000 into common stock of the Company at the
specified conversion price of $2.50 per share, along with all but one of the
other Series B holders.  The Company issued 400,000 common shares to
Clarex, on the conversion.
  5.         Notes
Payable - Other
  As part
of the purchase price of MRC on October 19, 2004, a $175,000 Note was issued to
the sole shareholder of the acquired company.  The note bears interest
at the rate of 6% per annum and is payable annually on the anniversary of the
closing date.  Under the terms of the note, $50,000 of the note amount
was repaid on October 19, 2006.  The remaining $125,000 balance of the
note along with any accrued unpaid interest is due on June 1, 2009. The
outstanding principal is included with the current portion of notes
payable-other.  Three additional notes, totaling $295,725, were
assumed from note holders of MRC subsequent to its acquisition.  The
notes had interest rates ranging from 6.0% to 10.5% and were payable from 2 to 4
years.  In 2005, two of the notes totaling $199,525 were exchanged for
two notes totaling $125,000, 80,000 shares of common stock of the Company and
60,000 warrants exercisable for 60,000 shares of common stock at $1.35 per
share.  The warrants expire in 2011.  Two of the three
additional notes were paid in full in 2006.  The remaining note will
be fully paid in 2009. A note payable to the U.S. Small Business Administration
was also assumed by the Company.  The note in the amount of $362,663
bears interest at the rate of 4.0% and is due in 2032.
  Notes
payable - Other consist of the following:
 
 December
      31,2008
                    
                    
                    2007Notes
      payable - Other, payable in aggregate monthly installments of
      approximately $2,500, except for a note with a once yearly payment of
      interest of $60,500, and bearing interest at rates ranging from 4.0% to
      6.0% and expiring at various dates up to April 2032.
                    
                    $
                    490,555
                    
                    
                    $
                    505,544Less
      current portion
                    
                    
                    136,892
                    
                    
                    
                    14,814Long-term
      debt, excluding current portion
                    
                    $
                    353,663
                    
                    
                    $
                    490,730
  Notes
payable other, mature as follows:
 
 2009
                    
                    $
                    136,8922010
                    
                    
                    9,6002011
                    
                    
                    10,0002012
                    
                    
                    10,4002013
                    
                    
                    10,900Thereafter
                    
                    
                    312,763$
                    490,555
  6.         Accounts
Payable and Accrued Expenses
  Accounts
payable and accrued expenses are comprised of the following:
  December
      31,2008
                      
                      
                      2007Trade
      accounts payable and accrued purchases
                      
                      $
                      575,157
                      
                      
                      $
                      635,529Accrued
      vacation
                      
                      
                      388,639
                      
                      
                      
                      326,998Accrued
      payroll
                      
                      
                      149,794
                      
                      
                      
                      85,179Accrued
      interest
                      
                      
                      826,849
                      
                      
                      
                      1,135,377Accrued
      payroll tax payable
                      
                      
                      9,113
                      
                      
                      
                      6,532Accrued
      bonus
                      
                      
                      81,000
                      
                      
                      
                      177,000Accrued
      commission payable
                      
                      
                      250
                      
                      
                      
                      3,229State
      and Federal income tax (prepaid) payable
                      
                      
                      (91,768
                      )
                      
                      
                      177,212Accrued
      401K common stock contribution
                      
                      
                      53,468
                      
                      
                      
                      61,221Accrued
      expenses – other
                      
                      
                      168,163
                      
                      
                      
                      133,689$
                      2,160,655
                      
                      
                      $
                      2,741,966
  36
   7.         Capital Lease
Obligations
  All of
the Company’s capital lease obligations were fully satisfied in
2008.
  8.         Income
Taxes
  The
Company’s income tax benefit (provision) consists of the following:
 
 Years
      EndedDecember
      31,2008
                      
                      
                      2007
                      
                      
                      2006Current:Federal
      provision
                      
                      $
                      (5,000
                      )
                      
                      $
                      (50,000
                      )
                      
                      $
                      —State
      provision
                      
                      
                      (100,000
                      )
                      
                      
                      (
      200,000
                      )
                      
                      
                      (21,000
                      )Deferred:Federal
      tax benefit
                      
                      
                      408,000
                      
                      
                      
                      —
                      
                      
                      
                      —State
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —Total
                      
                      $
                      303,000
                      
                      
                      $
                      (250,000
                      )
                      
                      $
                      (21,000
                      )
  A
reconciliation of the income tax provision computed at the statutory Federal
income tax rate to our effective income tax rate follows (in
percent):
 
 Year
      EndedDecember
      31,2008
                      
                      
                      2007
                      
                      
                      2006Federal
      statutory rate
                      
                      
                      34.0
                      %
                      
                      
                      34.0
                      %
                      
                      
                      34.0
                      %Net
      operating loss carryforward - Federal
                      
                      
                      (34.0
                      )
                      
                      
                      (34.0
                      )
                      
                      
                      (34.0
                      )Federal
      AMT
                      
                      
                      0.6
                      
                      
                      
                      2.3
                      
                      
                      
                      —Expected
      tax benefit of net operating loss carry forwards
                      
                      
                      (51.3
                      )State
      tax  provision
                      
                      
                      12.6
                      
                      
                      
                      9.4
                      
                      
                      
                      9.0Net
      Operating Loss carry forward - State
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      (5.5
                      )Allowable
      state manufacturing credit
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      (0.9
                      )Effective
      income tax rate
                      
                      
                      (38.1
                      )
      %
                      
                      
                      11.7
                      %
                      
                      
                      2.6
                      %
  At
December 31, 2008, the Company has Federal and State net operating loss carry
forwards for tax purposes of approximately $5,418,000 and $636,000,
respectively.  The tax loss carry forwards expire at various dates
through 2028.
  Internal
Revenue Code Section 382 places a limitation on the utilization of Federal net
operating loss and other credit carry forwards when an ownership change, as
defined by the tax law, occurs.  Generally, this occurs when a greater
than 50 percentage point change in ownership occurs.  Accordingly, the
actual utilization of the net operating loss and carryforwards for tax purposes
may be limited annually to a percentage (approximately 6%) of the fair market
value of the Company at the time of any such ownership change.
  37
  Deferred
tax assets (liabilities) comprise the following:
 
 December
      31,2008
                              
                              
                              2007Inventory
      reserves
                              
                              $
                              410,000
                              
                              
                              $
                              344,000Accrued
      Vacation
                              
                              
                              133,000
                              
                              
                              
                              111,000Section
      263A adjustment
                              
                              
                              —
                              
                              
                              
                              1,000Depreciation
                              
                              
                              (280,000
                              )
                              
                              
                              (256,000
                              )Loss
      carry forwards
                              
                              
                              1,878,000
                              
                              
                              
                              1,841,000Gross
      deferred tax assets
                              
                              
                              2,141,000
                              
                              
                              
                              2,041,000Valuation
      allowance
                              
                              
                              (1,733,000
                              )
                              
                              
                              (2,041,000
                              )Net
      deferred tax asset
                              
                              $
                              408,000
                              
                              
                              $
                              —
  SFAS No.
109 “Accounting for Income Taxes” provides for the recognition of deferred tax
assets if realization of such assets is more likely than not to
occur.  The Company assesses the recoverability of its deferred tax
assets and, to the extent recoverability does not satisfy the “more likely than
not” recognition criteria under SFAS 109, a valuation allowance is recorded
against its deferred tax assets. The Company considers its recent operating
results and anticipated future taxable income in assessing the need for its
valuation allowance.  As a result, in 2008, the Company adjusted its
valuation allowance to reflect the realization of deferred tax assets of $1.2
million, as reflected in the effective tax rate.
 The
remaining portion of the Company’s valuation allowance as of December 31, 2008
will be maintained until there is sufficient positive evidence to conclude that
it is more likely than not that the remaining deferred tax assets will be
realized. When sufficient positive evidence exists, the Company’s income tax
expense will be reduced by the decrease in its valuation allowance. An increase
or reversal of the Company’s valuation allowance could have a significant
negative or positive impact on the Company’s future earnings.
  9.
              Equity
      Compensation Program and Stock-based
  Compensation
  a.
              2000 Equity
      Compensation Program
  The
Company’s 2000 Equity Compensation Program provides for grants of options, stock
appreciation rights and performance shares to employees, officers, directors,
and others who render services to the Company.  The program consists
of four plans including:  (i) the Incentive Equity Compensation
Program which provide for grants of “incentive stock options”, (ii) the
Supplemental Program which provide for grants of stock options to non-employees,
(iii) the SAR Program which allows the granting of stock appreciation rights
and, (iv) the Performance Share Program under which eligible participants may
receive stock awards, including restricted stock and restricted stock
units.  The plans are administered by the Compensation Committee of
the Board of Directors.  Under these plans, an aggregate of up to
6,000,000 shares of common stock may be granted.  The 2000 Equity
Compensation plan expires in August 2010.
  b.
              Stock Option
      Expense
  The
Company's results for the years ended December 31, 2008, 2007 and 2006 include
stock-based compensation expense for stock option grants, as required by SFAS
123(R), totaling $47,000, $34,000 and $118,000, respectively.  Such
amounts have been included in the Consolidated Statements of Income within cost
of goods sold ($8,000 for 2008, $8,000 for 2007 and $31,000 for 2006), and
selling, general and administrative expenses ($39,000 for 2008, $26,000 for 2007
and $87,000).  No income tax benefit has been recognized in the income
statement due to the Company’s history of operating losses.
  As of
December 31, 2008, 2007 and 2006, there were $17,000, $52,300 and $56,600 of
unrecognized compensation costs, net of estimated forfeitures, related to
non-vested stock options, which are expected to be recognized over a weighted
average period of approximately 1.1 years, 2.1 years and 2.3 years,
respectively.
  The
Company did not issue any stock options during 2008.  The weighted
average estimated fair value of stock options granted in the previous two years
ended December 31, 2007 and 2006 was $1.47 and $1.46,
respectively.  The fair value of options at the date of grant was
estimated using the Black-Scholes option pricing model.  The Company
follows guidance under SFAS 123(R) and SEC Staff Accounting Bulletin
No. 107 (“SAB 107”) when reviewing and updating assumptions.  The
expected volatility is based upon historical volatility of our stock and other
contributing factors.  The risk-free rate is based on the U.S.
Treasury yield curve in effect at the time of the grant.  The expected
term is based upon the contractual term of the option.
  38
  The
following range of weighted-average assumptions were used for to determine the
fair value of stock option grants during the years ended December 31, 2008, 2007
and 2006:
  Years
      EndedDecember
      31,2008
                    
                    
                    2007
                    
                    
                    2006Dividend
      yield
                    
                    
                    —
                    %
                    
                    
                    0.00
                    %
                    
                    
                    0.00
                    %Volatility
                    
                    
                    —
                    %
                    
                    
                    144.9
                    %
                    
                    
                    121.1
                    %Risk-free
      interest rate
                    
                    
                    —
                    %
                    
                    
                    4.7
                    %
                    
                    
                    5.2
                    %Expected
      life
                    
                    
                    —
                    
                    
                    10
      years
                    
                    
                    10
      years
  c.
              Stock Option
      Activity
  No stock
options were granted in 2008.  The Company granted 29,039 stock
options during the year ended December 31, 2007 at an exercise price of $1.50,
which was equal to the closing market price on the date of the
grant.  The Company granted 77,200 options during the year ended
December 31, 2006 at exercise prices ranging between $1.50 and $1.75, which was
equal to the closing market price on the date of each grant.
  A summary
of the Company’s outstanding stock options as of and for the years ended
December 31, 2008, 2007 and 2006 are as follows:
 
 Options
                            
                            
                            Weighted
                              Average
                              Exercise
                              Price
                            
                            
                            Weighted
                              Average
                              Remaining
                              Contractual
                              Term
                              (In
      Years)
                            
                            
                            Aggregate
                              Intrinsic
                              Value(a)
                              (in
                              thousands)Outstanding
      as of January 1, 2006
                            
                            
                            2,199,800
                            
                            
                            $
                            1.16Granted
                            
                            
                            77,200
                            
                            
                            
                            1.53Exercised
                            
                            
                            (145,000
                            )
                            
                            
                            0.78
                            
                            
                            
                            
                            
                            $
                            129,000Forfeited
                            
                            
                            (252,300
                            )
                            
                            
                            1.11Outstanding
      as of December 31, 2006
                            
                            
                            1,879,700
                            
                            
                            $
                            1.25
                            
                            
                            
                            4.6
                            
                            
                            $
                            789,000Granted
                            
                            
                            29,039
                            
                            
                            
                            1.98Exercised
                            
                            
                            (651,100
                            )
                            
                            
                            0.68
                            
                            
                            
                            
                            
                            
                            $
                            2,159,000Forfeited
                            
                            
                            (29,000
                            )
                            
                            
                            1.98Outstanding
      as of December 31, 2007
                            
                            
                            1,228,639
                            
                            
                            $
                            1.52
                            
                            
                            
                            4.0
                            
                            
                            $
                            3,049,000Granted
                            
                            
                            —
                            
                            
                            
                            —Exercised
                            
                            
                            (182,000
                            )
                            
                            
                            1.42
                            
                            
                            
                            
                            
                            
                            $
                            60,000Forfeited
                            
                            
                            (16,500
                            )
                            
                            
                            3.25Outstanding
      as of December 31, 2008
                            
                            
                            1,030,139
                            
                            
                            
                            1.50
                            
                            
                            
                            3.9
                            
                            
                            $
                            161,000Exercisable
      as of December 31, 2006
                            
                            
                            1,728,276
                            
                            
                            
                            1.28
                            
                            
                            
                            4.4
                            
                            
                            $
                            674,000Exercisable
      as of December 31, 2007
                            
                            
                            1,171,855
                            
                            
                            
                            1.52
                            
                            
                            
                            3.8
                            
                            
                            $
                            2,906,000Exercisable
      as of December 31, 2008
                            
                            
                            996,919
                            
                            
                            
                            1.50
                            
                            
                            
                            2.8
                            
                            
                            $
                            253,000
 
 (a)
Intrinsic value for purposes of this table represents the amount by which the
fair value of the underlying stock, based on the respective market prices as of
December 31, 2008, 2007 and 2006 exceeds the exercise prices of the respective
options.
  39
  The
following table represents non-vested stock options granted, vested, and
forfeited for the year ended December 31, 2008.
 Non-vested Options
                    
                    Options
                    
                    
                    Weighted-Average
      Grant-
                      Date Fair ValueNon-vested  -
      January 1, 2008
                    
                    
                    56,784
                    
                    
                    $
                    1.48Granted
                    
                    
                    —
                    
                    
                    
                    —Vested
                    
                    
                    (23,564
                    )
                    
                    $
                    1.48Forfeited
                    
                    
                    —
                    
                    
                    
                    —Non-vested
      – December 31, 2008
                    
                    
                    33,220
                    
                    
                    $
                    1.48
  The total
fair value of options vested during the years ended December 31, 2008, 2007 and
2006, was $35,000, $71,000 and $101,000, respectively.
  The
following table summarizes information about stock options outstanding at
December 31, 2008:
 Options
      Outstanding
                              
                              Options
      ExercisableWeightedAverage
                              
                              Weighted
                              
                              
                              
                              WeightedRemaining
                              
                              Average
                              
                              
                              
                              AverageRange of
                              
                              Number
                              
                              Contractual
                              
                              Exercise
                              
                              Number
                              
                              ExerciseExercise
      Price (1)
                              
                              Outstanding
                              
                              Life
      in Years
                              
                              Price
                              
                              Outstanding
                              
                              Price$0.50
      - $2.00
                              
                              957,539
                              
                              6.1
                              
                              $
                              1.32
                              
                              1,099,255
                              
                              $
                              1.31$3.25
      - $5.00
                              
                              72,600
                              
                              2.1
                              
                              $
                              3.48
                              
                              72,600
                              
                              $
                              2.98
  (1)   There were no
outstanding options with an exercise price between $2.01 and
$3.24.
  d.
              Restricted Stock Unit
      Awards
  During
2008, the Company granted 23,500 restricted stock units under the 2000
Performance Share Program with a fair market value of $85,300 based on the
closing market price of the Company’s stock on the grant date.  In
December 2007, the Company granted 12,000 restricted stock units to one
individual under the 2000 Performance Share Program with a fair market value of
$48,000 based on the closing market price of the Company’s stock on the grant
date.  These grants vest over a three year period contingent on
continued employment over the vesting period.  There were no previous
grants of restricted stock units under this plan.  The company
recognized related stock compensation expense of $41,000 ($5,000 in Cost of
Goods Sold and $36,000 in Selling, General and Administrative expenses) in 2008
and $0 in 2007.
 
 A summary
of the Company’s non-vested restricted stock unit awards shares is as
follows:
 
 RSUs
                                          
                                          
                                          Weighted
                                            Average
                                            Grant
      Date
                                            Fair
      ValueOutstanding
      as of January 1, 2007
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —Granted
                                          
                                          
                                          12,000
                                          
                                          
                                          
                                          4.00Vested
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —Forfeited
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —Outstanding
      as of December 31, 2007
                                          
                                          
                                          12,000
                                          
                                          
                                          
                                          4.00Granted
                                          
                                          
                                          23,500
                                          
                                          
                                          
                                          3.63Vested
                                          
                                          
                                          (4,000
                                          )
                                          
                                          
                                          4.00Forfeited
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —Outstanding
      as of December 31, 2008
                                          
                                          
                                          31,500
                                          
                                          
                                          
                                          3.72
 
 The total
fair value of restricted stock units which vested during 2008 was $6,600 as of
the vesting date.
  40
  10.
              Commitments
  a.
              Lease
      commitment
  The
Company occupies approximately 42,000 square feet of space located at 181
Legrand Avenue, Northvale, New Jersey pursuant to a net lease.  On
November 1, 2008, the lease was renewed for a two year term to October 31, 2010,
at substantially the same terms.  The Company has options to renew the
Northvale lease for two additional two year terms running through October 21,
2012, with fixed terms.
  The
Company’s MRC Optics subsidiary occupies approximately 25,000 square feet of
space located at 6405 Parkland Drive, Sarasota, FL pursuant to a net lease
originally expiring on August 31, 2006.  During 2006, MRC Optics
negotiated terms for the renewal of the lease until August 31,
2008.  In 2008, the Company elected to extend the lease until August
31, 2010 and has the option of three additional two year renewal periods through
August 31, 2016.
  The
Company‘s total rental expense was approximately $588,000, $570,000 and $549,000
in 2008, 2007 and 2006, respectively, and real estate taxes and insurance were
$179,000, $189,000, and $156,000 in 2008, 2007 and 2006,
respectively.
  Future
minimum annual rentals which cover the remaining lease terms, excluding
uncommitted option renewal periods are $526,000 for 2009 and $406,000 for
2010.
  b.
              Retirement
      plans
  The
Company maintains a 401(k) savings plan for all eligible employees (as defined
in the plan).  The 401(k) plan allows employees to contribute up to
20% of their compensation on a salary reduction, pre-tax basis up to the
statutory limitation.  The 401(k) plan also provides that the Company,
at the discretion of the Board of Directors, may match employee contributions
based on a pre-determined formula.
  In 2008,
the Company matched employee contributions in the amount of $179,068 contributed
in the form of 66,469 shares of the Company’s common stock, which were
distributed in February 2009.  In 2007, the Company matched employee
contributions in the amount of $160,181 contributed in the form of 75,907 shares
of the Company’s common stock, distributed in March 2008.  The Company
contributed $166,694 in the form of 124,133 shares of the Company’s common stock
distributed in March 2007. The Company records the distribution of the common
shares in the Consolidated Statement of Shareholders’ Equity as of the date of
distribution to the 401(k) plan administrator.
  c.
              Employment
      agreements
  The
Company is not party to any employment agreements as of December 31,
2008
  11.
              Product
      Sales, Foreign Sales and Sales to Major
  Customers
  The
following table summarizes the Company’s product sales by product categories
during the past three years:
 
 Year
      Ended December 31,
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006Category
                  
                  Sales
                  
                  
                  %
                  
                  
                  Sales
                  
                  
                  %
                  
                  
                  Sales
                  
                  
                  %Optical
      Components
                  
                  $
                  14,750,000
                  
                  
                  
                  90
                  
                  
                  $
                  13,410,000
                  
                  
                  
                  89
                  
                  
                  $
                  12,274,000
                  
                  
                  
                  88Laser
      Accessories
                  
                  
                  1,551,000
                  
                  
                  
                  10
                  
                  
                  
                  1,690,000
                  
                  
                  
                  11
                  
                  
                  
                  1,647,000
                  
                  
                  
                  12TOTAL
                  
                  $
                  16,301,000
                  
                  
                  
                  100
                  
                  
                  $
                  15,100,000
                  
                  
                  
                  100
                  
                  
                  $
                  13,921,000
                  
                  
                  
                  100
  The
Company’s export sales, are primarily to customers in countries within Europe,
the Near East and Japan, and amounted to 5.2%, 9.5%, and 8.7% of product sales
in 2008, 2007 and 2006, respectively. In 2008, sales to these markets, which are
mainly through independent distributors, decreased from the two previous
year's.
  In 2008,
the Company had sales to two major domestic customers which accounted for 21.6%
and 13.0% of sales.  One customer is an electro-optical systems
division of a major U.S. defense corporation who manufactures systems for U.S.
and allied foreign governments.  The second customer is in the process
control and metrology industry.  In 2007, two domestic customers
accounted for 19.0% and 13.5% of sales.  Both customers were
electro-optical systems divisions of major U.S defense industry
corporations.  In 2006, the same two domestic customers accounted for
15%, 16% of sales.  One customer in the Defense/Aerospace sector has
represented the highest percentage of sales for the past three
years.  Given the concentration of sales within a small number of
customers, the loss of any of these customers would have a significant negative
impact on the Company and its business units.
  41
  12.
              Shareholders’
      Equity
  a.
              Common shares reserved
      at December 31, 2008, are as
follows:
 
 1991
      Stock option plan
                    
                    
                    105,0002000
      Equity compensation plan
                    
                    
                    6,000,000Convertible
      preferred stock
                    
                    
                    —Subordinated
      convertible notes
                    
                    
                    2,500,000Warrants
      issuable on conversion of Subordinated convertible notes
                    
                    
                    1,875,000Warrants
      outstanding
                    
                    
                    1,003,790
  b.
              Preferred
      stock
  The
Company has authorized 1,000,000 shares of preferred stock, no par value, which
the Board of Directors has the authority to issue from time to time in a
series.  The Board of Directors also has the authority to fix, before
the issuance of each series, the number of shares in each series and the
designation, preferences, rights and limitations of each series.
  The
Company had no shares of preferred stock issued and outstanding as of December
31, 2008.
  In 2007,
the Series A preferred stock consisting of 500 shares at a stated value of
$1,000 per share and convertible into common shares at the rate of $1.00 per
share was converted into 500,000 common shares of the Company’s stock in April
2007.
  A total
of 2,032 shares of the Series B preferred stock consisting of 2,082 shares at a
stated value of $1,000 per share and convertible into common shares at the rate
of $2.50 per share were converted in October and November of
2007.  One holder of the remaining 50 shares of Series B preferred
stock elected to redeem their shares for a cash payment of $50,000 and an
accrued stock dividend of 1,332 common shares of the Company.
  There
were no common stock dividends for the year ended December 31,
2008.  For the years ended December 31, 2007 and 2006, the Company
paid a common stock dividend on preferred stock of 134,612 and 134,000 common
shares for each year equal to $238,167 and $234,500 at the closing market price
of the common shares on the issue date, respectively.
  c.
              Warrants
  Warrants
outstanding expire from July 2009 to May 2010 as per the below
schedule:
  Shares
                        
                        Exercisable
      through
                        
                        Exercise
      Price
                        
                        
                        Fair
      Value943,790
                        
                        July
      2009
                        
                        $
                        1.35
                        
                        
                        $
                        1.2960,000
                        
                        May
      2010
                        
                        $
                        1.35
                        
                        
                        $
                        1.31
  13.
                Fair
      Value of Financial
Instruments
  The
methods and assumptions used to estimate the fair value of the following classes
of financial instruments were:
  Current
Assets and Current Liabilities:  The carrying amount of cash,
certificates of deposits, current receivables and payables and certain other
short-term financial instruments approximate their fair value.
  Long-Term
Debt:  The fair value of the Company’s long-term debt, including the
current portion, for notes payable and subordinated convertible debentures, was
estimated using a discounted cash flow analysis, based on the Company’s assumed
incremental borrowing rates for similar types of borrowing
arrangements.  The carrying amount of variable and fixed rate debt at
December 31, 2008 approximates fair value.
  42
  14.
              Quarterly
      Data(Unaudited)
  Summary
quarterly results were as follows:
  Year
      2008
                            
                            First
                            
                            
                            Second
                            
                            
                            Third
                            
                            
                            FourthNet
      sales
                            
                            
                            4,164,248
                            
                            
                            
                            4,007,412
                            
                            
                            
                            3,802,935
                            
                            
                            
                            4,326,614Gross
      profit
                            
                            
                            1,501,593
                            
                            
                            
                            1,219,202
                            
                            
                            
                            1,065,424
                            
                            
                            
                            1,028,370Net
      Income
                            
                            
                            491,200
                            
                            
                            
                            294,017
                            
                            
                            
                            169,120
                            
                            
                            
                            144,084Net
      Income per share - Basic
                            
                            
                            0.05
                            
                            
                            
                            0.03
                            
                            
                            
                            0.02
                            
                            
                            
                            0.01Net
      Income per share - Diluted
                            
                            
                            0.03
                            
                            
                            
                            0.02
                            
                            
                            
                            0.01
                            
                            
                            
                            0.01
  Year 2007
                    
                    First
                    
                    
                    Second
                    
                    
                    Third
                    
                    
                    FourthNet
      sales
                    
                    $
                    3,540,874
                    
                    
                    $
                    3,678,796
                    
                    
                    $
                    3,837,660
                    
                    
                    $
                    4,042,548Gross
      profit
                    
                    
                    1,381,500
                    
                    
                    
                    1,393,238
                    
                    
                    
                    815,825
                    
                    
                    
                    1,368,266Net
      Income
                    
                    
                    434,860
                    
                    
                    
                    396,488
                    
                    
                    
                    797,413
                    
                    
                    
                    251,320Net
      Income per share - Basic
                    
                    
                    0.06
                    
                    
                    
                    0.02
                    
                    
                    
                    0.09
                    
                    
                    
                    0.03Net
      Income per share - Diluted
                    
                    
                    0.04
                    
                    
                    
                    0.02
                    
                    
                    
                    0.06
                    
                    
                    
                    0.02
 
 Year 2006
                    
                    First
                    
                    
                    Second
                    
                    
                    Third
                    
                    
                    FourthNet
      sales
                    
                    $
                    3,662,776
                    
                    
                    $
                    3,531,420
                    
                    
                    $
                    3,049,333
                    
                    
                    $
                    3,677,598Gross
      profit
                    
                    
                    1,187,617
                    
                    
                    
                    1,121,216
                    
                    
                    
                    882,936
                    
                    
                    
                    1,352,045Net
      Income
                    
                    
                    201,653
                    
                    
                    
                    6,839
                    
                    
                    
                    173,000
                    
                    
                    
                    390,774Net
      Income (loss) per share - Basic
                    
                    
                    0.03
                    
                    
                    
                    (0.03
                    )
                    
                    
                    0.02
                    
                    
                    
                    0.05Net
      Income (loss) per share - Diluted
                    
                    
                    0.02
                    
                    
                    
                    (0.03
                    )
                    
                    
                    0.02
                    
                    
                    
                    0.04
  43
  Report
of Independent Registered Public Accounting Firm on Supplemental
Information
 
 Board of
Directors and Shareholders
 Photonic
Products Group, Inc.
 and Subsidiaries
 Northvale,
New Jersey
  The
audits referred to in our report relating to the consolidated financial
statements of Photonic Products Group, Inc. and Subsidiaries which is contained
in Item 8 in the Form 10-K, include the audits of the financial statement
schedule listed in the accompanying Schedule II for the years ended December 31,
2008, 2007 and 2006.  This financial statement schedule is the
responsibility of the Company’s management.  Our responsibility is to
express an opinion on this financial statement schedule based upon our
audits.
 
 In our
opinion, such financial statement schedule when considered in relation to the
basic consolidated financial statements take as a whole, presents fairly, in all
material respects, the information set forth therein.
 
 /s/Holtz
Rubenstein Reminick LLP
 
 March 30,
2009
 Melville,
NY
  44
  Schedule
II –Valuation and Qualifying Accounts
  PHOTONIC
PRODUCTS GROUP, INC.
 SCHEDULE
II VALUATION AND QUALIFYING ACCOUNTS
 
 Balance
      at
                                        Beginning
                                        of
      Period
                                      
                                      
                                      Charged
                                        (Credited)
                                        to
      Cost and
                                        Expenses
                                      
                                      
                                      Acquired
                                        Balance
                                      
                                      
                                      Deductions
                                      
                                      
                                      Balance
                                        at
      End of
                                        PeriodAllowance for Doubtful
    AccountsYear
      ended December 31, 2008
                                      
                                      $
                                      15,000
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      $
                                      15,000Year
      ended December 31, 2007
                                      
                                      $
                                      15,000
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      $
                                      
                                      
                                      
                                      $
                                      15,000Year
      Ended December 31, 2006
                                      
                                      $
                                      15,000
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      $
                                      15,000
  45