**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-K**

 

ý**                ****ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the fiscal year ended    December 31, 2003**

**OR**

 

o                 **TRANSITION REPORTPURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition periodfrom                          to**

 

**Commission file number  0-11668**

 
| **Photonic Products Group, Inc.**                                                 |
|-----------------------------------------------------------------------------------|
| (Exact name of registrant as specified in its charter)                            |
|                                                                              |   |   |
| **New Jersey**                                                                    |   | **22-2003247** |
| (State or other jurisdiction of incorporation                                     |   | (I.R.S. Employer |
| or organization)                                                                  |   | Identification No.) |
|                                                                              |   |   |
| **181 Legrand Avenue, Northvale, NJ 07647**                                       |
| (Address of principal executive  offices)     (Zip Code) |
|                                                                              |   |   |
| **(201) 767-1910**                                                                |
| (Registrant’s telephone number, including area code)                         |
|                                                                              |   |   |
| Securities Registered Pursuant to Section 12(b) of the Act:**None**               |

 
| **Title of  each class** |       | **Name of  each exchange on  which registered** |       |
|--------------------------|------------|-------------------------------------------------|------------|
|                     | ** ** |                                            | ** ** |
|                     |       |                                            |       |

 

SecuritiesRegistered Pursuant to Section 12(g) of the Act:

 
|   | **Common Stock, par value $0.01 Per Share** |   |
|--------|---------------------------------------------|--------|
|   | (Title of class)                            |   |

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  **ý** ..  No o.

 

Indicate bycheck mark if disclosure of delinquent filers pursuant to Item 405 of RegulationS-K (§ 229.405 of this chapter) is not contained herein, and will not becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K  ý

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Act).  Yes o.  No **ý**

 

Aggregatemarket value of the registrant’s Common Stock, par value $0.01 per share, heldby non-affiliates as of April 8, 2004 was approximately **$1,184,000**

 

Common shares of stock outstanding as ofApril 8, 2004:

**5,441,303shares**

 

Documents incorporated by reference: **None**

 

 

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Photonic Products Group, Inc.

 
| INDEX                                 |                                                                                       |
|---------------------------------------|--------------------------------------------------------------------------------------------|
|                                  |                                                                                       |
| **Part I**                            |                                                                                       |   |
|                                  |                                                                                       |   |
| Item 1.                               | Business                                                                                   |   |
|                                  |                                                                                       |   |
| Item 2.                               | Properties                                                                                 |   |
|                                  |                                                                                       |   |
| Item 3.                               | Legal Proceedings                                                                          |   |
|                                  |                                                                                       |   |
| Item 4.                               | Submission of Matters to a Vote of Security  Holders                                       |   |
|                                  |                                                                                       |   |
| **Part II**                           |                                                                                       |   |
|                                  |                                                                                       |   |
| Item 5.                               | Market for Registrant’s Common Equity and  Related Stockholder Matters                |   |
|                                  |                                                                                       |   |
| Item  6.                              | Selected Financial Data                                                                    |   |
|                                  |                                                                                       |   |
| Item 7.                               | Management’s Discussion and Analysis of  Financial Condition and Results of Operation |   |
|                                  |                                                                                       |   |
| Item 7A.                              | Quantitative and Qualitative Disclosures  about market risk                                |   |
|                                  |                                                                                       |   |
| Item 8.                               | Financial Statements and Supplementary Data                                                |   |
|                                  |                                                                                       |   |
| Item 9.                               | Changes in and Disagreements with Accountants  on Accounting and Financial Disclosure      |   |
|                                  |                                                                                       |   |
| Item 9A                               | Controls and Procedures                                                                    |   |
|                                  |                                                                                       |   |
| **Part  III**                         |                                                                                       |   |
|                                  |                                                                                       |   |
| Item 10.                              | Directors and Executive Officers of the  Registrant                                        |   |
|                                  |                                                                                       |   |
| Item 11.                              | Executive Compensation                                                                     |   |
|                                  |                                                                                       |   |
| Item 12.                              | Security Ownership of Certain Beneficial  Owners and Management                            |   |
|                                  |                                                                                       |   |
| Item 13.                              | Certain Relationships and Related  Transactions                                            |   |
|                                  |                                                                                       |   |
| Item 14.                              | Principal Accounting Fees and Services                                                     |   |
|                                  |                                                                                       |   |
| **Part IV**                           |                                                                                       |   |
|                                  |                                                                                       |   |
| Item 15                               | Exhibits, Financial Statement Schedules,  and Reports on Form 8-K                          |   |
|                                  |                                                                                       |   |
| Signatures                            |                                                                                       |
|                                  |                                                                                       |
| Note:  Page F-1 follows Page 26. |                                                                                       |

 

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#### **PART I**

#### ** **

##### **ForwardLooking Statements**

 

This AnnualReport contains forward-looking statements as that term is defined in thefederal securities laws.  The Companywishes to insure that any forward-looking statements are accompanied bymeaningful cautionary statements in order to comply with the terms of the safeharbor provided by the Private Securities Litigation Reform Act of 1995.  The events described in the forward-lookingstatements contained in this Annual Report may not occur.  Generally, these statements relate tobusiness plans or strategies, projected or anticipated benefits or otherconsequences of the Company’s plans or strategies, projected or anticipatedbenefits of acquisitions to be made by the Company, or projections involvinganticipated revenues, earnings, or other aspects of the Company’s operatingresults.  The words “may”, “will”,“expect”, “believe”, “anticipate”, “project”, “plan”, “intend”, “estimate”, and“continue”, and their opposites and similar expressions are intended toidentify forward-looking statements. The Company cautions you that these statements are not guarantees offuture 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 uponwhich the statements are based.  Factorswhich may affect the Company’s results include, but are not limited to, therisks and uncertainties discussed in Items 1, 7 and 7A.  Any one or more of these uncertainties,risks, and other influences could materially affect the Company’s results ofoperations and whether forward-looking statements made by the Company ultimatelyprove to be accurate.  Readers are furthercautioned that the Company’s financial results can vary from quarter toquarter, and the financial results for any period may not necessarily beindicative of future results.  Theforegoing is not intended to be an exhaustive list of all factors that couldcause actual results to differ materially from those expressed inforward-looking statements made by the Company.  The Company’s actual results, performance and achievements coulddiffer materially from those expressed or implied in these forward-lookingstatements.  The Company undertakes noobligation to publicly update or revise any forward looking statements, whetherfrom new information, future events, or otherwise.

 

The followingdiscussion and analysis should be read in conjunction with the Company’sconsolidated financial statements and the notes thereto presented elsewhereherein.  The discussion of resultsshould not be construed to imply any conclusion that such results willnecessarily continue in the future.

 

**Item 1.****                    Business**

 

Photonic ProductsGroup, Inc. (the “Company” or “PPGI”), incorporated in 1973, develops,manufactures and markets products and services for use in diverse Photonicsindustry sectors via its distinct business units.  Prior to its name change in September, 2003, PPGI was named anddid business solely as Inrad, Inc.

 

Companymanagement, the Board of Directors, and shareholders approved the name changein 2003, reinforcing the transformation of the Company’s business model intothat of a portfolio of business units whose branded products conform to theparadigm:  Products Enabling PhotonicsTM.  In summary, the Company is a component,subassembly, and sub-system supplier to original equipment manufacturers andresearchers in the Photonics industry.

 

The Companyhad announced in 2002 that it was implementing its plan to transform theCompany into a portfolio of businesses serving the Photonics industry.  In November 2003, the Company concluded itsfirst acquisition, that of the assets and certain liabilities of Laser Optics,Inc. of Bethel, CT, via a new subsidiary, Laser Optics Holdings, Inc.  Laser Optics, Inc. is a custom optics andoptical coating services provider, in business since 1966.  PPGI announced it will integrate the Bethelteam and their operations into the Company’s Northvale, NJ operations in 2004.

 

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PPGI’sbusiness units’ products continue, at present, to fall into two productcategories: optical components (including standard and custom optical componentsand assemblies, crystals, and crystal components), and laser accessories(including wavelength conversion and waveform metrology products that employnonlinear crystals to perform the function of wavelength conversion orpulse-width measurement).  PPGI expectsthat in the future its products will also include other productcategories.  Currently, its opticalcomponents product lines and operations are brought to market via two PPGIbusiness units: INRAD and Laser Optics. Laser accessories are brought to market by INRAD.

 

The Companydevelops, manufactures and delivers precision custom optics and thin filmoptical coating services via its Laser Optics business unit.  Glass and crystal substrates are processedusing modern manufacturing equipment and techniques to prepare and polishsubstrates, deposit optical thin films, and assemble sub-components, therebyproducing optical components used in advanced Photonic systems of manykinds.  The majority of custom optical componentsand optical coating services supplied are used in inspection and processcontrol systems, in defense electro-optical systems, in laser systemapplications, and in medical system applications.

 

The Companyalso currently develops, manufactures, and delivers synthetic crystals, crystalcomponents, and laser accessories via its INRAD business unit.  INRAD grows synthetic crystals withelectro-optic (EO), non-linear and optical properties for use in both itsstandard products and custom products. The majority of crystals, crystal components and laser accessoriessupplied are used in laser system, defense EO system, and in R&Dapplications.

 

PPGI’sbusiness units’ current customers include leading companies in the followingindustries: commercial laser systems, inspection and process control equipment,and defense electro-optics.  TheCompany’s customers also include researchers in industry, in NationalLaboratories and in universities worldwide.

 

The Company isimplementing its plan to assemble a portfolio of businesses serving thePhotonics industry, and is engaged in ongoing strategic merger and acquisitiondiscussions.  The Company is alsoengaged in discussions regarding the raising of acquisition capital.

 

The followingtable summarizes the Company’s product sales by product categories during thepast three years:

 

 
|               |   | **Year Ended  December 31** |            |
|--------------------|--------|-----------------------------|-----------------|
|               |   | **2003**                    |            | **2002** |   | **2001** |   |
| **Category**       |   | **Sales**                   |            | **%** |   | **Sales** |   | **%** |   | **Sales** |   | **%** |   |
| Optical Components |   | $                           | 4,469,000  | * | 83 |   | $ | 4,325,905 |   | 79 |   | $ | 6,035,049 |   | 77 |   |
| Laser Accessories  |   | 893,000                     |            | 17 |   | 1,155,816 |   | 21 |   | 1,850,988 |   | 23 |   |
| TOTAL              |   | $                           | 5,362,000       | * | 100 |   | $ | 5,481,721 |   | 100 |   | $ | 7,886,037 |   | 100 |   |

 

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*      a)     2003 Optical Component sales include$78,000 from operations acquired from Laser Optics, Inc.

 

b)             Not included above are (non-product)contract R&D sales of approximately $26,000, $87,000 and $189,000 in 2003,2002, and 2001, respectively.

 

**ProductsManufactured by the Company**

 

**OpticalComponents**

 

a) CustomOptics and Optical Coating Services

 

Manufacturingof high-performance custom optics is at present a major product area for PPGI,

 

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and is addressed in themarketplace via its Laser Optics business unit.  This business unit was formed in 2003 via the combination ofINRAD’s Northvale, NJ-based custom optics and optical coating servicesoperations and those of the former Laser Optics, Inc. of Bethel, CT.  The Company has been active in the fieldsince 1973, and Laser Optics, Inc. since 1966.

 

The “new”Laser Optics provides both standard and custom products.  It specializes in the manufacture of opticalcomponents, optical coatings (ultra-violet wavelengths through infra-redwavelengths) and subassemblies for military, industrial, process control,photonic instrument, and medical end-use. Planar, prismatic, spherical, and cylindrical components are fabricatedfrom glasses of all kinds and crystals of most kinds, including fused silica,quartz, infra-red materials, calcite, magnesium fluoride, silicon, and yttriumaluminum garnate.  Component typesinclude mirrors, lenses, prisms, waveplates, polarizing optics, monochrometers,x-ray mirrors, and cavity optics for lasers.

 

To meetperformance requirements, most optical components and sub-assemblies requirethin film coatings on their surfaces. Depending on the design, optical coatings can refract, reflect, ortransmit specific wavelengths.  LaserOptics coating service specialties include high laser damage resistance,infra-red, polarizing, high reflective, anti-reflective, and coating to complexcustom requirements on a wide range of substrate materials.  Laser Optics both coats customer furnishedcomponents and components it manufactures. Coating deposition process technologies employed included electron beam,thermal, and ion assist.

 

b) Crystalsand Crystal Components

 

PPGI producesand brings to market crystals and crystal components via its INRAD businessunit.  Certain synthetic crystals,because of their internal structure, have unique optical, non-linear, orelectro-optical properties. 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 andmanufacturing and design processes for crystal components lies at the heart ofthe INRAD product line.  Syntheticcrystals currently in production include Lithium Niobate, Beta Barium Borate,Alpha Barium Borate, KDP, deuterated KDP, Lithium Fluoride, Barium Nitrate, andZinc Germanium Phosphide, among others.

 

INRAD hasdeveloped and manufactures a line of Q-switches, Pockels Cells (opticalshutters) and associated electronics, and has been a leading company in thisfield since 1973.  Pockels cells areused in applications that require the fast switching of the polarizationdirection of a beam of light.  These usesinclude Q-switching of laser cavities (i.e., to generate laser output pulses),coupling light into and out from regenerative amplifiers, and light intensitymodulation.  These devices are sold onan OEM basis to laser manufacturers and individually to researchers throughoutthe world.  In 2002, the Companydeveloped and introduced a new line of miniature Q-switches, designated the“IMP” series.  Additionally, the Companyintroduced a series of high speed and quick rise-time Q-switch electronicdrivers designated the “RapidPulse” series.

 

INRAD PockelsCell products include the following:

 

•                  Single crystaland dual crystal KD*P Pockels Cells

 

•                  PKC-21 andPKC-02

 

•                  9 mm through 25mm apertures

 

•                  Single crystalLithium Niobate Pockels Cells

 

•                  PLC-01

 

•                  8.5 mm through10.5 mm apertures

 

•                  Single crystalBBO Pockels Cells

 

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•                  PBC-03

 

•                  2.5 mm x 2.5 mmthrough 5 mm x 16 mm sizes

 

•                  Electronicdrivers

 

•                  Gimbal mounts

 

The INRADcrystals and crystal components product lines also include crystalline filtermaterials, including patent protected materials, that have unique transmissionand absorption characteristics that enable them to be used in criticalapplications in defense systems such as missile warning sensors.  Other crystal components, both standard andcustom, are used in laser applications research and in commercial laser systemsto change the wavelength of laser light.

 

**LaserAccessories**

 

PPGI designs,manufactures, and brings to market a line of harmonic generation and pulsemeasurement laser accessories via its INRAD business unit.

 

a) Harmonic Generation Systems 

 

Harmonicgeneration systems enable the users of lasers to convert the fundamentalfrequency of the laser to another frequency required for a specific enduse.  Harmonic generators are currentlyused in spectroscopy, semiconductor processing, medical lasers, optical datastorage and scientific research.

 

Manycommercial lasers have automatic tuning features, allowing them to produce arange of frequencies.  The INRADAutotracker, when used in conjunction with these lasers, automaticallygenerates tunable ultraviolet light or infrared light for use in spectroscopicapplications.

 

Productsoffered for such nano-second laser systems include the following:

 

•                  AT-III — anAutotracker with servo controlled tuning

 

•                  5-200, 5-300 —temperature-stabilized crystals

 

•                  Harmonicseparators — for ultra-violet (UV), infra-red (IR), and second frequency mixing(SFM)

 

The Companyproduces a Harmonic Generator, the 5-050, for use with ultra-fast lasers havingpulsewidths in the femtosecond and picosecond regime.  This product is sold on an OEM basis to manufacturers of ultrafast lasers and to researchers in the scientific community.

 

b) Laser Pulse Measurement Instruments

 

The Companymarkets a line of Autocorrelators that can measure extremely short laserpulses.  Accurate measurement andcharacterization of pulses is important in studies of chemical and biologicalreactions, as well as in the development of high-speed electronics, ultra fastlasers and laser diodes for communications. Since January 2000, a strategic alliance has been in effect withAngewandte Physik & Electronik, GmbH of Berlin, Germany, to market aproduct line of five Autocorrelators in the U.S., manufactured by AngewandtePhysik & Electronik, GmbH.   In2002, the Company was instrumental in conceptualizing and introducing an OEMAutocorrelator for the medical community, the Carpe, that measures thepulsewidth of ultrafast laser excitation pulses used in Multi-Photon Excitationmicroscopy right at the surface of the specimen under test and interfacesdirectly with confocal microscopes.

 

The otherproducts in the Autocorrelator line include the following:

 

•                  PulseCheck-Built-incolor graphic display, options for high sensitivity, low rep rate, LabView âinterface.

 

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•                  PulseScope-Allthe features of a PulseCheck, plus a spectrometer.

 

•                  Mini-Compact,built-in display, femtosecond, picosecond operation.

 

•                  Micro-Ultra-compact,wavelength, femtosecond, basic alignment tool for modelocked oscillators.

 

**Researchand Development**

 

The Company’sresearch and development activities currently focus on developing newproprietary crystal products, improving growth processes, and on newmanufacturing process technologies for optical components.  This combination allows the Company tointroduce new products based on crystals, and to enhance its capabilities andproductivity in optical component manufacturing.

 

Company-fundedinternal research and development expenditures during the years ended December31, 2003, 2002, and 2001 were $154,000 (2.9% of net product sales), $134,000(2.5% of net product sales), and $202,000 (2.6% of net product sales),respectively.

 

**Markets**

 

In 2003, 2002and 2001 the Company’s product sales were made to customers in the followingmarket areas:

 
| **Market**                               |   | **2003**  |      | **2002**  |   | **2001**  |   |
|------------------------------------------|--------|-----------|-----------|-----------|--------|-----------|--------|
|                                     |   |      |      |      |   |      |   |
| Laser systems (non-military)             |   | $         | 1,066,000 | (20)%     | $      | 1,318,000 | (24)%  | $ | 2,602,000 | (32)% |
|                                     |   |      |      |      |   |      |   |
| Process control &  metrology    |   | 844,000   | (16)%     | 1,239,000 | (22)%  | 2,051,000 | (25)%  |
|                                     |   |      |      |      |   |      |   |
| Defense/aerospace                        |   | 2,321,000 | (43)%     | 1,738,000 | (31)%  | 867,000   | (11)%  |
|                                     |   |      |      |      |   |      |   |
| Telecomm                                 |   | 58,000    | (1)%      | 102,000   | (2)%   | 947,000   | (12)%  |
|                                     |   |      |      |      |   |      |   |
| Universities & national laboratories |   | 641,000   | (12)%     | 615,000   | (11)%  | 1,025,000 | (13)%  |
|                                     |   |      |      |      |   |      |   |
| Other                                    |   | 458,000   | (8)%      | 557,000   | (10)%  | 583,000   | (7)%   |
|                                     |   |      |      |      |   |      |   |
| Total                                    |   | $         | 5,388,000 | (100)%    | $      | 5,569,000 | (100)% | $ | 8,075,000 | (100)% |

 

Major marketsectors served by the Company include laser systems (non-military), processcontrol & metrology, defense/aerospace, telecomm, universities and nationallaboratories, and various other markets not separately classified.  The “laser systems” market area consistsprincipally of customers who are OEM manufacturers of industrial, medical, andR&D lasers.  The “process controland metrology” area consists of customers who are OEM manufacturers of capitalequipment used in manufacturing and quality assurance, such as in semiconductor(i.e., chip) fabrication and testing. The “defense/aerospace” area consists of sales to OEM defense systemsand subsystems manufacturers, manufacturers of non-military satellite-basedsystems and subsystems, and direct sales to governments where the products havethe same end-use.  The “telecomm” areaincludes sales of sub-components and

 

5

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components to customers whoseproducts’ principal end-use is in the telecommunications equipmentindustry.  “Universities and NationalLaboratories” is a sector that is an indicator of product sales toresearchers.  The “other” categoryrepresents sales to market areas that, while they may be the object ofpenetration plans by the Company, are not currently large enough to list individually.

 

Within theLaser Systems customer sector, sales in 2003 were down 19% from the prior year,reflecting the impact of declines in shipments of pulsed medical lasers and oflaser system shipments for semiconductor inspection equipment by the Company’scustomer community.  2001 had been anexceptionally strong year for the Company and its products serving thesesectors.  The Company competes formarket share to increase its revenue levels for this sector, and the Companycontinues to develop, and to seek to acquire, complementary products to broadenits product lines.  The Company servesthe laser industry as a supplier of standard and custom optical components andas such continues to seek opportunities to increase revenues from this customersector.

 

Demand in theProcess Control and Metrology (semiconductor tools) market for the Company’sproducts continued to be weak for the second successive year, as that marketsector continued to experience a cyclical downturn with an attendant drop-offin capital spending on new tools and instruments.  Sales in 2003 were down 32% from the prior year.  Nevertheless, the optical and x-rayinspection segment of the semiconductor industry offers continued opportunitiesfor the Company’s capabilities in precision optics, crystal products, andmonochrometers.

 

The Company isa provider of optical components, both specialty crystal components and highprecision custom optical components for customers in the aerospace and defenseelectro-optical systems sector.  End-useapplications include military laser systems, electro-optical systems,satellite-based systems, and missile warning sensors and systems intended toprotect aircraft.  The dollar volume ofshipments of product within this sector depends in large measure on the U.S.Defense Department budget and its priorities, that of foreign governments, thetiming of their release of contracts to their prime equipment and systemscontractors, and the timing of competitive awards from this customer communityto the Company.  In the post-9/11 era,government spending priorities for such systems have risen sharply anddeployment of new systems has been accelerated.  The Company’s sales of products to this customer sector continuedtheir upward trend, increasing by 34% in 2003 from that in 2002.

 

TheTelecommunications customer sector experienced a precipitous downturn in 2001(the last year in which revenues from customers in this sector weresignificant), and remained stagnant throughout 2003, with virtually no newsales of components for inspection instruments.  The Company’s future participation as a supplier to the networkcomponent manufacturers will depend upon the technology approaches employed atthe time the industry recovers and capital spending resumes.

 

Sales tocustomers within the University and National Laboratories market sectorincreased by 4% in 2003 from that in 2002, as research budgets and prioritiesstabilized after the precipitous decline a year earlier.  This sector remains an important source ofrevenues and new product introduction opportunities for the Company.

 

Export sales,primarily to sixteen customers in six countries within Europe, the Near Eastand Japan, amounted to 19%, 19% and 31.4% of product sales in 2003, 2002 and2001, respectively.  No foreign customeraccounted for more than 10% of product sales in 2003 or 2002.  One foreign customer accounted for 10.7% ofproduct sales in 2001.  In 2003, oneU.S. customer accounted for 16% of total sales, and one U.S. customer accountedfor 10% of total sales.  Both customersare defense industry prime contractors who manufacture electro-optical systemsunder multi-year production contracts for the U.S. and foreign governments. Inthe short-term the loss of either of these customers would have a significantnegative impact on the company and its business units. In 2002, one U.S.customer accounted for 13.4% of total sales. One U.S. customer accounted for 17.7% of total sales in 2001.

 

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**Long-TermContracts**

 

Certain of theCompany’s orders from customers provide for periodic deliveries at fixed pricesover a period that may be greater than one year.  In such cases, as in most other cases as well, the Companyattempts to obtain firm price commitments from its suppliers for the materialsnecessary to fulfill the order.

 

**Marketingand Business Development**

 

The Company’stwo Northvale, NJ-based business units market their products domesticallythrough their own sales and marketing teams, supervised by the Vice President -Marketing and Sales, and a Vice President of Business Development.  Independent sales agents are used incountries in major non-U.S. markets, including Canada, Europe, the Near Eastand Japan.  Trade show participation andInternet-based marketing and promotion are coordinated at the Corporate levelby the PPGI Vice President for Marketing Communications

 

**Backlog**

 

The Company’sorder backlog as of December 31, 2003 was $2,286,000.  The Company’s order backlog as of December 31, 2002 was$1,328,000.  Backlog on December 31,2001 was $1,630,000.

 

**Competition**

 

Within eachproduct category in which the Company’s business units are active, there iscompetition.

 

Changes in thePhotonics industry have had an effect on suppliers of custom optics.  As end users have introduced productsrequiring large volumes of optical components, suppliers have responded eitherby carving out niche product areas or by ramping up their own manufacturingcapacity and modernizing their manufacturing methods to meet higher volume runrates.  Many custom optics manufacturerslack in-house thin film coating capability. As a result, there are fewer well-rounded competitors in the customoptics arena, but they are equipped with modern facilities and progressivemanufacturing methods.  The Company hasjudiciously deployed capital towards modernizing its facility, and has staffedthe manufacturing group with individuals with comprehensive experience inmanufacturing management, manufacturing engineering, advanced finishingprocesses, thin-film coating processes, and capacity expansion.  The Company competes on the basis ofproviding consistently high quality products, establishing strong customerrelations, and continuously improving its labor productivity, cost structure,and product cycle times.

 

Competitionfor the Company’s systems is limited, but competitors’ products are generallylower priced.  The Company’s systems areconsidered to be high end and generally offer a combination of features notavailable elsewhere.  Because of theCompany’s in-house crystal growth capability, the Company’s staff isknowledgeable about matching appropriate crystals to given applications.

 

For thecrystal product area, quality, delivery, and customer service are marketdrivers.  Many of the Company’scompetitors are overseas and can offer significantly reduced pricing for somecrystal species.  The Company has beenable to retain and grow its customer base by providing the quality and customerservice needed by OEM customers.  Onmany occasions, the quality of the crystal component drives the ultimateperformance of the component or instrument into which it is installed.  Thus, quality and technical support areconsidered to be valuable attributes for a crystal supplier by many, but notall, OEM customers.

 

Although priceis the principal factor in most product categories, competition is also basedon product design, product performance, quality, delivery, and customerservice.  Based on its performance todate, the Company believes that it can continue to compete successfully,although no assurances can be given in this regard.

 

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**Employees**

 

As of December31, 2003, the Company had 62 full-time employees (including 18 hired from LaserOptics, Inc. after acquisition of its assets) and 1 part-time employee.

 

**Patentsand Licenses**

 

The Companyrelies on its manufacturing and technological expertise, rather than onpatents, to maintain its competitive position in the industry.  The Company takes precautionary andprotective measures to safeguard its design and technical and manufacturingdata, and relies on nondisclosure agreements with its employees to protect itsproprietary information.

 

**Regulation**

 

Foreign salesof certain of the Company’s products may require export licenses from theUnited States Department of Commerce or Department of State.  Such licenses are generally available to allbut a limited number of countries and are obtained when necessary. One product,representing 4.5% of Company sales, required U.S. State Department export approvalin 2003, and approvals were granted.

 

There are nofederal regulations nor any unusual state regulations that directly affect thesale of the Company’s products other than those environmental complianceregulations that generally affect companies engaged in manufacturing operationsin New Jersey and Connecticut.

 

**BusinessRisk**

 

a) As generaleconomic conditions deteriorate, the Company’s financial results suffer

 

Significanteconomic downturns or recessions in the United States or Europe could adverselyaffect the Company’s business, by causing a temporary or longer term decline indemand for the Company’s goods and services. Additionally, the Company’s revenues and earnings may be affected bygeneral economic factors, such as excessive inflation, currency fluctuationsand employment levels.

 

b) Many of theCompany’s customer’s industries are cyclical

 

The Company’sbusiness is significantly dependent on the demand its customers experience fortheir products.  Many of their end usersare in industries that historically have experienced a cyclical demand fortheir products, including but not limited to process control capital equipmentmanufacturing in the semiconductor industry, defense electro-optics systemsmanufacturing, and telecommunications infrastructure expansion.  Therefore, as a result, demand for theCompany’s products and its financial results of operations are subject tocyclical fluctuations.

 

c) The Companyfaces competition

 

The Companymay encounter substantial competition from other companies positioned to servethe same market sectors that the Company serves.  Some competitors may have financial, technical, marketing orother resources more extensive than ours, or may be able to respond more quicklythan the Company can to new or emerging technologies and other competitivepressures.  The Company may not besuccessful in winning orders against the Company’s present or futurecompetitors, which may adversely affect the Company’s business, its growth objectives,its financial condition, and its operating results.

 

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d) TheCompany’s manufacturing processes require products from limited sources ofsupply

 

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

 

e) TheCompany’s business success depends on its ability to recruit and retain keypersonnel

 

The Company’sexisting business and its expansion plans depend on the expertise, experience,and continuing services of certain scientists, engineers, production andmanagement personnel, and on the Company’s ability to recruit additionalpersonnel.  There is competition for theservices of these personnel, and there is no assurance that the Company will beable to retain or attract the personnel necessary for its success, despite theCompany’s effort to do so.  The loss ofthe services of the Company’s key personnel could have a material adverseaffect on its business, on its results of operations, or on its financialresults.

 

f) The Companydepends on, but may not succeed in, developing and acquiring new products and****processes

 

In order tomeet the Company’s strategic objectives, the Company must continue to develop,manufacture and market new products, and to develop new processes and toimprove existing processes.  As aresult, the Company expects to continue to make investments in research anddevelopment and to continue to consider from time to time the strategicacquisition of businesses, products, or technologies complementary to theCompany’s business.  There can be noassurance that the Company will be able to develop and introduce new productsor enhancements to its existing products and processes in a way that achievesmarket acceptance or other pertinent targeted results.  Nor can the Company be sure that it will besuccessful in acquiring complementary businesses, products, ortechnologies.  Failure to do so couldhave a material adverse affect on the Company’s ability to grow its business.

 

g) The Companymay not be able to fully protect its intellectual property

 

The Companydoes not currently hold any material patents applicable to its most importantproducts or manufacturing processes. The Company relies on a combination of trade secret and employeenon-competition and nondisclosure agreements to protect its intellectualproperty rights.  There can be noassurance that the steps the Company takes will be adequate to preventmisappropriation of the Company’s technology. In addition, there can be no assurance that, in the future, thirdparties will not assert infringement claims against the Company.  Asserting the Company’s rights or defendingagainst third-party claims could involve substantial expense, thus materiallyand adversely affecting the Company’s business, results of operations orfinancial condition.

 

h) The Companymay not succeed in its strategy of acquiring complementary businesses or inintegrating acquired businesses

 

The Company’sbusiness strategy includes expanding its production capacities, product linesand market reach through both internal growth and acquisition of complementarybusinesses.  The Company may not succeedin finding or completing acquisitions of such businesses, nor can the Companybe assured that it will be able to raise the financial capital needed for suchacquisitions.  Acquisitions may resultin substantial per share financial dilution of the Company’s Common Stock fromthe issuance of

 

9

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equity securities.  They may also result in the taking on ofdebt and contingent liabilities, and amortization expenses related tointangible assets acquired, any of which could have a material adverse affecton the Company’s business, financial condition or results of operations.  Also, acquired businesses may beexperiencing operating losses.  Anyacquisition will involve numerous risks, including difficulties in theassimilation of the acquired company’s people, operations and products,uncertainties associated with operating in new markets and working with newcustomers, and the potential loss of the acquired company’s key employees.  To date, the Company has had littleexperience in acquiring or integrating businesses.

 

i) TheCompany’s operations may be adversely affected if it fails to keep pace withindustry developments

 

The Companyserves industries and market sectors which will be affected by futuretechnological developments.  Theintroduction of products or processes utilizing new developments could renderthe Company’s existing products or processes obsolete or unmarketable.  The Company’s continued success will dependupon its ability to develop and introduce on a timely and cost-effective basisnew products, processes, and manufacturing capabilities that keep pace withdevelopments and address increasingly sophisticated customer requirements.  There can be no assurance that the Companywill be successful.

 

j) Productyield problems and product defects that are not detected until products are inservice could increase the Company’s costs and/or reduce its revenues

 

Changes in theCompany’s own or in its suppliers’ manufacturing processes, or the use ofdefective or contaminated materials by the Company, could result in an adverseeffect on its ability to achieve acceptable manufacturing yields, deliveryperformance, and product reliability. To the extent that the Company does not achieve such yields, deliveryperformance or product reliability, its business, operating results, financialcondition and customer relationships could be adversely affected.  Additionally, the Company’s customers maydiscover defects in the Company’s products after the products have been putinto service in their systems.  Inaddition, some of the Company’s products are combined by the Company’scustomers with products from other vendors, which may contain defects, makingit difficult and costly to ascertain whose product carries liability.  Any of the foregoing developments couldresult in increased costs and warranty expenses, loss of customers, diversionof technical resources, legal action by the Company’s customers, or damage tothe Company’s reputation.

 

k) The Company’s stock price may fluctuate

 

Many factors,including, but not limited to, future announcements concerning the Company, itscompetitors or customers, as well as quarterly variations in operating results,announcements of technological innovations, seasonal or other variations inanticipated or actual results of operations, changes in earnings estimates byanalysts or reports regarding the Company’s industries in the financial pressor investment advisory publications, could cause the market price of theCompany’s stock to fluctuate substantially. In addition, the Company’s stock price may fluctuate widely for reasonswhich may be unrelated to operating results. These fluctuations, as well as general economic, political and marketconditions such as recessions, military conflicts, or market or market-sectordeclines, may materially and adversely affect the market price of the Company’sCommon Stock.  In addition, anyinformation concerning the Company, including projections of future operatingresults, appearing in investment advisory publications or on-line bulletinboards or otherwise emanating from a source other than the Company could in thefuture contribute to volatility in the market price of the Company’s CommonStock.

 

l)International sales account for a significant portion of revenues

 

Sales tocustomers in countries other than the United States accounted for approximately19%,

 

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19% and 31% of revenues duringthe years ended December 31, 2003, 2002, and 2001, respectively.  The Company anticipates that internationalsales will continue to account for a significant portion of the Company’srevenues for the foreseeable future.  Inparticular, although the Company’s international sales are denominated in U.S.dollars, currency exchange fluctuations in countries where the Company doesbusiness could have a material adverse effect on its business, financialcondition or results of operations, by making the Company lessprice-competitive than foreign manufacturers.

 

m) The companyhas incurred operating losses for the pass three years

 

The companyhas suffered significant operating losses for the past three years.  As a result there has been a substantialincrease in borrowing to provide working capital during this time.  Continued losses puts the Company at risk,in that there are no assurances the Company will be able to borrow additionalfunds to sustain the operation.

 

**Item2.****                                                           Properties**

 

PPGI occupiesapproximately 31,000 square feet of space located at 181 Legrand Avenue,Northvale, New Jersey pursuant to a net lease expiring on October 31,2006.  PPGI has an option to renew theNorthvale lease for an additional term of five years.  In November 2003, the Company exercised its option to lease11,000 square feet of additional adjoining space in the same building, bringingthe total square feet of space occupied by PPGI in Northvale, New Jersey to42,000 square feet.  Laser OpticsHoldings, Inc., a Subsidiary of the Company, acquired the rights to the leaseof 8,000 square feet of space in Bethel, CT, formerly occupied by Laser Optics,Inc., upon purchase of the assets of Laser Optics, Inc.  This lease expires in May of 2004, and theCompany has the right to renew such lease on a month-by-month basis, at itssole option, for three months.  TheCompany does not plan to renew the lease, and it intends to vacate the premisesupon the expiration of such lease in May of 2004 and relocate the facility toNorthvale, NJ.  The 2003 annual rent wasapproximately $238,000 for all properties. The Company also paid real estate taxes and insurance premiums thattotaled approximately $48,000 in 2003.

 

The Companyalso leased approximately 950 square feet of storage space at 148 VeteransDrive, Northvale, New Jersey pursuant to a gross lease renewable on amonth-to-month basis, through 2003. This lease was terminated by the Company in 2003.

 

**Item3.****                                                           LegalProceedings**

 

There are nolegal proceedings involving the Company as of the date hereof.

 

**Item4.****                                                           Submissionof Matters to a Vote of Security Holders**

 

NotApplicable.

 

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**PART II**

 

**Item5.****                                                           Marketfor Registrant’s Common Equity and Related Stockholder Matters**

 

a) MarketInformation

 

The Company’sCommon Stock, par value $0.01 per share, is traded on the OTC Bulletin Boardunder the symbol PHPG.

 

The followingtable sets forth the range of closing prices for the Company’s Common Stock ineach fiscal quarter from the quarter ended March 31, 2002 through the quarterended December 31, 2003, as reported by the National Association of SecuritiesDealers NASDAQ System.  Such over-the-counterquotations reflect inter-dealer prices, without retail mark-up, mark-down orcommission and may not necessarily represent actual transactions.

 
|                             |   | **Price** |   |
|----------------------------------|--------|-----------|--------|
|                             |   | **High**  |   | **Low** |   |
| Quarter ended December 31, 2003  |   | .80       |   | .45 |   |
| Quarter ended September 30, 2003 |   | .58       |   | .35 |   |
| Quarter ended June 30, 2003      |   | .60       |   | .36 |   |
| Quarter ended March 31, 2003     |   | .60       |   | .41 |   |
| Quarter ended December 31, 2002  |   | .57       |   | .30 |   |
| Quarter ended September 30, 2002 |   | .82       |   | .25 |   |
| Quarter ended June 30, 2002      |   | 1.10      |   | .70 |   |
| Quarter ended March 31, 2002     |   | 1.85      |   | .91 |   |

 

As of April 8, 2004 the Company’s stock pricewas $0.58 per share.

 

b)Shareholders

 

As of April 8, 2004, there wereapproximately 650 record owners of the Common Stock.  The number of record owners of common stock was approximatedbased upon the number of Proxy Statements requested by the Company’s TransferAgent for the Annual shareholders’ Meeting held August 27, 2003

 

c) Dividends

 

The Companydid not pay any cash dividends on its Common Stock during the years endedDecember 31, 2003, 2002 and 2001.  TheCompany paid a Common Stock dividend of 134,000 shares of Common Stock on itsSeries A and Series B convertible preferred stock in 2003, valued at$54,000.  The Company paid a CommonStock dividend of 134,000 shares of Common Stock on its Series A and Series Bconvertible preferred stock in 2002, valued at $121,000.  The Company paid a Common Stock dividend of92,000 shares of Common Stock on its Series A and Series B convertiblepreferred stock in 2001, valued at $155,000. Payment of cash dividends will be at the discretion of the Company’sBoard of Directors and will depend, among other factors, upon the earnings,capital requirements, operations and financial condition of the Company.  The Company does not anticipate paying cashdividends in the immediate future.

 

d) RecentSales of Unregistered Securities

 

In April 2004the Company received a commitment for $1,000,000 in exchange for the issuanceof a three-year Subordinated Convertible Promissory Note.  The Note will bear interest at the rate of6%

 

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per annum. Interest will accrueyearly and along with principal may be converted into Common Stock, (and/orsecurities convertible into common shares), at a conversion rate equal to thepurchase price of stock issued (and/or securities issued that are convertibleinto Common Stock) for cash after the date of the Note to an unrelated thirdparty investor, or if no such issuance takes place within twelve months of thedate of the Note, April 2004, at a price mutually agreed upon as fair value bythe Issuer and Holder.  The Holder ofthe Note is a related party to a major shareholder of the Company.

 

In 2003, theCompany issued a Subordinated Convertible Promissory Note pursuant toRegulation D for proceeds of $1,500,000. The Holder of the Note is a related party to a major Shareholder of theCompany.  The Note bears interest at therate of 6% per annum and has a maturity date of January 31, 2006.  The Note was amended in 2004 to clarify itsconversion features. The Note is convertible into common shares of the Company,(and/or securities convertible into common shares) at a conversion price thatshall be (a) the price at which Common Stock issued (and/or securities issuedthat are convertible into Common Stock) is first issued for cash after the date of the Note to an unrelatedthird party investor or (b) the price mutually agreed upon by the Issuer andHolder at its then fair market value if no such issuance has occurred within 12months of the date of the Note, December 31, 2003.

 

In 2002, theCompany issued a Subordinated Convertible Promissory Note pursuant toRegulation D for proceeds of $1,000,000. The Holder of the Note is a related party to a major Shareholder of theCompany.  The Note bears interest at therate of 6% per annum and has a maturity date of January 31, 2006.  The Note was amended in 2004 to clarify itsconversion features. The Note is convertible into Common Stock (and/orsecurities convertible into common stock) of the Company at a conversion pricethat shall be (a) the price at which Common Stock, or securities convertibleinto Common Stock, is first issued for cash after the date of the Note to anunrelated third party investor or (b) the price mutually agreed upon by theIssuer and Holder at its then fair market value if no such issuance hasoccurred within 24 months of the date of the Note, December 31, 2002.

 

**Item6.****                                                           SelectedFinancial Data**

 

The followingdata is qualified in its entirety by the financial statements presentedelsewhere in this Annual Report on Form 10-K.

 
|                                                 |   | **As of  December 31, or  For the Year Ended December 31,** |      |
|------------------------------------------------------|--------|-------------------------------------------------------------|-----------|
|                                                 |   | **2003**                                                    |      | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| Revenues                                             |   | $                                                           | 5,388,184 |   | $ | 5,569,118 |   | $ | 8,075,205 |   | $ | 7,909,967 |   | $ | 6,206,092 |   |
| Net (loss) profit                                    |   | (1,777,309                                                  | )         | (1,715,972 | ) | 43,634 |   | 707,869 |   | 21,789 |   |
| Net (loss) profit applicable to common  shareholders |   |                                                        |      |   |   |   |   |   |   |   |   |
| Basic                                                |   | (.35                                                        | )         | (.35 | ) | (.02 | ) | .14 |   | .01 |   |
| Diluted                                              |   | (.35                                                        | )         | (.35 | ) | (.02 | ) | .12 |   | .01 |   |
|                                                 |   |                                                        |      |   |   |   |   |   |   |   |   |
| Weighted average shares                              |   |                                                        |      |   |   |   |   |   |   |   |   |
| Basic                                                |   | 5,287,849                                                   |      | 5,210,322 |   | 5,046,666 |   | 4,563,350 |   | 4,096,078 |   |
| Diluted                                              |   | 5,287,849                                                   |      | 5,210,322 |   | 5,046,666 |   | 5,608,513 |   | 4,096,078 |   |
|                                                 |   |                                                        |      |   |   |   |   |   |   |   |   |
| Dividends paid                                       |   | 53,600                                                      |      | 120,600 |   | 155,000 |   | 50,000 |   | — |   |
|                                                 |   |                                                        |      |   |   |   |   |   |   |   |   |
| Total assets                                         |   | 8,851,121                                                   |      | 8,508,925 |   | 8,599,072 |   | 7,829,755 |   | 4,113,227 |   |
|                                                 |   |                                                        |      |   |   |   |   |   |   |   |   |
| Long-term obligations                                |   | 4,405,576                                                   |      | 1,188,512 |   | 287,170 |   | 326,059 |   | 350,000 |   |
|                                                 |   |                                                        |      |   |   |   |   |   |   |   |   |
| Shareholders’ equity                            |   | 3,284,439                                                   |      | 5,049,879 |   | 6,745,489 |   | 6,388,780 |   | 2,995,161 |   |
|                                                      |        |                                                             |           |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

TheCompany completed the acquisition of Laser Optics, Inc.’s assets andliabilities at the end of

 

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November,2003.  The comparability of informationin the selected  financial data was notmaterially impacted by the inclusion of financial activity of Laser OpticsHoldings, Inc. for a one-month period.

 

**Item7.****                                                           Management’sDiscussion and Analysis of Financial Condition and Results of Operation**

 

CriticalAccounting Policies

 

The Company’ssignificant accounting polices are described in Note 1 of the consolidatedfinancial statements, that were prepared in accordance with accountingprinciples generally accepted in the United States of America.  In preparing the Company’s financialstatements, the Company made estimates and judgments that affect the results ofits operations and the value of assets and liabilities the Companyreports.  The Company’s actual resultsmay differ from these estimates.

 

The Companybelieves that the following summarizes critical accounting polices that requiresignificant judgments and estimates in the preparation of the Company’sconsolidated financial statements.

 

RevenueRecognition

 

The Companyrecords revenue, other than on Contract R&D revenues, when a product isshipped.  Revenue on Contract R&D isaccounted for using the percentage-of-completion method, whereby revenue andprofits are recognized throughout the performance of the contracts.  Percentage-of-completion is determined byrelating the actual cost of work performed to date to the estimated total costfor each contract.  Losses on contractsare recorded when identified.

 

AccountsReceivable

 

The Companyrecords an allowance for doubtful accounts receivable as a charge againstearnings for revenue for items that have been reviewed and carry a risk ofnon-collection in the future.  TheCompany has not experienced a non-collection of accounts receivable materiallyaffecting the results of operations.

 

Inventory

 

The Companyrecords slow moving inventory reserve as a charge against earnings for allproducts on hand that have not been sold to customers in the past twelvemonths.  An additional reserve isrecorded for product on hand that may not be sold to customers within theupcoming twelve months.

 

From time totime, estimated accruals are recorded as a charge against earnings based onknown circumstances where it is probable that a liability has been incurred oris expected to be incurred and the amount can be reasonably estimated.

 

**Resultsof Operations**

 

The followingtable summarizes the Company’s product sales by product categories during thepast three years:

 
|               |   | **Year Ended  December 31,** |      |
|--------------------|--------|------------------------------|-----------|
|               |   | **2003**                     |      | **2002** |   | **2001** |   |
| **Category**       |   | **Sales**                    |      | **%** |   | **Sales** |   | **%** |   | **Sales** |   | **%** |   |
| Optical components |   | $                            | 4,469,000 | * | 83 |   | $ | 4,325,905 |   | 79 |   | $ | 6,035,049 |   | 77 |   |
| Laser accessories  |   | 893,000                      |      | 17 |   | 1,155,816 |   | 21 |   | 1,850,988 |   | 23 |   |
| Total              |   | $                            | 5,362,000 | * | 100 |   | $ | 5,481,721 |   | 100 |   | $ | 7,886,037 |   | 100 |   |

 

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*      a)     2003Optical Component sales include $78,000 from operations acquired from LaserOptics, Inc.

 

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b)             Not included above are (non-product)contract R&D sales of approximately $26,000, $87,000 and $189,000 in 2003,2002, and 2001, respectively.

 

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

 
|                                          |   | **Year ended  December 31,** |   |
|-----------------------------------------------|--------|------------------------------|--------|
|                                          |   | **2003**                     |   | **2002** |   | **2001** |   |
| Revenues:                                     |   |                         |   |   |   |   |   |
| Product sales                                 |   | 100.0                        | %      | 100.0 | % | 100.0 | % |
| Costs and expenses:                           |   |                         |   |   |   |   |   |
| Cost of goods sold                            |   | 72.7                         | %      | 83.7 | % | 62.9 | % |
| Gross profit margin                           |   | 27.3                         | %      | 16.3 | % | 37.1 | % |
| Selling, general and administrative  expenses |   | 44.3                         | %      | 40.9 | % | 31.0 | % |
| Internal research and development             |   | 2.9                          | %      | 2.4 | % | 2.6 | % |
| Special charges                               |   | 10.8                         | %      | — | % | 3.7 | % |
| (Loss) from operations                        |   | (30.6                        | )%     | (27.0 | )% | (0.01 | )% |
| Net (loss) profit                             |   | (32.9                        | )%     | (30.1 | )% | .5 | % |

 

**Revenues**

 

Sales wereapproximately $5,388,000, $5,569,000 and $8,075,000, in 2003, 2002 and 2001respectively.  Total revenues declined2% in 2003 to $5,388,000, from $5,482,0000 in 2002, reflecting “flat” productsales year to year, as demand from several industry sectors remained sluggishin 2003. 2002 sales were off 30% from $7,886,000 in 2001 reflecting the deeprecession pervasive in the Photonics industry throughout that year.

 

New bookingsin 2003 increased to $6,018,000, 16% higher than in 2002.  New bookings in 2002 were $5,190,000,approximately 14% lower than in 2001. The main market sector contributing tothe increase in 2003 was Defense/Aerospace.

 

The annualizedproduct book to bill ratio in 2003 was greater than 1.0 for the first time inthree years at 1.1, reflecting a positive change overall across market sectorsserved. The product book-to-bill ratio was 0.96 and 0.76 in 2002 and 2001,respectively.

 

The Company’sbacklog of product orders as of December 31, 2003 was approximately $2,286,000,an increase of 76% over the approximately $1,300,000 backlog as December 31,2002. The backlog on December 31, 2001 was $1,541,000.

 

Revenuesdeclined for the second successive year in the non-military Laser Systemssector, down $252,000, or 19%, from the prior year. This downward trendreflected the impact of decline in industry shipments of pulsed medical lasersand of laser system shipments for semiconductor inspection equipment by ourcustomer community. Sales to this sector accounted for 20%, 24%, and 32% oftotal sales in 2003, 2002, and 2001, respectively.

 

Revenuesdeclined as well for the second consecutive year in the Process Control andMetrology sector, down $395,000, or 32% from 2002. Demand from customers in theProcess Control and Metrology sector continued its downward trend for thesecond straight year, as the semiconductor industry’s investments in new plantand equipment spending continued to be adversely affected by the deepest andlongest downturn in years. Sales to this sector accounted for 16%, 22%, and 25%of total sales in 2003, 2002, and 2001, respectively.

 

Sales to theDefense/Aerospace sector increased sharply for the second consecutive year, to

 

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$2,321,000 up $583,000, or 34%,from 2002. Sales of $1,738,000 in 2002 were up 31% from sales of $867,000 in2001. Increased military spending on electro-optical systems and R&D in thepost-9/11 era has boosted demand for the Company’s products. Sales to thissector accounted for 43%, 31%, and 11% of total sales in 2003, 2002, and 2001,respectively.

 

Whileaccounting for $947,000, or 12%, of sales in 2001, sales to the Telecom sectorare no longer material, accounting for 1% of total sales in 2003 and 2% in2002. It is unlikely that sales to the sector will rebound in the near futurefor the Company’s current product lines.

 

 Sales to Universities, National Labs and“Other” (i.e. non-separately classified) sectors have remained relativelysteady at 20% to 21% of total Company revenues for the past three years.

 

**Costof Goods Sold and Gross Profit Margin**

 

As apercentage of product sales, cost of goods sold was 72.7%, 83.7% and 62.9% forthe years ended December 31, 2003, 2002 and 2001, respectively.  Gross profit margin as a percentage ofproduct sales was 27.3%, 16.3%, and 37.1% for 2003, 2002, and 2001,respectively.

 

In 2003 thecost of goods sold percentage decreased as a result of successfulimplementation of cost containment policies. Such polices included executive salary reductions, temporary layoffs,salary freezes and reductions in discretionary spending.  As a result, gross margins increased despitethe drop in overall sales volume.  In2002 the cost of goods sold percentage increased due to a declining salesvolumes and a draw-down of inventories. In 2001 the cost of goods sold percentage increased due to increasedmanufacturing overhead costs for newly formed departments including productioncontrol and manufacturing engineering and the absorption of additional overheadcosts in production that resulted from decreased volumes in Contract R&Dsales.

 

Fixed costsare a major component of the Company’s total cost structure.  Management and the Board of Directorsdecided to reduce such costs in 2002 only up to the point where furtherreductions would impede the Company’s ability to perform for its currentcustomers or to rebound in the future when macroeconomic conditionsimprove.  This philosophy continuedthroughout 2003.  The implementation ofhead-count reduction, reduced work-hours, and other cost saving measuresdecreased overhead expenses by approximately 9% in 2003 and 15% in 2002 overthe respective prior years.

 

Costs ofpurchased components have been relatively stable in 2003, 2002 and 2001.  Unit costs of raw materials such as crystalquartz and high grade optical glasses have increased in the last year.

 

**Selling,General and Administrative Expenses**

 

Selling,general and administrative expenses in 2003 increased $113,000 or 5% comparedto 2002.  In 2002, selling, general andadministrative expenses decreased $226,000 or 9.0% compared to 2001.

 

The increasein SG&A costs in 2003 was due in part to increased professional servicescosts and travel expenses relative to the Company’s merger and acquisitionprogram.  S,G&A expenses alsoincreased due to increased travel for customer visits by all sales and businessdevelopment personnel. Other contributing factors to the increase was theaccelerated increase in patent reserves and an overall increase in insurancecosts. Management continued to implement its philosophy of increasing, notdecreasing, expenditures on direct selling and business development activitiesin a period of declining top line performance.

 

The decreasein SG&A costs in 2002 was attributable to overall reduction in personnelcosts as well as cost savings implemented in other expense areas.  The costs decreased overall, while theCompany implemented its plan to augment its sales force during that year.

 

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**InternalResearch and Development Expenses**

 

Company-fundedresearch expenditures during the years ended December 31, 2003, 2002, and 2001were $154,000 (2.9% of net product sales), $134,000 (2.5% of net productsales), and $202,000 (2.6% of net product sales), respectively.

 

During 2003,2002 and 2001, the Company narrowed its focus of internal research anddevelopment efforts onto new crystal products and production methods, and newoptical component manufacturing technologies. As a result, internal R&D expenditures remained relatively constantin 2003, and are expected to continue at this level in 2004.

 

**SpecialCharges**

 

During 2003,the Company acquired the assets and liabilities of Laser Optics, Inc.  A strategic decision was made at that timeto relocate the assets and employees from Bethel, CT to Northvale, NJ and tocombine the Laser Optics, Inc. business lines with the Custom Optics businessline.  The entity created by thiscombination is now a PPGI business unit called Laser Optics.  The assets acquired and employees will berelocated to Northvale, NJ into consolidated operations during the spring of2004. The costs of relocating employees included relocation costs, stay onbonuses and relocation bonuses, that were accrued in 2003.  The accrual amounted to $107,000 ($0.02 pershare on a basic and diluted basis) and has been included in the consolidatedstatement of operations as a special charge.

 

During 2003the Company determined that there was excess inventory, relative to forecastedfuture needs, of certain crystals and solutions.  Based on this determination, a reserve was taken in the amount of$475,000 ($0.09 per share on a basic and diluted basis) in order to recognizethe diminished future economic benefit of the inventory.  The increased reserve has been included inthe consolidated statement of operations as a special charge.

 

At the end of2000, the Company announced a sweeping manufacturing process re-engineeringprogram to modernize manufacturing methods, implement modern production machinery,incorporate a production control function for planning and scheduling,modernize and reconfigure its physical plant for efficient operational flow,increase labor productivity, improve operating margins, and lead ultimately toISO certification of the Company.  Thespecial charges associated with this program were $299,763 ($0.06 per share ona basic and diluted basis) for the year ended December 31, 2001.  This effort continued throughout 2002,although at a greatly diminished rate.

 

**OperatingIncome**

 

Losses fromoperations in 2003 were $(1,654,329) compared to operating losses in 2002 of$(1,504,400) and $(6,104) in 2001. Losses during 2003, 2002, and 2001 were due to slackened and continuingweak demand in major market sectors served by the Company and its products.These losses occurred despite strict cost containment measures, and they wereabsorbed. The cost containment program implemented by Management and the Boardstopped short, by design, of impeding the ability of the Company’s operations toperform again in the future, or of impeding the Company’s ability to find newcustomers for its products. Management’s efforts to restore profitability tooperations are focused on building the Company’s top line through its mergersand acquisition program and through continued focus on business development andselling activities.

 

**OtherIncome and Expenses**

 

Interestexpense increased over prior periods due to the increased borrowing needsexperienced by the Company.  Thecompany’s average borrowings in 2003 were approximately $3,300,000 versus$2,000,000 in 2002. Interest rates in 2003 were approximately 1.5% higher thanin 2002.  Borrowing needs increased dueto the acquisition made during 2003 and as a result of continued losses fromoperations. During 2003, a secured note replaced bank debt.  Also in 2003 a subordinated convertible note

 

17

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was placed for acquisitionpurposes. Interest on the secured and convertible notes is accrued, and paymentis due upon the maturity of the notes. During 2001, the Company received $44,800 from the sale of 40,000 commonstock warrants received as part of the compensation from the sale of itstunable mid-IR laser technology in 2000.

 

**PreferredStock Dividend**

 

During 2003 dividendsin Common Stock valued at $53,600 were issued to holders of the Company’s ClassB preferred stock (84,000 shares of Common Stock valued at $0.40 per share) andthe holder of the Company’s Class A preferred stock (50,000 shares valued at$0.40 per share).  During 2002 dividendsin Common Stock valued at $120,600 were issued to holders of the Company’sClass B preferred stock (84,000 shares of Common Stock valued at $0.90 pershare) and the holder of the Company’s Class A preferred stock (50,000 sharesvalued at $0.90 per share).  During 2001dividends in Common Stock valued at $155,000 were issued to holders of theCompany’s Class B preferred stock (42,000 shares of Common Stock valued at$2.50 per share) and the holder of the Company’s Class A preferred stock(50,000 shares of Common Sock at $1.00 per share).  Net income used in earnings per share calculations included thesecharges in 2003, 2002 and 2001 in order to derive net income available tocommon shareholders.

 

**IncomeTaxes**

 

During 2003the Company sold its New Jersey net operating loss for $135,235.  The sale was made under the State’sTechnology Tax transfer Certificate program. The Company recognizes deferred tax liabilities and assets for theexpected future tax consequences of events that have been recognized in theCompany’s financial statements or tax returns. Deferred tax liabilities and assets are determined based on thedifference between the financial statement carrying amounts and the tax basisof assets and liabilities using enacted tax rates in effect in the years inwhich the differences are expected to reverse. At December 31, 2003, the Company had a net deferred tax asset ofapproximately $3,348,000, the primary component of which was its significantnet operating loss carryforward.  TheCompany has established a valuation allowance to offset this deferred tax assetin the event that the tax asset will not be realized in the future.  In 2002, $100,000 of the deferred tax assetpreviously classified as an asset was reserved due to the Company’s recurringlosses and uncertainty as to the Company’s ability to generate taxable incomein future years.

 

**Inflation**

 

The Company’spolicy is to periodically review pricing of its products to keep pace withcurrent costs, market demands, and competitive factors.  As to special and long-term contracts,management endeavors to take potential inflation into account in pricingdecisions.  The impact of inflation onthe Company’s business has not been material to date.

 

**Liquidityand Capital Resources**

 

During thesecond quarter of 2003, the Company’s Bank sold loans totaling approximately$1,700,000 to another lender.  At thetime of the sale the loans were in technical default due to the violation ofcertain financial covenants.  Thepurchasing lender exercised its rights under the loan agreement and demandedfull payment of all outstanding balances. The Company received $1,700,000 in proceeds from the issuance of aSecured Note Payable and used the proceeds to pay off the total bankbalance.  The Secured Note Payable isdue in January 2005 and bears an interest rate of 6% that is accruedannually.  The Note is secured by theassets of the Company.  The holder ofthe Note is a related party to a major shareholder of the Company.

 

In April 2004the Company received $1,000,000 in proceeds from the issuance of a SubordinatedConvertible Promissory Note.  The Noteis due in march 2007 and bears an interest rate of 6%. Interest

 

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accrues yearly and along withprincipal may be converted into Common Stock, (and/or securities convertibleinto common shares), at a conversion rate equal to the purchase price of stockissued (and/or securities issued that are convertible into Common Stock) forcash after the date of the Note to an unrelated third party investor, or if nosuch issuance takes place within twenty four months of the date of the Note, ata price mutually agreed upon as fair value by the Issuer and Holder.  The Holder of the Note is a related party toa major shareholder of the Company.

 

At the end ofthe fourth quarter of 2003 the Company received $1,500,000 in proceeds from theissuance of a Subordinated Convertible Promissory Note.  The Note is due in January 2006 and bears aninterest rate of 6%.  The note wasamended in 2004 to clarify its conversion features.  Interest accrues yearly and along with principal may be convertedinto Common Stock, and/or securities convertible into Common Stock, at aconversion rate equal to the purchase price of stock issued, and/or securitiesissued that are convertible into Common Stock, for cash after the date of theNote to an unrelated third party investor, or if no such issuance takes placewithin twelve months of the date of the Note, at a price mutually agreed uponas fair value by the Issuer and Holder. The Holder of the Note is a related party to a major shareholder of theCompany.  The proceeds from the Note areintended for use in the Company’s acquisition program.

 

At the end ofthe fourth quarter of 2002 the Company received $1,000,000 in proceeds from theissuance of a Subordinated Convertible Promissory Note.  The Note is due in January 2006 and bears aninterest rate of 6%. The note was amended in 2004 to clarify its conversionfeatures. Interest accrues yearly and along with principal may be convertedinto Common Stock, (and/or securities convertible into common shares), at aconversion rate equal to the purchase price of stock issued (and/or securitiesissued that are convertible into Common Stock) for cash after the date of theNote to an unrelated third party investor, or if no such issuance takes placewithin twenty four months of the date of the Note, at a price mutually agreedupon as fair value by the Issuer and Holder. The Holder of the Note is a related party to a major shareholder of theCompany.

 

Capitalexpenditures, including internal labor and overhead charges, for the yearsended December 31, 2003, 2002 and 2001 were approximately $101,000, $554,000,and $2,224,000, respectively.  Capitalexpenditures in 2002 and 2001 were used for expansion and renovation offacilities and for the acquisition of equipment.  The expenditures were financed in part from capital raised in the2000 private offering of series B convertible preferred stock and in part bythe asset loan secured in the second quarter of 2002.  There are no major expenditures for capital equipment anticipatedfor fiscal year 2004.

 

A summary of the Company’scontractual cash obligations at December 31, 2003 is as follows:

 
| **Contractual  Obligations**       |   | **Total** |      | **Less than  1 Year** |   | **1-3 Years** |   | **3-5 Years** |      | **Greater  Than 5  Years** |   |
|------------------------------------|--------|-----------|-----------|-----------------------|--------|---------------|--------|---------------|-----------|----------------------------|--------|
| Notes payable                      |   | $         | 1,700,000 |                  | $      | —        |   | $             | 1,700,000 |                       | $      | — |   | $ | — |   |
| Convertible notes payable          |   | 2,500,000 |      | —                |   | —        |   | 2,500,000     |      | —                     |   |
| Note payable-other                 |   | 185,020   |      | 68,292                |   | 116,728       |   | —        |      | —                     |   |
|                               |   |      |      |                  |   | —        |   | —        |      | —                     |   |
| Operating leases                   |   | 944,000   |      | 304,000               |   | 640,000       |   | —        |      | —                     |   |
| Capital leases including interest  |   | 220,020   |      | 124,543               |   | 95,477        |   | —        |      | —                     |   |
| Total contractual cash obligations |   | $         | 5,549,040 |                  | $      | 496,835       |   | $             | 2,552,205 |                       | $      | 2,500,000 |   | $ | — |   |

 

19

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**Overviewof Financial Condition**

 

As shown inthe accompanying financial statements, the Company reported a net lossapproximately of ($1,777,000) for 2003 and ($1,716,000) for 2002, and net incomeof approximately $44,000 for the year ended December 31, 2001.  During the past three years, the Company’sworking capital requirements were met by additional bank borrowings, issuanceof secured and subordinated convertible notes and the issuance of common andpreferred stock to shareowners.

 

Net cash usedin operations was ($283,000).  Noadditional borrowing was used to augment operating capital during 2003.  In 2003 $3,200,000 of secured andconvertible notes were issued to replace bank debt and for use in the Company’sacquisition program.  Net cash used inoperations, in 2002, was ($807,000). Operating capital was augmented by borrowings of $1,000,000 from theCompany’s asset based credit facility. Net cash used in operations was approximately ($283,000).  Operating capital was augmented byborrowings of $750,000 from the Company’s revolving credit agreement.  In June of 2003 demand was made by a lenderto pay approximately $1,700,000 in settlement of bank debts that were intechnical default due to a violation of certain financial covenants.  The Company issued a Secured Note, payableto an affiliate of a major shareholder and used the proceeds to satisfy thedemand for payment.

 

In October of2003 the Company issued a $1,500,000 Subordinated Convertible Promissory Noteto an affiliate of a major shareholder. Proceeds from this note are to be used in the furtherance of theCompany’s merger and acquisition program.

 

In December2002 the Company received $1,000,000 in proceeds from the issuance of a SubordinatedConvertible Promissory Note.  TheCompany did so anticipating continued distressed market conditions during 2003and it used the proceeds from the note to meet its working capital needs in2003.

 

Wherepossible, the Company will continue to increase sales, and reduce expenses andcash requirements to improve future operating results and cash flows.  Management expects that cash flow fromoperations and use of available cash reserves will provide adequate liquidityfor the Company’s operations in 2004.

 

The Companyhas an active program to align its expenses with present and projected revenuesand with its commitments to its customers. During the recessionary year of 2001, employment was reduced inSeptember from 83 to 69, a decline of 17%, through lay-off and attrition.  Senior executives of the Company voluntarilyaccepted a 15% cut in pay, and directors’ fees were reduced 20%.  In the first week of January 2002, employmentwas further reduced to 58, a further decline of 16%, through lay-off andattrition.  Temporary layoffs resultedfrom reducing the number of work-weeks in the year for all non-executiveemployees, resulting in additional expense savings. Reductions were again madein January 2003 to 44 employees, reflecting the continued decrease in bookingsdue to a weakened market for the Company’s products.  In 2004 salaries and fees were restored to pre 2002 levels forofficers and directors and temporary layoffs were halted.  The Company believes that its current cashreserves coupled with its plan to acquire additional companies and its costreductions and control programs will allow the Company to maintain its fiscalviability throughout 2004.  Cash andinvestments were $1,282,000 at the end of 2003 and $1,155,000 at the end of2002.

 

The Companyannounced in 2002 that it is intent on implementing a plan to transform the

 

20

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Company into a portfolio ofbusinesses serving the Photonics industry. A merger and acquisitions advisory firm was employed in the fourthquarter of 2002 to assist management in this process.  Capital needed to make the acquisitions or mergers will beobtained through the issuance of equity-based instruments, as necessary.  The first acquisition was completed inNovember 2003 and the necessary capital was raised via a $1,500,000subordinated convertible note.  TheCompany currently has capital, and commitments for additional capital, tocontinue the acquisition plan.  TheCompany continues to search for additional sources for infusion of equity basedcapital to be used for acquisitions for the next three years.

 

No assurancescan be given that the Company will be able to identify and attract appropriateacquisition targets or raise the capital required.

 

**Item7A.****                 Quantitative and QualitativeDisclosures About Market Risk**

 

The Companybelieves that it has limited exposure to changes in interest rates frominvestments in certain money market accounts. The Company does not utilize derivative instruments or other market risksensitive instruments to manage exposure to interest rate changes.  The Company believes that a hypothetical 100basis point adverse move in interest rates along the entire interest rate yieldcurve would not materially affect the fair value of the Company’s interestsensitive money market accounts at December 31, 2003.

 

**Item8.****                                                           FinancialStatements and Supplementary Data**

 

The financialstatements and supplementary financial information required to be filed underthis Item are presented commencing on page F-1 of the Annual Report on Form10-K, and are incorporated herein by reference.

 

**Item9.****                                                           ChangesIn and Disagreements With Accountants on Accounting and Financial Disclosure**

 

None

 

**Item9A.****                                                  Controlsand Procedures**

 

**Disclosure controls and procedures**

 

As of the end of the Company’s most recentlycompleted fiscal quarter (the registrant’s fourth fiscal quarter in the case ofan annual report) covered by this report, the Company carried out anevaluation, with the participation of the Company’s management, including theCompany’s Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the Company’s disclosure controls and procedures pursuant toSecurities Exchange Act Rule 13a-15. Based upon that evaluation, the Company’s Chief Executive Officer andChief Financial Officer, concluded that the Company’s disclosure controls andprocedures are effective in ensuring that information required to be disclosedby the Company in the reports that it files or submits under the SecuritiesExchange Act is recorded, processed, summarized and reported, within the timeperiods specified in the SEC’s rules and forms.

 

**Changes in internal controls over financialreporting**

 

There have been no changes in the Company’sinternal controls over financial reporting that occurred during the Company’slast fiscal quarter to which this report relates that have materially affected,or are reasonably likely to materially affect, the Company’s internal controlover financial reporting.

 

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**PARTIII**

 

**Item10.****                                                    Directorsand Executive Officers of the Registrant**

 

**Directors of the Registrant**

 

The followingtable sets forth the name and age of each director of the Company, the periodduring which each such person has served as a director and the positions andbusiness experience of each such person:

 
|              |   |      |   | **Positions; Business**                                                                                                                                                     |
|-------------------|--------|-----------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Name and  Age** |   | **Since** |   | **Experience**                                                                                                                                                              |
| Thomas  Lenagh,   |   | 1998      |   | Chairman of  the Board of Directors (May 2000-Present).                                                                                                                     |
| 78                |   |      |   | Management Consultant (1990-Present)                                                                                                                                        |
|              |   |      |   | Past Chairman and CEO, Systems Planning  Corporation                                                                                                                        |
|              |   |      |   | Financial Vice President, the Aspen  Institute                                                                                                                              |
|              |   |      |   | Treasurer and Chief Investment Officer, The  Ford Foundation                                                                                                                |
|              |   |      |   | Captain, US Navy Reserve (ret.)                                                                                                                                             |
|              |   |      |   |                                                                                                                                                                        |
| Daniel  Lehrfeld, |   | 1999      |   | Director                                                                                                                                                                    |
| 60                |   |      |   | President and Chief Executive Officer  (2000-present),                                                                                                                      |
|              |   |      |   | President and Chief Operating Officer  (1999-2000),                                                                                                                         |
|              |   |      |   | Vice President/General Manager (1995-1999)                                                                                                                                  |
|              |   |      |   | Raytheon/GM Hughes Electro-Optics Center,                                                                                                                                   |
|              |   |      |   | President (1989-1991)                                                                                                                                                       |
|              |   |      |   | New England Research Center, (subsidiary)                                                                                                                                   |
|              |   |      |   | Deputy General Manager (1989-1995) &                                                                                                                                    |
|              |   |      |   | Director, Business Development,                                                                                                                                             |
|              |   |      |   | International Business, Operations,  Cryogenic Products                                                                                                                     |
|              |   |      |   | Magnavox Electronic Systems E. Coast Div.,                                                                                                                                  |
|              |   |      |   | Deputy Sector Director & Program  Director                                                                                                                              |
|              |   |      |   | Philips Laboratories Briarcliff                                                                                                                                             |
|              |   |      |   | North American Philips subs. Philips  Electronics NV,                                                                                                                       |
|              |   |      |   | Group Leader/Project Leader                                                                                                                                                 |
|              |   |      |   | Grumman Aerospace Corporation                                                                                                                                               |
|              |   |      |   |                                                                                                                                                                        |
| Frank  Wiedeman,  |   | 1998      |   | Director                                                                                                                                                                    |
| 88                |   |      |   | Executive Director (1980-Present)                                                                                                                                           |
|              |   |      |   | American Capital Management Inc.                                                                                                                                            |
|              |   |      |   |                                                                                                                                                                        |
| Jan Winston       |   | 2000      |   | Director                                                                                                                                                                    |
| 67                |   |      |   | Principal (1997-Present) Winston  Consulting,                                                                                                                               |
|              |   |      |   | Division Director/General Manager (1981-1997) IBM Corporation.  Executive positions held in Development,  Finance and Marketing.                                       |
|              |   |      |   |                                                                                                                                                                        |
| John Rich,        |   | 2000      |   | Director                                                                                                                                                                    |
| 66                |   |      |   | Vice President/General Manager (1999-2002) Power Electronics  Division, C&D technologies                                                                                |
|              |   |      |   | President (1990-1999), Raytheon/GM Hughes  Optical Systems                                                                                                                  |
|              |   |      |   | Vice President (1983-1989), Perkin Elmer Microlithography,  Electro-Optics, and Systems Colonel, Commander, Air Force Avionics Laboratory  and Air Force Weapons Laboratory |

 

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The directorshold office for staggered terms of three years.

 

**ExecutiveOfficers of the Registrant**

 

The followingtable sets forth the name and age of each executive officer of the Company, theperiod during which each such person has served as an executive officer and thepositions with the Company held by each such person:

 
| **Name and  Age**        |   | **Since** |   | **Position With the Company**                |
|--------------------------|--------|-----------|--------|----------------------------------------------|
|                     |   |      |   |                                         |
| Daniel  Lehrfeld, 60     |   | 1999      |   | President  and Chief Executive Officer       |
|                     |   |      |   |                                         |
| Maria  Murray, 46        |   | 1993      |   | Vice  President—Special Projects        |
|                     |   |      |   |                                         |
| William S.  Miraglia, 54 |   | 1999      |   | Chief  Financial Officer and Secretary       |
|                     |   |      |   |                                         |
| Devaunshi  Sampat, 50    |   | 1999      |   | Vice  President—Marketing Communication |

 

DanielLehrfeld has served as Chief Executive Officer and President since May2000.  He joined the Company in 1999 asPresident and Chief Operating Officer. Prior to joining the Company, Mr. Lehrfeld held the position of VicePresident and General Manager of Electro-Optic Systems, a division, successively,of the Raytheon, GM/Hughes Electronics and Magnavox Electronic SystemsCorporations.  He has also heldexecutive positions with Philips Laboratories Briarcliff and Grumman AerospaceCorporation.  Mr. Lehrfeld holds B.S.and M.S. degrees from Columbia University School of Engineering and AppliedScience and an M.B.A. degree from the Columbia Graduate School of Business.

 

Maria Murrayjoined the Company in January 1989, became Vice President of R&D Programsin 1993, and was appointed INRAD’s Sr. Vice President, Business Development in1999.  In 2003 she also assumed thetitle of Vice President for Special Projects at PPGI.  Prior to joining the Company, Ms. Murray held positions inelectronic design engineering in the laser and communication industries.  She holds a B.S. degree in ElectricalEngineering from the University of Central Florida.

 

William S.Miraglia joined the Company as Secretary and Chief Financial Officer in June1999.  Previously, he held the positionof Vice President of Finance for a division of UNC, Inc., a New York StockExchange aviation company.  Prior to hislast position, Mr. Miraglia has held management positions in the aerospaceindustry and in public accounting.  Heholds a B.B.A. from Pace University, and an M.B.A from Long Island Universityand is a Certified Public Accountant.

 

DevaunshiSampat joined the Company in 1998.  In1999 she was appointed Vice President of Marketing and Sales.  In 2003 she also assumed the title of VicePresident for Marketing Communications for PPGI.  Prior to joining the Company, Ms. Sampat held sales managementpositions within the Photonics industry with Princeton Instruments and OrielInstruments.  Ms. Sampat holds a B.S. inMedical Technology from the University of Bridgeport.

 

Each of theexecutive officers has been elected by the Board of Directors to serve as anofficer of the Company until the next election of officers, as provided by theCompany’s by-laws.

 

**Committees of the Board of Directors**

 

Composition of the Board of Directors*.* Since the adoption of the Sarbanes-Oxley Act in July 2002, there hasbeen a growing public and regulatory focus on the independence ofdirectors.  Requirements relating toindependence are imposed by the Sarbanes-Oxley Act with respect to members

 

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of the Audit Committee.  TheBoard of Directors has determined that the members of the Audit Committeesatisfy all such definitions of independence.

 

Audit Committee*.*  During 2003, theAudit Committee was comprised of 3 Directors.  The Audit Committee is empowered by the Board of Directors to,among other things, serve as an independent and objective party to monitor theCompany’s financial reporting process, internal control system and disclosurecontrol system, review and appraise the audit efforts of the Company’sindependent accountants, assume direct responsibility for the appointment,compensation, retention and oversight of the work of the outside auditors andfor the resolution of disputes between the outside auditors and the Company’smanagement regarding financial reporting issues, and provide an open avenue ofcommunication among the independent accountants, financial and seniormanagement, and the Company’s Board of Directors.

 

Audit Committee Financial Expert*. *TheBoard of Directors of the Company has determined that Mr. John Rich is an“audit committee financial expert”, as such term is defined by the SEC.  Mr. Rich, as well as Mr. Thomas Lenagh andMr. Jan Winston, have been determined to be “independent” within the meaning ofSEC regulations.

 

Compensation Committee.  During 2003, the Compensation Committee wascomprised of Mr. Frank Wiedeman, Mr. Jan Winston and Mr. John Rich.  The Compensation Committee reviews, approvesand makes recommendations to the Board of Directors on matters regarding thecompensation of the Company’s senior executive officer(s).

 

**Section 16(a) Beneficial Ownership ReportingCompliance**

 

Section 16(a)of the Securities Exchange Act of 1934 requires the Company’s directors andofficers, and persons who own more than 10% of a registered class of theCompany’s equity securities, to file initial reports of ownership and reportsof changes in ownership with the Securities and Exchange Commission.  These persons are required by the Securitiesand Exchange Commission to furnish the Company with copies of all Section 16(a)reports that they file.  Based solely onthe Company’s review of these reports and written representations furnished tothe Company, the Company believes that in 2003 each of the reporting personscomplied with these filing requirements, except that reports on Form 4 were notfiled reporting the grant of stock options in January 2, 2003 to the followingindividuals in the amounts set forth next to their names:

 

| Mr. Dan Lehrfeld        | 50,000 options |
|-------------------------|----------------|
| Ms. Maria Murray        | 24,000 options |
| Ms. Devaunshi Sampat    | 24,000 options |
| Mr. William S. Miraglia | 24,000 options |
| Mr. Thomas Lenagh       | 12,000 options |
| Mr. Frank Wiedeman      | 12,000 options |
| Mr. Jan Winston         | 12,000 options |
| Mr. John Rich           | 12,000 options |

 

All optionsgranted on this date expire on January 1, 2013. These late filings wereinadvertent, and the required filings will be made promptly.

 

**Codeof Ethics**

 

The Companyhas adopted a Code of Ethics that applies to the Company’s principal executiveofficer, principal financial officer, principal accounting officer orcontroller (or persons performing similar functions).  A copy of such Code of Ethics has been filed as Exhibit 14.1 tothis Annual Report on Form 10-K.

 

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**Item11.****                                                    ExecutiveCompensation**

 

**Summaryof Cash and Certain Other Compensation**

 

The followingtable sets forth, for the years ended December 31, 2003, 2002 and 2001, thecash compensation paid by the Company and its Subsidiaries, with respect to theCompany’s officers, whose total annual salary and bonus exceeded $100,000, forservices rendered in all capacities as an executive officer during such period:

 

**Summary Compensation Table**

 
| **Name and  Principal Position** |   | **Year** |   | **Salary** |    | **Bonus** |   | **Stock  Options** |   |
|----------------------------------|--------|----------|--------|------------|---------|-----------|--------|--------------------|--------|
| Daniel Lehrfeld,                 |   | 2003     |   | $          | 156,000 |      | $      | —             |   | 85,000 |   |
| President and                    |   | 2002     |   | 148,000    |    | 32,500    | *      | 110,000            |   |
| Chief Executive Officer          |   | 2001     |   | 156,000    |    | —    |   | —             |   |
|                             |   |     |   |       |    |      |   |               |   |
| Maria Murray,                    |   | 2003     |   | 112,000    |    | —    |   | 40,000             |   |
| Vice President,                  |   | 2002     |   | 107,000    |    | —    |   | 89,000             |   |
| Special Projects                 |   | 2001     |   | 115,000    |    | —    |   | —             |   |
|                             |   |     |   |       |    |      |   |               |   |
| Devaunshi Sampat,                |   | 2003     |   | 113,000    |    | —    |   | 50,000             |   |
| Vice President,                  |   | 2002     |   | 105,000    |    | —    |   | 59,500             |   |
| Marketing Communications         |   | 2001     |   | 139,000    |    | —    |   | —             |   |
|                             |   |     |   |       |    |      |   |               |   |
| William Miraglia                 |   | 2003     |   | 104,000    |    | —    |   | 40,000             |   |
| Vice President,                  |   | 2002     |   | 101,000    |    | —    |   | 45,000             |   |
| Chief Financial Officer          |   | 2001     |   | 105,000    |    | —    |   | —             |   |
|                                  |        |          |        |            |         |           |        |                    |        |  |  |

 

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*                                         Reflects deferredpayout of bonus granted in recognition of asset sale in 2000.  Full proceeds invested in Company Series BPreferred stock.

 

The Company isparty to an employment agreement with Mr. Dan Lehrfeld, President and CEO, thatprovides for a minimum annual salary during its term, and severance benefitsunder certain conditions that include change of control of the Company.

 

The aggregate minimum commitment under thisagreement is as follows:

 

| **Year Ending  December 31,** |   |   |    |
|-------------------------------|--------|--------|---------|
| 2004                          |   | $      | 175,000 |   |
| 2005                          |   | $      | 175,000 |   |
| 2006                          |   | $      | 175,000 |   |
| 2007                          |   | $      | 175,000 |   |
| 2008                          |   | $      | 175,000 |   |

 

Should Mr. Lehrfeld be terminated withoutcause during this contract period he would be entitled to one year’s salary.

 

There is anSEC requirement to report officer received perquisites or other personalbenefits in excess of the lesser of $50,000 or 10% of such individual’sreported salary and bonus. During fiscal year 2003, 2002 and 2001,respectively, no officer received any perquisites or other personal benefits,nor were any granted.

 

25

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**Compensationof Directors**

 

Eachnon-employee director was paid $400 during fiscal year 2003 and 2002,respectively, for each board meeting he/she attended, and $200 during fiscalyear 2003 and 2002, respectively, for each conference call meeting in whichhe/she participated.

 

**CompensationCommittee Interlocks and Insider Participation in Compensation Committee**

 

The followingdirectors of the Company served as members of the Compensation Committee of theCompany’s Board of Directors during 2003: Mr. Frank Wiedeman, Mr. Jan Winston and Mr. John Rich.  Officer’s compensation is guided by overalljob performance and the market salaries for those positions for companies ofthe same relative size and within industries similar to the Company’s industry,as well as relativity to other salaries within the Company.

 

**OptionExercises and Holdings**

 

The followingtable provides information concerning options exercised during 2003 and thevalue of unexercised options held by each of the executive officers named inthe Summary Compensation Table at December 31, 2003.

 

**Option Values at December 31, 2003**

 
|             |   | **Shares  Acquired  on  Exercise** |   | **Value**    |   | **Number of  Securities Underlying  Unexercised Options  at December 31, 2003  (# of shares)** |   | **Value of  In-the-Money Options at  December 31, 2003 ($)(1)** |   |
|------------------|--------|------------------------------------|--------|--------------|--------|------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------|--------|
| **Name**         |   | **(# shares)**                     |   | **Realized** |   | **Exercisable**                                                                                |   | **Unexercisable**                                               |   | **Exercisable** |   | **Unexercisable** |   |
| Daniel Lehrfeld  |   | 0                                  |   | 0            |   | 396,300                                                                                        |   | 123,700                                                         |   | 0 |   | 0 |   |
|             |   |                               |   |         |   |                                                                                           |   |                                                            |   |   |   |   |   |
| Maria Murray     |   | 0                                  |   | 0            |   | 106,370                                                                                        |   | 83,630                                                          |   | 0 |   | 0 |   |
|             |   |                               |   |         |   |                                                                                           |   |                                                            |   |   |   |   |   |
| Devaunshi Sampat |   | 0                                  |   | 0            |   | 67,135                                                                                         |   | 63,865                                                          |   | 0 |   | 0 |   |
|             |   |                               |   |         |   |                                                                                           |   |                                                            |   |   |   |   |   |
| William Miraglia |   | 0                                  |   | 0            |   | 29,504                                                                                         |   | 59,496                                                          |   | 0 |   | 0 |   |

 

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(1)                                  Basedon $0.50 per share, the closing price of the Company’s Common Stock, asreported by the OTC Bulletin Board, on December 31, 2003.

 

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**Longterm Incentive Plans – Awards in the Last Fiscal Year**

 

The followingtable presents options granted to named Officers for the past two fiscal years:

 
|             |   |                                           |   |                                                           |   | **Estimated  Future Payouts  Under Non-Stock Price Based Plans** |   |
|------------------|--------|------------------------------------------------|--------|----------------------------------------------------------------|--------|------------------------------------------------------------------|--------|
| **(a)**          |   | **(b)**                                        |   | **(c)**                                                        |   | **(d)**                                                          |   | **(e)** |   | **(f)** |   |
| **Name**         |   | **Number of  Shares, Units  or Other  Rights** |   | **Performance  or Other  Period Until  Maturities or  Payout** |   | **Threshold**                                                    |   | **Target** |   | **Maximum** |   |
| Dan Lehrfeld     |   | 50,000                                         |   | January 2013                                                   |   |                                                             |   |   |   |   |   |
| Maria Murray     |   | 24,000                                         |   | January 2013                                                   |   |                                                             |   |   |   |   |   |
| Devaunshi Sampat |   | 24,000                                         |   | January 2013                                                   |   |                                                             |   |   |   |   |   |
| William Miraglia |   | 24,000                                         |   | January 2013                                                   |   |                                                             |   |   |   |   |   |

 

27

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**Option/SARGrants in Last Fiscal Year**

 
| **Individual  Grants** |   | **Potential  Floatable  Values at  Assumed  Annual Rates  of Stock Price  Appreciation  for Option  Term** |   | **Alternative  to (f) and  (g) Grant  Date Value**                     |   |
|------------------------|--------|------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------|--------|
| **(a)**                |   | **(b)**                                                                                                    |   | **(c)**                                                                |   | **(d)** |   | **(e)** |   | **(f)** |   | **(g)** |   | **(f)** |   |
| **Name**               |   | **Number of  Securities  Underlying  Options/  SARs  Granted**                                             |   | **% of Total  Options/  SARs  Granted to  Employees  in Fiscal  Year** |   | **Expiration  or Base  Price  ($/Sh)** |   | **Expiration  Date** |   | **5%  ($)** |   | **10%  ($)** |   | **Grant Date  Payment  Value ($)** |   |
| Dan Lehrfeld           |   | 50,000                                                                                                     |   | 16.7                                                                   | %      | $ | 0.50 |   | Jan 2013 |   |   |   |   |   | $ |  0.48 |   |
| Maria Murray           |   | 24,000                                                                                                     |   | 8.0                                                                    | %      | $ | 0.50 |   | Jan 2013 |   |   |   |   |   | $ |  0.48 |   |
| Devaunshi Sampat       |   | 24,000                                                                                                     |   | 8.0                                                                    | %      | $ | 0.50 |   | Jan 2013 |   |   |   |   |   | $ |  0.48 |   |
| William Miraglia       |   | 24,000                                                                                                     |   | 8.0                                                                    | %      | $ | 0.50 |   | Jan 2013 |   |   |   |   |   | $ |  0.48 |   |

 

**Item12.****                                                    SecurityOwnership of Certain Beneficial Owners and Management**

 

The followingtable presents certain information with respect to the security ownership ofthe directors and named executive officers of the Company and the securityownership of each individual or entity known by the Company to be thebeneficial owner of more than 5% of the Company’s Common Stock outstanding(5,445,903 shares) as of March 25, 2004. Percentages that include ownership of options or convertible securitiesare calculated assuming exercise or conversion by each individual or entity ofthe options, (including “out-of-the-money options”), or convertible securitiesowned by each individual or entity separately without considering the dilutiveeffect of option exercises and security conversions by any other individual orentity.  The Company has been advisedthat all individuals, or entities, listed have the sole power to vote anddispose of the number of shares set opposite their names in the table.  Unless otherwise indicated, the address ofeach beneficial owner is c/o Photonic Products Group, Inc., 181 Legrand Avenue,Northvale, New Jersey 07674.

 

28

----

 
|                                      |   |                  |       | **Percent of**    |       |
|-------------------------------------------|--------|-----------------------|------------|-------------------|------------|
| **Name and  Address of Beneficial Owner** |   | **Number of  shares** | ** ** | **Common  Stock** | ** ** |
|                                      |   |                  |       |              |       |
| Clarex, Ltd. & Welland Ltd.           |   | 8,737,866             | (1)        | 74.7              | %          |
| Bay Street and Rawson Square              |   |                  |       |              |       |
| P.O. Box N 3016                           |   |                  |       |              |       |
| Nassau, Bahamas                           |   |                  |       |              |       |
|                                      |   |                  |       |              |       |
| Warren Ruderman                           |   | 1,467,046             |       | 27.1              | %          |
| 45 Duane Lane                             |   |                  |       |              |       |
| Demarest, NJ 07627                        |   |                  |       |              |       |
|                                      |   |                  |       |              |       |
| Daniel Lehrfeld                           |   | 556,300               | (2)        | 9.5               | %          |
| C/O PPGI                                  |   |                  |       |              |       |
| 181 Legrand Ave                           |   |                  |       |              |       |
| Northvale, NJ 07647                       |   |                  |       |              |       |
|                                      |   |                  |       |              |       |
| Hoechst Celanese Corp.                    |   | 300,000               |       | 5.5               | %          |
| Routes 202-206 North                      |   |                  |       |              |       |
| Box 2500                                  |   |                  |       |              |       |
| Somerville, NJ 08876                      |   |                  |       |              |       |
|                                      |   |                  |       |              |       |
| Thomas Lenagh                             |   | 105,000               | (3)        | 1.9               | %          |
| C/O PPGI                                  |   |                  |       |              |       |
| 181 Legrand Ave                           |   |                  |       |              |       |
| Northvale, NJ 07647                       |   |                  |       |              |       |
|                                      |   |                  |       |              |       |
| Frank Wiedeman                            |   | 97,000                | (4)        | 1.8               | %          |
| C/O PPGI                                  |   |                  |       |              |       |
| 181 Legrand Ave                           |   |                  |       |              |       |
| Northvale, NJ 07647                       |   |                  |       |              |       |
|                                      |   |                  |       |              |       |
| John Rich                                 |   | 30,300                | (5)        | 0.6               | %          |
| C/O PPGI                                  |   |                  |       |              |       |
| 181 Legrand Ave                           |   |                  |       |              |       |
| Northvale, NJ 07647                       |   |                  |       |              |       |
|                                      |   |                  |       |              |       |
| Jan Winston                               |   | 27,000                | (6)        | 0.5               | %          |
| C/O PPGI                                  |   |                  |       |              |       |
| 181 Legrand Ave                           |   |                  |       |              |       |
| Northvale, NJ 07647                       |   |                  |       |              |       |
|                                      |   |                  |       |              |       |
| Maria Murray                              |   | 185,830               | (7)        | 3.3               | %          |
| C/O PPGI                                  |   |                  |       |              |       |
| 181 Legrand Ave                           |   |                  |       |              |       |
| Northvale, NJ 07647                       |   |                  |       |              |       |
|                                      |   |                  |       |              |       |
| William Miraglia                          |   | 67,400                | (8)        | 1.2               | %          |
| C/O PPGI                                  |   |                  |       |              |       |
| 181 Legrand Ave                           |   |                  |       |              |       |
| Northvale, NJ 07647                       |   |                  |       |              |       |
|                                      |   |                  |       |              |       |
| Devaunshi Sampat                          |   | 110,400               | (9)        | 2.0               | %          |
| C/O PPGI                                  |   |                  |       |              |       |
| 181 Legrand Ave                           |   |                  |       |              |       |
| Northvale, NJ 07647                       |   |                  |       |              |       |
|                                      |   |                  |       |              |       |
| Directors and Executive                   |   | 1,179,730             | (10)       | 18.6              | %          |
| Officers as a group                       |   |                  |       |              |       |
| (8 persons)                               |   |                  |       |              |       |

 

29

----

 

----

(1)                                  Including 900,000shares subject to convertible preferred stock exercisable or convertible within60 days, 2,380,952 shares subject to convertible promissory notes at a statedconversion of $0.42, the market value of the Company’s Common Stock on the dateof issuance of the Note and 3,000,000 shares subject to convertible promissorynotes at a stated conversion of $0.50, the market value of the Company’s CommonStock on the date of issuance of the Note.

 

(2)                                  Including 48,000shares subject to convertible preferred stock and 396,300 shares subject tooptions exercisable within 60 days.

 

(3)                                  Including 80,500shares subject to options exercisable within 60 days.

 

(4)                                  Including 47,000shares subject to options exercisable within 60 days.

 

(5)                                  Including 12,000shares subject to convertible preferred stock and 15,300 shares subject tooptions exercisable or convertible within 60 days.

 

(6)                                  Including 4,000shares subject to convertible preferred stock and 22,000 shares subject tooptions exercisable or convertible within 60 days.

 

(7)                                  Including 180,855shares subject to convertible preferred stock, stock options, and warrantsexercisable or convertible within 60 days.

 

(8)                                  Including 65,600shares subject to convertible preferred stock, stock options, and warrantsexercisable or convertible within 60 days.

 

(9)                                  Including 108,400shares subject to convertible preferred stock, stock options, and warrantsexercisable or convertible within 60 days.

 

(10)                            Including 979,655 sharessubject to convertible preferred stock, stock options, and warrants exercisableor convertible within 60 days.

 

**EquityCompensation Plan Information**

 

The followingtable gives information about the Company’s Common Stock that may be issuedupon the exercise of options, warrants and rights under the Company’s KeyEmployee Compensation Plan and the Company’s 2000 Equity Compensation Program,as of December 31, 2003.  These planswere the Company’s only equity compensation plans in existence as of December31, 2003.

 

 
| **Plan  Category**                                      |   | **(a)  Number of Securities to  be Issued Upon Exercise  of Outstanding Options,  Warrants and Rights** |   | **(b)  Weighted-Average  Exercise Price of  Outstanding Options,  Warrants and Rights** |   | **(c)  Number of Securities  Remaining Available for  Future Issuance Under  Equity Compensation  Plans (Excluding  Securities Reflected in   Column (a)** |      |
|---------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------|
|                                                    |   |                                                                                                    |   |                                                                                    |   |                                                                                                                                                       |      |
| Equity Compensation Plans Approved by  Shareholders     |   | 1,449,100                                                                                               |   | $                                                                                       | 1.42   |                                                                                                                                                       | 2,550,900 |   |
|                                                    |   |                                                                                                    |   |                                                                                    |   |                                                                                                                                                       |      |
| Equity Compensation Plans Not Approved by  Shareholders |   | —                                                                                                  |   | —                                                                                  |   | —                                                                                                                                                     |      |
|                                                    |   |                                                                                                    |   |                                                                                    |   |                                                                                                                                                       |      |
| Total                                                   |   | 1,449,100                                                                                               |   | $                                                                                       | 1.42   |                                                                                                                                                       | 2,550,900 |   |

 

30

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**Item13.****                                                    CertainRelationships and Related Transactions**

 

During theyears ended December 31, 2003, 2002 and 2001 approximately 3%, 4%, and 3%,respectively, of the Company’s net product sales were through a foreign agent,in which, Warren Ruderman, a principal shareholder of the Company, has aninvestment.  Terms of sales to thisforeign agent were substantially the same as to unrelated foreign agents.

 

During 2003,Clarex, Ltd., a shareowner and debt holder, received a 6% Secured PromissoryNote for $1,700,000 due January 2005. In October 2003, Clarex, Ltd. received a $1,500,000 6% Subordinated ConvertiblePromissory Note due January 2006.

 

During 2002,Welland, Ltd., a related party to Clarex, Ltd., received a 6% SubordinatedConvertible Promissory Note due January 31, 2006, resulting in proceeds to theCompany of $1,000,000.

 

**Item 14.****                                                    PrincipalAccounting Fees and Services**

 

In accordancewith the requirements of the Sarbanes-Oxley Act of 2002 and the Audit Committee’s charter, allaudit and audit-related work and all non-audit work performed by the Company’sindependent accountants is approved in advance by the Audit Committee,including the proposed fees for such work. The Audit Committee is informed of each service actually rendered

 

Audit Fees*.*  Audit fees billed or expected to be billedto the Company by the Company’sprincipal accountant for the audit of the financial statements includedin the Company’s Annual Reports on Form 10-K, and reviews of the financialstatements included in the Company’s Quarterly Reports on Form 10-Q, for theyears ended December 31, 2003 and 2002 totaled approximately $74,000 and$71,000,respectively.

 

Audit-Related Fees*. *The Company wasbilled $0and $0by the Company’s principal accountant for the fiscal years ended December 31,2003 and 2002, respectively, for assurance and related services that arereasonably related to the performance of the audit or review of the Company’sfinancial statements and are not reported under the caption *Audit Fees* above.

 

Tax Fees*.*  The Company was billed an aggregate of$7,500 and $7,500 by the Company’sprincipal accountant for the fiscal years ended December 31, 2003 and2002, respectively, for tax services, principally the preparation of income taxreturns.

 

All Other Fees*.*  The Company did not incur any fees for thefiscal years ended December 31, 2003 and 2002, respectively, for permittednon-audit services.

 

Applicable lawand regulations provide an exemption that permits certain services to beprovided by the Company’s outside auditors even if they are notpre-approved.  The Company has notrelied on this exemption at any time since the Sarbanes-Oxley Act was enacted.

 

31

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#### **PARTIV**

#### ** **

**Item 15.****                                                    Exhibits,Financial Statement Schedules, and Reports on Form 8-K**

 

**(a)(1)     Financial Statements.**

 

Reference ismade to the Index to Financial Statements and Financial Statement Schedule onPage F-1.

 

**(a)(2)     Financial Statement Schedule.**

 

Reference is made to the Index to Financial Statements and FinancialStatement Schedule on Page F-1.

 

All other schedules have been omitted because the required informationis not present or is not present in amounts sufficient to require submission ofthe schedule, or because the information required is included in the FinancialStatements or Notes thereto.

 

**(a)(3)     Exhibits.**

 
| **Exhibit  No.** |   | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                            |
|------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 3.1              |   | Restated  Certificate of Incorporation, as filed with the Secretary of State of the  State of New Jersey in September 2003 (Incorporated by reference to Exhibit  3.1 of the Company’s Registration Statement or amendments thereto on Form  S-18 (Registration No. 2-83689), initially filed with the Securities and  Exchange Commission on May 11, 1983)      |
|             |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 3.2              |   | Certificate  of Amendment of Certificate of Incorporation, as filed with the Secretary of  State of the State of New Jersey on September 2003 (Incorporated by reference  to the Company’s definitive proxy statement, pursuant to Section 14(A) of the  Securities Exchange Act of 1934, filed with the Securities and Exchange  commission on July 28th, 2003. |
|             |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 3.3              |   | Series A 10%  Convertible Preferred Stock (Incorporated by reference to the Company’s  definitive proxy statement, pursuant to Section 14(A) of the Securities  Exchange Act of 1934, filed with the Securities and Exchange commission on  July 28th, 2003.                                                                                                     |
|             |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 3.4              |   | Series B 10%  Convertible Preferred Stock (Incorporated by reference to the Company’s  definitive proxy statement, pursuant to Section 14(A) of the Securities  Exchange Act of 1934, filed with the Securities and Exchange commission on  July 28th, 2003.                                                                                                     |
|             |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 3.5              |   | By-laws  (Incorporated by reference to Exhibit 3.2 of the Company’s Registration  Statement or amendments thereto on Form S-18 (Registration No. 2-83689),  initially filed with the Securities and Exchange Commission on May 11, 1983)                                                                                                                         |
|             |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.10*           |   | Employment  contract with Daniel Lehrfeld (Incorporated by reference to the Report to the  Securities and Exchange Commission on Form 10-K for the fiscal year ended  December 31, 1999)                                                                                                                                                                              |
|             |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.2*            |   | INRAD, Inc.  2000 Equity Compensation Program (Incorporated by reference to the Report to  the Securities and Exchange Commission on Form 14-A Proxy Statement for the  fiscal year ended December 31, 1999)                                                                                                                                                          |
|             |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.3             |   | Secured  Promissory note dated June 30, 2003 between Clarex, LTD and Photonic                                                                                                                                                                                                                                                                                         |
|             |   |                                                                                                                                                                                                                                                                                                                                                                  |

32

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|   |   | Products  Group, Inc.                                                                                                                               |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                |
| 10.4   |   | Secured  Promissory note dated October 31, 2003 between Clarex, LTD and Photonic  Products Group, Inc.                                              |
|   |   |                                                                                                                                                |
| 10.5   |   | Secured  Promissory note dated December 31, 2002 between Welland, LTD and Photonic  Products Group, Inc.                                            |
|   |   |                                                                                                                                                |
| 14.1   |   | Code of  Ethics for Senior Financial Officers                                                                                                       |
|   |   |                                                                                                                                                |
| 21.1   |   | Subsidiaries  of the Company                                                                                                                        |
|   |   |                                                                                                                                                |
| 23.1   |   | Consent from  Holtz Rubenstein & Co, LLP.                                                                                                       |
|   |   |                                                                                                                                                |
| 31.1   |   | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002                                                |
|   |   |                                                                                                                                                |
| 31.2   |   | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002                                                |
|   |   |                                                                                                                                                |
| 32.1   |   | Certification  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
|   |   |                                                                                                                                                |
| 32.2   |   | 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 |

 

----

* Managementcontracts and employment agreements

 

33

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**SIGNATURES**

 

Pursuant tothe 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 theundersigned, thereunto duly authorized.

 

 
|   |   | PHOTONIC  PRODUCTS GROUP, INC. |
|--------|--------|--------------------------------|
|   |   |                           |   |
|   |   |                           |   |
|   |   | By:                            | /s/ Daniel Lehrfeld |   |
|   |   |                           | Daniel Lehrfeld |
|   |   |                           | Chief Executive Officer |
|   |   |                           |   |
|   |   | Dated:   April 9, 2004    |

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Signature**            |   | **Title**                                        |   | **Date**       |
|--------------------------|--------|--------------------------------------------------|--------|----------------|
|                     |   |                                             |   |           |
| /s/ Thomas  Lenagh       |   | Chairman of  the Board of Directors              |   | April 9,  2004 |
| Thomas  Lenagh           |   |                                             |   |           |
|                     |   |                                             |   |           |
| /s/ Daniel  Lehrfeld     |   | President,  Chief Executive Officer and Director |   | April 9,  2004 |
| Daniel  Lehrfeld         |   |                                             |   |           |
|                     |   |                                             |   |           |
| /s/ Frank  Wiedeman      |   | Director                                         |   | April 9,  2004 |
| Frank  Wiedeman          |   |                                             |   |           |
|                     |   |                                             |   |           |
| /s/ John  Rich           |   | Director                                         |   | April 9,  2004 |
| John Rich                |   |                                             |   |           |
|                     |   |                                             |   |           |
| /s/ Jan  Winston         |   | Director                                         |   | April 9,  2004 |
| Jan Winston              |   |                                             |   |           |
|                     |   |                                             |   |           |
| /s/ William  S. Miraglia |   | Chief  Financial Officer and Secretary           |   | April 9,  2004 |
| William S.  Miraglia     |   |                                             |   |           |

 

34

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**PHOTONIC PRODUCTSGROUP , INC. AND SUBSIDIARIES**

 

**REPORT ON AUDITS OFCONSOLIDATED FINANCIAL STATEMENTS**

 

**THREE YEARS ENDEDDECEMBER 31, 2003**

 

**CONTENTS**

 
| Report of Holtz Rubenstein & Co., LLP, Independent Certified  Public Accountants              |   |
|---------------------------------------------------------------------------------------------------|--------|
|                                                                                              |   |
| Consolidated balance sheets as of  December 31, 2003 and 2002                                     |   |
|                                                                                              |   |
| Consolidated statements of operations for  the three years ended December 31, 2003                |   |
|                                                                                              |   |
| Consolidated statements of shareholders’  equity for the three years ended December 31, 2003 |   |
|                                                                                              |   |
| Consolidated statements of cash flows for  the three years ended December 31, 2003                |   |
|                                                                                              |   |
| Notes to consolidated financial statements                                                        |   |

 

F-1

----

 

IndependentAuditors’ Report

 

 

Board of Directors andShareholdersPhotonic Products Group, Inc. and SubsidiariesNorthvale, New Jersey

 

We haveaudited the accompanying consolidated balance sheets Photonic Products Group,Inc. and Subsidiaries as of December 31, 2003 and 2002, and the relatedconsolidated statements of operations, shareholders’ equity and cash flows forthe three years ended December 31, 2003. These consolidated financial statements are the responsibility of theCompany’s management.  Ourresponsibility is to express an opinion on these financial statements based onour audits.

 

We conductedour audits in accordance with auditing standards generally accepted in theUnited States of America.  Those standardsrequire that we plan and perform the audits to obtain reasonable assuranceabout whether the financial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the consolidated financial positionof Photonic Products Group, Inc. and Subsidiaries as of December 31, 2003 and2002 and the results of their operations and their cash flows for the threeyears then ended, in conformity with accounting principles generally acceptedin the United States of America.

 

 

HOLTZRUBENSTEIN & CO., LLP

 

 

Melville, New YorkMarch 25, 2004

 

F-2

----

 

**PHOTONICPRODUCTS GROUP, INC AND SUBSIDIARIES**

 

**CONSOLIDATED BALANCESHEETS**

 

 
|                                                                                                                                              |   | **December  31,** |      |
|---------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|-----------|
|                                                                                                                                              |   | **2003**          |      | **2002** |   |
|                                                                                                                                              |   |              |      |   |   |
| **Assets**                                                                                                                                        |   |              |      |   |   |
| **Current assets:**                                                                                                                               |   |              |      |   |   |
| Cash and cash equivalents                                                                                                                         |   | $                 | 1,282,160 |   | $ | 1,155,074 |   |
| Accounts receivable (after allowance for  doubtful accounts of $40,000 in 2003 and 2002)                                                          |   | 973,415           |      | 1,041,262 |   |
| Inventories                                                                                                                                       |   | 2,219,116         |      | 2,082,932 |   |
| Unbilled contract costs                                                                                                                           |   | 191,767           |      | 341,541 |   |
| Other current assets                                                                                                                              |   | 76,941            |      | 80,675 |   |
| **Total Current Assets**                                                                                                                          |   | 4,743,399         |      | 4,701,484 |   |
| **Plant and equipment,**                                                                                                                          |   |              |      |   |   |
| Plant and equipment at cost                                                                                                                       |   | 9,824,498         |      | 9,307,753 |   |
| Less: Accumulated depreciation and  amortization                                                                                                  |   | (6,572,278        | )         | (6,008,008 | ) |
| Total plant and equipment                                                                                                                         |   | 3,252,220         |      | 3,299,745 |   |
| **Precious Metals**                                                                                                                               |   | 309,565           |      | 309,565 |   |
| **Intangible Assets**                                                                                                                             |   | 443,750           |      |   |   |
| **Other Assets**                                                                                                                                  |   | 102,187           |      | 198,131 |   |
| **Total Assets**                                                                                                                                  |   | $                 | 8,851,121 |   | $ | 8,508,925 |   |
|                                                                                                                                              |   |              |      |   |   |
| **Liabilities and Shareholders’ Equity**                                                                                                     |   |              |      |   |   |
| **Current Liabilities:**                                                                                                                          |   |              |      |   |   |
| Notes Payable - Bank                                                                                                                              |   | $                 | —    |   | $ | 751,074 |   |
| Note payable - Other                                                                                                                              |   | 68,292            |      | 124,917 |   |
| Current portion of long term debt                                                                                                                 |   | —            |      | 927,549 |   |
| Accounts payable and accrued liabilities                                                                                                          |   | 993,150           |      | 368,337 |   |
| Current obligations under capital leases                                                                                                          |   | 99,664            |      | 98,657 |   |
| **Total current liabilities**                                                                                                                     |   | 1,161,106         |      | 2,270,534 |   |
|                                                                                                                                              |   |              |      |   |   |
| **Related Party Covertible and Secured Notes  Payable**                                                                                           |   | 4,200,000         |      | 1,000,000 |   |
| **Other Long Term Notes**                                                                                                                         |   | 116,728           |      | — |   |
| **Capital Lease Obligations**                                                                                                                     |   | 88,848            |      | 188,513 |   |
| **Total liabilities**                                                                                                                             |   | 5,566,682         |      | 3,459,047 |   |
|                                                                                                                                              |   |              |      |   |   |
| **Shareholders’ equity:**                                                                                                                    |   |              |      |   |   |
| 10% convertible preferred stock, Series A  no par value;****500 shares issued and outstanding respectively                                        |   | 500,000           |      | 500,000 |   |
|                                                                                                                                              |   |              |      |   |   |
| 10% convertible preferred stock, Series B  no par value;  2,100 shares issued and outstanding respectively                                        |   | 2,100,000         |      | 2,100,000 |   |
|                                                                                                                                              |   |              |      |   |   |
| Common stock: $.01 par value; 40,000,000  authorized 5,445,903 shares issued at December 31, 2003 and  5,283,640 issued at December 31, 2002 |   | 54,459            |      | 52,836 |   |
| Capital in excess of par value                                                                                                                    |   | 9,534,523         |      | 9,470,676 |   |
| Accumulated deficit                                                                                                                               |   | (8,889,593        | )         | (7,058,684 | ) |
|                                                                                                                                              |   | 3,299,389         |      | 5,064,828 |   |
| Less - Common stock in treasury, at cost  (4,600 shares respectively)                                                                             |   | (14,950           | )         | (14,950 | ) |
| **Total Shareholders’ Equity**                                                                                                               |   | 3,284,439         |      | 5,049,878 |   |
| **Total Liabilities & Shareholders’  Equity**                                                                                            |   | $                 | 8,851,121 |   | $ | 8,508,925 |   |

 

SeeNotes to Consolidated Financial Statements

 

F-3

----

 

**PHOTONICPRODUCTS GROUP, INC AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
|                                                                      |   | **Years  Ended December 31,** |       |
|---------------------------------------------------------------------------|--------|-------------------------------|------------|
|                                                                      |   | **2003**                      |       | **2002** |   | **2001** |   |
|                                                                      |   |                          |       |   |   |   |   |
| REVENUES                                                                  |   |                          |       |   |   |   |   |
| Net sales                                                                 |   | $                             | 5,388,184  |   | $ | 5,569,118 |   | $ | 8,075,205 |   |
|                                                                      |   |                          |       |   |   |   |   |
| COST AND EXPENSES                                                         |   |                          |       |   |   |   |   |
| Cost of goods sold                                                        |   | 3,917,123                     |       | 4,662,599 |   | 5,078,352 |   |
| Selling, general and admistrative expense                                 |   | 2,389,547                     |       | 2,276,495 |   | 2,501,621 |   |
| Internal research and development expense                                 |   | 153,843                       |       | 134,424 |   | 201,603 |   |
| Special charges                                                           |   |                          |       | — |   | 299,733 |   |
|                                                                      |   | 7,042,513                     |       | 7,073,518 |   | 8,081,309 |   |
|                                                                      |   |                          |       |   |   |   |   |
| OPERATING LOSS                                                            |   | (1,654,329                    | )          | (1,504,400 | ) | (6,104 | ) |
|                                                                      |   |                          |       |   |   |   |   |
| OTHER INCOME (EXPENSE)                                                    |   |                          |       |   |   |   |   |
| Gain on sale of technology                                                |   | —                        |       | — |   | 44,800 |   |
| Interest expense                                                          |   | (270,946                      | )          | (135,001 | ) | (91,154 | ) |
| Interest income                                                           |   | 4,781                         |       | 10,883 |   | 50,919 |   |
| Other                                                                     |   | 8,950                         |       | 13,126 |   | (38,071 | ) |
|                                                                      |   | (257,215                      | )          | (110,992 | ) | (33,506 | ) |
|                                                                      |   |                          |       |   |   |   |   |
| LOSS BEFORE INCOME TAX BENEFIT (PROVISION)  AND PREFERRED STOCK DIVIDENDS |   | (1,911,544                    | )          | (1,615,392 | ) | (39,610 | ) |
|                                                                      |   |                          |       |   |   |   |   |
| INCOME TAX BENEFIT (PROVISION)                                            |   | 134,235                       |       | (100,580 | ) | 83,244 |   |
|                                                                      |   |                          |       |   |   |   |   |
| NET (LOSS) PROFIT                                                         |   | (1,777,309                    | )          | (1,715,972 | ) | 43,634 |   |
|                                                                      |   |                          |       |   |   |   |   |
| PREFERRED STOCK DIVIDENDS                                                 |   | (53,600                       | )          | (120,600 | ) | (155,000 | ) |
|                                                                      |   |                          |       |   |   |   |   |
| NET LOSS APPLICABLE TO TO COMMMON  SHAREHOLDERS                           |   | $                             | (1,830,909 | ) | $ | (1,836,572 | ) | $ | (111,366 | ) |
|                                                                      |   |                          |       |   |   |   |   |
| NET LOSS PER COMMON SHARE-BASIC                                           |   | $                             | (0.35      | ) | $ | (0.35 | ) | $ | (0.02 | ) |
|                                                                      |   |                          |       |   |   |   |   |
| NET LOSS PER COMMON SHARE-DILUTED                                         |   | $                             | (0.35      | ) | $ | (0.35 | ) | $ | (0.02 | ) |

 

See notes to consolidated financial statements

 

F-4

----

 

**PHOTONICPRODUCTS GROUP, INC. AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENT OF SHAREHOLDERS’ EQUITY**

 
|                           |   |                    |       |        |       | **Preferred** |       | **Stock**   |       | **Preferred** |       | **Stock**     |       | **Capital in** |          |           |   |           |       |                   |           | **Total**     |   |
|--------------------------------|--------|-------------------------|------------|-------------|------------|---------------|------------|-------------|------------|---------------|------------|---------------|------------|----------------|---------------|----------------|--------|----------------|------------|------------------------|----------------|---------------|--------|
|                           |   | **Common********Stock** |       | **(Series** |       | **A)**        |       | **(Series** |       | **B)**        |       | **excess of** |       |           |          | **Payable/**   |   | **Treasury**   |       | **Shareholders’** |           |
|                           |   | **Shares**              |       | **Amount**  |       | **Shares**    |       | **Amount**  |       | **Shares**    |       | **Amount**    |       | **par value**  |          | **Deficit**    |   | **Receivable** |       | **Stock**              |           | **Equity**    |   |
| Balance, December 31, 2000     |   | 4,957,678               |       | $           | 49,577     |          | 500        |        | $          | 500,000       |       | 2,100         |       | $              | 2,100,000     |           | $      | 9,084,898      |       | $                      | (5,110,745     | )             | $      | (220,000 | ) | $ | (14,950 | ) | $ | 6,388,780 |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| Exercise of Options            |   | 29,250                  |       | 293         |       | —        |       | —      |       | —        |       | —        |       | 30,833         |          | —         |   | —         |       | —                 |           | 31,126        |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| Exercise of Warrants           |   | 51,675                  |       | 516         |       | —        |       | —      |       | —        |       | —        |       | 56,683         |          | —         |   | —         |       | —                 |           | 57,199        |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| Dividend on Preferred Stock    |   | 92,000                  |       | 920         |       | —        |       | —      |       | —        |       | —        |       | 154,080        |          | (155,000       | )      | —         |       | —                 |           | —        |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| Subscription received          |   | —                  |       | —      |       | —        |       | —      |       | —        |       | —        |       | —         |          | —         |   | 220,000        |       | —                 |           | 220,000       |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| Contribution                   |   | 5,000                   |       | 50          |       | —        |       | —      |       | —        |       | —        |       | 4,700          |          | —         |   | —         |       | —                 |           | 4,750         |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| Net income for the year        |   | —                  |       | —      |       | —        |       | —      |       | —        |       | —        |       | —         |          | 43,633         |   | —         |       | —                 |           | 43,633        |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| **Balance, December 31, 2001** |   | **5,135,603**           | ** ** | **51,356**  | ** ** | **500**       | ** ** | **500,000** | ** ** | **2,100**     | ** ** | **2,100,000** | ** ** | **9,331,194**  | ** **    | **(5,222,112** | **)**  | **—**     | ** ** | **(14,950**            | **)**          | **6,745,488** |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| 401K contribution              |   | 14,037                  |       | 140         |       | —        |       | —      |       | —        |       | —        |       | 20222          |          | —         |   |           |       |                   |           | 20,362        |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| Dividend on Preferred Stock    |   | 134,000                 |       | 1,340       |       | —        |       | —      |       | —        |       | —        |       | 119260         |          | (120,600       | )      |           |       |                   |           | —        |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| Net loss for the year          |   | —                  |       | —      |       | —        |       | —      |       | —        |       | —        |       | —         |          | (1,715,972     | )      | —         |       | —                 |           | (1,715,972    | )      |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| **Balance, December 31, 2002** |   | **5,283,640**           | ** ** | **52,836**  | ** ** | **500**       | ** ** | **500,000** | ** ** | **2,100**     | ** ** | **2,100,000** | ** ** | **9,470,676**  | ** **    | **(7,058,684** | **)**  | **—**     | ** ** | **(14,950**            | **)**          | **5,049,878** |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| 401K contribution              |   | 28,263                  |       | 283         |       | —        |       | —      |       | —        |       | —        |       | 11,587         |          | —         |   | —         |       | —                 |           | 11,870        |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| Dividend on Preferred Stock    |   | 134,000                 |       | 1,340       |       | —        |       | —      |       | —        |       | —        |       | 52,260         |          | (53,600        | )      | —         |       | —                 |           | —        |   |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| Net loss for the period        |   | —                  |       | —      |       | —        |       | —      |       | —        |       | —        |       | —         |          | (1,777,309     | )      | —         |       | —                 |           | (1,777,309    | )      |
|                           |   |                    |       |        |       |          |       |        |       |          |       |          |       |           |          |           |   |           |       |                   |           |          |   |
| **Balance, December 31, 2003** |   | **5,445,903**           | ** ** | **$**       | **54,459** | ** **    | **500**    | ** **  | **$**      | **500,000**   | ** ** | **2,100**     | ** ** | **$**          | **2,100,000** | ** **     | **$**  | **9,534,523**  | ** ** | **$**                  | **(8,889,593** | **)**         | **$**  | **—** | ** ** | **$** | **(14,950** | **)** | **$** | **3,284,439** |   |

 

See notes to consolidated financial statements

 

F-5

----

 

**PHOTONICPRODUCTS GROUP, INC AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
|                                                                         |   | **Years  Ended December 31,** |       |
|------------------------------------------------------------------------------|--------|-------------------------------|------------|
|                                                                         |   | **2003**                      |       | **2002** |   | **2001** |   |
|                                                                         |   |                          |       |   |   |   |   |
| **Cash flows from operating activities:**                                    |   |                          |       |   |   |   |   |
| Net (loss) profit                                                            |   | $                             | (1,777,309 | ) | $ | (1,715,972 | ) | $ | 43,634 |   |
|                                                                         |   |                          |       |   |   |   |   |
| **Adjustments to reconcile net loss to cash  used in operating activities:** |   |                          |       |   |   |   |   |
| Depreciation and amortization                                                |   | 566,764                       |       | 508,510 |   | 349,980 |   |
| Deferred taxes                                                               |   | —                        |       | 100,000 |   | (100,000 | ) |
| 401K common stock contribution                                               |   | 11,870                        |       | 20,362 |   | 4,750 |   |
| Allowance for uncollectible accounts                                         |   |                          |       | (14,000 | )  | — |   |
| Inventory reserve                                                            |   | 475,000                       |       |   |   |   |   |
| **Changes in assets and liabilities:**                                       |   |                          |       |   |   |   |   |
| Accounts receivable                                                          |   | 244,670                       |       | 268,132 |   | (58,344 | ) |
| Inventories                                                                  |   | (319,892                      | )          | 273,953 |   | (594,195 | ) |
| Unbilled contract costs                                                      |   | 149,774                       |       | 50,215 |   | 132,347 |   |
| Other current assets                                                         |   | 7,656                         |       | 59,691 |   | (78,059 | ) |
| Other assets                                                                 |   | 102,097                       |       | 3,329 |   | 117,876 |   |
| Accounts payable and accrued liabilities                                     |   | 255,987                       |       | (361,055 | ) | (287,929 | ) |
|                                                                         |   |                          |       |   |   |   |   |
| Total adjustments                                                            |   | 1,493,926                     |       | 909,137 |   | (513,574 | ) |
| **Net cash used in operating activities**                                    |   | (283,383                      | )          | (806,835 | ) | (469,940 | ) |
|                                                                         |   |                          |       |   |   |   |   |
| **Cash flows from investing activities:**                                    |   |                          |       |   |   |   |   |
| Capital expenditures                                                         |   | (101,045                      | )          | (553,556 | ) | (2,223,850 | ) |
| Net cash used for acquisition of business                                    |   | (183,780                      | )          | — |   | — |   |
|                                                                         |   |                          |       |   |   |   |   |
| **Net cash used in investing activities**                                    |   | (284,825                      | )          | (553,556 | ) | (2,223,850 | ) |
|                                                                         |   |                          |       |   |   |   |   |
| **Cash flows from financing activities:**                                    |   |                          |       |   |   |   |   |
| Proceeds from preferred stock                                                |   |                          |       |   |   | 220,000 |   |
| Proceeds from  notes payable                                            |   | 3,200,000                     |       | 2,125,991 |   | 750,000 |   |
| Proceeds from evercise of warrants and  options                              |   | —                        |       | — |   | 88,325 |   |
| Principal payments of notes payable                                          |   | (727,425                      | )          | (72,452 | ) | — |   |
| Principal payments of bank debt                                              |   | (1,678,623                    | )          | — |   | — |   |
| Principal payments of capital lease  obligations                             |   | (98,658                       | )          | (87,023 | ) | (49,464 | ) |
|                                                                         |   |                          |       |   |   |   |   |
| **Net cash   provided by financing activities**                         |   | 695,294                       |       | 1,966,516 |   | 1,008,861 |   |
|                                                                         |   |                          |       |   |   |   |   |
| **Net increase (decrease) in cash and cash  equivalents**                    |   | 127,086                       |       | 606,125 |   | (1,684,929 | ) |
|                                                                         |   |                          |       |   |   |   |   |
| **Cash and cash equivalents at beginning of  the year**                      |   | 1,155,074                     |       | 548,949 |   | 2,233,878 |   |
|                                                                         |   |                          |       |   |   |   |   |
| **Cash and cash equivalents at end of the  year**                            |   | $                             | 1,282,160  |   | $ | 1,155,074 |   | $ | 548,949 |   |

** **

SeeNotes to Consolidated Financial Statements

 

F-6

----

 

 

**PHOTONIC PRODUCTS GROUP, INC. ANDSUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**THREE YEARS ENDED DECEMBER 31, 2003**

 

**1.         Nature of Business and Summary ofSignificant Accounting Policies**

 

a.   Natureof Operations

 

PHOTONIC PRODUCTS GROUP, Inc. andSubsidiaries (the “Company”, formerly known as Inrad, Inc.) is a manufacturerof crystals, crystal devices, electro-optic and optical components, andsophisticated laser subsystems and instruments.  The Company’s principal customers include commercialinstrumentation 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 independentsales agents.

 

b.   Principlesof consolidation

 

The accompanying consolidated financialstatements include the accounts of the Company and its wholly-ownedSubsidiaries.  Upon consolidation, allintercompany accounts and transactions are eliminated.

c.   Allowancefor doubtful accounts

 

Management must make estimates of theuncollectability of accounts receivable. Management specifically analyzes accounts receivable and analyzeshistorical bad debts, customer concentrations, customer credit-worthiness,current economic trends and changes in customer payment terms when evaluatingthe adequacy of the allowance for doubtful accounts.

 

d.   Depreciationand amortization

 

Depreciation is computed using thestraight-line method over the estimated useful lives of the relatedassets.  Amortization of leaseholdimprovements is computed using the straight-line method over the estimateduseful lives of the related assets or the remaining term of the lease,whichever is shorter.  Maintenance andrepairs of property and equipment are charged to operations and majorimprovements are capitalized.  Uponretirement, sale or other disposition of property and equipment, the cost andaccumulated depreciation are eliminated from the accounts and gain or loss isincluded in operations.

 

e.   Inventories

 

Inventories, including certain preciousmetals consumed in the manufacturing process, are stated at the lower of cost(first-in, first-out method) or market.

 

f.    Incometaxes

 

Deferred tax assets and liabilities aredetermined based on differences between financial reporting and tax bases ofassets and liabilities, and are measured using the enacted tax rates and lawsthat will be in effect when the differences are expected to reverse. 

 

g.   Impairmentof long-lived assets

 

In accordance with SFAS No. 144, long-livedassets, such as property, plant and equipment and purchased intangibles subjectto amortization, are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable.  Recoverability of assetsto be held and used is measured by a comparison of the carrying amount of anasset to estimate undiscounted future cash flows expected to be generated bythe asset.  If the carrying amount of anasset exceeds its estimated future cash flows, and impairment charge isrecognized by the amount by which the carrying amount of the asset exceeds thefair value of

 

F-7

----

 

the assets. Assets to be disposed of would be separately presented in the balancesheet and reported at the lower of the carrying amount or fair value less coststo sell and are no longer depreciated. The assets and liabilities of a disposed group classified as held forsale would be presented separately in the appropriate asset and liability sectionsof the balance sheet.

 

Goodwill and intangible assets not subject toamortization are tested annually for impairment and are tested for impairmentmore frequently if events and circumstances indicate that the assets might beimpaired.  An impairment loss isrecognized to the extent that the carrying amount exceeds the asset’s fairvalue.

 

h.   Intangibleassets resulting from business acquisition

 

Intangible assets resulting from theCompany’s business acquisition principally consists of non-contractual customerrelationships that approximated $446,000. The intangible assets are amortized on a straight-line basis over theassets’ estimated useful life up to 14 years. The Company periodically evaluates whether events or circumstances haveoccurred indicating the carrying amount of intangible assets may not berecoverable.  When factors indicate thatintangible assets should be evaluated for possible impairment, the Company usesan estimate of the associated undiscounted future cash flows compared to therelated carrying amount of assets to determine if an impairment loss should berecognized.  

 

The gross carrying amount of intangibleassets as of December 31, 2003 was $446,000. Accumulated amortization related to intangible assets approximates$2,000 as of December 31, 2003. Amortization expense was approximately $2,000 for the year endedDecember 31, 2003.  Aggregateamortization for the five succeeding years ending December 31, 2004 throughDecember 31, 2009 approximates $32,000.

 

i.    Stock-basedcompensation

 

The Company accounts for stock-basedcompensation arrangements in accordance with the provisions of AccountingPrinciples Board (“APB”) Opinion No. 25, Accounting for Stock Issued toEmployees, and accounts for stock issued for services provided by other thanemployees in accordance with and complies with the disclosure provisions ofSFAS No. 123, Accounting for Stock-Based Compensation.  Under APB No. 25, compensation expense isbased on the difference, if any, on the date of the grant, between the fairvalue of the Company’s stock and the exercise price.  During December 2003, the Company issued all stock options atfair market value.  A new measurementdate for purposes of determining compensation is established when there is asubstantive change to the terms of an underlying option. 

 

 (ii)The Company has elected the disclosure-only provisions of Statement ofFinancial Accounting Standard No. 123, “Accounting for Stock-BasedCompensation” (“FASB 123”) in accounting for its employee stock options.  Accordingly, no compensation expense hasbeen recognized.  Had the Companyrecorded compensation expense for the stock options based on the fair value atthe grant date for awards, consistent with the provisions of FASB 123, theCompany’s net income (loss) and net income (loss) per share applicable tocommon shareholders would have changed to the following pro forma amounts:

 
|                     |   | **Years  Ended  December 31,** |       |
|--------------------------|--------|--------------------------------|------------|
|                     |   | **2003**                       |       | **2002** |   | **2001** |   |
| Net (loss) income:       |   |                           |       |   |   |   |   |
| As reported              |   | $                              | (1,830,909 | ) | $ | (1,836,572 | ) | $ | (111,366 | ) |
| Pro forma                |   | (1,907,464                     | )          | (2,188,584 | ) | (320,423 | ) |
|                     |   |                           |       |   |   |   |   |
| Income (loss) per share: |   |                           |       |   |   |   |   |
| Basic:                   |   |                           |       |   |   |   |   |
| As reported              |   | $                              | (.35       | ) | $ | (.35 | ) | $ | (.02 | ) |
| Pro forma                |   | (.36                           | )          | (.42 | ) | (.06 | ) |
|                     |   |                           |       |   |   |   |   |
| Diluted:                 |   |                           |       |   |   |   |   |
| As reported              |   | $                              | (.35       | ) | $ | (.35 | ) | $ | (.02 | ) |
| Pro forma                |   | (.36                           | )          | (.42 | ) | (.06 | ) |

 

The fair value of each option grant is estimated on the date of grantusing the Black-Scholes option-pricing model. The following range of weighted-average assumptions were used for grantsduring the years ended

 

F-8

----

 

December 31, 2003, 2002 and 2001:

 
|                    |   | **Years  Ended**  |   |
|-------------------------|--------|-------------------|--------|
|                    |   | **December  31,** |   |
|                    |   | **2003**          |   | **2002** |   | **2001** |   |
|                    |   |              |   |   |   |   |   |
| Dividend yield          |   | 0.00              | %      | 0.00 | % | 0.00 | % |
| Volatility              |   | 127.16            | %      | 128.11 | % | 168.67 | % |
| Risk-free interest rate |   | 5.2               | %      | 5.2 | % | 6.0 | % |
| Expected life           |   | 10 years          |   | 10 years |   | 10 years |   |

 

j.    Revenuerecognition

 

The company records revenue, other than onContract R&D, when the product is shipped. Revenues from sponsored researchand development are recorded using the percentage-of-completion method.  Under this method, revenues are recognizedbased on direct labor and other direct costs incurred compared with totalestimated direct costs.  ContractR&D costs include allocations of plant overhead and general and administrativecosts. Losses on contracts are recorded when identified.

 

k.   Internalresearch and development costs

 

Internal research and development costs arecharged to expense as incurred.

 

l.    Preciousmetals

 

Precious metals not consumed in the manufacturingprocess are valued at cost, cost being determined on the first-in, first-outbasis.

 

m.  Useof estimates

 

The preparation of financial statements inconformity with generally accepted accounting principles requires management tomake estimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period.  Actualamounts could differ from those estimates.

 

n.   Advertisingcosts

 

Advertising costs are charged to operationswhen the advertising first takes place. Included in selling, general and administrative expenses are advertisingcosts of $32,000, $62,000 and $45,000 for the years ended December 31, 2003,2002 and 2001.

 

o.   Statementsof cash flows

 

For purposes of the consolidated statementsof cash flows, the Company considers all highly liquid debt instrumentspurchased with a maturity of three months or less to be cash equivalents. 

 

Interest paid during the years ended December31, 2003, 2002 and 2001 was $114,946, $135,001 and $91,154, respectively.

 

Income taxes paid were $1,000 in 2003, $580in 2002, $16,756 in 2001.

 

p.   Concentrationof risk

 

The Company invests its excess cash indeposits and money market accounts with major financial institutions and incommercial paper of companies with strong credit ratings.  Generally, the investments mature withinninety days, and therefore, are subject to little risk.  The Company has not experienced lossesrelated to these investments.

 

The concentration of credit risk in theCompany’s accounts receivable is mitigated by the Company’s credit

 

F-9

----

 

evaluation process, reasonably shortcollection terms and the geographical dispersion of revenue.

 

The Company utilizes many relatively uncommonmaterials and compounds to manufacture its products.  Therefore, any failure by its suppliers to deliver materials ofan adequate quality and quantity could have an adverse effect on the Company’sability to meet the commitments of its customers.

 

q.   Net(loss) income per common share

 

The basic net (loss) income per share iscomputed using weighted average number of common shares outstanding for theapplicable period.  The diluted (loss)income per share is computed using the weighted average number of common sharesplus common equivalent shares outstanding, except if the effect on the pershare amounts, including equivalents, would be anti- dilutive.

 

r.    Shippingand handling costs

 

The Company has included freight out as acomponent of selling, general and administrative expenses that amounted to$26,643 in 2003, $30,242 in 2002 and $42,675 in 2001.

 

s.   Recentlyissued accounting pronouncements

 

In November 2002, the FASB issued FASBInterpretation (FIN) No. 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers, an interpretation of FASB Statements No. 5, 57 and 107 and Rescissionof FASB Interpretation No. 34”.  FIN 45elaborates on the existing disclosure requirements for most guarantees,including loan guarantees such as standby letters of credit and warrantyobligations. It also clarifies that at the time a company issues a guarantee, acompany must recognize an initial liability for the fair value of theobligations it assumes under that guarantee and must disclose that informationin its interim and annual financial statements. The provisions of FIN 45relating to initial recognition and measurement must be applied on aprospective basis to guarantees issued or modified after December 31, 2002. Theadoption of the initial recognition and measurement provisions did not have asignificant impact on the Company’s financial condition or results ofoperations. The disclosure requirements of FIN 45 were effective for bothinterim and annual periods that end after December 15, 2002.  The adoption of FIN No. 45 did not have amaterial impact on the Company’s consolidated financial statements.

 

The Financial Accounting Standards Board(FASB) issued interpretation No. 46 (FIN 46), “Consolidation of VariableInterest Entities,” in January 2003, and amended the Interpretation in December2003.  FIN 46 requires an investor witha majority of the variable interests (primary beneficiary) in a variableinterest entity (VIE) to consolidate the entity and also requires majority andsignificant variable interest investors to provide certain disclosures.  A VIE is an entity in which the votingequity investors do not have a financial controlling interest, or the equityinvestment at risk, is sufficient to finance the entity’s activities withoutreceiving additional subordinated financial support from the other parties.  Development-stage entities that havesufficient equity invested to finance the activities they are currently engagedin and entities that are businesses, as defined in the Interpretation, are notconsidered VIE’s.  The provisions of FIN.46 were effective immediately for all arrangements entered into with new VIE’screated after January 31, 2003. The adoption of FIN No. 46 did not have amaterial impact on the Company’s consolidated financial statements.

 

In April 2003, the FASB issued SFAS No. 149,“Amendment of Statement 133 on Derivative Instruments and HedgingActivities”.  This Statementclarifies  accounting and reporting forderivative instruments, including certain embedded derivatives, and for hedgingactivities under SFAS No. 133.  SFAS No.149 is effective for contracts entered into or modified after June 30, 2003 andfor hedging relationships designated after June 30, 2003. The guidance shouldbe applied prospectively.  The adoptionof SFAS No. 149 did not have a material impact on the Company’s consolidatedfinancial statements.

 

In May 2003, the FASB issued SFAS No. 150,“Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity”. This Statement was developed to respond to concernsexpressed by users of financial statements about issuers’ classification in thestatement of financial position of certain financial instruments that havecharacteristics of both liabilities and equity but that have been presentedeither entirely as equity or between the liabilities section and the equitysection of the statement of financial position “mezzanine equity”). ThisStatement also addresses questions about the classification of certainfinancial instruments that embody obligations to issue equity shares.  SFAS No. 150 aims to eliminate diversity inpractice by requiring certain

 

F-10

----

 

types of “freestanding” financialinstruments, such as mandatorily redeemable instruments, to be reported asliabilities.  Preferred dividends onthese instruments are now classified as interest expense. Retroactivereclassification of amounts reported in historical financial statements forperiods prior to the effective date of SFAS No. 150 is not permitted. Theprovisions of SFAS No. 150, which also include a number of new disclosurerequirements, was effective for instruments entered into or modified after May31, 2003 and pre-existing instruments as of the beginning of the first interimperiod that commenced after June 15, 2003. 

 

F-11

----

 

**2.         Inventories**

Inventories are comprised of the following:

 
|                                                          |   | **December  31,** |      |
|---------------------------------------------------------------|--------|-------------------|-----------|
|                                                          |   | **2003**          |      | **2002** |   |
|                                                          |   |              |      |   |   |
| Raw materials                                                 |   | $                 | 543,116   |   | $ | 379,838 |   |
| Work in process, including manufactured  parts and components |   | 1,275,000         |      | 1,510,890 |   |
| Finished goods                                                |   | 401,000           |      | 192,204 |   |
|                                                          |   | $                 | 2,219,116 |   | $ | 2,082,932 |   |

 

**3.         Property and Equipment**

Property and equipment are comprised of the following:

 
|                                            |   | **December  31,** |      |
|-------------------------------------------------|--------|-------------------|-----------|
|                                            |   | **2003**          |      | **2002** |   |
|                                            |   |              |      |   |   |
| Office and computer equipment                   |   | $                 | 919,725   |   | $ | 863,603 |   |
| Machinery and equipment                         |   | 7,544,364         |      | 7,106,236 |   |
| Leasehold improvements                          |   | 1,360,409         |      | 1,337,914 |   |
|                                            |   | 9,824,498         |      | 9,307,753 |   |
| Less accumulated depreciation and  amortization |   | 6,572,278         |      | 6,008,008 |   |
|                                            |   | $                 | 3,252,220 |   | $ | 3,299,745 |   |

 

**4.         Bank Loans**

 

In January 2002, the Company repaid its obligation with its bank andentered into a new agreement with another bank.  This agreement provided for a $1,000,000 Line of Credit at thebank’s prime rate, and a $1,000,000 Asset Based Loan at 5.61%.  

 

In January 2003, the Company was in violation of certain financialcovenants required under the loan agreements the Bank agreed to extend the loans through March 2003.  As a result of the violations of the covenantsall bank debt had been classified as a current liability in 2002.  

 

In June 2003, the Bank sold the then outstanding loans aggregatingapproximately $1,680,000 to a third party who demanded payment due to defaultof certain financial covenants contained in the loan documents.  In June 2003, the Company received$1,700,000 from a major Shareholder and Debt Holder of the Company.  The proceeds of the note were used to paythe outstanding bank debt.  The note issecured by the assets of the Company. The note bears interest at the rate of 6%per annum and is due January 2005.

 

**5.         SubordinatedConvertible Promissory Note**

 

In 2003, the Company issued a SubordinatedConvertible Promissory Note for proceeds of $1,500,000.  The note was amended in 2004 to clarify itsconversion features.  The Holder of theNote is a major Shareholder and Debt Holder of the Company.  The note bears interest at the rate of 6%per annum and has a maturity date of January 31, 2006.  The note is convertible into common shares(and/or securities convertible into common shares) of the Company at aconversion price that shall be (a) the price at which common stock (orsecurities convertible into common stock) is first issued for cash after thedate of the Note to an unrelated third party investor or (b) the price mutuallyagreed upon by the Issuer and Holder at its then fair market value if no suchissuance has occurred within 12 months of December 31, 2003, the date of theNote.****

** **

In 2002, the Company issued a Subordinated Convertible Promissory Notefor proceeds of $1,000,000.  The notewas amended in 2004 to clarify its conversion features.  The Holder of the Note is a related party toa major Shareholder of the Company.  Thenote bears interest at the rate of 6% per annum and has a maturity date ofJanuary

 

F-12

----

 

31, 2006.  The note is convertible into common shares(and/or securities convertible into common shares) of the Company at aconversion price that shall be (a) the price at which common stock (orsecurities convertible into common stock) is first issued for cash after thedate of the Note to an unrelated third party investor or (b) the price mutuallyagreed upon by the Issuer and Holder at its then fair market value if no suchissuance has occurred within 24 months of December 31, 2002, the date of the Note.

 

**6.         Notes Payable Other**

 

At the time of the purchase of Laser Optics, Inc., the Companyconverted certain liabilities to notes payable.  Notes totaling $100,728 were issued to former officers of LaserOptics, Inc. for back pay and unreimbursed business expenses.  These notes are for a three year period andcarry an interest rate defined as the prime rate in the United States aspublished in the Wall Street Journal. A note in the amount of $86,777 wasissued to the former landlord for back rent. It is a 36-month note with an interest rate of 2% per annum.  At the time of the closing a former officerof Laser Optics, Inc. received a $15,000 prepayment on his note. All notebalances are payable monthly commencing January 2004.

 

Notes payable other consist of the following:

 
|                                                                                                                                                                                     |   | **December  31,** |    |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|---------|
|                                                                                                                                                                                     |   | **2003**          |    | **2002** |   |
| Notes payable, payable in aggregate monthly  installments of $5,017, including interest at rates ranging from 2.0% to  prime (4% at December 31, 2003) expiring   in November 2006, |   | $                 | 185,020 |   | $ | — |   |
| Less current portion                                                                                                                                                                     |   | 68,292            |    | — |   |
|                                                                                                                                                                                     |   |              |    |   |   |
| Long-term debt, excluding current portion                                                                                                                                                |   | $                 | 116,728 |   | $ | — |   |

 

Notes payable other, mature as follows:

 
| 2004   |   | $      | 68,292  |   |
|--------|--------|--------|---------|--------|
| 2005   |   | 57,490 |    |
| 2006   |   | 59,238 |    |
|   |   | $      | 185,020 |   |

 

**7.         Accounts Payable and AccruedExpenses**

** **

Accounts payable and accrued expenses are comprised of the following:

 
|                                          |   | **December  31,** |    |
|-----------------------------------------------|--------|-------------------|---------|
|                                          |   | **2003**          |    | **2002** |   |
|                                          |   |              |    |   |   |
| Trade accounts payable and accrued  purchases |   | $                 | 318,090 |   | $ | 131,903 |   |
| Accrued vacation                              |   | 251,794           |    | 79,017 |   |
| Accrued payroll                               |   | 92,391            |    | 100,267 |   |
| Accrued interest                              |   | 156,000           |    |   |   |
| Accrued relocation costs                      |   | 107,000           |    |   |   |
| Accrued expenses - other                      |   | 67,875            |    | 57,150 |   |
|                                          |   |              |    |   |   |
|                                          |   | $                 | 993,150 |   | $ | 368,337 |   |

 

**8.         Capital Leases**

** **

Capital leases consist of the following:

 
|                                                                                                                                                                                              |   | **December  31,** |    |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|---------|
|                                                                                                                                                                                              |   | **2003**          |    | **2002** |   |
| Capital leases, payable in aggregate  monthly installments of $10,000, including interest at rates ranging from  11.0% to 11.6% expiring  through  October 2005, collateralized by equipment |   | $                 | 188,512 |   | $ | 287,169 |   |
| Less current portion                                                                                                                                                                              |   | 99,664            |    | 98,657 |   |
|                                                                                                                                                                                              |   |              |    |   |   |
| Long-term debt, excluding current portion                                                                                                                                                         |   | $                 | 88,848  |   | $ | 188,512 |   |

 

Maturities of capital leases are as follows:

 
| **Year Ending**                    |   |    |    |
|------------------------------------|--------|---------|---------|
| **December 31,**                   |   |    |    |
| 2004                               |   | 124,543 |    |
| 2005                               |   | 95,477  |    |
|                               |   |    |    |
| Total minimum payments             |   | 220,020 |    |
| Less amounts representing interest |   | 31,508  |    |
|                               |   |    |    |
| Present value of minimum payments  |   | $       | 188,512 |   |
|                                    |        |         |         |  |

 

F-13

----

 

Capital lease obligations are collateralized by property and equipmentwith cost and related accumulated depreciation approximating $415,000 and $134,000respectively at December 31, 2003.

 

**9.         Income Taxes**

** **

A reconciliation of the income tax (benefit) computed at the statutoryFederal income tax rate to the reported amount follows:

 
|                                                |   | **Year Ended  December 31,** |      |
|-----------------------------------------------------|--------|------------------------------|-----------|
|                                                |   | **2003**                     |      | **2002** |   | **2001** |   |
|                                                |   |                         |      |   |   |   |   |
| Federal statutory rate                              |   | 34                           | %         | 34 | % | 34 | % |
| Tax provision (benefit) at Federal  statutory rates |   | $                            | (604,255  | ) | $ | (549,233 | ) | $ | 14,836 |   |
| Loss in excess of available benefit                 |   | 604,255                      |      | 549,233 |   | — |   |
| Change in valuation allowance                       |   | —                       |      | 100,000 |   | (114,836 | ) |
| State taxes                                         |   | (134,235                     | )         | 580 |   | 16,756 |   |
|                                                |   |                         |      |   |   |   |   |
|                                                |   | $                            | (134,235) |   | $ | 100,580 |   | $ | (83,244 | ) |

 

At December 31, 2003, the Company has Federaland State net operating loss carryforwards for tax purposes of approximately$8,814,000 and $1,497,000, respectively. The tax loss carryforwards expire at various dates through 2023.

 

The State of New Jersey has enacted a programthat allows new or emerging technology and biotechnology businesses to selltheir unused Net Operating Loss (NOL) carryover to any corporation for at least75% of the value of the tax benefits. In 2003, the Company sold $1,767,783 of their NOL for $135,235.

 

Internal Revenue Code Section 382 places alimitation on the utilization of Federal net operating loss and other creditcarryforwards when an ownership change, as defined by the tax law, occurs.  Generally, this occurs when a greater than50 percentage point change in ownership occurs.  Accordingly, the actual utilization of the net operating loss andcarryfowards for tax purposes may be limited annually to a percentage(approximately 6%) of the fair market value of the Company at the time of anysuch ownership change.

 

F-14

----

 

The provision (benefit) for income taxesconsists of the following:

 
|                                                       |   | **Years Ended**   |     |
|------------------------------------------------------------|--------|-------------------|----------|
|                                                       |   | **December  31,** |     |
|                                                       |   | **2003**          |     | **2002** |   | **2001** |   |
|                                                       |   |              |     |   |   |   |   |
| Current:                                                   |   |              |     |   |   |   |   |
| State                                                      |   | $                 | (134,235 | ) | $ | 580 |   | $ | 16,756 |   |
| Deferred:                                                  |   |              |     |   |   |   |   |
| Federal                                                    |   | —            |     | 100,000 |   | (100,000 | ) |
| State                                                      |   | —            |     | — |   | — |   |
|                                                       |   |              |     |   |   |   |   |
| Total                                                      |   | $                 | (134,235 | ) | $ | 100,580 |   | $ | (83,244 | ) |
|                                                       |   |              |     |   |   |   |   |
| Deferred tax assets (liabilities) comprise  the following: |   |              |     |   |   |   |   |
|                                                       |   |              |     |   |   |   |   |
|                                                       |   |              |     | **December 31,** |   |
|                                                       |   |              |     | **2003** |   | **2002** |   |
|                                                       |   |              |     |   |   |   |   |
| Inventory reserves                                         |   |              |     | $ | 240,000 |   | $ | 50,000 |   |
| Vacation liabilities                                       |   |              |     | 101,000 |   | 32,000 |   |
| Other                                                      |   |              |     | 32,000 |   | 83,000 |   |
| Depreciation                                               |   |              |     | (21,000 | ) | (3,000 | ) |
| Loss carryforwards                                         |   |              |     | 2,996,000 |   | 2,500,000 |   |
| Gross deferred tax assets                                  |   |              |     | 3,348,000 |   | 2,662,000 |   |
| Valuation allowance                                        |   |              |     | (3,348,000 | ) | (2,662,000 | ) |
|                                                       |   |              |     | $ | — |   | $ | — |   |

 

**10.          Related Party Transactions**

 

During theyears ended December 31, 2003, 2002 and 2001 approximately 3%, 4%, and 3%,respectively of the Company’s net product sales were through a foreign agent,in which Warren Ruderman, a principal shareholder has an investment.  Terms of sales to this foreign agent weresubstantially the same as to unrelated foreign agents.

 

During 2003Clarex, LTD. A shareowner and debt holder received a 6% Secured Promissory Notefor $1,700,000 due December 2005.  InOctober 2003 Clarex, LTD received a $1,500,000, 6% Convertible Promissory Notedue January 2006.

 

During 2002,Welland Ltd., a related party to Clarex, Ltd., received a 6% SubordinatedConvertible Promissory Note due January 31, 2006, resulting in proceeds to theCompany of $1,000,000.

 

**11.      Commitments**

** **

a.     Lease commitment

 

PPGI occupies approximately 31,000 squarefeet of space located at 181 Legrand Avenue, Northvale, New Jersey pursuant toa net lease expiring on October 31, 2006. PPGI has an option to renew the Northvale lease for an additional termof five years.  In November 2003, theCompany exercised its option to lease 11,000 square feet of additionaladjoining space in the same building, bringing the total square feet of spaceoccupied by PPGI in Northvale, New Jersey to 42,000 square feet.  Laser Optics Holdings, Inc., a subsidiary ofthe Company, acquired the rights to lease 8,000 square feet of space in Bethel,CT, formerly occupied by Laser Optics, Inc., upon the acquisition of LaserOptics, Inc.  This lease expires in May2004, and the Company has the right to renew the lease on a month-by-monthbasis, at its sole option, for three months. The Company does not plan to renew the lease, and it intends to vacatethe premises upon the expiration of such lease in May 2004 and relocate the facilityto Northvale, NJ.  Rental expense wasapproximately $238,000, $224,000 and $212,000 in 2003, 2002 and 2001,respectively, and real estate taxes were $48,000, $41,000 and $39,000 in 2003,20021 and 2001, respectively.

 

F-15

----

 

Future minimumannual rentals are payable as follows:

 
| **Year Ending**  |   |   |    |
|------------------|--------|--------|---------|
| **December 31,** |   |   |    |
| 2004             |   | $      | 304,000 |   |
| 2005             |   | $      | 315,000 |   |
| 2006             |   | $      | 325,000 |   |

 

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 from 1% to 15% of their compensation on asalary reduction, pre-tax basis.  The401(k) plan also provides that the Company, at the discretion of the Board ofDirectors, may match employee contributions. The Company contributed $12,945 in the form of 25,891 shares of theCompany’s common stock in 2003, distributed in March 2004. The Companycontributed $11,870 in the form of 28,263 shares of the Company’s common stockin 2002, distributed in March 2003 

 

c.     Employment agreements

 

The Company is party to an employment agreement with an officer thatprovides for a minimum annual salary. The aggregate minimum commitment underthis agreement is as follows:

 
| **Year Ending**  |   |   |    |
|------------------|--------|--------|---------|
| **December 31,** |   |   |    |
| 2004             |   | $      | 175,000 |   |
| 2005             |   | $      | 175,000 |   |
| 2006             |   | $      | 175,000 |   |
| 2007             |   | $      | 175,000 |   |
| 2008             |   | $      | 175,000 |   |

 

Should the agreement be terminated withoutcause during the term of the contract, the officer would be entitled to oneyear’s salary.

 

**12.      Product Sales, Foreign Sales and Salesto Major Customers**

** **

The Company’s sales for each major category of its product line are asfollows:

 
|               |   | **2003**  |            | **2002** |   | **2001**  |   |
|--------------------|--------|-----------|-----------------|----------|--------|-----------|--------|
| **Category**       |   | **Sales** |            | **%**    |   | **Sales** |   | **%** |   | **Sales** |   | **%** |   |
| Optical Components |   | $         | 4,469,000       |     | 83     |      | $      | 4,325,905 |   | 79 |   | $ | 6,035,049 |   | 77 |   |
| Laser Accessories  |   | 893,000   |            | 17       |   | 1,155,816 |   | 21 |   | 1,850,988 |   | 23 |   |
| TOTAL              |   | $         | 5,362,000  |     | 100    |      | $      | 5,481,721 |   | 100 |   | $ | 7,886,037 |   | 100 |   |

 

Export sales, primarily to approximatelysixteen customers in six countries within Europe, Asia and Canada, amounted to19%, 19% and 31% of net product sales in 2003, 2002 and 2001, respectively.

 

No foreign customer accounted for more than10% of product sales in 2003 or 2002. One foreign customer accounted for 10.7% of product sales in 2001.  In 2003, two U.S. customers accounted for16.0% and 10.0% of total sales.  In 2002one U.S. customer accounted for 13.4% of total sales.  One U.S. customer accounted for 17.7% of total sales in 2001.

 

**13.      Shareholders’ Equity**

** **

            a.     Common shares reserved

 

F-16

----

 

Common sharesreserved at December 31, 2003, are as follows:

 
| 1991 Stock option plan         |   | 314,500   |   |
|--------------------------------|--------|-----------|--------|
| 2000 Stock option plan         |   | 4,000,000 |   |
| Convertible preferred stock    |   | 1,340,000 |   |
| Subordinated convertible notes |   | 5,380,952 |   |

 

b.     Preferred stock

 

The Company has authorized 1,000,000 sharesof preferred stock, no par value, which the Board of Directors has theauthority to issue from time to time in a series.  The Board of Directors also has the authority to fix, before theissuance of each series, the number of shares in each series and thedesignation, preferences, rights and limitations of each series.

 

For the years ended December 31, 2003, 2002 and 2001, the Company paida common stock dividend on preferred stock equal to  $54,000, $121,000 and $155,000, respectively.

 

c.     Stock options

 

The Company has adopted two stock optionplans that provide for the granting of options to employees, officers,directors, and others who render services to the Company.  Under these plans in the aggregate, options topurchase no more than 4,500,000 shares of common stock may be granted, at aprice that may not be less than the fair market value per share.

 

Under the 1991 Stock Option Plan the Companymay grant options to purchase up to 500,000 shares of Common Stock to its officers,key employees and other who render services to the Company.  The 1991 Stock Option Plan expired inDecember 2001.

 

The Equity Compensation Program authorizes the issuance of incentivestock options. At the annual Shareholders’ meeting held in 2003, shareholders’approved a recommendation by the Board to increase the number of options to begranted under the 2000 Equity Compensation Program, from 1,500,000 to4,000,000.    The 2000 equitycompensation plan expires in August 2010.

 

A summary of the status of the Company’s program as of December 31,2003, 2002 and 2001, and changes during the years then ended is presentedbelow:

 
|                                                         |   | **Years  Ended  December 31,** |       |
|--------------------------------------------------------------|--------|--------------------------------|------------|
|                                                         |   | **2003**                       |       | **2002** |   | **2001** |   |
|                                                         |   |                           |       | **Weighted** |   |   |   | **Weighted** |   |   |   | **Weighted** |   |
|                                                         |   |                           |       | **Average** |   |   |   | **Average** |   |   |   | **Average** |   |
|                                                         |   |                           | ** ** | **Exercise** | ** ** |   | ** ** | **Exercise** | ** ** |   | ** ** | **Exercise** | ** ** |
| **Fixed Stock Options**                                      |   | **Shares**                     |       | **Price** |   | **Shares** |   | **Price** |   | **Shares** |   | **Price** |   |
| Outstanding, beginning of year                               |   | 1,173,800                      |       | $ | 1.69 |   | 698,600 |   | $ | 2.20 |   | 729,500 |   | $ | 1.96 |   |
| Granted                                                      |   | 299,900                        |       | 0.50 |   | 475,200 |   | 0.94 |   | 289,700 |   | 4.97 |   |
| Exercised                                                    |   | —                         |       | — |   | — |   | — |   | (29,250 | ) | 1.05 |   |
| Expired                                                      |   | —                         |       | — |   | — |   | — |   | (15,500 | ) | 1.25 |   |
| Forfeited                                                    |   | (24,600                        | )          | 2.26 |   | — |   | — |   | (276,350 | ) | 1.90 |   |
| Outstanding, end of year                                     |   | 1,449,100                      |       | 1.42 |   | 1,173,800 |   | 1.69 |   | 698,600 |   | 2.20 |   |
| Options exercisable, end of year                             |   | 881,424                        |       | 1.88 |   | 402,163 |   | .98 |   | 242,650 |   | 1.70 |   |
| Weighted-average fair values of options  granted during year |   |                           |       | $ | .48 |   |   |   |   |   | $ | .91 |   | $ | 4.97 |   |
|                                                              |        |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-17

----

 

The following table summarizes information about stock optionsoutstanding at December 31, 2003:

 
|               |   | **Options  Outstanding** |   | **Options  Exercisable** |   |
|--------------------|--------|--------------------------|--------|--------------------------|--------|
|               |   |                     |   | **Weighted**             |   |   |   |   |   |   |   |
|               |   |                     |   | **Average**              |   | **Weighted** |   |   |   | **Weighted** |   |
|               |   |                     |   | **Remaining**            |   | **Average** |   |   |   | **Average** |   |
| **Range of**       |   | **Number**               |   | **Contractual**          |   | **Exercise** |   | **Number** |   | **Exercise** |   |
| **Exercise Price** |   | **Outstanding**          |   | **Life**                 |   | **Price** |   | **Outstanding** |   | **Price** |   |
| $0.50 -  $2.00     |   | 1,292,000                |   | 8.59 yrs.                |   | $ | 1.14 |   | 724,324 |   | $ | 1.48 |   |
| $3.00 -  $5.00     |   | 157,100                  |   | 7.27 yrs.                |   | $ | 3.72 |   | 157,100 |   | $ | 3.72 |   |

 

d.     Warrants

 

In 2001, warrants were exercised resulting innet proceeds to the Company of $57,200.

 

F-18

----

 

e.     Income per common share

 

A reconciliation of income from continuing operations andbasic todiluted share amounts is presented below.

 
|                                                              |   | **Years  Ended  December 31,** |       |
|-------------------------------------------------------------------|--------|--------------------------------|------------|
|                                                              |   | **2003**                       |       | **2002** |   | **2001** |   |
|                                                              |   |                           |       | **Average** |   |   |   | **Average** |   |   |   | **Average** |   |
|                                                              |   | **(Loss)**                     |       | **Shares** |   | **(Loss)** |   | **Shares** |   | **Income** |   | **Shares** |   |
| (Loss) income before preferred dividends                          |   | $                              | (1,777,309 | ) |   |   | $ | (1,715,972 | ) |   |   | $ | 43,634 |   |   |   |
|                                                              |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Less: preferred stock dividends                                   |   | (53,600                        | )          |   |   | (120,600 | ) |   |   | (155,000 | ) |   |   |
| Basic:                                                            |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Available to common shareholders                                  |   | (1,830,909                     | )          | 5,287,849 |   | (1,836,572 | ) | 5,210,322 |   | (111,366 | ) | 5,046,666 |   |
| Dilutive effect of convertible preferred  stock and stock options |   | —                         |       | — |   | — |   | — |   | — |   | — |   |
| Diluted:                                                          |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Available to common shareowners and assumed  conversions          |   | $                              | (1,830,909 | ) | 5,287,849 |   | $ | (1,836,572 | ) | 5,608,513 |   | $ | (111,366 | ) | 5,046,666 |   |

 

**14.      Fair Value of Financial Instruments**

 

The methods and assumptions used to estimatethe fair value of the following classes of financial instruments were:

 

*Current Assets and Current Liabilities:*  The carrying amount of cash, currentreceivables and payables and certain other short-term financial instrumentsapproximate their fair value. 

 

*Long-Term Debt:*  The fair value of the Company’s long-termdebt, including the current portion, for notes payable and subordinatedconvertible debentures, was estimated using a discounted cash flow analysis,based on the Company’s assumed incremental borrowing rates for similar types ofborrowing arrangements.  The carryingamount of variable and fixed rate debt at December 31, 2003 approximates fairvalue.

 

**15.      Quarterly Data** (Unaudited)

 

Summary quarterly results were as follows:

 
| **Year 2003**                      |   | **First** |      | **Second** |      | **Third** |      | **Fourth** |      |
|------------------------------------|--------|-----------|-----------|------------|-----------|-----------|-----------|------------|-----------|
| Net sales                          |   | $         | 1,200,853 |       | 1,147,117 |      | 1,405,663 |       | 1,634,551 |   |
| Gross profit                       |   | 279,963   |      | 201,856    |      | 285,690   |      | 228,552    |      |
| Net (loss)                         |   | (357,857  | )         | (491,787   | )         | (380,473  | )         | (600,792   | )         |
| Net income per share - Basic (a)   |   | (0.07     | )         | (0.09      | )         | (0.07     | )         | (0.11      | )         |
| Net income per share - Diluted (a) |   | (0.07     | )         | (0.09      | )         | (0.07     | )         | (0.11      | )         |
|                               |   |      |      |       |      |      |      |       |      |
| **Year 2002**                      |   | **First** |      | **Second** |      | **Third** |      | **Fourth** |      |
| Net sales                          |   | $         | 1,220,465 |       | 1,685,964 |      | 1,344,569 |       | 1,318,120 |   |
| Gross profit                       |   | 46,599    |      | 425,675    |      | 237,553   |      | 196,691    |      |
| Net (loss)                         |   | (476,688  | )         | (322,209   | )         | (409,056  | )         | (628,619   | )         |
| Net income per share - Basic (a)   |   | (0.09     | )         | (0.06      | )         | (0.08     | )         | (0.12      | )         |
| Net income per share - Diluted (a) |   | (0.09     | )         | (0.06      | )         | (0.08     | )         | (0.12      | )         |

 

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(a)          Quarterlyincome per share amounts may not total to the annual amounts due to changes inweighted-average shares outstanding during the year.

 

F-19

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**16.      Special Charges**

** **

During 2003 the Company accrued certainexpenses related to the relocation of 17 employees from Bethel, CT to itsfacility in Northvale, NJ.  The specialcharges accrued amounted to $107,000 ($.02 per share on a basic and dilutedbasis) and included the costs for permanent relocation, stay on bonuses andrelocation bonuses, anticipated to be expended in the next fiscal year.

 

During 2003 the Company determined that therewas excess inventory, relative to forecasted future needs, of certain crystalsand solutions.  Based on thisdetermination, a reserve was taken in the amount of $475,000 ($.09 per share ona basic and diluted basis) in order to recognize the diminished future economicbenefit of the inventory.

 

At the end of 2000, the Company announced aprocess engineering redesign program to formalize production operations, andimprove profitability through margin improvement.  The special charges associated with this program were $299,763($.06 per share on a basic and diluted basis) for the year ended December 31,2001. 

 

**17.****                               Acquisitions**

 

In November 2003, the Company acquired the assets and liabilities ofLaser Optics, Inc.  an opticalmanufacturing and thin films coating operation.  Capital assets along with the employees of Laser optics, Inc,will be relocated from Bethel, CT to the Company’s facility in Northvale, NJduring the second quarter of 2004.

 

The assets acquired and liabilities assumed were recorded at estimatedfair values as determined by the Company’s management based on informationcurrently available and on current assumptions as to future operations.  The Company has obtained independentappraisals of the fair values of the acquired property, plant & equipment.A summary of the assets acquired and liabilities assumed in the acquisitionfollows:

 
| Estimated fair values      |   |       |    |
|----------------------------|--------|------------|---------|
| Assets acquired            |   | $          | 894,725 |   |
| Liabilities assumed        |   | (1,158,422 | )       |
| Intangible assets acquired |   | 446,000    |    |
| Net assets acquired        |   | $          | 182,303 |   |

 

As a result of the acquisition, the Company plans to incur integrationexpenses for the incremental costs to consolidate activities at the Northvale,NJ location.  Generally acceptedaccounting principles require that integration expenses that are associatedwith future revenues and have future economic benefit must be expensed asincurred.  See footnote 15.

 

F-20

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