**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**Washington,D. C. 20549**

 

**FORM 10-K**

 

| **(Mark One)**                                                                                                                                                                                                                                                |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                                                                    |
| **ý**                                                                                                                                                                                                                                                    | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                          |
| **For  the fiscal year ended: December 31, 2005**                                                                                                                                                                                                             |
|                                                                                                                                                                                                                                                          |
| **OR**                                                                                                                                                                                                                                                        |
| ** **                                                                                                                                                                                                                                                    |
| **o**                                                                                                                                                                                                                                                         | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                                                                    |   |
| **For  the transition period from                   to                      ** |
|                                                                                                                                                                                                                                                          |
| **Commission  file number: 0-11668**                                                                                                                                                                                                                          |

 

**Photonic Products Group, Inc.**

(Exactname of registrant as specified in its charter)

 

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

 

Registrant’s telephonenumber, including area code  **201-767-1910**

 

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

 

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

 

Securities registeredpursuant to section 12(g) of the Act:

**Commonstock, par value $.01 Per Share**

 

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

 

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) of theAct.  Yes  o.      No ý.

 

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

 

Indicate by check mark whether the registrant (1)has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.

 

| ** ** | ** ** |   | Yes | ý | No | o |
|------------|------------|--------|-----|--------|----|---|

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K(§ 229.405 of this chapter) is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K orany amendment to this Form 10-K. ý

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of accelerated filer and largeaccelerated filer in Rule 12b2 of the Exchange Act. (Check one):

 

| Large accelerated filer  o |   | Accelerated  filer   o |   | Non-accelerated  filer  ý |
|--------------------------------------|--------|---------------------------------------|--------|------------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

 

| ** ** | ** ** |   | Yes | o | No | ý |
|------------|------------|--------|-----|---|----|--------|

 

State the aggregate marketvalue of the voting and non-voting common equity held by non-affiliatescomputed by reference to the price at which the common equity was last sold, orthe average bid and asked price of such common equity, as of the last businessday of the registrant’s most recently completed second fiscal quarter.$3,657,500

 

**Note.**If adetermination as to whether a particular person or entity is an affiliatecannot be made without involving unreasonable effort and expense, the aggregatemarket value of the common stock held by non-affiliates may be calculated onthe basis of assumptions reasonable under the circumstances, provided that theassumptions are set forth in this Form.

 

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

 

CommonShares outstanding as of March 25, 2006

[7,433,634]

 

 

----

 

Photonic Products Group, Inc.

 

INDEX

 
| **Part I**   |       |                                                                                                                |   |
|--------------|------------|---------------------------------------------------------------------------------------------------------------------|--------|
|         |       |                                                                                                                |   |
| Item 1.      |       | Business                                                                                                            |   |
|         |       |                                                                                                                |   |
| Item 1A.     |       | Risk Factors                                                                                                        |   |
|         |       |                                                                                                                |   |
| Item 1B.     |       | Unresolved Staff Comments                                                                                           |   |
|         |       |                                                                                                                |   |
| 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 and Issuer Purchased Equity  Securities |   |
|         |       |                                                                                                                |   |
| 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                                                                                             |   |
|         |       |                                                                                                                |   |
| Item 9B      |       | Other Information                                                                                                   |   |
|         |       |                                                                                                                |   |
| **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 and Financial  Statement Schedules                                                                         |   |
|         |       |                                                                                                                |   |
| Signatures   |       |

 

Note: Page F-1 follows Page 48.

 

----

 

#### **PARTI**

 

##### **Caution Regarding Forward Looking Statements**

 

This Annual Report containsforward-looking statements as that term is defined in the federal securitieslaws.  The Company wishes to insure thatany forward-looking statements are accompanied by meaningful cautionarystatements in order to comply with the terms of the safe harbor provided by thePrivate 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 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 to identifyforward-looking statements.  The Companycautions you that these statements are not guarantees of future performance orevents and are subject to a number of uncertainties, risks, and otherinfluences, many of which are beyond the Company’s control, that may influencethe accuracy of the statements and the projections upon which the statementsare based.  Factors which may affect theCompany’s results include, but are not limited to, the risks and uncertaintiesdiscussed in Items 1A, 7 and 7A.  Any oneor more of these uncertainties, risks, and other influences could materiallyaffect the Company’s results of operations and whether forward-lookingstatements made by the Company ultimately prove to be accurate.  Readers are further cautioned that theCompany’s financial results can vary from quarter to quarter, and the financialresults for any period may not necessarily be indicative of futureresults.  The foregoing is not intendedto be an exhaustive list of all factors that could cause actual results todiffer materially from those expressed in forward-looking statements made bythe Company.  The Company’s actualresults, performance and achievements could differ materially from thoseexpressed or implied in these forward-looking statements.  The Company undertakes no obligation topublicly update or revise any forward looking statements, whether from newinformation, future events, or otherwise.

 

The following discussion and analysisshould be read in conjunction with the Company’s consolidated financialstatements and the notes thereto presented elsewhere herein.  The discussion of results should not beconstrued to imply any conclusion that such results will necessarily continuein the future.

 

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

 

Photonic Products Group, Inc. (the “Company” or “PPGI”), incorporated in1973, develops, manufactures and markets products and services for use indiverse Photonics industry sectors via its multiple business units.  Prior to its name change in September, 2003,PPGI was named and did business solely as Inrad, Inc.

 

The Company had announced in 2002 that it was implementing its plan totransform the Company from a single business unit into a portfolio ofbusinesses serving the Photonics industry. Company management, the Board of Directors, and shareholders approvedthe name change in 2003, reinforcing the transformation of the Company’sbusiness model into that of a portfolio of business units whose brandedproducts conform to the paradigm: Products Enabling PhotonicsTM.

 

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

 

1

----

 

In October 2004 the Company completed itssecond acquisition of a complementary business with the purchase of 100% of thestock of MRC Precision Metal Optics, Inc. of Sarasota, FL.  MRC Optics, now a wholly-owned subsidiary ofPPGI, is a fully integrated precision metal optics and diamond-turned asphericoptics manufacturer, specializing in CNC and single point diamond machining,optical polishing, plating, beryllium machining, and opto-mechanical design andassembly services.

 

PPGI’s business units’ products continue,at present, to fall into two product categories: optical components (includingstandard and custom optical components and assemblies, crystals, and crystalcomponents), and laser accessories (including wavelength conversion productsand Pockel’s Cells (optical shutters) that employ nonlinear crystals to performthe function of wavelength conversion). Currently, its optical components product lines and services are broughtto market via three PPGI business units: INRAD, Laser Optics, and MRCOptics.  Laser accessories are brought tomarket by INRAD.

 

In summary, the Company is at present an optical component, subassembly,and sub-system supplier to major original equipment manufacturers andresearchers in the Photonics industry. PPGI expectsthat in the future its products may also include other product categories.

 

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

 

Custom optic manufacturing is at present a major product area forPPGI.  The Company specializes inhigh-end precision components.  Itdevelops, manufactures and delivers precision custom optics and thin filmoptical coating services via its Laser Optics and MRC Precision Optics brandedbusiness units.  Glass, metal, andcrystal substrates are processed using modern manufacturing equipment andtechniques to prepare and polish substrates, deposit optical thin films, andassemble sub-components, thereby producing optical components used in advancedPhotonic systems of many kinds.  Themajority of custom optical components and optical coating services supplied areused in inspection and process control systems, in defense and aerospaceelectro-optical systems, in laser system applications, in industrial scanners,and in medical system applications.

 

The Company also currently develops, manufactures, and delivers syntheticoptical crystals, optical crystal components, and laser accessories via itsINRAD brand.  It grows synthetic crystalswith electro-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 systems, defense EO systems, and in R&Dapplications by researchers within corporations, universities, and nationallaboratories.

 

The Company has been implementing itsplan to assemble a portfolio of businesses serving the Photonics industry, andis engaged from time to time in exploratory strategic merger and acquisitiondiscussions.  The Company is also engagedfrom time to time in discussions regarding the raising of capital to financeits growth. The Company’s policy is to not comment on such exploratorydiscussions, due to their indefinite nature.

 

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

 
| ** **           | ** ** | **Years Ended December 31,** | ** ** |
|----------------------|------------|------------------------------|------------|
| ** **           | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Category**         | ** ** | **Sales**                    | ** ** | **%** | ** ** | **Sales** | ** ** | **%** | ** ** | **Sales** | ** ** | **%** | ** ** |
| Optical  Components* |       | $                            | 12,279,000 |   | 89 |   | $ | 7,877,000 |   | 85 |   | $ | 4,469,000 |   | 83 |   |
| Laser  Accessories   |       | 1,506,000                    |       | 11 |   | 1,345,000 |   | 15 |   | 893,000 |   | 17 |   |
| TOTAL**              |       | $                            | 13,785,000 |   | 100 |   | $ | 9,222,000 |   | 100 |   | $ | 5,362,000 |   | 100 |   |

 

2

----

 

----

* a)  2003 Optical Componentsales included $78,000 from operations acquired from Laser Optics, Inc.

   b)  2004 OpticalComponent sales include $901,000 from the Company’s new MRC Optics subsidiary.

 **   Not included above are(non-product) contract R&D sales of approximately $26,000 in 2003.

 

# **ProductsManufactured by the Company**

 

# **OpticalComponents**

 

# a)  CustomOptics and Optical Coating Services

 

Manufacturing of high-performance customoptics is at present a major product area for PPGI, and is addressed in themarketplace principally via its Laser Optics and its MRC Optics business units.

 

The Laser Optics business unit was formedin 2003 via the combination of INRAD’s Northvale, NJ based custom optics andoptical coating services operations and those of the former Laser Optics, Inc.of Bethel, CT.  The Company had beenactive in the field since 1973, and Laser Optics, Inc. since 1966.

 

The “new” Laser Optics provides customproducts.  It specializes in themanufacture of optical components, optical coatings (ultra-violet wavelengthsthrough infra-red wavelengths) and subassemblies for military, industrial,process control, photonic instrument, and medical end-use.  Planar, prismatic and spherical componentsare fabricated from glasses of all kinds and crystals of most kinds, includingfused silica, quartz, infra-red materials (including germanium, zinc selenideand zinc sulfide), calcite, magnesium fluoride and silicon.  Component types include mirrors, lenses,prisms, waveplates, polarizing optics, monochrometers, x-ray mirrors, andcavity optics for lasers.

 

To meet performance requirements, mostoptical components and sub-assemblies require thin film coatings on theirsurfaces.  Depending on the design,optical coatings can refract, reflect, or transmit specific wavelengths.  Laser Optics coating service specialtiesinclude high laser damage resistance, infra-red, polarizing, high reflective,anti-reflective, and coating to complex custom requirements on a wide range ofsubstrate materials.  Laser Optics bothcoats customer furnished components and components it manufactures.  Coating deposition process technologiesemployed included electron beam, thermal, and ion assist.

 

MRC Optics, established in1983 is a fully integrated precision metal optics and optical assemblymanufacturer.  The Company provides highquality precision CNC and diamond machining, polishing, plating, berylliummachining, and opto-mechanical design and assembly services. MRC has developedcustom processes to support prototypes through high rate production quantitiesof large flat mirrors, thermally stable optical mirrors***,***reflective porroprisms, low RMS surface finish polished mirrors, diamond machined and precisionaspheric and plano mirrors, and arc-second accuracy polygons and motorassemblies.  Optical plating specialtiesinclude void-free gold and electroless nickel.

 

###### **b)  Crystals and Crystal Components**

 

PPGI produces and brings to marketcrystals and crystal components via its INRAD business unit.  Certain synthetic crystals, because of theirinternal structure, have unique optical, non-linear, or electro-opticalproperties.  Electro-optic and nonlinearcrystal devices can alter the intensity, polarization or wavelength of a laserbeam.  Developing growth processes forhigh quality synthetic crystals and manufacturing and design processes forcrystal components lies at the heart of the INRAD product line.  Synthetic crystals currently in productioninclude Nickel Sulfate, Lithium Niobate, Beta Barium Borate, Alpha BariumBorate, KDP, deuterated KDP and Zinc Germanium Phosphide, among others.

 

The INRAD crystals and crystal componentsproduct lines also include crystalline filter materials,

 

3

----

 

includingpatent protected materials, that have unique transmission and absorptioncharacteristics that enable them to be used in critical applications in defensesystems such as missile warning sensors. Other crystal components, both standard and custom, are used in laserapplications research and in commercial laser systems to change the wavelengthof laser light.

 

INRAD has developed and manufactures aline of Q-switches, Pockels Cells (optical shutters) and associatedelectronics, and has been active in this field since 1973.  Pockels cells are used in applications thatrequire the fast switching of the polarization direction of a beam oflight.  These uses include Q-switching oflaser cavities (i.e., to generate laser output pulses), coupling light into andout from regenerative amplifiers, and light intensity modulation.  These devices are sold on an OEM basis tolaser manufacturers and individually to researchers.

 

INRAD Pockels Cell products include thefollowing:

 

•                  Singlecrystal and dual crystal KD*P Pockels Cells

•                  PKC-21 andPKC-02

•                  9 mm through50 mm apertures

•                   Singlecrystal Lithium Niobate Pockels Cells

•                  PLC-01

•                  8.5 mmthrough 10.5 mm apertures

•                  Singlecrystal and dual crystal BBO Pockels Cells

•                  PBC-03

•                  2.5 mm x 2.5mm through 2.5 mm x 7 mm sizes

•                  Electronicdrivers

•                  Gimbalmounts

 

**Laser Accessories**

 

PPGI designs, manufactures, and brings tomarket a line of harmonic generation laser accessories via its INRAD businessunit.

 

a)  HarmonicGeneration Systems 

 

Harmonic generation systems enable theusers of lasers to convert the fundamental frequency of the laser to anotherfrequency required for a specific end use. Harmonic generators are currently used in spectroscopy, semiconductor processing,medical lasers, optical data storage and scientific research.

 

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

 

Products offered for such nano-secondlaser systems include the following:

 

•                  AT-III – anAutotracker with servo controlled tuning

 

•                  5-304 –temperature-stabilized crystals

 

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

 

The Company produces a HarmonicGenerator, the 5-050, for use with ultra-fast lasers having pulsewidths in thefemtosecond and picosecond regime.  Thisproduct is sold on an OEM basis to manufacturers of ultra fast lasers and toresearchers in the scientific community.

 

4

----

 

b)  LaserPulse Measurement Instruments

 

The Company marketed, through December 31,2005, a line of Autocorrelators that measure extremely short laser pulses.  Autocorrelatorsare used for measuring laser pulses from ultrafast lasers, with pulse durationsin the picosecond and femtosecond ranges. INRAD had pioneered the design,manufacture, and introduction of autocorrelators as accessories for theemerging field of ultrafast lasers back in 1979. In 2000, INRAD joined forceswith AngewandtePhysik & Electronik, GmbH of Berlin, Germany, (A.P.E.)and became the source for supply of products manufactured by A.P.E. to customersin the Americas, Israel, and selected other markets. Effective January 1, 2006,the Company and A.P.E. ended their alliance in this field.  At the present time the Company does notoffer Autocorrelators for sale in the market place.

 

# **Research and Development**

 

Company-funded research expendituresduring the years ended December 31, 2005, 2004, and 2003 were $20,000, $98,000,and $154,000, 0.4%, 1.1%, and 2.9% of net product sales, respectively.

 

During 2005and 2004, the Company narrowed its focus of internal research and developmentefforts onto improving certain crystal growth processes, and on improvingmanufacturing process technologies for optical components.  Technical resources were focused onsupporting the integration of Laser Optics into Northvale operations andramp-up of production rates within Northvale operations and Sarasotaoperations.  As a result, internalR&D expenditures were at historically low levels in 2005 and 2004.

 

# **Markets**

 

In 2005, 2004 and 2003 the Company’sproduct sales were made to customers in the following market areas:

 
| **Market**                               | ** ** | **2005**      | ** **      | **2004**      | ** ** | **2003**       | ** ** |
|------------------------------------------|------------|---------------|-----------------|---------------|------------|----------------|------------|
| Defense/Aerospace                        |       | $             | 8,352,000 (60   | )%            | $          | 4,127,000 (45  | )%         | $ | 2,321,000 (43 | )% |
| Process control & metrology          |       | 3,259,000 (24 | )%              | 1,817,000 (20 | )%         | 844,000 (16    | )%         |
| Laser systems (non-military)             |       | 1,044,000 (8  | )%              | 1,753,000 (19 | )%         | 1,066,000 (20  | )%         |
| Universities & National laboratories |       | 522,000 (4    | )%              | 763,000 (8    | )%         | 641,000 (11    | )%         |
| Other                                    |       | 608,000 (4    | )%              | 662,000 (8    | )%         | 516,000 (9     | )%         |
| Total                                    |       | $             | 13,785,000 (100 | )%            | $          | 9,222,000 (100 | )%         | $ | 5,388,000 (100 | )% |
|                                          |            |               |                 |               |            |                |            |  |  |  |  |  |  |

 

Major marketsectors served by the Company include defense/aerospace, process control &metrology, laser systems (non-military), telecomm, universities and nationallaboratories, and various other markets not separately classified.  The “defense/aerospace” area consists ofsales to OEM defense systems and subsystems manufacturers, manufacturers ofnon-military satellite-based systems and subsystems, and direct sales togovernments where the products have the same end-use.  The “process control and metrology” areaconsists of customers who are OEM manufacturers of capital equipment used inmanufacturing and quality assurance, such as in semiconductor (i.e., chip)fabrication and testing.  The “lasersystems” market area consists principally of customers who are OEMmanufacturers of industrial, medical, and R&D lasers.  “Universities and National Laboratories” consistsof product sales to researchers.  The “Other”category represents sales to market areas that, while they may be the object ofpenetration plans by the Company, are not currently large enough to listindividually, and as well sales

 

5

----

 

through third partiesfor whom the end-use sector is not known.

 

The Company is a provider of opticalcomponents, both specialty crystal components and high precision custom opticalcomponents for customers in the aerospace and defense electro-optical systemssector.  End-use applications includemilitary laser systems, military electro-optical systems, satellite-basedsystems, and missile warning sensors and systems intended to protectaircraft.  The dollar volume of shipmentsof product within this sector depends in large measure on the U.S. DefenseDepartment budget and its priorities, that of foreign governments, the timingof their release of contracts to their prime equipment and systems contractors,and the timing of competitive awards from this customer community to theCompany.  In the post-9/11 era,government spending priorities for such systems have risen sharply anddeployment of new systems has been accelerated, as has refurbishment of fieldedsystems.  The Company’s sales of productsto this customer sector continued their upward trend in 2005, increasing by 102%in dollar terms in 2005 from 2004, to 60% of total Company sales.  The defense and aerospace sector offerscontinued opportunities for the Company’s capabilities in precision optics.

 

Demand in the Process Control andMetrology (semiconductor tools) market for the Company’s products rebounded in2004 from a protracted and deep cyclical downturn in capital spending for newtools and instruments in 2002 and 2003. Sales in 2005 increased 79% over sales in 2004, representing 24% oftotal Company sales.  The optical andx-ray inspection segment of the semiconductor industry offers continuedopportunities for the Company’s capabilities in precision optics, crystalproducts, and monochrometers.

 

The Company serves the laser industry asan OEM supplier of standard and custom optical components and laser accessories.Within the Laser Systems customer sector, sales in 2005 declined 40% from salesin 2004, representing 8% of total revenues and reflecting a return to 2003sales levels. Sales in 2004 had been up 64% from the prior year on a surge ofdemand from both old and new customers for the Company’s laser accessoryproducts. The Company continues to seek to acquire complementary products tobroaden its laser accessory and laser optical components product lines.

 

Sales to customers within the Universityand National Laboratories market sector decreased in 2005, now representing 4%of total revenues.  Sales to this sectorhave been in the $500,000 to $750,000 range historically, now representing asmaller percentage of total revenues.

 

Export sales, primarily to customers incountries within Europe, the Near East and Japan, amounted to 14%, 12%, 19% ofproduct sales in 2005, 2004 and 2003, respectively.  No foreign customer accounted for more than10% of product sales in 2005, 2004, or 2003.

 

In 2005, two U.S. customers accounted for13% and 14%, respectively, of sales. The two customers are each divisions ofdefense industry prime contractors who manufacture electro-optical systemsunder multi-year production contracts for the U.S. and allied foreign governments.In 2004, the two U.S. customers each accounted for 12% of sales, and onecustomer accounted for 10% of sales.   The latter customer manufactures process control and metrologysystems.  In the short-term the loss of anyof these customers would have a significant negative impact on the company andits business units.  In 2003, one U.S.customer accounted for 16% of total sales, and one U.S. customer accounted for10% of total sales.  Both customers aredefense industry prime contractors who manufacture electro-optical systemsunder multi-year production contracts for the U.S. and foreign governments.

 

# **Long-Term Contracts**

 

Certain of the Company’s orders fromcustomers provide for periodic deliveries at fixed prices over a period thatmay be greater than one year.  In suchcases, as in most other cases as well, the Company attempts to obtain firmprice commitments from its suppliers for the materials necessary to fulfill theorder.

 

6

----

 

# **Marketing and Business Development**

 

The Company’s two Northvale, NJ-basedbusiness units market their products domestically through their own sales andmarketing teams, led by the Vice President - Marketing and Sales.  Independent sales agents are used in countriesin major non-U.S. markets, including Canada, Europe, the Near East and Japanand domestically in the west coast region of the USA.

 

The Company’s MRC Optics subsidiarymarkets its products domestically through their own sales and marketing team,led by the MRC Vice President of Marketing and Business Development

 

Trade show participation andInternet-based marketing and promotion are coordinated at the Corporate level.

 

**Backlog**

 

The Company’s order backlog as ofDecember 31, 2005 was $7,857,000, more than 95% of which is shippable duringfiscal year 2006.  The Company’s orderbacklog as of December 31, 2004 was $6,433,000. The Company’s order backlog as of December 31, 2003 was $2,286,000.

 

# **Competition**

 

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

 

Changes in the Photonics industry havehad an effect on suppliers of custom optics. As end users have introduced products requiring large volumes of opticalcomponents, suppliers have responded either by carving out niche product areasor by ramping up their own manufacturing capacity and modernizing theirmanufacturing methods to meet higher volume run rates.  Many custom optics manufacturers lackin-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.

 

Competition for the Company’s systems islimited, but competitors’ products are generally lower priced.  The Company’s systems are considered to behigh end and generally offer a combination of features not availableelsewhere.  Because of the Company’sin-house crystal growth capability, the Company’s staff is knowledgeable aboutmatching appropriate crystals to given applications.

 

For thecrystal product area, price, 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.  On manyoccasions, the quality of the crystal component drives the ultimate performanceof 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 price is the principal factor inmany product categories, competition is also based on product design, productperformance, customer confidence, quality, delivery, and customer service.  The Company is a sole-source supplier ofproducts to many major customers. Based on its performance to date, the Companybelieves that it can continue to compete successfully, although no assurancescan be given in this regard.

 

7

----

 

# **Employees**

 

As of December 31, 2005, the Company had102 full-time employees.

 

# **Patentsand Licenses**

 

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

 

# **Regulation**

 

Foreign sales of certain of the Company’sproducts may require export licenses from the United States Department ofCommerce or Department of State.  Suchlicenses are generally available to all but a limited number of countries andare obtained when necessary.  Oneproduct, representing less than 1% of Company sales in 2005 and 2004, and lessthan 4% of Company sales in 2003, required U.S. State Department exportapproval and the required approvals were granted.

 

There are no federal regulations nor anyunusual state regulations that directly affect the sale of the Company’sproducts other than those environmental compliance regulations that generallyaffect companies engaged in manufacturing operations in New Jersey and Florida.

 

# **Item 1A. Risk Factors**

 

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

 

The Company’s business is significantlydependent on the demand its customers experience for their products.  Many of their end users are in industriesthat historically have experienced a cyclical demand for their products, Theindustries include but are not limited to, the defense electro-optics industryand the manufacturers of process control capital equipment for the semiconductortools industry, As a result, demand for the Company’s products and itsfinancial results of operations are subject to cyclical fluctuations.

 

b)  TheCompany faces competition

 

The Company encounters substantialcompetition from other companies positioned to serve the same market sectorsthat the Company serves.  Somecompetitors may have financial, technical, capacity, marketing or otherresources more extensive than ours, or may be able to respond more quickly thanthe Company can to new or emerging technologies and other competitivepressures.  Some competitors havemanufacturing operations in low-cost labor regions such as the far-east andeastern-Europe and can offer products at lower price than the Company.  The Company may not be successful in winningorders against the Company’s present or future competitors.

 

c)  Asgeneral economic 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.

 

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

 

The Company’s existing business and itsexpansion plans depend on the expertise, experience,

 

8

----

 

andcontinuing services of certain scientists, engineers, production and managementpersonnel, and on the Company’s ability to recruit additional personnel.  There is competition for the services ofthese personnel, and there is no assurance that the Company will be able toretain or attract the personnel necessary for its success, despite the Company’seffort to do so.  The loss of theservices of the Company’s key personnel could have a material adverse affect onits business, on its results of operations, or on its financial results.

 

e)  The Company has incurred operating losses fortwo of the past three years and net losses for each of the past three years

 

The Company had income from operations of$358,000 in 2005 but had sustained operating losses of $(410,000) in 2004, and$(1,654,000) in 2003.  Net losses for the3 years were $(11,000) in 2005, $(673,000) in 2004 and $(1,777,000) in 2003. TheCompany has been following a strategy of growing via acquisition into aportfolio of Photonics businesses, and in this period had required capital bothto fund working capital needs and to acquire businesses.  The Company borrowed $1,000,000 via asubordinated convertible note to a major investor in December 2002 providingworking capital during this period, and borrowed $2,500,000 million via asubordinated convertible note to finance acquisitions.  Additionally, the Company has long-term debtin the form of a secured promissory note in the amount of $1,700,000 as well toa major investor, and the Company raised over $1,170,000 via a privateplacement of stock in 2004. The Company cannot establish lending lines frombanking institutions at this time due to its prior net losses, absent a longerrecent history of profitable fiscal quarters. In December 2005, the Companyinitiated a financing arrangement with a major shareholder and debt holder inthe amount of $700,000 to fund acquisition of capital assets needed to absorbgrowth opportunities. The funds were received in February 2006.

 

If the Company continues to sustainlosses, the Company would be put at risk, since there are no assurances that theCompany would be able to obtain additional financing it would require tocontinue to implement growth-by-acquisition or to supply the working capitalneeds of its existing operations.

 

f)  The Company may not succeed in acquiringcomplementary businesses or in integrating acquired businesses

 

The Company’s business strategy includesexpanding its production capacities, product lines and market reach throughboth internal growth and acquisition of complementary businesses.  The Company may not succeed in finding orcompleting acquisitions of such businesses, nor can the Company be assured thatit will be able to raise the financial capital needed for such acquisitions.  Acquisitions may result in substantial pershare financial dilution of the Company’s Common Stock from the issuance ofequity securities.  They may also resultin the taking on of debt and contingent liabilities, and amortization expensesrelated to intangible assets acquired, any of which could have a materialadverse affect on the Company’s business, financial condition or results ofoperations.  Also, acquired businessesmay be experiencing operating losses. Any acquisition will involve numerous risks, including difficulties inthe assimilation 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 limitedexperience in acquiring or integrating businesses.

 

g)  The Company depends on, but may not succeedin, developing and acquiring new products and****processes

 

In order to meet the Company’s strategicobjectives, the Company must continue to develop, manufacture and market newproducts, and to develop new processes and to improve existing processes.  As a result, the Company expects to continueto make investments in research and development and to

 

9

----

 

continueto consider from time to time the strategic acquisition of businesses,products, or technologies complementary to the Company’s business.  There can be no assurance that the Companywill be able to develop and introduce new products or enhancements to itsexisting products and processes in a way that achieves market acceptance orother pertinent targeted results.  Norcan the Company be sure that it will be successful in acquiring complementarybusinesses, products, or technologies.  Norcan there be assurance that the Company will have the human or financialresources to pursue or succeed in such activitites.

 

h)  The Company’s operations may be adverselyaffected if it fails to keep pace with industry developments

 

The Company serves industries and marketsectors which will be affected by future technological developments.  The introduction of products or processesutilizing new developments could render the Company’s existing products orprocesses obsolete or unmarketable.  TheCompany’s continued success will depend upon its ability to develop andintroduce on a timely and cost-effective basis new products, processes, andmanufacturing capabilities that keep pace with developments and addressincreasingly sophisticated customer requirements.

 

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

 

TheCompany utilizes many relatively uncommon materials and compounds tomanufacture its products.  Examplesinclude optical grade quartz, specialty optical glasses, scarce natural andmanmade crystals, and high purity chemical compounds.  Failure of the Company’s suppliers to deliversufficient quantities of these necessary materials on a timely basis, or todeliver contaminated or inferior quality materials, or to markedly increasetheir prices could have an adverse effect on the Company’s business, despiteits efforts to secure long term commitments from the Company’s suppliers.  Adverse results might include reducing theCompany’s ability to meet commitments to its customers, compromising theCompany’s relationship with its customers, adversely affecting the Company’sability to meet expanding demand for its products, or causing the Company’sfinancial results to deteriorate.

 

j)  Product yield problems and product defectsthat are not detected until products are in service could increase the Company’scosts and/or reduce its revenues

 

Changesin the Company’s own or in its suppliers’ manufacturing processes, or the useof defective or contaminated materials by the Company, could result in anadverse effect on its ability to achieve acceptable manufacturing yields,delivery performance, 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)  International sales account for a significantportion of revenues

 

Sales to customers in countries otherthan the United States accounted for approximately 14%, 12% and 19% of revenuesduring the years ended December 31, 2005, 2004, and 2003, 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.

 

10

----

 

l)  TheCompany may not be able to fully protect its intellectual property

 

The Company does not currently hold anymaterial patents applicable to its most important products or manufacturingprocesses.  The Company relies on acombination of trade secret and employee non-competition and nondisclosureagreements to protect its intellectual property rights.  There can be no assurance that the steps theCompany takes will be adequate to prevent misappropriation of the Company’stechnology.  In addition, there can be noassurance that, in the future, third parties will not assert infringementclaims against the Company.  Assertingthe Company’s rights or defending against third-party claims could involvesubstantial expense, thus materially and adversely affecting the Company’sbusiness, results of operations or financial condition.

 

m) The Company’s stock price may fluctuate widely

 

Many factors, including, but not limitedto, future announcements concerning the Company, its competitors or customers,as well as quarterly variations in operating results, announcements oftechnological innovations, seasonal or other variations in anticipated oractual results of operations, changes in earnings estimates by analysts orreports regarding the Company’s industries in the financial press or investmentadvisory publications, could cause the market price of the Company’s stock tofluctuate substantially.  In addition,the Company’s stock price may fluctuate widely for reasons which may beunrelated to operating results.  Thesefluctuations, as well as general economic, political and market conditions suchas recessions, military conflicts, or market or market-sector declines, maymaterially and adversely affect the market price of the Company’s Common Stock. In addition, any information concerningthe Company, including projections of future operating results, appearing ininvestment advisory publications or on-line bulletin boards or otherwiseemanating from a source other than the Company could in the future contributeto volatility in the market price of the Company’s Common Stock.

 

Item1B.                  Unresolved StaffComments

 

There were no unresolved Staff commentsas of March 15, 2006.

 

**Item2.                    Properties**

 

Administrative, engineering andmanufacturing operations are housed at present in a 42,000 square foot buildinglocated in Northvale and in a 25,000 square foot building located in Sarasota,FL.  The headquarters of the Company arelocated within its Northvale, NJ facility.

 

PPGI, INRAD and Laser Optics occupy approximately42,000 square feet of space located at 181 Legrand Avenue, Northvale, NewJersey pursuant to a net lease expiring on October 31, 2006.  PPGI has an option to renew the Northvalelease for an additional term of five years. In November 2003, the Company exercised its option to lease 11,000square feet of additional adjoining space in the same building, which broughtthe total square feet of leased space occupied by PPGI in Northvale, New Jerseyto its present 42,000 square feet.  In2003, Laser Optics Holdings, Inc., a Subsidiary of the Company, acquired therights to the lease of 8,000 square feet of space in Bethel, CT, formerlyoccupied by Laser Optics, Inc., upon purchase of the assets of Laser Optics,Inc.  This lease expired in May of 2004 coincidentwith the Company’s vacating that facility and relocating the assets of LaserOptics, Inc. to its Northvale operations center.

 

PPGI’s MRC Optics subsidiary occupiesapproximately 25,000 square feet of space located at 6405 Parkland Drive,Sarasota, FL pursuant to a net lease expiring on August 31, 2006.  MRC Optics has negotiated terms for renewalof that lease, an offer from the landlord is in-hand and is under managementreview.

 

The facilities are adequate to meetcurrent and future projected production requirements.

 

The total rent in 2005 for these leaseswas approximately $525,000.  The Companyalso paid real

 

11

----

 

estate taxes andinsurance premiums that totaled approximately $95,000 in 2005.

 

**Item 3.**                    **Legal Proceedings**

 

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

 

**Item 4.                    Submissionof Matters to a Vote of Security Holders**

 

Not Applicable.

 

12

----

 

**PART II**

 

**Item 5.**                    **Market for Registrant’s Common Equity and RelatedStockholder Matters**

 

a)  Market Information

 

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

 

The following table sets forth the rangeof closing prices for the Company’s Common Stock in each fiscal quarter fromthe quarter ended March 31, 2004 through the quarter ended December 31, 2005,as reported by the National Association of Securities Dealers NASDAQSystem.  Such over-the-counter quotationsreflect inter-dealer prices, without retail mark-up, mark-down or commissionand may not necessarily represent actual transactions.

 
| ** **                        | ** ** | **Price** | ** ** |
|-----------------------------------|------------|-----------|------------|
| ** **                        | ** ** | **High**  | ** ** | **Low** | ** ** |
|                              |       |      |       |   |   |
| Quarter  ended December 31, 2005  |       | 1.45      |       | .90 |   |
|                              |       |      |       |   |   |
| Quarter  ended September 30, 2005 |       | 0.98      |       | .75 |   |
|                              |       |      |       |   |   |
| Quarter  ended June 30, 2005      |       | 1.00      |       | .65 |   |
|                              |       |      |       |   |   |
| Quarter  ended March 31, 2005     |       | 1.40      |       | 1.05 |   |
|                              |       |      |       |   |   |
| Quarter  ended December 31, 2004  |       | 1.60      |       | .70 |   |
|                              |       |      |       |   |   |
| Quarter  ended September 30, 2004 |       | 1.50      |       | .65 |   |
|                              |       |      |       |   |   |
| Quarter  ended June 30, 2004      |       | 2.00      |       | .46 |   |
|                              |       |      |       |   |   |
| Quarter  ended March 31, 2004     |       | .65       |       | .37 |   |

 

As of March 21, 2006 the Company’s stockprice was $1.25 per share.

 

b)  Shareholders

 

As of March 24, 2006, therewere approximately 230 owners of record of the Common Stock.  The number of record owners of common stockwas approximated based upon the Shareholders’ Listing provided by the Company’sTransfer Agent.

 

c)  Dividends

 

The Company did not pay any cashdividends on its Common Stock during the years ended December 31, 2005, 2004and 2003.  The Company paid a dividend of134,000 shares of Common Stock on its Series A and Series B convertiblepreferred stock in 2005, valued at $134,000. The Company paid a dividend of 134,000 shares of Common Stock on itsSeries A and Series B convertible preferred stock in 2004, valued at$165,000.  The Company paid a dividend of134,000 shares of Common Stock on its Series A and Series B convertiblepreferred stock in 2003, valued at $54,000. Payment of cash dividends will beat the discretion of the Company’s Board of Directors and will depend, amongother factors, upon the earnings, capital requirements, operations andfinancial condition of the Company.  TheCompany does not anticipate paying cash dividends in the immediate future.

 

d)  Recent Sales of Unregistered Securities andRegistration of Securities

 

There were no sales of unregisteredsecurities, nor were any sales of securities registered during 2005.

 

13

----

 

**Item 6.**                    **Selected Financial Data**

 

The following data is qualified in itsentirety by the financial statements presented elsewhere in this Annual Reporton Form 10-K.

 
| ** **                                           | ** ** | **As of December 31, or**           | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|-------------------------------------|------------|------------|------------|------------|------------|
| ** **                                           | ** ** | **For the Year Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                           | ** ** | **2005**                            | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002** | ** ** | **2001** | ** ** |
|                                                 |       |                                |       |       |       |       |       |   |   |   |   |
| Revenues                                             |       | $                                   | 13,785,057 |       | $          | 9,221,857  |       | $ | 5,388,184 |   | $ | 5,569,118 |   | $ | 8,075,205 |   |
| Net (loss)  profit                                   |       | (11,398                             | )          | (672,937   | )          | (1,777,309 | )          | (1,715,972 | ) | 43,634 |   |
|                                                 |       |                                |       |       |       |       |       |   |   |   |   |
| Net (loss)  profit applicable to common shareholders |       |                                |       |       |       |       |       |   |   |   |   |
| Basic                                                |       | (.02                                | )          | (.15       | )          | (.35       | )          | (.35 | ) | (.02 | ) |
| Diluted                                              |       | (.02                                | )          | (.15       | )          | (.35       | )          | (.35 | ) | (.02 | ) |
|                                                 |       |                                |       |       |       |       |       |   |   |   |   |
| Weighted  average shares                             |       |                                |       |       |       |       |       |   |   |   |   |
| Basic                                                |       | 7,218,244                           |       | 5,710,354  |       | 5,287,849  |       | 5,210,322 |   | 5,046,666 |   |
| Diluted                                              |       | 7,218,244                           |       | 5,710,354  |       | 5,287,849  |       | 5,210,322 |   | 5,046,666 |   |
| Dividends  paid                                      |       | 134,000                             |       | 164,820    |       | 53,600     |       | 120,600 |   | 155,000 |   |
| Total assets                                         |       | 13,481,021                          |       | 13,526,634 |       | 8,851,121  |       | 8,508,925 |   | 8,599,072 |   |
| Long-term  obligations                               |       | 5,963,411                           |       | 6,459,088  |       | 4,405,576  |       | 1,188,512 |   | 287,170 |   |
| Shareholders’  equity                           |       | 3,929,407                           |       | 3,965,129  |       | 3,284,439  |       | 5,049,879 |   | 6,745,489 |   |
|                                                      |            |                                     |            |            |            |            |            |  |  |  |  |  |  |  |  |  |

 

TheCompany completed the acquisition of the stock of MRC Precision Metal Optics,Inc. in mid-October 2004.  Also, theCompany completed the acquisition of Laser Optics, Inc.’s assets andliabilities at the end of November 2003. The comparability of information in the selected financial data is aidedby details provided in the management discussion, which attribute certainportions of revenue growth in 2004 to these two acquisitions.

 

**Item 7.**                    **Management’s Discussion and Analysis of FinancialCondition and Results of Operation**

 

##### **Critical Accounting Policies**

 

The Company’s significant accountingpolices are described in Note 1 of the consolidated financial statements, thatwere prepared in accordance with accounting principles generally accepted inthe United States of America.  Inpreparing the Company’s financial statements, the Company made estimates andjudgments that affect the results of its operations and the value of assets andliabilities the Company reports.  TheCompany’s actual results may differ from these estimates.

 

The Company believes that the followingsummarizes critical accounting polices that require significant judgments andestimates in the preparation of the Company’s consolidated financialstatements.

 

RevenueRecognition

 

The Company records revenue when aproduct is shipped.  Losses on contractsare recorded when identified. The Company, from time to time, may recognizerevenue using the percentage of completion method for certain long termmanufacturing projects.  No revenues in2005 were accounted for using the percentage of completion method.

 

14

----

 

AccountsReceivable

 

The Company records an allowance fordoubtful accounts receivable as a charge against earnings for revenue for itemsthat have been reviewed and carry a risk of non-collection in the future.  The Company has not experienced anon-collection of accounts receivable materially affecting the results ofoperations.

 

Inventory

 

The Company records a reserve for slowmoving inventory as a charge against earnings for all products on hand thathave not been sold to customers in the past twelve months.  An additional reserve is recorded for producton hand that may not be sold to customers within the upcoming twelve months.

 

From time to time, estimated costs arerecorded as a charge against earnings based on known circumstances where it isprobable that a manufacturing cost over run has been incurred or is expected tobe incurred and the amount can be reasonably estimated.

 

##### **Resultsof Operations**

 

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

 
| ** **           | ** ** | **Years Ended December 31** | ** ** |
|----------------------|------------|-----------------------------|------------|
| ** **           | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Category**         | ** ** | **Sales**                   | ** ** | **%** | ** ** | **Sales** | ** ** | **%** | ** ** | **Sales** | ** ** | **%** | ** ** |
| Optical  Components* |       | $                           | 12,279,000 |   | 89 |   | $ | 7,877,000 |   | 85 |   | $ | 4,469.000 |   | 83 |   |
| Laser  Accessories   |       | 1,506,000                   |       | 11 |   | 1,345,000 |   | 15 |   | 898,000 |   | 17 |   |
| TOTAL**              |       | $                           | 13,785,000 |   | 100 |   | $ | 9,222,000 |   | 100 |   | $ | 5,367,000 |   | 100 |   |
|                      |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

* a)  2003 Optical Componentsales included $78,000 from operations acquired from Laser Optics, Inc.

   b)  2004 OpticalComponent sales include $901,000 from the Company’s new MRC Optics subsidiary.

 **   Not included aboveare (non-product) contract R&D sales of approximately $26,000 in 2003.

 

The following table setsforth, for the past three years, the percentage relationship of statement ofoperations categories to total revenues.

 
| ** **                                    | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                     |       |                                        |       |   |   |   |   |
| Product sales                                 |       | 100.0                                       | %          | 100.0 | % | 100.0 | % |
| Costs and  expenses:                          |       |                                        |       |   |   |   |   |
| Cost of goods sold                            |       | 72.2                                        | %          | 71.9 | % | 72.7 | % |
| Gross profit margin                           |       | 27.8                                        | %          | 28.1 | % | 27.3 | % |
| Selling,  general and administrative expenses |       | 25.0                                        | %          | 31.5 | % | 44.3 | % |
| Internal  research and development            |       | 0.1                                         | %          | 1.1 | % | 2.9 | % |
| Special charges                               |       | 0                                           | %          | 0 | % | 10.8 | % |
| Profit/(Loss)  from operations                |       | 3.0                                         | %          | (4.5 | )% | (30.6 | )% |
| Net Loss                                      |       | (0.1                                        | )%         | (7.3 | )% | (32.9 | )% |

 

15

----

 

**Item 7.**                    **Management’sDiscussion and Analysis of Financial Condition and Results of Operation**

 

**Revenues**

 

Total revenues wereapproximately $13,785,000, $9,222,000, and $5,388,000 in 2005, 2004 and 2003,respectively.  Revenues increased 49% in2005 to $13,785,000, from $9,222,000 in 2004, aided by strong ending backlog in2004 and strong new order intake throughout 2005.  Additionally, sales in 2005 included a secondyear of twelve full months of revenues from legacy Laser Optics, Inc. lines ofbusiness acquired in November of 2003, synergies from the combination andintegration of Laser Optics and Inrad custom optics operations in 2004, andtwelve full months of revenues from the Company’s MRC Optics subsidiary,acquired in October of 2004. 2004 sales had been up 71% from 2003 sales.

 

Examining these results by customerindustry sector:

 

Sales to theDefense/Aerospace sector continued their three year upward trendin 2005, increasing by 102% in dollar terms in 2005 from 2004, to 60% of totalCompany sales.  A majority of sales atthe Company’s MRC Optics subsidiary are to customers in this sector, and 2005represented a full twelve months of revenue contribution from that subsidiary.2005 sales to the sector were $8,352,000 as compared with $4,127,000 in 2004. Salesin 2003 were $2,321,000, up 34% from 2002. Increased military spending on electro-optical systems and R&D inthe post-9/11 era combined with strategic re-positioning by the Company hasboosted demand for the Company’s products. Sales to this sector accounted for 60%, 45%, and 43%, of total sales in2005, 2004, and 2003, respectively.

 

Revenues from customers in the ProcessControl and Metrology (ie. semiconductor tools, instruments) sector in 2005increased 79% over sales in 2004, to $3,259,000 from $1,817,000, nowrepresenting 24% of total Company sales. A large fraction of this growth is dueto inclusion of a full twelve months of sales to this sector by the Company’sMRC Optics subsidiary. Sales in the sector had rebounded in 2004 from aprotracted and deep cyclical downturn in capital spending for new tools andinstruments in 2002 and 2003.  Revenuesrose to $1,817,000 in 2004 from $844,000 in 2003, up 115%.  The optical and x-ray inspection segmentof the semiconductor industry offers continued opportunities for the Company’scapabilities in precision optics, crystal products, and monochrometers. Salesto this sector accounted for 24%, 20%, and 16% of total sales in 2005, 2004,and 2003, respectively.

 

Revenuesdecreased in the non-military Laser Systems sector, declining 40%in 2005 to $1,044,000 from $1,753,000 in 2004, and now representing 8% of totalrevenues. Sales here in 2005 reflect a return to 2003 sales levels. The similarsales level in 2003 then represented 20% of sales and now represent 8% ofsales, as total Company sales have grown by 155% since 2003. Sales in 2004 hadbeen up 64% from the prior year on a surge of demand from customers for theCompany’s laser accessory products and certain optical components. This demanddeclined in 2005 to pre 2004 levels. Reasons included decline in sales of onecustomer’s product line, acquisition of another customer by a largercorporation with in-house resources for the production of the product, and ageneral decline in demand for harmonic generators. . Salesto this sector accounted for 8%, 19%, 20%, of total sales in 2005, 2004, and2003, respectively.

 

Sales to customers within the Universityand National Laboratories market sector decreased in 2005, representing 4% oftotal revenues.  Sales to this sectorhave been in the $500,000 to $750,000 range historically, now representing asmaller percentage of total revenues.

 

Sales tocustomers in “Other” (i.e. non-separately classified) sectors were $608,000 in2005 as compared with $659,000 in 2004. Sales in 2004 were up 4% from $458,000in 2003.  Sales in these sectors haveaccounted for 4%, 8%, and 9% of total sales in 2005, 2004, and 2003,respectively.

 

New orders in2005 were $15,308,000, as compared with $11,240,000 in 2004. 2005 results

 

16

----

 

include a fullyear of new orders from the Company’s MRC Optics subsidiary, as compared withonly partial year contributions from newly acquired MRC Optics of $530,000 in2004. New orders in 2004 had increased to $11,240,000 from $6,018,000 in 2003,up 85% from those in 2003. Order intake in 2005 was especially strong in 2005from customers in the Defense/Aerospace, and Process Control and Metrologysectors.

 

Theannualized product book-to-bill ratio for 2005 was 1.11 as compared with 1.22in 2004.. The annualized product book-to-bill ratio for 2004 net of the MRCOptics acquisition, was 1.28. The annualized product book to bill ratio in 2003had been greater than 1.0 for the first time in three years at 1.1, reflectinga positive change overall across all market sectors served.

 

TheCompany’s backlog of product orders as of December 31, 2005 wasapproximately $7,876,000, up 22% from December 31, 2004. The Company’s endof year backlogs in 2004 and 2003 were $6,433,000 and$2,286,000, respectively.

 

###### **Cost of Goods Sold andGross Profit Margin**

 

As a percentage ofproduct sales, cost of goods sold was 72.2%, 71.9%, and 72.7% for the yearsended December 31, 2005, 2004 and 2003, respectively. Gross profit marginas a percentage of product sales was 27.8%, 28.1%, and 27.3%, for 2005, 2004,and 2003, respectively.

 

In 2005, the cost ofgoods sold remained relatively constant, as a percentage, to 2004 levels. Salesincreased by 49%, while cost of goods sold increased by 51%. Theincrease in the total cost of goods sold in 2005 in comparison to 2004 was theresult of increased costs for material and personnel associated with theincreased sales volumes and the inclusion of MRC Optics costs as well as sales.

 

Grossmargins for the Company in 2005 represent the combined results from its twocenters of operation: Northvale, NJ (site of INRAD and Laser Optics) andSarasota, FL, site of MRC Optics.

 

Grossmargins from the Company’s Northvale operations continued their year-over-yearimprovement in 2005, the second year following the integration of the acquiredoperations of Connecticut-based Laser Optics into Northvale. During the period,labor productivity rose, economies of scale, and cost controls there resultedin increases in gross profit margin during 2005.

 

2005represented the first full year of fiscal contribution from operations at theCompany’s Sarasota-based MRC Optics subsidiary, where gross margins in 2005lagged those in Northvale significantly. Negative gross margins at our new MRCOptics subsidiary during the first quarter, were followed by improved marginsduring the remainder of the year, as sales volumes there rose by 35% year overyear. Problem vendors were replaced with qualified new suppliers, and capacityconstraints were eased with the addition of these new vendors, new personneland new equipment resources that were brought on line, and key manufacturingprocesses were re-optimized for use of higher productivity methods.

 

In 2004, the cost ofgoods sold remained relatively constant, as a percentage, to 2003 levels. Salesincreased by over 71%. However, fixed costs for facilities related expendituresand depreciation also increased and along with increases in variable costs forlabor and material created a situation in which cost of sales remained at the samerelative percentage for the year.

 

Fixed costs are a majorcomponent of the Company’s total cost structure. Management and the Board ofDirectors decided to reduce such costs in 2002 only up to the point wherefurther reductions would impede the Company’s ability to perform for itscurrent customers or to rebound in the future when macroeconomic conditionsimproved, and to invest in new operations and lines of business. Thisphilosophy continued throughout 2003 and 2004, and enabled the Company to be well-positionedwith its operations to manufacture and deliver the goods that are behind thegrowth that has characterized 2004 and 2005.

 

17

----

 

Costs of most purchasedcomponents have been relatively stable in 2005, 2004, and 2003. However, unitcosts of certain raw materials such as crystal quartz, high grade opticalglasses, nickel and gold plating solutions have increased significantly in thepast year.

 

**Selling,General and Administrative Expenses**

 

Selling, general andadministrative expenses as a percentage of sales were 25.0%, 31.5%, and 44.3%in 2005, 2004, and 2003, respectively.

 

Selling, general andadministrative expenses in 2005 increased in dollar terms from those in 2004 by$534,000, or 18.3%, while sales increased by 49%, resulting in a drop in theSG&A cost as a percentage of sales. The increase in SG&A expendituresreflected the first full year of costs from the Company’s MRC Opticssubsidiary, acquired in October of 2004.

 

Selling, general andadministrative expenses in 2004 increased $526,000, or 22% compared to 2003,while revenues increased 71%, resulting in a drop in the SG&A cost as apercentage of sales. The increase in SG&A costs in 2004 was attributable toa full year of costs for the newly acquired Laser Optics operations and two andone half months of costs incurred as a result of the MRC acquisition. Alsoadding to the increase were the restoration of salaries for executive personnelto pre-2002 levels and increased costs for commissions that resulted from thehigher sales volume in 2004.

 

**InternalResearch and Development Expenses**

 

Company-funded researchexpenditures during the years ended December 31, 2005, 2004, and 2003 were$20,000, $98,000, and $154,000, 0.4%, 1.1%, and 2.9% of net product sales,respectively.

 

During 2005 and 2004,the Company narrowed its focus of internal research and development effortsonto improving certain crystal growth processes, and on improving manufacturingprocess technologies for optical components. Technical resources were focusedon supporting the integration of Laser Optics into Northvale operations andramp-up of production rates within Northvale operations and Sarasota operations.As a result, internal R&D expenditures were at historically low levels in2005 and 2004.

 

**SpecialCharges**

 

During 2003, the Companyacquired the assets and liabilities of Laser Optics, Inc. A strategicdecision was made at that time to relocate the assets and employees fromBethel, CT to Northvale, NJ and to combine the Laser Optics, Inc. businesslines with the Custom Optics business line. The entity created by thiscombination is now a PPGI business unit called Laser Optics. The assetsacquired and employees were relocated to Northvale, NJ into consolidatedoperations during the spring of 2004. The costs of relocating employeesincluded relocation costs, stay on bonuses and relocation bonuses, that wereaccrued in 2003. The accrual amounted to $107,000 ($0.02 per share on a basicand diluted basis) and has been included in the consolidated statement ofoperations as a special charge.

 

During2003 the Company determined that there was excess inventory, relative toforecasted future needs, of certain crystals and solutions. Based on thisdetermination, a reserve was taken in the amount of $475,000 ($0.09 per shareon a basic and diluted basis) in order to recognize the diminished futureeconomic benefit of the inventory. The increased reserve has beenincluded in the consolidated statement of operations as a special charge.

 

**OperatingIncome**

 

The profit fromoperations in 2005 was $358,000 compared to an operating loss of $(410,000) in2004 and $(1,654,000) in 2003. The improved performance was a direct result ofthe success of management’s acquisition program and an overall strengthening ofbusiness from existing and new

 

18

----

 

customers.

 

Losses in 2003 were dueto slackened and continuing weak demand in major market sectors served by theCompany and its products. These losses occurred despite strict cost containmentmeasures, and they were absorbed. The cost containment program implemented bymanagement and the Board stopped short, by design, of impeding the ability ofthe Company’s operations to perform again in the future, or of impedingthe Company’s ability to find new customers for its products. Management’sefforts to restore profitability to operations through 2005 have been focusedon building the Company’s top line, driving improvements in operations, andthrough continued focus on business development and selling activities.

 

**OtherIncome and Expenses**

 

Interest expenseincreased over prior periods due to the assumption of MRC debt. The Company’saverage borrowings in 2005 and 2004 were approximately $6,500,000 versus $4,500,000in 2003. In 2003, borrowing needs increased due principally to obtaining thecapital needed for the acquisition made during 2003. A subordinated convertiblenote was placed for acquisition purposes. Interest on the secured andconvertible notes is accrued, and payment is due upon the maturity of the notes.Also during 2003, a secured note replaced all of the Company’s prior bank debt.

 

During2005, the Company sold approximately 60% of platinum inventory, deemed to benon-productive and in excess, for net proceeds of $314,000. The transactionresulted in a gain of $136,000. The proceeds were used to augment cash reservesthat were required to support working capital needs at mid-year.

 

**Liquidityand Capital Resources**

 

In December of 2005,a major shareholder and debt holder agreed to provide the Company with $700,000in financing to fund the acquisition of certain capital assets required forexpanded capabilities to meet customer demand. The Note was executed and thefunds received in February 2006. The terms for the Note call for theamount to be repaid in equal monthly installments, including interest &principal, commencing March 2006, until maturity in March 2013. TheNote bears an annual interest rate of 6.75%.

 

At the end of the fourthquarter of 2002, the Company received $1,000,000 in proceeds from the issuanceof a Subordinated Convertible Promissory Note. The Note, originally due in January 2006,has been extended to December 31, 2008 and bears an interest rate of 6%. Interestaccrues yearly and along with principal may be converted into CommonStock, (and/or securities convertible into common shares). The note isconvertible into 1,000,000 Units consisting of 1,000,000 shares of Common Stockand Warrants to acquire 750,000 shares of Common Stock at a price of $1.35 pershare. The Holder of the Note is a related party to a major shareholder of theCompany.

 

In the second quarter of2002, the Company secured an asset loan from Wachovia Bank. In January 2003the Company was in violation of certain financial covenants required under theloan agreements. As a result Wachovia Bank sold both the asset based loan andworking capital revolver to APC Investments. In June of 2003, the Companypaid off the loan held by APC with $1,700,000 in proceeds received from theissuance of a Secured Promissory Note that is held by a major investor in theCompany. The Secured Promissory Note was for a period of 36 months andbears interest at the rate of 6% per annum. The Company’s Board of Directorsapproved the issuance of 200,000 warrants to Clarex, Ltd. as a fee for theissuance of the Note and in the 2nd quarter of 2004 approved the issuance of anadditional 200,000 warrants as a fee for extending the note to September 30,2007. The note was subsequently extended to December 31, 2008 withoutissuance of warrants or any other consideration. The warrants are exercisableat $0.425 per share and $1.08 per share, respectively, approximately a 20%discount to market, and expire in March 2008 and May 2008. The Noteis secured by all assets of the

 

19

----

 

Company.

 

At the end of the fourthquarter of 2003, the Company received $1,500,000 in proceeds from the issuanceof a Subordinated Convertible Promissory Note. The Note, originally due in January 2006,has been extended to December 31, 2008 and bears an interest rate of 6%. Interestaccrues yearly and along with principal may be converted into CommonStock, and/or securities convertible into Common Stock. The note is convertibleinto 1,500,000 Units consisting of 1,500,000 shares of Common Stock andWarrants to acquire 1,125,000 shares of Common stock at a price of $1.35 pershare. The Holder of the Note is a major shareholder of the Company. Theproceeds from the Note were used in the Company’s acquisition program.

 

In April 2004, theCompany received $1,000,000 in proceeds from the issuance of a SubordinatedConvertible Promissory Note. The Note is due in March 2007 and bears aninterest rate of 6%. Interest accrues yearly and along with principal may beconverted into Common Stock, (and/or securities convertible into common shares).The note is convertible into 1,000,000 Units consisting of 1,000,000 shares ofCommon Stock and Warrants to acquire 750,000 shares of Common Stock at a priceof $1.35 per share. The Holder of the Note is a major shareholder of theCompany.

 

During the 2nd quarterof 2004, the Company entered into an agreement with an investment banking firmto raise equity via a private placement accordance with Regulation D that wasnot registered with the Securities and Exchange Commission. In July 2004the Company issued 1,581,000 Units consisting of 1,581,000 shares and warrantsto acquire an additional 1,185,750 shares at $1.35 per share. In addition,262,276 Warrants were issued to Casimir Capital, LP, the placement agent forthe private placement. Casimir Capital earned commissions of $142,391 as theunderwriter of this private placement. This private placement resulted in netproceeds to the Company of approximately $1,173,000. The funds were utilized inthe furtherance to the company’s M&A program, capital equipment purchasesand to meet general working capital requirements. The issued shares and sharesunderlying warrants were subsequently registered under an S-1 Registrationfiling.

 

Capital expenditures,including internal labor and overhead charges, for the years ended December 31,2005, 2004 and 2003 were approximately $454,000, $1,014,000, and $101,000,respectively. Capital expenditures in 2005 were used for the build up oftooling for new customer requirements and for the acquisition of equipment. Amajor portion of the 2004 capital expenditures were for the relocation andintegration of the Laser Optics Bethel operations into the Northvale facility. Approximately$600,000 was used in this facility rearrangement and expansion, including$190,000 of capitalized internal labor and overhead. Additional large capitalexpenditures for the year included a certain production-critical machine tool,upgraded coating equipment in the Laser Optics business unit, and metrologyequipment and computer hardware and software upgrades. Capital expenditures in2003 were used for expansion and renovation of facilities and for theacquisition of equipment. The expenditures were financed in part fromcapital raised in the 2000 private offering of Series B convertiblepreferred stock and in part by the asset loan secured in the secondquarter of 2002.

 

20

----

 

A summary of the Company’scontractual cash obligations at December 31, 2005 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          |       | 3,500,000 |       | —                          |       | 3,500,000          |       |           |       | —                          |       |
| Note payable-other                 |       | 779,483   |       | 260,697                         |       | 168,612            |       | 20,385         |       | 329,789                         |       |
| Operating leases                   |       | 418,312   |       | 418,312                         |       |               |       | —         |       | —                          |       |
| Capital leases including interest  |       | 565,468   |       | 293,224                         |       | 272,244            |       |           |       | —                          |       |
| Total contractual cash obligations |       | $         | 6,963,263  |                            | $          | 972,233            |       | $              | 5,640,856  |                            | $          | 20,385 |   | $ | 329,789 |   |
|                                    |            |           |            |                                 |            |                    |            |                |            |                                 |            |  |  |  |  |  |

 

**Overviewof Financial Condition**

 

As shown in theaccompanying financial statements, the Company reported a net loss ofapproximately ($11,000) in 2005, ($673,000) in 2004, and ($1,777,000) in theyear ended December 31, 2003. During the past three years, the Company’sworking capital requirements were met by additional borrowings from a majorshareholder, the issuance of secured and subordinated convertible notes and theissuance of common and preferred stock to shareowners.

 

Net cash provided byoperations was $360,000 in 2005. The positive operating cash flow for 2005and the positive operating cash flow of $632,000 in 2004 resulted from thesharply higher level of sales, which resulted in lower operating losses than inprior years, and availability of customer milestone payments on certain longterm contracts. Operating cash flow in 2005 was lower than in the prior yeardue to, in part, the need to fund increases in accounts receivable resultingfrom the higher sales levels and to low gross margins at its new MRC Opticssubsidiary during the first half of 2005. Net cash used in operations was($283,000) in 2003. In 2003, $3,200,000 of secured and convertible notes wereissued to both replace bank debt and for use in the Company’s acquisitionprogram. In June of 2003, demand was made by a lender to pay approximately$1,700,000 in settlement of bank debts that were in technical default due to aviolation of certain financial covenants. The Company issued a Secured Note,payable to an affiliate of a major shareholder and used the proceeds to satisfythe demand for payment.

 

In April 2004, theCompany issued a $1,000,000 Subordinated Convertible Promissory Note to a majorshareholder. In July 2004 the Company raised approximately $1,173,000,net, via a private equity offering. Proceeds from this note and the privateequity placement were used in the furtherance of the Company’s merger andacquisition program.

 

In October of 2003,the Company issued a $1,500,000 Subordinated Convertible Promissory Note to amajor shareholder. Proceeds from this note were used in the furtherance of theCompany’s merger and acquisition program.

 

In December 2002,the Company received $1,000,000 in proceeds from the issuance of a SubordinatedConvertible Promissory Note to a related party of a major shareholder. TheCompany did so anticipating continued distressed market conditions during 2003and it used the proceeds from the note to meet its working capital needs in2003.

 

The Company has madeprogress in transforming itself into a portfolio of businesses serving the

 

21

----

 

Photonics industry. The Company assessesmerger and acquisition opportunities from time to time, and seeks financingfrom time to time in the private equity and public equity financial markets. TheCompany’s first acquisition was completed in November 2003 and thenecessary capital was raised in-part via a $1,500,000 subordinatedconvertible note. Additional financing was obtained in 2004 via placement of a$1,000,000 convertible note proceeds of approximately $1,173,000 from a privateplacement of units consisting of the Company’s common stock and warrants. Thesefunds were earmarked for acquisitions and capital expenditures, and werepartially used to complete its second acquisition in 2004. .

 

Where possible, theCompany will continue to increase sales, and reduce expenses and cashrequirements to improve future operating results and cash flows. Management expectsthat cash flow from operations and use of available cash reserves will provideadequate liquidity for the Company’s operations in 2006.

 

No assurances can begiven that the Company will be able to identify and acquire appropriate targetsfor acquisition or merger, or to raise the capital required for any suchacquisition. Additional capital from financings would be needed if it were tomake further acquisitions.

 

**Item 7A.****                                                  Quantitativeand Qualitative Disclosures About Market Risk**

 

The Company believes thatit has limited exposure to changes in interest rates from investments incertain money market accounts. The Company does not utilize derivativeinstruments or other market risk sensitive instruments to manage exposure tointerest rate changes. The Company believes that a hypothetical 100 basis pointadverse move in interest rates along the entire interest rate yield curve wouldnot materially affect the fair value of the Company’s interest sensitive moneymarket accounts at December 31, 2005.

 

**Item 8.****                                                           FinancialStatements and Supplementary Data**

 

The financial statements and supplementary financial informationrequired to be filed under this Item are presented commencing on page F-1of the Annual Report on Form 10-K, and are incorporated herein by reference.

 

**Item 9.****                                                           ChangesIn and Disagreements With Accountants on Accounting and Financial Disclosure**

 

None

 

**Item 9A.****                                                  Controlsand Procedures**

 

**Disclosure controls andprocedures**

 

As of December 31, 2005, the Company carried out an evaluation,with the participation of the Company’s management, including the Company’sChief Executive Officer and Chief Financial Officer, of the effectiveness ofthe Company’s disclosure controls and procedures pursuant to SecuritiesExchange Act Rule 13a-15. Based upon that evaluation, the Company’s ChiefExecutive Officer and Chief Financial Officer, concluded that the Company’sdisclosure controls and procedures are effective in ensuring that informationrequired to be disclosed by the Company in the reports that it files or submitsunder the Securities Exchange Act is recorded, processed, summarized andreported, within the time periods specified in the SEC’s rules and forms.

 

22

----

 

**Changes in internal controls over financial reporting**

 

There have been no significant changes in the Company’s internalcontrols over financial reporting that occurred during the Company’s lastfiscal year to which this report relates that have materially affected, or arereasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

**Item 9B****                                                    ****OtherInformation**

 

None.

 

23

----

 

**PART III**

 

**Item 10.****                                                    Directorsand Executive Officers of the Registrant**

 

**Directors of the Registrant**

 

The following table setsforth the name and age of each director of the Company, the period during whicheach such person has served as a director and the positions and businessexperience of each such person:

 
| ** **                | ** ** | ** ** | ** ** | **Positions; Business**                                                                      |
|---------------------------|------------|------------|------------|----------------------------------------------------------------------------------------------|
| **Name  and Age**         | ** ** | **Since**  | ** ** | **Experience**                                                                               |
| John C. Rich,             |       | 2000       |       | Chairman of the Board of Directors (September 2004 to Present)                          |
| 68                        |       |       |       | Director (2000 to August 2004)                                                          |
|                      |       |       |       | 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          |
| Daniel Lehrfeld,          |       | 1999       |       | Director                                                                                     |
| 62                        |       |       |       | 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                                                                |
| Luke P. LaValle, Jr. |       | 2006       |       | Director                                                                                     |
| 63                        |       |       |       | President and CEO, American Capital  Management Inc.                                         |
|                      |       |       |       | Past senior investment officer, United  Trust Company of NY                                  |
|                      |       |       |       | Lt. Colonel, US Army Reserve (Ret.)                                                          |
| Thomas H. Lenagh,         |       | 1998       |       | Director – (September 2004 to Present)                                             |
| 80                        |       |       |       | Chairman of  the Board of Directors (May 2000 – August 2004).                 |
|                      |       |       |       | 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.) |

 

24

----

 
| Jan M. Winston |   | 2000   |   | Director                                                                                                                         |
|----------------|--------|--------|--------|----------------------------------------------------------------------------------------------------------------------------------|
| 69             |   |   |   | Principal (1997-Present) Winston  Consulting,                                                                                    |
|           |   |   |   | Division Director/General Manager  (1981-1997) IBM Corporation. Executive positions held in Development, Finance  and Marketing. |

 

The directors holdoffice for staggered terms of three years.

 

###### **Executive Officers ofthe Registrant**

 

The following table setsforth the name and age of each executive officer of the Company, the periodduring 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, 62     |       | 1999      |       | President and Chief Executive Officer                 |
|                    |       |      |       |                                                  |
| William S. Miraglia, 56 |       | 1999      |       | Vice President, Chief Financial Officer and Secretary |
|                    |       |      |       |                                                  |
| Devaunshi Sampat, 53    |       | 1999      |       | Vice President – Marketing Communication         |

 

Daniel Lehrfeld hasserved as Chief Executive Officer and President since May 2000. He joinedthe Company in 1999 as President and Chief Operating Officer. Prior to joiningthe Company, Mr. Lehrfeld held the position of Vice President and GeneralManager of Electro-Optic Systems, a division, successively, of the Raytheon,GM/Hughes Electronics and Magnavox Electronic Systems Corporations. He has alsoheld executive positions with Philips Laboratories Briarcliff and GrummanAerospace Corporation. Mr. Lehrfeld holds B.S. and M.S. degrees fromColumbia University School of Engineering and Applied Science and an M.B.A.degree from the Columbia Graduate School of Business.

 

William S. Miragliajoined the Company as Secretary and Chief Financial Officer in June 1999. Previously,he held the position of Vice President of Finance for a division of UNC, Inc.,a New York Stock Exchange aviation company. Prior to his last position, Mr. Miragliahas held management positions in the aerospace industry and in publicaccounting. He holds a B.B.A. from Pace University, and an M.B.A from LongIsland University and is a Certified Public Accountant.

 

Devaunshi Sampat joinedthe Company in 1998. In 1999 she was appointed Vice President of Marketing andSales. In 2003 she also assumed the title of Vice President for MarketingCommunications for PPGI. Prior to joining the Company, Ms. Sampat heldsales management positions within the Photonics industry with PrincetonInstruments and Oriel Instruments. Ms. Sampat holds a B.S. in MedicalTechnology from the University of Bridgeport.

 

Each of the executiveofficers has been elected by the Board of Directors to serve as an officer ofthe Company until the next election of officers, as provided by the Company’sby-laws.

 

**Committees of the Board of Directors**

 

Composition of the Board of Directors*.*In October of 2005, the Boardagreed unanimously to discontinue the Executive Committee, for reasons of thesmall size of the Board and the frequent number of Board meetings customarilyheld. At the same time the Board agreed to make each outside director a memberof each Committee.

 

Since the adoption of the Sarbanes-Oxley Actin July 2002, there has been a growing public and regulatory focus on theindependence of directors. Requirements relating to independence are imposed

 

25

----

 

by the Sarbanes-Oxley Act with respect tomembers of the Audit Committee. The Board of Directors has determined that themembers of the Audit Committee satisfy all such definitions of independence.

 

Audit Committee*.*Thomas Lenagh, Chairman. The Audit Committee is empowered by the Board of Directors to, among other things, serve as an independent and objective party to monitor the Company’s financial reporting process, internal control system and disclosure control system, review and appraise the audit efforts of the Company’s independent accountants, assume direct responsibility for the appointment, compensation, retention and oversight of the work of the outside auditors and for the resolution of disputes between the outside auditors and the Company’s management regarding financial reporting issues, and provide an open avenue of communication among the independent accountants, financial and senior management, and the Company’s Board of Directors.

 

Audit Committee Financial Expert*.*The Board of Directors of the Companyhas 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. ThomasLenagh, Mr. Luke P. LaValle and Mr. Jan Winston, have been determinedto be “independent” within the meaning of SEC regulations.

 

Compensation Committee. Mr. Jan Winston, Chairman. The Compensation Committee reviews, approves and makes recommendations to the Board of Directors on matters regarding the compensation of the executives of the Company.

 

Nominating Committee. Mr. Frank Wiedeman through August 1, 2005, Chairman, Mr. John Rich, Chairman (acting). The Nominating Committee makes recommendations to the Board of Directors for the selection of individuals to be nominated to the Board of Directors.

 

Executive Committee. Discontinued during 2005.

 

**Section 16(a) BeneficialOwnership Reporting Compliance**

 

Section 16(a) ofthe 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. Thesepersons are required by the Securities and Exchange Commission to furnish theCompany with copies of all Section 16(a) reports that they file. Basedsolely on the Company’s review of these reports and written representationsfurnished to the Company, the Company believes that in 2005 each of thereporting persons complied with these filing requirements.

 

**Code of Ethics**

 

The Company has adopteda Code of Ethics that applies to the Company’s principal executive officer,principal financial officer, principal accounting officer or controller (orpersons performing similar functions). A copy of such Code of Ethics has beenfiled as Exhibit 14.1 to this Annual Report on Form 10-K.

 

**Item 11.****                                                    ExecutiveCompensation**

 

###### **Summary of Cash andCertain Other Compensation**

 

The following table setsforth, for the years ended December 31, 2005, 2004 and 2003, the cashcompensation paid by the Company and its Subsidiaries, with respect to the Company’sChief Executive Officer and other officer, whose total annual salary and bonusexceeded $100,000, for services rendered in all capacities as an executiveofficer during such period:

 

26

----

 

**Summary Compensation Table**

 
| ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Securities** | ** ** |
|------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|----------------|------------|
| ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Underlying** | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Stock**      | ** ** |
| **Name and Principal Position** | ** ** | **Year**   | ** ** | **Salary** | ** ** | **Bonus**  | ** ** | **Options**    | ** ** |
| Daniel Lehrfeld,                               |       | 2005       |       | $          | 183,000    |       | N/A        |           | 0          |   |
| President and                                  |       | 2004       |       | $          | 183,000    |       | N/A        |           | 200,000    |   |
| Chief Executive Officer                        |       | 2003       |       | $          | 156,000    |       | N/A        |           | 85,000     |   |
| Devaunshi Sampat,                              |       | 2005       |       | $          | 165,000    |       | N/A        |           | 20,000     |   |
| Vice President,                                |       | 2004       |       | $          | 171,000    |       | N/A        |           | 20,000     |   |
| Marketing Comm.                                |       | 2003       |       | $          | 105,000    |       | N/A        |           | 50,000     |   |
| William Miraglia                               |       | 2005       |       | $          | 126,000    |       | N/A        |           | 15,000     |   |
| Vice President,                                |       | 2004       |       | $          | 126,000    |       | N/A        |           | 25,000     |   |
| Chief Financial Officer and Secretary          |       | 2003       |       | $          | 101,000    |       | N/A        |           | 40,000     |   |

 

The Company is party toan 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 a change of control of the Company.

 

The aggregate minimum commitment under this agreement is as follows:

 

| **Year Ending**  | ** ** | ** ** | ** ** | ** ** |
|-----------------------|------------|------------|------------|------------|
| **December 31,** | ** ** | ** ** | ** ** | ** ** |
| 2006                  |       |       | $          | 185,000    |   |
| 2007                  |       |       | $          | 185,000    |   |
| 2008                  |       |       | $          | 185,000    |   |
| 2009                  |       |       | $          | 185,000    |   |

 

Should Mr. Lehrfeld be terminated without cause during thiscontract period he would be entitled to one year’s salary payable in one lumpsum within 30 days of termination.

 

There is an SEC requirement to report officer received perquisites orother personal benefits in excess of the lesser of $50,000 or 10% of suchindividual’s reported salary and bonus. During fiscal years 2005, 2004 and 2003,respectively, no officer received any such perquisites or other personal benefits,nor were any granted.

 

###### **Compensation ofDirectors**

 

Fees for non-employee directors were $500 during fiscal year 2005 andfiscal year 2004 for each board meeting attended, and $250 during 2005 and 2004for each conference call meeting in which they participated. The board agreedto defer payment of fees to its directors after October, 2005 in the interestof conserving cash. The total deferral amounted to $5,500 that is expected tobe paid in 2006. Each non-employee director received 11,000 stock options,exercisable at $1.03, in 2005 and 20,000 stock options, exercisable at $.50 in2004.

 

###### **Compensation CommitteeInterlocks and Insider Participation**

 

The following directorsof the Company served as members of the Compensation Committee of the Company’sBoard of Directors during 2005:  Mr. FrankWiedeman, through August 1, 2005, Mr. Jan Winston, Mr. LukeLaValle and Mr. John Rich. None of these individuals are officers oremployees of the Company. Officer’s compensation is guided by overall jobperformance and the market salaries for

 

27

----

 

those positions for companies of the samerelative size and within industries similar to the Company’s industry, as wellas relativity to other salaries within the Company.

 

###### **Option Exercises andHoldings**

 

The following tableprovides information concerning options exercised during 2005 and the value ofunexercised options held by each of the executive officers named in the SummaryCompensation Table at December 31, 2005.

 

**OptionGrants in Last Fiscal Year**

 

Shown below is information on grants of stock options pursuant to the2000 Equity Compensation plan during the Fiscal year ended December 31,2005 to the officers named below:
| **Individual Grants** | ** ** | **Alternative  to Grant  Date Value  (a)**              | ** ** |
|-----------------------|------------|---------------------------------------------------------|------------|
| **Name**              | ** ** | **Number of  Securities  Underlying  Options  Granted** | ** ** | **% of Total  Options  Granted to  Employees  in Fiscal  Year** | ** ** | **Expiration  or Base  Price  ($/Sh)** | ** ** | **Expiration  Date** | ** ** | **Grant Date  Payment  Value ($)** | ** ** |
| Dan Lehrfeld          |       | 0                                                       |       | 0 | % |   |   |   |   | $ | 0 |   |
| Devaunshi Sampat      |       | 20,000                                                  |       | 14.3 | % | $ | 1.03 |   | Jan 2015 |   | $ | 20,600 |   |
| William Miraglia      |       | 15,000                                                  |       | 10.8 | % | $ | 1.03 |   | Jan 2015 |   | $ | 15,450 |   |

 

----

(a)                                  Based on agrant date present value of $1.03, derived using the Black-Scholes optionpricing model with the following assumptions: Volatility of 210.54%, Risk free rate of return of 5.20%, Dividend Yieldof 0% and a 10 year option life.

 

**AggregatedOption Exercises in Last fiscal Year and Fiscal Year end Option Values**

 
| ** **       | ** ** | **Shares  Acquired  on  Exercise** | ** ** | **Value**    | ** ** | **Number of  Securities Underlying  Unexercised Options  at December 31, 2005  (# of shares)** | ** ** | **Value of  In-the-Money Options at  December 31, 2005 ($)(1)** | ** ** |
|------------------|------------|------------------------------------|------------|--------------|------------|-----------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| **Name**         | ** ** | **(# shares)**                     | ** ** | **Realized** | ** ** | **Exercisable**                                                                                     | ** ** | **Unexercisable**                                                    | ** ** | **Exercisable** | ** ** | **Unexercisable** | ** ** |
| Daniel Lehrfeld  |       | 0                                  |       | 0            |       | 731,550                                                                                             |       | 73,450                                                               |       | 363,275 |   | 36,725 |   |
| Devaunshi Sampat |       | 0                                  |       | 0            |       | 159,580                                                                                             |       | 41,420                                                               |       | 119,165 |   | 20,710 |   |
| William Miraglia |       | 0                                  |       | 0            |       | 119,280                                                                                             |       | 34,720                                                               |       | 81,890 |   | 17,360 |   |

 

----

(1)                                  Based on $1.50 pershare, the closing price of the Company’s Common Stock, as reported by the

 

28

----

 

OTC Bulletin Board, on December 31, 2005

 

No stock appreciation rights were granted during the fiscal year ended December 31,2005.

 

29

----

 

**Item 12.****                                                    SecurityOwnership of Certain Beneficial Owners and Management**

 

The following tablepresents certain information with respect to the security ownership of thedirectors 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 (7,282,898shares) as of March 23, 2006. Percentages that include ownership ofoptions or convertible securities are calculated assuming exercise orconversion by each individual or entity of the options, (including “out-of-the-moneyoptions”), or convertible securities owned by each individual or entityseparately without considering the dilutive effect of option exercises andsecurity conversions by any other individual or entity. The Company has beenadvised that all individuals, or entities, listed have the solepower to vote and dispose of the number of shares set opposite their names inthe table. Unless otherwise indicated, the address of each beneficial owner isc/o Photonic Products Group, Inc., 181 Legrand Avenue, Northvale, NewJersey 07674.

 
| ** **                                | ** ** | ** **           | ** ** | **Percent of**   | ** ** |
|-------------------------------------------|------------|----------------------|------------|------------------|------------|
| **Name  and Address of Beneficial Owner** | ** ** | **Number of shares** | ** ** | **Common Stock** | ** ** |
| Clarex, Ltd. & Welland Ltd.      |       | 9,971,914            | (1)        | 67.8             | %          |
| Scotia House                              |       |                 |       |             |       |
| 404 East Bay Street                       |       |                 |       |             |       |
| Nassau, Bahamas                           |       |                 |       |             |       |
| The estate of Warren Ruderman             |       | 1,172,000            |       | 16.1             | %          |
| 45 Duane Lane                             |       |                 |       |             |       |
| Demarest, NJ 07627                        |       |                 |       |             |       |
| Daniel Lehrfeld                           |       | 896,350              | (2)        | 11.1             | %          |
| Thomas Lenagh                             |       | 209,540              | (3)        | 2.8              | %          |
| The estate of Frank Wiedeman              |       | 168,400              | (4)        | 2.3              | %          |
| John Rich                                 |       | 63,840               | (5)        | 0.9              | %          |
| Jan Winston                               |       | 53,440               | (6)        | 0.7              | %          |
| William Miraglia                          |       | 129,720              | (7)        | 1.8              | %          |
| Devaunshi Sampat                          |       | 171,180              | (8)        | 2.3              | %          |
| Directors and Executive                   |       | 1,692,470            | (9)        | 19.5             | %          |
| Officers as a group (7 persons)           |       |                 |       |             |       |

 

----

(1)                                  Including 900,000 sharesissuable within 60 days on conversion of convertible preferred stock, 3,500,000shares subject to convertible promissory notes at a conversion of $1.00, and3,025,000 warrants exercisable as follows: 2,625,000 at $1.35, 200,000 at $1.08and 200,000 at $.425.

 

(2)                                  Including 731,550shares subject to options exercisable within 60 days and 48,000 shares issuablewithin 60 days on conversion of convertible preferred stock

 

(3)                                  Including 122,640shares subject to options exercisable within 60 days.

 

(4)                                  Including 90,000shares subject to options exercisable or convertible within 60 days.

 

(5)                                  Including 12,000shares issuable within 60 days on conversion of convertible preferred stock and47,640 shares subject to options exercisable within 60 days.

 

(6)                                  Including 4,000shares issuable within 60 days on conversion of convertible preferred stock and47,640 shares subject to options exercisable within 60 days.

 

(7)                                  Including 7,200shares issuable within 60 days on conversion of convertible preferred

 

30

----

 

stock and 119,280 shares subject to options exercisable within 60 days.

 

(8)                                  Including 8,000shares issuable within 60 days on conversion of convertible preferred stock and159,850 shares subject to options exercisable within 60 days.

 

(9)                                  Including 79,200shares issuable within 60 days on conversion of convertible preferred stock and1,318,330 shares subject to options exercisable within 60 days.

 

**EquityCompensation Plan Information**

 

The following tablegives information about the Company’s Common Stock that may be issued uponthe exercise of options, warrants and rights under the Company’s Key EmployeeCompensation Plan and the Company’s 2000 Equity Compensation Program, as of December 31,2005. These plans were the Company’s only equity compensation plans inexistence as of December 31, 2005.

 
| **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     |       | 2,577,860                                                                                                                                                 |       | $                                                                                                                | 1.18       |                                                                                                                                                                                                             | 3,422,140  |   |
| Equity Compensation Plans Not Approved by  Shareholders |       | —                                                                                                                                                    |       | —                                                                                                           |       | —                                                                                                                                                                                                           |       |
|                                                    |       |                                                                                                                                                      |       |                                                                                                             |       |                                                                                                                                                                                                             |       |
| Total                                                   |       | 2,577,860                                                                                                                                                 |       | $                                                                                                                | 1.18       |                                                                                                                                                                                                             | 3,422,140  |   |

 

**Item 13.****                                                    CertainRelationships and Related Transactions**

 

During the years ended December 31,2005, 2004 and 2003, approximately 1%, 3%, and 3%, respectively of the Company’snet product sales were through a foreign agent, in which the estate of WarrenRuderman, a principal shareholder has an investment. Terms of sales to thisforeign agent were substantially the same as to unrelated foreign agents.

 

In December 2005the Company initiated a financing arrangement with Clarex, Ltd. a majorshareholder and debt holder in the amount of $700,000, to fund acquisition ofcapital assets needed to absorb growth opportunities. The funds were receivedin February 2006.

 

During 2005 two notesdue to Clarex, Ltd., a shareowner and debt holder had their maturity datesextended from January 31, 2006 to December 31, 2008.

 

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

 

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

 

31

----

 

Audit Fees*.*Audit fees billed or expected to be billed to the Companyby the Company’s principal accountantfor the audit of the financial statements included in the Company’s AnnualReports on Form 10-K, and reviews of the financial statements included inthe Company’s Quarterly Reports on Form 10-Q, for the years ended December 31,2005 and 2004 totaled approximately $110,000 and $98,500, respectively.

 

Audit-Related Fees*.*The Company was billed $0 and $0 by theCompany’s principal accountant for the fiscal years ended December 31, 2005and 2004, respectively, for assurance and related services that are reasonablyrelated to the performance of the audit or review of the Company’s financialstatements and are not reported under the caption *Audit Fees* above.

 

Tax Fees*.*The Company was billed an aggregate of $10,000 and $8,500by the Company’s principal accountantfor the fiscal years ended December 31, 2005 and 2004, respectively, fortax services, principally the preparation of income tax returns.

 

All Other Fees*.*In 2004 the Company incurred approximately $125,000 infees in connection with activities related to the MRC acquisition due diligence,audit of MRC, 8-K filing, S-8 registration and S-1 registration for resale ofcommon stock issued as a result of the private equity offering.

 

Applicable law and regulations provide an exemption that permitscertain services to be provided by the Company’s outside auditors even if theyare not pre-approved. The Company has not relied on this exemption at any timesince the Sarbanes-Oxley Act was enacted. All other fees have been pre-approvedby the Audit Committee of the Board of Directors.

 

32

----

 

#### **PART IV**

#### ** **

**Item 15.****                                                    Exhibitsand Financial Statement Schedules**

 

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

 

Reference is made to theIndex to Financial Statements and Financial Statement Schedule on Page F-1.

 

**(a) (2)****               ****Financial StatementSchedule.**

 

Reference is made to the Index to FinancialStatements and Financial Statement Schedule on Page F-1.

 

All other schedules have been omitted becausethe required information is not present or is not present in amounts sufficientto require submission of the schedule, or because the information required isincluded in the Financial Statements or Notes thereto.

 

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

 
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                         |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                  |       | Stock Purchase Agreement between Photonic Products Group, Inc.,  MRC Precision Metal Optics and Frank E. Montone (incorporated by  reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K  filed with the Securities and Exchange Commission on October 25, 2004) |
| 3.1                  |       | Restated Certificate of Incorporation of Photonics Products Group, Inc.  (incorporated by reference to Exhibit 3.1 to the Company’s Registration  Statement on Form S-1 filed with the Securities and Exchange Commission  on August 25, 2004)                                            |
| 3.2                  |       | By-Laws of Photonic Products Group, Inc. (incorporated by reference  to Exhibit 3.2 to the Company’s Registration Statement on Form S-1  filed with the Securities and Exchange Commission on August 25, 2004)                                                                            |
| 4.1                  |       | Specimen Common Stock Certificate (incorporated by reference to Exhibit 4.1  to the Company’s Registration Statement on Form S-1 filed with the  Securities and Exchange Commission on August 25, 2004)                                                                                        |
| 4.2                  |       | Form of Warrants issued pursuant to June 2004 Private  Placement (incorporated by reference to Exhibit 4.2 to the Company’s  Registration Statement on Form S-1 filed with the Securities and  Exchange Commission on August 25, 2004)                                               |
| 4.3                  |       | Form of Placement Agent Warrants issued pursuant to June 2004  Private Placement (incorporated by reference to Exhibit 4.3 to the  Company’s Registration Statement on Form S-1 filed with the Securities  and Exchange Commission on August 25, 2004)                               |
| 4.4                  |       | Promissory Note Dated June 30, 2003 held by Clarex, Ltd.  (incorporated by reference to Exhibit 4.4 to the Company’s Registration  Statement on Form S-1 filed with the Securities and Exchange Commission  on August 25, 2004)                                                           |
| 4.5                  |       | Subordinated Convertible Promissory Note dated April 1, 2004  held by Clarex, Ltd. (incorporated by reference to Exhibit 4.5 to the  Company’s Registration Statement on Form S-1 filed with the Securities  and Exchange Commission on August 25, 2004)                                  |
| 4.6                  |       | Subordinated Convertible Promissory Note dated October 31, 2003  held by Clarex, Ltd. (incorporated by reference to Exhibit 4.6 to the  Company’s Registration Statement on Form S-1 filed with the Securities  and Exchange Commission on August 25, 2004)                               |

 

33

----

 
| 4.7  |   | Subordinated Convertible Promissory Note dated December 31, 2002  held by Welland, Ltd. (incorporated by reference to Exhibit 4.7 to the  Company’s Registration Statement on Form S-1 filed with the Securities  and Exchange Commission on August 25, 2004) |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.8  |   | Warrant dated March 31, 2004 issued to Clarex, Ltd.  (incorporated by reference to Exhibit 10.2 to the Company’s Registration  Statement on Form S-1 filed with the Securities and Exchange Commission  on August 25, 2004)                                   |
| 4.9  |   | Warrant dated May 19, 2004 issued to Clarex, Ltd. (incorporated  by reference to Exhibit 10.3 to the Company’s Registration Statement on Form S-1  filed with the Securities and Exchange Commission on August 25, 2004)                                      |
| 10.1 |   | 2000 Equity Compensation Program (incorporated by reference to Exhibit 10.1  to the Company’s Registration Statement on Form S-1 filed with the  Securities and Exchange Commission on August 25, 2004)                                                            |
| 10.2 |   | Daniel Lehrfeld Employment Contract, dated October 20, 1999  (incorporated by reference to Exhibit 10.4 to the Company’s Registration  Statement on Form S-1 filed with the Securities and Exchange Commission  on August 25, 2004)                           |
| 14.1 |   | Code of Ethics                                                                                                                                                                                                                                                                         |
| 21.1 |   | List of Subsidiaries                                                                                                                                                                                                                                                                   |
| 23.1 |   | Consent of Holtz Rubenstein Reminick LLP Independent Auditors                                                                                                                                                                                                                          |
| 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                                                                                                                           |

 

34

----

 

**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
|   | PHOTONIC  PRODUCTS GROUP, INC. |
|--------|-------------------------------------|
|   |                                |
|   |                                |   |
|   | By:                                 | /s/ Daniel Lehrfeld |   |
|   |                                | Daniel Lehrfeld |
|   |                                | Chief Executive Officer |
|   |                                |
|   | Dated: March 22, 2006          |

 

Pursuant to therequirements 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/ John Rich           |       | Chairman of the Board   |       | March 22, 2006 |
| John Rich               |       | of Directors            |       |                |
|                    |       |                    |       |                |
|                    |       |                    |       |                |
| /s/ Daniel Lehrfeld     |       | President, Chief        |       | March 22, 2006 |
| Daniel Lehrfeld         |       | Executive Officer       |       |                |
|                    |       | and Director            |       |                |
|                    |       |                    |       |                |
|                    |       |                    |       |                |
| /s/ Luke P. Lavalle     |       | Director                |       | March 22, 2006 |
| Luke P. Lavalle         |       |                    |       |                |
|                    |       |                    |       |                |
|                    |       |                    |       |                |
| /s/ Thomas Lenagh       |       | Director                |       | March 22, 2006 |
| Thomas Lenagh           |       |                    |       |                |
|                    |       |                    |       |                |
|                    |       |                    |       |                |
| /s/ Jan Winston         |       | Director                |       | March 22, 2006 |
| Jan Winston             |       |                    |       |                |
|                    |       |                    |       |                |
|                    |       |                    |       |                |
| /s/ William S. Miraglia |       | Chief Financial Officer |       | March 22, 2006 |
| William S. Miraglia     |       | and Secretary           |       |                |

 

35

----

 

**PHOTONICPRODUCTS GROUP , INC. AND SUBSIDIARIES**

 

**REPORT ON AUDITS OF CONSOLIDATED FINANCIAL STATEMENTS**

 

**THREE YEARS ENDED DECEMBER 31, 2005**

 

**CONTENTS**

 
| Report of Independent  Registered Public Accounting Firm                                          |   |
|---------------------------------------------------------------------------------------------------|--------|
|                                                                                              |   |
| Consolidated balance sheets as of  December 31, 2005 and 2004                                     |   |
|                                                                                              |   |
| Consolidated statements of  operations for the three years ended December 31, 2005                |   |
|                                                                                              |   |
| Consolidated statements of  shareholders’ equity for the three years ended December 31, 2005 |   |
|                                                                                              |   |
| Consolidated statements of  cash flows for the three years ended December 31, 2005                |   |
|                                                                                              |   |
| Notes to consolidated  financial statements                                                       |   |
|                                                                                              |   |
| Report of Independent  Registered Certified Public Accountants on supplemental schedule           |   |
|                                                                                              |   |
| Schedule II – Valuation and  Qualifying Accounts                                             |   |

 

F-1

----

 

Report of Independent Registered Public Accounting Firm

 

Boardof Directors and ShareholdersPhotonic Products Group, Inc. and SubsidiariesNorthvale, New Jersey

 

Wehave audited the accompanying consolidated balance sheets of Photonic ProductsGroup, Inc. and Subsidiaries as of December 31, 2005 and 2004, and the relatedconsolidated statements of operations, shareholders’ equity and cash flows forthe three years ended December 31, 2005. These consolidated financial statements are the responsibility of theCompany’s management.  Our responsibilityis to express an opinion on these financial statements based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States of America).  Those standards require that we plan andperform the audits to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonablebasis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofPhotonic Products Group, Inc. and Subsidiaries as of December 31, 2005 and 2004and the results of their operations and their cash flows for the three yearsended December 31, 2005, in conformity with accounting principles generallyaccepted in the United States of America.

 

 

HOLTZRUBENSTEIN REMINICK LLP

 

 

Melville,New YorkFebruary 24, 2006

 

F-2

----

 

**PHOTONICPRODUCTS GROUP, INC AND SUBSIDIARIES**

** **

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|
| ** **                                                                                                                                   | ** ** | **2005**         | ** ** | **2004** | ** ** |
| **Assets**                                                                                                                                   |       |             |       |   |   |
| **Current  assets:**                                                                                                                         |       |             |       |   |   |
| Cash and cash equivalents                                                                                                                    |       | $                | 1,156,563  |   | $ | 1,393,507 |   |
| Accounts receivable (after allowance for  doubtful accounts of $15,000 in 2005 and $88,000 in 2004)                                          |       | 2,265,934        |       | 1,447,994 |   |
| Inventories                                                                                                                                  |       | 2,423,879        |       | 2,479,074 |   |
| Other current assets                                                                                                                         |       | 153,723          |       | 87,540 |   |
| **Total Current Assets**                                                                                                                     |       | 6,000,099        |       | 5,408,115 |   |
| **Plant  and equipment:**                                                                                                                    |       |             |       |   |   |
| Plant and equipment at cost                                                                                                                  |       | 12,472,480       |       | 12,018,865 |   |
| Less: Accumulated depreciation and  amortization                                                                                             |       | (8,143,592       | )          | (7,255,427 | ) |
| Total plant and equipment                                                                                                                    |       | 4,328,888        |       | 4,763,438 |   |
| **Precious  Metals**                                                                                                                         |       | 130,732          |       | 309,565 |   |
| **Goodwill**                                                                                                                                 |       | 1,869,646        |       | 1,727,971 |   |
| **Intangible Assets, net of accumulated  amortization of $112,602 and $32,425, respectively**                                                |       | 987,272          |       | 1,067,449 |   |
| **Other  Assets**                                                                                                                            |       | 164,384          |       | 250,096 |   |
| **Total Assets**                                                                                                                             |       | $                | 13,481,021 |   | $ | 13,526,634 |   |
|                                                                                                                                         |       |             |       |   |   |
| **Liabilities  and Shareholders’ Equity**                                                                                               |       |             |       |   |   |
| **Current  Liabilities:**                                                                                                                    |       |             |       |   |   |
|                                                                                                                                         |       |             |       |   |   |
| Current portion of notes payable -Other                                                                                                      |       | $                | 260,697    |   | $ | 226,146 |   |
| Accounts payable and accrued liabilities                                                                                                     |       | 2,426,692        |       | 2,189,744 |   |
| Customer advances                                                                                                                            |       | 652,264          |       | 385,714 |   |
| Current obligations under capital leases                                                                                                     |       | 248,550          |       | 300,813 |   |
| **Total Current Liabilities**                                                                                                                |       | 3,588,203        |       | 3,102,417 |   |
|                                                                                                                                         |       |             |       |   |   |
| **Related  Party Convertible and Secured Notes Payable**                                                                                     |       | 5,200,000        |       | 5,200,000 |   |
| **Notes  Payable – Other, net of current portion**                                                                                      |       | 518,786          |       | 794,379 |   |
| **Capital  Lease Obligations, Net of Current Obligation**                                                                                    |       | 244,625          |       | 464,709 |   |
| **Total Liabilities**                                                                                                                        |       | 9,551,614        |       | 9,561,505 |   |
|                                                                                                                                         |       |             |       |   |   |
| **Commitments**                                                                                                                              |       | —           |       | — |   |
|                                                                                                                                         |       |             |       |   |   |
| **Shareholders’  equity:**                                                                                                              |       |             |       |   |   |
| 10% convertible preferred stock, Series A  no par value; 500 shares issued and outstanding                                                   |       | 500,000          |       | 500,000 |   |
|                                                                                                                                         |       |             |       |   |   |
| 10% convertible preferred stock, Series B  no par value; 2,100 shares issued and outstanding                                                 |       | 2,100,000        |       | 2,100,000 |   |
|                                                                                                                                         |       |             |       |   |   |
| Common stock: $.01 par value; 60,000,000  authorized shares 7,287,398 issued at December 31, 2005 and 7,186,794 issued  at December 31, 2004 |       | 72,862           |       | 71,868 |   |
| Capital in excess of par value                                                                                                               |       | 11,145,243       |       | 11,036,561 |   |
| Accumulated deficit                                                                                                                          |       | (9,873,748       | )          | (9,728,350 | ) |
|                                                                                                                                         |       | 3,944,357        |       | 3,980,079 |   |
|                                                                                                                                         |       |             |       |   |   |
| Less - Common stock in treasury, at cost  (4,600 shares)                                                                                     |       | (14,950          | )          | (14,950 | ) |
| **Total Shareholders’ Equity**                                                                                                          |       | 3,929,407        |       | 3,965,129 |   |
| **Total Liabilities & Shareholders’  Equity**                                                                                       |       | $                | 13,481,021 |   | $ | 13,526,634 |   |

 

See Notes to ConsolidatedFinancial Statements

 

F-3

----

 

**PHOTONICPRODUCTS GROUP, INC AND SUBSIDIARIES**

** **

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                                    | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                          |       |                         |       |   |   |   |   |
| **REVENUES**                                                                  |       |                         |       |   |   |   |   |
| Net sales                                                                     |       | $                            | 13,785,057 |   | $ | 9,221,857 |   | $ | 5,388,184 |   |
|                                                                          |       |                         |       |   |   |   |   |
| **COST AND  EXPENSES**                                                        |       |                         |       |   |   |   |   |
| Cost of goods sold                                                            |       | 9,956,125                    |       | 6,618,506 |   | 3,917,123 |   |
| Selling, general and administrative expense                                   |       | 3,450,224                    |       | 2,916,056 |   | 2,389,547 |   |
| Internal research and development expense                                     |       | 20,279                       |       | 97,685 |   | 153,843 |   |
| Special charges                                                               |       | —                       |       | — |   | 582,000 |   |
|                                                                          |       | 13,426,628                   |       | 9,632,247 |   | 7,042,513 |   |
|                                                                          |       |                         |       |   |   |   |   |
| **OPERATING  PROFIT (LOSS)**                                                  |       | 358,429                      |       | (410,390 | ) | (1,654,329 | ) |
|                                                                          |       |                         |       |   |   |   |   |
| **OTHER  INCOME (EXPENSE)**                                                   |       |                         |       |   |   |   |   |
|                                                                          |       |                         |       |   |   |   |   |
| Interest expense                                                              |       | (504,509                     | )          | (358,940 | ) | (266,165 | ) |
| Gain on sale of precious metals                                               |       | 135,931                      |       | — |   |   |   |
| Other                                                                         |       | (1,249                       | )          | 49 |   | 8,950 |   |
|                                                                          |       | (369,827                     | )          | (358,891 | ) | (257,215 | ) |
|                                                                          |       |                         |       |   |   |   |   |
| **LOSS BEFORE INCOME TAX BENEFIT (PROVISION) AND  PREFERRED STOCK DIVIDENDS** |       | (11,398                      | )          | (769,281 | ) | (1,911,544 | ) |
|                                                                          |       |                         |       |   |   |   |   |
| **INCOME  TAX BENEFIT (PROVISION)**                                           |       |                         |       | 96,344 |   | 134,235 |   |
|                                                                          |       |                         |       |   |   |   |   |
| **NET  (LOSS)**                                                               |       | (11,398                      | )          | (672,937 | ) | (1,777,309 | ) |
|                                                                          |       |                         |       |   |   |   |   |
| **PREFERRED  STOCK DIVIDENDS**                                                |       | (134,000                     | )          | (164,820 | ) | (53,600 | ) |
|                                                                          |       |                         |       |   |   |   |   |
| **NET LOSS APPLICABLE TO COMMMON SHAREHOLDERS**                               |       | $                            | (145,398   | ) | $ | (837,757 | ) | $ | (1,830,909 | ) |
|                                                                          |       |                         |       |   |   |   |   |
| **NET LOSS  PER COMMON SHARE-BASIC**                                          |       | $                            | (0.02      | ) | $ | (0.15 | ) | $ | (0.35 | ) |
|                                                                          |       |                         |       |   |   |   |   |
| **NET LOSS  PER COMMON SHARE-DILUTED**                                        |       | $                            | (0.02      | ) | $ | (0.15 | ) | $ | (0.35 | ) |
|                                                                          |       |                         |       |   |   |   |   |
| **WEIGHTED AVERAGE SHARES OUTSTANDING BASIC  AND DILUTED**                    |       | 7,218,244                    |       | 5,710,354 |   | 5,287,849 |   |

 

See notes to consolidated financial statements

 

F-4

----

 

**PHOTONICPRODUCTS GROUP, INC. AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY**

 
| ** **                     | ** ** | ** **        | ** ** | ** **      | ** **       | **Preferred  Stock** | ** ** | **Preferred  Stock** | ** ** | **Capital  in** | ** ** | ** **    | ** ** | ** **             | ** **     | **Total**      | ** **     |
|--------------------------------|------------|-------------------|------------|-----------------|------------------|----------------------|------------|----------------------|------------|-----------------|------------|---------------|------------|------------------------|----------------|----------------|----------------|
| ** **                     | ** ** | **Common  Stock** | ** ** | **(Series  A)** | ** **       | **(Series  B)**      | ** ** | **excess  of**       | ** ** | ** **      | ** ** | **Treasury**  | ** ** | **Shareholders’** | ** **     |
| ** **                     | ** ** | **Shares**        | ** ** | **Amount**      | ** **       | **Shares**           | ** ** | **Amount**           | ** ** | **Shares**      | ** ** | **Amount**    | ** ** | **par  value**         | ** **     | **Deficit**    | ** **     | **Stock** | ** ** | **Equity** | ** ** |
| **Balance, December 31, 2002** | ** ** | **5,283,640**     | ** ** | **$**           | ** 52,836** | ** **           | **500**    | ** **           | **$**      | **500,000**     | ** ** | **2,100**     | ** ** | **$**                  | **2,100,000**  | ** **     | **$**          | **9,471,676** | ** ** | **$** | **(7,059,684** | **)** | **$** | **(14,950** | **)** | **$** | **5,048,878** | ** ** |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| 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 year          |       | —            |       | —          |             | —               |       | —               |       | —          |       | —        |       | —                 |           | (1,777,309     | )              | — |   | (1,777,309 | ) |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| **Balance, December 31, 2003** | ** ** | **5,445,903**     | ** ** | **54,459**      | ** **       | **500**              | ** ** | **500,000**          | ** ** | **2,100**       | ** ** | **2,100,000** | ** ** | **9,535,523**          | ** **     | **(8,890,593** | **)**          | **(14,950** | **)** | **3,283,439** | ** ** |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| 401K contribution              |       | 25,891            |       | 259             |             |                 |       |                 |       |            |       |          |       | 12,686                 |           |           |           |   |   | 12,945 |   |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| Dividend on Preferred Stock    |       | 134,000           |       | 1,340           |             |                 |       |                 |       |            |       |          |       | 163,480                |           | (164,820       | )              |   |   | 0 |   |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| Common stock private placement |       | 1,581,000         |       | 15,810          |             |                 |       |                 |       |            |       |          |       | 1,157,174              |           |           |           |   |   | 1,172,984 |   |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| Warrants issued to lender      |       |              |       |            |             |                 |       |                 |       |            |       |          |       | 167,698                |           |           |           |   |   | 167,698 |   |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| Net loss for the period        |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           | (672,937       | )              |   |   | (672,937 | ) |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| **Balance, December 31, 2004** | ** ** | **7,186,794**     | ** ** | **71,868**      | ** **       | **500**              | ** ** | **500,000**          | ** ** | **2,100**       | ** ** | **2,100,000** | ** ** | **$**                  | **11,036,561** | ** **     | **(9,728,350** | **)** | **(14,950** | **)** | **3,964,129** | ** ** |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| Dividend on preferred stock    |       | 39,200            |       | 380             |             |                 |       |                 |       |            |       |          |       | 38,808                 |           | (134,000       | )              |   |   | (94,812 | ) |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| Accelerated stock options      |       |              |       |            |             |                 |       |                 |       |            |       |          |       | 21,398                 |           |           |           |   |   | 21,398 |   |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| Common stock private placement |       |              |       |            |             |                 |       |                 |       |            |       |          |       | (19,690                | )              |           |           |   |   | (19,690 | ) |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| 401K contribution              |       | 61,404            |       | 614             |             |                 |       |                 |       |            |       |          |       | 68,166                 |           |           |           |   |   | 68,780 |   |
|                           |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           |           |           |   |   |   |   |
| Net loss for the period        |       |              |       |            |             |                 |       |                 |       |            |       |          |       |                   |           | (11,398        | )              |   |   | (11,398 | ) |
| ** **                     | ** ** | ** **        | ** ** | ** **      | ** **       | ** **           | ** ** | ** **           | ** ** | ** **      | ** ** | ** **    | ** ** | ** **             | ** **     | ** **     | ** **     | ** ** | ** ** | ** ** | ** ** |
| **Balance, December 31, 2005** | ** ** | **7,287,398**     | ** ** | **$**           | **72,862**       | ** **           | **500**    | ** **           | **$**      | **500,000**     | ** ** | **2,100**     | ** ** | **$**                  | **2,100,000**  | ** **     | **$**          | **11,145,243** | ** ** | **$** | **(9,873,748** | **)** | **$** | **(14,950** | **)** | **$** | **3,928,407** | ** ** |

 

**See notesto consolidated financial statements**

 

F-5

----

 

**PHOTONICPRODUCTS GROUP, INC AND SUBSIDIARIES**

** **

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                   | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                         |       |                         |       |   |   |   |   |
| **Cash  flows from operating activities:**                                   |       |                         |       |   |   |   |   |
| Net (loss)                                                                   |       | $                            | (11,398    | ) | $ | (672,937 | ) | $ | (1,777,309 | ) |
|                                                                         |       |                         |       |   |   |   |   |
| **Adjustments to reconcile net loss to cash used  in operating activities:** |       |                         |       |   |   |   |   |
| Depreciation and amortization                                                |       | 1,025,074                    |       | 713,080 |   | 566,764 |   |
| Gain on sale of precious metal                                               |       | (135,931                     | )          | — |   | — |   |
| 401K common stock contribution                                               |       | 68,780                       |       | 12,945 |   | 11,870 |   |
| Stock option acceleration expense                                            |       | 21,398                       |       | — |   | — |   |
| Change in allowance for doubtful accounts                                    |       | 73,000                       |       |   |   |   |   |
| Inventory reserve                                                            |       | (254,526                     | )          | 372,106 |   | 475,000 |   |
| **Changes in assets and liabilities:**                                       |       |                         |       |   |   |   |   |
| Accounts receivable                                                          |       | (744,939                     | )          | (10,756 | ) | 244,670 |   |
| Inventories                                                                  |       | 309,720                      |       | (486,535 | ) | (319,892 | ) |
| Unbilled contract costs                                                      |       | —                       |       | 191,767 |   | 149,774 |   |
| Other current assets                                                         |       | (66,184                      | )          | (10,599 | ) | 7,656 |   |
| Other assets                                                                 |       | 28,981                       |       | 28,133 |   | 102,097 |   |
| Accounts payable and accrued liabilities                                     |       | 81,740                       |       | 599,590 |   | 255,987 |   |
| Customer advances                                                            |       | 110,546                      |       | (105,291 | ) | — |   |
| Total adjustments                                                            |       | 371,659                      |       | 1, 304,440 |   | 1,493,926 |   |
| **Net cash provided by (used in) operating  activities**                     |       | 360,261                      |       | 631,503 |   | (283,383 | ) |
|                                                                         |       |                         |       |   |   |   |   |
| **Cash  flows from investing activities:**                                   |       |                         |       |   |   |   |   |
| Capital expenditures                                                         |       | (453,615                     | )          | (1,013,569 | ) | (101,045 | ) |
| Proceeds from sale of precious metals                                        |       | 314,764                      |       |   |   |   |   |
| Cash used for business acquisition, net                                      |       | —                       |       | (732,000 | ) | (183,780 | ) |
|                                                                         |       |                         |       |   |   |   |   |
| **Net cash used in investing activities**                                    |       | (138,851                     | )          | (1,745,569 | ) | (284,825 | ) |
|                                                                         |       |                         |       |   |   |   |   |
| **Cash  flows from financing activities:**                                   |       |                         |       |   |   |   |   |
| Net (uses) proceeds from issuance of common  stock                           |       | (19,492                      | )          | 1,172,984 |   |   |   |
| Proceeds from secured notes payable                                          |       |                         |       |   |   | 1,700,000 |   |
| Proceeds from senior convertible debentures                                  |       |                         |       | 1,000,000 |   | 1,500,000 |   |
| Principal payments of notes payable                                          |       | (166,515                     | )          | (847,907 | ) | (727,425 | ) |
| Principal payments of bank debt                                              |       |                         |       |   |   | (1,678,623 | ) |
| Principal payments of capital lease  obligations                             |       | (272,347                     | )          | (99,664 | ) | (98,658 | ) |
|                                                                         |       |                         |       |   |   |   |   |
| **Net cash (used in) provided by financing  activities**                     |       | (458,354                     | )          | 1,225,413 |   | 695,294 |   |
|                                                                         |       |                         |       |   |   |   |   |
| **Net  (decrease) increase in cash and cash equivalents**                    |       | (236,944                     | )          | 111,347 |   | 127,086 |   |
|                                                                         |       |                         |       |   |   |   |   |
| **Cash and  cash equivalents at beginning of the year**                      |       | 1,393,507                    |       | 1,282,160 |   | 1,155,074 |   |
|                                                                         |       |                         |       |   |   |   |   |
| **Cash and  cash equivalents at end of the year**                            |       | $                            | 1,156,563  |   | $ | 1,393,507 |   | $ | 1,282,160 |   |

 

F-6

----

 

**PHOTONIC PRODUCTS GROUP, INC. AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**THREE YEARS ENDED DECEMBER 31, 2005**

 

**1.****                         ****Nature of Business andSummary of Significant Accounting Policies**

 

a.   Nature of Operations

 

PHOTONICPRODUCTS GROUP, Inc. and Subsidiaries (the “Company”, formerly known as Inrad,Inc.) is a manufacturer of crystals, crystal devices, electro-optic and opticalcomponents, and sophisticated laser subsystems and instruments.  The Company’s principal customers includecommercial instrumentation companies and OEM laser manufacturers, researchlaboratories, government agencies, and defense contractors.  The Company’s products are sold domesticallyusing its own sales staff, and in major overseas markets, principally Europeand the Far East, using independent sales agents.

 

b.        Principles of consolidation

 

Theaccompanying consolidated financial statements include the accounts of theCompany and its wholly-owned Subsidiaries. Upon consolidation, all intercompany accounts and transactions areeliminated.

 

c.         Allowance for doubtful accounts

 

Managementmust make estimates of the uncollectability of accounts receivable.  Management specifically analyzes accountsreceivable and analyzes historical bad debts, customer concentrations, customercredit-worthiness, current economic trends and changes in customer paymentterms when evaluating the adequacy of the allowance for doubtful accounts.

 

d.        Depreciation and amortization

 

Depreciationis computed using the straight-line method over the estimated useful lives ofthe related assets.  Amortization ofleasehold improvements is computed using the straight-line method over theestimated useful lives of the related assets, 3-7 years, or the remaining termof the lease, 10 years, whichever is shorter. Maintenance and repairs of property and equipment are charged tooperations and major improvements are capitalized.  Upon retirement, sale or other disposition ofproperty and equipment, the cost and accumulated depreciation are eliminatedfrom the accounts and gain or loss is included in operations.

 

e.         Inventories

 

Inventories, including certain precious metals consumed in themanufacturing process, are stated at the lower of cost (first-in, first-outmethod) or market.

 

f.           Income taxes

 

Deferred tax assets and liabilities are determined based on differencesbetween financial reporting and tax bases of assets and liabilities, and aremeasured using the enacted tax rates and laws that will be in effect when thedifferences are expected to reverse.

 

F-7

----

 

g.        Impairment of long-lived assets

 

In accordance with SFAS No. 144, long-lived assets, such as property,plant and equipment and purchased intangibles subject to amortization, arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable.  Recoverability of assets to be held and usedis measured by a comparison of the carrying amount of an asset to estimateundiscounted future cash flows expected to be generated by the asset.  If the carrying amount of an asset exceedsits estimated future cash flows, an impairment charge is recognized by theamount by which the carrying amount of the asset exceeds the fair value of theassets.  Assets to be disposed of wouldbe separately presented in the balance sheet and reported at the lower of thecarrying amount or fair value less costs to sell and are no longerdepreciated.  The assets and liabilities ofa disposed group classified as held for sale would be presented separately inthe appropriate asset and liability sections of the balance sheet.

 

Goodwill and intangible assets not subject to amortization are testedin December of each year for impairment and are tested for impairment more frequentlyif events and circumstances indicate that the assets might be impaired.  An impairment loss is recognized to theextent that the carrying amount exceeds the asset’s fair value.

 

h.        Acquired Goodwill and Intangible assets

 

Acquired intangible assets and goodwill consists of goodwillapproximating $1,870,000 and other intangible assets, principally ofnon-contractual customer relationships that approximated $987,000.  The intangible assets are amortized on a straight-linebasis over the assets’ estimated useful life up to 14 years.  The Company periodically evaluates whetherevents or circumstances have occurred indicating the carrying amount ofintangible assets may not be recoverable. When factors indicate that intangible assets should be evaluated forpossible impairment, the Company uses an estimate of the associatedundiscounted future cash flows compared to the related carrying amount ofassets to determine if an impairment loss should be recognized.

 

The gross carrying amount of intangible assets as of December 31, 2005and as of December 31, 2004 was $1,100,000. Accumulated amortization related to intangible assets approximates$113,000 as of December 31, 2005 and $32,000 as of December 31, 2004.  Amortization expense was approximately$81,000 for the year ended December 31, 2005 and $32,000 for the year endedDecember 31, 2004.  Aggregateamortization for the five succeeding years ending December 31, 2006 throughDecember 31, 2011 approximates $405,000, accumulating at the rate of $81,000per year. The weighted average lives of the Company’s intangible assets is 14years.

 

The changes in the carrying amounts of goodwill, by acquisition, forthe year ended December 31, 2004, are as follows:

 
| ** **   | ** ** | **Balance  Jan. 1, 2005** | ** ** | **Goodwill Additions** | ** ** | **Purchase Price  Adjustment** | ** ** | **Balance  Dec. 31, 2005** | ** ** |
|--------------|------------|---------------------------|------------|------------------------|------------|--------------------------------|------------|----------------------------|------------|
| Laser Optics |       | $                         | 311,572    |                   |       |                           |       |                       | $          | 311,572 |   |
|         |       |                      |       |                   |       |                           |       |                       |       |
| MRC          |       | $                         | 1,416,399  |                   |       |                           | $          | 141,675                    |       | $ | 1,558,074 |   |
|         |       |                      |       |                   |       |                           |       |                       |       |
| Total        |       | $                         | 1,727,971  |                   |       |                           | $          | 141,675                    |       | $ | 1,869,646 |   |

 

F-8

----

 

The following schedule details the Company’s intangible asset balanceby major asset class.

 
| ** **            | ** ** | **At December 31, 2005**    | ** ** |
|-----------------------|------------|-----------------------------|------------|
| ** **            | ** ** | **Gross Carrying   Amount** | ** ** | **Accumulated   Amortization** | ** ** | **Net Carrying   Amount** | ** ** |
|                  |       |                        |       |   |   |   |   |
| Customer-related      |       | $                           | 549,937    |   | $ | (56,301 | ) | $ | 493,636 |   |
| Completed  technology |       | 362,958                     |       | (37,159 | ) | 325,799 |   |
| Trademarks            |       | 186,979                     |       | (19,142 | ) | 167,837 |   |
|                  |       |                        |       |   |   |   |   |
| Total                 |       | $                           | 1,099,874  |   | $ | (112,602 | ) | $ | 987,272 |   |

 
| ** **            | ** ** | **At December 31, 2004**    | ** ** |
|-----------------------|------------|-----------------------------|------------|
| ** **            | ** ** | **Gross Carrying   Amount** | ** ** | **Accumulated   Amortization** | ** ** | **Net Carrying   Amount** | ** ** |
|                  |       |                        |       |   |   |   |   |
| Customer-related      |       | $                           | 549,937    |   | $ | (16,213 | ) | $ | 533,725 |   |
| Completed  technology |       | 362,958                     |       | (10,700 | ) | 352,258 |   |
| Trademarks            |       | 186,979                     |       | (5,512 | ) | 181,466 |   |
|                  |       |                        |       |   |   |   |   |
| Total                 |       | $                           | 1,099,874  |   | $ | (32,425 | ) | $ | 1,067,449 |   |

 

i.            Stock-based compensation

 

The Company accounts for stock-based compensation arrangements inaccordance with the provisions of Accounting Principles Board (“APB”) OpinionNo. 25, Accounting for Stock Issued to Employees, and accounts for stock issuedfor services provided by other than employees in accordance with and complieswith the disclosure provisions of SFAS No. 123, Accounting for Stock-BasedCompensation.  Under APB No. 25,compensation expense is based on the difference, if any, on the date of thegrant, between the fair value of the Company’s stock and the exerciseprice.  A new measurement date forpurposes of determining compensation is established when there is a substantivechange to the terms of an underlying option.

 

(ii) The Company has elected the disclosure-only provisions ofStatement of Financial Accounting Standard No. 123, “Accounting for Stock-BasedCompensation” (“FASB 123”) in accounting for its employee stock options.  Accordingly, no compensation expense has beenrecognized.  Had the Company recordedcompensation expense for the stock options based on the fair value at the grantdate for awards, consistent with the provisions of FASB 123, the Company’s netincome (loss) and net income (loss) per share applicable to common shareholderswould have changed to the following pro forma amounts:

 

F-9

----

 
| ** ** | ** **                                                                                                            | **Years Ended**  | ** ** |
|------------|-----------------------------------------------------------------------------------------------------------------------|------------------|------------|
| ** ** | ** **                                                                                                            | **December 31,** | ** ** |
| ** ** | ** **                                                                                                            | **2005**         | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net Loss:  |                                                                                                                  |             |       |   |   |   |   |
|       | As reported                                                                                                           |             | $          | (11,398 | ) | $ | (672,937 | ) | $ | (1,777,309 | ) |
|       | Add: Stock-based employee Compensation  included in reported net income, net of related tax effects                   |             | 21,398     |   | — |   | — |   |
|       | Less: Stock based employee compensation  expense determined under fair value based method, net of related tax effects |             | (140,630   | ) | (237,565 | ) | (76,555 | ) |
|       | Pro forma                                                                                                             |             | $          | (130,630 | ) | $ | (910,502 | ) | $ | (1,853,864 | ) |
|       |                                                                                                                  |             |       |   |   |   |   |   |
|       | Loss per share:                                                                                                       |             |       |   |   |   |   |   |
|       | Basic:                                                                                                                |             |       |   |   |   |   |   |
|       | As reported                                                                                                           |             | $          | (.02 | ) | $ | (.15 | ) | $ | (.35 | ) |
|       | Pro forma                                                                                                             |             | $          | (.02 | ) | $ | (.19 | ) | $ | (.36 | ) |
|       | Diluted:                                                                                                              |             |       |   |   |   |   |   |
|       | As reported                                                                                                           |             | $          | (.02 | ) | $ | (.15 | ) | $ | (.35 | ) |
|       | Pro forma                                                                                                             |             | $          | (.02 | ) | $ | (.19 | ) | $ | (.36 | ) |

 

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 December 31, 2005, 2004 and 2003:

 
| ** **               | ** ** | **Years Ended**  | ** ** |
|--------------------------|------------|------------------|------------|
| ** **               | ** ** | **December 31,** | ** ** |
| ** **               | ** ** | **2005**         | ** ** | **2004** | ** ** | **2003** | ** ** |
|                     |       |             |       |   |   |   |   |
| Dividend  yield          |       | 0.00             | %          | 0.00 | % | 0.00 | % |
| Volatility               |       | 210.54           | %          | 166.32 | % | 127.16 | % |
| Risk-free  interest rate |       | 5.2              | %          | 5.2 | % | 5.2 | % |
| Expected  life           |       | 10 years         |       | 10 years |   | 10 years |   |

 

j.            Revenue recognition

 

The Company records revenue, other than on contractual type work, whena product is shipped.  Revenue oncontractual type work is accounted for using the percentage-of-completionmethod, whereby revenue and profits are recognized throughout the performanceof the contracts. Percentage-of-completion is determined by relating the actual cost ofwork performed to date to the estimated total cost for each contract.  Losses on contracts are recorded whenidentified.

 

k.         Internal research and development costs

 

Internal research and development costs are charged to expense asincurred.

 

l.            Precious metals

 

Precious metals not consumed in the manufacturing process are valued atcost, cost being determined on the first-in, first-out basis.

 

m.      Use of estimates

 

The preparation of financial statements in conformity with generallyaccepted accounting principles requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period.  Actual

 

F-10

----

 

amounts could differ from thoseestimates.

 

n.        Advertising costs

 

Advertising costs are charged to operations when the advertising firsttakes place.  Included in selling,general and administrative expenses are advertising costs of $34,000, $28,000and $32,000 for the years ended December 31, 2005, 2004 and 2003.

 

o.        Statements of cash flows

 

For purposes of the consolidated statements of cash flows, the Companyconsiders all highly liquid debt instruments purchased with a maturity of threemonths or less to be cash equivalents.

 

Interest paid during the years ended December 31, 2005, 2004 and 2003was $183,000, $194,000 and $63,000, respectively.

 

Income taxes paid were $7,000 in 2005, $1,200 in 2004, $580 in 2003.

 

In 2005, non- cash transactions resulting from the exchange of debt forstock amounted to $59,200.

 

In 2005, non- cash transactions resulting from goodwill adjustmentsamounted to $141,675.

 

p.        Concentration of risk

 

The Company invests its excess cash in deposits and money marketaccounts with major financial institutions and in commercial paper of companieswith strong credit ratings.  Generally,the investments mature within ninety days, and therefore, are subject to littlerisk.  The Company has not experiencedlosses related to these investments.

 

The concentration of credit risk in the Company’s accounts receivableis mitigated by the Company’s credit evaluation process, reasonably shortcollection terms and the geographical dispersion of revenue.  The Company generally does not requirecollateral.

 

The Company utilizes many relatively uncommon materials and compoundsto manufacture its products.  Therefore,any failure by its suppliers to deliver materials of an adequate quality andquantity could have an adverse effect on the Company’s ability to meet thecommitments of its customers.

 

q.        Net Loss per common share

 

The basic net loss per share is computed using weighted average numberof common shares outstanding for the applicable period.  The diluted loss per share is computed usingthe weighted average number of common shares plus common equivalent sharesoutstanding, except if the effect on the per share amounts, includingequivalents, would be anti-dilutive.  Theweighted average number of common shares plus common equivalent sharesoutstanding was 9,565,564.

 

r.           Shipping and handling costs

 

The Company has included freight out as a component of selling, generaland administrative expenses that amounted to $32,000 in 2005, $31,000 in 2004and $27,000 in 2003.  When applicable theCompany bills its customers for freight costs.

 

s.         Recently issued accounting pronouncements

 

InJune 2005, the FASB issued SFAS No. 154, “Accounting Changes and ErrorCorrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3,(“SFAS 154”).  SFAS 154 replaces

 

F-11

----

 

APB Opinion No. 20, “AccountingChanges” (“APB 20”), and SFAS No. 3, “Reporting Accounting Changes in InterimFinancial Statements”.  SFAS 154 requiresretrospective application to prior periods’ financial statements of a voluntarychange in accounting principle unless it is impracticable to determine eitherthe period-specific effects or the cumulative effects of the change.  APB 20 previously required that mostvoluntary changes in accounting principle be recognized by including in net incomein the period of the change the cumulative effect of changing to the newaccounting principle.  This standardgenerally will not apply with respect to the adoption of new accountingstandards, as new accounting standards usually include specific transitionprovisions, and will not override transition provisions contained in new orexisting accounting literature.  SFAS 154is effective for fiscal years beginning after December 15, 2005, and earlyadoption is permitted for accounting changes and error corrections made inyears beginning after the date that SFAS 154 was issued.  The Company does not expect that the adoptionof SFAS 154 on January 1, 2006 will have a significant effect on its financialcondition or results of operations.

 

OnDecember 21, 2004, the Financial Accounting Standards Board (“FSAB”) issuedFASB Staff Position No. FAS 109-1, “Application of FASB Statement No. 109,Accounting for Income Taxes, to the Tax Deduction on Qualified ProductionActivities Provided by the American Jobs Creation Act of 2004” (FSP No 109-1”),and FASB Staff Position No. FAS 109-2, “Accounting and Disclosure Guidance forthe Foreign Earnings Repatriation Provision within the American Jobs CreationAct of 2004” (“FSP No. 109-2”).  Thesestaff positions provide accounting guidance on how companies should account forthe effects of the American Jobs Creation Act of 2004 that was signed into lawon October 22, 2004.  FSP No. 109-1states that the tax deduction for domestic manufacturing activities from thislegislation should be accounted for as a “special deduction” and reduce taxexpense in the period(s) the amounts are deductible on the tax returns, not asan adjustment of recorded deferred tax assets and liabilities.  FSP No. 109-2 gives a company additional timeto evaluate the effects of the legislation on any plan for reinvestment orrepatriation of foreign earnings for purposes of applying FASB Statement No.109.  The Company has determined that itwill not repatriate any undistributed foreign earnings under the new taxlegislation and, therefore, the legislation as it relates to the undistributedforeign earnings will not have an effect on the Company’s consolidatedfinancial statements.

 

InDecember 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment.”  This statement replaces SFAS No. 123,“Accounting for Stock-Based Compensation” and supersedes APB No. 25.“Accounting for Stock Issued to Employees.” SFAS 123(R) requires all stock-based compensation to be recognized as anexpense in the financial statements and that such cost be measured according tothe grant-date fair value of the stock options or other equityinstruments.  SFAS 123(R) will beeffective for the first annual period beginning after June 15, 2005.  Additionally, in March 2005, the Securitiesand Exchange Commission staff issued Staff Accounting Bulletin No. 107,“Share-Based Payment” (SAB No. 107), which provides additional guidance oncertain implementation issues with respect to SFAS No. 123(R).  While the Company currently provides the proforma disclosures required by SFAS No. 148, “Accounting for Stock-BasedCompensation - Transition and Disclosure,” on a quarterly basis (see “Note 1 -Accounting for Stock-Based Compensation”), it is currently evaluating theimpact this statement will have on its consolidated financial statements.  Unrecognized stock-based compensation expenserelated to unvested options as of December 31, 2005 was $131,000.

 

InNovember 2004, the FASB issued SFAS No. 151, “Inventory Costs - an amendment ofARB No. 43, Chapter 4” (“SFAS No. 151”). SFAS No. 151 requires all companies to recognize a current-period chargefor abnormal amounts of idle facility expense, freight, handling costs andwasted materials.  This statement alsorequires that the allocation of fixed production overhead to the costs ofconversion be based on the normal capacity of the production facilities.  SFAS No. 151 will be effective for fiscalyears beginning after June 15, 2005.  TheCompany is currently evaluating the effect that this statement will have on itsconsolidated financial statements.

 

F-12

----

 

t.           Comprehensive income (loss)

 

Comprehensive income (loss) refers to revenue, expenses, gains andlosses that under generally accepted accounting principles are included incomprehensive income but are excluded from net income as these amounts arerecorded directly as an adjustment to stockholders’ equity.  At December 31, 2005 and 2004, there were nosuch adjustments.

 

**2.****                         ****Inventories**

 

Inventories are comprised of the following:

 
| ** **                                                    | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------|------------|------------------|------------|
| ** **                                                    | ** ** | **2005**         | ** ** | **2004** | ** ** |
|                                                          |       |             |       |   |   |
| Raw  materials                                                |       | $                | 616,000    |   | $ | 579,000 |   |
| Work in  process, including manufactured parts and components |       | 1,350,000        |       | 1,420,000 |   |
| Finished  goods                                               |       | 458,000          |       | 480,000 |   |
|                                                          |       | $                | 2,424,000  |   | $ | 2,479,000 |   |

 

**3.****                         ****Property and Equipment**

 

Property and equipment are comprised of the following:

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|------------------|------------|
| ** **                                      | ** ** | **2005**         | ** ** | **2004** | ** ** |
| Office and  computer equipment                  |       | $                | 1,067,000  |   | $ | 985,000 |   |
| Machinery  and equipment                        |       | 9,505,000        |       | 9,161,000 |   |
| Leasehold  improvements                         |       | 1,900,000        |       | 1,873,000 |   |
|                                            |       | 12,472,000       |       | 12,019,000 |   |
| Less  accumulated depreciation and amortization |       | 8,143,000        |       | 7,255,000 |   |
|                                            |       | $                | 4,329,000  |   | $ | 4,764,000 |   |

 

**4.****                         ****Subordinated ConvertiblePromissory Notes**

 

In April 2004, the Company received $1,000,000 inproceeds from the issuance of a Subordinated Convertible Promissory Note.  The Note is due in March 2007 and bearsan interest rate of 6%.  Interest accruesyearly and along with principal may be converted into Common Stock, (and/orsecurities convertible into common shares). As a result of the June 2004 private placement, the note is convertibleinto 1,000,000 Units consisting of 1,000,000 shares of Common Stock andWarrants to acquire 750,000 shares of Common Stock at a price of $1.35 pershare.  The Holder of the Note is a majorshareholder of the Company.

 

In 2003, the Company issued a Subordinated Convertible Promissory Notefor proceeds of $1,500,000.  The note wasamended in 2004 to clarify its conversion features.  The Holder of the Note is a major Shareholderand Debt Holder of the Company.  The notebears interest at the rate of 6% per annum and has a maturity date of December31, 2008.  The note was extended from itsoriginal maturity date of January 31, 2006. The note is convertible into common shares (and/or securitiesconvertible into common shares) of the Company. As a result of the June 2004 private placement, the note is convertible

 

F-13

----

 

into 1,500,000 Units consistingof 1,500,000 shares of Common Stock and Warrants to acquire 1,125,000 shares ofCommon Stock at a price of $1.35 per share. The Holder of the Note is a major shareholder of the Company.  The proceeds from the Note are intended foruse in the Company’s acquisition program.

 

In June 2003, the Company received $1,700,000 from a major Shareholderand Debt Holder of the Company.  Theproceeds of the note were used to pay outstanding bank debt.  The note is secured by the assets of theCompany.  The note bears interest at therate of 6% per annum and is due December 2008.

 

In2002, the Company issued a Subordinated Convertible Promissory Note forproceeds of $1,000,000.  The note wasamended in 2004 to clarify its conversion features.  The note bears interest at the rate of 6% perannum and has a maturity date of December 31, 2008.  The note was extended from its originalmaturity date of January 31, 2006.  Thenote is convertible into common shares (and/or securities convertible intocommon shares) of the Company.  As a result of the June 2004 private placement,the note is convertible into 1,000,000 Units consisting of 1,000,000 shares ofCommon Stock and Warrants to acquire 750,000 shares of Common Stock at a priceof $1.35 per share.  The Holder ofthe Note is a related party to a major Shareholder of the Company.

 

**5.****                         ****Notes Payable Other**

 

Aspart of the purchase price of MRC on October 19, 2004, a $175,000 Note wasissued to the sole shareholder of the company. The note bears interest at the rate of 6% per annum and is payable annually   on the anniversary of the closing date.  On the second anniversary of the ClosingDate, $50,000 of the Note amount shall be due and payable.  The remaining portion of the Note along withany accrued unpaid interest shall be paid in full on October 19, 2009.  Three notes, totaling $295,725, were assumedfrom note holders of MRC.  The notes bearinterest rates from 6.0% to 10.5% and are payable from 2 to 4 years.  During FY 2005 two of the notes totaling$199,525 were exchanged for two notes totaling $125,000, 80,000 shares ofcommon stock of the Company and 60,000 warrants convertible into 60,000 sharesof common stock at $1.35 per share. A Note payable to the SBA was alsoassumed.  The Note in the amount of $390,497bears interest at the rate of 4.0% and is due in 2032.

 

Atthe time of the purchase of Laser Optics, Inc., the Company converted certainliabilities to notes payable.  Notestotaling $100,728 were issued to former officers of Laser Optics, Inc. for backpay and unreimbursed business expenses. These notes are for a three year period and carry an interest ratedefined as the prime rate in the United States as published in the Wall StreetJournal.  A note in the amount of $86,777was issued to the former landlord for back rent.  It is a 36-month note with an interest rateof 2% per annum.  At the time of theclosing a former officer of Laser Optics, Inc. received a $15,000 prepayment onhis note.  All note balances are payablemonthly commencing January 2004.

 

Notes payable other consist of the following:

 
| ** **                                                                                                                                                                                                          | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|
| ** **                                                                                                                                                                                                          | ** ** | **2005**         | ** ** | **2004** | ** ** |
| Notes payable other, payable in aggregate including  interest at monthly installments of $20,000 rates ranging from 2.0% to 10.5%  expiring in April 2032, and a once yearly payment including interest of  $60,500 |       | $                | 779,483    |   | $ | 1,020,525 |   |
| Less current portion                                                                                                                                                                                                |       | 260,697          |       | 226,146 |   |
| Long-term debt, excluding current portion                                                                                                                                                                           |       | $                | 518,786    |   | $ | 794,379 |   |

 

Notes payable other, mature as follows:

 
| 2006       |   | $       | 260,697 |   |
|------------|--------|---------|---------|--------|
| 2007       |   | 15,182  |    |
| 2008       |   | 15,916  |    |
| 2009       |   | 137,514 |    |
| 2010       |   | 9,998   |    |
| Thereafter |   | 340,176 |    |
|       |   | $       | 779,483 |   |

 

F-14

----

 

**6.****                         ****Accounts Payable and AccruedExpenses**

 

Accounts payable and accrued expenses are comprised of the following:

 
| ** **                                    | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|------------------|------------|
| ** **                                    | ** ** | **2005**         | ** ** | **2004** | ** ** |
| Trade accounts  payable and accrued purchases |       | $                | 668,352    |   | $ | 837,830 |   |
| Accrued  vacation                             |       | 335,153          |       | 347,357 |   |
| Accrued  payroll                              |       | 217,653          |       | 197,639 |   |
| Accrued  interest                             |       | 748,048          |       | 433,433 |   |
| Accrued  relocation costs                     |       | —           |       | 179,825 |   |
| Accrued  bonus                                |       | 53,990           |       | — |   |
| Accrued common  stock payable                 |       | 155,200          |       | — |   |
| Accrued 401K  common stock contribution       |       | 140,689          |       | 60,659 |   |
| Accrued  expenses - other                     |       | 107,607          |       | 133,001 |   |
|                                          |       | $                | 2,426,692  |   | $ | 2,189,744 |   |

 

**7.****                         ****Capital Lease Obligations**

 

Capital lease obligations consist of the following:

 
| ** **                                                                                                                                                    | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|
| ** **                                                                                                                                                    | ** ** | **2005**         | ** ** | **2004** | ** ** |
| Capital leases, payable in aggregate  monthly installments of $23,000, including interest at rates ranging from 11.0%  to 11.6% expiring through October 2008 |       | $                | 493,175    |   | $ | 765,522 |   |
| Less current  portion                                                                                                                                         |       | 248,550          |       | 300,813 |   |
|                                                                                                                                                          |       |             |       |   |   |
| Long-term  debt, excluding current portion                                                                                                                    |       | $                | 244,625    |   | $ | 464,709 |   |

 

Maturities of capital leases are as follows:

 
| **Year Ending**                     | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------|------------|
| **December 31,**                    | ** ** | ** ** | ** ** |
|                                |       |       |       |
| 2006                                |       | 293,224    |       |
| 2007                                |       | 223,100    |       |
| 2008                                |       | 49,144     |       |
| Total  minimum payments             |       | 565,468    |       |
| Less amounts  representing interest |       | 72,293     |       |
|                                |       |       |       |
| Present  value of minimum payments  |       | $          | 493,175    |   |
|                                     |            |            |            |  |

 

Capital lease obligations are collateralized by property and equipmentwith cost and related accumulated depreciation approximating $858,000 and$139,000 at December 31, 2005.

 

**8.****                         ****Income Taxes**

 

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

 

F-15

----

 
| ** **                                          | ** ** | **Year Ended**   | ** ** |
|-----------------------------------------------------|------------|------------------|------------|
| ** **                                          | ** ** | **December 31,** | ** ** |
| ** **                                          | ** ** | **2005**         | ** ** | **2004** | ** ** | **2003** | ** ** |
| Federal statutory rate                              |       | 34               | %          | 34 | % | 34 | % |
| Tax provision (benefit) at Federal  statutory rates |       | $                | (3,876     | ) | $ | (228,797 | ) | $ | (604,255 | ) |
| Loss in  excess of available benefit                |       | 3,876            |       | 228,797 |   | 604,255 |   |
| State taxes                                         |       | 0                |       | (96,344 | ) | (134,235 | ) |
|                                                |       | $                | 0          |   | $ | (96,344 | ) | $ | (134,235 | ) |

 

At December31, 2005, the Company has Federal and State net operating loss carryforwardsfor tax purposes of approximately $9,805,000 and $1,002,000, respectively. Thetax loss carryforwards expire at various dates through 2025.

 

The State ofNew Jersey has enacted a program that allows new or emerging technology andbiotechnology businesses to sell their unused Net Operating Loss (NOL)carryover to any corporation for at least 75% of the value of the tax benefits.In 2004, the Company sold $1,550,800 of their NOL for $96,344.

 

InternalRevenue Code Section 382 places a limitation on the utilization of Federal netoperating loss and other credit carryforwards when an ownership change, asdefined by the tax law, occurs. Generally, this occurs when a greater than 50percentage point change in ownership occurs. Accordingly, the actualutilization of the net operating loss and carryfowards for tax purposes may belimited annually to a percentage (approximately 6%) of the fair market value ofthe Company at the time of any such ownership change.

 

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

 
| ** ** | ** ** | **Years Ended**  | ** ** |
|------------|------------|------------------|------------|
| ** ** | ** ** | **December 31,** | ** ** |
| ** ** | ** ** | **2005**         | ** ** | **2004** | ** ** | **2003** | ** ** |
|       |       |             |       |   |   |   |   |
| Current:   |       |             |       |   |   |   |   |
| State      |       | $                |       |   | $ | 96,344 |   | $ | 134,235 |   |
| Deferred:  |       |             |       |   |   |   |   |
| Federal    |       | —           |       | — |   |   |   |
| State      |       | —           |       | — |   | — |   |
|       |       |             |       |   |   |   |   |
| Total      |       | $                | 0          |   | $ | 96,344 |   | $ | 134,235 |   |
|            |            |                  |            |  |  |  |  |  |  |  |  |

 

Deferredtax assets (liabilities) comprise the following:

 
| **December 31,**     | ** ** | ** ** | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|---------------------------|------------|------------|------------|------------|------------|------------|------------|
|                      |       |       |       |       |       |       |       |
| Inventory reserves        |       | 283,000    |       | $          | (79,000    | )          | $          | 332,000 |   |
| Vacation liabilities      |       | 127,000    |       | (2,000     | )          | 118,000    |       |
| Section 263A adjustment   |       | 19,000     |       | 14,000     |       | 116,000    |       |
| Depreciation              |       | (83,000    | )          | 51,000     |       | 102,000    |       |
| Loss carryforwards        |       | 3,424,000  |       | 2,993,000  |       | 2,992,000  |       |
| Gross deferred tax assets |       | 3,936,000  |       | 2,977,000  |       | 3,660,000  |       |
| Valuation allowance       |       | (3,936,000 | )          | (2,977,000 | )          | (3,660,000 | )          |
|                      |       |       |       |       |       |       |       |
|                      |       | $          | —     |       | $          | —     |       | $ | — |   |
|                           |            |            |            |            |            |            |            |  |  |  |

 

F-16

----

 

**9.****                                      RelatedParty Transactions**

 

During the years ended December 31, 2005,2004 and 2003, approximately 1%, 3%, and 3%, respectively of the Company’s netproduct sales were through a foreign agent, in which Warren Ruderman, aprincipal shareholder has an investment. Terms of sales to this foreign agentwere substantially the same as to unrelated foreign agents.

 

In December 2005 the Company initiated afinancing arrangement with a major shareholder and debt holder in the amount of$700,000 to fund acquisition of capital assets needed to absorb growthopportunities. The funds were received in February 2006.

 

During 2005 two notes due to Clarex,LTD., a shareowner and debt holder had their maturity dates extended fromJanuary 31, 2006 to December 31, 2008.

 

During 2004, Clarex, LTD., a shareownerand debt holder received a 6% Convertible Promissory Note for $1,000,000 dueMarch 2007. In March 2004, Clarex, LTD received 200,000 warrants for offeringthe 2003 $1,700,000 secured promissory note and an additional 200,000 warrantsfor extending the maturity date of the Note to December 2008.

 

During 2003, Clarex, LTD. a shareownerand debt holder received a 6% Secured Promissory Note for $1,700,000 dueDecember 2005, that was subsequently extended to December 31, 2008. In October2003, Clarex, LTD received a $1,500,000, 6% Convertible Promissory Note dueJanuary 2006. that was subsequently extended to December 31, 2008.

 

During 2002, Welland Ltd., a relatedparty to Clarex, Ltd., received a 6% Subordinated Convertible Promissory Notedue January 31, 2006, that was subsequently extended to December 31, 2008,resulting in proceeds to the Company of $1,000,000.

 

**10.****                              ****Commitments**

 

a.  Leasecommitment

 

The Company occupies approximately 42,000square feet of space located at 181 Legrand Avenue, Northvale, New Jerseypursuant to a net lease expiring on October 31, 2006. The Company has an optionto renew the Northvale lease for an additional term of five years.

 

The Company’s MRC Optics subsidiaryoccupies approximately 25,000 square feet of space located at 6405 ParklandDrive, Sarasota, FL pursuant to a net lease expiring on August 31, 2006. MRCOptics has negotiated preliminary terms for a renewal of that lease, but doesnot currently have an option in place to renew the lease.

 

Rental expense was approximately$525,000, $370,000 and $238,000 in 2005, 2004 and 2003, respectively, and realestate taxes were $95,000, $64,000 and $41,000 in 2005, 2004 and 2003,respectively.

 

Future minimumannual rentals are payable as follows:

 
| **Year Ending**  | ** ** | ** ** | ** ** |
|------------------|------------|------------|------------|
| **December 31,** | ** ** | ** ** | ** ** |
| 2006             |       | $          | 418,000    |   |
|                  |            |            |            |  |

 

b.  Retirementplans

 

The Companymaintains a 401(k) savings plan for all eligible employees (as defined in theplan). The 401(k) plan allows employees to contribute from 1% to 15% of theircompensation on a salary reduction, pre-tax basis. The 401(k) plan alsoprovides that the Company, at the discretion of the Board of Directors, maymatch employee contributions. The Company contributed $141,519 in the form of144,836 shares of the Company’s common stock in 2005, distributed in March2006. The Company contributed $68,166 in the form of 61,404 shares of theCompany’s common stock in 2004, distributed in

 

F-17

----

 

March 2005.

 

c.  Employmentagreements

 

The Company isparty to an employment agreement with an officer that provides for a minimum annualsalary. The aggregate minimum commitment under this agreement is as follows:

 
| **Year Ending**  | ** ** | ** ** | ** ** |
|------------------|------------|------------|------------|
| **December 31,** | ** ** | ** ** | ** ** |
| 2006             |       | ** ** | $          | 175,000 | ** ** |
| 2007             |       |       | $          | 175,000 |   |
| 2008             |       |       | $          | 175,000 |   |
| 2009             |       |       | $          | 175,000 |   |

 

Should the agreement be terminated without cause during the term of thecontract, the officer would be entitled to one year’s salary.

 

**11.****                              ****Product Sales, Foreign Sales and Sales to MajorCustomers**

 

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

 
| **Year Ended December 31,** | ** ** | **2005**  | ** ** | **2004** | ** ** | **2003**  | ** ** |
|-----------------------------|------------|-----------|------------|----------|------------|-----------|------------|
| **Category**                | ** ** | **Sales** | ** ** | **%**    | ** ** | **Sales** | ** ** | **%** | ** ** | **Sales** | ** ** | **%** | ** ** |
| Optical Components*         |       | $         | 12,279,000 |     | 89         |      | $          | 7,860,000 |   | 85 |   | $ | 4,469,000 |   | 83 |   |
| Laser Accessories           |       | 1,506,000 |       | 11       |       | 1,362,000 |       | 15 |   | 893,000 |   | 17 |   |
| TOTAL**                     |       | $         | 13,785,000 |     | 100        |      | $          | 9,222,000 |   | 100 |   | $ | 5,362,000 |   | 100 |   |

 

----

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

 

  b)  2004 Optical Component sales include $901,000from the Company’s new MRC Optics subsidiary.

 

**  Not included above are (non-product) contract R&Dsales of approximately $26,000 in 2003.

 

Exportsales, primarily to approximately sixteen customers in six countries withinEurope, Asia and Canada, amounted to 14%, 12% and 19% of net product sales in2005, 2004 and 2003, respectively.

 

No foreign customer accounted for morethan 10% of product sales in 2005, 2004 or 2003. In 2005 two U.S. customersaccounted for 13% and 14% of total product sales. In 2004, three U.S. customersaccounted for 12%, 12%, and 10% of total product sales. In 2003, two U.S.customers accounted for 16.0% and 10.0% of total sales.

 

**12.****                              ****Shareholders’ Equity**

 

a.  Commonshares reserved at December 31, 2005, are as follows:

 
| Common Shares Preferred         |   |      |   |
|---------------------------------|--------|-----------|--------|
| 1991 Stock  option plan         |   | 302,500   |   |
| 2000 Stock  option plan         |   | 6,000,000 |   |
| Convertible  preferred stock    |   | 1,340,000 |   |
| Subordinated  convertible notes |   | 3,500,000 |   |
| Warrants                        |   | 4,473,026 |   |

 

F-18

----

 

b.  Preferredstock

 

The Company hasauthorized 1,000,000 shares of preferred stock, no par value, which the Boardof Directors has the authority to issue from time to time in a series. TheBoard of Directors also has the authority to fix, before the issuance of eachseries, the number of shares in each series and the designation, preferences,rights and limitations of each series. Series A consist of 500 shares at astated value of $1,000 per share convertible into common shares at the rate of$1.00 per share. Series B consist of 2,100 shares at a stated value of $1,000per share convertible into common shares at the rate of $2.50 per share.

 

For the yearsended December 31, 2005, 2004 and 2003, the Company paid a common stockdividend on preferred stock equal to $134,000, $165,000 and $54,000,respectively.

 

c.  Stockoptions

 

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 inthe aggregate, options to purchase no more than 6,000,000 shares of commonstock may be granted, at a price that may not be less than the fair marketvalue per share.

 

The EquityCompensation Program authorizes the issuance of incentive stock options. At theannual Shareholders’ meeting held in 2004, shareholders’ approved arecommendation by the Board to increase the number of options to be grantedunder the 2000 Equity Compensation Program, from 4,000,000 to 6,000,000. The2000 equity compensation plan expires in August 2010.

 

A summary of the status of the Company’s stock option program as ofDecember 31, 2005, 2004 and 2003, and changes during the years then ended ispresented below:

 
| ** **                                                   | ** ** | **Years Ended**  | ** ** |
|--------------------------------------------------------------|------------|------------------|------------|
| ** **                                                   | ** ** | **December 31,** | ** ** |
| ** **                                                   | ** ** | **2005**         | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                   | ** ** | ** **       | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                                   | ** ** | ** **       | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                   | ** ** | ** **       | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| **Fixed Stock Options**                            | ** ** | **Shares**       | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| Outstanding, beginning of year                               |       | 2,121,600        |       | $ | 1.21 |   | 1,449,100 |   | $ | 1.42 |   | 1,173,800 |   | $ | 1.69 |   |
| Granted                                                      |       | 139,500          |       | 1.03 |   | 680,000 |   | 0.74 |   | 299,900 |   | 0.50 |   |
| Exercised                                                    |       | —           |       | — |   | — |   | — |   | — |   | — |   |
| Expired                                                      |       | (2000            | )          | 1.25 |   | — |   | — |   | — |   | — |   |
| Forfeited                                                    |       | (68,800          | )          | 1.18 |   | (7,500 | ) | .50 |   | (24,600 | ) | 2.26 |   |
| Outstanding, end of year                                     |       | 2,190,300        |       | 1.18 |   | 2,121,600 |   | 1.21 |   | 1,449,100 |   | 1.42 |   |
| Options exercisable, end of year                             |       | 1,666,124        |       | 1.43 |   | 1,301,047 |   | 1.53 |   | 881,424 |   | 1.88 |   |
| Weighted-average fair values of options  granted during year |       |             |       | $ | 1.03 |   |   |   | $ | .67 |   |   |   | $ | .48 |   |

 

Warrants outstanding expirefrom March 2008 to July 2009 as per the below schedule:

 
| **Shares** | ** ** | **Exercisable through** | ** ** | **Exercise Price** | ** ** | **Fair Value** | ** ** |
|------------|------------|-------------------------|------------|--------------------|------------|----------------|------------|
| 1,448,026  |       | July 2009               |       | $                  | 1.35       |           | $          | 1.29 |   |
| 200,000    |       | May 2008                |       | $                  | 1.08       |           | $          | .42 |   |
| 200,000    |       | March 2008              |       | $                  | .425       |           | $          | .42 |   |
| 80,000     |       | July 2009               |       | $                  | 1.35       |           | $          | 1.31 |   |

 

F-19

----

 

 

The followingtable summarizes information about stock options outstanding atDecember 31, 2005:

 
| ** **         | ** ** | **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     |       |                    | 2,049,200  |                    | 6.99 yrs.  |   | $ | 1.01 |   | 2,073,610 |   | $ | 1.27 |   |
| $3.00 -  $5.00     |       |                    | 141,100    |                    | 4.95 yrs.  |   | $ | 3.57 |   | 504,250 |   | $ | 3.70 |   |

 

F-20

----

 

**13.****                              ****Fair Value of Financial Instruments**

 

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

 

*CurrentAssets and Current Liabilities:* The carrying amount of cash, current receivables and payables andcertain other short-term financial instruments approximate their fair value.

 

*Long-TermDebt:*  The fair value ofthe Company’s long-term debt, including the current portion, for notes payableand subordinated convertible debentures, was estimated using a discounted cashflow analysis, based on the Company’s assumed incremental borrowing rates forsimilar types of borrowing arrangements. The carrying amount of variable andfixed rate debt at December 31, 2005 approximates fair value.

 

**14.****                               QuarterlyData** (Unaudited)

 

Summaryquarterly results were as follows:

 
| **Year 2005**                             | ** ** | **First** | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
|-------------------------------------------|------------|-----------|------------|------------|------------|-----------|------------|------------|------------|
|                                      |       |      |       |       |       |      |       |       |       |
| Net sales                                 |       | $         | 3,233,846  |       | $          | 3,107,079 |       | $          | 3,581,339  |   | $ | 3,862,793 |   |
| Gross profit                              |       | 597,601   |       | 745,376    |       | 1,105,767 |       | 1,380,188  |       |
| Net Income (loss)                         |       | (374,884  | )          | (286,248   | )          | 307,524   |       | 342,210    |       |
| Net Income (loss) per share - Basic (a)   |       | (0.05     | )          | (0.06      | )          | .04       |       | .05        |       |
| Net Income (loss) per share - Diluted (a) |       | (0.05     | )          | (0.06      | )          | .03       |       | .03        |       |
|                                           |            |           |            |            |            |           |            |            |            |  |  |  |  |

 
| **Year 2004**                        | ** ** | **First** | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
|-------------------------------------------|------------|-----------|------------|------------|------------|-----------|------------|------------|------------|
|                                      |       |      |       |       |       |      |       |       |       |
| Net sales                                 |       | $         | 1,805,802  |       | $          | 1,917,221 |       | $          | 2,582,372  |   | $ | 2,916,372 |   |
| Gross profit                              |       | 277,393   |       | 532,589    |       | 846,991   |       | 946,377    |       |
| Net Income (loss)                         |       | (489,393  | )          | (264,722   | )          | 95,167    |       | (13,430    | )          |
| Net Income (loss) per share - Basic (a)   |       | (0.09     | )          | (0.08      | )          | .01       |       | (0.2       | )          |
| Net Income (loss) per share - Diluted (a) |       | (0.09     | )          | (0.08      | )          | .01       |       | (0. 2      | )          |
|                                           |            |           |            |            |            |           |            |            |            |  |  |  |  |

 
| **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  | )          | (438,187   | )          | (380,473  | )          | (600,792   | )          |
| Net loss per share - Basic (a)   |       | (0.07     | )          | (0.09      | )          | (0.07     | )          | (0.04      | )          |
| Net loss per share - Diluted (a) |       | (0.07     | )          | (0.09      | )          | (0.07     | )          | (0.04      | )          |
|                                  |            |           |            |            |            |           |            |            |            |  |  |  |  |

 

**15.****                               SpecialCharges**

 

During 2003,the Company accrued certain expenses related to the relocation of 17 employeesfrom Bethel, CT to its facility in Northvale, NJ. The special charges accruedamounted to $107,000 ($.02 per share on a basic and diluted basis) and includedthe costs for permanent relocation, stay on bonuses and relocation bonuses,anticipated to be expended in the next fiscal year.

 

During 2003,the Company determined that there was excess inventory, relative to forecastedfuture needs, of certain crystals and solutions. Based on this determination, areserve was taken in the amount of $475,000 ($.09 per share on a basic anddiluted basis) in order to recognize the diminished future economic benefit ofthe inventory.

 

F-21

----

 

REPORT OF INDEPENDENT REGISTERED CERTIFIED PUBLIC ACCOUNTANTS ONSUPPLEMENTAL SCHEDULE

 

The audits referred to in our report dated February 24, 2006 relatingto the consolidated financial statements of Photonic Products Group, Inc. andsubsidiaries, which is contained in Item 8 in the Form 10K, include the auditsof the financial statement schedule listed in the accompanying Schedule II forthe years ended December 31, 2005, 2004 and 2003. This financial statementschedule is the responsibility of the Company’s management. Our responsibilityis to express an opinion on this financial statement schedule based upon ouraudits.

 

It is our opinion such financial statement schedule presents fairly, inall material respects, the information set forth therein.

 

 
| Holtz  Rubenstein Reminick LLP |
|--------------------------------|
| Melville, NY                   |
|                           |
| February 24,  2006             |

 

F-22

----

 

Schedule II –Valuation and Qualifying Accounts

 

PHOTONIC PRODUCTS GROUP, INC.

SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS

(in thousands)

 

 
| ** **                         | ** ** | **Balance at  Beginning  of Period** | ** ** | **Charged  (Credited)  to Cost and  Expenses** | ** ** | **Acquired  Balance** | ** ** | **Deductions** | ** ** | **Balance  at End of  Period** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------------------------|------------|
| Allowance for Doubtful Accounts    |       |                                 |       |                                           |       |                  |       |           |       |                           |       |
| Year ended December 31, 2005       |       | $                                    | 40,000     |                                           |       |                  |       |           | $          | 25,000                         |       | $ | 15,000 |   |
| Year ended December 31, 2004       |       | $                                    | 40,000     |                                           |       |                  |       |           |       |                           | $          | 40,000 |   |
| Year Ended December 31, 2003       |       | $                                    | 40,000     |                                           |       |                  |       |           |       |                           | $          | 40,000 |   |
|                               |       |                                 |       |                                           |       |                  |       |           |       |                           |       |
| Reserve for Inventory Obsolescence |       |                                 |       |                                           |       |                  |       |           |       |                           |       |
| Year ended December 31, 2005       |       | $                                    | 807,000    |                                           | $          | (61,000               | )          |           |       |                           |       | $ | 746,000 |   |
| Year ended December 31, 2004       |       | $                                    | 992,000    |                                           | $          | (185,000              | )          |           |       |                           |       | $ | 807,000 |   |
| Year ended December 31, 2003       |       | $                                    | 600,000    |                                           | $          | 392,000               |       |           |       |                           |       | $ | 992,000 |   |
|                                    |            |                                      |            |                                                |            |                       |            |                |            |                                |            |  |  |  |  |

 

F-23

----