**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

**FORM 10-K**
| **(Mark  One)**                                                                                                                     |
|-------------------------------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                               | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                |
| **For the  fiscal year ended: December 31, 2006**                                                                                   |
| **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**                                                                                                |

**PhotonicProducts Group, Inc.******(Exact name 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 registered pursuant to Section 12(b) of theAct: **None**
|                         | ** ** | **Name of each exchange** |
|-------------------------|------------|---------------------------|
| **Title of each class** | ** ** | **on which registered**   |

Securitiesregistered pursuant to section 12(g) of the Act:**Common stock, par value $.01 Per Share**

Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule405 of the Securities Act. Yes  o.      No x.

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

Note — Checking the boxabove will not relieve any registrant required to file reports pursuant toSection 13 or 15(d) of the Exchange Act from their obligations under thoseSections.

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.
| ** ** | ** ** |   | Yes | x | 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.  o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule12b2 of the Exchange Act.  (Check one):
| Large  accelerated filer  o |   | Accelerated  filer  o |   | Non-accelerated filer  x |
|---------------------------------------|--------|---------------------------------|--------|------------------------------------|

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. **  $6,671,750**

**Note. **If a determination as to whether a particular personor entity is an affiliate cannot be made without involving unreasonable effortand expense, the aggregate market value of the common stock held bynon-affiliates may be calculated on the basis of assumptions reasonable under thecircumstances, provided that the assumptions are set forth in this Form

Indicate thenumber of shares outstanding of each of the registrant’s classes of commonstock, as of the latest practicable date.

**Common Shares outstanding as ofMarch 29, 2007**

**[8,001,607]**

 

 

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Photonic ProductsGroup, 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   |       |                                                                                                               |       |       |

 

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#### **PART 1**

**CautionRegarding Forward Looking Statements**

This Annual Reportcontains forward-looking statements as that term is defined in the federalsecurities laws.  The Company wishes toinsure that any forward-looking statements are accompanied by meaningfulcautionary statements in order to comply with the terms of the safe harborprovided by the Private Securities Litigation Reform Act of 1995.  The events described in the forward-lookingstatements contained in this Annual Report may not occur.  Generally, these statements relate tobusiness plans or strategies, projected or anticipated benefits or otherconsequences of the Company’s plans or strategies, projected or anticipatedbenefits of acquisitions made by the Company, projections involving anticipatedrevenues, earnings, or other aspects of the Company’s operating results.  The words “may”, “will”, “expect”, “believe”,“anticipate”, “project”, “plan”, “intend”, “estimate”, and “continue”, andtheir 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 discussionand analysis should be read in conjunction with the Company’s consolidatedfinancial statements 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 in 1973, develops, manufacturesand markets products and services for use in diverse Photonics industry sectorsvia its multiple business units.  Priorto its name change in September, 2003, PPGI was named and did business solelyas Inrad, Inc.

The Company had announcedin 2002 that it was implementing its plan to transform the Company from asingle business unit into a portfolio of businesses serving the Photonicsindustry.  Company management, the Boardof Directors, and shareholders approved the name change in 2003, reinforcingthe transformation of the Company’s business model into that of a portfolio ofbusiness units whose branded products conform to the paradigm:  Products Enabling PhotonicsTM.

In November 2003, theCompany concluded its first acquisition, that of the assets and certainliabilities 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.

In October 2004 theCompany completed its second acquisition of a complementary business with thepurchase of 100% of the stock 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 unitproducts continue, at present, to fall into two product categories: opticalcomponents (including standard and custom optical components and assemblies,crystals, and crystal components), and laser accessories (including wavelengthconversion products and Pockel’s cells (optical shutters, also known as “Q-switches”)that employ nonlinear crystals to perform the function of wavelengthconversion).  Currently, its opticalcomponents product lines and services are brought to market via three PPGIbusiness units: INRAD, Laser Optics, and MRC Optics.  Laser accessories are brought to market byINRAD.

In summary, the Companyis at present an optical component, subassembly, and sub-system supplier tomajor original equipment manufacturers and researchers in the Photonicsindustry.  PPGI expects that in thefuture 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 arelocated within its Northvale, NJ facility.

Custom optic manufacturing is at present a majorproduct area for PPGI.  The Companyspecializes in high-end precision components. It develops, manufactures and delivers precision custom optics and thinfilm optical coating services via its Laser Optics and MRC Precision Opticsbranded business units.  Glass, metal,and crystal substrates are processed using modern manufacturing

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equipment and techniques to prepare and polishsubstrates, deposit optical thin films, and assemble sub-components, therebyproducing optical components used in advanced Photonic systems of manykinds.  The majority of custom opticalcomponents and optical coating services supplied are used in inspection andprocess control systems, in defense and aerospace electro-optical systems, in lasersystem applications, in industrial scanners, and in medical systemapplications.

The Company also currently develops, manufactures, anddelivers synthetic optical crystals, optical crystal components, and laseraccessories via its INRAD brand.  It growssynthetic crystals with electro-optic (EO), non-linear and optical propertiesfor use in both its standard products and custom products.  The majority of crystals, crystal componentsand laser accessories supplied are used in laser systems, defense EO systems,and in R&D applications by researchers within corporations, universities,and national laboratories.

The Company has been implementing its plan to assemblea portfolio of businesses serving the Photonics industry, and is engaged fromtime to time in exploratory strategic merger and acquisition discussions.  The Company is also engaged from time to timein discussions regarding the raising of capital to finance its growth.  The Company’s policy is to not comment onsuch exploratory discussions, due to their indefinite nature.

The following table summarizes the Company’s productsales by product categories during the past three years:
| ** **         | ** ** | **Years Ended December 31,** | ** ** |
|--------------------|------------|------------------------------|------------|
| ** **         | ** ** | **2006**                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Category**       | ** ** | **Sales**                    | ** ** | **%** | ** ** | **Sales** | ** ** | **%** | ** ** | **Sales** | ** ** | **%** | ** ** |
| Optical Components |       | $12,761,000                  |       | 92 |   | $12,279,000 |   | 89 |   | $7,877,000 |   | 85 |   |
| Laser Accessories  |       | 1,160,000                    |       | 8 |   | 1,506,000 |   | 11 |   | 1,345,000 |   | 15 |   |
| TOTAL              |       | $13,921,000                  |       | 100 |   | $13,785,000 |   | 100 |   | $9,222,000 |   | 100 |   |

 

**ProductsManufactured by the Company**

**OpticalComponents**

# a)             Custom Optics and Optical CoatingServices

Manufacturing of high-performance custom optics is atpresent a major product area for PPGI, and is addressed in the marketplaceprincipally via its Laser Optics and its MRC Optics business units.

The Laser Optics business unit was formed in 2003 viathe combination of INRAD’s Northvale, NJ based custom optics and opticalcoating services operations and those of the former Laser Optics, Inc. ofBethel, CT.  The Company had been activein the field since 1973, and Laser Optics, Inc. since 1966.

The “new” Laser Optics provides custom products.  It specializes in the manufacture of opticalcomponents, optical coatings (ultra-violet wavelengths through infra-redwavelengths) and subassemblies for military, industrial, process control,photonic instrument, and medical end-use. Planar, prismatic and spherical components are fabricated from glassesof all kinds and crystals of most kinds, including fused silica, quartz,infra-red materials (including germanium, zinc selenide and zinc sulfide),calcite, magnesium fluoride and silicon. Component types include mirrors, lenses, prisms, waveplates, polarizingoptics, monochrometers, x-ray mirrors, and cavity optics for lasers.

To meet performance requirements, most opticalcomponents and sub-assemblies require thin film coatings on theirsurfaces.  Depending on the design,optical coatings can refract, reflect, or transmit specific wavelengths.  Laser Optics optical coating specialtiesinclude high laser damage resistance, polarizing, high reflective, anti-reflective,infra-red, and coating to complex custom multi-wavelength requirements on awide range of substrate materials.  LaserOptics coats both components it manufactures and customer furnished components.  Coating deposition process technologies employedincluded electron beam, thermal, and ion assist.

MRC Optics, established in 1983 is a fully integratedprecision metal optics and optical assembly manufacturer.  The Company provides high quality precisionCNC and diamond machining, polishing, plating, beryllium machining, andopto-mechanical design, component manufacturing and assembly services.  MRC has developed custom processes to supportprototyping through high rate production of large and small metal mirrors,thermally stable optical mirrors, low RMS surface finish polished mirrors,diamond machined precision aspheric and plano mirrors, ***reflective*** porroprisms, and arc-second accuracy polygons and motor assemblies.  Optical plating specialties include void-freegold and electroless nickel.

# b)                                    Crystalsand Crystal Components

PPGI produces and brings to market crystals andcrystal components via its INRAD business unit. Certain synthetic crystals, because of their internal structure, haveunique optical, non-linear, or electro-optical properties.  Electro-optic and nonlinear crystal devicescan alter the intensity, polarization or wavelength of a laser beam.  Developing growth processes for high qualitysynthetic crystals and manufacturing and design processes for crystalcomponents lies at the heart of the INRAD product line.  Synthetic

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crystals currently inproduction include Nickel Sulfate, Lithium Niobate, Beta Barium Borate, AlphaBarium Borate, KDP, deuterated KDP and Zinc Germanium Phosphide, among others.

The INRAD crystals and crystal components productlines also include crystalline filter materials, including patented materials,that have unique transmission and absorption characteristics that enable themto be used in critical applications in defense systems such as missile warningsensors.  Other crystal components, bothstandard and custom, are used in laser applications research and in commerciallaser systems to change the wavelength of laser light.

**LaserAccessories**

# a)                                     Pockel’sCells

INRAD has developed and manufactures a line of Q-switches,Pockel’s Cells (optical shutters) and associated electronics, and has beenactive in this field since 1973.  Pockel’scells are used in applications that require the fast switching of thepolarization direction of a beam of light. These uses include Q-switching of laser cavities (i.e., to generatelaser output pulses), coupling light into and out from regenerative amplifiers,and light intensity modulation.  Thesedevices are sold on an OEM basis to laser manufacturers and individually toresearchers.

INRAD Pockel’s cell products include the following:

·                  Singlecrystal and dual crystal KD*P Pockel’s Cells

·                  PKC-21 andPKC-02

·                  9 mm through50 mm apertures

·                  Singlecrystal Lithium Niobate Pockel’s Cells

·                  PLC-01

·                  8.5 mmthrough 10.5 mm apertures

·                  Singlecrystal and dual crystal BBO Pockel’s Cells

·                  PBC-03

·                  2.5 mm x 2.5mm through 2.5 mm x 7 mm sizes

·                  Electronicdrivers

·                  Gimbalmounts

# b)                                    HarmonicGeneration Systems

PPGI designs,manufactures, and brings to market a line of harmonic generation laseraccessories via its INRAD business unit.** **Harmonic generation systems enablethe users of lasers to convert the fundamental frequency of the laser toanother frequency required for a specific end use.  Harmonic generators are currently used inspectroscopy, semiconductor processing, medical lasers, optical data storageand scientific research.

Many commercial lasershave automatic tuning features, allowing them to produce a range offrequencies.  The INRAD Autotracker, whenused in conjunction with these lasers, automatically generates tunableultraviolet light or infrared light for use in spectroscopic applications.

Products offered for suchnano-second laser systems include the following:

·                  AT-III — anAutotracker with servo controlled tuning

·                  5-304 — temperature-stabilizedcrystals

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

TheCompany produces a Harmonic Generator, the 5-050, for use with ultra-fastlasers having pulse durations in the femtosecond and picosecond regime.  This product is sold on an OEM basis tomanufacturers of ultra fast lasers and to researchers in the scientificcommunity.

# c)                                     LaserPulse Measurement Instruments

The Company marketed,through December 31, 2005, a line of Autocorrelators that measure extremelyshort laser pulses.  Autocorrelators areused for measuring laser pulses from ultrafast lasers, with pulse durations inthe picosecond and femtosecond ranges. INRAD had pioneered the design, manufacture, and introduction of autocorrelatorsas accessories for the emerging field of ultrafast lasers back in 1979.  In 2000, INRAD joined forces with AngewandtePhysik & Electronik, GmbH of Berlin, Germany, (A.P.E.) and became thesource for supply of products manufactured by A.P.E. to customers in theAmericas, Israel, and selected other

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markets.  Effective January 1, 2006, the Company andA.P.E. ended their alliance in this field. The Company no longer offers Autocorrelators for sale in themarketplace.

**Researchand Development**

Company-funded researchexpenditures during the years ended December 31, 2006, 2005, and 2004 were approximately1% of net product sales.  During theseyears, the Company narrowed its focus on internal research and developmentefforts on 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 and Sarasota operations.  As a result, internal R&D expenditureswere at historically low levels in these years.

**Markets**

In 2006, 2005 and 2004the Company’s product sales were made to customers in the following marketareas:

 
| **Market**                                | ** ** | **2006**  | ** ** | **2005**  | ** ** | **2004**   | ** ** |
|-------------------------------------------|------------|-----------|------------|-----------|------------|------------|------------|
| Defense/Aerospace                         |       | $         | 9,048,000  | (65)%     | $          | 8,352,000  | (60)%      | $ | 4,127,000 | (45)% |
| Process control  & metrology          |       | 2,862,000 | (21)%      | 3,259,000 | (24)%      | 1,817,000  | (20)%      |
| Laser systems  (non-military)             |       | 1,001,000 | (7)%       | 1,044,000 | (8)%       | 1,753,000  | (19)%      |
| Universities  & National laboratories |       | 502,000   | (3)%       | 522,000   | (4)%       | 763,000    | (8)%       |
| Other                                     |       | 508,000   | (4)%       | 608,000   | (4)%       | 662,000    | (8)%       |
| Total                                     |       | $         | 13,921,000 | (100)%    | $          | 13,785,000 | (100)%     | $  | 9,222,000 | (100)% |

 

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

The Company is a providerof optical components, both specialty crystal components and high precisioncustom optical components for customers in the aerospace and defenseelectro-optical systems sector.  End-useapplications include military laser systems, military electro-optical systems,satellite-based systems, and missile warning sensors and systems that 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, representing 65% of salesin 2006 and 60% of sales in 2005 and 45% of sales in 2004.  In dollar terms, sales to customers in thissector increased by 8.3% in 2006 as compared with 2005.  The defense and aerospace sector offerscontinued opportunities for the Company’s capabilities in specialty crystal andprecision optics.

Demand in the ProcessControl and Metrology market for the Company’s products rebounded in 2004 froma protracted and deep cyclical downturn in capital spending for new tools andinstruments in 2002 and 2003.  Sales in2006 represented 20% of total Company sales, down from 24% in 2005.  In dollar terms, 2006 sales to this sectorwere down 12% from sales in 2005.  Theoptical and x-ray inspection segment of the semiconductor industry offerscontinued opportunities for the Company’s capabilities in precision optics,crystal products, and monochrometers.

The Company serves thenon-defense laser industry as an OEM supplier of standard and custom opticalcomponents and laser accessories.  Salesin 2004 had been up 64% in dollar terms from the prior year on a surge ofdemand from both old and new customers for the Company’s laser accessoryproducts, but have since declined.  Salesin 2006 represented 7% of total sales, and in 2005 represented 8%.  In dollar terms, this represents a decline of4% in sales in 2006, and was expected with the discontinuation of the INRAD/APEalliance and sales of autocorrellators on December 31, 2006.  Sales to customers in this sector in dollarterms, net of autocorrellator sales, increased between 2005 and 2006.

 

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Sales to customers withinthe University and National Laboratories market sector represented 4% of totalrevenues in both 2006 and 2005.  Sales tothis sector have been in the $500,000 to $750,000 range historically, nowrepresenting a smaller percentage of total revenues.  Sales to this sector in dollar terms net ofautocorrellator sales increased between 2005 and 2006.

Export sales, primarilyto customers in countries within Europe, the Near East and Japan, amounted to10%, 14%, and 12% of product sales in 2006, 2005 and 2004, respectively.  No single foreign customer accounted for morethan 10% of product sales in 2006, 2005, or 2004.

In 2006, three domesticcustomers accounted for 15%, 16%, and 11%, of sales.  Each of these three customers are electro-opticalsystems divisions of major U.S. defense industry corporations who manufacturesystems for the U.S. and allied foreign governments.  In 2005, two U.S. customers accounted for 13%and 14%, respectively, of sales.  Thesetwo customers, were two of the same three 2006 customers.  In 2004, two U.S. customers each accountedfor 12% of sales, and one customer accounted for 10% of sales.  The first two are defense industry electro-opticsmanufacturers, while the third customer manufactures process control andmetrology systems.  In the short-term,the loss of any of these customers would have a significant negative impact onthe company and its business units.

**Long-TermContracts**

Certain of the Company’sorders from customers provide for periodic deliveries at fixed prices over aperiod that may be greater than one year. In such cases, as in most other cases as well, the Company attempts toobtain firm price commitments from its suppliers for the materials necessary tofulfill the order.

**Marketingand Business Development**

The Company’s twoNorthvale, NJ-based business units market their products domestically throughtheir own sales and marketing teams, led by the Vice President - Marketing andSales.  Independent sales agents are usedin countries in major non-U.S. markets, including Canada, Europe, Israel, andJapan.

The Company’s MRC Opticssubsidiary markets its products domestically through a combination of their ownsales and marketing team, led by the MRC Director of Sales, a salesrepresentative in the west coast region, and a member of the Company’sNorthvale sales team who serves as an MRC sales representative in the northeastregion.

Trade show participationand Internet-based marketing and promotion are coordinated at the corporatelevel.

**Backlog**

The Company’s orderbacklog as of December 31, 2006 was $6,969,000, essentially all of which isexpected to be shipped in 2007.  TheCompany’s order backlog as of December 31, 2005 was $7,857,000.  The Company’s order backlog as of December31, 2004 was $6,433,000.

**Competition**

Within each productcategory in which the Company’s business units are active, there iscompetition.

Changes in the Photonicsindustry have had an effect on suppliers of custom optics.  As end users have introduced productsrequiring large volumes of optical components, suppliers have responded eitherby carving out niche product areas or by ramping up their own manufacturingcapacity and modernizing their manufacturing methods to meet higher volumeproduction rates.  Many custom optics manufacturerslack in-house thin film coating capability. As a result, there are fewer well-rounded competitors in the customoptics arena, but they are equipped with modern facilities and manufacturingmethods.  The Company has judiciouslydeployed capital towards modernizing its facility, and has staffed themanufacturing group with individuals with comprehensive experience inmanufacturing management, manufacturing engineering, advanced finishingprocesses, optical coating processes, and capacity expansion.  The Company competes on the basis ofproviding consistently high quality products delivered on time, its experiencedtechnical and manufacturing employees, developing and maintaining strongcustomer relationships, and continuously improving its labor productivity, coststructure, and product cycle times.

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

For the crystal productarea, price, quality, delivery, and customer service are market drivers.  With advancing globalization, many of theCompany’s competitors supplying non-linear optical crystals are overseas andcan offer significantly reduced pricing for some crystal species.  Sales in this arena are declining, but theCompany has been able to retain a base by providing the quality and customerservice needed by certain OEM customers not readily available from others, andby offering proprietary crystal components for which the Company is either solesource or one of few available sources. On many occasions, the quality of the crystal component 

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drives the ultimateperformance of the component or instrument into which it is installed.  Thus, quality and technical support are consideredto be valuable attributes for a crystal supplier by some, but not all, OEMcustomers.

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

**Employees**

As of December 31, 2006,the Company had 89 full-time employees.

**Patentsand Licenses**

The Company relies on itsmanufacturing and technological expertise, rather than on patents, to maintainits competitive 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 certainof the Company’s products may require export licenses from the United StatesDepartment of Commerce or Department of State. Such licenses are generally available to all but a limited number ofcountries and are obtained when necessary. One product, representing less than 1% of Company sales in 2006, 2005,and 2004, required U.S. State Department export approval and the requiredapprovals were granted.

There are no federalregulations nor any unusual state regulations that directly affect the sale ofthe Company’s products other than those environmental compliance regulationsthat generally affect companies engaged in manufacturing operations in NewJersey and Florida.

**Item 1A.Risk Factors**

The Company cautions investorsthat its performance (and, therefore, any forward looking statements) issubject to risks and uncertainties. Various important factors, including but not limited to, the followingmay cause the Company’s future results to differ materially from thoseprojected in any forward looking statement.

# a)                                     TheCompany faces competition

The Company encounterssubstantial competition from other companies positioned to serve the samemarket sectors that the Company serves. Some competitors may have financial, technical, capacity, marketing orother resources more extensive than ours, or may be able to respond morequickly than the Company can to new or emerging technologies and othercompetitive pressures.  Some competitorshave manufacturing operations in low-cost labor regions such as the far-eastand eastern-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, and competition mayhave a material adverse effect on our business, results of operations orfinancial condition.

# b)                                    TheCompany has exposure to Government Markets

Sales to customers in thedefense industry have increased.  Thesecustomers in turn generally contract with a governmental entity, typically theU.S. government.  Most governmentalprograms are subject to funding approval and can be modified or terminated withno warning upon the determination of a legislative or administrative body.  The loss or failure to obtain certaincontracts or a loss of a major government customer could have a materialadverse effect on our business, results of operations or financial condition.

# c)                                     TheCompany’s revenues are concentrated in its largest customer accounts

For the year endedDecember 31, 2006, seven customer accounts represented in the aggregate 62% oftotal revenues, and three customers represented 42% of revenues.  These three customers each represented 16%,15%, and 11% of sales, respectively.  Asa supplier of custom manufactured components for its OEM customers, therelative size and identity of our largest customer accounts changes somewhatfrom year to year.  In the short term,the loss of any of these large customer accounts could have a material adverseeffect on business, our results of operations, and our financial condition.

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

The Company depends onthe expertise, experience, and continuing services of certain scientists,engineers, production and management personnel, and on the Company’s ability torecruit additional personnel.  There iscompetition for the services of these personnel, and there is no assurance thatthe Company will be able to retain or attract the personnel necessary for its success,despite 

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the Company’s effort todo so.  The loss of the services of theCompany’s key personnel could have a material adverse affect on its business,on its results of operations, or on its financial condition.

# e)                                     TheCompany may not succeed in expanding product lines and markets by acquiringother businesses

The Company’s businessstrategy includes expanding its production capacities, product lines and marketreach through both internal growth and acquisition of complementarybusinesses.  The Company may not succeedin finding or completing acquisitions of such businesses, nor can the Companybe assured that it will be able to raise the financial capital needed for suchacquisitions.  Acquisitions may result insubstantial per share financial dilution of the Company’s Common Stock from theissuance of equity securities.  They mayalso result in the taking on of debt and contingent liabilities, andamortization expenses related to intangible assets acquired, any of which couldhave a material adverse affect on the Company’s business, financial conditionor results of operations.  Also, acquiredbusinesses may be experiencing operating losses.  Any acquisition will involve numerous risks,including difficulties in the assimilation of the acquired company’s people,operations and products, uncertainties associated with operating in new marketsand working with new customers, and the potential loss of the acquired company’skey employees.  To date, the Company hashad limited experience in acquiring and integrating two businesses.

# f)                                       TheCompany depends on, but may not succeed in, developing and acquiring newproducts and processes

In order to meet theCompany’s strategic objectives, the Company must continue to develop newprocesses, to improve existing processes, and to manufacture and market newproducts.  As a result, the Companyexpects to continue to make investments in future in process development andadditions to its product portfolio. There can be no assurance that the Company will be able to develop andintroduce new products or enhancements to its existing products and processesin a way that achieves market acceptance or other pertinent targetedresults.  Nor can the Company be surethat it will be successful in acquiring complementary products, ortechnologies.  Nor can there be assurancethat the Company will have the human or financial resources to pursue orsucceed in such activities.

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

The Company currentlyholds one material patent applicable to an important product, but does not ingeneral rely on patents to protect its products or manufacturingprocesses.  The Company generally relieson a combination 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.

# h)                                    TheCompany has incurred operating losses for one of the past three years and netlosses for two of the past three years

The Company had incomefrom operations of  $917,000 in 2006 and$358,000 in 2005 but had an operating loss of $(410,000) in 2004.  The Company had net income of $772,000 in2006, but sustained net losses of $(11,000) in 2005, and $(673,000) in 2004.  If the Company were to sustain future losses,there are no assurances that the Company would be able to obtain additionalfinancing that it may require to supply the working capital needs of itsexisting operations, or to continue to implement its growth strategy.

# i)                                        TheCompany’s stock price may fluctuate widely

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

# j)                                        TheCompany has experienced certain material weaknesses in our internal controlover financial reporting

Subsequent to thepreparation of our consolidated financial statements for the year endedDecember 31, 2005, certain material weaknesses became evident to our managementwith the discovery that our former Chief Financial Officer had paid forunauthorized and personal expenses through the Company.  This discovery showed that internal controlsfor monitoring the use and reporting of charges on the Company’s debit card andwith respect to the Company’s handling of disbursements by check wereinadequate.  A material weakness is asignificant deficiency in one or more of the internal control components thatalone or in the aggregate precludes 

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our internal controlsfrom reducing to an appropriately low level the risk that materialmisstatements in our financial statements will not be prevented or detected ona timely basis.

In light of the foregoingdiscoveries resulting from the investigation and from management’s review ofits internal control procedures, the Audit Committee directed the Company totake a number of steps to strengthen its internal controls, described herein.

We believe that thesecorrective steps enable us to conclude that the material weaknesses in internalcontrols over financial reporting, as identified above, have been eliminated.

# k)                                     Asgeneral economic conditions deteriorate, the Company’s financial results suffer

Significant economicdownturns or recessions in the United States or Europe could adversely affectthe Company’s business, by causing a temporary or longer term decline in demandfor the Company’s goods and services and thus its revenues.  Additionally, the Company’s revenues andearnings may also be affected by general economic factors, such as excessiveinflation, currency fluctuations and employment levels.

# l)                                        Manyof the Company’s customer’s industries are cyclical

The Company’s business issignificantly dependent on the demand its customers experience for theirproducts.  Many of their end users are inindustries that historically have experienced a cyclical demand for theirproducts.  The industries include but arenot limited to, the defense electro-optics industry and the manufacturers ofprocess control capital equipment for the semiconductor tools industry.  As a result, demand for the Company’sproducts are subject to cyclical fluctuations, and this could have a materialadverse effect on our business, results of operations, or financial condition.

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

The Company servesindustries and market sectors which will be affected by future technologicaldevelopments.  The introduction ofproducts or processes utilizing new developments could render the Company’sexisting products or processes obsolete or unmarketable.  The Company’s continued success will dependupon its ability to develop and introduce on a timely and cost-effective basisnew processes, manufacturing capabilities, and products that keep pace withdevelopments and address increasingly sophisticated customer requirements.

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

The Company utilizes manyrelatively uncommon materials and compounds to manufacture its products.  Examples include optical grade quartz,specialty optical glasses, scarce natural and manmade crystals, beryllium andits alloys, and high purity chemical compounds. Failure of the Company’s suppliers to deliver sufficient quantities ofthese necessary materials on a timely basis, or to deliver contaminated orinferior quality materials, or to markedly increase their prices could have anadverse effect on the Company’s business, despite its efforts to secure longterm commitments from the Company’s suppliers. Adverse results might include reducing the Company’s ability to meetcommitments to its customers, compromising the Company’s relationship with itscustomers, adversely affecting the Company’s ability to meet expanding demandfor its products, or causing the Company’s financial results to deteriorate.

**Item 1B.Unresolved Staff Comments**

Not applicable

**Item 2.                    Properties**

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

PPGI, INRAD and LaserOptics occupy approximately 42,000 square feet of space located at 181 LegrandAvenue, Northvale, New Jersey.  InSeptember 2006, the Company signed an extension of its lease until October 31,2008.  In addition, the Companynegotiated an option for renewing the lease for two additional two year periodsthrough October 31, 2012.

PPGI’s MRC Opticssubsidiary occupies approximately 25,000 square feet of space located at 6405Parkland Drive, Sarasota, FL pursuant to a net lease expiring on August 31,2008.  MRC Optics has the option ofextending the lease for two additional two year periods through August 31,2012.

The facilities areadequate to meet current and future projected production requirements.

The total rent in 2006for these leases was approximately $549,000. The Company also paid real estate taxes and insurance premiums thattotaled approximately $156,000 in 2006.

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**Item 3.                    LegalProceedings**

There are no legalproceedings involving the Company as of the date hereof.

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

On November 8, 2006, atthe Company’s Annual Meeting of Shareholders, John Rich and Luke P. LaValle,Jr. were re-elected as Class II Directors, each for a three year term and eachby a vote of 6,726,334 in favor and 1,200 votes withheld.  Class 1 directors, Tom Lenagh and DanielLehrfeld continue to serve the remainder of their three year terms until2008.  Class III director, Jan Winston,continues to serve the remainder of his three year term until 2007.

**PART II**

**Item 5.                    Marketfor Registrant’s Common Equity and Related Stockholder Matters**

# a)             Market Information

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

The following table setsforth the range of closing prices for the Company’s Common Stock in each fiscalquarter from the quarter ended March 31, 2005 through the quarter endedDecember 31, 2006, as reported by the National Association of SecuritiesDealers NASDAQ System.  Suchover-the-counter quotations reflect inter-dealer prices, without retailmark-up, mark-down or commission and may not necessarily represent actualtransactions.
| ** **                        | ** ** | **Price** | ** ** |
|-----------------------------------|------------|-----------|------------|
| ** **                        | ** ** | **High**  | ** ** | **Low** | ** ** |
|                              |       |      |       |   |   |
| Quarter ended  December 31, 2006  |       | 1.67      |       | 1.05 |   |
|                              |       |      |       |   |   |
| Quarter ended  September 30, 2006 |       | 1.48      |       | 0.86 |   |
|                              |       |      |       |   |   |
| Quarter ended  June 30, 2006      |       | 1.89      |       | 1.25 |   |
|                              |       |      |       |   |   |
| Quarter ended  March 31, 2006     |       | 1.65      |       | 1.35 |   |
|                              |       |      |       |   |   |
| Quarter ended  December 31, 2005  |       | 1.45      |       | 0.90 |   |
|                              |       |      |       |   |   |
| Quarter ended  September 30, 2005 |       | 0.98      |       | 0.75 |   |
|                              |       |      |       |   |   |
| Quarter ended  June 30, 2005      |       | 1.00      |       | 0.65 |   |
|                              |       |      |       |   |   |
| Quarter ended March 31,  2005     |       | 1.40      |       | 1.05 |   |

As of March 23, 2007 theCompany’s closing stock price was $ 1.70 per share.

# b)            Shareholders

As of March 21, 2006,there were approximately 176 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 pays anannual dividend of 134,000 shares of Common Stock on its Series A and Series Bconvertible preferred stock which is valued at the closing price on thedividend date.  The value of the dividendwas $234,500 in 2006, $134,000 in 2005 and $165,000 in 2004.

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

# d)            Recent Sales of UnregisteredSecurities

There were no sales ofunregistered securities during 2006.

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**Item 6.                    SelectedFinancial Data **

The following data isqualified in its entirety by the financial statements presented elsewhere inthis Annual Report on Form 10-K.
| ** **                                           | ** ** | **As of December 31, or**                | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                           | ** ** | **For the Year Ended December 31,** | ** ** |
| ** **                                           | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                 |       |                                                         |       |   |   |   |   |   |   |   |   |
| Revenues                                             |       | $                                                            | 13,921,127 |   | $ | 13,785,057 |   | $ | 9,221,857 |   | $ | 5,388,184 |   | $ | 5,569,118 |   |
|                                                 |       |                                                         |       |   |   |   |   |   |   |   |   |
| Net income  (loss)                                   |       | 772,266                                                      |       | (11,398 | ) | (672,937 | ) | (1,777,309 | ) | (1,715,972 | ) |
|                                                 |       |                                                         |       |   |   |   |   |   |   |   |   |
| Net income  (loss) applicable to common shareholders |       | $                                                            | 537,766    |   | $ | (145,398 | ) | $ | (837,757 | ) | $ | (1,830,909 | ) | $ | (1,836,572 | ) |
|                                                 |       |                                                         |       |   |   |   |   |   |   |   |   |
| Earnings per  share                                  |       |                                                         |       |   |   |   |   |   |   |   |   |
| Basic earnings (loss) per share                      |       | .07                                                          |       | (.02 | ) | (.15 | ) | (.35 | ) | (.35 | ) |
| Diluted earnings (loss) per share                    |       | .06                                                          |       | (.02 | ) | (.15 | ) | (.35 | ) | (.35 | ) |
|                                                 |       |                                                         |       |   |   |   |   |   |   |   |   |
| Weighted average  shares                             |       |                                                         |       |   |   |   |   |   |   |   |   |
| Basic                                                |       | 7,572,637                                                    |       | 7,218,244 |   | 5,710,354 |   | 5,287,849 |   | 5,210,322 |   |
| Diluted                                              |       | 11,915,090                                                   |       | 7,218,244 |   | 5,710,354 |   | 5,287,849 |   | 5,210,322 |   |
|                                                 |       |                                                         |       |   |   |   |   |   |   |   |   |
| Dividends paid                                       |       | 234,500                                                      |       | 134,000 |   | 164,820 |   | 53,600 |   | 120,600 |   |
| Total assets                                         |       | 15,316,260                                                   |       | 13,481,021 |   | 13,526,634 |   | 8,851,121 |   | 8,508,925 |   |
| Long-term  obligations                               |       | 6,299,767                                                    |       | 5,963,411 |   | 6,459,088 |   | 4,405,576 |   | 1,188,512 |   |
| Shareholders’ equity                            |       | 5,236,703                                                    |       | 3,929,407 |   | 3,965,129 |   | 3,284,439 |   | 5,049,879 |   |

The Company completed theacquisition of the stock of MRC Precision Metal Optics, Inc. in mid-October2004.  Also, the Company completed theacquisition of Laser Optics, Inc.’s assets and liabilities at the end ofNovember 2003.  The comparability ofinformation in the selected financial data provided for 2006, 2005 and 2004,above, is aided by details provided in the management discussion, whichattribute certain portions of revenue growth to these two acquisitions.

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

**Critical Accounting Policies**

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

The Company believes thatthe following summarizes critical accounting polices that require significantjudgments and estimates in the preparation of the Company’s consolidatedfinancial statements.

**Revenue Recognition**

The Company recordsrevenue when a product is shipped. Losses on contracts are recorded when identified.  The Company, from time to time, may recognizerevenue using the percentage of completion method for certain long termmanufacturing projects.  No revenues in2006 were accounted for using the percentage of completion method.

**Accounts Receivable**

Accounts receivable arestated at the historical carrying amount, net of write-offs andallowances.  The Company establishes anallowance for doubtful accounts based on estimates as to the collectibility ofaccounts receivable.  Managementspecifically analyzes past-due accounts receivable balances and, additionally,considers bad debts history, customer credit-worthiness, current economictrends and changes in customer payment terms when evaluating the adequacy ofthe allowance for doubtful accounts. Uncollectible accounts receivable are written-off when it is determinedthat the balance will not be collected.

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**Inventory**

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

The Company records areserve for slow moving inventory as a charge against earnings for all productsidentified as surplus, slow moving or discontinued.  Excess work-in-process costs are chargedagainst earnings whenever estimated costs-of-completion exceed unbilledrevenues.

**AcquiredGoodwill and Intangible assets**

The intangible assets areamortized on a straight-line basis over the assets’ estimated useful life up to14 years.  The Company periodicallyevaluates whether events or circumstances have occurred indicating the carryingamount of intangible assets may not be recoverable.  When factors indicate that intangible assetsshould be evaluated for possible impairment, the Company uses an estimate ofthe associated undiscounted future cash flows compared to the related carryingamount of assets to determine if an impairment loss should be recognized.

## Share-based compensation

Effective January 1,2006, the Company adopted the recognition and measurement provisions ofStatement of Financial Accounting Standards (“FAS”) No. 123 (revised 2004),Share-Based Payment (“FAS 123(R)”), which replaces FAS No. 123, Accounting for Stock-BasedCompensation, and supersedes Accounting Principles Board Opinion (“APB”) No.25, Accounting for Stock Issued to Employees, and related interpretations.

FAS 123 (R) requirescompensation costs related to share-based payment transactions, includingemployee stock options, to be recognized in the financial statements.  In addition, the Company adheres to theguidance set forth within Securities and Exchange Commission (“SEC”) StaffAccounting Bulletin (“SAB”) No. 107, which provides the Staff’s views regardingthe interaction between SFAS No. 123(R) and certain SEC rules and regulationsand provides interpretations with respect to the valuation of share-basedpayments for public companies.

Prior to January 1, 2006,the Company accounted for similar transactions in accordance with APB No. 25which employed the intrinsic value method of measuring compensation cost.  Accordingly, compensation expense was notrecognized for fixed stock options if the exercise price of the option equaledor exceeded the fair value of the underlying stock at the grant date.

While FAS No. 123encouraged recognition of the fair value of all stock-based awards on the dateof grant as expense over the vesting period, companies were permitted tocontinue to apply the intrinsic value-based method of accounting prescribed byAPB No. 25 and disclose certain pro-forma amounts as if the fair value approachof SFAS No. 123 had been applied.  InDecember 2002, FAS No. 148, Accounting for Stock-Based Compensation-Transitionand Disclosure, an amendment of SFAS No. 123, was issued, which, in addition toproviding alternative methods of transition for a voluntary change to the fairvalue method of accounting for stock-based employee compensation, required moreprominent pro-forma disclosures in both the annual and interim financialstatements.  The Company complied withthese disclosure requirements for all applicable periods prior to January 1,2006.

In adopting FAS 123(R),the Company applied the modified prospective approach to transition.  Under the modified prospective approach, theprovisions of FAS 123 (R) are to be applied to new awards and to awardsmodified, repurchased, or cancelled after the required effective date.  Additionally, compensation cost for theportion of awards for which the requisite service has not been rendered thatare outstanding as of the required effective date shall be recognized as therequisite service is rendered on or after the required effective date.  The compensation cost for that portion ofawards shall be based on the grant-date fair value of those awards ascalculated for either recognition or pro-forma disclosures under FAS 123.

**Resultsof Operations**

The following tablesummarizes the Company’s product sales by product categories during the pastthree years:
| ** **         | ** ** | **Years Ended December 31,** | ** ** |
|--------------------|------------|------------------------------|------------|
| ** **         | ** ** | **2006**                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Category**       | ** ** | **Sales**                    | ** ** | **%** | ** ** | **Sales** | ** ** | **%** | ** ** | **Sales** | ** ** | **%** | ** ** |
| Optical Components |       | $12,761,000                  |       | 92 |   | $12,279,000 |   | 89 |   | $7,877,000 |   | 85 |   |
| Laser Accessories  |       | 1,160,000                    |       | 8 |   | 1,506,000 |   | 11 |   | 1,345,000 |   | 15 |   |
| TOTAL              |       | $13,921,000                  |       | 100 |   | $13,785,000 |   | 100 |   | $9,222,000 |   | 100 |   |

 

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The following table setsforth, for the past three years, the percentage relationship of statement ofoperations categories to total revenues.
| ** **                                    | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                     |       |                                        |       |   |   |   |   |
| Product sales                                 |       | 100.0                                       | %          | 100.0 | % | 100.0 | % |
| Costs and  expenses:                          |       |                                        |       |   |   |   |   |
| Cost of goods sold                            |       | 67.4                                        | %          | 72.2 | % | 71.9 | % |
| Gross profit margin                           |       | 32.6                                        | %          | 27.8 | % | 28.1 | % |
| Selling, general  and administrative expenses |       | 26.1                                        | %          | 25.0 | % | 31.5 | % |
| Internal  research and development            |       | 0.0                                         | %          | 0.1 | % | 1.1 | % |
| Profit (loss)  from operations                |       | 6.6                                         | %          | 2.6 | % | (4.5 | )% |
| Net income (loss)                             |       | 5.5                                         | %          | (0.1 | )% | (7.3 | )% |

 

**Revenues**

Total revenues wereapproximately $13,921,000, $13,785,000, and $9,222,000 in 2006, 2005 and 2004,respectively.  Revenues leveled off in2006, increasing by 1%.  Sales in 2006included a third year of 12 full months of revenues from legacy Laser Optics,Inc. lines of business acquired in November of 2003, synergies resulting fromthe combination and integration of Laser Optics and Inrad custom opticsoperations in 2004, and a second full year of revenues from the Company’s MRCOptics subsidiary, acquired in October of 2004.

Revenues increased 49% in2005 to $13,785,000 from $9,222,000 in 2004, aided by strong ending backlog in2004, increased demand for the Company’s products in 2005, and a full twelvemonth of revenues from the Company’s MRC Optics, Inc. subsidiary, acquired inOctober 2004.  Approximately two-thirdsof the total revenue growth seen between 2004 and 2005 came from the acquisitionof MRC Optics.

In 2004, sales rose 71%from 2003.  This rapid sales growthresulted from the combination of several factors.  Revenues in 2004 included two and one halfmonth of sales, $901,000 in dollar terms, from newly acquired MRC Optics.  When considering the $8,321,000 of 2004revenues net of the contribution from the MRC Optics acquisition, revenuegrowth in 2004 was 55% over the prior year. 2004 also marked the first year with 12 full months of revenuecontribution from legacy Laser Optics, Inc. lines of business, acquired inNovember 2003.  Approximately one-thirdof the remaining sales increase in 2004 was directly attributable to theCompany’s acquisition of the assets of Laser Optics in November 2003.  The remaining two-thirds of that increase wasattributable to synergies realized from that acquisition and from increaseddemand for the Company’s products in general.

Examining these resultsby customer industry sector:

Sales to theDefense/Aerospace sector continued their three year upward trend in 2006,increasing by 8.3% in dollar terms in 2006 from 2005, to 65% of total Companysales.  In 2006, sales to the sector were$9,048,000 as compared with $8,352,000 in 2005. Sector sales in 2004 were $4,127,000. 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 services in manufacturing custom products forits OEM customers.  Sales to this sectoraccounted for 65%, 60%, and 45%, of total sales in 2006, 2005, and 2004,respectively.

Revenues from customersin the Process Control and Metrology (i.e. semiconductor tools, instruments,inventory management equipment) sector in 2006 decreased 12% from sales in2005, to $2,862,000 from $3,259,000, and now represent 21% of total Companysales.  Sales declined due to reduceddemand from two major OEM customers in this industry in 2006.  Sales to this sector in 2005 had increased79% from sales of $1,817,000 in 2004 due to inclusion of a full 12 months ofsales to this sector by the Company’s MRC Optics subsidiary.  Sales in the sector had rebounded in 2004from a protracted and deep cyclical downturn in capital spending for new toolsand instruments in 2002 and 2003. Revenues rose to $1,817,000 in 2004 from $844,000 in 2003, up 115%.  The optical and x-ray inspection segment ofthe semiconductor industry offers continued opportunities for the Company’scapabilities in precision optics, crystal products, and X-ray monochrometers.  Sales to this sector accounted for 21%, 24%,and 20% of total sales in 2006, 2005, and 2004, respectively.

Revenues decreased in thenon-military Laser Systems sector, declining 4.2% in 2006 to $1,000,000 from$1,044,000 in 2005, and now representing 7% of total revenues.  A decline was expected with thediscontinuation of the INRAD/APE alliance and sales to OEM’s ofautocorrellators on December 31, 2005. Sales to this sector in dollar terms net of autocorrellator salesincreased between 2005 and 2006.  Salesto this sector in 2006 and 2005 reflect a return to 2003 sales levels.  The similar sales level in 2003 thenrepresented 20% of sales and now represents 7% of sales, as total Company saleshave grown substantially since 2003 because of acquisition and internalgrowth.  Sales in 2004 had been up 64%from the prior year on a surge of demand from customers for the Company’s laseraccessory products and certain optical components.  This demand declined in 2005 to pre-2004levels.  Reasons included decline insales of one customer’s product line, acquisition of another customer by alarger corporation with in-house resources for the production of the product,and a general decline in demand for harmonic generators.  Sales to this sector accounted

14

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for 7%, 8%, and 19%, oftotal sales in 2006, 2005, and 2004, respectively.  Sales to customers within the University andNational Laboratories market sector represented 4% of total revenues in both2006 and 2005.  Sales to this sector havebeen in the $500,000 to $750,000 range historically, now representing a smallerpercentage of total revenues.  Sales tothis sector in dollar terms net of autocorrellator sales to researchersincreased between 2005 and 2006.

Sales to customers in “Other”(i.e. non-separately classified) sectors were $512,000 in 2006, $608,000 in2005, and $659,000 in 2004.  Sales in2004 were up 4% from $458,000 in 2003. Sales in these sectors have accounted for 4%, 4%, and 8% of total salesin 2006, 2005, and 2004, respectively.

Total new orders bookedin 2006 were $13,269,000, down approximately 13% from 2005 new orders of$15,308,000.  Orders from certain OEMcustomers were up during the year while orders from others declined. Order intake from three large OEM customers in the Defense/Aerospacesector increased in 2006.  The net decline of $2.039,000 in new ordersthis year was largely due to changes in ordering patterns and reduced demandfrom four customers.  One OEM customer inthe Process Control and Metrology sector changed his ordering pattern from anannual blanket order arrangement in 2005 to periodic order releases during thecourse of the year.  Another commercialOEM customer in that sector, a start-up high technology company addressing theautomotive capital equipment market, cancelled his outstanding order inmid-2006, while forecasting demand would resume late in 2007.  A third OEM customer in that sector indicatedin 2006 that certain custom optical components would no longer be required.  A defense electro-optical systems manufacturersaw his needs for a specialty optical component drop sharply from levelsexperienced in 2005, and forecast reordering would not occur until early2007.  Additionally, an expected decisionon a major new multi-year order, was deferred to the spring of 2007.  Such slippages in awards are not uncommon inthe defense industry’s procurement cycles.  New orders in 2005 hadincreased 36% from orders of $11,240,000 in 2004.  2005 results included a full 12 months of neworders from the Company’s MRC Optics subsidiary, as compared with only two andone half months of new orders in 2004. New orders in 2004 rose 85% from those in 2003, reflecting strongincreases in demand for all product lines as well as both a full twelve monthsof new orders from the legacy lines of business of Laser Optics, Inc., acquiredin November 2003, and two and one-half months of new orders from newly acquiredMRC Optics.

The Company’s backlog ofproduct orders as of December 31, 2006 was approximately $6,969,000, down11.5% from the record closing backlog on December 31, 2005 of$7,876,000.  The Company’s end of yearbacklog in 2004 was $6,433,000.

**Costof Goods Sold and Gross Profit Margin**

As a percentage ofproduct sales, cost of goods sold was 67.4%, 72.2%, and 71.9% for the years endedDecember 31, 2006, 2005 and 2004, respectively.  Gross profit margin as a percentage ofproduct sales was 32.6%, 27.8%, and 28.1% for 2006, 2005, and 2004,respectively.

In 2006, the cost ofgoods sold declined as a percentage of sales, from 2005 levels, due toproductivity increases within operations. Sales increased by 1.0%, while cost of goods sold decreased by6.0%.  In 2005, the cost of goods soldremained relatively constant, as a percentage of sales compared to 2004.  Sales in 2005 increased by 49%, while cost ofgoods sold increased by 51%.  In dollarterms, the higher cost of goods sold in 2005 in comparison to 2004 wasprimarily due to increased costs for material and personnel associated withincreased sales volumes.

Gross margins for the Companyin 2006 represent the combined results from its two centers of operation:Northvale, NJ (site of INRAD and Laser Optics) and Sarasota, FL (site of MRCOptics).  Gross margins from the Company’sNorthvale operations continued their year-over-year improvement in 2006, thethird year following the integration of the acquired operations ofConnecticut-based Laser Optics into Northvale. During 2002, gross margins improved due to improved labor productivity,economies of scale, and reduced expenses.

In 2006, the Companyrecorded its second full year of operations at the Company’s Sarasota-based MRCOptics subsidiary.  Gross margins at MRCOptics in 2006 improved somewhat from the prior year on 6.9% higher sales.  2005 represented the first full year of fiscalcontribution from operations at the Company’s Sarasota-based MRC Opticssubsidiary.  Negative gross marginsduring the first quarter of 2005 was followed by improved margins during theremainder of the year as sales volumes rose by 35% year over year.  Problem vendors were replaced with qualifiednew suppliers, capacity constraints were eased with the addition of these newvendors, new personnel and equipment resources were brought on line, and keymanufacturing processes were re-optimized for use of higher productivitymethods.

Fixed costs are a majorcomponent of the Company’s total cost structure.  Management and the Board of Directors decidedto reduce such costs in 2002 and 2003 only up to the point where furtherreductions would impede the Company’s ability to perform for its currentcustomers or to rebound in the future when macroeconomic conditions improved,and to invest in and integrate new operations, assets, and lines ofbusiness.  This philosophy enabled theCompany to be well-positioned with its operations to manufacture and deliverthe goods that are behind the stronger revenues and improved margins that hascharacterized financial results in 2006.

In the aggregate, costsof most purchased components have been relatively stable in 2006, 2005, and2004.

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**Selling,General and Administrative Expenses**

Selling, general andadministrative expenses as a percentage of sales were 26.1%, 25.0%, and 31.5%in 2006, 2005, and 2004, respectively.

Selling, general andadministrative expenses in 2006 increased in dollar terms from those in 2005 by$205,000, or 5.9%, while sales increased by 1.0%, resulting in the increase inthe 2006 SG&A cost as a percentage of sales.  The increase in SG&A expenditures in 2006resulted in large measure from non-recurring expenses that were incurred inconnection with the investigation into misappropriation of Company funds forpersonal use by its former CFO, as we reported in our Form 8-K filed on June26, 2006, and the resolution of this matter. These included additional costs for legal advice, forensic consulting,temporary accounting assistance, and special meetings of the Audit Committee ofthe Board of Directors.  Increasedexpenses also resulted from recruitment costs incurred in connection with theCompany’s search for its new CFO, and assistant controller, and higher legaland accounting expenses related to day-to-day corporate matters.

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 expenditures in that year reflected the firstfull year of SG&A costs from the Company’s MRC Optics subsidiary, acquiredin October of 2004.

**InternalResearch and Development Expenses**

Company-funded researchexpenditures during the years ended December 31, 2006, 2005, were less than 1%of net product sales, down slightly from just over 1% in 2004.  During these years, the Company narrowed itsfocus of internal research and development efforts on improving certain crystalgrowth processes, and on improving manufacturing process technologies foroptical components.  Technical resourceswere focused on supporting the integration of Laser Optics into Northvale operationsand ramp-up of production rates within Northvale and Sarasota operations.  As a result, internal R&D expenditureswere at historically low levels in these years.

**OperatingIncome**

Profit from operations in2006 was $917,000.  This compares with a profitin 2005 of $358,000, and an operating loss of $(410,000) in 2004.  Management’s efforts to restore and increaseprofitability from operations through 2006 have been focused on expanding thescope of the Company’s product lines, increasing the Company’s top line, and onimproving productivity in its operations. Throughout 2006, the Company continued to focus on cost savingopportunities with respect to its overhead structure and other manufacturingexpenses.  The improved results have beena direct result of the success to date of these efforts.

**OtherIncome and Expenses**

The Company incurredinterest expense at fixed rates on a $1,700,000 secured note, threesubordinated convertible notes totaling $5,200,000, certain equipment leases,and other notes related to its acquisition of MRC Optics and Laser Optics,Inc.  Net interest in 2006 declined to$402,000 in 2006 from $505,000 in 2005. The reduction in interest expense reflects both the positive impact ofinterest income earned on this year’s higher cash balances and an approximately$580,000 reduction in higher rate long term notes and capital lease balancesdue to scheduled amortization payments, although the overall debt balanceincreased by approximately $120,000 with the addition of new debt, at a lowerrate, which was used to finance the acquisition of new equipment in the firstquarter of 2006.

In the third quarter of2006, the Company received notification of a settlement for $300,000, thepolicy limit, from a claim under its employee dishonesty insurance policy andthe Company reported the recovery as other income (expense) for theperiod.  These proceeds were largelyoffset by the additional general and administrative costs related to theinvestigation of the employee involved and costs associated with remediation ofthe Company’s internal controls.  Bycomparison, in the third quarter of 2005, the Company realized a gain of$136,000 on the sale of excess and non-productive precious metals.

The Company also incurredcosts of $13,000 during 2006 to liquidate liabilities for property tax andunemployment and disability tax that were incurred as part of its acquisitionin December 2003 of the assets and certain liabilities of the former LaserOptics, Inc.

**Liquidityand Capital Resources**

The Company’s primarysource of cash has been provided from operating cash flows and long-termborrowings.  Other sources of cashinclude proceeds received from a private placement of stock and preferredshares during 2004.  The Company’s majoruses of cash have been for capital expenditures, for repayment and servicing ofoutstanding debt and acquisition of new business.  Supplemental information pertaining to oursource and use of cash is presented below:

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| **Selected Sources (uses) of cash ($ thousands)** | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                      | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net cash  provided by (used in) operations                                      |       | $                                           | 2,672      |   | $ | 360 |   | $ | 632 |   |
|                                                                            |       |                                        |       |   |   |   |   |
| Proceeds from  issuance of common stock                                         |       | 113                                         |       | (19 | ) | 1,173 |   |
|                                                                            |       |                                        |       |   |   |   |   |
| Capital  Expenditures                                                           |       | (987                                        | )          | (454 | ) | (1,014 | ) |
|                                                                            |       |                                        |       |   |   |   |   |
| Net borrowing  (payment) on debt obligations                                    |       | 123                                         |       | (439 | ) | 52 |   |
|                                                                            |       |                                        |       |   |   |   |   |
| Cash used for business  acquisition, net                                        |       | —                                      |       | — |   | (732 | ) |
|                                                                                 |            |                                             |            |  |  |  |  |  |  |  |

In February 2006, a majorshareholder and debt holder provided the Company with $700,000 in financing tofund the acquisition of certain capital assets required for expandedcapabilities to meet customer demand. The terms call for repayment of the Company’s Promissory note in equalmonthly installments, including interest & principal, commencingMarch 2006, until maturity in March 2013. The Note bears an annual interest rate of 6.75%.

In 2002, the Companyreceived $1,000,000 in proceeds from the issuance of a Subordinated ConvertiblePromissory Note.  The note, originallydue in January 2006, has been extended to December 31, 2008 and bearsan interest rate of 6%.  Interest accruesyearly and along with principal may be converted into Common Stock,(and/or securities convertible into common shares).  The note is convertible into 1,000,000 Unitsconsisting of 1,000,000 shares of Common Stock and Warrants to acquire 750,000shares of Common Stock at a price of $1.35 per share.  The Holder of the Note is a related party toa major shareholder of the Company.

In June of 2003, theCompany paid off existing debt with the proceeds of a $1,700,000 SecuredPromissory Note held by a major investor in the Company.  The note was for a period of 36 monthsat an interest rate of 6% per annum.  TheCompany’s Board of Directors approved the issuance of 200,000 warrants toClarex, Ltd., the lender, as a fee for the issuance of the Note.  In 2004, the Company approved the issuance of200,000 additional warrants to Clarex, The note was subsequently extended toDecember 31, 2008 without issuance of warrants or any other consideration.  The warrants are exercisable at $0.425 pershare and $1.08 per share, respectively, approximately a 20% discount tomarket, and expire in March 2008 and May 2008.  The note is secured by all assets of theCompany.

A SubordinatedConvertible Promissory Note for $1,500,000 originally due in January 2006,has been extended to December 31, 2008 and bears an interest rate of6%.  Interest accrues yearly and alongwith principal may be converted into Common Stock, and/or securitiesconvertible into Common Stock.  The noteis convertible into 1,500,000 Units consisting of 1,500,000 shares of CommonStock and Warrants to acquire 1,125,000 shares of Common stock at a price of$1.35 per share.  The Holder of the Noteis a major shareholder of the Company. The proceeds from the Note were used in the Company’s acquisitionprogram.

In 2004, the Companyreceived $1,000,000 in proceeds from the issuance of a Subordinated ConvertiblePromissory Note.  The note bears aninterest rate of 6% and was initially due on March 31, 2007, but its term has beenextended to March 31, 2008.  Interestaccrues yearly and along with principal may be converted into CommonStock, (and/or securities convertible into common shares).  The note is convertible into 1,000,000 Unitsconsisting of 1,000,000 shares of Common Stock and Warrants to acquire 750,000shares of Common Stock at a price of $1.35 per share.  The note holder is a major shareholder of theCompany.

During 2004, the Companyentered into an agreement with an investment banking firm to raise equity via aprivate placement of the Company’s common stock.  In July 2004 the Company issued1,581,000 Units consisting of 1,581,000 shares and warrants to acquire anadditional 1,185,750 shares at $1.35 per share. In addition, 262,276 Warrants were issued to Casimir Capital, LP, the placementagent for the private placement.  CasimirCapital earned commissions of $142,391 as the underwriter of this privateplacement.  This private placementresulted in net proceeds to the Company of approximately $1,173,000.  The funds were utilized in the furtherance tothe company’s M&A program, capital equipment purchases and to meet generalworking capital requirements.  The issuedshares and shares underlying warrants were subsequently registered under an S-1Registration filing.

Capital expenditures,including internal labor and overhead charges, for the years endedDecember 31, 2006, 2005 and 2004 were approximately $987,000, $454,000,and $1,014,000, respectively.  Capitalexpenditures in 2006 and 2005 were used for the acquisition of manufacturingand test equipment and the build up of tooling for new customerrequirements.  A major portion of the2004 capital expenditures were for the relocation and integration of the LaserOptics Bethel operations into the Northvale facility.  Approximately $600,000 was used in thisfacility rearrangement and expansion, including $190,000 of capitalizedinternal labor and overhead.  Additionallarge capital expenditures for that year included a certain production-criticalinstrument for lens assembly, upgraded coating equipment in the Laser Opticsbusiness unit, and metrology equipment and computer hardware and softwareupgrades.

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A summary of the Company’scontractual cash obligations at December 31, 2006 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          |       | —         |       | —                          |       |
| Notes  payable-other, including interest |       | 1,487,349 |       | 155,091                         |       | 432,194            |       | 297,648        |       | 602,416                         |       |
| Operating leases                         |       | 992,235   |       | 563,262                         |       | 428,973            |       | —         |       | —                          |       |
| Capital leases,  including interest      |       | 262,397   |       | 213,256                         |       | 49,141             |       | —         |       | —                          |       |
| Total  contractual cash obligations      |       | $         | 7,941,981  |                            | $          | 931,609            |       | $              | 6,110,308  |                            | $          | 297,648 |   | $ | 602,416 |   |

**Overviewof Financial Condition**

As shown in theaccompanying financial statements, the Company reported net income ofapproximately $772,000 in fiscal year 2006 and losses of approximately($11,000) in 2005, and ($673,000) in 2004, respectively.  During 2006, 2005 and 2004, the Company’s workingcapital requirements were provided by positive cash flow from its operations.

Net cash provided byoperations was $2,672,000 in 2006, $360,000 in 2005, and $632,000 in 2004.  The significantly higher operating cash flowfor 2006 resulted from the increase in net income and the higher level ofcustomer advances received during the year on certain long term contracts.  Operating cash flow in 2005 was lower than inthe prior year due to, in part, the need to fund increases in accountsreceivable resulting from the higher sales levels and to increased workingcapital requirements at its new MRC Optics subsidiary during the first half of2005.

The Company has madeprogress in transforming itself into a portfolio of businesses serving thePhotonics industry.  The Company assessesmerger and acquisition opportunities from time to time, and seeks financingfrom time to time in the private equity and public equity financialmarkets.  The Company’s first acquisitionwas completed in November 2003 and the necessary capital was raised inpart via the $1,500,000 subordinated convertible note.  Additional financing was obtained in 2004 viaplacement of a $1,000,000 convertible note proceeds of approximately $1,173,000from a private placement of units consisting of the Company’s common stock andwarrants.  These funds were earmarked foracquisitions and capital expenditures, and were partially used to complete itssecond acquisition in 2004.

The Company continues toseek new opportunities to increase sales and minimize expenses and cashrequirements, in order to improve future operating results and cash flows.  Management expects that cash flow fromoperations and use of available cash reserves will provide sufficient liquidityto fund the Company’s operations, working capital requirements and capitalexpenditure plans in 2007.

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 fromfinancings may be needed if it were to make further acquisitions.

**Item 7A.                      Quantitative andQualitative Disclosures About Market Risk**

The Company believes thatit has limited exposure to changes in interest rates from investments incertain money market accounts.  TheCompany does not utilize derivative instruments or other market risk sensitiveinstruments to manage exposure to interest rate changes.  The Company believes that a hypothetical 100basis point adverse move in interest rates along the entire interest rate yieldcurve would not materially affect the fair value of the Company’s interestsensitive money market accounts at December 31, 2006.

**Item 8.                         Financial Statementsand Supplementary Data**

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

**Item 9.                         Changes In andDisagreements With Accountants on Accounting and Financial Disclosure**

None

**Item 9A.                      Controls and Procedures**

**Backgroundto Matters related to Controls and Procedures Resulting in Filing of 10-K/A**

In the second quarter of2006, the Company discovered that over a period of approximately six years,from the second quarter of 2000 through the second quarter of 2006, Mr. WilliamMiraglia, the Company’s former chief financial officer, had engaged inunauthorized and personal transactions totaling approximately $860,000.  This included unauthorized charges on theCompany’s debit

18

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card of approximately$711,000.  In addition, the investigationby the audit committee arising from these discoveries revealed inadequateinternal controls with respect to the Company’s handling of disbursements bycheck and its corporate debit card.  The auditcommittee investigation concluded that Mr. Miraglia acted alone and there wasno evidence implicating any other employees, in these or any other unauthorizedand personal transactions.  Mr. Miragliahad created a control environment that contributed to the failure of Companyemployees charged with certain financial and accounting duties to exerciseappropriate judgment, skepticism and objectivity in detecting and preventingthese unauthorized personal transactions by Mr. Miraglia.  As a result of the foregoing discoveries, Mr.Miraglia was terminated for cause from his employment with the Company on June14, 2006.

The Company filed a claimto recover a portion of these losses under its employee dishonesty insurancepolicy, to the extent permitted as a result of policy limits on time andamounts of coverage.  This claim has beensettled and the company recovered $300,000 from our insurance carrier, which isthe policy limit and which has been reflected in the Company’s financialresults for 2006.  Upon termination ofhis employment, Mr. Miraglia signed an agreement to make restitution to theCompany.  To date, he has repaid$5,000.  In light of a number of factors,the Company does not believe that any significant recoveries from Mr. Miragliaare likely in the near term, but the Company is keeping all of its optionsopen.  The Company has been cooperatingwith the U.S. Attorney’s office in its investigation into this matter.

**Disclosure controls andprocedures**

The Company carried out an evaluation with theparticipation of the Company’s management, including our Chief ExecutiveOfficer and current Chief Financial Officer, of the effectiveness of theCompany’s disclosure controls and procedures pursuant to Securities ExchangeAct Rule 13a-15, as of the end of the period covered by this Annual Report onForm 10-K.  Disclosure controls andprocedures are designed to ensure that the information required to be disclosedby us in the reports we file or submit under the Exchange Act is recorded,processed, summarized and reported on a timely basis and that such informationis accumulated and reported to management, including our CEO and CFO, asappropriate.

At the time of the filingour Annual Report on Form 10-K for the fiscal 2005, our Chief Executive Officerand former Chief Financial Officer concluded that our disclosure controls andprocedures were effective as of December 31, 2005.  Subsequent to that evaluation, our ChiefExecutive Officer and current Chief Financial Officer concluded that ourdisclosure controls were not effective in ensuring that information required tobe disclosed in the reports that the Company files or submits under theSecurities Exchange Act is recorded, processed, summarized and reported, withinthe time periods specified in the SEC’s rules and forms, as of December31, 2005, because of the internal control inadequacies discussed above.  However, based upon the substantial workperformed as a result of the audit committee investigation of Mr. Miraglia’sactions, management has concluded that the Company’s consolidated financialstatements for the periods covered by and included in the Annual Report on Form10-K are fairly stated in all material respects.

**Changesin internal controls over financial reporting**

In light of the foregoingdiscoveries resulting from the investigation and from management’s review ofits internal control procedures during 2006, the Audit Committee directed theCompany to take a number of steps to strengthen its internal controls,including (a) recall and cancellation of the corporate debit card and (b)implementation of a policy requiring two authorized signatures on all checks inamounts of $5,000 or more.  These changeshave been implemented.  The Company hasextended this policy to all wire transfers initiated from its bank.  In addition, a joint meeting with theaccounting staff, the Chief Executive Officer and the new Chief FinancialOfficer was conducted to review internal controls and procedures, to promote acontrol environment that emphasizes appropriate judgment, skepticism andobjectivity and to reinforce each employee’s responsibility to report unusualor suspicious financial transactions to an independent officer or member of theAudit Committee.

Other initiatives tofurther strengthen internal controls have been implemented by the Company.  These include but are not limited to: (i)establishing a written ethics policy to cover all employees which supplementsthe existing policy that covers senior financial executives and members of theBoard of Directors, (ii) improving internal procedures for reporting suspectedethics violations, and (iii) extending the requirement for the written approvalof business expenses to corporate officers’ expense reports and, (iv)identification and documentation of all critical internal controls within anInternal Control Policies and Procedures Manual.

Except as stated above,there were no other changes in our internal control over financial reportingthat occurred during our current fiscal year to which this Annual Report onForm 10-K relates that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

**Item 9B                  Other Information**

None.

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#### **PART III**

**Item 10.                 Directors and ExecutiveOfficers of the Registrant**

**Directorsof 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)                               |
| 69                        |       |       |       | Director (2000 to August 2004)                                                                |
|                           |       |       |       | Vice President/General Manager Power Electronics  Division, C&D technologies (1999-2002)       |
|                           |       |       |       | President, Raytheon/GM Hughes Optical Systems  (1990-1999)                                         |
|                           |       |       |       | Vice President), Perkin Elmer Microlithography,  Electro-Optics, and Systems(1983-1989)            |
|                           |       |       |       | Colonel, Commander, Air Force Avionics Laboratory  and Air Force Weapons Laboratory (Ret.)         |
|                           |       |       |       |                                                                                               |
| Daniel Lehrfeld,          |       | 1999       |       | Director (1999 to present)                                                                         |
| 63                        |       |       |       | President and Chief Executive Officer (2000-present)                                               |
|                      |       |       |       | President and Chief Operating Officer (1999-2000)                                                  |
|                      |       |       |       | Vice President/General Manager Raytheon/GM Hughes  Electro-Optics Center, (1995- 1999)             |
|                      |       |       |       | President, New England Research Center, (1989-1991)                                                |
|                      |       |       |       | Deputy General Manager, Magnavox Electronic Systems,  Division Philips Electronics, NV (1989-1995) |
|                      |       |       |       |                                                                                               |
| Luke P. LaValle, Jr. |       | 2006       |       | Director                                                                                           |
| 64                        |       |       |       | President and CEO, American Capital Management Inc.  (1950 to present)                             |
|                           |       |       |       | Senior investment officer, United States Trust  Company of NY (1967-1980)                          |
|                           |       |       |       | Lt. Colonel, US Army Reserve (Ret.)                                                                |
|                      |       |       |       |                                                                                               |
| Thomas H. Lenagh,         |       | 1998       |       | Director (May 2000 to present)                                                                     |
| 81                        |       |       |       | Chairman of the Board of Directors (May 2000 —  August 2004)                        |
|                      |       |       |       | Management Consultant (1990 - present)                                                             |
|                      |       |       |       | Past Chairman and CEO, Systems Planning Corporation                                                |
|                      |       |       |       | Treasurer and Chief Investment Officer, The Ford  Foundation                                       |
|                      |       |       |       | Captain, US Navy Reserve (Ret.)                                                                    |
| Jan M. Winston            |       | 2000       |       | Director                                                                                           |
| 70                        |       |       |       | Principal, Winston Consulting, (1997-present)                                                      |
|                           |       |       |       | Division Director/General Manager IBM Corporation  (1981-1997)                                     |

 

The directors hold officefor staggered terms of three years.

**ExecutiveOfficers of the 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, 63  |       | 1999      |       | President and Chief Executive Officer                                                      |
|                 |       |      |       |                                                                                       |
| William J. Foote, 56 |       | 2006      |       | Vice President, Chief Financial Officer and Chief  Accounting Officer, Corporate Secretary |
|                 |       |      |       |                                                                                       |
| Devaunshi Sampat, 54 |       | 1999      |       | Vice President — Northvale Sales and PPGI Marketing  Communication                    |

 

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Daniel Lehrfeld hasserved as Chief Executive Officer and President since May 2000.  He joined the Company in 1999 as Presidentand Chief Operating Officer.  Prior tojoining the Company, Mr. Lehrfeld held the position of Vice President andGeneral Manager of Electro-Optical Systems, a division, successively, of the MagnavoxElectronic Systems, GM/Hughes Electronics and Raytheon Corporations.  He has also held executive and managementpositions within Philips Laboratories Briarcliff (the U.S. researchlaboratories of Philips Electronics, NV), and Grumman Aerospace Corporation.  Mr. Lehrfeld holds B.S. and M.S. degreesfrom Columbia University School of Engineering and Applied Science and anM.B.A. degree from the Columbia Graduate School of Business.

William J. Foote joined the Company in May 2006 andwas appointed its Chief Financial Office, Chief Accounting Officer, andCorporate Secretary on May 16, 2006. Mr. Foote served as Chief Financial Officer of INSL-X ProductsCorporation, a $100 million privately held paint and coatings manufacturer,from 2002 through 2005.  From 2000 to2002, he was CFO of ASD Group, Inc., a $14 million public contractmanufacturer serving the OEM marketplace in the high-tech sector.  Prior to that, from 1990 through 1999, Mr.Foote held several executive positions including Director and Vice-President ofFinance positions, with Benjamin Moore & Co., a public $750 millionglobal paint and coatings manufacturer. Earlier in his career, Mr. Foote served as Controller for a numberof manufacturing firms in Canada. Mr. Foote is both a Certified Public Accountant and a CharteredAccountant (Canada), and worked for more than three years, as an auditor inpublic accounting with KPMG (Canada). Mr. Foote holds a B.A. from Carleton University in Ottawa and a MastersDegree in Accounting from the University of British Columbia.

Devaunshi Sampat joined theCompany in 1998.  In 1999 she wasappointed Vice President of Marketing and Sales.  In 2003 she also assumed the title of VicePresident for Marketing Communications for PPGI.  Prior to joining the Company, Ms. Sampatheld sales management positions within the Photonics industry with PrincetonInstruments and Oriel Instruments. Ms. Sampat holds a B.S. in Medical Technology from the Universityof 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.

**TheBoard of Directors and its Committees**

Compositionof the Board of Directors. Since the adoption of the Sarbanes-Oxley Act in July 2002, there hasbeen a growing public and regulatory focus on the independence ofdirectors.  Requirements relating toindependence are imposed by the Sarbanes-Oxley Act with respect to members ofthe Audit Committee.  In accordance tothe NASDAQ National Market definition of “independence” the Board of Directorshas determined that the members of the Audit Committee satisfy such definitionsof independence.  The Board met 21 timesduring fiscal year 2006 with all members in attendance

Each outside director ofthe Company is also a member of each Committee of the Board of Directors.

Audit Committee*.*  During 2006, the Audit Committee was comprised of four Directors: Thomas H. Lenagh (Chairman through November 2006), Jan M. Winston, John C. Rich, and Luke P. LaValle, Jr. (Chairman commencing December 2006).  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.  The Audit Committee met 21 times during the 2006 with all four members in attendance at 18 of the meetings.

AuditCommittee Financial Expert*. *The Board of Directors of theCompany has determined that Mr. John C Rich is an “audit committee financialexpert”; as such term is defined by the SEC. Mr. Rich, as well as Mr. Thomas H. Lenagh, Mr. Jan M. Winston, and Mr.Luke P. LaValle, Jr. have been determined to be “independent” within themeaning of the NASDAQ National Market definition. 

Compensation Committee.  During 2006, the Compensation Committee was comprised of Mr. Jan M. Winston, Chairman, Mr. Thomas H. Lenagh, Mr. Luke P. LaValle, Jr., and Mr. John C. Rich.  The Compensation Committee reviews, approves and makes recommendations to the Board of Directors on matters regarding the compensation of the executive officers and other executives of the Company.  The Compensation Committee met six (6) times during the year with all members in attendance.  In February 2007, the Board delegated approval of compensation decisions within the purview of the Compensation Committee to the Committee

Nominating Committee.  During 2006, the Nominating Committee was comprised of the four outside directors: Mr. John C. Rich, Chairman, Mr. Thomas H. Lenagh, Mr. Luke P. LaValle, Jr., and Mr. Jan M. Winston.  The Nominating Committee makes recommendations to the Board of Directors for the selection of individuals to be nominated to the Board of Directors.  The Nominating Committee met once (1) during the year with all members in attendance.

21

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**Section16(a) Beneficial Ownership Reporting Compliance**

Section 16(a) of theSecurities Exchange Act of 1934 requires the Company’s directors and officers,and persons who own more than 10% of a registered class of the Company’sequity securities, to file initial reports of ownership and reports of changesin ownership with the Securities and Exchange Commission.  These persons are required by the Securitiesand Exchange Commission to furnish the Company with copies of all Section 16(a)reports that they file.  Based solely onthe Company’s review of these reports, the Company believes that during 2006,Form 3 filings were not made on a timely basis for Mr. LaValle and Foote,disclosing their initial grant of stock options.  Additionally, Form 4 filings were not made ona timely basis for Mr. Lenagh, Rich, Winston and Miraglia.  In addition, Ms. Sampat failed to file on atimely basis a report disclosing the grant of stock options in February 2006and Mr. Lehrfeld failed to file on a timely basis a report disclosing the saleof common stock in April 2006 and November 2006.

**Codeof Ethics**

The Company has adopted aCode of Ethics that applies to the Company’s principal executive officer,principal financial officer, principal accounting officer or controller (orpersons performing similar functions).  Acopy of such Code of Ethics has been filed as Exhibit 14.1 to this AnnualReport on Form 10-K.

**Item 11.                 Executive Compensation**

**Compensation Discussion and Analysis**

The CompensationCommittee is comprised of all of the independent, non-management directors, andis responsible for establishing appropriate salaries and bonuses for allexecutive officers and senior management of the Company.  The Compensation Committee has theresponsibility of granting equity-based incentive compensation (i.e. stockoptions) to eligible employees including the executive officers, and to itsdirectors.  The Compensation Committeeduties also include administering and interpreting the Photonic Products Group,Inc.  2000 Equity Compensation Program (“theStock-Option Plan”).  The duties relatingto the Company’s Stock Option Plan include selecting from eligible employeesthose persons to whom awards will be granted and determining the type of award,the number of shares to be included in each award, any restrictions for some orall of the shares subject to the award and the award price.  The Compensation Committee has the authorityto hire independent advisors to help fulfill its duties.

**Compensation Philosophy**

To link the interests ofexecutives and managers to the interests of shareholders and other potentialinvestors. 

To attract and retainindividuals with the leadership and technical skills required to carry theCompany into the future, and to grow the business.

To provide compensationin a manner that allows for shared compensation risks by the executives andmanagers but also the potential for shared rewards.

To provide incentives forworking toward increasing short-term and long-term shareholder value throughgrowth-driven financial compensation.

To reward extra-ordinaryachievement and thereby to provide incentive for such performance in future.

The Company uses a three-pronged approach to itsexecutive compensation program: 1) base salary; 2) potential for cashbonuses; and 3) potential for equity-based compensation.  The Company’s compensation philosophy ties aportion of executive compensation to performance goals, which places thatportion of the total compensation package “at-risk”.  This means it is not guaranteed but rather isreceived through cash bonuses or equity-based compensation based on the Company’sperformance.  The proportion of incentivecompensation to base compensation, and the proportion of cash incentive ascompared with equity-based incentive compensation is set by the CompensationCommittee.  These proportions areindividually determined for each executive by the Committee.  From year to year the relative proportion ofequity-based vs. cash based compensation has been adjusted by the CompensationCommittee and the Board depending on the financial strength of the Company andthe relative impact to the Company’s net income and period cash flow of theproportion of cash vs. equity-based compensation components.

The Company does not require equity ownership by itsexecutive officers, nor by its directors.

**Base Salary**: TheCompensation Committee reviews base salary levels for executive officers andother senior executives, typically once per year, each year.  The process begins with the CompensationCommittee reviewing recommendation that have been prepared by the President andChief Executive Officer regarding changes, if any, in the base salary of eachexecutive other than the President/CEO. The Compensation Committee considers a number of factors, including thestatus of the competitive marketplace for such positions, the responsibilitiesof the position, the experience of the individual, the individual’s performanceduring the past year, and equity in relationship to other positions within theCompany.  The Committee draws on informationgathered by the Company’s VP of Human Resources and Administration, and mayalso engage independent consulting assistance in this regard, although it hasnot done so in the past year.  Based onthe information it has gathered and upon its judgment and knowledge of salarypractices,

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national and local surveys of compensation ranges for similarresponsibilities in the sub-grouping of small high technology manufacturingcompanies, affordability to the Company, and an individual’s performance and contributionto the Company, the Committee modifies or approves the recommendation of thePresident/CEO.

**Incentive Compensation:**TheCompany’s compensation activities include determining annually an accrual foraward as cash bonuses and as stock option grants.  Employees at all levels are eligible for cashbonuses, and executives and senior managers are eligible for award of both cashbonuses and stock option grants.  Earningof awards is based in large part upon achievement of annual financialperformance goals, not publicly disclosed, especially profits and cashflow.  Both the Company and its businessunits must achieve their financial goals for employees at each business unit toearn and be awarded a full cash bonus and/or stock option award under the annualincentive compensation plan.  In 2006,the Company established its financial goals at the start of the year andinformed the executive officers of the target awards that could be achieved ifthe Company’s cash flow and net income targets were met or exceeded.

The Compensation Committee solicits recommendationsfrom the President and Chief Executive Officer near the start of the year toobtain management’s recommendations on the size of the cash award and stockoption accrual budgets, and then solicits recommendations at the end of theyear regarding the awards to be made to executives and other employees.  Based on the Committee’s judgment andknowledge of compensation practices, as well as each individual’s performanceand contribution to the Company, and anticipated financial strength of theCompany that year, the Committee modifies or approves such recommendations asto awards for each individual.  Ingeneral, if financial goals are only partially met the Compensation Committeeand the Board can at their discretion make lesser cash and/or stock optionbonus awards, or greater cash and/or stock option awards if financial goals areexceeded or if other dimensions of executive performance indicate to theCommittee that in their judgment “something extra” is appropriate.

**Cash Incentives and Bonuses**:Additionally, cash bonuses may be awarded at the discretion of the CompensationCommittee for other purposes, such as recruitment bonuses.  The Committee does not distinguish inannouncement of its awards, what proportion of a cash award is for strictperformance against financial targets and what proportion of an award, if any,is a “bonus” for performance or achievements in other areas.  During the past six years, cash bonuses havebeen rarely awarded to executives by the Board because the Company had not yetachieved positive net income.  In 2006,cash bonuses were earned by corporate executives and executives at certain ofits business units based upon levels of profit and cash flow achieved.  Executive cash bonuses in 2006 ranged from 2%to 10% of base pay.

**Equity-based Compensation**: TheCompany has a Stock Option Plan covering directors, and employees, includingexecutive officers, and awards under this plan are made by the CompensationCommittee.  Periodically, theCompensation Committee considers granting executive officers and seniormanagement of the Company awards under the Plan, a companion activity to theprocess in which cash incentives are set, and applying to the same financialperformance targets.  These grants aretypically made in January or February, following the end of the prior fiscalyear, and upon analysis and determination of that prior year’s financialperformance relative to goals.  Thegrants are made as of the date of the Compensation Committee meeting at whichthe share size and list of recipients is determined.  The equity-based compensation component mayat present consist of stock options, stock appreciation rights and performanceshares.  Other instruments may be addedin the future, following evaluation of their merits by the CompensationCommittee.  The Company has, to date,limited itself to stock option grants. The Compensation Committee may also award stock options at othertimes.  Examples of such times are assign-on bonuses for executives and senior managers as part of the recruitmentprocess, and as bonuses awarded to recognize special achievements.  Stock option awards are made by theCompensation Committee with the strike price chosen as the closing price of theCompany stock as of that date.  Theseawards are designed to align the interests of the Company’s executivemanagement and directors with that of the Company’s shareholders, and tomotivate the Company’s executive officers and senior management to remainfocused on the overall long-term performance of the Company.  Prior to 2005, the Company had favored stockoption grants as opposed to cash bonuses as the preferred form of incentivecompensation for its executives, as the Company was strategically following apath to improving profitability and positive net cash flow.  Beginning in 2005, the Compensationphilosophy shifted to a balance between cash and stock options, while theadvantage of stock option incentive grants in the compensation tool-kit wasdiminished due to the impact of Statement of Financial Accounting Standards (“FAS”)No. 123 (revised 2004), Share-Based Payment (“FAS 123(R)” which the companyadopted effective January 1, 2006 and which requires compensation costs relatedto share-based payment transactions, including employee stock options, to berecognized in the financial statements.

**President and ChiefExecutive Officer Compensation**

In setting compensation for the President and ChiefExecutive Officer, the Compensation Committee considers objective criteriaincluding performance of the business, accomplishments of long-term strategicgoals and the development of management. The Compensation Committee considers the Company’s earnings growth andcash flow to be the most important factors in determining the Chief ExecutiveOfficer’s compensation package.  Alongwith the financial performance factors, the Compensation Committee alsoconsiders achievement of long-term strategic goals, including enhancing theCompany’s reputation among both its customer and investor bases during theyear, and the market base salary of comparable positions.  No cash bonus awards were made to the ChiefExecutive Officer for the years 2002 through 2005.  The Chief Executive Officer received stockoption awards for the years 2002 through 2004, none in 2005, and he declined anearned award in 2006.

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The following is the Chief Executive Officer’sCompensation Tally Sheet for the fiscal year ended December 31, 2006.
| **Component**         | ** ** | **Amount Earned /  Granted**                                                                                                              | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                         |
|-----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Base Salary           |       | Current figure: $180,250                                                                                                                            |       | Mr. Lehrfeld received a salary increase of 4% on  January 1, 2007. He had not received a salary increase since 2002.                                                                                                                                                                                                                                                    |
|                  |       |                                                                                                                                                |       |                                                                                                                                                                                                                                                                                                                                                                    |
|  Cash  Incentive |       | Minimum: $0 Target: $25,000 Actual earned: $20,000                                                                                                  |       | Mr. Lehrfeld received a cash bonus of $20,000 based  upon achieved levels of net income and cash flow in 2006, and other factors  considered by the Compensation Committee.                                                                                                                                                                                             |
|                  |       |                                                                                                                                                |       |                                                                                                                                                                                                                                                                                                                                                                    |
| Stock Options         |       | Minimum: 0 Target: $25,000 (grant value) Actual  earned: $15,000 (January 2007 award) Actual accepted: $0 Accrual in 2006 for  prior grant: $13,600 |       | Mr. Lehrfeld did not receive a stock option grant in  January 2006, relative to 2005 performance. Mr. Lehrfeld earned a grant of  stock options valued at $15,000, based on achieved levels of net income and  cash flow in 2006, and other factors considered by the Compensation  Committee. Mr. Lehrfeld declined to accept the grant when offered in January  2007. |

 
| Other Compensation                                                                          |   | Life insurance premiums in excess of group term life  insurance minimum coverage: $13,100. |   | Company-paid premiums on term life insurance on  which the Company is not the beneficiary. (The Company also pays the premium  on a term life insurance policy on which the Company is the beneficiary.)                                                                                                                                                                                                       |
|---------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                        |   |                                                                                       |   |                                                                                                                                                                                                                                                                                                                                                                                                           |
| Severance  (Termination scenario under “for cause” and “not for cause”) |   | —                                                                                     |   | Estimated payout  amounts for cash, equity and benefits under different scenarios: For  cause—$0, not for cause, or for change in control—12 months base pay payable  in 30 days plus accrued bonuses if earned. Should Mr. Lehrfeld’s  employment be terminated without cause or due to a change in control, Mr.  Lehrfeld has three years in which to exercise his vested stock options. |

**TotalPackage in 2006                                              **$226,950

 

**Summaryof Cash and Certain Other Compensation**

The following SummaryCompensation Table sets forth, for the years ended December 31, 2006, 2005and 2004, the compensation paid by the Company and its Subsidiaries, withrespect to the Company’s Chief Executive Officer and other executives

 

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# **Summary Compensation Table**

| Name &   Principal   Position | ** ** | **Year** | ** ** | **Salary ($)** | ** ** | **Option Awards ($)  (1), (2)** | ** ** | **Non-equity  Incentive  Plan  Compensation  ($)** | ** ** | **All Other  Compensation  ($)** | ** ** | **Total ($)** | ** ** |
|--------------------------------------------------|------------|----------|------------|---------------------|------------|------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------|------------|--------------------|------------|
| Daniel Lehrfeld,                                 |       | 2006     |       | $                   | 180,250    |                                           | $          | 13,600                                             |       | $                                     | 20,000     |               | $          | 13,100 | (3) | $ | 226,950 |   |
| President and                                    |       | 2005     |       | $                   | 180,250    |                                           | $          | 108,378                                            |       | $                                     | 0          |               | $          | 13,100 | (3) | $ | 301,728 |   |
| CEO (8)                                          |       | 2004     |       | $                   | 180,250    |                                           | $          | 157,456                                            |       | $                                     | 0          |               | $          | 5,300 | (3) | $ | 343,006 |   |
| William J. Foote,                                |       | 2006     |       | $                   | 81,850     |                                           | $          | 3,267                                              | (5)        | $                                     | 2,000      |               | $          | 0 |   | $ | 87,117 |   |
| VP & CFO (4)                                 |       | 2005     |       | N/A                 |       | N/A                                            |       | N/A                                                |       | N/A                                   |       | N/A                |       |
|                                             |       | 2004     |       | N/A                 |       | N/A                                            |       | N/A                                                |       | N/A                                   |       | N/A                |       |
| Devaunshi                                        |       | 2006     |       | $                   | 128,750    |                                           | $          | 13,898                                             |       | $                                     | 10,000     |               | $          | 0 |   | $ | 152,648 |   |
| Sampat, VP                                       |       | 2005     |       | $                   | 128,750    |                                           | $          | 35,915                                             |       | $                                     | 36,250     | (6)                | $          | 0 |   | $ | 200,915 |   |
| Northvale Sales                                  |       | 2004     |       | $                   | 128,750    |                                           | $          | 29,900                                             |       | $                                     | 42,250     | (6)                | $          | 0 |   | $ | 200,900 |   |
| and Marketing                                    |       |     |       |                |       |                                           |       |                                               |       |                                  |       |               |       |
| William Miraglia,                                |       | 2006     |       | $                   | 62,030     |                                           | $          | 15,409                                             |       | $                                     | 0          |               | $          | 0 |   | $ | 77,439 |   |
| Former CFO (7)                                   |       | 2005     |       | $                   | 126,000    |                                           | $          | 35,734                                             |       | $                                     | 0          |               | $          | 0 |   | $ | 161,734 |   |
|                                             |       | 2004     |       | $                   | 126,000    |                                           | $          | 24,495                                             |       | $                                     | 0          |               | $          | 0 |   | $ | 151,495 |   |

 

(1)             Thevalue of stock option grants are determined from the value computed inaccordance with FASB 123R, using the Black-Scholes options pricing model withthe following assumptions (unless otherwise noted): volatility rates rangingfrom 119.3% to 210.5%, risk-free rate of return of 5.2%, dividend yield of 0%,and 10 year option life.

(2)             Thevalue of stock option awards is the value accrued and imputed to Companyexpenses in each year and reflected in net income (or in notes to the financialstatements before 2006).  Stock optionsvest over three years, one-third upon each anniversary of the grant, unlessvesting is accelerated by resolution of the Compensation Committee.  Stock option imputed expense accruesproportionally over the three year vesting period.

(3)             Company-paidterm life insurance premiums in excess of group term life insurance minimumcoverage.

(4)             Mr.William J. Foote was appointed CFO and Secretary on May 16, 2006

(5)             Additionally,Mr. Foote was granted a 10 year stock option grant of 3,378 shares at a strikeprice of $1.50 on January 19, 2007, for achievements in 2006.

(6)             Through2005, Ms. Sampat’s compensation plan included a commission if bookings wereachieved in excess of certain annual targets. In 2006, this incentive compensation methodology was changed to onefocused on achievement of a mix of financial performance and bookingsobjectives.

(7)             Mr.Miraglia was removed as CFO and Secretary of the Company on May 16, 2006, andhis employment was terminated by the Company for cause on June 14, 2006.  All of Mr. Miraglia’s outstanding stockoption grants were forfeited, however the imputed value of his stock optionsnevertheless are reflected in net income.

(8)             InJanuary 2007, the Board increased Mr. Lehrfeld’s base salary to $187,500,effective January 1, 2007.  The Companyis party to an employment agreement with Mr. Lehrfeld, President and CEO,that provides for a minimum annual salary during its term, and severancebenefits under certain conditions that include termination without cause and achange of control of the Company.  ShouldMr. Lehrfeld’s employment be terminated for these reasons during the contract’sterm, he would be entitled to one year’s salary payable in one lump sum within30 days of termination, any pro-rata accrued bonuses if earned, and he wouldhave three years in which to exercise his vested stock options.  The aggregate minimum commitment under thisagreement is as follows:

 
| **Year Ending**  | ** ** | ** ** | ** ** |
|-----------------------|------------|------------|------------|
| **December 31,** | ** ** | ** ** | ** ** |
|                  |       |       |       |
| 2007                  |       | $          | 187,500    |   |
| 2008                  |       | $          | 187,500    |   |
| 2009                  |       | $          | 187,500    |   |

# ** **

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# **Grants of Plan-Based Awards**

Shown below isinformation on grants of stock options pursuant to the 2000 Equity Compensationplan made during the fiscal year ended December 31, 2006 to the executiveofficers named below, and/or earned for performance during the fiscal year butawarded in the weeks following (under “Estimated Future Payouts Under EquityIncentive Plan Awards”:

**Grants of Plan-Based Awards**
| Name                                                 | ** ** | **Grant Date** | ** ** | **Estimated  Future  Payouts  Under Non-  Equity  Incentive  Plan  Awards  (1)** | ** ** | **Estimated  Future  Payouts  Under Equity  Incentive  Plan Awards  (2), (3)** | ** ** | **All Other  Option  Awards:  Number of  Securities  Underlying  Options (#)** | ** ** | **Exercise  or Base  Price of  Option  Awards  ($/Sh)** | ** ** | **Grant Date  Fair Value  of Stock  Option Awards ($)  (3)** | ** ** |
|------------------------------------------------------|------------|---------------------|------------|---------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | ** **          | ** ** | **Target ($)**                                                                   | ** ** | **Target ($)**                                                                           | ** ** | ** **                                                                                    | ** ** | ** **                                                        | ** ** | ** **                                                                            | ** ** |
| Daniel Lehrfeld, President and CEO                   |       |                |       | N/A                                                                                   |       | N/A                                                                                           |       | 0                                                                                             |       | N/A                                                               |       | N/A                                                                                   |       |
| William J. Foote,                                    |       | May 16, 2006        |       | N/A                                                                                   |       | N/A                                                                                           |       | 10,000                                                                                        |       | $                                                                 | 1.75       |                                                                                  | $          | 16,800 |   |
| VP, CFO &  Secretary                             |       | January 19, 2007    | (4)        |                                                                                  |       |                                                                                          |       | 3,378                                                                                         |       | $                                                                 | 1.50       |                                                                                  | $          | 5,000 |   |
| Devaunshi Sampat, VP, Northvale Sales  and Marketing |       | February 13, 2006   |       | N/A                                                                                   |       | N/A                                                                                           |       | 13,500                                                                                        |       | $                                                                 | 1.50       |                                                                                  | $          | 19,305 |   |
| William Miraglia, former  CFO(5)                     |       | February 13, 2007   |       | N/A                                                                                   |       | N/A                                                                                           |       | 6,300                                                                                         |       | $                                                                 | 1.50       |                                                                                  | $          | 9,009 |   |

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(1)             Valuesin this column represent the estimated target value of future cash incentiveplan awards based on performance targets for fiscal year 2007.  These have not yet been established.

(2)             Valuesin this column represent the estimated target value of future equity-basedawards that would be reflected in 2007 net income.  These targets have not yet been determined.

(3)             Thegrant date fair value of stock option grants is the value computed inaccordance with FASB 123R, using the Black-Scholes options pricing model withthe following assumptions (unless otherwise noted):  volatility of 121%, risk-free rate of returnof 5.2%, dividend yield of 0%, and 10 year option life.

(4)             Stockoption grant made in January 2007 based on performance in 2006.

(5)             Mr.Miraglia was removed as CFO and Secretary of the Company on May 16, 2006, andhis employment was terminated for cause on June 14, 2006.  All of Mr. Miraglia’s outstanding stockoption grants were forfeited.

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# **Outstanding Equity-Based Awards at Fiscal Year-End**

The following tableprovides information pertaining to vested and non-vested stock options held byeach of the executive officers named in the Summary Compensation Table as ofDecember 31, 2006.

# **Outstanding Equity-Based Awards at Fiscal Year-End**

| **Name**                                            | ** ** | **Number of  Securities  Underlying  Unexercised  Options (#)  Exercisable  (1)** | ** ** | **Number of  Securities  Underlying  Unexercised  Options (#)   Unexercisable** | ** ** | **Equity Incentive  Plan Awards:  Number of  Securities  Underlying  Earned but  Unawarded Options (#)** | ** ** | **Option Exercise  Price ($)**             | ** ** | **Option  Expiration Date**                                                             | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| Daniel Lehrfeld,  President and CEO                 |       | 100,000   100,000   56,670   20,000   50,000   60,000   310,000   50,000   Total: 746,670   |       | 0.   0.   28,330   0.  0.  0.  0.  0.  Total: 28,330                                           |       | N/A  N/A  N/A  N/A  N/A

N/A  N/A  N/A                                                                                                 |       | 1.35  0.95  0.50  0.50  0.85  1.00  2.00  2.00       |       | 8/12/2009  8/12/2014  1/2/2014  1/2/2013  6/1/2012  1/2/2012  5/24/2010  5/24/2010           |       |
| William J.  Foote, VP and CFO                       |       | N/A  0.  Total:0                                                                            |       | N/A  10,000  Total: 10,000                                                                     |       | 3,378  N/A  Total:3,378                                                                                                                | (2)        | 1.50  1.75                                           |       | 1/19/2017  5/16/2016                                                                         |       |
| Devaunshi  Sampat, VP Northvale Sales and Marketing |       | 0  20,000  33,335

24,000  31,500  28,000  20,000  20,000  7,500  Total: 184,335            |       | 13,500  0.  16,665  0.  0.  0.  0.  0.  0.  Total:30,156                                       |       | N/A  N/A  N/A  N/A  N/A  N/A  N/A  N/A  N/A                                                                                            |       | 1.50  1.03  0.50  0.50  0.85  1.00  3.25  1.00  1.00 |       | 2/13/2016  1/12/2015  1/2/2014  1/2/2013  6/1/2012  1/2/2012  9/18/2010  1/2/2009  10/1/2007 |       |
| William Miraglia,  former CFO (3)                   |       | 0.  Total:0                                                                                 |       | 0  Total:0                                                                                     |       | 0.                                                                                                                                     |       | 0.                                                   |       | N/A                                                                                          |       |

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(1)             Notall options exercisable as of December 31, 2006 were “in-the-money” options asof that date.

(2)             Mr.Foote earned a grant of 3,378 stock options for performance in 2006.  This grant was awarded after the end of thefiscal year, on January 19, 2007.

(4)             Mr.Miraglia was removed as CFO and Secretary of the Company on May 16, 2006, andhis employment terminated by the Company for cause on June 14, 2006.  All of Mr. Miraglia’s outstanding stockoption grants were forfeited.

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**OptionExercises**

The following tableprovides information concerning options exercised during 2006 by each of theexecutive officers named in the Summary Compensation Table.

# **Option Exercises and Stock Vested**

| **Name**                                            | ** ** | **Number of Shares Acquired on  Exercise (#)** | ** ** | **Value Realized on Exercise   ($)  (1)** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Daniel Lehrfeld,  President and CEO (2)             |       | 30,000 @ $0.50                                                          |       | $                                                             | 25,800     |   |
| William J.  Foote, VP and CFO                       |       | N/A                                                                     |       | N/A                                                           |       |
| Devaunshi  Sampat, VP Northvale Sales and Marketing |       | N/A                                                                     |       | N/A                                                           |       |
| William  Miraglia, former CFO                       |       | N/A                                                                     |       | N/A                                                           |       |
|                                                     |            |                                                                         |            |                                                               |            |  |

----

(1)             Thevalue realized on exercise is the number of shares exercised times thedifference between the market price when exercised and the exercise price.

**Compensationof Directors**

Directors’ compensationconsists of two components: cash (i.e. meeting attendance fees) and stockoption grants.  Stock option grants aremade by the Compensation Committee, and are intended to align the interests ofthe Company’s directors with that of other shareholders.  The Company does not require its directors toown stock.

Fees for non-employeedirectors were $500 during fiscal years 2006, 2005 and 2004 for each boardmeeting attended in person, and $250 for each meeting in which theyparticipated via telephone.

At the January 19, 2007meeting of the Compensation Committee the Committee approved, and at themeeting of the full Board on February 16, 2007 the Board ratified the additionof an annual retainer fee to Director compensation, effective January 1,2007.  The annual retainer is $15,000 forthe Chairman and $10,000 for other outside Directors.

In 2005, the board agreedto defer payment of fees to its Directors after October, 2005 in the interestof conserving cash.  The total deferralfor all four outside directors amounted to $5,500 and was paid at mid-year in2006.  Each outside director received3,950 stock options exercisable at $1.50, in 2006, 11,000 stock options,exercisable at $1.03, in 2005 and 20,000 stock options, exercisable at $0.50 in2004.

The table that followsprovides information on components of Director compensation in 2006.

# **Director Compensation in Fiscal Year 2006**

| **Name**             | ** ** | **Fees earned or paid in cash  ($)** | ** ** | **Option awards ($)  (1), (2)** | ** ** | **Total ($)** | ** ** |
|----------------------|------------|---------------------------------------------------------------|------------|------------------------------------------------|------------|--------------------|------------|
| John C. Rich         |       | 14,750                                                        |       | 4,926                                          |       | 19,676             |       |
| Thomas H. Lenagh     |       | 14,750                                                        |       | 4,926                                          |       | 19,676             |       |
| Jan M. Winston       |       | 15,250                                                        |       | 4,926                                          |       | 20,176             |       |
| Luke P. LaValle, Jr. |       | 14,500                                                        |       | 1,726                                          |       | 16,226             |       |

----

(1)             Thevalue of stock option awards is the value accrued and imputed to Companyexpenses in 2006 and reflected in 2006 net income.  Stock options vest over three years,one-third upon each anniversary of the grant. Stock option expenses accrue proportionally over the three year vestingperiod.

(2)             Thevalue of stock option grants are determined from the value computed inaccordance with FASB 123R, using the Black-Scholes options pricing model withthe following assumptions (unless otherwise noted): volatility of 119.26%,risk-free rate of return of 5.2%, dividend yield of 0%, and 10 year optionlife.

 

28

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**Compensation CommitteeInterlocks and Insider Participation**

The following outsidedirectors of the Company served as members of the Compensation Committee of theCompany’s Board of Directors during 2006: Mr. Jan M. Winston, Mr. Thomas H. Lenagh, Mr. Luke P. LaValleand Mr. John C. Rich.  None of theseindividuals are officers or employees of the Company.

**CompensationCommittee Report**

The CompensationCommittee has reviewed and discussed the information provided under the caption“Compensation Discussion and Analysis” set forth above.  Based on that review and those discussions,the Compensation Committee recommended to the Board that such “CompensationDiscussion and Analysis” be included in the annual report.

(signed)

The Compensation Committee, Mr. Jan M. Winston, Chairman,

Mr. John C. Rich, Mr.Thomas H. Lenagh, Mr. Luke P. LaValle, Jr., members

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

The following tablepresents certain information available to the Company at the date hereof withrespect to the security ownership of the Company’s Common Stock by (i) each ofthe Company’s directors and their nominees, (ii) named executive officers ofthe Company, (iii) all executive officers and directors as group, and (iv) thesecurity ownership of each person known by the Company to beneficially own morethan five percent (5%) of the Company’s common stock outstanding as of March29, 2007.  Percentages that includeownership of options or convertible securities are calculated assuming exerciseor conversion 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 address of each principal shareholder,unless otherwise indicated, is C/O Photonic Products Group, Inc., 181 LegrandAvenue, Northvale, NJ 07647.

**Beneficial Ownership of CommonStock (1)**
| ** **                                                        | ** ** | **Amount and Nature of** | ** ** | ** ** | ** ** | **Percent of**   | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------------|------------|------------|------------|-----------------------|------------|
| **Name and Address of Beneficial Owner** | ** ** | **Beneficial Ownership**           | ** ** | ** ** | ** ** | **Common Stock** | ** ** |
| Luke P. LaValle, Jr.                                              |       |                                    | 1,317      | (2)        |       |                  |       |   | * |   |   |
| Thomas H. Lenagh                                                  |       |                                    | 224,550    | (3)        |       |                  |       |   | 2.8 | % |   |
| John C. Rich                                                      |       |                                    | 81,250     | (4)        |       |                  |       |   | 1.0 | % |   |
| Jan M. Winston                                                    |       |                                    | 68,850     | (5)        |       |                  |       |   | * |   |   |
| Daniel Lehrfeld                                                   |       |                                    | 834,000    | (6)        |       |                  |       |   | 9.5 | % |   |
| Devaunshi Sampat                                                  |       |                                    | 211,233    | (7)        |       |                  |       |   | 2.6 | % |   |
|                                                              |       |                                    |       |       |       |                  |       |   |   |   |   |
| William J. Foote                                                  |       |                                    | 0          |       |       |                  |       |   | * |   |   |
|                                                              |       |                                    |       |       |       |                  |       |   |   |   |   |
| All Directors and  Executive                                      |       |                                    | 1,421,200  | (8)        |       |                  |       |   | 15.3 | % |   |
| Officers as a group (7  persons)                                  |       |                                    |       |       |       |                  |       |   |   |   |   |
|                                                              |       |                                    |       |       |       |                  |       |   |   |   |   |
| Clarex, Ltd. &  Welland Ltd.                                  |       |                                    | 10,151,914 | (9)        |       |                  |       |   | 65.8 | % |   |
| Bay Street and Rawson  Square                                     |       |                                    |       |       |       |                  |       |   |   |   |   |
| P.O. Box N 3016                                                   |       |                                    |       |       |       |                  |       |   |   |   |   |
| Nassau, Bahamas                                                   |       |                                    |       |       |       |                  |       |   |   |   |   |
|                                                              |       |                                    |       |       |       |                  |       |   |   |   |   |
| William Nicklin                                                   |       |                                    | 927,200    | (10)       |       |                  |       |   | 11.0 | % |   |
| 3 Rivers Edge                                                     |       |                                    |       |       |       |                  |       |   |   |   |   |
| Newburgh, NY 12550-1457                                           |       |                                    |       |       |       |                  |       |   |   |   |   |
|                                                              |       |                                    |       |       |       |                  |       |   |   |   |   |
| Brown Advisory Holdings, Inc.                                     |       |                                    | 1,055,250  | (11)       |       |                  |       |   | 13.2 | % |   |
| 901 South Bond Street, Suite 400                                  |       |                                    |       |       |       |                  |       |   |   |   |   |
| Baltimore, MD 21231                                               |       |                                    |       |       |       |                  |       |   |   |   |   |

* Less than 1%

(1)          Unlessotherwise indicated, each of the shareholders named in the table has solevoting and investment power with respect to the shares beneficially owned,subject to the information contained in the footnotes to the table.

(2)          Including1,317 shares issuable upon conversion of options exercisable within 60 days.

29

 

----

 

(3)          Including137,650 shares issuable upon conversion of options exercisable within 60 days.

(4)          Including12,000 shares issuable upon conversion of convertible preferred stock and62,650 shares issuable upon conversion of options exercisable within 60 days.

(5)          Including4,000 shares issuable upon conversion of convertible preferred stock and 62,650shares issuable upon conversion of options exercisable within 60 days.

(6)          Including775,000 shares issuable upon conversion of options exercisable within 60 daysand 48,000 shares issuable upon conversion of convertible preferred stockconvertible within 60 days.  Alsoincludes 5,000 shares held in a trust over which Mr. Lehrfeld has shared votingand investment power, and 6,000 shares held by Mr. Lehrfeld’s daughter, as towhich shares he disclaims beneficial ownership.

(7)          Including8,000 shares issuable upon conversion of convertible preferred stock and198,833 shares issuable upon exercise of options exercisable within 60 days.

(8)          Including72,000 shares issuable upon conversion of convertible preferred stock and1,238,100 shares issuable upon conversion of options exercisable within 60days.

(9)          Including900,000 shares issuable upon conversion of preferred stock convertible within60 days, 3,500,000 shares issuable upon conversion of convertible promissorynotes at a per share conversion price of $1.00, and warrants to purchase3,025,000 shares exercisable as follows: 2,625,000 at $1.35 per share, 200,000at $1.08 per share and 200,000 at $0.425 per share

(10)    Including523,450 shares over which Mr. Nicklin has shared voting power, 160,000 sharesissuable upon conversion of convertible preferred stock and 243,750 sharesissuable upon exercise of warrants at $1.35 per share.

(11)    Including1,055,250 shares over which Brown Advisory Holdings, Inc. has shared investmentpower but no voting power.

**EquityCompensation Plan Information**

The following table givesinformation about the Company’s Common Stock that may be issued upon theexercise of options, warrants and rights under the Company’s Key EmployeeCompensation Plan and the Company’s 2000 Equity Compensation Program, as ofDecember 31, 2006.  These plans werethe Company’s only equity compensation plans in existence as ofDecember 31, 2006.
| **Plan Category**                                  | ** ** | **(a)  Number of Securities to  be Issued Upon Exercise  of Outstanding Options,  Warrants and Rights** | ** ** | **(b)  Weighted-Average  Exercise Price of  Outstanding Options,  Warrants and Rights** | ** ** | **(c)  Number of Securities  Remaining Available for  Future Issuance Under  Equity Compensation  Plans (Excluding  Securities Reflected in  Column (a)** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  Compensation Plans Approved by Shareholders     |       | 1,874,740                                                                                                                                                 |       | $                                                                                                                | 1.25       |                                                                                                                                                                                                             | 3,344,940  |   |
| Equity  Compensation Plans Not Approved by Shareholders |       | —                                                                                                                                                    |       | —                                                                                                           |       | —                                                                                                                                                                                                           |       |
|                                                    |       |                                                                                                                                                      |       |                                                                                                             |       |                                                                                                                                                                                                             |       |
| Total                                                   |       | 1,874,740                                                                                                                                                 |       | $                                                                                                                | 1.25       |                                                                                                                                                                                                             | 3,344,940  |   |

 

30

 

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

The documented ethicspolicies of the Company restrict certain types of related-party transactionsbetween the Company and its directors, officers, and employees of theCompany.  Specifically, compensation forservices provided by directors, officers, and employees to the Company may notbe through any source but the Company. The Company’s policies do permit related-parties to participate infinancial transactions, limited to financing via debt or equity.  In such instances, the Board of Directors hasan informal policy of requiring that when financing through a related party,that the terms of such financing, including but not limited to interest ratesand fees, are at least equal to or better than the terms obtainable viafinancing from other sources.

During the years endedDecember 31, 2005 and 2004, approximately 1% and 3%, respectively, of theCompany’s net product sales were through a foreign agent, in which WarrenRuderman (deceased), who was a principal shareholder in those years, had aninvestment.  Terms of sales to thisforeign agent were substantially the same as to unrelated foreign agents.

In December 2005, theCompany entered into a financing arrangement in the amount of $700,000, with amajor shareholder and debt holder of the Company, to fund the acquisition ofcapital assets needed to capture new business opportunities.  The funds were received in February 2006 andthe Company issued a secured Promissory Note for $700,000.  The note is payable in installments over aterm of seven years and bears interest at 6.75%.

During 2005, two notesfor $1,000,000 and $1,500,000 due to Clarex, Ltd., a shareowner and debtholder, had their maturity dates extended from January 31, 2006 toDecember 31, 2008.

During 2004, Clarex, Ltd., a shareowner and debtholder received a 6% Convertible Promissory Note for $1,000,000 due March2007.  This note was extended to March31, 2008.

In March 2004, Clarex, Ltd. received 200,000 warrantsfor offering the 2003 $1,700,000 secured promissory note and an additional200,000 warrants for extending the maturity date of the note to December 2008.

The Company’s Board of Directors has determined thateach of its four outside directors, Mr. John C. Rich, Mr. Thomas H. Lenagh, Mr.Jan M. Winston, and Mr. Luke P. LaValle, Jr., has no material relationship withthe Company (other than as director) and is therefore “independent” within themeaning of the current listing standards of the NASDAQ and the Sarbanes OxleyAct.  In its annual review of directorindependence, the Board of Directors considers all commercial, banking,consulting, legal, accounting or other business relationships any director mayhave with the Company.  The Board ofDirectors considers a “material relationship” to be one that impairs orinhibits, or has the potential to impair or inhibit, a director’s exercise ofcritical and disinterested judgment on behalf of the Company and itsshareholders.  When assessing the “materiality”of a director’s relationship with the Company, the Board of Directors considersall relevant facts and circumstances not only from the standpoint of thedirector in his or her individual capacity, but also from the standpoint of thepersons to whom the director is related and organizations with which thedirector is affiliated.

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

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

AuditFees*. *Audit fees billed or expected tobe billed to the Company by theCompany’s principal accountant for the audit of the financial statementsincluded in the Company’s Annual Reports on Form 10-K, and reviews of thefinancial statements included in the Company’s Quarterly Reports onForm 10-Q, for the years ended December 31, 2006 and 2005 totaledapproximately $105,300and  $110,000, respectively.

Audit-Related Fees*. *TheCompany was billed $0 and $0 by the Company’s principal accountant for the fiscal yearsended December 31, 2006 and 2005, respectively, for assurance and relatedservices that are reasonably related to the performance of the audit or reviewof the Company’s financial statements and are not reported under the caption “Audit Fees” above.

TaxFees*. *The Company was billed anaggregate of $14,700 and $10,000 bythe Company’s principal accountant for the fiscal years endedDecember 31, 2006 and 2005, respectively, for tax services, principallythe preparation of income tax returns.

AllOther Fees*. *In 2004 the Company incurredapproximately $125,000 in fees in connection with activities related to the MRCacquisition due diligence, audit of MRC, 8-K filing, S-8 registration and S-1registration for resale of common stock issued as a result of the privateequity offering.

Applicable law and regulationsprovide an exemption that permits certain services to be provided by theCompany’s outside auditors even if they are not pre-approved.  The Company has not relied on this exemptionat any time since the Sarbanes-Oxley Act was enacted.  All other fees have been pre-approved by theAudit Committee of the Board of Directors.

31

 

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#### **PART IV**

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

**(a) (1)     FinancialStatements.**

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

**(a) (2)     FinancialStatement Schedule.**

Reference is made to theIndex to Financial Statements and Financial Statement Schedule onPage F-1.   All other schedules havebeen omitted because the required information is not present or is not presentin amounts sufficient to require submission of the schedule, or because theinformation required is included 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)                                |
| 4.7         |       | Subordinated Convertible Promissory Note dated  December 31, 2002 held by Welland, Ltd. (incorporated by reference to  Exhibit 4.7 to the Company’s Registration Statement on Form S-1  filed with the Securities and Exchange Commission on August 25, 2004)                              |
| 4.8         |       | Warrant dated March 31, 2004 issued to Clarex,  Ltd. (incorporated by reference to Exhibit 10.2 to the Company’s  Registration Statement on Form S-1 filed with the Securities and  Exchange Commission on August 25, 2004)                                                                |
| 4.9         |       | Warrant dated May 19, 2004 issued to Clarex,  Ltd. (incorporated by reference to Exhibit 10.3 to the Company’s  Registration Statement on Form S-1 filed with the Securities and  Exchange Commission on August 25, 2004)                                                                  |
| 4.10        |       | Extension of Promissory Note dated March 26, 2007  originally issued to Clarex, Ltd. on April 1, 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 (incorporated by reference to the  Company’s Annual Report on Form 10-K filed with the Securities and  Exchange Commission on March 31, 2006)                                                                                                                                              |
| 21.1        |       | List of Subsidiaries (incorporated by reference to  the Company’s Annual Report on Form 10-K filed with the Securities and  Exchange Commission on March 31, 2006)                                                                                                                                        |
| 23.1        |       | Consent of Holtz Rubenstein Reminick LLP Independent  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                                                                                                                                                       |

 

32

 

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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 29, 2007              |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.
| Signature                | ** ** | **Title**                               | ** ** | **Date**       |
|--------------------------|------------|-----------------------------------------|------------|----------------|
|                     |       |                                    |       |           |
|                     |       |                                    |       |           |
| /s/ John C. Rich         |       | Chairman of the Board                   |       | March 29, 2007 |
| John C. Rich             |       | of Directors                            |       |           |
|                     |       |                                    |       |           |
|                     |       |                                    |       |           |
| /s/ Daniel Lehrfeld      |       | President, Chief                        |       | March 29, 2007 |
| Daniel Lehrfeld          |       | Executive Officer                       |       |           |
|                     |       | and Director                            |       |           |
|                     |       |                                    |       |           |
|                     |       |                                    |       |           |
| /s/ Luke P. LaValle, Jr. |       | Director                                |       | March 29, 2007 |
| Luke P. LaValle,  Jr.    |       |                                    |       |           |
|                     |       |                                    |       |           |
|                     |       |                                    |       |           |
| /s/ Thomas H. Lenagh     |       | Director                                |       | March 29, 2007 |
| Thomas H. Lenagh         |       |                                    |       |           |
|                     |       |                                    |       |           |
|                     |       |                                    |       |           |
| /s/ Jan M. Winston       |       | Director                                |       | March 29, 2007 |
| Jan M. Winston           |       |                                    |       |           |
|                     |       |                                    |       |           |
|                     |       |                                    |       |           |
| /s/ William J. Foote     |       | Vice-President, Chief Financial Officer |       | March 29, 2007 |
| William J. Foote         |       | and Secretary                           |       |           |

 

33

 

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

**REPORTON AUDITS OF CONSOLIDATED FINANCIAL STATEMENTS**

**THREEYEARS ENDED DECEMBER 31, 2006**

**CONTENTS**
| Report of Independent  Registered Public Accounting Firm                                           |
|----------------------------------------------------------------------------------------------------|
|                                                                                               |
| Consolidated  balance sheets as of December 31, 2006 and 2005                                      |
|                                                                                               |
| Consolidated  statements of operations for the three years ended December 31, 2006                 |
|                                                                                               |
| Consolidated  statements of shareholders’ equity for the three years ended December 31,  2006 |
|                                                                                               |
| Consolidated  statements of cash flows for the three years ended December 31, 2006                 |
|                                                                                               |
| Notes to  consolidated financial statements                                                        |
|                                                                                               |
| Report of  Independent Registered Certified Public Accountants on supplemental schedule            |
|                                                                                               |
| Schedule II —  Valuation and Qualifying Accounts                                              |

 

34

 

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Report of IndependentRegistered Public Accounting Firm

Board of Directors and Shareholders

Photonic Products Group, Inc. and Subsidiaries

Northvale, New Jersey

We have audited theaccompanying consolidated balance sheets of Photonic Products Group, Inc. andSubsidiaries as of December 31, 2006 and 2005, and the related consolidatedstatements of operations, shareholders’ equity and cash flows for the threeyears ended December 31, 2006.  Theseconsolidated financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audits.

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States of America).  Thosestandards require that we plan and perform the audits to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Photonic ProductsGroup, Inc. and Subsidiaries as of December 31, 2006 and 2005 and the resultsof their operations and their cash flows for the three years ended December 31,2006, in conformity with accounting principles generally accepted in the UnitedStates of America.

As discussed in Note 1 tothe financial statements, effective January 1, 2006, the Company adoptedStatement of Financial Accounting Standards No. 123(R), *Share-BasedPayment.*

HOLTZ RUBENSTEIN REMINICKLLP

Melville,New York

March 2, 2007

35

 

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**PHOTONICPRODUCTS GROUP, INC AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                               | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                               | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Assets**                                                                                                                                                               | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Current  assets:**                                                                                                                                                     | ** ** | ** **            | ** ** | ** ** | ** ** |
| Cash and cash equivalents                                                                                                                                                |       | $                     | 3,078,052  |   | $ | 1,156,563 |   |
| Accounts receivable (after allowance for doubtful  accounts of $15,000 in 2006 and 2005)                                                                                 |       | 2,396,486             |       | 2,265,934 |   |
| Inventories                                                                                                                                                              |       | 2,336,033             |       | 2,423,879 |   |
| Other current assets                                                                                                                                                     |       | 176,587               |       | 153,723 |   |
| **Total Current Assets**                                                                                                                                                 |       | 7,987,158             |       | 6,000,099 |   |
| **Plant  and equipment:**                                                                                                                                                | ** ** | ** **            | ** ** | ** ** | ** ** |
| Plant and equipment at cost                                                                                                                                              |       | 13,459,212            |       | 12,472,480 |   |
| Less: Accumulated depreciation and amortization                                                                                                                          |       | (9,164,031            | )          | (8,143,592 | ) |
| Total plant and equipment                                                                                                                                                |       | 4,295,181             |       | 4,328,888 |   |
| **Precious  Metals**                                                                                                                                                     |       | 130,732               |       | 130,732 |   |
| **Goodwill**                                                                                                                                                             |       | 1,869,646             |       | 1,869,646 |   |
| **Intangible  Assets, net of accumulated amortization**                                                                                                                  |       | 908,708               |       | 987,272 |   |
| **Other  Assets**                                                                                                                                                        |       | 124,835               |       | 164,384 |   |
| **Total Assets**                                                                                                                                                         |       | $                     | 15,316,260 |   | $ | 13,481,021 |   |
|                                                                                                                                                                     |       |                  |       |   |   |
| **Liabilities  and Shareholders’ Equity**                                                                                                                           | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Current  Liabilities:**                                                                                                                                                | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                                                                                                                                                     |       |                  |       |   |   |
| Current portion of notes payable — Other                                                                                                                            |       | $                     | 100,079    |   | $ | 260,697 |   |
| Accounts payable and accrued liabilities                                                                                                                                 |       | 2,495,398             |       | 2,426,692 |   |
| Customer advances                                                                                                                                                        |       | 987,963               |       | 652,264 |   |
| Current obligations under capital leases                                                                                                                                 |       | 196,350               |       | 248,550 |   |
| **Total Current Liabilities**                                                                                                                                            |       | 3,779,790             |       | 3,588,203 |   |
|                                                                                                                                                                     |       |                  |       |   |   |
| **Related  Party — Convertible and Secured Notes Payable**                                                                                                          |       | 5,200,000             |       | 5,200,000 |   |
| **Notes  Payable — Other, net of current portion**                                                                                                                  |       | 1,052,680             |       | 518,786 |   |
| **Capital  Lease Obligations, Net of Current Obligation**                                                                                                                |       | 47,087                |       | 244,625 |   |
| **Total Liabilities**                                                                                                                                                    |       | 10,079,557            |       | 9,551,614 |   |
|                                                                                                                                                                     |       |                  |       |   |   |
| **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; 2,082 shares issued and outstanding at December 31, 2006 and 2,100  issued and outstanding at December 31, 2005 |       | 2,082,000             |       | 2,100,000 |   |
|                                                                                                                                                                     |       |                  |       |   |   |
| Common stock:  $.01 par value; 60,000,000 authorized shares 7,882,074 issued at December 31,  2005 and 7,287,398 issued at December 31, 2005                             |       | 78,820                |       | 72,862 |   |
| Capital in excess of par value                                                                                                                                           |       | 11,926,815            |       | 11,145,243 |   |
| Accumulated deficit                                                                                                                                                      |       | (9,335,982            | )          | (9,873,748 | ) |
|                                                                                                                                                                     |       | 5,251,653             |       | 3,944,357 |   |
|                                                                                                                                                                     |       |                  |       |   |   |
| Less — Common stock in treasury, at cost (4,600  shares)                                                                                                            |       | (14,950               | )          | (14,950 | ) |
| **Total Shareholders’ Equity**                                                                                                                                      |       | 5,236,703             |       | 3,929,407 |   |
| **Total  Liabilities & Shareholders’ Equity**                                                                                                                   |       | $                     | 15,316,260 |   | $ | 13,481,021 |   |

 

See Notes toConsolidated Financial Statements

36

 

----

 

**PHOTONICPRODUCTS GROUP, INC AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                                             | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                             | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                   |       |                                        |       |   |   |   |   |
| **Revenues**                                                                           | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                                                              |       | $                                           | 13,921,127 |   | $ | 13,785,057 |   | $ | 9,221,857 |   |
|                                                                                   |       |                                        |       |   |   |   |   |
| **Cost and  Expenses**                                                                 | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of goods sold                                                                     |       | 9,377,313                                   |       | 9,956,125 |   | 6,618,506 |   |
| Selling, general and administrative expense                                            |       | 3,627,244                                   |       | 3,450,224 |   | 2,916,056 |   |
| Internal research and development expense                                              |       | —                                      |       | 20,279 |   | 97,685 |   |
|                                                                                   |       | 13,004,557                                  |       | 13,426,628 |   | 9,632,247 |   |
|                                                                                   |       |                                        |       |   |   |   |   |
| **Operating  profit (loss)**                                                           |       | 916,570                                     |       | 358,429 |   | (410,390 | ) |
| ** **                                                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Other  income (expense)**                                                            | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                                   |       |                                        |       |   |   |   |   |
| Interest expense, net                                                                  |       | (402,154                                    | )          | (504,509 | ) | (358,940 | ) |
| Settlement of insurance claim                                                          |       | 300,000                                     |       | — |   | — |   |
| Gain on sale of precious metals                                                        |       | —                                      |       | 135,931 |   | — |   |
| Other                                                                                  |       | (21,150                                     | )          | (1,249 | ) | 49 |   |
|                                                                                   |       | (123,304                                    | )          | (369,827 | ) | (358,891 | ) |
|                                                                                   |       |                                        |       |   |   |   |   |
| **Income  (loss) before income tax provision (benefit) and preferred stock dividends** |       | 793,266                                     |       | (11,398 | ) | (769,281 | ) |
|                                                                                   |       |                                        |       |   |   |   |   |
| **Income  tax provision (benefit)**                                                    |       | 21,000                                      |       | — |   | (96,344 | ) |
|                                                                                   |       |                                        |       |   |   |   |   |
| **Net  income (loss)**                                                                 |       | 772,266                                     |       | (11,398 | ) | (672,937 | ) |
|                                                                                   |       |                                        |       |   |   |   |   |
| **Preferred  stock dividends**                                                         |       | (234,500                                    | )          | (134,000 | ) | (164,820 | ) |
|                                                                                   |       |                                        |       |   |   |   |   |
| **Net  income (loss) applicable to common shareholders**                               |       | $                                           | 537,766    |   | $ | (145,398 | ) | $ | (837,757 | ) |
|                                                                                   |       |                                        |       |   |   |   |   |
| **Net  income (loss) per share — basic**                                          |       | $                                           | 0.07       |   | $ | (0.02 | ) | $ | (0.15 | ) |
|                                                                                   |       |                                        |       |   |   |   |   |
| **Net  income (loss) per share — diluted**                                        |       | $                                           | 0.06       |   | $ | (0.02 | ) | $ | (0.15 | ) |
|                                                                                   |       |                                        |       |   |   |   |   |
| **Weighted  average shares outstanding — basic**                                  |       | 7,572,637                                   |       | 7,218,244 |   | 5,710,354 |   |
| ** **                                                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Weighted  average shares outstanding — diluted**                                |       | 11,915,090                                  |       | 7,218,244 |   | 5,710,354 |   |
| ** **                                                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |

 

See notes toconsolidated financial statements

37

 

----

**PHOTONICPRODUCTS GROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENT OFSHAREHOLDERS’ 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, 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       | )              | — |   | — |   |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| 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** | ** ** |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| 401K contribution                  |       | 61,404                |       | 614                 |       | —                   |       | —                   |       | —              |       | —        |       | 68,166                 |           | —         |           | — |   | 68,780 |   |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| Dividend on Preferred  Stock       |       | 39,200                |       | 380                 |       | —                   |       | —                   |       | —              |       | —        |       | 38,808                 |           | (134,000       | )              | — |   | (94,812 | ) |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| Accelerated stock  options         |       | —                |       | —              |       | —                   |       | —                   |       | —              |       | —        |       | 21,398                 |           | —         |           | — |   | 21,398 |   |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| Costs of issuance of  common stock |       | —                |       | —              |       | —                   |       | —                   |       | —              |       | —        |       | (19,690                | )              | —         |           | — |   | (19,690 | ) |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| 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** | **)** | **3,929,407** | ** ** |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| 401K contribution                  |       | 144,836               |       | 1,448               |       | —                   |       | —                   |       | —              |       | —        |       | 149,053                |           | —         |           | — |   | 150,501 |   |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| Dividend on preferred  stock       |       | 134,000               |       | 1,340               |       | —                   |       | —                   |       | —              |       | —        |       | 233,160                |           | (234,500       | )              | — |   | — |   |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| Issuance of common stock  payable  |       | 174,800               |       | 1,760               |       | —                   |       | —                   |       | —              |       | —        |       | 152,252                |           | —         |           | — |   | 154,012 |   |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| Exercise of stock  options         |       | 145,000               |       | 1,450               |       | —                   |       | —                   |       | —              |       | —        |       | 111,380                |           | —         |           | — |   | 112,830 |   |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| Cancellation of common  stock      |       | (3,960                | )          | (40                 | )          | —                   |       | —                   |       | —              |       | —        |       | 40                     |           | —         |           | — |   | — |   |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| Cancellation of  preferred stock   |       | —                |       | —              |       | —                   |       | —                   |       | (18                 | )          | (18,000       | )          | 18,000                 |           | —         |           | — |   | — |   |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| Share-based compensation  expense  |       | —                |       | —              |       | —                   |       | —                   |       | —              |       | —        |       | 117,687                |           | —         |           | — |   | 117,687 |   |
|                               |       |                  |       |                |       |                     |       |                     |       |                |       |          |       |                   |           |           |           |   |   |   |   |
| Net income for the  period         |       | —                |       | —              |       | —                   |       | —                   |       | —              |       | —        |       |                   |           | 772,266        |           | — |   | 772,266 |   |
| ** **                         | ** ** | ** **            | ** ** | ** **          | ** ** | ** **               | ** ** | ** **               | ** ** | ** **          | ** ** | ** **    | ** ** | ** **             | ** **     | ** **     | ** **     | ** ** | ** ** | ** ** | ** ** |
| **Balance, December 31, 2006**     | ** ** | **7,882,074**         | ** ** | **$**               | **78,820** | ** **               | **500**    | ** **               | **$**      | **500,000**         | ** ** | **2,082**     | ** ** | **$**                  | **2,082,000**  | ** **     | **$**          | **11,926,815** | ** ** | **$** | **(9,335,982** | **)** | **$** | **(14,950** | **)** | **$** | **5,236,703** | ** ** |
|                                    |            |                       |            |                     |            |                          |            |                          |            |                     |            |               |            |                        |                |                |                |  |  |  |  |  |  |  |  |  |  |  |

 

See notes toconsolidated financial statements

38

----

 

**PHOTONICPRODUCTS GROUP, INC AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Cash  flows from operating activities:**                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                        |       | $                                           | 772,266    |   | $ | (11,398 | ) | $ | (672,937 | ) |
|                                                                                      |       |                                        |       |   |   |   |   |
| **Adjustments  to reconcile net income (loss) to cash provided by operating activities:** | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Depreciation and amortization                                                             |       | 1,099,003                                   |       | 1,025,074 |   | 713,080 |   |
| Gain on sale of precious metal                                                            |       | —                                      |       | (135,931 | ) | — |   |
| 401K common stock contribution                                                            |       | 150,501                                     |       | 68,780 |   | 12,945 |   |
| Stock option acceleration expense                                                         |       | —                                      |       | 21,298 |   | — |   |
| Share-based compensation                                                                  |       | 117,687                                     |       | — |   | — |   |
| Change in allowance for doubtful accounts                                                 |       | —                                      |       | (73,000 | ) | — |   |
| Inventory reserve                                                                         |       | 102,817                                     |       | (254,526 | ) | 372,106 |   |
| ** **                                                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Changes  in assets and liabilities:**                                                   | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Accounts receivable                                                                       |       | (130,552                                    | )          | (744,939 | ) | (10,756 | ) |
| Inventories                                                                               |       | (14,971                                     | )          | 309,720 |   | (486,535 | ) |
| Unbilled contract costs                                                                   |       | —                                      |       | — |   | 191,767 |   |
| Other current assets                                                                      |       | (22,864                                     | )          | (66,184 | ) | (10,599 | ) |
| Other assets                                                                              |       | 39,549                                      |       | 28,981 |   | 28,133 |   |
| Accounts payable and accrued liabilities                                                  |       | 222,718                                     |       | 81,740 |   | 599,590 |   |
| Customer advances                                                                         |       | 335,699                                     |       | 110,546 |   | (105,291 | ) |
| Total adjustments                                                                         |       | 1,899,587                                   |       | 371,659 |   | 1, 304,440 |   |
| **Net cash provided by operating activities**                                             |       | 2,671,853                                   |       | 360,261 |   | 631,503 |   |
|                                                                                      |       |                                        |       |   |   |   |   |
| **Cash  flows from investing activities:**                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Capital expenditures                                                                      |       | (986,732                                    | )          | (453,615 | ) | (1,013,569 | ) |
| Proceeds from sale of precious metals                                                     |       | —                                      |       | 314,764 |   | — |   |
| Cash used for business acquisition, net                                                   |       | —                                      |       | — |   | (732,000 | ) |
|                                                                                      |       |                                        |       |   |   |   |   |
| **Net cash used in investing activities**                                                 |       | (986,732                                    | )          | (138,851 | ) | (1,745,569 | ) |
|                                                                                      |       |                                        |       |   |   |   |   |
| **Cash  flows from financing activities:**                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net proceeds (uses) from issuance of common stock                                         |       | 112,830                                     |       | (19,492 | ) | 1,172,984 |   |
| Proceeds from secured notes payable                                                       |       | 700,000                                     |       | — |   | — |   |
| Proceeds from senior convertible debentures                                               |       | —                                      |       | — |   | 1,000,000 |   |
| Principal payments of notes payable                                                       |       | (326,724                                    | )          | (166,515 | ) | (847,907 | ) |
| Principal payments of bank debt                                                           |       |                                        |       |   |   |   |   |
| Principal payments of capital lease obligations                                           |       | (249,738                                    | )          | (272,347 | ) | (99,664 | ) |
|                                                                                      |       |                                        |       |   |   |   |   |
| **Net cash provided by (used in) financing  activities**                                  |       | 236,368                                     |       | (458,354 | ) | 1,225,413 |   |
|                                                                                      |       |                                        |       |   |   |   |   |
| **Net  increase (decrease) in cash and cash equivalents**                                 |       | 1,921,489                                   |       | (236,944 | ) | 111,347 |   |
|                                                                                      |       |                                        |       |   |   |   |   |
| **Cash  and cash equivalents at beginning of the year**                                   |       | 1,156,563                                   |       | 1,393,507 |   | 1,282,160 |   |
|                                                                                      |       |                                        |       |   |   |   |   |
| **Cash and cash equivalents at  end of the year**                                         |       | $                                           | 3,078,052  |   | $ | 1,156,563 |   | $ | 1,393,507 |   |

 

See notes toconsolidated financial statements

 

39

----

**PHOTONICPRODUCTS GROUP, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**THREEYEARS ENDED DECEMBER 31, 2006**

**1.****                                      Natureof Business and Summary of Significant Accounting Policies**

## a.                                       Natureof Operations

PHOTONIC PRODUCTS GROUP,Inc. and Subsidiaries (the “Company”, formerly known as Inrad, Inc.) is amanufacturer 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.                                      Principlesof consolidation

The accompanyingconsolidated financial statements include the accounts of the Company and itswholly-owned Subsidiaries.  Uponconsolidation, all inter-company accounts and transactions are eliminated.

## c.                                       Accountsreceivable

Accounts receivable arestated at the historical carrying amount, net of write-offs andallowances.  The Company establishes anallowance for doubtful accounts based on estimates as to the collectibility ofaccounts receivable.  Managementspecifically analyzes past-due accounts receivable balances and, additionally,considers bad debts history, customer credit-worthiness, current economictrends and changes in customer payment terms when evaluating the adequacy ofthe allowance for doubtful accounts. Uncollectible accounts receivable are written-off when it is determinedthat the balance will not be collected.

## d.                                      Inventories

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

The Company records areserve for slow moving inventory as a charge against earnings for all productsidentified as surplus, slow moving or discontinued.  Excess work-in-process costs are chargedagainst earnings whenever estimated costs-of-completion exceed unbilledrevenues.

## e.                                       FixedAssets

Fixed assets aredepreciated using the straight-line method over the estimated useful lives ofthe related assets which range between 5 and 7 years.  Amortization of leasehold improvements iscomputed using the straight-line method over the lesser of 10 years or theremaining term of the lease including optional renewal periods.  Maintenance and repairs of property andequipment are charged to operations and major improvements are capitalized.  Upon retirement, sale or other disposition ofproperty and equipment, the cost and accumulated depreciation are eliminatedfrom the accounts and a gain or loss is recorded.

## f.                                         Incometaxes

The Company accounts forincome taxes under Statement of Financial Accounting Standards (“SFAS”) No,109, “Accounting for 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.

## g.                                      Impairmentof long-lived assets

In accordance with SFASNo. 144, long-lived assets, such as property, plant and equipment and purchasedintangibles subject to amortization, are reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amount of anasset may not be recoverable. Recoverability of assets to be held and used is measured by a comparisonof the carrying amount of an asset to estimate undiscounted future cash flowsexpected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cashflows, an impairment charge is recognized by the amount by which the carryingamount of the asset exceeds the fair value of the assets.  Assets to be disposed of would be separatelypresented in the balance sheet and reported at the lower of the carrying amountor fair value less costs to sell and are no longer depreciated.  The assets and liabilities of a disposedgroup classified as held for sale would be presented separately in theappropriate asset and liability sections of the balance sheet.

40

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Goodwill and intangible assets not subject toamortization are tested in December of each year for impairment and are testedfor impairment more frequently if events and circumstances indicate that theassets might be impaired.  An impairmentloss is recognized to the extent that the carrying amount exceeds the asset’sfair value.

## h.                                      AcquiredGoodwill and Intangible assets

Acquired intangibleassets and goodwill consists of goodwill approximating $1,870,000 and otherintangible assets, principally of non-contractual customer relationships thatapproximated $1,100,000.  The intangibleassets are amortized on a straight-line basis over the assets’ estimated usefullife up to 14 years.  The Companyperiodically evaluates whether events or circumstances have occurred indicatingthe carrying amount of intangible assets may not be recoverable.  When factors indicate that intangible assetsshould be evaluated for possible impairment, the Company uses an estimate ofthe associated undiscounted future cash flows compared to the related carryingamount of assets to determine if an impairment loss should be recognized.

The gross carrying amountof intangible assets as of December 31, 2006, and as of December 31, 2005 was$1,100,000, respectively.  Accumulatedamortization related to intangible assets approximates $191,000 as of December31, 2006 and $113,000 as of December 31, 2005. Amortization expense was approximately $79,000 for the year endedDecember 31, 2006 and $81,000 for the year ended December 31, 2005.  Aggregate amortization for the five succeedingyears from January 1, 2007 through December 31, 2011 approximates $405,000,accumulating at the rate of $81,000 per year. The weighted average life of the Company’s intangible assets is 11.5years.

The changes in thecarrying amounts of goodwill, by acquisition, for the year ended December 31,2006, are as follows:

 
| ** **   | ** ** | **Balance  Jan. 1, 2006** | ** ** | **Goodwill Additions** | ** ** | **Purchase Price  Adjustment** | ** ** | **Balance  Dec. 31, 2006** | ** ** |
|--------------|------------|-------------------------------------|------------|-----------------------------|------------|-------------------------------------|------------|--------------------------------------|------------|
| Laser Optics |       | $                                   | 311,572    |                        | $          | —                              |       | $                                    | —     |   | $ | 311,572 |   |
|         |       |                                |       |                        |       |                                |       |                                 |       |
| MRC          |       | $                                   | 1,558,074  |                        | $          | —                              |       | $                                    | —     |   | $ | 1,558,074 |   |
|         |       |                                |       |                        |       |                                |       |                                 |       |
| Total        |       | $                                   | 1,869,646  |                        | $          | —                              |       | $                                    | —     |   | $ | 1,869,646 |   |

 

The following scheduledetails the Company’s intangible asset balance by major asset class.

 

|                       | ** ** | **At December 31, 2006** | ** ** |
|-----------------------|------------|-----------------------------------------|------------|
| ** **            | ** ** | **Gross Carrying  Amount**         | ** ** | **Accumulated   Amortization** | ** ** | **Net Carrying   Amount** | ** ** |
|                  |       |                                    |       |   |   |   |   |
| Customer-related      |       | $                                       | 549,937    |   | $ | (95,583 | ) | $ | 454,354 |   |
| Completed  technology |       | 362,958                                 |       | (63,085 | ) | 299,873 |   |
| Trademarks            |       | 186,979                                 |       | (32,498 | ) | 154,481 |   |
|                  |       |                                    |       |   |   |   |   |
| Total                 |       | $                                       | 1,099,874  |   | $ | (191,166 | ) | $ | 908,708 |   |

 

|                       | ** ** | **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 |   |

## i.                                          Stock-basedcompensation

The Company’s 2000 EquityCompensation Program, which is shareholder approved, permits the grant of shareoptions to its employees for up to 400,000 shares of common stock as stockcompensation per calendar year.  Allstock options under the Plan are granted at the fair market value of the commonstock at the grant date.  Employee stockoptions vest ratably over a three year period and expire 10 years from thegrant date.

Effective January 1,2006, the Company’s Plan is accounted for in accordance with the recognitionand measurement provisions of Statement of Financial Accounting Standards (“FAS”)No. 123 (revised 2004), Share-Based Payment (“FAS 123(R)”), which replaces FASNo. 123, Accounting for Stock-Based Compensation, and supersedes AccountingPrinciples Board Opinion (“APB”) No. 25, Accounting for Stock Issued toEmployees, and related interpretations.

41

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FAS 123 (R) requirescompensation costs related to share-based payment transactions, includingemployee stock options, to be recognized in the financial statements.  In addition, the Company adheres to theguidance set forth within Securities and Exchange Commission (“SEC”) StaffAccounting Bulletin (“SAB”) No. 107, which provides the Staff’s views regardingthe interaction between SFAS No. 123(R) and certain SEC rules and regulationsand provides interpretations with respect to the valuation of share-basedpayments for public companies.

Prior to January 1, 2006,the Company accounted for similar transactions in accordance with APB No. 25which employed the intrinsic value method of measuring compensation cost.  Accordingly, compensation expense was notrecognized for fixed stock options if the exercise price of the option equaledor exceeded the fair value of the underlying stock at the grant date.

While FAS No. 123encouraged recognition of the fair value of all stock-based awards on the dateof grant as expense over the vesting period, companies were permitted tocontinue to apply the intrinsic value-based method of accounting prescribed byAPB No. 25 and disclose certain pro-forma amounts as if the fair value approachof SFAS No. 123 had been applied.  InDecember 2002, FAS No. 148, Accounting for Stock-Based Compensation-Transitionand Disclosure, an amendment of SFAS No. 123, was issued, which, in addition toproviding alternative methods of transition for a voluntary change to the fairvalue method of accounting for stock-based employee compensation, required moreprominent pro-forma disclosures in both the annual and interim financial statements.  The Company complied with these disclosurerequirements for all applicable periods prior to January 1, 2006.

In adopting FAS 123(R),the Company applied the modified prospective approach to transition.  Under the modified prospective approach, theprovisions of FAS 123 (R) are to be applied to new awards and to awardsmodified, repurchased, or cancelled after the required effective date.  Additionally, compensation cost for theportion of awards for which the requisite service has not been rendered thatare outstanding as of the required effective date shall be recognized as therequisite service is rendered on or after the required effective date.  The compensation cost for that portion ofawards shall be based on the grant-date fair value of those awards ascalculated for either recognition or pro-forma disclosures under FAS 123.

As a result of theadoption of FAS 123 (R), the Company’s results for the year ended December 31,2006 include share-based compensation expense totaling $118,000.  Such amounts have been included in theConsolidated Statements of Operations within cost of goods sold ($31,000), andselling, general and administrative expenses ($87,000), as appropriate.  No income tax benefit has been recognized inthe income statement for share-based compensation arrangements due to historyof operating losses.  Stock compensationexpense recorded under APB No. 25 in the Consolidated Statements of Operationsfor the year ended December 31, 2005 was $-0-. In the fourth quarter of 2005, the Company’s Board of Director approvedthe acceleration of certain stock option grants which resulted in the Companyrecognizing stock-based compensation expense of $21,000 for the year.

Stock-based compensationexpense in 2006 is the estimated fair value of options granted amortized on astraight-line basis over the requisite service period.

The weighted averageestimated fair value of stock options granted in the years ended December 31,2006 and December 31, 2005 was $1.46 and $1.02, respectively.  The fair value of options at the date ofgrant was estimated using the Black-Scholes option pricing model.  During 2006, the Company took intoconsideration guidance under SFAS 123R and SEC Staff Accounting BulletinNo. 107 (SAB 107) when reviewing and updating assumptions.  The expected volatility is based uponhistorical volatility of our stock and other contributing factors.  The expected term is based upon thecontractual term of the option.

The following range ofweighted-average assumptions were used for grants during the years endedDecember 31, 2006, 2005 and 2004:

 

|                          | ** ** | **Years Ended**  | ** ** |
|--------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **December 31,** | ** ** |
| ** **               | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Dividend yield           |       | 0.00                  | %          | 0.00 | % | 0.00 | % |
| Volatility               |       | 121.1                 | %          | 210.5 | % | 166.3 | % |
| Risk-free  interest rate |       | 5.2                   | %          | 5.2 | % | 5.2 | % |
| Expected life            |       | 10 years              |       | 10 years |   | 10 years |   |

 

42

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The following tableaddresses the additional disclosure requirements of 123(R) in the period ofadoption.  The table illustrates theeffect on net income and earnings per share as if the fair value recognitionprovisions of FAS No. 123 had been applied to all outstanding and unvestedawards in the prior years’ comparable period.

 

|                                                                                                                       | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2005**                                    | ** ** | **2004** | ** ** |
| Net loss:                                                                                                             |       |                                        |       |   |   |
| As reported                                                                                                           |       | $                                           | (11,398    | ) | $ | (672,937 | ) |
| Add: Stock-based employee Compensation included in  reported net loss, 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 | ) |
| Pro forma                                                                                                             |       | $                                           | (130,630   | ) | $ | (910,502 | ) |
|                                                                                                                  |       |                                        |       |   |   |
| Net loss per share:                                                                                                   |       |                                        |       |   |   |
| Basic:                                                                                                                |       |                                        |       |   |   |
| As reported                                                                                                           |       | $                                           | (.02       | ) | $ | (.15 | ) |
| Pro forma                                                                                                             |       | $                                           | (.02       | ) | $ | (.19 | ) |
| Diluted:                                                                                                              |       |                                        |       |   |   |
| As reported                                                                                                           |       | $                                           | (.02       | ) | $ | (.15 | ) |
| Pro forma                                                                                                             |       | $                                           | (.02       | ) | $ | (.19 | ) |

 

The Company granted77,000 options under the Plan during the year ended December 31, 2006 atexercise prices ranging between $1.50 and $1.75, which was equal to the closingmarket price on the date of each grant. For the year ended December 31, 2005, the Company granted 125,500options at an exercise price equal to the closing market price on the date ofeach grant, ranging between $0.99 and $1.03.

The following tablerepresents our stock options granted, exercised, and forfeited during 2006.

 
| **Stock Options**            | ** ** | **Number of  Options** | ** ** | **Weighted Average Exercise  Price per Option** | ** ** | **Weighted Average Remaining  Contractual Term** | ** ** | **Intrinsic Value** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|---------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|--------------------------|------------|
| Outstanding at  January 1, 2006   |       | 2,194,800                   |       | $                                                                   | 1.16       |                                                            |       |                     |       |   |
| Granted                           |       | 77,200                      |       | $                                                                   | 1.53       |                                                            |       |                     |       |   |
| Exercised                         |       | (145,000                    | )          | $                                                                   | 0.78       |                                                            |       |                     |       |   |
| Forfeited/expired                 |       | (252,300                    | )          | $                                                                   | 1.11       |                                                            |       |                     |       |   |
| Outstanding  atDecember 31, 2006  |       | 1,874,700                   |       | $                                                                   | 1.25       |                                                            | 4.6        |                     | $          | 0.42 |   |
|                              |       |                        |       |                                                                |       |                                                            |       |                     |       |
| Exercisable at December  31, 2006 |       | 1,728,276                   |       | $                                                                   | 1.28       |                                                            | 4.4        |                     | $          | 0.39 |   |

 

The following tablerepresents non-vested stock options granted, vested, and forfeited for the yearended December 31, 2006.

43

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| Non-vested Options              | ** ** | **Options** | ** ** | **Weighted-Average Grant-Date  Fair Value** | ** ** |
|--------------------------------------|------------|-------------|------------|-------------------------------------------------------|------------|
| Non-vested —  January 1, 2006   |       | 296,126     |       | $                                                     | 0.69       |   |
| Granted                              |       | 77,200      |       | $                                                     | 1.46       |   |
| Vested                               |       | (204,802    | )          | $                                                     | 0.49       |   |
| Forfeited                            |       | (22,100     | )          | $                                                     | 1.43       |   |
| Non-vested — December  31, 2006 |       | 146,424     |       | $                                                     | 0.85       |   |

 

As of December 31, 2006,there was $56,600 of unrecognized compensation cost, net of estimatedforfeitures, related to non-vested stock options, which is expected to berecognized over a weighted average period of approximately 2.3 years.  The total fair value of shares vested duringthe years ended December 31, 2006 and 2005, was $101,000 and $141,000,respectively.

## j.                                          Revenuerecognition

The Company recordsrevenue, other than on contractual type work, when a product is shipped.  Revenue on contractual type work is accountedfor using the percentage-of-completion method, whereby revenue and profits arerecognized throughout the performance of the contracts.  Percentage-of-completion is determined byrelating the actual cost of work performed to date to the estimated total costfor each contract.  Losses on contractsare recorded when identified.

## k.                                       Internalresearch and development costs

Internal research anddevelopment costs are charged to expense as incurred.

## l.                                          Preciousmetals

Precious metals notconsumed in the manufacturing process are valued at the lower of cost, on afirst-in, first-out basis.

## m.                                    Useof estimates

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.  Actual amounts could differ from thoseestimates.

## n.                                      Advertisingcosts

Advertising costsincluded in selling, general and administrative expenses were $27,000, $34,000and $28,000 for the years ended December 31, 2006, 2005 and 2004,respectively.  Advertising costs arecharged to expense when the related services are incurred or related eventstake place.

## o.                                      Statementsof cash flows

For purposes of theconsolidated statements of cash flows, the Company considers all highly liquid debtinstruments purchased with a maturity of three months, or less, to be cashequivalents.

Interest paid during theyears ended December 31, 2006, 2005 and 2004 was $116,000, 183,000 and$194,000, respectively.

Income taxes paid were$7,000 in 2006, $7,000 in 2005, and $1,200 in 2004.

In 2005, non- cashtransactions resulting from the exchange of debt for stock amounted to $59,200.

There were no adjustmentsto goodwill in 2006.  In 2005, non- cashtransactions resulting from goodwill adjustments amounted to $141,675.

44

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## p.                                      Concentrationof risk

The Company invests itsexcess cash in deposits and money market accounts with major financialinstitutions and in commercial paper of companies with strong creditratings.  Generally, the investmentsmature within three to six months, and therefore, are subject to littlerisk.  The Company has not experiencedlosses related to these investments.

The concentration ofcredit risk in the Company’s accounts receivable is mitigated by the Company’scredit evaluation process, reasonably short collection terms and thegeographical dispersion of revenue.  TheCompany generally does not require collateral but, in some cases, the Companynegotiates cash advances prior to the undertaking of the work.  These cash advances are recorded as currentliabilities on the balance sheet until corresponding revenues are realized.

The Company utilizes manyrelatively uncommon materials and compounds to manufacture its products.  Therefore, any failure by its suppliers todeliver materials of an adequate quality and quantity could have an adverseeffect on the Company’s ability to meet the commitments of its customers.

## q.                                      Netincome (loss) per common share

The basic net income(loss) per share is computed using the weighted average number of common sharesoutstanding for the applicable period. The diluted income (loss) per share is computed using the weightedaverage number of common shares plus potential common equivalent sharesoutstanding, including the additional dilution related to the conversion of stockoptions, warrants, convertible preferred shares, and potential common sharesissuable upon conversion of outstanding convertible notes, except if the effecton the per share amounts is anti-dilutive. For the years ended December 31, 2005 and 2004, the effect ofoutstanding stock options, warrants, convertible preferred shares andconvertible notes is anti-dilutive since the Company had net losses, and hasbeen excluded from the calculation of diluted net loss per share.  The weighted average number of common sharesplus common equivalent shares outstanding for the year ended December 31, 2006was 11,915,090.

The following is thereconciliation of the basic and diluted earnings per share computationsrequired by Statement of Financial Standards (“SFAS”) No. 128 (“Earnings perShare”)

 
| ** **                                                        | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                        | ** ** | **2006 (1)**                          | ** ** | **2005 (2)** | ** ** | **2004 (2)** | ** ** |
| **Numerators**                                                    |       |                                       |       |   |   |   |   |
|                                                              |       |                                       |       |   |   |   |   |
| Net income (loss)  applicable to common shareholders—basic   |       | $                                          | 537,766    |   | $ | (145,398 | ) | $ | (837,757 | ) |
| Interest on Convertible  Debt                                     |       | 210,000                                    |       | — |   | — |   |
| Net income (loss)  applicable to common shareholders—diluted |       | $                                          | 747,766    |   | $ | (145,398 | ) | $ | (837,757 | ) |
| ** **                                                        |       |                                       |       |   |   |   |   |
| **Denominators**                                                  |       |                                       |       |   |   |   |   |
|                                                              |       |                                       |       |   |   |   |   |
| Weighed average shares  outstanding—Basic                    |       | 7,572,637                                  |       | 7,218,244 |   | 5,710,354 |   |
| Convertible Debt                                                  |       | 3,500,000                                  |       | — |   | — |   |
| Warrrants                                                         |       | 287,353                                    |       | — |   | — |   |
| Stock options                                                     |       | 555,100                                    |       | — |   | — |   |
| Weighted average shares  outstanding—diluted                 |       | 11,915,090                                 |       | 7,218,244 |   | 5,710,354 |   |
|                                                              |       |                                       |       |   |   |   |   |
| Net income (loss) per  common share—basic                    |       | $                                          | 0.07       |   | $ | (0.02 | ) | $ | (0.15 | ) |
| Net income (loss) per commons share—diluted                  |       | $                                          | 0.06       |   | $ | (0.02 | ) | $ | (0.15 | ) |

----

(1)             Forthe year ended December 31, 2006, 1,332,800 shares on the conversion ofconvertible debt have not been included in dilutive shares as the effect wouldbe anti-dilutive.

(2)             Forthe year ended December 31, 2005 and 2004, all options, convertible debt,warrants and convertible preferred shares have not been included in dilutiveshares as the effect would be anti-dilutive.

## r.                                         Shippingand handling costs

The Company has includedfreight out as a component of selling, general and administrative expenses thatamounted to $27,000 in 2006, $32,000 in 2005 and $31,000 in 2004**.**  When applicable theCompany bills its customers for freight costs.

45

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## s.                                                              Recentlyissued accounting pronouncements

In July 2006, the FASBissued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,”(“FIN 48”) an interpretation of FASB Statement No. 109, “Accounting for IncomeTaxes”. FIN 48 is effective for fiscal years beginning after December 15, 2006,the year beginning January 1, 2007 for the Company. FIN 48 requires that aposition taken or expected to be taken in a tax return be recognized in thefinancial statements when it is more likely than not (i.e. a likelihood of morethan fifty percent) that the position would be sustained upon examination bytax authorities.  The Company does notexpect the adoption of FIN 48 to have a significant impact on its financialstatements.

In September 2006, theFASB issued SFAS No. 157, “Fair Value Measures” (“SFAS 157”).  SFAS 157 defines fair value, establishes aframework for measuring fair value and enhances disclosures about fair valuemeasures required under other accounting pronouncements, but does not changeexisting guidance as to whether or not an instrument is carried at fair value.  SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007, the year beginning January 1, 2008 for theCompany.  The Company does not expect theadoption of SFAS No.157 to have a significant impact on its financialstatements.

In February 2007, theFASB issued SFAS No. 159 “The Fair Value Option for Financial Assets andFinancial Liabilities,” (“SFAS 159”). SFAS 159 provides companies with an option to report selected financialassets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option hasbeen elected are reported in earnings at each subsequent reporting date.  SFAS 159 is effective for fiscal yearsbeginning after November 15, 2007, the year beginning January 1, 2008 forthe Company.  We are currently reviewingthe provisions of SFAS 159 to determine any impact for the Company.

**2.            **Impact of Unauthorized Personal Transactions byFormer CFO

The results of an investigation by our Audit Committeethrough an independent forensic accounting specialist revealed that over aperiod of approximately six years, from the second quarter of 2000 through thesecond quarter of 2006, the Company’s former Chief Financial Officer, WilliamMiraglia, had engaged in unauthorized and personal transactions totaling$860,000.  This included unauthorizedcharges on the Company’s debit card of approximately $711,000.  In addition, the investigation discoveredthat Mr. Miraglia made payments totaling $94,500, by check to the IRS withrespect to a personal tax levy against him over a period of approximately twoyears (third quarter 2004 through second quarter 2006), in addition to otherunapproved payments and misappropriation of funds totaling approximately$36,000.  As a result of the foregoingdiscoveries, Mr. Miraglia was terminated for cause from his employment with theCompany on June 14, 2006.

A summary of unauthorizedpersonal transactions which occurred from approximately the second quarter of2000 through the second quarter of 2006, follows:

 
| ** **                                         | ** ** | **QUARTER ENDED** | ** ** | ** **       | ** ** |
|----------------------------------------------------|------------|------------------------|------------|------------------|------------|
| ** **                                         | ** ** | **March 31**      | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** | **TOTAL** | ** ** |
|                                               |       |                   |       |             |       |   |   |   |   |   |   |
| From the second  quarter 2000 to December 31, 2000 |       | $                      | n/a        |             | $          | 1,000 |   | $ | 24,000 |   | $ | 25,000 |   | $ | 50,000 |   |
| From January 1,  2001 to December 31, 2001         |       | 31,000                 |       | 50,000           |       | 17,000 |   | 15,000 |   | 113,000 |   |
| From January 1,  2002 to December 31, 2002         |       | 20,000                 |       | 21,000           |       | 8,000 |   | 16,000 |   | 66,000 |   |
| From January 1,  2003 to December 31, 2003         |       | 15,000                 |       | 32,000           |       | 54,000 |   | 29,000 |   | 130,000 |   |
| From January 1,  2004 to December 31, 2004         |       | 44,000                 |       | 43,000           |       | 67,000 |   | 81,000 |   | 235,000 |   |
| From January 1,  2005 to December 31, 2005         |       | 39,000                 |       | 62,000           |       | 52,000 |   | 55,000 |   | 209,000 |   |
| Total through December 31, 2005                    |       |                   |       |             |       |   |   |   |   | $ | 803,000 |   |
| From January 1,  2006 to June 30, 2006             |       | 47,000                 |       | 10,000           |       | — |   | — |   | 57,000 |   |
| Total Unauthorized Personal Transactions           |       |                   |       |             |       |   |   |   |   | $ | 860,000 |   |
|                                                    |            |                        |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |

Mr. Miraglia recordedthese transactions primarily through journal entries prepared and entered byhimself into the Company’s accounts.  Thetransactions were reflected as Selling, General and Administrativeexpenses.  Although the transactions wereunauthorized and personal in nature, based upon a review of the accountingtreatment of individual transactions, the Company has concluded that allmaterial charges have been reflected as part of the reported expenses, reportednet income, earnings per share and cash flows in the appropriate periods.

46

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**3.         Inventories**

Inventories are comprisedof the following:
| ** **                                                    | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **2006**              | ** ** | **2005** | ** ** |
|                                                          |       |                  |       |   |   |
| Raw materials                                                 |       | $                     | 635,000    |   | $ | 616,000 |   |
| Work in process,  including manufactured parts and components |       | 1,213,000             |       | 1,350,000 |   |
| Finished goods                                                |       | 488,000               |       | 458,000 |   |
|                                                          |       | $                     | 2,336,000  |   | $ | 2,424,000 |   |

 

**4.         Property and Equipment**

Property andequipment are comprised of the following:
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Office and  computer equipment                  |       | $                     | 1,126,000  |   | $ | 1,067,000 |   |
| Machinery and  equipment                        |       | 10,381,000            |       | 9,505,000 |   |
| Leasehold  improvements                         |       | 1,952,000             |       | 1,900,000 |   |
|                                            |       | 13,459,000            |       | 12,472,000 |   |
| Less accumulated  depreciation and amortization |       | 9,164,000             |       | 8,143,000 |   |
|                                            |       | $                     | 4,295,000  |   | $ | 4,329,000 |   |

**5.         Subordinated Convertible PromissoryNotes**

In April 2004, theCompany received $1,000,000 from the issuance of a Subordinated ConvertiblePromissory Note.  The note is due inMarch 2008 and bears an interest rate of 6%.  The note was extended from its originalmaturity date of March 31, 2007. Interest accrues yearly and along with principal may be converted intoCommon Stock, (and/or securities convertible into common shares).  As a result of the June 2004 privateplacement, the note is convertible into 1,000,000 Units consisting of 1,000,000shares of Common Stock and Warrants to acquire 750,000 shares of Common Stockat a price of $1.35 per share.  TheHolder of the Note is a major shareholder of the Company.

In 2003, the Companyissued a Subordinated Convertible Promissory Note for proceeds of$1,500,000.  The note was amended in 2004to clarify its conversion features.  Theholder of the note is a major shareholder and debt holder of the Company.  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 aresult of the June 2004 private placement, the note is convertible into1,500,000 Units consisting of 1,500,000 shares of Common Stock and Warrants toacquire 1,125,000 shares of Common Stock at a price of $1.35 per share.  The proceeds from the note were used in theCompany’s acquisition program.

In June 2003, the Companyreceived $1,700,000 from a major Shareholder and Debt Holder of theCompany.  The proceeds of the note wereused to pay outstanding bank debt.  Thenote is secured by the assets of the Company. The note bears interest at the rate of 6% per annum and is due December2008.

In 2002, the Companyissued a Subordinated Convertible Promissory Note for proceeds of$1,000,000.  The note was amended in 2004to clarify its conversion features.  Thenote bears interest at the rate of 6% per annum and has a maturity date ofDecember 31, 2008.  The note was extendedfrom its original maturity date of January 31, 2006.  The note is convertible into common shares(and/or securities convertible into common shares) of the Company.  As a result of the June 2004 privateplacement, the note is convertible into 1,000,000 Units consisting of 1,000,000shares of Common Stock and Warrants to acquire 750,000 shares of Common Stockat a price of $1.35 per share.  TheHolder of the Note is a related party to a major Shareholder of the Company.

**6.         Notes Payable - Other**

In December 2005, theCompany entered into a financing arrangement in the amount of $700,000, with amajor shareholder and debt holder of the Company, to fund the acquisition ofcapital assets needed to capture new business opportunities.  The funds were received in February 2006 andthe Company issued a secured Promissory Note for $700,000.  The note is payable in installments over aterm of seven years and bears interest at 6.75%.

As part of the purchaseprice of MRC on October 19, 2004, a $175,000 Note was issued to the soleshareholder of the company.  The notebears interest at the rate of 6% per annum and is payable annually on theanniversary of the closing date.  Under 

47

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the terms of the note, $50,000of the note amount was repaid on October 19, 2006.  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.  Anote payable to the SBA was also assumed by the Company.  The note in the amount of $390,497 bearsinterest at the rate of 4.0% and is due in 2032.

At the time of thepurchase of Laser Optics, Inc., the Company converted certain liabilities tonotes payable.  Notes totaling $100,728were issued to former officers of Laser Optics, Inc. for back pay andun-reimbursed business expenses.  A notein the amount of $86,777 was also issued to the former landlord for backrent.  These note had repayment termsover three years and were fully repaid in 2006.

Notes payable, otherconsist of the following:

 
| ** **                                                                                                                                                                                                           | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                           | ** ** | **2006**              | ** ** | **2005** | ** ** |
| 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 |       | $                     | 1,152,759  |   | $ | 779,483 |   |
| Less current  portion                                                                                                                                                                                                |       | 100,079               |       | 260,697 |   |
| Long-term debt,  excluding current portion                                                                                                                                                                           |       | $                     | 1,052,680  |   | $ | 518,786 |   |

 

Notes payable other,mature as follows:

| 2007       |   | $       | 100,079   |   |
|------------|--------|---------|-----------|--------|
| 2008       |   | 107,389 |      |
| 2009       |   | 235,385 |      |
| 2010       |   | 114,717 |      |
| Thereafter |   | 595,189 |      |
|       |   |    |      |
|       |   | $       | 1,152,759 |   |

 

**7.         Accounts Payable and AccruedExpenses**

Accounts payable andaccrued expenses are comprised of the following:

|                                               | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Trade accounts  payable and accrued purchases |       | $                     | 575,261    |   | $ | 668,352 |   |
| Accrued vacation                              |       | 332,031               |       | 335,153 |   |
| Accrued payroll                               |       | 200,497               |       | 217,653 |   |
| Accrued interest                              |       | 1,043,500             |       | 748,048 |   |
| Accrued state  taxes payable                  |       | 14,700                |       | — |   |
| Accrued bonus                                 |       | 76,500                |       | 53,990 |   |
| Accrued common  stock payable                 |       | —                |       | 155,200 |   |
| Accrued 401K  common stock contribution       |       | 164,623               |       | 140,689 |   |
| Accrued expenses  — other                |       | 82,280                |       | 107,607 |   |
|                                          |       | $                     | 2,495,398  |   | $ | 2,426,692 |   |

**8.         Capital Lease Obligations**

Capital lease obligationsconsist of the following:
| ** **                                                                                                                                                                        | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                        | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Capital leases,  payable in aggregate monthly installments ranging from $22,000, to $14,000  including interest at rates ranging from 11.0% to 11.6% expiring through  April 2008 |       | $                     | 243,437    |   | $ | 493,175 |   |
| Less current  portion                                                                                                                                                             |       | 196,350               |       | 248,550 |   |
|                                                                                                                                                                              |       |                  |       |   |   |
| Long-term debt,  excluding current portion                                                                                                                                        |       | $                     | 47,087     |   | $ | 244,625 |   |

 

 

48

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Maturities of capitalleases are as follows:

| Year Ending                    | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------|------------|
| **December 31,**               | ** ** | ** ** | ** ** |
|                                |       |       |       |
| 2007                                |       | 213,256    |       |
| 2008                                |       | 49,141     |       |
|                                |       |       |       |
| Total minimum payments              |       | 262,397    |       |
| Less amounts  representing interest |       | 18,961     |       |
|                                |       |       |       |
| Present value of minimum payments   |       | $          | 243,437    |   |
|                                     |            |            |            |  |

 

Capital lease obligationsare collateralized by property and equipment with cost and related accumulateddepreciation approximating $858,000 and $196,000 at December 31, 2006.

**9.****                          IncomeTaxes**

A reconciliation of theincome tax provision (benefit) computed at the statutory Federal income taxrate to the reported amount follows:

|                                            | ** ** | **Year Ended**   | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **December 31,** | ** ** |
| ** **                                 | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Federal statutory rate                     |       | 34.0                  | %          | (34.0 | )% | (34.0 | )% |
| Net operating loss  carryforward - Federal |       | (34.0                 | )          |   |   |   |   |
| Loss in excess of  available benefit       |       |                  |       | 34.0 |   | 34.0 |   |
| State tax provision  (benefit)             |       | 9.0                   |       |   |   | (12.5 | ) |
| Net Operating Loss  carryforward - State   |       | (5.5                  | )          |   |   |   |   |
| Allowable state  manufacturing credit      |       | (1.5                  | )          |   |   |   |   |
| Effective income tax rate                  |       | 2.0                   | %          | — | % | (12.5 | )% |

At December 31, 2006, theCompany has Federal and State net operating loss carry forwards for taxpurposes of approximately $9,805,000 and $0, respectively.  The tax loss carry forwards expire at variousdates through 2025.

In 2004, the Company sold$1,550,800 of their NOL for $96,344 as part of a program enacted by the Stateof New Jersey that allowed new or emerging technology and biotechnologybusinesses to sell their unused Net Operating Loss (NOL) carryover to anycorporation for at least 75% of the value of the tax benefits.

Internal Revenue CodeSection 382 places a limitation on the utilization of Federal net operatingloss and other credit carry forwards when an ownership change, as defined bythe tax law, occurs.  Generally, this occurswhen a greater than 50 percentage point change in ownership occurs.  Accordingly, the actual utilization of thenet operating loss and carryforwards for tax purposes may be limited annuallyto a percentage (approximately 6%) of the fair market value of the Company atthe time of any such ownership change.

The provision (benefit)for income taxes consists of the following:

 

|            | ** ** | **Years Ended**  | ** ** |
|------------|------------|-----------------------|------------|
| ** ** | ** ** | **December 31,** | ** ** |
| ** ** | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
|       |       |                  |       |   |   |   |   |
| Current:   |       |                  |       |   |   |   |   |
| Federal    |       | $                     | —     |   | $ | — |   | $ | — |   |
| State      |       | 21,000                |       | — |   | (96,344 | ) |
| Deferred:  |       |                  |       |   |   |   |   |
| Federal    |       | —                |       | — |   | — |   |
| State      |       | —                |       | — |   | — |   |
|       |       |                  |       |   |   |   |   |
| Total      |       | $                     | 21,000     |   | $ | — |   | $ | (96,344 | ) |

 

49

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Deferred tax assets(liabilities) comprise the following:

|                            | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2006**              | ** ** | **2005** | ** ** |
|                       |       |                  |       |   |   |
| Inventory reserves         |       | $                     | 323,000    |   | $ | 283,000 |   |
| Vacation liabilities       |       | 126,000               |       | 127,000 |   |
| Section 263A adjustment    |       | 12,000                |       | 19,000 |   |
| Depreciation               |       | (116,000              |       | (83,000 |   |
| Loss carry forwards        |       | 2,720,000             |       | 3,424,000 |   |
| Gross deferred tax  assets |       | 3,065,000             |       | 3,936,000 |   |
| Valuation allowance        |       | (3,065,000            | )          | (3,936,000 | ) |
|                       |       | $                     | —     |   | $ | — |   |

 

**10.****                               RelatedParty Transactions**

During the years endedDecember 31, 2005 and 2004, approximately 1% and 3%, respectively, of theCompany’s net product sales were through a foreign agent, in which WarrenRuderman (deceased), a principal shareholder in those years, had aninvestment.  Terms of sales to thisforeign agent were substantially the same as to unrelated foreign agents

In December 2005, theCompany entered into a financing arrangement in the amount of $700,000, with amajor shareholder and debt holder of the Company, to fund the acquisition ofcapital assets needed to capture new business opportunities.  The funds were received in February 2006 andthe Company issued a secured Promissory Note for $700,000.  The note is payable in installments over aterm of seven years and bears interest at 6.75%.

During 2005, two notesfor $1,000,000 and $1,500,000 due to Clarex, Ltd., a shareowner and debtholder, had their maturity dates extended from January 31, 2006 toDecember 31, 2008.

During 2004, Clarex,Ltd., a shareowner and debt holder received a 6% Convertible Promissory Notefor $1,000,000 due March 2007.  This notewas extended to March 31, 2008.  In March2004, Clarex, Ltd. received 200,000 warrants for offering the 2003 $1,700,000secured promissory note and an additional 200,000 warrants for extending thematurity date of the note to December 2008.

During 2003, Clarex, Ltd.a shareowner and debt holder received a 6% Secured Promissory Note for $1,700,000due December 2005, that was subsequently extended to December 31, 2008.  In October 2003, Clarex, Ltd., received a$1,500,000, 6% Convertible Promissory Note due January 2006 that wassubsequently extended to December 31, 2008.

During 2002, WellandLtd., a related party to Clarex, Ltd., received a 6% Subordinated ConvertiblePromissory Note due January 31, 2006, that was subsequently extended toDecember 31, 2008, resulting in proceeds to the Company of $1,000,000.

**11.****                               Commitments**

## a.                                       Leasecommitment

The Company occupiesapproximately 42,000 square feet of space located at 181 Legrand Avenue,Northvale, New Jersey pursuant to a net lease. In September 2006, the lease was renewed for a two year term to October31, 2008, at substantially the same terms. The Company has also negotiated an option to renew the Northvale leasefor two additional two year terms running through October 21, 2012.

The Company’s MRC Opticssubsidiary occupies approximately 25,000 square feet of space located at 6405Parkland Drive, Sarasota, FL pursuant to a net lease originally expiring onAugust 31, 2006.  During 20006, MRCOptics negotiated terms for the renewal the lease until August 31, 2008 and arenewal period for an additional two years, at the option of the Company.

Rental expense wasapproximately $549,000, $525,000 and $370,000 in 2006, 2005 and 2004,respectively, and real estate taxes were $98,200, $95,000, and $64,000 in 2006,2005 and 2004, respectively.

50

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Future minimum annualrentals are payable as follows:

 

| Year Ending      | ** ** | ** ** | ** ** |
|-----------------------|------------|------------|------------|
| **December 31,** | ** ** | ** ** | ** ** |
| 2007                  |       | $          | 548,000    |   |
| 2008                  |       | $          | 416,000    |   |

 

## b.                                      Retirementplans

The Company maintains a401(k) savings plan for all eligible employees (as defined in the plan).  The 401(k) plan allows employees to contributeup to 20% of their compensation on a salary reduction, pre-tax basis up to thestatutory limitation.  The 401(k) planalso provides that the Company, at the discretion of the Board of Directors,may match employee contributions based on a pre-determined formula.

In 2006, the Companymatched employee contributions in the amount of $164,623 contributed in theform of 124,133 shares of the Company’s common stock, distributed in March2007.  The Company contributed $150,501in the form of 144,836 shares of the Company’s common stock in 2005,distributed in March 2006.  The Companycontributed $68,780 in the form of 61,404 shares of the Company’s common stockin 2004, distributed in March 2005.

## c.                                       Employmentagreements

The Company is party toan employment agreement with an officer that provides for a minimum annualsalary.  The aggregate minimum commitmentunder this agreement is as follows:

 

| Year Ending      | ** ** | ** ** | ** ** |
|-----------------------|------------|------------|------------|
| **December 31,** | ** ** | ** ** | ** ** |
| 2006                  |       | $          | 187,500    |   |
| 2007                  |       | $          | 187,500    |   |
| 2008                  |       | $          | 187,500    |   |
| 2009                  |       | $          | 187,500    |   |

 

Should the agreement beterminated without cause during the term of the contract, the officer would beentitled to one year’s salary payable within 30 days plus accrued bonus, ifearned, and vested stock options would be exercisable for three years.

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

The following tablesummarizes the Company’s product sales by product categories during the pastthree years:

 
| **Year Ended December 31,** | ** ** | **2006**  | ** ** | **2005** | ** ** | **2004**  | ** ** |
|--------------------------------------------|------------|-----------|------------|----------|------------|-----------|------------|
| **Category**                               | ** ** | **Sales** | ** ** | **%**    | ** ** | **Sales** | ** ** | **%** | ** ** | **Sales** | ** ** | **%** | ** ** |
| Optical Components                         |       | $         | 12,761,000 |     | 92         |      | $          | 12,279,000 |   | 89 |   | $ | 7,877,000 |   | 85 |   |
| Laser Accessories                          |       | 1,160,000 |       | 8        |       | 1,506,000 |       | 11 |   | 1,345,000 |   | 15 |   |
| TOTAL                                      |       | $         | 13,921,000 |     | 100        |      | $          | 13,785,000 |   | 100 |   | $ | 9,222,000 |   | 100 |   |

 

Export sales, primarilyto customers in countries within Europe, the Near East and Japan, amounted to10%, 14%, and 12% of product sales in 2006, 2005 and 2004, respectively.  No single foreign customer accounted for morethan 10% of product sales in 2006, 2005, or 2004.

In 2006, three domesticcustomers accounted for 15%, 16%, and 11%, of sales.  Each of these three customers areelectro-optical systems divisions of major U.S. defense industry corporationswho manufacture systems for the U.S. and allied foreign governments.  In 2005, two U.S. customers accounted for 13%and 14%, respectively, of sales.  Thesetwo customers, were two of the same three 2006 customers.  In 2004, two U.S. customers each accountedfor 12% of sales, and one customer accounted for 10% of sales.  The first two are defense industryelectro-optics manufacturers, while the third customer manufactures processcontrol and metrology systems.  In theshort-term, the loss of any of these customers would have a significantnegative impact on the company and its business units.

Export sales, primarilyto customers in countries within Europe, the Near East and Japan, amounted to10%, 14%, and 12% of product sales in 2006, 2005 and 2004, respectively.  No single foreign customer accounted for morethan 10% of product sales in 2006, 2005, or 2004.

In 2006, three domesticcustomers accounted for 15%, 16%, and 11%, of sales.  Each of these three customers areelectro-optical systems divisions of major U.S. defense industry corporationswho manufacture systems for the U.S. and allied foreign governments.  In 2005, two U.S. customers accounted for 13%and 14%, respectively, of sales.  Thesetwo customers, were two of the

51

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same three 2006customers.  In 2004, two U.S. customerseach accounted for 12% of sales, and one customer accounted for 10% ofsales.  The first two are defenseindustry electro-optics manufacturers, while the third customer manufacturesprocess control and metrology systems. In the short-term, the loss of any of these customers would have asignificant negative impact on the company and its business units.

**13.****                               Shareholders’Equity**

## a.                                       Commonshares reserved at December 31, 2006, are as follows:

 

| 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                        |   | 4,487,000 |   |

 

## 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.  The Board of Directors also has the authorityto fix, before the issuance of each series, the number of shares in each seriesand the designation, preferences, rights and limitations of each series.  Series A consist of 500 shares at a statedvalue of $1,000 per share convertible into common shares at the rate of $1.00per share.  Series B consist of 2,082shares at a stated value of $1,000 per share convertible into common shares atthe rate of $2.50 per share.

For the years endedDecember 31, 2006, 2005 and 2004, the Company paid a common stock dividend onpreferred stock of 134,000 common shares for each year equal to $235,000,$134,000 and $165,000, at the closing market price of the common shares on theissue date, respectively.

## c.                                       Stockoptions

The Company has adoptedtwo stock option plans that provide for the granting of options to employees,officers, directors, and others who render services to the Company.  Under these plans in the aggregate, optionsto purchase no more than 6,000,000 shares of common stock may be granted, at aprice that may not be less than the fair market value per share.

The Equity CompensationProgram authorizes the issuance of incentive stock options.  At the annual Shareholders’ meeting held in2004, shareholders’ approved a recommendation by the Board to increase thenumber of options to be granted under the 2000 Equity Compensation Program,from 4,000,000 to 6,000,000.  The 2000equity compensation plan expires in August 2010.

A summary of the statusof the Company’s stock option program as of December 31, 2006, 2005 and 2004,and changes during the years then ended is presented below:

 

|                                                              | ** ** | **Years Ended**  | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                   | ** ** | **December 31,** | ** ** |
| ** **                                                   | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                   | ** ** | ** **            | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                                   | ** ** | ** **            | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                   | ** ** | ** **            | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| **Fixed Stock Options**                            | ** ** | **Shares**            | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| Outstanding,  beginning of year                              |       | 2,194,800             |       | $ | 1.18 |   | 2,126,100 |   | $ | 1.21 |   | 1,453,600 |   | $ | 1.42 |   |
| Granted                                                      |       | 77,200                |       | 1.53 |   | 139,500 |   | 1.03 |   | 680,000 |   | 0.74 |   |
| Exercised                                                    |       | (145,000              | )          | 0.78 |   | — |   | — |   | — |   | — |   |
| Expired                                                      |       | —                |       | — |   | (2000 | ) | 1.25 |   | — |   | — |   |
| Forfeited                                                    |       | (252,300              | )          | 1.11 |   | (68,800 | ) | 1.18 |   | (7,500 | ) | .50 |   |
| Outstanding, end  of year                                    |       | 1,874,700             |       | 1.25 |   | 2,194,800 |   | 1.18 |   | 2,126,100 |   | 1.21 |   |
| Options exercisable,  end of year                            |       | 1,728,276             |       | 1.28 |   | 1,666,124 |   | 1.43 |   | 1,301,047 |   | 1.53 |   |
| Weighted-average fair  values of options granted during year |       |                  |       | $ | 1.46 |   |   |   | $ | 1.03 |   |   |   | $ | .67 |   |

 

52

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Warrants outstandingexpire from 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 |   |
| 60,000     |       | July 2009                    |       | $                       | 1.35       |                | $          | 1.31 |   |

 

The following table summarizes information about stockoptions outstanding at December 31, 2006:
| ** **              | ** ** | **Options Outstanding** | ** ** | ** **                  | ** ** | **Options Exercisable** | ** ** |
|-------------------------|------------|------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **              | ** ** | ** **                   | ** ** | **Weighted**                | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **              | ** ** | ** **                   | ** ** | **Average**                 | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **              | ** ** | ** **                   | ** ** | **Remaining**               | ** ** | **Average**                  | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Range of**       | ** ** | **Number**                   | ** ** | **Contractual**             | ** ** | **Exercise**                 | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Exercise Price** | ** ** | **Outstanding**              | ** ** | **Life in Years** | ** ** | **Price**                    | ** ** | **Outstanding** | ** ** | **Price** | ** ** |
| $0.50 - $2.00           |       | 1,759,600                    |       | 7.38                        |       | $                            | 1.08       |   | 1,613,167 |   | $ | 1.10 |   |
| $3.00 - $5.00           |       | 115,100                      |       | 5.09                        |       | $                            | 3.56       |   | 115,100 |   | $ | 3.56 |   |

 

**14.**                               **Fair Value of Financial Instruments**

The methods andassumptions used to estimate the fair value of the following classes offinancial 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 of theCompany’s long-term debt, including the current portion, for notes payable andsubordinated convertible debentures, was estimated using a discounted cash flowanalysis, based on the Company’s assumed incremental borrowing rates for similartypes of borrowing arrangements.  Thecarrying amount of variable and fixed rate debt at December 31, 2006approximates fair value.

**15****                                  QuarterlyData** (Unaudited)

Summaryquarterly results were as follows:
| **Year 2006**                    | ** ** | **First** | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
|---------------------------------------|------------|-----------|------------|------------|------------|-----------|------------|------------|------------|
|                                  |       |      |       |       |       |      |       |       |       |
| Net sales                             |       | $         | 3,662,776  |       | $          | 3,531,420 |       | $          | 3,049,333  |   | $ | 3,677,598 |   |
| Gross profit                          |       | 1,187,617 |       | 1,121,216  |       | 882,936   |       | 1,352,045  |       |
| Net Income                            |       | 201,653   |       | 6,839      |       | 173,000   |       | 390,774    |       |
| Net Income (loss) per  share - Basic  |       | 0.03      |       | (0.03      | )          | 0.02      |       | 0.05       |       |
| Net Income (loss) per share - Diluted |       | 0.02      |       | (0.03      | )          | 0.02      |       | 0.04       |       |
|                                       |            |           |            |            |            |           |            |            |            |  |  |  |  |

 
| **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  |       | (0.05     | )          | (0.06      | )          | .04       |       | .05        |       |
| Net Income (loss) per share - Diluted |       | (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  |       | (0.09     | )          | (0.08      | )          | .01       |       | (0.2       | )          |
| Net Income (loss) per share - Diluted |       | (0.09     | )          | (0.08      | )          | .01       |       | (0.2       | )          |
|                                       |            |           |            |            |            |           |            |            |            |  |  |  |  |

 

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**REPORT OFINDEPENDENT REGISTERED CERTIFIED PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULE**

The audits referred to inour report dated March 2, 2007 relating to the consolidated financialstatements of Photonic Products Group, Inc. and subsidiaries, which is containedin Item 8 in the Form 10K, include the audits of the financial statementschedule listed in the accompanying Schedule II for the years ended December31, 2006, 2005 and 2004.  This financialstatement schedule is the responsibility of the Company’s management.  Our responsibility is to express an opinionon this financial statement schedule based upon our audits.

It is our opinion suchfinancial statement schedule presents fairly, in all material respects, theinformation set forth therein.
| Holtz  Rubenstein Reminick LLP |
|--------------------------------|
| Melville, NY                   |
|                           |
| March 2, 2007                  |

 

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**ScheduleII —Valuation and Qualifying Accounts**

**PHOTONIC PRODUCTS GROUP, INC.**

**SCHEDULE II VALUATION ANDQUALIFYING ACCOUNTS**

**(inthousands)**
| ** **                          | ** ** | **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,  2006       |       | $                                              | 15,000     |                                                     | —     |                  | —     |           | —     |                                     | $          | 15,000 |   |
| Year ended December 31,  2005       |       | $                                              | 40,000     |                                                     |       |                  |       |           | $          | 25,000                                   |       | $ | 15,000 |   |
| Year Ended December 31,  2004       |       | $                                              | 40,000     |                                                     | —     |                  | —     |           | —     |                                     | $          | 40,000 |   |
|                                |       |                                           |       |                                                     |       |                  |       |           |       |                                     |       |
| Reserve for Inventory  Obsolescence |       |                                           |       |                                                     |       |                  |       |           |       |                                     |       |
| Year ended December 31,  2006       |       | $                                              | 746,000    |                                                     | $          | 103,000               |       | —         |       | —                                   |       | $ | 849,000 |   |
| Year ended December 31,  2005       |       | $                                              | 807,000    |                                                     | $          | (61,000               | )          | —         |       | —                                   |       | $ | 746,000 |   |
| Year ended December 31, 2004        |       | $                                              | 992,000    |                                                     | $          | (185,000              | )          | —         |       | —                                   |       | $ | 807,000 |   |
|                                     |            |                                                |            |                                                          |            |                       |            |                |            |                                          |            |  |  |  |  |

 

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