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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the quarterly period ended September 30, 2004, or



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from  to
 .



000-21669

(Commission File Number)



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Digital Lightwave, Inc.

(Exact name of Registrant as specified in its
charter)



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|                                         |  |                                     
|---------------------------------------- |  | ------------------------------------
|Delaware                                 |  | 95-4313013                          
|(State or other jurisdiction of          |  | (I.R.S. Employer Identification No.)
|incorporation or organization)           |  |                                     
|                                         | 
|15550 Lightwave Drive                    |  |                                     
|Clearwater, Florida                      |  | 33760                               
|(Address of principal executive offices) |  | (Zip Code)                          



(727) 442-6677

(Registrants telephone number, including area code)



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



Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    YES ̈NO  x



The number of shares outstanding of the Registrants Common Stock as of November 9, 2004, was 34,183,204.



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##### Table of Contents

DIGITAL LIGHTWAVE, INC.



QUARTERLY
REPORT ON FORM 10-Q

For the Period Ended September 30, 2004



INDEX



|              |  |                                                                                                                            |  |     
|------------- |  | -------------------------------------------------------------------------------------------------------------------------- |  | ----
|              |  |                                                                                                                            |  | Page
|              |  | PART I. FINANCIAL INFORMATION                                                                                              |  |     
|              |  |                                                                                                                           
|Item 1.       |  | Consolidated Condensed Financial Statements:                                                                               |  |     
|              |  |                                                                                                                           
|              |  | Consolidated Condensed Balance Sheets  September 30, 2004 (Unaudited) and December 31, 2003                               |  | 1   
|              |  |                                                                                                                           
|              |  | Consolidated Condensed Statements of Operations (Unaudited)  Three Months Ended September 30, 2004 and September 30, 2003 |  | 2   
|              |  |                                                                                                                           
|              |  | Consolidated Condensed Statements of Operations (Unaudited)  Nine Months Ended September 30, 2004 and September 30, 2003  |  | 3   
|              |  |                                                                                                                           
|              |  | Consolidated Condensed Statements of Cash Flows (Unaudited)  Nine Months Ended September 30, 2004 and September 30, 2003  |  | 4   
|              |  |                                                                                                                           
|              |  | Notes to Consolidated Condensed Financial Statements (Unaudited)                                                           |  | 5   
|              |  |                                                                                                                           
|Item 2.       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                      |  | 16  
|              |  |                                                                                                                           
|Item 3.       |  | Quantitative and Qualitative Disclosures About Market Risk                                                                 |  | 24  
|              |  |                                                                                                                           
|Item 4.       |  | Controls and Procedures                                                                                                    |  | 24  
|              |  |                                                                                                                           
|              |  | PART II. OTHER INFORMATION                                                                                                 |  |     
|              |  |                                                                                                                           
|Item 1.       |  | Legal Proceedings                                                                                                          |  | 25  
|              |  |                                                                                                                           
|Item 6.       |  | Exhibits and Reports on Form 8-K                                                                                           |  | 25  
|              | 
|SIGNATURES    |  | 26                                                                                                                        
|              | 
|EXHIBIT INDEX |  | 27                                                                                                                        



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##### Table of Contents

PART I

FINANCIAL INFORMATION



Item 1.Consolidated Condensed Financial Statements



DIGITAL LIGHTWAVE, INC.



CONSOLIDATED CONDENSED BALANCE SHEETS

(In thousands, except share data)



|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|----------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                                      |  | September 30,2004 |          |   | December 31,2003 |  
|                                                                                                                                                      |  | (Unaudited)       |          |   |                  |  
|ASSETS                                                                                                                                                |  |                   |          |   |                  |   |          |  
|Current assets:                                                                                                                                       |  |                   |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                                             |  | $                 | 585      |   |                  | $ | 312      |  
|Restricted cash and cash equivalents                                                                                                                  |  |                   | 1,392    |   |                  |   | 1,994    |  
|Accounts receivable, less allowance of $1,774 and $1,622 in 2004 and 2003, respectively                                                               |  |                   | 3,144    |   |                  |   | 1,204    |  
|Notes receivable                                                                                                                                      |  |                   | 366      |   |                  |   | 366      |  
|Inventories, net                                                                                                                                      |  |                   | 5,357    |   |                  |   | 8,268    |  
|Prepaid expenses and other current assets                                                                                                             |  |                   | 719      |   |                  |   | 473      |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Total current assets                                                                                                                                  |  |                   | 11,563   |   |                  |   | 12,617   |  
|Property and equipment, net                                                                                                                           |  |                   | 2,772    |   |                  |   | 4,247    |  
|Other assets                                                                                                                                          |  |                   | 853      |   |                  |   | 1,060    |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Total assets                                                                                                                                          |  | $                 | 15,188   |   |                  | $ | 17,924   |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)                                                                                                        |  |                   |          |   |                  |   |          |  
|Current liabilities:                                                                                                                                  |  |                   |          |   |                  |   |          |  
|Accounts payable and accrued liabilities                                                                                                              |  | $                 | 6,063    |   |                  | $ | 5,123    |  
|Accrued litigation charge                                                                                                                             |  |                   |         |   |                  |   | 14,203   |  
|Notes payable to related party                                                                                                                        |  |                   | 27,000   |   |                  |   | 13,635   |  
|Notes payable - current portion                                                                                                                       |  |                   | 1,292    |   |                  |   | 5,586    |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Total current liabilities                                                                                                                             |  |                   | 34,355   |   |                  |   | 38,547   |  
|Notes payable other - long-term                                                                                                                       |  |                   | 3,025    |   |                  |   |         |  
|Other long-term liabilities                                                                                                                           |  |                   | 368      |   |                  |   | 517      |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Total liabilities                                                                                                                                     |  |                   | 37,748   |   |                  |   | 39,064   |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Stockholders equity (deficit):                                                                                                                       |  |                   |          |   |                  |   |          |  
|Preferred stock, $.0001 par value; authorized 20,000,000 shares; no shares issued or outstanding                                                      |  |                   |         |   |                  |   |         |  
|Common stock, $.0001 par value; authorized 200,000,000 shares; issued and outstanding 34,172,608 and 31,591,890 shares in 2004 and 2003,
respectively |  |                   | 3        |   |                  |   | 3        |  
|Additional paid-in capital                                                                                                                            |  |                   | 86,060   |   |                  |   | 81,261   |  
|Accumulated deficit                                                                                                                                   |  |                   | (108,623 | ) |                  |   | (102,404 | )
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Total stockholders equity (deficit)                                                                                                                  |  |                   | (22,560  | ) |                  |   | (21,140  | )
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Total liabilities and stockholders equity (deficit)                                                                                                  |  | $                 | 15,188   |   |                  | $ | 17,924   |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  



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



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DIGITAL LIGHTWAVE, INC.



CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except share and per-share data)



|                                                                 |  |                                 |            |   |      |   |            |  
|---------------------------------------------------------------- |  | ------------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                 |  | Three Months EndedSeptember 30, |           
|                                                                 |  | 2004                            |            |   | 2003 |  
|Net sales                                                        |  | $                               | 2,492      |   |      | $ | 2,583      |  
|Cost of goods sold                                               |  |                                 | 923        |   |      |   | 1,631      |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Gross profit                                                     |  |                                 | 1,569      |   |      |   | 952        |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Operating expenses:                                              |  |                                 |            |   |      |   |            |  
|Engineering and development                                      |  |                                 | 1,975      |   |      |   | 1,546      |  
|Sales and marketing                                              |  |                                 | 3,582      |   |      |   | 2,401      |  
|General and administrative                                       |  |                                 | 964        |   |      |   | 1,469      |  
|Restructuring charges                                            |  |                                 |           |   |      |   | 4          |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Total operating expenses                                         |  |                                 | 6,521      |   |      |   | 5,420      |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Operating loss                                                   |  |                                 | (4,952     | ) |      |   | (4,468     | )
|Other income (expense), net                                      |  |                                 | 2,862      |   |      |   | (252       | )
|                                                                 |  |                                 |            |   |      |   |            |  
|Loss before income taxes                                         |  |                                 | (2,090     | ) |      |   | (4,720     | )
|Benefit from income taxes                                        |  |                                 |           |   |      |   |           |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Net loss                                                         |  | $                               | (2,090     | ) |      | $ | (4,720     | )
|                                                                 |  |                                 |            |   |      |   |            |  
|Per share of common stock:                                       |  |                                 |            |   |      |   |            |  
|Basic net loss per share                                         |  | $                               | (0.06      | ) |      | $ | (0.15      | )
|                                                                 |  |                                 |            |   |      |   |            |  
|Diluted net loss per share                                       |  | $                               | (0.06      | ) |      | $ | (0.15      | )
|                                                                 |  |                                 |            |   |      |   |            |  
|Weighted average common shares outstanding                       |  |                                 | 34,169,531 |   |      |   | 31,527,149 |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Weighted average common and common equivalent shares outstanding |  |                                 | 34,169,531 |   |      |   | 31,527,149 |  
|                                                                 |  |                                 |            |   |      |   |            |  



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



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DIGITAL LIGHTWAVE, INC.



CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except share and per-share data)



|                                                                 |  |                                 |            |   |      |   |            |  
|---------------------------------------------------------------- |  | ------------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                 |  | Nine Months Ended September 30, |           
|                                                                 |  | 2004                            |            |   | 2003 |  
|Net sales                                                        |  | $                               | 12,681     |   |      | $ | 5,872      |  
|Cost of goods sold                                               |  |                                 | 5,728      |   |      |   | 7,602      |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Gross profit (loss)                                              |  |                                 | 6,953      |   |      |   | (1,730     | )
|                                                                 |  |                                 |            |   |      |   |            |  
|Operating expenses:                                              |  |                                 |            |   |      |   |            |  
|Engineering and development                                      |  |                                 | 5,168      |   |      |   | 6,465      |  
|Sales and marketing                                              |  |                                 | 7,616      |   |      |   | 7,527      |  
|General and administrative                                       |  |                                 | 2,764      |   |      |   | 6,486      |  
|Restructuring charges                                            |  |                                 | 40         |   |      |   | 1,075      |  
|Impairment of long-lived assets                                  |  |                                 |           |   |      |   | 3,302      |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Total operating expenses                                         |  |                                 | 15,588     |   |      |   | 24,855     |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Operating loss                                                   |  |                                 | (8,635     | ) |      |   | (26,585    | )
|Other income (expense), net                                      |  |                                 | 2,415      |   |      |   | (1,439     | )
|                                                                 |  |                                 |            |   |      |   |            |  
|Loss before income taxes                                         |  |                                 | (6,220     | ) |      |   | (28,024    | )
|Benefit from income taxes                                        |  |                                 |           |   |      |   |           |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Net loss                                                         |  | $                               | (6,220     | ) |      | $ | (28,024    | )
|                                                                 |  |                                 |            |   |      |   |            |  
|Per share of common stock:                                       |  |                                 |            |   |      |   |            |  
|Basic net loss per share                                         |  | $                               | (0.19      | ) |      | $ | (0.89      | )
|                                                                 |  |                                 |            |   |      |   |            |  
|Diluted net loss per share                                       |  | $                               | (0.19      | ) |      | $ | (0.89      | )
|                                                                 |  |                                 |            |   |      |   |            |  
|Weighted average common shares outstanding                       |  |                                 | 32,691,107 |   |      |   | 31,473,217 |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Weighted average common and common equivalent shares outstanding |  |                                 | 32,691,107 |   |      |   | 31,473,217 |  
|                                                                 |  |                                 |            |   |      |   |            |  



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



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DIGITAL LIGHTWAVE, INC.



CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)



|                                                                        |  |                                |         |   |      |   |         |  
|----------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------- | -
|                                                                        |  | Nine Months EndedSeptember 30, |        
|                                                                        |  | 2004                           |         |   | 2003 |  
|Cash flows from operating activities:                                   |  |                                |         |   |      |   |         |  
|Net loss                                                                |  | $                              | (6,220  | ) |      | $ | (28,024 | )
|Adjustments to reconcile net loss to cash used in operating activities: |  |                                |         |   |      |   |         |  
|Depreciation and amortization                                           |  |                                | 1,789   |   |      |   | 2,812   |  
|Loss on disposal of property                                            |  |                                | 37      |   |      |   | 16      |  
|Provision for uncollectible accounts                                    |  |                                | 1,299   |   |      |   | 13      |  
|Provision for excess and obsolete inventory                             |  |                                | (53     | ) |      |   | 3,400   |  
|Impairment of long-lived assets                                         |  |                                |        |   |      |   | 3,302   |  
|Restructuring charges                                                   |  |                                | 40      |   |      |   | 84      |  
|Compensation expense for stock option grants                            |  |                                |        |   |      |   | 112     |  
|Settlement of accounts payable and accrued litigation                   |  |                                | (386    | ) |      |   | (606    | )
|Gain on settlement of debt                                              |  |                                | (259    | ) |      |   |        |  
|Changes in operating assets and liabilities:                            |  |                                |         |   |      |   |         |  
|(Increase) decrease in accounts receivable                              |  |                                | (3,239  | ) |      |   | 2,109   |  
|Decrease in inventories                                                 |  |                                | 3,001   |   |      |   | 2,584   |  
|Increase in prepaid expenses and other assets                           |  |                                | (293    | ) |      |   | (726    | )
|Increase in accounts payable and accrued expenses                       |  |                                | 1,414   |   |      |   | 5,000   |  
|Decrease in accrued litigation charge                                   |  |                                | (5,802  | ) |      |   | (3,379  | )
|Decrease in deferred gain debt settlement                               |  |                                | (3,701  | ) |      |   |        |  
|                                                                        |  |                                |         |   |      |   |         |  
|Net cash used in operating activities                                   |  |                                | (12,373 | ) |      |   | (13,303 | )
|                                                                        |  |                                |         |   |      |   |         |  
|Cash flows from investing activities:                                   |  |                                |         |   |      |   |         |  
|Purchases of short-term investments                                     |  |                                |        |   |      |   | (2,400  | )
|Proceeds from sale of short-term investments                            |  |                                |        |   |      |   | 1,002   |  
|Proceeds from the maturity of short-term investments                    |  |                                |        |   |      |   | 3,006   |  
|Decrease in restricted cash and cash equivalents                        |  |                                | 602     |   |      |   | 817     |  
|Purchases of property and equipment                                     |  |                                | (134    | ) |      |   | (158    | )
|Repayment of notes receivable                                           |  |                                |        |   |      |   | 800     |  
|                                                                        |  |                                |         |   |      |   |         |  
|Net cash provided by investing activities                               |  |                                | 468     |   |      |   | 3,067   |  
|                                                                        |  |                                |         |   |      |   |         |  
|Cash flows from financing activities:                                   |  |                                |         |   |      |   |         |  
|Proceeds from notes payable - related party                             |  |                                | 13,365  |   |      |   | 10,812  |  
|Principal payments on notes payable - related party                     |  |                                |        |   |      |   | (962    | )
|Payments/settlements on notes payable - other                           |  |                                | (1,287  | ) |      |   | (94     | )
|Proceeds from sale of common stock, net of expense                      |  |                                | 100     |   |      |   | 205     |  
|Principal payments on capital lease obligations                         |  |                                |        |   |      |   | (199    | )
|                                                                        |  |                                |         |   |      |   |         |  
|Net cash provided by financing activities                               |  |                                | 12,178  |   |      |   | 9,762   |  
|                                                                        |  |                                |         |   |      |   |         |  
|Net increase (decrease) in cash and cash equivalents                    |  |                                | 273     |   |      |   | (474    | )
|Cash and cash equivalents at beginning of period                        |  |                                | 312     |   |      |   | 612     |  
|                                                                        |  |                                |         |   |      |   |         |  
|Cash and cash equivalents at end of period                              |  | $                              | 585     |   |      | $ | 138     |  
|                                                                        |  |                                |         |   |      |   |         |  
|Other supplemental disclosures:                                         |  |                                |         |   |      |   |         |  
|Cash paid for interest                                                  |  | $                              |        |   |      | $ | 100     |  



Non-cash Transactions:



See Note 10 - Non-Cash Transactions



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



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##### Table of Contents

DIGITAL LIGHTWAVE, INC.



NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(Unaudited)



1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Business and Basis of Presentation



Digital Lightwave, Inc. (the Company) designs, develops and markets a portfolio
of portable and network-based products for installing, maintaining and monitoring fiber optic circuits and networks. Network operators and telecommunications service providers use fiber optics to provide increased network bandwidth to transmit voice
and other non-voice traffic such as internet, data and multimedia video transmissions. The Company provides telecommunications service providers and equipment manufacturers with product capabilities to cost-effectively deploy and manage fiber optic
networks. The Companys product lines include: Network Information Computers (NIC), Network Access Agents (NAA), Optical Test Systems (OTS), and Optical Wavelength Managers (OWM). The
Companys wholly owned subsidiaries are Digital Lightwave (UK) Limited (DLL), Digital Lightwave Asia Pacific Pty, Ltd. (DLAP), and Digital Lightwave Latino Americana Ltda. (DLLA). DLL, DLAP, and DLLA provide
international sales support. All significant intercompany transactions and balances are eliminated in consolidation.



The accompanying unaudited consolidated condensed financial statements of Digital Lightwave, Inc. and its subsidiaries (the Company, Digital
Lightwave, us, we, our, etc.) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, these statements include all adjustments,
consisting of normal and recurring adjustments, considered necessary for a fair presentation of results for such periods. The results of operations for the nine-month period ended September 30, 2004, are not necessarily indicative of results which
may be achieved for the full fiscal year or for any future period. The unaudited interim financial statements should be read in conjunction with the financial statements and notes thereto contained in Digital Lightwaves Annual Report on Form
10-K for the year ended December 31, 2003.



Operational Matters



As of November 12, 2004, the Company continues to have insufficient
short-term resources for the payment of its current liabilities. During the first nine months of 2004, the Company has addressed this shortfall by obtaining financing from Optel, LLC and Optel Capital, LLC (collectively Optel), entities
controlled by the Companys largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan. The Company has used the financing provided by Optel (i) to fund the satisfaction of substantially all of its outstanding debt
and liabilities owed to creditors other than Optel, (ii) to fund the settlement of all outstanding legal disputes, and (iii) to fund the Companys short term working capital needs.



From February 2003 through September 16, 2004 the Company borrowed approximately $26.6 million from Optel pursuant to a series of secured
promissory notes (the Optel Notes), of which approximately $25.65 million in principal and approximately $2.0 million in accrued interest was outstanding as of September 16, 2004. The Optel Notes were secured by a first priority security
interest in substantially all of the assets of the Company, bore interest at a rate of 10% per annum and were due and payable in full upon demand by Optel at any time. On September 16, 2004, the Company and Optel executed definitive financing
agreements to restructure all of the outstanding Optel Notes. Pursuant to the agreements, Optel extended the maturity of the outstanding principal amount until December 31, 2005 and extended the maturity of the outstanding accrued interest, plus
additional interest that accrues in the future, until September 16, 2005. In connection with the restructuring, on September 17, 2004, Optel advanced to the Company an additional $1.35 million, bringing the total principal amount of debt owed by the
Company to Optel to $27.0 million, plus accrued interest of approximately $2.0 million (collectively, the Restructured Debt). The Restructured Debt continues to bear interest at a rate of 10% per annum and is secured by a first priority
security interest in substantially all of the assets of the Company.



In
conjunction with the debt restructuring, the Company issued to Optel a Secured Convertible Promissory Note (the Convertible Note). Pursuant to the Convertible Note, the Company has agreed to make the Restructured Debt or any portion
thereof convertible into common stock of the Company at the option of Optel at any time following approval of the conversion feature by the disinterested stockholders at a conversion price based on the volume-weighted average trading price of the
stock during the five-day period preceding the date of any conversion. Stockholder approval will be determined at the next Annual Stockholders Meeting.



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##### Table of Contents

All of the foregoing transactions with Optel were approved by the Companys board of directors on September 15,
2004, upon the recommendation of the special committee of the board. The special committee is composed solely of independent directors.



On October 1, October 14, October 15 and November 10, 2004, the Company borrowed an additional $360,000, $300,000, $1,000,000 and $2,300,000, respectively, from Optel to
fund its ongoing working capital needs. Each of the new loans were evidenced by separate secured promissory notes, bear a rate of interest of 10.0% per annum and are secured by a security interest in substantially all of the Companys assets.
The total principal amount of $3.96 million and any accrued, but unpaid interest under each of the secured promissory notes is due and payable upon demand by Optel at any time after December 31, 2004.



As of November 12, 2004, the total principal owed by the Company to Optel approximates $31.0
million, plus accrued and unpaid interest of approximately $2.4 million.



On
August 23, 2004, Optel entered into a guarantee agreement (the Guarantee Agreement) with Jabil Circuits, Inc. (Jabil), pursuant to which Optel guaranteed certain obligations of the Company owing to Jabil relating to purchase
orders for production material issued by the Company to Jabil after June 30, 2004. Optels maximum obligation under the Guarantee Agreement is $1.88 million. Prior to the completion of the Guarantee Agreement, the Company was required to prepay
Jabil for all orders of production material. With the Guarantee Agreement in place, the Company is now able to pay for production material purchased from Jabil upon receipt of that material. (See Note 8  Related Party Transactions)



The Companys ability to meet cash requirements and maintain sufficient liquidity
over the next 12 months is dependent on its ability to obtain additional financing from funding sources which may include, but may not be limited to Optel. If the Company is not able to obtain additional financing, it expects that it will not have
sufficient cash to fund its working capital and capital expenditure requirements for the near term. Optel currently continues to be the principal source of financing for the Company. Further, the Company has not identified any funding source other
than Optel that would be prepared to provide current or future financing to the Company.



The Company cannot assure that it will be able to obtain adequate financing, that it will achieve profitability or, if it achieves profitability that the profitability will be sustainable or that it will continue as a
going concern. As a result, our independent certified public accountants have included an explanatory paragraph for a going concern in their report for the year ended December 31, 2003, that was included in our Annual Report on Form 10-K filed on
April 14, 2004.



Impairment of Long-Lived Assets



Long-lived assets are reviewed for impairment whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable. During the first quarter of 2003, the Company performed an impairment analysis related to the long-lived assets associated with the OTS product line. The impairment was calculated
in accordance with the guidelines set forth in Financial Accounting Standards Board Statement Number 144, Accounting for the Impairment or Disposal of Long-Lived Assets, and indicated future cash flows from the Companys OTS product line
were insufficient to cover the carrying value of the long-lived assets supporting the OTS product line. During the nine months ended September 30, 2004, no impairment charges were recorded because there were no events which occurred that required a
measurement for impairment.



Accrued Warranty



The Company provides its customers a warranty with each product sold, which guarantees the
reliability of the product for a period of one to three years. The Companys policy for product warranties is to review the warranty reserve on a quarterly basis for specifically identified or new matters and to review the reserve for estimated
future costs associated with any open warranty years. The reserve amount is an estimate based on historical trends, the number of products under warranty, the costs of replacement parts and the expected reliability of our products. A change in these
factors could result in a change in the reserve balance. Warranty costs are charged against the reserve when incurred.



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The reconciliation of the warranty reserve is as follows:



|                                 |  |                                 |      |   |      |   |       |  
|-------------------------------- |  | ------------------------------- | ---- | - | ---- | - | ----- | -
|                                 |  | Nine Months Ended September 30, |     
|(In thousands)                   |  | 2004                            |      |   | 2003 |  
|Beginning balance                |  | $                               | 678  |   |      | $ | 1,191 |  
|Adjustment to warranty provision |  |                                 | 258  |   |      |   | (289  | )
|Cost of warranty services        |  |                                 | (393 | ) |      |   | (174  | )
|                                 |  |                                 |      |   |      |   |       |  
|Ending balance                   |  | $                               | 543  |   |      | $ | 728   |  
|                                 |  |                                 |      |   |      |   |       |  



Revenue Recognition



The Company derives its revenue from product sales. The Company recognizes revenue from
the sale of products when persuasive evidence of an arrangement exists, the product has been delivered, the price is fixed and determinable, and collection of the resulting receivable is reasonably assured.



For all sales, the Company uses a binding purchase order as evidence that a sales arrangement
exists. Sales through international distributors are evidenced by a master agreement governing the relationship with the distributor. The Company either obtains an end-user purchase order documenting the order placed with the distributor or proof of
delivery to the end-user as evidence that a sales arrangement exists. For demonstration units sold to distributors, the distributors binding purchase order is evidence of a sales arrangement.



For domestic sales, delivery generally occurs when product is delivered to a common carrier.
Demonstration units sold to international distributors are considered delivered when the units are delivered to a common carrier. An allowance is provided for sales returns based on historical experience.



For sales made under an original equipment manufacturer (OEM) arrangement,
delivery generally occurs when the product is delivered to a common carrier. OEM sales are defined as sales of Company products to a third party that will market the products under the third partys brand.



For trade-in sales, including both Company and competitor products, that have a cash
component of greater than 25% of the fair value of the sale, the Company recognizes revenue based upon the fair value of what is sold or received, whichever is more readily determinable, if the Company has demonstrated the ability to sell its
trade-in inventory for that particular product class. Otherwise, the Company accounts for the trade-in sale as a non-monetary transaction and follows the guidance found in Accounting Principles Board (APB) Opinion No. 29, Accounting
for Non-monetary Transactions and related interpretations. Revenue and cost of sales are recorded based upon the cash portion of the transaction. The remaining costs associated with the new units are assigned to the units received on trade. When
the trade-in units are resold, revenue is recorded based upon the sales price and cost of goods sold is charged with the value assigned to trade-in units from the original transaction.



At the time of the transaction, the Company assesses whether the price associated with its revenue transactions is fixed and determinable
and whether or not collection is reasonably assured. The Company assesses whether the price is fixed and determinable based on the payment terms associated with the transaction. Standard payment terms for domestic customers are 30 days from the
invoice date. Distributor contracts provide standard payment terms of 60 days from the invoice date. The Company does not generally offer extended payment terms.



The Company assesses collection based on a number of factors, including past transaction history with the customer and the credit-worthiness
of the customer. Collateral is not requested from customers. If it is determined that collection of an account receivable is not reasonably assured, the amount of the account receivable is deferred and revenue is recognized at the time collection
becomes reasonably assured.



Most sales arrangements do not generally include
acceptance clauses. However, if a sales arrangement includes an acceptance clause, acceptance occurs upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.



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##### Table of Contents

Computation of Net Loss Per Share



Basic net loss per share is based on the weighted average number of common shares outstanding during the periods presented. For the
nine-month periods ended September 30, 2004 and 2003, diluted loss per share does not include the effect of incremental shares from common stock equivalents using the treasury stock method, as the inclusion of such equivalents would be
anti-dilutive. The total incremental shares from common stock equivalents were 101,207 and 318,339 for the three months and nine months ended September 30, 2004, respectively. The table below shows the calculation of basic weighted average common
shares outstanding and the incremental number of shares arising from common stock equivalents under the treasury stock method:



|         |  |                                                 |  |                                 |  |           
|-------- |  | ----------------------------------------------- |  | ------------------------------- |  | ----------
|         |  |                                                 |  | Three Months EndedSeptember 30,
|         |  |                                                 |  | 2004                            |  | 2003      
|Basic:   |  |                                                 |  |                                 |  |           
|         |  | Weighted average common shares outstanding      |  | 34,169,531                      |  | 31,527,149
|         |  | Total basic                                     |  | 34,169,531                      |  | 31,527,149
|         |  |                                                 |  |                                 |  |           
|Diluted: |  |                                                 |  |                                 |  |           
|         |  | Incremental shares for common stock equivalents |  |                                |  |          
|         |  |                                                 |  |                                 |  |           
|         |  | Total dilutive                                  |  | 34,169,531                      |  | 31,527,149
|         |  |                                                 |  |                                 |  |           
|         |  |                                                
|         |  |                                                 |  | Nine Months EndedSeptember 30, 
|         |  |                                                 |  | 2004                            |  | 2003      
|Basic:   |  |                                                 |  |                                 |  |           
|         |  | Weighted average common shares outstanding      |  | 32,691,107                      |  | 31,473,217
|         |  | Total basic                                     |  | 32,691,107                      |  | 31,473,217
|         |  |                                                 |  |                                 |  |           
|Diluted: |  |                                                 |  |                                 |  |           
|         |  | Incremental shares for common stock equivalents |  |                                |  |          
|         |  |                                                 |  |                                 |  |           
|         |  | Total dilutive                                  |  | 32,691,107                      |  | 31,473,217
|         |  |                                                 |  |                                 |  |           



Stock Based Compensation



At September 30, 2004, the Company had two stock-based employee
compensation plans. The Company accounts for the plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is
reflected in net loss because all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The stock-based compensation recorded in 2003 resulted from options issued to the
Companys Strategic Restructuring Advisor as more fully described in Note 8  Related Party Transactions. The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition
provisions of Financial Accounting Standards Board (FASB) Statement No. 148, Accounting for Stock-Based Compensation, to stock-based employee compensation:



|                                                                                                                |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |         |  
|--------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------- | -
|                                                                                                                |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|(In thousands, except per-share data)                                                                           |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003   |  
|Net (loss), as reported                                                                                         |  | $                               | (2,090 | ) |                                | $ | (4,720 | )    |  | $ | (6,220 | ) |  | $ | (28,024 | )
|Add: Stock-based employee compensation included in reported net (loss), net of related tax effects              |  |                                 |       |   |                                |   | 37     |      |  |   |       |   |  |   | 112     |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards |  |                                 | (872   | ) |                                |   | (2,063 | )    |  |   | (2,715 | ) |  |   | (3,731  | )
|                                                                                                                |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |         |  
|Pro forma net (loss)                                                                                            |  | $                               | (2,962 | ) |                                | $ | (6,746 | )    |  | $ | (8,935 | ) |  | $ | (31,643 | )
|                                                                                                                |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |         |  
|Earnings (loss) per share:                                                                                      |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |         |  
|Basic - as reported                                                                                             |  | $                               | (0.06  | ) |                                | $ | (0.15  | )    |  | $ | (0.19  | ) |  | $ | (0.89   | )
|Basic - pro forma                                                                                               |  | $                               | (0.09  | ) |                                | $ | (0.21  | )    |  | $ | (0.27  | ) |  | $ | (1.01   | )
|                                                                                                                |  |                                 |        |  
|Diluted - as reported                                                                                           |  | $                               | (0.06  | ) |                                | $ | (0.15  | )    |  | $ | (0.19  | ) |  | $ | (0.89   | )
|Diluted - pro forma                                                                                             |  | $                               | (0.09  | ) |                                | $ | (0.21  | )    |  | $ | (0.27  | ) |  | $ | (1.01   | )



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##### Table of Contents

During the quarter ended September 30, 2004, the Company granted options to purchase an aggregate of 345,000 shares of
the Companys common stock at a weighted average exercise price of $1.19 per share. These options, which vest quarterly over three years, were granted to employees and directors under the Digital Lightwave, Inc. 2001 Stock Option Plan.



New Accounting Pronouncements



In January 2003, FASB Interpretation 46, Consolidation of Variable Interest Entities an
Interpretation of ARB No. 51(FIN 46) was issued.This Interpretation clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements(ARB 51), to certain entities in
which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties.
Application of the majority voting interest requirement in ARB 51 to certain types of entities may not identify the party with a controlling financial interest because the controlling financial interest may be achieved through arrangements that do
not involve voting interests. All enterprises with variable interests in variable interest entities (VIEs) created after January 31, 2003, shall apply the provisions of this Interpretation to those entities immediately. A public
entity with a VIE created before February 1, 2003, shall apply the provisions of this Interpretation (other than the transition disclosure provisions in paragraph 26) to that entity no later than the beginning of the first interim or annual
reporting period beginning after June 15, 2003.



In December 2003, a revision
to FIN 46 (FIN 46R) was published to clarify some of the provisions of FIN 46 and exempt certain entities from its requirements. Under FIN 46R, a legal entity is considered a VIE, with some exceptions if specific criteria are met, if it
does not have sufficient equity at risk to finance its own activities without relying on financial support from other parties. Additional criteria must be applied to determine if this condition is met or if the equity holders, as a group, lack any
one of three stipulated characteristics of a controlling financial interest. If the legal entity is a VIE, then the reporting entity determined to be the primary beneficiary of the VIE must consolidate it. Even if the reporting entity is not
obligated to consolidate the VIE, then certain disclosures must be made about the VIE if the reporting entity has a significant variable interest. The effective date of the interpretation was modified under FIN 46R. A reporting entity is required to
apply the provisions of FIN 46R to all VIEs that previously were subject to certain previously issued special purpose entity, or SPE, accounting pronouncements for all reporting periods ending after December 14, 2003. For all other VIEs, a reporting
entity is required to adopt the provisions of FIN 46R for all reporting periods after May 15, 2004. The Company does not believe it has ownership in any variable interest entities as of September 30, 2004. The Company will apply the consolidation or
disclosure requirements of this interpretation in future periods if it should own any interest deemed to be a VIE.



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In November 2002, the Emerging Issues Task Force (the EITF) reached a consensus opinion on EITF 00-21,
Revenue Arrangements with Multiple Deliverables. The consensus provides that revenue arrangements with multiple deliverables should be divided into separate units of accounting if certain criteria are met. The consideration for the
arrangement should be allocated to the separate units of accounting based on their relative fair values, with different provisions if the fair value of all deliverables are not known or if the fair value is contingent on delivery of specified items
or performance conditions. Applicable revenue recognition criteria should be considered separately for each separate unit of accounting. EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003.
Entities may elect to report the change as a cumulative effect adjustment in accordance with APB Opinion 20, Accounting Changes. Implementation of EITF 00-21 did not have a material impact on the Companys financial statements.



Reclassifications



Certain amounts relating primarily to accrued liabilities and warranty reserve and
disclosures regarding proceeds from the sale and maturity of short-term investments in the March 31, 2003 financial statements have been reclassified to conform to the September 30, 2004 financial statement presentation.



2. BRANCH OFFICE CLOSINGS



During the quarter ended March 31, 2003, the Company closed sales offices located in Brazil,
Singapore, India and Australia as part of restructuring efforts. There were no branch office closings in the first nine months of 2004. (See Note 5  Restructuring Charges)



3. INVENTORIES



Inventories are summarized as follows:



|                |  |                   |       |                  |   |      
|--------------- |  | ----------------- | ----- | ---------------- | - | -----
|(In thousands)  |  | September 30,2004 |       | December 31,2003
|Raw materials   |  | $                 | 4,209 |                  | $ | 4,925
|Work-in-process |  |                   | 164   |                  |   | 72   
|Finished goods  |  |                   | 984   |                  |   | 3,271
|                |  |                   |       |                  |   |      
|                |  | $                 | 5,357 |                  | $ | 8,268
|                |  |                   |       |                  |   |      



In December 2001, the Company signed a
manufacturing service agreement with Jabil Circuit, Inc. (Jabil), a leading provider of technology manufacturing services with a customer base of industry-leading companies. Under the terms of the agreement, Jabil purchased the
Companys existing inventory to fulfill orders until the Companys inventory was depleted to safety stock levels. Under the terms of the agreement, Jabil served as the Companys primary contract manufacturer for the Companys
circuit board and product assembly and provided engineering design services.



On May 11, 2004, the Company and Jabil entered into a settlement agreement to resolve and settle certain disputes between the Company and Jabil, and Jabil agreed to continue to provide manufacturing services to the Company. As previously
reported, on February 27, 2003, Jabil terminated the manufacturing services agreement and on March 19, 2003, commenced an arbitration proceeding against the Company seeking damages in excess of $6.8 million. On December 5, 2003, the Company entered
into a manufacturing services letter agreement with Jabil specifying the terms under which Jabil would provide the Company with certain manufacturing services. The manufacturing services letter agreement expired on December 30, 2003, and the term of
such letter agreement was extended through December 31, 2004. (See Note 4  Legal Proceedings)



In 2003, the Company recorded approximately $4.0 million in provisions for excess and obsolete inventory (primarily in the second and fourth quarters) relating principally to its OTS and OWM inventory. When evaluating
the adequacy of the reserve for excess and obsolete inventory, the Company analyzes current and expected sales trends, the amount of parts on-hand, the market value of parts on-hand and the viability and technical obsolescence of products and
components. No additional reserves were taken in the first nine months of 2004.



4. LEGAL PROCEEDINGS



CIT Technologies Corporation



As described below, litigation between CIT Technologies Corporation
(CIT) and the Company has been dismissed.



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Effective as of June 8, 2004, the Company entered into a settlement agreement (the Mediation Settlement
Agreement) with CIT, which resolved and settled certain disputes between the Company and CIT. At December 31, 2003 and March 31, 2004, the Companys financial statements reflected a liability of $13.6 million as an accrued litigation
charge relating to this dispute. Under the Mediation Settlement Agreement, and in full satisfaction of all claims by CIT against the Company, CIT received $5.2 million in cash, 2,500,000 shares of common stock of the Company and certain equipment
subject to the original lease agreements between the Company and CIT. Further, CIT dismissed the lawsuit it filed in April 2003.



As a result of the Mediation Settlement Agreement, the Company realized a gain of $3.7 million from debt forgiveness. This gain was contingent upon the timing of certain
events which expired during the third quarter of 2004. Accordingly, at June 30, 2004, the Company reported in the balance sheet a deferred gain of $3.7 million. This gain was recognized as other income in the quarter ended September 30, 2004.



As previously reported, in April 2003, CIT, which had been the Companys
largest unsecured creditor, served the Company with a complaint in connection with a lawsuit commenced in the Circuit Court for Pinellas County, Florida. This complaint was filed in connection with the non-payment of monies due for equipment
provided under various lease agreements between CIT and the Company. The complaint sought, among other things, damages in excess of $15.6 million as well as the return of all leased equipment. The Company disputed certain of the amounts claimed by
CIT and proceeded with the defense of its position in court. The Company filed its Amended Answer, Affirmative Defenses, and Counterclaim wherein the Company asserted, among other things, that CIT violated usury laws in connection with the
agreements subject of the suit. Mediation was held on November 3, 2003, but the mediation was unsuccessful. The state court issued an order directing the clerk of the court to enter a writ of replevin in favor of CIT. The writ of replevin entitled
CIT to secure possession of the equipment subject of the agreements pending the outcome of the lawsuit. The Company returned to CIT approximately 80% of the units under lease. The Mediation Settlement Agreement satisfied any requirement to return
any other equipment to CIT.



Lightwave Drive, LLC



As described below, litigation between Lightwave Drive, LLC (Landlord) for the
headquarters of the Company located at 15550 Lightwave Drive, Clearwater, Florida 33760 (the Leased Property) and the Company has been dismissed.



As of the date of this report, the Company is current on all of its rental payment and real estate tax obligations owed in connection with the Leased Property.



As previously reported, in April 2003, the Landlord, filed a complaint against
the Company in the Sixth Judicial Circuit for Pinellas County, Florida, Case No. 0300241CI-15 (the Lawsuit), seeking eviction and monetary damages for unpaid rent and real estate taxes under the Lease Agreement between the Landlord and
the Company dated as of January 14, 1998, as amended (the Lease). In connection with the foregoing, on July 22, 2003, the Company and the Landlord entered into a Settlement and Lease Modification Agreement (the Lease Modification
Agreement and together with the Lease, the Lease Agreement). Under the terms of the Lease Modification Agreement, the Landlord agreed to forbear from pursuing the relief requested in the Lawsuit and the parties agreed to amend the
Lease pursuant to the Lease Modification Agreement. In connection with the foregoing settlement, the Landlord filed a Notice of Voluntary Dismissal Without Prejudice with respect to the lawsuit. A detailed discussion of the Lease Modification
Agreement is set forth in the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2003 filed April 14, 2004.



Jabil Circuit, Inc.



As described below, litigation between Jabil Circuit, Inc. (Jabil) and the Company has been dismissed.



Effective as of May 11, 2004, the Company entered into a settlement agreement (the Settlement Agreement) with Jabil, which supersedes and controls over prior
agreements, and resolves and settles certain disputes between the Company and Jabil. Under the Settlement Agreement, the Company and Jabil have agreed to dismiss the two lawsuits filed by Jabil in 2003, and Jabil agreed to continue to provide
manufacturing services to the Company. As part of the Settlement Agreement, the Company executed renewal promissory notes in favor of Jabil for unpaid accounts and certain inventory for which the Company had not paid. Further, the Company also
placed additional purchase orders with Jabil and made cash payments to Jabil in conjunction with new purchase orders and as payments on the renewal notes.



As of September 30, 2004, the combined value of notes payable to Jabil are reported in the balance sheet as current and long term portions of those notes payable
approximating $1.2 million and $3.0 million, respectively. As a result of the Settlement Agreement, the Company realized a gain from debt forgiveness of approximately $0.5 million, of which $0.2 million has been



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##### Table of Contents

recognized in the nine months ended September 30, 2004, as other income. The remaining $0.3 million is included as part
of the restructured Jabil Notes (defined below), is reported in the balance sheet as a component of debt, and will be amortized monthly as a reduction to interest expense through December 31, 2005.



In conjunction with the Settlement Agreement, the Company (i) executed a renewal promissory
note in the original principal amount of $3,011,404 to renew an existing promissory note in favor of Jabil for unpaid accounts (the Renewal A/R Note) and (ii) executed a renewal promissory note in the original principal amount of
$2,227,500 to renew a second existing promissory note in favor of Jabil for certain inventory for which the Company had not paid Jabil (the Renewal Inventory Note and, together with the Renewal A/R Note, the Renewal Notes).
Each of the Renewal Notes bears interest at a rate of six percent (6.0%) per annum. Under the Renewal A/R Note, Digital made a payment to Jabil of $100,000 on May 13, 2004, and is required to make a payment of $150,000 on each of July 1, 2004,
October 1, 2004, January 1, 2005, April 1, 2005, July 1, 2005 and October 1, 2005 and a payment of all outstanding principal and interest on December 31, 2005. Under the Renewal Inventory Note, Digital is required to make a payment of $400,000 on
July 1, 2004, a $400,000 payment on October 1, 2004 and a payment of all outstanding principal and interest on December 31, 2005. If Digital or a third party pays for any amount due by Digital to Jabil for component inventory, work-in-process
inventory, or finished goods inventory that exists and is in Jabils possession as of May 11, 2004 (the Existing Inventory), the amounts paid to Jabil will be credited to reduce the amount owed by Digital under the Renewal Inventory
Note. Each of the Renewal Notes may be prepaid at any time and each of the Renewal Notes provides for the acceleration of all amounts due upon the occurrence of certain events of default described in the Renewal Notes.



On October 1, 2004, the Company made a payment to Jabil of $550,000 to meet the requirement
for installments due under the Renewal A/R Note and Renewal Inventory Note of $150,000 and $400,000, respectively.



Pursuant to the Settlement Agreement, the Company also placed a $1,121,000 purchase order with Jabil (the Initial Purchase Order) and made a cash payment on
May 13, 2004 to Jabil in the amount of $1,391,000 for the following: (a) $170,000 for amounts due for recent purchase orders; (b) $100,000 as payment on the Renewal A/R Note; (c) $617,000 as a payment on the Renewal Inventory Note, provided that
Digital will be given credit on the amount due on the Initial Purchase Order up to $617,000 to the extent that Existing Inventory is used to complete the Initial Purchase Order; and (d) $504,000 as a deposit on the Initial Purchase Order; provided,
that if $617,000 of Existing Inventory is not used by Jabil to complete the Initial Purchase Order, Digital is required to pay an additional amount to Jabil on the Initial Purchase Order equal to $617,000 less the value of the Existing Inventory
used by Jabil to complete the Initial Purchase Order. As of September 30, 2004, the Company had obtained approximately $756,000 of existing inventory from Jabil.



Under the terms of the Settlement Agreement, Jabil agreed to reevaluate the Companys financial condition as of January 2005 and to
offer the Company credit terms similar to those offered by Jabil to other customers with a similar financial condition and business relationship with Jabil. The Settlement Agreement also provides that the Company is required to prepay any
non-cancelable portion of new inventory purchased by Jabil based on purchase orders issued by the Company for all purchase orders dated prior to January 1, 2005.



On August 23, 2004, Optel and Jabil entered into an agreement whereby Optel agreed to financially guarantee purchase commitments made by the
Company to Jabil up to an amount not to exceed $1.88 million. As a result of Optel providing the guarantee, the Company is required to pay for new orders upon delivery of material by Jabil. The Company is required to prepay any non-cancelable
portion of new inventory purchased by Jabil based on purchase orders issued by the Company for cumulative purchase orders exceeding $1.88 million dated prior to January 1, 2005.



As previously reported, in February 2003, Jabil terminated the manufacturing services agreement with the Company, and in March 2003, Jabil
commenced an arbitration proceeding against the Company with the American Arbitration Association. The arbitration was commenced in connection with the non-payment by the Company of amounts due under the manufacturing services agreement. On May 21,
2003 (but effective as of May 1, 2003), the Company and Jabil entered into a forbearance agreement (the Forbearance Agreement) relating to Jabils claims against the Company in connection with the manufacturing services agreement.
In addition, the company executed and delivered to Jabil two promissory notes in the aggregated original principal amount of approximately $5.6 million for certain unpaid accounts receivable and inventory for which the Company had not yet paid Jabil
(the Jabil Notes). A detailed discussion of the Forbearance Agreement is set forth in the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2003. Because the Company did not timely perform its obligations
and defaulted under the Forbearance Agreement and the Jabil Notes, on October 7, 2003, Jabil filed two complaints in the Circuit Court of the Thirteenth Judicial Circuit in and for Hillsborough County, Florida, Civil Division, Case No. 03 9331 DIV 1
and Case No. 03 9332 DIV B with respect to the Jabil Notes seeking payment in full of the Jabil Notes.



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As detailed above, on February 27, 2003, Jabil terminated the manufacturing services agreement and on March 19, 2003,
commenced an arbitration proceeding against the Company seeking damages in excess of $6.8 million. On December 5, 2003, the Company entered into a manufacturing services letter agreement with Jabil specifying the terms under which Jabil would
provide the Company with certain manufacturing services. The manufacturing services letter agreement expired on December 30, 2003, and the term of such letter agreement was extended through December 31, 2004.



Plaut Sigma Solutions, Inc.



As described below, the dispute between Plaut Sigma Solutions, Inc. and the Company has been
resolved.



Effective as of May 26, 2004, the Company entered into a settlement
agreement (the Settlement and Renewal Agreement) with Plaut Sigma Solutions, Inc. (Plaut), which resolves and settles certain disputes between the Company and Plaut. Under the Settlement and Renewal Agreement, the Company
made a lump sum payment of $210,000 to Plaut in full and final satisfaction of all amounts owed by the Company to Plaut, which were previously included in accounts payable, and Plaut agreed to provide SAP Maintenance Services to the Company through
December 31, 2004.



As previously reported, the Company had no litigation with
Plaut; however, the Company received in October 2003 notification of default on payments due. On July 15, 2003, the Company entered into letter agreements with Plaut with respect to outstanding payments due to Plaut under that certain document
entitled Plaut Sigma Solutions, Inc. Presents a MYSAP.com Business Solution for Digital Lightwave, Inc. dated May 30, 2002 in the amount of $360,630 (the Consulting Letter Agreement) and that certain Software End-User License
Agreement dated May 30, 2002 in the amount of $83,120 (the Maintenance Letter Agreement, and together with the Consulting Letter Agreement, the Letter Agreements). Under the Consulting Letter Agreement, the Company agreed to
pay Plaut the full amount of the debt as follows: (i) upon execution of the Consulting Letter Agreement, a payment of $36,063 and (ii) on the first day of each calendar month beginning on October 1, 2003 through November 1, 2004, a payment equal to
$23,183. Under the Maintenance Letter Agreement, the Company agreed to pay Plaut the full amount of the debt as follows: (i) upon execution of the Maintenance Letter Agreement, a payment of $8,312 and (ii) on the first day of each calendar month
beginning on August 1, 2003 through December 1, 2003, a payment equal to $14,962. The Company was unable to make the October and November payments and defaulted under the Letter Agreements. On October 9, 2003, the Company received notification of
default under the Letter Agreements from Plaut. No further action was taken by Plaut with respect to the notification of default.



Employee Matters



As described below, the disputes between certain former employees and the Company have been resolved.



During the quarter ended June 30, 2004, the Company entered into settlement agreements with two former officers, George Matz and Dr. Glenn Dunlap. The settlements related
to obligations outstanding and accrued for at March 31, 2004 for previously negotiated severance agreements approximating $155,000 and $32,000 for Mr. Matz and Dr. Dunlap, respectively.



Effective as of April 30, 2004, the Company entered into a settlement agreement with Mr. Matz. Under the terms of the settlement agreement,
the Company agreed to engage Mr. Matz as a consultant through March 31, 2006 for a consulting fee of $50,000, of which $15,000 was paid on May 6, 2004, and the remainder of which is payable in (i) eleven monthly payments of $1,000 beginning May 31,
2004 and on the last day of each month thereafter through March 31, 2005, and (ii) twelve monthly payments of $2,000 beginning April 30, 2005 and on the last day of each month thereafter through March 31, 2006. In the event that the Company fails to
make any monthly payment to Mr. Matz and the Company fails to cure such default within ten days from receipt of written notice of such default, then the total remaining unpaid amount of the consulting fee may be declared immediately due and payable
at Mr. Matzs option, and such unpaid amount shall bear interest from the date of occurrence of such default until such default is cured at a rate of 10% per annum. In addition, the Company granted Mr. Matz options to purchase 60,000 shares of
the Companys common stock at an exercise price of $0.92 per share, which was the closing price of the Companys common stock on April 30, 2004. These options were granted under the Companys 2001 Stock Option Plan and vest quarterly
over three years. The Company also agreed to provide Mr. Matz medical insurance coverage through April 30, 2006 at the Companys expense. Further, the Company agreed Mr. Matz can apply for standard COBRA benefits for coverage after April 30,
2006 at Mr. Matzs expense. In addition, the settlement agreement contained mutual releases.



Effective as of May 6, 2004, the Company entered into a settlement agreement with Dr. Dunlap whereby all claims, demands, liabilities and causes of action between Dr. Dunlap and the Company were settled for a lump sum
payment of $25,000, which was paid upon execution of the settlement agreement. This settlement agreement terminated all previous agreements between



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Dr. Dunlap and the Company, but Dr. Dunlap retained the right to exercise an option to purchase 66,666 shares of the
Companys common stock at an exercise price of $1.42 per share through August 16, 2004. In addition, the settlement agreement contained mutual releases.



Other



The Company from time to time may be involved in various other lawsuits and actions by third parties arising in the ordinary course of business. The Company is not aware of any additional pending litigation, claims or
assessments that could have a material adverse effect on the Companys business, financial condition and results of operations.



5. RESTRUCTURING CHARGES



In January 2002, the Companys board of directors approved cost reduction initiatives aimed at reducing operating costs. These included a reduction in force of 46
employees and contractors and the outsourcing of manufacturing and production for our product lines. All affected employees were terminated in January 2002 and given severance based upon years of service with the Company. The Company recorded a
restructuring charge of approximately $1.3 million in the first quarter of 2002 and reported it as an accrued liability. As of December 31, 2003, approximately $55,000 of this charge was payable to a former officer under the terms of a severance
agreement. On January 1, 2004, an additional $100,000 of this charge became payable to the former officer. As a result of the Companys working capital deficit, this $155,000 remained unpaid. Effective as of April 30, 2004, the Company entered
into a settlement agreement related to this outstanding liability. All other liabilities associated with this charge have been satisfied at amounts approximating the original charge. (See Note 4  Legal Proceedings, Employee Matters)



In January 2003, the board of directors approved two reductions in workforce
totaling an additional 85 positions, or approximately 45% of the Companys employment base. This included closing the Companys sales offices in Brazil, Singapore, India and Australia. The Company recorded a restructuring charge of
approximately $1.3 million related to the employment reduction. The total costs associated with the restructuring were expected to be paid by July 2003. Approximately $300,000 of previously recorded restructuring charges related to certain executive
severance agreements were reversed in the first quarter of 2003 as the timeframe for the reimbursement of these costs expired. In March 2003, the board of directors approved another reduction in workforce of 12 positions and no restructuring charge
was taken. In each of April 2003 and June 2003, the board of directors approved further reductions in workforce of five positions. As a result of these reductions, the Company recorded a restructuring charge of $80,000 for the second quarter of
2003. In September 2003, five positions were eliminated and in October 2003, an additional seven positions were eliminated.



At December 31, 2003, approximately $32,000 of the January 2003 charge was due and payable to a former officer under the terms of the severance agreement and was
reflected in accounts payable. Effective as of May 6, 2004, the Company entered into a settlement agreement related to this outstanding liability. (See Note 4  Legal Proceedings, Employee Matters) In the first quarter of 2004, the
workforce was further reduced and an additional $40,000 was charged to restructuring. As of March 31, 2004, $4,000 of this restructuring charge remained unpaid. The remaining $4,000 restructuring charges were paid during the quarter ended June 30,
2004. With the exception of approximately $20,000, which is expected to be paid in 2004, the remaining liabilities associated with the 2003 restructuring charges have been satisfied. The following table sets forth a summary of activity associated
with the restructuring charges for the nine-month period ended September 30, 2004:



|                         |  |                            |    |           |   |                      |  |   |                             |   |  |   |   
|------------------------ |  | -------------------------- | -- | --------- | - | -------------------- |  | - | --------------------------- | - |  | - | --
|(In thousands)           |  | Balance atDecember 31,2003 |    | Additions |   | Payments &Reductions |  |   | Balance atSeptember 30,2004
|Severance                |  | $                          | 15 |           | $ | 40                   |  | $ | (40                         | ) |  | $ | 15
|Legal and other expenses |  |                            | 5  |           |   |                     |  |   |                            |   |  |   | 5 
|                         |  |                            |    |           |   |                      |  |   |                             |   |  |   |   
|                         |  | $                          | 20 |           | $ | 40                   |  | $ | (40                         | ) |  | $ | 20
|                         |  |                            |    |           |   |                      |  |   |                             |   |  |   |   



6. COMMITMENTS



At September 30, 2004, the Company had non-cancelable purchase order commitments to purchase
certain inventory items totaling approximately $2.3 million, with approximately $1.7 million of those purchase order commitments placed with Jabil Circuits, Inc. in conjunction with contract manufacturing services.



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7. REVOLVING CREDIT FACILITY



In April 2002, the Company entered into a Revolving Credit and Security Agreement (the Agreement) with Wachovia Bank (the
Bank). The terms of the Agreement provide the Company with a $27.5 million line of credit at LIBOR plus 0.7% collateralized by the Companys cash and cash equivalents and short-term investments. The advance rate varies between 80%
and 95% and is dependent upon the composition and maturity of the available collateral. An availability fee of 0.10% per annum is payable quarterly based on the Average Available Principal Balance (as defined in the Agreement) for such three months.
The Agreement has an initial term of three years. The Agreement may be terminated by the Company at any time upon at least fifteen days prior written notice to the Bank, and the Bank may terminate the Agreement at any time, without notice upon or
after the occurrence of an event of default.



At September 30, 2004, there was
approximately $1.4 million of letters of credit outstanding under this facility collateralized by approximately $1.4 million of the Companys cash and cash equivalents, which were classified as restricted at September 30, 2004. The Company
currently has no additional borrowing capacity under this facility.



8.
RELATED PARTY TRANSACTIONS



In February 2001, James Green, the current
chief executive officer of the Company, borrowed $200,000 from the Company. This loan had a stated interest rate at the prime rate plus one percent (1.0%) with the principal sum and accrued interest thereon payable on demand or, if earlier, from the
proceeds of any sale of Mr. Greens stock holdings or on the date of termination of Mr. Greens employment with the Company. This loan was collateralized by Mr. Greens stock holdings in the Company and future cash bonuses which may
become payable.



In April 2002, Mr. Green borrowed an additional $175,000 from
the Company. On April 12, 2002, this borrowing was combined with the previous note of $200,000 plus accrued interest of approximately $16,000 into one note with a principal balance of approximately $391,000, which is classified in notes receivable.
This loan bears interest at 8.0% per annum with the principal and accrued interest thereon payable on demand or, if earlier, from the proceeds of any sale of Mr. Greens stock holdings or on the date of termination of Mr. Greens
employment with the Company. This loan is collateralized by Mr. Greens stock holdings in the Company, future cash bonuses which may become payable and a second lien on Mr. Greens residence.



Effective August 1, 2003, $50,000 a year of Mr. Greens annual salary is being used to
repay the April 12, 2002 note discussed above. This repayment is deducted proportionally each pay period. The repayments are first being applied to accrued interest. As of September 30, 2004, the outstanding balance, reflecting a voluntary
prepayment of $25,000 made during the fourth quarter of 2002 and regular monthly payments beginning August 2003, was approximately $366,000 exclusive of accrued interest of approximately $15,400.



On January 23, 2003, Robert Hussey, a director of the Company, was appointed Strategic
Restructuring Advisor, effective as of December 1, 2002. In connection with such appointment, Mr. Hussey was granted options to purchase 100,000 shares of the Companys common stock, vesting quarterly over a three-year period, at an exercise
price of $1.28 per share, which was the market price of the Companys common stock on the date of the grant. In addition, Mr. Hussey received service fees of $182,500 for the period from December 2002 through December 31, 2003. As of December
2003, Mr. Hussey no longer receives a monthly service fee.



As described above
in Note 1 under the paragraph entitled Operational Matters, since February 2003 and through the date of this report, the Company has borrowed approximately $31.9 million from Optel, entities controlled by the Companys largest
stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan, of which approximately $31.0 in principal and $2.4 million in accrued and unpaid interest remain outstanding.



Also as described above in Note 1 under the paragraph entitled Operational
Matters, on August 23, 2004, Optel entered into a Guarantee Agreement with Jabil relating to purchase orders for production material issued by the Company to Jabil after June 30, 2004.



9. SUBSEQUENT EVENTS



As described above in Note 1 under the paragraph entitled Operational Matters, on October 1, October 14, October 15 and November
10, 2004, the Company borrowed an additional $360,000, $300,000, $1,000,000 and $2,300,000, respectively, from Optel to fund its ongoing working capital needs. Each of the new loans were evidenced by separate secured promissory notes, bear a rate of
interest of 10.0% per annum and are secured by a security interest in substantially all of the Companys assets. The total principal amount of $3.96 million and any accrued, but unpaid interest under each of the secured promissory notes is due
and payable upon demand by Optel at any time after December 31, 2004.



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10. NON-CASH TRANSACTIONS



During the nine months ended September 30, 2004, the Company completed litigation settlements representing $14.2 million of accrued
litigation liabilities reported at December 31, 2003. Related to the CIT settlement, the Company paid $5.2 million in cash and recognized a non-cash other income of $3.7 million and an increase of $4.7 million to additional paid-in capital related
to the issuance of 2,500,000 shares of common stock to CIT. The Company paid $0.4 million in cash related to certain other litigation settlements.



Further, the Jabil settlement, also completed in the nine months ending September 30, 2004, resulted in a $0.3 reduction in accounts payable and accrued expenses and a
net increase of $0.1 million to notes payable. During the nine months ended September 30, 2003, a settlement completed with Jabil resulted in a $1.1 million increase to prepaid assets for future inventory purchases, a reduction of $4.5 million in
accounts payable, and a $5.6 million increase in notes payable.



During the
nine months ending September 30, 2003, the Company incurred deferred compensation expenses associated with stock option grants of approximately $112,000.



Item 2.Managements Discussion and Analysis of Financial Condition and Results of Operations



FORWARD LOOKING STATEMENTS



The following discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange
Act of 1934. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as may, will, should, expect, plan, anticipate, believe, estimate, predict,
potential or continue, the negative of terms like these or other comparable terminology. Additionally, statements concerning future matters such as the development of new products, enhancements or technologies, possible changes in legislation and
other statements regarding matters that are not historical are forward-looking statements. These statements are only predictions. These statements involve known and unknown risks and uncertainties and other factors that may cause actual events or
results to differ materially from the results and outcomes discussed in the forward-looking statements. All forward-looking statements included in this document are based on information available to us on the date of filing, and we assume no
obligation to update any such forward-looking statements. In evaluating these statements, you should specifically consider various factors, including the risks outlined under the caption Factors That May Affect Future Results set forth at the end of
Item 1 of Part I of our annual report on Form 10-K and those contained from time to time in our other filings with the SEC. We caution you that our business and financial performance are subject to substantial risks and uncertainties.



This information should be read in conjunction with (i) the
consolidated condensed financial statements and notes thereto included in Item 1 of Part I of this quarterly report on Form 10-Q, (ii) the consolidated financial statements and notes thereto, as well as the accompanying Managements Discussion
and Analysis of Results of Operations, for the years ended December 31, 2003 and 2002 included in our Annual Reports on Form 10-K.



OVERVIEW



Executive Summary



The
telecommunications industry is continuing to recover from the industry-wide downturn that began in 2001. For the nine months of 2004, the Companys net sales increased 116% as compared to same period in 2003. On a year-to-date basis, new order
bookings in 2004 more than doubled when compared with the first three quarters of the prior year. Further, new order bookings for the quarter ended September 30, 2004 exceeded revenue, representing the seventh consecutive quarter where bookings
exceeded revenue. We believe these results reflect the general improvement in capital spending by the telecommunications carriers and equipment manufacturers.



During the quarter ended September 30, 2004, net sales of approximately $2.5 million were lower than the comparable period in 2003 by approximately $0.1 million.
Although new order bookings in the quarter were more than two-and-a-half times net sales, the Company experienced material shortages and weather-related production disruptions that negatively impacted net sales performance. The material shortages
resulted from a combination of financing issues for purchased material and supply deficiencies of key components from certain vendors. On August 23, 2004, Optel agreed to guarantee purchase obligations of



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the Company to Jabil. Prior to the Optel guarantee, the Company was required to prepay Jabil for all orders of production
material. Material shortages in the quarter resulted when the guarantee agreement was not completed in a timely manner to meet vendor purchase lead times and accommodate Company production cycle times to support sales for the quarter. Production
disruptions were also experienced at the Company due to severe weather conditions in Florida during August and September of 2004.



During 2003, the Company reduced its workforce by 119 employees and focused on controlling expenses by reducing operating expenses in all areas. The results of these
efforts are seen in the year-to-date 2004 results as compared to the same period of 2003; general and administrative expenses decreased by 57% and engineering and development expenses were lower by 20%.



Despite the increase in net sales and the reduction in operating expenses, net operating
losses that started in the third quarter of 2001 have continued until the present and the Company has insufficient short-term resources for the payment of its current liabilities. During the first nine months of 2004, the Company has addressed this
shortfall by obtaining financing from Optel, LLC and Optel Capital, LLC (collectively Optel), entities controlled by the Companys largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan. As of the date
of this report, the Company has used substantially all of the financing provided by Optel (i) to fund the satisfaction of substantially all of its outstanding debt and liabilities owed to creditors other than Optel, (ii) to fund the settlement of
all outstanding legal disputes, and (iii) to fund the Companys short term working capital needs.



Accordingly, the Company can give no assurance as to whether its revenues will return to previous levels, when it will generate positive cash flows from operations, when it will return to profitability or whether it
will be able to continue as a going concern.



Overview



Digital Lightwave, Inc. (the Company) designs, develops and markets a portfolio
of portable and network-based products for installing, maintaining and monitoring fiber optic circuits and networks. Network operators and telecommunications service providers use fiber optics to provide increased network bandwidth to transmit voice
and other non-voice traffic such as internet, data and multimedia video transmissions. The Company provides telecommunications service providers and equipment manufacturers with product capabilities to cost-effectively deploy and manage fiber optic
networks. The Companys product lines include: Network Information Computers (NIC), Network Access Agents (NAA), Optical Test Systems (OTS), and Optical Wavelength Managers (OWM). The
Companys products are sold worldwide to leading and emerging telecommunications service providers, telecommunications equipment manufacturers, equipment leasing companies and international distributors.



The Companys net sales are generated from sales of its products less an estimate for
customer returns. We expect that the average selling price (ASP) of our products will fluctuate based on a variety of factors, including market demand, product configuration, potential volume discounts to customers, the timing of new
product introductions and enhancements and the introduction of competitive products. Because the cost of goods sold tends to remain relatively stable for any given product, fluctuations in the ASP may have a material adverse effect on our business,
financial condition and results of operations.



For the nine months ended
September 30, 2004, two customers accounted for approximately 20.7% and 10.7% of total sales, respectively. No other customers accounted for more than 10% of sales.



The Company recognizes revenue from the sale of products when persuasive evidence of an arrangement exists, the product has been delivered,
the price is fixed and determinable and collection of the resulting receivable is reasonably assured. When selling through a distributor to an end-user customer, we either obtain an end-user purchase order documenting the order placed with the
distributor or proof of delivery to the end-user as evidence that a sales arrangement exists. No revenue is recognized on products shipped on a trial basis. We believe that our accrued warranty reserve is sufficient to meet our responsibilities for
potential future warranty work on products sold.



The Company has not entered
into long-term agreements or blanket purchase orders for the sale of its products. It generally obtains purchase orders for immediate shipment. The Company does not expect to carry substantial backlog from quarter to quarter. Our sales during a
particular quarter are highly dependent upon orders placed by customers during that quarter. Most of our operating expenses are fixed and cannot be easily reduced in response to decreased revenues. Variations in the timing of revenues could cause
significant variations in results of operations from quarter to quarter and result in continuing quarterly losses. The deferral of any large order from one quarter to another would negatively affect the results of operations for the earlier quarter.
The Company must obtain orders during each quarter for shipment in that quarter to achieve revenue and profit objectives.



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In order to maintain our market share, we are focused on maintaining technological leadership with our product lines. We
have evaluated our sales efforts to identify opportunities where our account presence can be improved and are working to exploit those opportunities. Subject to resolution of our working capital constraints, we are seeking new applications for our
installed product base to be realized with use of new modular add-ons and enhancements. We also established channel partners such as independent sales representatives and distributors to complement our sales force.



We are concentrating on the products and technologies that we believe are most important to
our customers. Subject to resolution of our working capital constraints, we plan to introduce enhancements to our product lines to support the telecommunications network evolution of the next generation protocols and services. These plans include
the introduction of enhancements that support the convergence of the telecommunications and data communications networks and enhance our data communications network analysis capabilities. These enhancements will position us to meet growing global
needs including global high-speed data service requirements.



During the fourth
quarter of 2002, we acquired certain assets related to the OWM product line of LightChip, Inc., a Salem, New Hampshire-based provider of components and subsystems for optical networks. Since that time, we have complemented the OWM product line of
remote wavelength management solutions for dense wavelength division multiplexed (DWDM) systems with our own NAA product line for centralized network testing and monitoring.



On November 5, 2002 we acquired certain assets related to the OTS product line of Tektronix, Inc. Since the acquisition, we have integrated
this technology into our NIC product line.



We believe that these new products
and product enhancements, strategic partnerships, and third-party distribution agreements will further complement our product portfolio and enable us to offer a broader range of products to our global customers.



Critical Accounting Policies



We believe that estimating valuation allowances and accrued liabilities are critical in that
they are important to the portrayal of our financial conditions and results and they require difficult, subject and complex judgments that are often the result of estimates that are inherently uncertain. Specifically, we believe the following
estimates to be critical:



| |  | sales returns and other allowances;
| | - | -----------------------------------



| |  | reserve for uncollectible accounts;
| | - | -----------------------------------



| |  | reserve for excess and obsolete inventory;
| | - | ------------------------------------------



| |  | impairment of long-lived assets;
| | - | --------------------------------



| |  | warranty accrual; and
| | - | ---------------------



| |  | assessment of the probability of the outcome of any litigation.
| | - | ---------------------------------------------------------------



We make significant judgments, estimates and assumptions in connection with establishing the above-mentioned valuation allowances. If we made different judgments or used
different estimates or assumptions for establishing such amounts, it is likely that the amount and timing of our revenue or operating expenses for any period would be materially different.



We estimate the amount of potential future product returns related to current period product
revenue. We consider many factors when making our estimates, including analyzing historical returns, current economic trends, changes in customer demand and acceptance of our products to evaluate the adequacy of the sales returns and other
allowances. Our estimate for the provision for sales returns and other allowances as of September 30, 2004 was $0.3 million.



We also estimate the collectability of our accounts receivables. We consider many factors when making our estimates, including analyzing accounts receivable and
historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the reserve for uncollectible accounts. Our accounts receivable balance as
of September 30, 2004 was $3.1 million, net of our estimated reserve for uncollectible accounts of approximately $1.8 million.



We estimate the amount of excess and obsolete inventory. When evaluating the reserve for excess and obsolete inventory, we consider many factors, including analyzing
current and expected sales trends, the amount of current parts on hand, the current market value of parts on hand and the viability and technical obsolescence of our products. The assumptions made relative to expected sales trends are subjective in
nature and have a material impact on the estimate of the reserve requirement. Should



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future sales trends, in total or by product line, fluctuate from that used in our estimates, this reserve could be
overstated or understated. Our inventory balance was $5.4 million as of September 30, 2004, net of our estimated reserve for excess and obsolete inventory of $16.4 million.



We estimate the impairment of long-lived assets. We monitor events and changes in circumstances that could indicate carrying amounts of
long-lived assets may not be recoverable. These events and circumstances include decrease in market price of a long-lived asset, change in the manner in which a long-lived asset is used, changes in legal factors and a current-period operating loss
or cash flow loss combined with a history of operating losses or cash flow losses or a forecast that demonstrates continuing losses associated with the use of long-lived assets. When such an event or changes in circumstance occur, we assess the
recoverability of long-lived assets by determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows. We recognize impairments when there is an excess of the assets carrying value over the
fair value as estimated using a discounted expected future cash flows model. In estimating undiscounted expected future cash flows, we must make judgments and estimates related to future sales and profitability. Should future sales trends or
profitability be significantly less than that forecasted, our impairment could be understated. We could be required to take an additional impairment charge in the future should our actual cash flows be less than forecasted. For the three months
ended March 31, 2003 we recognized an impairment of long-lived assets totaling $3.3 million. As of September 30, 2004 a review of the carrying value of our long-lived assets and the probability of recovering such value indicated that no additional
impairment charge was required.



We estimate the amount of our warranty
reserve. We consider many factors when making our estimate, including historical trends, the number of products under warranty, the costs of replacement parts and the expected reliability of our products. We believe that our accrued warranty reserve
is sufficient to meet our responsibilities for potential future warranty work on products sold. Our accrued warranty reserve as of September 30, 2004 was approximately $0.5 million.



We estimate the amount of liability the Company may incur as a result of pending litigation. As of September 30, 2004, substantially all
previously reported litigation and disputes have been settled and resolved. Accordingly, there is no accrual for pending litigation at September 30, 2004. See Part II Item 1 Legal Proceedings for information about certain legal
proceedings.



RESULTS OF OPERATIONS



The following is a discussion of significant changes in the results of operations of the
Company which occurred in the quarter and nine months ended September 30, 2004 compared to the quarter and nine months ended September 30, 2003. The following sets forth certain financial data as a percent of net sales:



|                                  |  |                                                          |    |  |                                                              |    |  |      |    |  |      |   
|--------------------------------- |  | -------------------------------------------------------- | -- |  | ------------------------------------------------------------ | -- |  | ---- | -- |  | ---- | --
|                                  |  | Percent of Net Sales for the Quarter Ended September 30, |    |  | Percent of Net Sales for the Nine Months Ended September 30, |   
|                                  |  | 2004                                                     |    |  | 2003                                                         |    |  | 2004 |    |  | 2003 |   
|Net sales                         |  | 100                                                      | %  |  | 100                                                          | %  |  | 100  | %  |  | 100  | % 
|Cost of goods sold                |  | 37                                                       |    |  | 63                                                           |    |  | 45   |    |  | 129  |   
|                                  |  |                                                          |    |  |                                                              |    |  |      |    |  |      |   
|Gross profit (loss)               |  | 63                                                       |    |  | 37                                                           |    |  | 55   |    |  | (29  | ) 
|                                  |  |                                                          |    | 
|Operating expenses:               |  |                                                          |    |  |                                                              |    |  |      |    |  |      |   
|Engineering and development       |  | 79                                                       |    |  | 60                                                           |    |  | 41   |    |  | 110  |   
|Sales and marketing               |  | 144                                                      |    |  | 93                                                           |    |  | 60   |    |  | 128  |   
|General and administrative        |  | 39                                                       |    |  | 57                                                           |    |  | 22   |    |  | 111  |   
|Restructuring charges             |  |                                                         |    |  |                                                             |    |  |     |    |  | 18   |   
|Impairment of long-lived assets   |  |                                                         |    |  |                                                             |    |  |     |    |  | 56   |   
|                                  |  |                                                          |    |  |                                                              |    |  |      |    |  |      |   
|Total operating expenses          |  | 262                                                      |    |  | 210                                                          |    |  | 123  |    |  | 423  |   
|                                  |  |                                                          |    |  |                                                              |    |  |      |    |  |      |   
|Operating (loss)                  |  | (199                                                     | )  |  | (173                                                         | )  |  | (68  | )  |  | (452 | ) 
|                                  |  |                                                          |    | 
|Other income (loss), net          |  | 115                                                      |    |  | (10                                                          | )  |  | 19   |    |  | (25  | ) 
|                                  |  |                                                          |    |  |                                                              |    |  |      |    |  |      |   
|Income (loss) before income taxes |  | (84                                                      | )  |  | (183                                                         | )  |  | (49  | )  |  | (477 | ) 
|Benefit from income taxes         |  |                                                         |    |  |                                                             |    |  |     |    |  |     |   
|                                  |  |                                                          |    |  |                                                              |    |  |      |    |  |      |   
|Net Income (loss)                 |  | (84                                                      | )% |  | (183                                                         | )% |  | (49  | )% |  | (477 | )%
|                                  |  |                                                          |    |  |                                                              |    |  |      |    |  |      |   



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Net Sales



Net sales for the quarter ended September 30, 2004, decreased $0.1 million, or 0.4%, to $2.5 million from $2.6 million for the quarter ended September 30, 2003. Although
new order bookings in the quarter were more than two-and-one-half times net sales, the Company experienced material shortages and weather-related production disruptions that negatively impacted net sales performance. The material shortages resulted
from a combination of financing issues for purchased material and supply deficiencies of key components from certain vendors. On August 23, 2004, Optel agreed to guarantee purchase obligations of the Company with Jabil. Prior to the Optel guarantee,
the Company was required to prepay Jabil for all orders of production material. Material shortages in the quarter resulted when the guarantee agreement was not completed in a timely manner to meet vendor purchase lead times and Company production
times to support sales for the quarter. Production disruptions were also experienced at the Company due to severe weather conditions in Florida during August and September of 2004.



International sales for the quarter ended September 30, 2004, were approximately $1.2 million or 48% of net sales as compared to
approximately $1.0 million, or 38% of net sales for the quarter ended September 30, 2003.



Net sales for the nine months ended September 30, 2004, increased $6.8 million, or 116%, to $12.7 million from $5.9 million for the nine months ended September 30, 2003. The sales increase related primarily to
increased volume reflecting increased strength in the telecommunications industry, as well as improved average selling prices for new technology features.



International sales for the nine months ended September 30, 2004, were approximately $5.1 million, or 40% of net sales as compared to approximately $1.5 million, or 25%
of net sales for the nine months ended September 30, 2003.



Cost of
Goods Sold



Cost of goods sold for the quarter ended September 30, 2004
totaled approximately $0.9 million or 37% of net sales as compared to $1.6 million or 63% of net sales for the quarter ended September 30, 2003. During the quarter, the Company recognized a benefit of $0.1 million as part of the legal settlement
with Jabil Circuits, Inc., whereby inventory that was written off at December 31, 2003 was shipped in the period, which reduced cost of sales by that amount. Excluding inventory adjustments, the reduction in cost of sales of approximately $0.6
million and as a percent of net sales, from 63% to 43% for the quarters ended September 30, 2003 and 2004, respectively, was due primarily to lower product costs resulting from cost reduction efforts and improved average selling prices for new
technology features.



Cost of goods sold for the nine months ended September
30, 2004 totaled approximately $5.7 million, or 45% of net sales as compared to $7.6 million, or 129% of net sales for the nine months ended September 30, 2003. During the nine months ended September 30, 2004, the Company recognized a benefit of
$0.8 million resulting from the settlement with Jabil Circuits, Inc. as described above, offset by an inventory adjustment of $0.6 million. During the prior year, cost of sales included charges for inventory reserve adjustments totaling $3.4 million
for the nine months ended September 30, 2003. The increase in cost of sales of approximately $1.9 million, excluding charges for inventory adjustments and reserves, reflects the corresponding increase in product shipments. The reduction in cost of
sales as a percent of net sales, excluding charges for inventory adjustments and reserves, from 72% to 47% for the nine months ended September 30, 2003 and 2004, respectively, was due primarily to higher volumes and improved average selling prices
for new technology features.



Gross Profit



Gross profit for the third quarter ended September 30, 2004 increased by approximately $0.6
million to approximately $1.6 million or 63% of net sales, from a gross profit of $1.0 million for the quarter ended September 30, 2003. Gross profit for the third quarter of 2004 was impacted by a benefit of $0.1 million resulting from the
settlement with Jabil Circuits, Inc., whereby inventory that was written off at December 31, 2003 was shipped in the period, which increased gross profit by that amount. Excluding inventory adjustments, the increase in gross profit of approximately
$0.5 million, and increased gross margin from 37% to 57% for the quarters ended September 30, 2003 and 2004, respectively, reflects lower product costs resulting from cost reduction efforts and improved average selling prices for new technology
features.



Gross profit for the nine-month period ended September 30, 2004
increased by approximately $8.7 million to approximately $7.0 million or 55% of sales from a loss of $1.7 million for the nine months ended September 30, 2003. Gross profit in 2004 was impacted by a benefit of approximately $0.8 million resulting
from the settlement with Jabil Circuits, Inc., offset by a corresponding inventory adjustment of $0.6 million. During the nine-month period ended September 30, 2003, gross profit was negatively impacted by a $3.4 million provision for excess and
obsolete inventory. The increase in gross profit of approximately $5.1 million, excluding charges for inventory adjustments and reserves, reflects the corresponding increase in product shipments. The increase in gross margin, excluding charges for
inventory adjustments and reserves, from 28% to 53% for the nine-month periods ended September 30, 2003 and 2004, respectively, was due primarily to higher volumes, lower product costs resulting from cost reduction efforts and improved average
selling prices for new technology features.



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Engineering and Development



Engineering and development expenses principally include salaries for engineering and development personnel, depreciation of production and
development assets, outside consulting fees and other development expenses. Engineering and development expenses for the quarter ended September 30, 2004 increased by approximately $0.4 million to $2.0 million from approximately $1.5 million for the
quarter ended September 30, 2003. The increased spending in the quarter ended September 30, 2004, reflects additional investment in product development through an increase in the engineering staff and the use of contract engineering services.



Engineering and development expenses for the nine months ended September 30,
2004 decreased by approximately $1.3 million to $5.2 million from $6.5 million for the nine months ended September 30, 2003. This decrease was primarily due to reductions in force implemented in 2003 and decreased spending resulting from the
Companys working capital constraints. As net sales increased for the nine months ending September 30, 2004, the Company has implemented controlled spending initiatives to further the development of technologies and corresponding new products.



Sales and Marketing



Sales and marketing expenses principally include salaries, commissions, travel, tradeshows,
and promotional materials, depreciation of demonstration units, bad debt and warranty expenses. Sales and marketing expenses for the quarter ended September 30, 2004 were $3.6 million, an increase of approximately $1.2 million over the quarter ended
September 30, 2003, spending of $2.4 million. The increase over the third quarter of 2003 is primarily attributable to an increase in the bad debt reserve and corresponding non-cash expense of approximately $1.3 million. The bad debt reserve was
increased due to slower than anticipated collections of international sales from the first half of 2004.



Sales and marketing expenses for the nine months ended September 30, 2004, totaled $7.6 million, an increase of approximately $0.1 million from $7.5 million for the nine-month period ending September 30, 2003. The
increase over the comparative period in 2003 is primarily attributable to an increase in the bad debt reserve and corresponding non-cash expense of approximately $1.3 million in 2004. The 2004 increase in bad debt expense offset the benefits of the
Companys cost containment efforts and lower spending related to reductions in force implemented in 2002 and 2003, the closing of branch offices in 2003 and decreased spending on travel and entertainment and marketing programs.



General and Administrative



General and administrative expenses principally include salaries, other compensation,
professional fees, facility rentals and information systems related to general management functions. General and administrative expenses for the quarter ended September 30, 2004 decreased by approximately $0.5 million to $1.0 million from $1.5
million for the quarter ended September 30, 2003. For the nine months ended September 30, 2004, general and administrative expenses decreased $3.7 million to $2.8 million from $6.5 million for the nine-month period ended September 30, 2003.



The decreases in spending are primarily attributable to reductions in force
implemented during 2003, reduced legal and professional fees, reduced business insurance expenses, reduced rent expense as a result of relocating the Massachusetts facility, and reductions in other discretionary spending resulting from the
Companys cost containment efforts. These decreases were offset in part by an increase in costs associated with the occurrence of the 2003 Annual Meeting of Stockholders, which was held in the first quarter of 2004. No such expenses were
incurred in the first quarter of 2003.



Impairment of Long-Lived Assets



For the quarter ended March 31, 2003, the Company recorded a non-cash
asset impairment charge of $3.3 million related to certain intangible assets and property and equipment acquired from Tektronix, Inc. in November 2002. The amount of the impairment was determined using estimates of future cash flows expected to be
generated from sales of the OTS product line. The Company did not record a non-cash asset impairment charge during the nine months ended September 30, 2004, because there were no events which occurred that required a measurement for impairment
during that period.



Other Income and Expense, net



Other income, net for the quarter ended September 30, 2004 was $2.9 million as compared to
other expense, net of $0.3 million



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for the quarter ended September 30, 2003. The increase of approximately $3.2 million is primarily attributable to the
forgiveness of debt associated with the vendor settlement of $3.7 million with CIT Technologies Corporation (CIT), offset by increased interest expense of approximately $0.6 million reflecting increased debt levels.



As a result of the Mediation Settlement Agreement with CIT, the Company realized a gain of
$3.7 million from debt forgiveness during June 2004. This gain was contingent upon the timing of certain events that expired during the third quarter of 2004. Accordingly, at June 30, 2004, the Company reported in the balance sheet a deferred gain
of $3.7 million, which was recognized as other income in the quarter ended September 30, 2004.



Other income, net for the nine months ended September 30, 2004 totaled $2.4 million, an increase of $3.9 million as compared to other expense, net of $1.4 million for the nine months ended September 30, 2003. The
increase in other income, net was the result of the gain realized from the forgiveness of debt with certain vendors approximating $4.5 million, including the CIT settlement during the third quarter of 2004, offset by increased interest expense
reflecting increased debt levels.



Provision for Income Taxes



No provision for income taxes was made for the three and nine-month
periods ending September 30, 2004 and 2003 due to the Companys expected annual net losses. Any tax benefits resulting from the Companys net loss have not been recognized due to a full valuation allowance for deferred tax assets being
recorded as a result of managements belief it is more likely than not that future tax benefits will not be realized as a result of future income.



Net Loss



Net loss for the quarter ended September 30, 2004 was approximately $2.1 million or $0.06 per diluted share compared with net loss of approximately $4.7 million or $0.15 per diluted share for the quarter ended
September 30, 2003, for the reasons discussed above. Net loss for the nine months ended September 30, 2004 approximated $6.2 million or $0.19 on a per diluted share basis compared to a net loss for the nine months ended September 30, 2004 of $28.0
million or $0.89 per diluted share, for the reasons stated above.



LIQUIDITY
AND CAPITAL RESOURCES



As of September 30, 2004, the Companys
unrestricted cash and cash equivalents totaled approximately $585,000, an increase of approximately $273,000 from December 31, 2003. As of September 30, 2004, the Companys working capital deficit was $22.8 million as compared to a working
capital deficit of $25.9 million at December 31, 2003. For the nine months ended September 30, 2004, the Company reported net loss of approximately $6.2 million and cash flows used by operations of approximately $12.4 million. The Company had an
accumulated deficit of approximately $108.6 million at September 30, 2004.



Beginning in the third quarter of 2001 and continuing through September 30, 2004, the Company experienced significant operating losses. During this period, management has addressed the shortfall in working capital caused by sustained
operating losses by reducing operating expenses and capital expenditures and by borrowing funds from Optel.



With respect to cost reductions, management has taken actions to restructure the Companys operations to more closely align operating costs with revenues. Beginning in the second quarter of 2004 and continuing in
the third quarter of 2004, management implemented controlled spending plans to strengthen engineering and marketing and sales, consistent with the increases in net sales and new order bookings experienced during the first nine months of 2004.



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From February 2003 through September 16, 2004 the Company borrowed approximately $26.6 million from Optel pursuant to a
series of secured promissory notes (the Optel Notes), of which approximately $25.65 million in principal and approximately $2.0 million in accrued interest was outstanding as of September 16, 2004. On September 16, 2004, the Company and
Optel executed definitive financing agreements to restructure all of the outstanding Optel Notes. Pursuant to the agreements, Optel extended the maturity of the outstanding principal amount until December 31, 2005 and extended the maturity of the
outstanding accrued interest, plus additional interest that accrues in the future, until September 16, 2005. In connection with the restructuring, on September 17, 2004, Optel advanced to the Company an additional $1.35 million, bringing the total
principal amount of debt owed by the Company to Optel to $27.0 million, plus accrued interest of approximately $2.0 million (collectively, the Restructured Debt). The Restructured Debt continues to bear interest at a rate of 10% per
annum and is secured by a first priority security interest in substantially all of the assets of the Company.



In conjunction with the debt restructuring, the Company issued to Optel a Secured Convertible Promissory Note (the Convertible Note). Pursuant to the Convertible Note, the Company has agreed to make the
Restructured Debt or any portion thereof convertible into common stock of the Company at the option of Optel at any time following approval of the conversion feature by the disinterested stockholders at a conversion price based on the
volume-weighted average trading price of the stock during the five-day period preceding the date of any conversion. Stockholder approval will be determined at the next Annual Stockholders Meeting. All of the foregoing transactions with Optel were
approved by the Companys board of directors on September 15, 2004, upon the recommendation of the special committee of the board. The special committee is composed solely of independent directors.



Since the closing of the Optel restructuring, the Company has required additional loans from
Optel to fund its ongoing working capital needs. On October 1, October 14, October 15 and November 10, 2004, the Company borrowed an additional $360,000, $300,000, $1,000,000 and $2,300,000, respectively, from Optel to fund its ongoing working
capital needs. Each of the new loans were evidenced by separate secured promissory notes, bear a rate of interest of 10.0% per annum and are secured by a security interest in substantially all of the Companys assets. The total principal amount
of $3.96 million and any accrued, but unpaid interest under each of the secured promissory notes is due and payable upon demand by Optel at any time after December 31, 2004.



On August 23, 2004, Optel entered into a guarantee agreement (the Guarantee Agreement), whereby Optel guarantees certain
obligations of the Company owing to Jabil Circuits, Inc. (Jabil) relating to purchase orders for production material issued by the Company to Jabil after June 30, 2004. The maximum amount of the Optel guarantee under the Guarantee
Agreement is capped at $1.88 million. Prior to the completion of the Guarantee Agreement, the Company was required to prepay Jabil for all orders of production material. With the Guarantee Agreement in place, the Company is obligated to pay for
production material purchased from Jabil upon receipt of that material.



The
Company has used substantially all of the financing previously provided by Optel to fund the satisfaction of substantially all of its outstanding debt and liabilities owed to creditors other than Optel, to fund the settlement of all outstanding
legal disputes and to fund its working capital needs. The Company has insufficient short-term resources to fund its working capital and capital expenditure requirements for the near term and does not have sufficient cash resources to to meet cash
requirements and maintain sufficient liquidity over the next 12 months. The Companys ability to satisfy its short term liquidity requirements and its liquidity requirements over the next 12 months is dependent on its ability to obtain
additional financing from funding sources which may include, but will not be limited to Optel. Further, the Company has not identified any funding source other than Optel that would be prepared to provide current or future financing to the Company.
The Company cannot assure that it will be able to obtain adequate financing, that it will achieve profitability or, if it achieves profitability that the profitability will be sustainable or that it will continue as a going concern. As a result, our
independent certified public accountants have included an explanatory paragraph for a going concern in their report for the year ending December 31, 2003, that was included in our Annual Report on Form 10-K filed on April 14, 2004.



Operating Activities



Net cash used by operating activities for the nine months ended September 30, 2004 was approximately $12.4 million. This was primarily the
result of funds disbursed in connection with settlements of certain disputes, litigation and other of $5.8 million, an increase in accounts receivable of $3.2 million, the loss from operations of $6.2 million, offset by a reduction in inventory of
$3.0 million and an increase in accounts payable of $1.4 million. Accrued litigation charges used operating cash of approximately $5.8 million during the nine-month period as a result of settlement payments made in January to Arrow Electronics for
$0.4 million, in February to Zurich American for $0.2 million and in September to CIT Technologies Corporation for $5.2 million. Accounts receivable used operating cash of approximately $3.2 million on net sales of approximately $12.7 million, as
new customer billings outpaced cash collections. Longer collection cycles for accounts



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receivable from international sales resulted in the Company increasing the reserve for potentially uncollectible accounts
by $1.3 million in the quarter ended September 30, 2004. Settlements of accounts payable and accrued litigation, inventories, and accounts payable and accrued expenses provided operating cash for the nine months ended September 30, 2004. Settlements
of accounts payable and accrued litigation provided approximately $0.4 million in operating cash flow resulting from the settlement of various trade accounts payable. Usage of on-hand inventory provided operating cash of approximately $3.0 million.
The cash provided by accounts payable and accrued expenses totaled approximately $1.4 million and resulted primarily from accrued but unpaid interest expenses totaling approximately $1.4 million.



Investing Activities



Net cash provided by investing activities for the nine months ended September 30, 2004 was approximately $0.5 million. This was primarily
the result of the payment of accrued litigation settlements discussed above which released restricted cash.



Financing Activities



Net cash provided
by financing activities for the nine months ended September 30, 2004 was approximately $12.2 million. This was primarily the result of proceeds of $13.4 million from borrowings from Optel and proceeds of approximately $0.1 million from the sale of
common stock under the Companys 2001 Stock Option Plan and the 1997 Employee Stock Purchase Plan, offset by payments of $1.3 million made on notes payable, primarily to Jabil Circuits, Inc. in conjunction with the settlement agreement made
with Jabil in May 2004.



Revolving Credit Facility



In April 2002, the Company entered into a Revolving Credit and Security Agreement (the
Agreement) with Wachovia Bank (the Bank). The terms of the Agreement provide the Company with a $27.5 million line of credit at LIBOR plus 0.7% collateralized by the Companys cash and cash equivalents and short-term
investments. The advance rate varies between 80% and 95% and is dependent upon the composition and maturity of the available collateral. An availability fee of 0.10% per annum is payable quarterly based on the Average Available Principal Balance (as
defined in the Agreement) for such three months. The Agreement has an initial term of three years. The Agreement may be terminated by the Company at any time upon at least fifteen days prior written notice to the Bank, and the Bank may terminate the
Agreement at any time, without notice upon or after the occurrence of an event of default. At September 30, 2004, there were approximately $1.4 million of letters of credit outstanding under this facility secured by approximately $1.4 million of the
Companys cash and cash equivalents which were classified as restricted at September 30, 2004. The Company currently has no additional borrowing capacity under this facility.



Legal Proceedings



The Company from time to time may be involved in various lawsuits and actions by third parties arising in the ordinary course of business. The Company is not aware of any
pending litigation, claims or assessments that could have a material adverse effect on the Companys business, financial condition and results of operations. For a detailed description of the Companys litigation and settlement agreements
with its creditors, see Part II-Item 1, Legal Proceedings.



Item 3.Quantitative and Qualitative Disclosures About Market Risk.



We are not exposed to material fluctuations in currency exchange rates because the majority of our sales and expenses are denominated in U.S. dollars. We are exposed to
the impact of interest rate changes on our restricted cash investments, consisting of U.S. Treasury obligations and other investments in institutions with the highest credit ratings, all of which have maturities of three months or less. These
short-term investments carry a degree of interest rate risk. We believe that the impact of a 10% increase or decline in interest rates would not be material to our investment income.



Item 4.Controls and Procedures.



Our principal executive officer and principal financial officer evaluated the effectiveness of our disclosure controls and procedures pursuant to the Securities Exchanges Act of 1934 (the Exchange Act), as defined in Rules
13a-15(e) and 15d-15(e), as of September 30, 2004. Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of September 30, 2004, our disclosure controls and procedures were effective in ensuring
that (1) information to be disclosed in reports we file under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the rules and forms promulgated under the Exchange Act and (2) information required
to be disclosed in reports filed under the Exchange Act is accumulated and communicated to the principal executive officer and



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principal financial officer as appropriate to allow timely decisions regarding required disclosure. There were no changes
in the Companys internal control over financial reporting that occurred during the Companys last fiscal quarter that have materially affected or are reasonably likely to materially affect, the Companys internal control over
financial reporting.



PART II

OTHER INFORMATION



Item 1.Legal Proceedings.



The Company from time to time may be involved in various other lawsuits and actions by third parties arising in the ordinary course of business. The Company is not aware of any additional pending litigation, claims or assessments that could
have a material adverse effect on the Companys business, financial condition and results of operations.



Item 6.Exhibits and Reports on Form 8-K.



(a) Exhibits



A list of exhibits is set forth in the Exhibit Index found on page 26 of the report.



(b) Reports on Form 8-K.



| | (i) | Current Report on Form 8-K dated as of August 25, 2004, filed on August 26, 2004 pursuant to Item 5, reporting the approval and ratification by the board of directors of Digital
Lightwave, Inc. (the Company) of a term sheet with Optel Capital, LLC (Optel) to provide financing and to restructure the Companys outstanding debt with Optel.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (ii) | Current Report on Form 8-K dated as of September 2, 2004, filed on September 3, 2004 pursuant to Item 8.01, reporting the approval by the board of directors of Digital Lightwave,
Inc. (the Company) to transfer the listing of the Companys securities to the Nasdaq SmallCap Market from the Nasdaq National Market. On September 3, 2004, the Company filed an application with The Nasdaq Stock Market to transfer
the listing of the Companys securities to the Nasdaq SmallCap Market.
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (iii) | Current Report on Form 8-K dated as of September 20, 2004, filed on September 21, 2004 pursuant to Item 3.01, reporting that Digital Lightwave, Inc. (the Company)
received notice from The Nasdaq Stock Market that it had approved the Companys application to transfer the listing of the Companys securities to the Nasdaq SmallCap Market.
| | ----- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (iv) | Current Report on Form 8-K dated as of September 16, filed on September 20, 2004 pursuant to Item 1.01, reporting that Digital Lightwave, Inc. (the Company) and Optel
Capital, LLC (Optel) executed definitive financing agreements to restructure the outstanding debt owed by the Company to Optel and Optel, LLC.
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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SIGNATURES



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



Digital Lightwave, Inc.(Registrant)By:

/s/ JAMES GREENChief Executive Officer and President(Principal Executive Officer)Date: November 12, 2004By:

/s/ JAMES GREENChief Accounting Officer(Principal Financial Officer)Date: November 12, 2004




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EXHIBIT INDEX



|              |  |                                                                                                                                                                                                                                                                      
|------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                                                                                                                                          
|10.1*         |  | Non-Binding Term Sheet between Digital Lightwave, Inc. and Optel Capital, LLC dated August 23, 2004 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on August 26, 2004).                                           
|              | 
|10.2*         |  | Loan and Restructuring Agreement between Digital Lightwave, Inc. and Optel Capital, LLC dated as of September 16, 2004 (incorporated by reference to Exhibit 10.1 to the Current Report on Form
8-K filed by the Company on September 21, 2004).                     
|              | 
|10.3*         |  | Twenty Second Amended and Restated Security Agreement between Digital Lightwave, Inc. and Optel Capital, LLC dated as of September 16, 2004 (incorporated by reference to Exhibit 10.2 to the
Current Report on Form 8-K filed by the Company on September 21, 2004).
|              | 
|10.4*         |  | Secured Convertible Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on September 16, 2004 (incorporated by reference to Exhibit 10.3 to the Current Report on Form 8-K
filed by the Company on September 21, 2004).                          
|              | 
|10.5*         |  | Registration Rights Agreement between Digital Lightwave, Inc. and Optel Capital, LLC dated as of September 16, 2004 (incorporated by reference to Exhibit 10.4 to the Current Report on Form
8-K filed by the Company on September 21, 2004).                        
|              | 
|10.6+         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on November 10, 2004.                                                                                                                                                                
|              | 
|31.1+         |  | Certification by the Chief Executive Officer pursuant to Section 302 of the SarbanesOxley Act of 2002.                                                                                                                                                              
|              | 
|31.2+         |  | Certification by the Principal Financial Officer pursuant to Section 302 of the Sarbanes  Oxley Act of 2002.                                                                                                                                                        
|              | 
|32.1+         |  | Certification by the Chief Executive Officer and Principal Financial Officer pursuant to Section 906 of the SarbanesOxley Act of 2002.                                                                                                                              

---

|+ | Filed herewithin.
|- | -----------------



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