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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 March 31, 2006,

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 incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|15550 Lightwave Drive Clearwater, Florida                      |  | 33760                               
|(Address of principal executive offices)                       |  | (Zip Code)                          

(727) 442-6677

(Registrants telephone number, including area code)

Not Applicable

(Former name, former address, and former fiscal year, if changed since last report)



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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 a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one)

Large Accelerated Filer ̈Accelerated Filer ̈Non-Accelerated Filer  x

Indicate by check mark whether the Registrant is a shell company (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 May 10, 2006, was 35,226,366.



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DIGITAL LIGHTWAVE, INC.

QUARTERLY REPORT ON FORM 10-Q

For the Period Ended March 31, 2006

INDEX



|              |  |                                                                                                                    |  |     
|------------- |  | ------------------------------------------------------------------------------------------------------------------ |  | ----
|              |  |                                                                                                                    |  | Page
|              |  | PART I. FINANCIAL INFORMATION                                                                                      |  |     
|              |  |                                                                                                                   
|Item 1.       |  | Financial Statements:                                                                                              |  |     
|              |  |                                                                                                                   
|              |  | Consolidated Condensed Balance Sheets  March 31, 2006 (Unaudited) and December 31, 2005                           |  | 1   
|              |  |                                                                                                                   
|              |  | Consolidated Condensed Statements of Operations (Unaudited)  Three Months Ended March 31, 2006 and March 31, 2005 |  | 2   
|              |  |                                                                                                                   
|              |  | Consolidated Condensed Statements of Cash Flows (Unaudited)  Three Months Ended March 31, 2006 and March 31, 2005 |  | 3   
|              |  |                                                                                                                   
|              |  | Notes to Consolidated Condensed Financial Statements (Unaudited)                                                   |  | 4   
|              |  |                                                                                                                   
|Item 2.       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                              |  | 10  
|              |  |                                                                                                                   
|Item 3.       |  | Quantitative and Qualitative Disclosures About Market Risk                                                         |  | 17  
|              |  |                                                                                                                   
|Item 4.       |  | Controls and Procedures                                                                                            |  | 18  
|              |  |                                                                                                                   
|              |  | PART II. OTHER INFORMATION                                                                                         |  |     
|              |  |                                                                                                                   
|Item 1.       |  | Legal Proceedings                                                                                                  |  | 18  
|              |  |                                                                                                                   
|Item 1A.      |  | Risk Factors                                                                                                       |  | 18  
|              |  |                                                                                                                   
|Item 2.       |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                        |  | 18  
|              |  |                                                                                                                   
|Item 3.       |  | Defaults Upon Senior Securities                                                                                    |  | 19  
|              |  |                                                                                                                   
|Item 4.       |  | Submission of Matters to a Vote of Security Holders                                                                |  | 19  
|              |  |                                                                                                                   
|Item 5.       |  | Other Information                                                                                                  |  | 19  
|              |  |                                                                                                                   
|Item 6.       |  | Exhibits and Reports on Form 8-K                                                                                   |  | 19  
|              | 
|SIGNATURES    |  | 19                                                                                                                
|              | 
|EXHIBIT INDEX |  | 20                                                                                                                



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PART I

FINANCIAL INFORMATION

Item 1.Financial Statements

DIGITAL LIGHTWAVE, INC.

CONSOLIDATED CONDENSED BALANCE SHEETS

(In thousands, except share data)



|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|----------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                                      |  | March 31,2006 |          |   | December 31,2005 |  
|                                                                                                                                                      |  | (Unaudited)   |          |   |                  |  
|ASSETS                                                                                                                                                |  |               |          |   |                  |   |          |  
|Current assets:                                                                                                                                       |  |               |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                                             |  | $             | 60       |   |                  | $ | 499      |  
|Accounts receivable, less allowance of $145 and $145 in 2006 and 2005, respectively                                                                   |  |               | 2,572    |   |                  |   | 2,672    |  
|Inventories, net                                                                                                                                      |  |               | 4,851    |   |                  |   | 4,765    |  
|Prepaid expenses and other current assets                                                                                                             |  |               | 236      |   |                  |   | 341      |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Total current assets                                                                                                                                  |  |               | 7,719    |   |                  |   | 8,277    |  
|Other assets, net                                                                                                                                     |  |               | 37       |   |                  |   | 37       |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Total assets                                                                                                                                          |  | $             | 7,756    |   |                  | $ | 8,314    |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|LIABILITIES AND STOCKHOLDERS DEFICIT                                                                                                                 |  |               |          |   |                  |   |          |  
|Current liabilities:                                                                                                                                  |  |               |          |   |                  |   |          |  
|Accounts payable and accrued liabilities                                                                                                              |  | $             | 11,293   |   |                  | $ | 10,181   |  
|Notes payable to related party                                                                                                                        |  |               | 49,778   |   |                  |   | 46,830   |  
|Notes payable                                                                                                                                         |  |               | 49       |   |                  |   | 55       |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Total current liabilities                                                                                                                             |  |               | 61,120   |   |                  |   | 57,066   |  
|Other long-term liabilities                                                                                                                           |  |               | 396      |   |                  |   | 438      |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Total liabilities                                                                                                                                     |  |               | 61,516   |   |                  |   | 57,504   |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Stockholders equity (deficit):                                                                                                                       |  |               |          |   |                  |   |          |  
|Preferred stock, $.0001 par value; authorized 20,000,000 shares; no shares issued or outstanding                                                      |  |               |         |   |                  |   |         |  
|Common stock, $.0001 par value; authorized 300,000,000 shares; issued and outstanding 35,226,366 and 35,204,425 shares in 2006 and 2005,
respectively |  |               | 3        |   |                  |   | 3        |  
|Additional paid-in capital                                                                                                                            |  |               | 87,373   |   |                  |   | 87,182   |  
|Accumulated deficit                                                                                                                                   |  |               | (141,136 | ) |                  |   | (136,375 | )
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Total stockholders deficit                                                                                                                           |  |               | (53,760  | ) |                  |   | (49,190  | )
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Total liabilities and stockholders deficit                                                                                                           |  | $             | 7,756    |   |                  | $ | 8,314    |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  

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



1



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DIGITAL LIGHTWAVE, INC.

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(Unaudited)

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



|                                                                 |  |                              |            |   |      |   |            |  
|---------------------------------------------------------------- |  | ---------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                 |  | Three Months Ended March 31, |           
|                                                                 |  | 2006                         |            |   | 2005 |  
|Net sales                                                        |  | $                            | 2,232      |   |      | $ | 2,865      |  
|Cost of goods sold                                               |  |                              | 1,916      |   |      |   | 2,969      |  
|                                                                 |  |                              |            |   |      |   |            |  
|Gross profit                                                     |  |                              | 316        |   |      |   | (104       | )
|                                                                 |  |                              |            |   |      |   |            |  
|Operating expenses:                                              |  |                              |            |   |      |   |            |  
|Engineering and development                                      |  |                              | 1,655      |   |      |   | 1,984      |  
|Sales and marketing                                              |  |                              | 1,238      |   |      |   | 1,863      |  
|General and administrative                                       |  |                              | 804        |   |      |   | 1,626      |  
|                                                                 |  |                              |            |   |      |   |            |  
|Total operating expenses                                         |  |                              | 3,697      |   |      |   | 5,473      |  
|                                                                 |  |                              |            |   |      |   |            |  
|Operating loss                                                   |  |                              | (3,381     | ) |      |   | (5,577     | )
|Other expense, net                                               |  |                              | (1,380     | ) |      |   | (846       | )
|                                                                 |  |                              |            |   |      |   |            |  
|Loss before income taxes                                         |  |                              | (4,761     | ) |      |   | (6,423     | )
|Provision from income taxes                                      |  |                              |           |   |      |   |           |  
|                                                                 |  |                              |            |   |      |   |            |  
|Net loss                                                         |  | $                            | (4,761     | ) |      | $ | (6,423     | )
|                                                                 |  |                              |            |   |      |   |            |  
|Per share of common stock:                                       |  |                              |            |   |      |   |            |  
|Basic net loss per share                                         |  | $                            | (0.14      | ) |      | $ | (0.19      | )
|                                                                 |  |                              |            |   |      |   |            |  
|Diluted net loss per share                                       |  | $                            | (0.14      | ) |      | $ | (0.19      | )
|                                                                 |  |                              |            |   |      |   |            |  
|Weighted average common shares outstanding                       |  |                              | 35,214,906 |   |      |   | 34,419,148 |  
|                                                                 |  |                              |            |   |      |   |            |  
|Weighted average common and common equivalent shares outstanding |  |                              | 35,214,906 |   |      |   | 34,419,148 |  
|                                                                 |  |                              |            |   |      |   |            |  

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



2



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DIGITAL LIGHTWAVE, INC.

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)



|                                                                        |  |                             |        |   |      |   |        |  
|----------------------------------------------------------------------- |  | --------------------------- | ------ | - | ---- | - | ------ | -
|                                                                        |  | Three Months EndedMarch 31, |       
|                                                                        |  | 2006                        |        |   | 2005 |  
|Cash flows from operating activities:                                   |  |                             |        |   |      |   |        |  
|Net loss                                                                |  | $                           | (4,761 | ) |      | $ | (6,423 | )
|Adjustments to reconcile net loss to cash used in operating activities: |  |                             |        |   |      |   |        |  
|Depreciation and amortization                                           |  |                             |       |   |      |   | 423    |  
|Provision for excess and obsolete inventory                             |  |                             |       |   |      |   | (125   | )
|Compensation expense for stock option grants                            |  |                             | 187    |   |      |   | 12     |  
|Gain on settlement of debt and accrued litigation                       |  |                             |       |   |      |   | (53    | )
|Loss on forgiveness of debt                                             |  |                             |       |   |      |   | 374    |  
|Loss on disposal of property                                            |  |                             |       |   |      |   | 2      |  
|Changes in operating assets and liabilities:                            |  |                             |        |   |      |   |        |  
|(Increase) decrease in accounts receivable                              |  |                             | 100    |   |      |   | 698    |  
|(Increase) decrease in inventories                                      |  |                             | (86    | ) |      |   | (1,050 | )
|(Increase) decrease in prepaid expenses and other assets                |  |                             | 105    |   |      |   | (743   | )
|Increase (decrease) in accounts payable and accrued expenses            |  |                             | 1,070  |   |      |   | 979    |  
|                                                                        |  |                             |        |   |      |   |        |  
|Net cash used in operating activities                                   |  |                             | (3,385 | ) |      |   | (5,906 | )
|                                                                        |  |                             |        |   |      |   |        |  
|Cash flows from investing activities:                                   |  |                             |        |   |      |   |        |  
|Purchases of property and equipment                                     |  |                             |       |   |      |   | (176   | )
|                                                                        |  |                             |        |   |      |   |        |  
|Net cash used in investing activities                                   |  |                             |       |   |      |   | (176   | )
|                                                                        |  |                             |        |   |      |   |        |  
|Cash flows from financing activities:                                   |  |                             |        |   |      |   |        |  
|Proceeds from notes payable - related party                             |  |                             | 2,948  |   |      |   | 5,800  |  
|Principal payments on notes payable - other                             |  |                             | (6     | ) |      |   | (154   | )
|Proceeds from sale of common stock, net of expense                      |  |                             | 4      |   |      |   |       |  
|                                                                        |  |                             |        |   |      |   |        |  
|Net cash provided by financing activities                               |  |                             | 2,946  |   |      |   | 5,646  |  
|                                                                        |  |                             |        |   |      |   |        |  
|Net decrease in cash and cash equivalents                               |  |                             | (439   | ) |      |   | (436   | )
|Cash and cash equivalents at beginning of period                        |  |                             | 499    |   |      |   | 809    |  
|                                                                        |  |                             |        |   |      |   |        |  
|Cash and cash equivalents at end of period                              |  | $                           | 60     |   |      | $ | 373    |  
|                                                                        |  |                             |        |   |      |   |        |  

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



3



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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) provides the global fiber-optic communications industry with products and technology used to develop, install, maintain, monitor and manage fiber-optic communication networks.
Telecommunications service providers, owners of private networks (utilities, government and large enterprises) and equipment manufacturers deploy the Companys products to provide quality assurance and ensure optimum performance of advanced
optical communications networks and network equipment. The Companys products are sold worldwide to telecommunications service providers, owners of private networks (utilities, government and large enterprises), telecommunications equipment
manufacturers, equipment leasing companies and international distributors. 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, but are currently inactive. 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 three-month period ended March 31, 2006, 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 the Companys Annual Report
on Form 10-K for the year ended December 31, 2005.

Operational Matters

The Company continues to have insufficient short-term resources for the payment of its current liabilities. During the first three months of 2006, the Company addressed this shortfall by obtaining financing from Optel
Capital, LLC (Optel), an entity controlled by the Companys largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan.

Optel currently is and continues to be the principal source of financing for the Company. 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 registered public accounting firm has included an explanatory paragraph for a going concern in its report for the year ended December 31, 2005, that was included in our Annual Report on Form 10-K filed on
March 30, 2006.

As of May 10, 2006, the Company owed Optel approximately $51.2 million in principal plus accrued interest thereon, which debt is
secured by a first priority security interest in substantially all of our assets and such debt accrues interest at a rate of 10% per annum. Approximately $49.5 million of principal plus accrued interest thereon is currently due and payable at
any time upon demand by Optel, and approximately $1.7 million in principal and accrued interest is payable on demand by Optel at any time after May 31, 2006.

On December 16, 2005, Optel established an irrevocable letter of credit in the amount of $2.0 million on our behalf and naming MC Test Service, Inc. as beneficiary. The letter of credit expires December 30, 2006. MC Test Service,
Inc. provides outsourced manufacturing services to us. With the letter of credit in place, MC Test Service, Inc. has extended to us regular payment terms to pay for purchased production material.



4



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The Companys ability to meet cash requirements and maintain sufficient liquidity over the next 12 months is
dependent on its ability to restructure its debt and continue its guarantees through letters of credit with Optel and 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, and restructure its debt and guarantees with Optel, it expects that it will not have sufficient cash to fund its working capital and capital expenditure requirements for the near term.

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 fiscal year ended December 31, 2005, the Companys impairment analysis calculated in accordance
with the guidelines set forth in SFAS 144, indicated future cash flows from the Companys operations were insufficient to cover the carrying value of the Companys long-lived assets. Therefore, the Company calculated an impairment using
the probability-weighted approach with an average life of five (5) years, and a risk-free rate of interest of 3%. As a result, during the fiscal year ended December 31, 2005, the Company recorded an impairment charge for the remaining
balance of its long-lived assets.

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. The reconciliation of the
warranty reserve is as follows:



|                   |  |                             |     |   |      |   |      |  
|------------------ |  | --------------------------- | --- | - | ---- | - | ---- | -
|                   |  | Three Months EndedMarch 31, |    
|                   |  | 2006                        |     |   | 2005 |  
|                   |  | (In thousands)              |    
|Beginning balance  |  | $                           | 813 |   |      | $ | 546  |  
|Warranty provision |  |                             | 88  |   |      |   | 227  |  
|Warranty costs     |  |                             | (76 | ) |      |   | (154 | )
|                   |  |                             |     |   |      |   |      |  
|Ending balance     |  | $                           | 825 |   |      | $ | 619  |  
|                   |  |                             |     |   |      |   |      |  

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.



5



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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,
as amended by SFAS No. 153 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.

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 three-month periods ended March 31, 2006 and 2005, 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 53,025,000 and 37,283,183 for the three months ended March 31, 2006, and
2005, respectively. The total incremental shares from common stock equivalents at March 31, 2006, included 221,000 from outstanding stock options and 52,804,000 shares that are issuable pursuant to the conversion feature of the Secured
Convertible Promissory Note. 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 EndedMarch 31,
|                                                |  | 2006                        |  | 2005      
|Basic:                                          |  |                             |  |           
|Weighted average common shares outstanding      |  | 35,214,906                  |  | 34,419,148
|Total basic                                     |  | 35,214,906                  |  | 34,419,148
|                                                |  |                             |  |           
|Diluted:                                        |  |                             |  |           
|Incremental shares for common stock equivalents |  |                            |  |          
|                                                |  |                             |  |           
|Total dilutive                                  |  | 35,214,906                  |  | 34,419,148
|                                                |  |                             |  |           

Stock Based Compensation

On January 1, 2006, the Company adopted the provisions of Statement 123 (revised 2004) (Statement 123(R)), Share-Based Payment, which revises Statement 123, Accounting for Stock-Based
Compensation,and supersedes APB Opinion 25, Accounting for Stock Issued to Employees(Opinion 25). Statement 123(R) requires us to recognize expense related to the fair value of our stock-based compensation awards, including
employee stock options.

Prior to the adoption of Statement 123(R), the Company accounted for stock-based compensation awards using the intrinsic value
method of Opinion 25. Accordingly, the Company did not recognize compensation expense in the statement of operations for options granted that had an exercise price equal to the market value of the underlying common stock on the date of grant. As
required by Statement 123, the Company also provided certain pro forma disclosures for stock-based awards as if the fair-value-based approach of Statement 123 had been applied.



6



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The Company has elected to use the modified prospective transition method as permitted by Statement 123(R) and therefore
has not restated financial results for prior periods. Under this transition method, the Company will apply the provisions of Statement 123(R) to new awards and to awards modified, repurchased, or cancelled after January 1, 2006. Additionally,
the Company will recognize compensation cost for the portion of awards for which the requisite service has not been rendered (unvested awards) that are outstanding as of January 1, 2006, as the remaining service is rendered. The compensation
cost the Company records for awards will be based on their grant-date fair value as calculated for the pro forma disclosures required by Statement 123. The Company has also determined to utilize a forfeiture rate which reflects the historic rates of
forfeitures of unvested shares in its determination of compensation expense.

The Companys compensation cost for stock-based employee compensation
was $187,000 and $0 for the first three months of fiscal 2006 and 2005, respectively. No tax benefits were recognized for these costs due to recurring losses. As a result of the adoption of Statement 123(R), the Companys financial results were
lower than under the previous accounting method for share-based compensation by the following amounts:



|                                                        |  |                                      |       |  
|------------------------------------------------------- |  | ------------------------------------ | ----- | -
|                                                        |  | Three Months Ended March 31, 2006    |      
|                                                        |  | (In thousands,except per share data) |      
|Earnings from continuing operations before income taxes |  | $                                    | 187   |  
|Earnings from continuing operations                     |  |                                      | 187   |  
|Net earnings                                            |  |                                      | 187   |  
|Basic and diluted net loss per common share             |  |                                      | (0.01 | )

Prior to the adoption of Statement 123(R), the Company presented all tax benefits resulting from the exercise of
stock options as operating cash flows in the Consolidated Statement of Cash Flows. Statement 123(R) requires that cash flows from the exercise of stock options resulting from tax benefits in excess of recognized cumulative compensation cost (excess
tax benefits) be classified as financing cash flows. For the three months ended March 31, 2006, there are no such excess tax benefits classified as financing cash flows.

The following table illustrates the effect on net income after tax and net income per common share as if the fair value recognition provisions of Statement 123 to stock-based compensation for the three-month period
ended March 31, 2005 were applied:



|                                                                                                                                      |  |                                      |        |  
|------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------ | ------ | -
|                                                                                                                                      |  | Three Months Ended March 31, 2005    |       
|                                                                                                                                      |  | (In thousands,except per share data) |       
|Net income:                                                                                                                           |  |                                      |        |  
|Net loss, as reported                                                                                                                 |  | $                                    | (6,423 | )
|Add: Stock-based employee compensation expense previously included in reported net income, net of related tax effects                 |  |                                      | 12     |  
|Deduct: Stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax
effects |  |                                      | (738   | )
|                                                                                                                                      |  |                                      |        |  
|Pro forma net loss                                                                                                                    |  | $                                    | (7,149 | )
|                                                                                                                                      |  |                                      |        |  
|Basic loss per common share:                                                                                                          |  |                                      |        |  
|As reported                                                                                                                           |  | $                                    | (0.19  | )
|Pro forma                                                                                                                             |  | $                                    | (0.21  | )
|Diluted loss per common share:                                                                                                        |  |                                      |        |  
|As reported                                                                                                                           |  | $                                    | (0.19  | )
|Pro forma                                                                                                                             |  | $                                    | (0.21  | )

The fair value of options granted is estimated on the date of grant using the Black-Scholes option pricing model
based on the assumptions in the table below.



7



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|                        |  |                |  |                |  
|----------------------- |  | -------------- |  | -------------- | -
|                        |  | March 31, 2006 |  | March 31, 2005 |  
|Expected term (years)   |  | na             |  | 4.0            |  
|Risk-free interest rate |  | na             |  | 3.9            | %
|Volatility              |  | na             |  | 269.0          | %
|Dividend yield          |  | na             |  |               |  

The expected term of the options is based on evaluations of historical and expected future employee exercise
behavior. The risk-free interest rate is based on the U.S. Treasury rates at the date of grant with maturity dates approximately equal to the expected life at the grant date. Volatility is based on historical volatility of the Companys stock.
The Company has not historically issued any dividends and does not expect to in the future.

Stock Option Plans

The Company has two stock option plans with shares available for grant March 31, 2006 as follows:



|                                                                             |  |                  |  |                 
|---------------------------------------------------------------------------- |  | ---------------- |  | ----------------
|                                                                             |  | Plan            
|                                                                             |  | 1996             |  | 2001            
|Minimum exercise price as a percentage of fair market value at date of grant |  | 100%             |  | 100%            
|Plan termination date                                                        |  | December 31,2006 |  | December 31,2007

Option grants under the two plans have a contractual life of ten years. Option grants generally vest in one-third
annual increments or quarterly over a three-year period, with the exception of certain option agreements that provide for various vesting schedules throughout the same three-year vesting period or options allowing vesting acceleration based on
certain performance milestones on each anniversary of the grant date, commencing with the first anniversary. The Company recognizes compensation costs for these awards on a straight-line basis over the service period.



8



---

The following is a summary of the changes in outstanding options for the three months ended March 31, 2006:



|                                 |  |                       |   |  |                                 |      |                                          |   |    
|-------------------------------- |  | --------------------- | - |  | ------------------------------- | ---- | ---------------------------------------- | - | ---
|                                 |  | Shares (In thousands) |   |  | Weighted Average Exercise Price |      | Aggregate Intrinsic Value (In
thousands)
|Outstanding at December 31, 2005 |  | 7,006                 |   |  | $                               | 3.40 |                                          |   |    
|Granted                          |  |                      |   |  |                                 |     |                                          |   |    
|Exercised                        |  |                      |   |  |                                 |     |                                          |   |    
|Forfeited and expired            |  | (869                  | ) |  | $                               | 5.83 |                                          |   |    
|                                 |  |                       |  
|Outstanding at March 31, 2006    |  | 6,137                 |   |  | $                               | 3.30 |                                          | $ | 128
|                                 |  |                       |   |  |                                 |      |                                          |   |    
|Exercisable at end of period     |  | 4,208                 |   |  | $                               | 3.93 |                                          | $ | 21 
|                                 |  |                       |   |  |                                 |      |                                          |   |    

The weighted-average grant-date fair value of share options granted during the first three months of fiscal 2005
was $0.90. There were no stock options exercised during the first three months of fiscal 2006 and 2005.

Reclassification of Costs

During 2005, the Company changed its presentation of costs associated with the production and customer service departments from engineering and development and sales and
marketing to cost of goods sold. These costs totaled approximately $1.4 million for the three months ended March 31, 2005.

New Accounting
Pronouncements

In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, which is effective for
inventory costs incurred by the Company beginning fiscal year 2006. The amendments made by SFAS No. 151 improve financial reporting by clarifying that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials
(spoilage) should be recognized as current-period charges and by requiring the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The adoption of SFAS No. 151 did not have a
significant effect on its financial statements.

2. INVENTORIES

Inventories are summarized as follows:



|               |  |                              |       |                                 |   |      
|-------------- |  | ---------------------------- | ----- | ------------------------------- | - | -----
|               |  | March 31,2006 (In thousands) |       | December 31,2005 (In thousands)
|Raw materials  |  | $                            | 4,276 |                                 | $ | 3,745
|Finished goods |  |                              | 575   |                                 |   | 1,020
|               |  |                              |       |                                 |   |      
|               |  | $                            | 4,851 |                                 | $ | 4,765
|               |  |                              |       |                                 |   |      

Effective as of January 31, 2005, the Company entered into an agreement with MC Test Service, Inc.
(MC) to provide outsourced manufacturing services. On March 15, 2005, Optel established an irrevocable letter of credit in the amount of $6.0 million on behalf of the Company and naming MC as beneficiary. MC Test Service, Inc.
provides outsourced manufacturing services to the Company. With the letter of credit in place, MC Test Service, Inc. has extended regular payment terms to pay for purchased production material. On December 16, 2005, Optel renewed the letter of
credit for the amount of $2.0 million and extended the expiration date to December 30, 2006.



9



---

The Company has established reserves for excess and obsolete inventory based upon 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.

3. 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.

4. COMMITMENTS

At March 31, 2006, the Company had outstanding
non-cancelable purchase order commitments to purchase certain inventory items totaling approximately $180,000 with MC Test Service, Inc.

5. RELATED
PARTY TRANSACTIONS

Notes Payable

As described in
Note 1 under the paragraph entitled Operational Matters, since December 31, 2005 through March 31, 2006, the Company has borrowed approximately $2.9 million from Optel. Additionally, on April 13, 2006, April 18,
2006 and April 25, 2006, the Company borrowed an additional $900,000, $200,000 and $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. As of May 10, 2005 the Company owed Optel approximately $51.2 million in principal plus accrued interest thereon.

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 report 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, and (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, 2005 and 2004 included in our Annual Reports on Form 10-K.



10



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OVERVIEW

Executive Summary

The Company has insufficient short-term resources for the payment of its current liabilities. During the three months
ended March 31, 2006, the Company has addressed this shortfall by obtaining financing from Optel Capital, LLC (Optel), an entity controlled by the Companys largest stockholder and current chairman of the board of directors,
Dr. Bryan J. Zwan. 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 and will not have the resources
required for the payment of its current liabilities when they become due. Optel currently is and continues to be the principal source of financing for the Company. 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.

Overview

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 three months ended March 31, 2006,
two customers accounted for approximately 17.7% and 11.0% of total net sales, respectively. No other customers accounted for more than 10% of net 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 and, accordingly, does not carry substantial backlog from
quarter to quarter. Our sales during a particular quarter are highly dependent upon orders placed by customers during that period. 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.



11



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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.

Critical Accounting Estimates

We believe that
estimating valuation allowances and accrued liabilities are critical in that they are important to the portrayal of our financial condition and results of operations and they require difficult, subjective 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;
| | - |  | ------------------------------------------



| |  |  | deferred tax valuation allowance;
| | - |  | ---------------------------------



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



| |  |  | warranty reserve; and
| | - |  | ---------------------



| |  |  | pending 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 March 31, 2006, was approximately $285,000.

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 March 31, 2006, was $2.7 million, net of our estimated reserve for uncollectible accounts of
approximately $145,000.

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 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 $4.9 million as of March 31, 2006, net of our estimated reserve for excess and obsolete inventory of $15.7 million.



12



---

The Company recognizes deferred tax liabilities and assets for expected future tax consequences of events that have been
included in the consolidated financial statements or tax returns. Deferred tax liabilities and assets are determined based on the difference between the consolidated financial statement and the tax basis of assets and liabilities using enacted tax
rates in effect for the year in which the differences are expected to reverse. The company provides for a valuation allowance for the deferred tax assets when it concludes that it is more likely than not that the deferred tax assets will not be
realized.

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 any decrease in the market price of a long-lived asset, changes 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. As of March 31,
2006 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 March 31, 2006 was approximately
$825,000.

We estimate the amount of liability the Company may incur as a result of pending litigation. As of March 31, 2006, the Company was not
aware of any pending litigation, claims or assessments. Accordingly, there is no accrual for pending litigation at March 31, 2006.



13



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RESULTS OF OPERATIONS

The following is a discussion of significant changes in the results of operations of the Company which occurred in the three months ended March 31, 2006, compared to the three months ended March 31, 2005. The following sets forth
certain financial data as a percent of net sales:



|                            |  |                                                     |    |  |      |   
|--------------------------- |  | --------------------------------------------------- | -- |  | ---- | --
|                            |  | Percent of Net Sales for theQuarter Ended March 31, |   
|                            |  | 2006                                                |    |  | 2005 |   
|Net sales                   |  | 100                                                 | %  |  | 100  | % 
|                            |  |                                                    
|Cost of goods sold          |  | 86                                                  |    |  | 104  |   
|                            |  |                                                     |    |  |      |   
|Gross profit                |  | 14                                                  |    |  | (4   | ) 
|                            |  |                                                    
|Operating expenses:         |  |                                                     |    |  |      |   
|Engineering and development |  | 74                                                  |    |  | 69   |   
|Sales and marketing         |  | 55                                                  |    |  | 65   |   
|General and administrative  |  | 36                                                  |    |  | 57   |   
|                            |  |                                                     |    |  |      |   
|Total operating expenses    |  | 165                                                 |    |  | 191  |   
|                            |  |                                                     |    |  |      |   
|Operating (loss)            |  | (151                                                | )  |  | (195 | ) 
|                            |  |                                                    
|Other (loss), net           |  | (61                                                 | )  |  | (30  | ) 
|                            |  |                                                     |    |  |      |   
|Loss before income taxes    |  | (212                                                | )  |  | (224 | ) 
|Benefit from income taxes   |  |                                                    |    |  |     |   
|                            |  |                                                     |    |  |      |   
|Net loss                    |  | (212                                                | )% |  | (224 | )%
|                            |  |                                                     |    |  |      |   

Net Sales

Net
sales for the quarter ended March 31, 2006, decreased $633,000, or 22%, to $2.2 million from $2.9 million for the quarter ended March 31, 2005. The decease in net sales primarily reflects the impact of engineering delays for the next
generation SONET/SDH feature set, which has slipped to the second quarter of 2006 and the enforcement of higher margin requirements for all sales. International net sales for the quarter ended March 31, 2006, were approximately $0.6 million or
27% of net sales as compared to approximately $1.6 million, or 36% of net sales for the quarter ended March 31, 2005.

Cost of Goods Sold

Cost of goods sold for the quarter ended March 31, 2006, totaled approximately $1.9 million or 86% of net sales as compared to $3.0 million or
104% of net sales for the quarter ended March 31, 2005. For the quarter ended March 31, 2006, cost of goods sold was lower due to the lower comparable net sales volume in the period. The lower percentage of cost of goods sold to net sales
reflects the enforcement of a higher margin policy for all sales.

Gross Profit

Gross profit for the quarter ended March 31, 2006, increased by approximately $420,000 to approximately $316,000 or 14% of net sales, from a gross loss of ($104,000) million or (4%) of net sales for the
quarter ended March 31, 2005. Gross profit increased from the prior period reflecting the enforcement of a higher margin policy for all sales.



14



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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 March 31, 2006, decreased by approximately $329,000 to $1.7 million from approximately $2.0 million for the quarter ended March 31, 2005. The decrease in spending in the quarter ended
March 31, 2006 reflected the elimination of prototyping costs associated with some hardware developments which were completed in the forth quarter of 2005, as well as a reduction in engineering personnel offset by additional expense related to
stock compensation.

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 March 31, 2006,
were $1.2 million, a decrease of approximately $625,000 over the quarter ended March 31, 2005, spending of $1.9 million. The decrease over the first quarter of 2005 was primarily attributable to a decrease in sales staff and greater scrutiny of
travel expenses.

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
March 31, 2006, decreased by approximately $822,000 to $804,000 from approximately $1.6 million for the quarter ended March 31, 2005. This decrease is the result of $424,000 of costs associated with the departure of the former President
and Chief Executive Officer in the first quarter of 2005, depreciation expense charged in 2005 and the results of cost cutting measures taken throughout 2005.

Other Income and Expense, net

Other expense, net for the quarter ended March 31, 2006 was approximately $1.4 million as compared to
other expense, net of approximately $846,000 for the quarter ended March 31, 2005. The increase of approximately $536,000 is primarily attributable to increased interest expense on the outstanding Optel debt.

Provision for Income Taxes

No provision for income taxes was made
for the three-month periods ending March 31, 2006 and 2005 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 March 31, 2006 was approximately $4.8 million or $0.14 per diluted
share compared with net loss of approximately $6.4 million or $0.19 per diluted share for the quarter ended March 31, 2005, for the reasons discussed above.

LIQUIDITY AND CAPITAL RESOURCES

As of March 31, 2006, the Companys unrestricted cash and cash equivalents totaled approximately
$60,000, a decrease of approximately $439,000 from December 31, 2005. As of March 31, 2006, the Companys working capital deficit was $53.4 million as compared to a working capital deficit of $48.8 million at December 31, 2005.
The Company had an accumulated deficit of approximately $141.1 million at March 31, 2006.

Beginning in the third quarter of 2001 and continuing
through March 31, 2006, the Company experienced significant losses. The Company expects to continue to incur operating losses in fiscal year 2006. Management has taken actions to reduce operating expenses and capital expenditures. The actions
include restructuring operations to more closely align operating costs with revenue. As further discussed below, our ability to maintain sufficient liquidity in the future is dependent on raising additional capital, successfully negotiating extended
payment terms with certain vendors and other creditors, maintaining tight controls over spending, successfully achieving our product release schedules and attaining our forecasted sales objectives.



15



---

The Company continues to have insufficient short-term resources for the payment of its current liabilities. During the
first three months of 2006, the Company has addressed this shortfall by obtaining financing from Optel Capital, LLC (Optel), an entity controlled by the Companys largest stockholder and current chairman of the board of directors,
Dr. Bryan J. Zwan.

As of May 10, 2006, the Company owed Optel approximately $51.2 million in principal plus accrued interest thereon, which
debt is secured by a first priority security interest in substantially all of our assets and such debt accrues interest at a rate of 10% per annum. The maturity dates and corresponding payment schedules related to these obligations are as
follows:



| |  |  | Secured Convertible Promissory Note. Pursuant to that certain secured convertible promissory note, dated as of September 16, 2004, the Company borrowed $27.0 million
from Optel on the following terms (the Secured Convertible Promissory Note):
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Accrued and unpaid interest as of September 16, 2004, plus any interest that accrues on the $27.0 million outstanding principal that became due and payable on
September 16, 2005, is now currently due and payable on demand at any time;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Interest that accrued from September 17, 2005, to May 10, 2006, is now currently due and payable on demand at any time; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | $27.0 million of principal is now currently due and payable on demand at any time.
| | - |  | ----------------------------------------------------------------------------------



| |  |  | Short-Term Notes. Pursuant to those several short-term secured promissory notes issued by the Company to Optel since September 30, 2004, the Company borrowed an
additional $24.2 million from Optel on the following terms (the Short-Term Notes):
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $22.5 million in principal plus accrued interest is now currently due and payable on demand at any time; and,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $1.7 million in principal plus accrued interest is payable on demand at any time after May 31, 2006.
| | - |  | ------------------------------------------------------------------------------------------------------------------

On February 10, 2005, at a special meeting of our stockholders, the conversion feature of the Secured Convertible Promissory Note was approved by the Companys
disinterested stockholders. Accordingly, all or any portion of such debt is convertible into the Companys common stock at the option of Optel at any time. The conversion price is based upon the volume-weighted average trading price of the
Companys common stock during the five-day period preceding the date of any conversion. The Company is required to file a registration statement covering the offer and sale by Optel of the shares of common stock issuable upon conversion and to
keep the registration statement effective until the date that is two years after the date that such registration statement is declared effective.

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

On March 11, 2005, the Company issued 981,258 shares of common stock to Optel in connection with Optels conversion of $1.0 million of the indebtedness
outstanding under the Secured Convertible Promissory Note. As of May 10, 2006, the aggregate outstanding principal and accrued interest under the Secured Convertible Promissory Note was approximately $32.8 million, and the Applicable Conversion
Price was approximately $0.442. Accordingly, on May 10, 2005, Optel had the right to convert the Secured Convertible Promissory Note into an aggregate of 74.2 million shares of common stock. Further conversion by Optel of all or any
portion of the Secured Convertible Promissory Note could significantly dilute the ownership interests of the Companys other stockholders and give Optel and Dr. Zwan even greater control over the Company. If Optel converted all of the
indebtedness evidenced by the Secured Convertible Promissory Note, including principal and accrued interest, into shares of common stock on May 10, 2006, at an applicable conversion price of $0.442 per share, Optel and other entities controlled
by the Companys largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan, would control, in the aggregate, approximately 79.2% of the then outstanding shares of common stock after giving effect to the
conversion.



16



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The Company has entered into discussions with Optel to restructure the Short-Term Notes and the Secured Convertible
Promissory Note by extending the maturity date of such debt, to arrange for additional short-term working capital and to continue guarantees through letters of credit to secure vendor obligations. If the Company does not reach an agreement to
restructure the Short-Term Notes and the Secured Convertible Promissory Note, continue its guarantees through letters of credit and obtain additional financing from Optel, the Company will be unable to meet its obligations to Optel and its other
creditors, and in an attempt to collect payment, its creditors, including Optel, may seek legal remedies.

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
financing, it expects that it will not have sufficient cash to fund its working capital and capital expenditure requirements for the near term and will not have the resources required for the payment of its current liabilities when they become due.
Optel currently continues to be the principal source of financing for the Company. 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 registered public accounting firm has included an explanatory paragraph for a going concern in its report for the year ended December 31, 2005, that
was included in our Annual Report on Form 10-K filed on March 30, 2006.

Operating Activities

Net cash used by operating activities for the three months ended March 31, 2006 was approximately $3.4 million. This was primarily the result of the loss from
operations of approximately $4.8 million, offset by a reduction in accounts receivable of approximately $100,000 and an increase in accounts payable of approximately $1.1 million.

Investing Activities

No net cash was used by investing activities for the three months ended March 31, 2006.

Financing Activities

Net cash provided by financing
activities for the three months ended March 31, 2006 was approximately $2.9 million. This was primarily the result of proceeds of $2.9 million from borrowings from Optel. The proceeds provided by Optels financing were used to fund the
Companys working capital requirements and operating losses.

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.

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. Our cash balances are invested in short-term, interest-bearing money market accounts. We believe the impact of a 1% increase or
decline in interest rates would not be material to our investment income.



17



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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 Exchange Act of 1934, as amended (the Exchange Act), as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of
March 31, 2006. Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of March 31, 2006, our disclosure controls and procedures are not sufficently effective to guarantee performance
pursuant to the requirements of the Sarbanes-Oxley Act of 2002 for companies our size 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 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.In conjunction with our procedures to implement the documentation and internal control requirements of the Sarbanes-Oxley
Act of 2002 for companies of our size, we will initiate corrective actions necessary to address internal control deficiencies, and thereafter we will continue to evaluate the effectiveness of our disclosure controls and internal controls and
procedures on an ongoing basis, taking corrective action as appropriate.

PART II

OTHER INFORMATION

Item 1.Legal Proceedings.

The Company has no current, pending, or threatened litigation that could
have a material adverse effect on the Companys business or financial condition. 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 1A.Risk Factors.

There have been no material changes from the risk factors previously
disclosed in the Companys Annual Report on Form 10-K for the year ended December 31, 2005 in response to Item 1A to Part 1 of Form 10-K.

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds.

On March 11, 2005, the
Company issued 981,258 shares of the Companys common stock to Optel Capital, LLC (Optel) in connection with Optels conversion of $1.0 million of the indebtedness outstanding under the Secured Convertible Promissory Note in
the original principal amount of $27.0 million that was issued to Optel by the Company on September 16, 2004. The portion of the indebtedness that was converted consisted of accrued and unpaid interest. Such shares were issued in accordance
with the exemption from registration set forth in Section 4(2) of the Securities Act of 1933, as amended, since such issuance was a transaction not involving a public offering.

Pursuant to the terms of the Secured Convertible Promissory Note, all or any portion of the debt is convertible into the Companys common stock at the option of Optel at any time. The conversion price is based
upon the volume-weighted average trading price of the Companys common stock during the five-day period preceding the date of any conversion. Further, as part of the conversion features approved by the disinterested stockholders at a special
meeting of the stockholders held on February 10, 2005, the Company is required to file a registration statement covering the offer and sale by Optel of the shares of common stock issuable upon conversion and to keep the registration statement
effective until the date that is two years after the date that such registration statement is declared effective.



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As of May 10, 2006, the aggregate outstanding principal and accrued interest under the Secured Convertible
Promissory Note was approximately $32.8 million, and the Applicable Conversion Price was approximately $0.442. Accordingly, on May 10, 2006, Optel had the right to convert the Secured Convertible Promissory Note into an aggregate of
74.2 million shares of common stock. Further, conversion by Optel of all or any portion of the Secured Convertible Promissory Note could significantly dilute the ownership interests of our other stockholders, and give Optel and Dr. Zwan
even greater control over the Company. If Optel converted all of the indebtedness evidenced by the Secured Convertible Promissory Note, including principal and accrued interest, into shares of common stock on May 10, 2006 at a conversion price
of $0.442 per share, Optel and other entities controlled by the Companys largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan, would control, in the aggregate, approximately 79.2% of the then
outstanding shares of common stock after giving effect to the conversion.

Item 3.Defaults Upon Senior Securities.

Not applicable.

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

None.

Item 5.Other Information.

None.

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

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

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report
to be signed on its behalf by the undersigned thereunto duly authorized.



Digital Lightwave, Inc.(Registrant)By:

/s/ KENNETH T. MYERSPresident and Chief Executive Officer (Principal Executive Officer)Date:

May 15, 2006By:

/s/ KENNETH T. MYERSInterim Chief Accounting Officer (Principal
Financial Officer)Date:

May 15, 2006




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EXHIBIT INDEX



|              |  |                                                                                                                                                                                                                                                                      
|------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                                                                                                                                          
|3.1*          |  | Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.02 to the Quarterly Report on Form 10-Q filed by the Company on August 14, 2002).                                                                                          
|              | 
|3.2*          |  | Certificate of Amendment of Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.1 to the Current Report on Form 8-K filed by the Company on February 16,
2004).                                                                
|              | 
|3.3*          |  | Amended and Restated Bylaws (incorporated by reference to Exhibit 3.03 to the Quarterly Report on Form 10-Q filed by the Company on August 14, 2002).                                                                                                                
|              | 
|4.1*          |  | Specimen Certificate for Common Stock (incorporated by reference to Exhibit 4.01 to the Companys Registration Statement on Form S-1 (File No. 333-09457), declared effective by the
Securities and Exchange Commission on February 5, 1997).                        
|              | 
|10.1*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on January 20, 2006 and January 23, 2006 (incorporated by reference to Exhibit 10.1 to the Current Report on
Form 8-K filed by the Company on January 26, 2006).                     
|              | 
|10.2*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on February 2, 2006 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on February 7, 2006).                                          
|              | 
|10.3*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on February 15, 2006 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on February 21, 2006).                                        
|              | 
|10.4*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on March 1, 2006 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on March 7, 2006).                                                
|              | 
|10.5*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on March 14, 2006 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on March 24, 2005).                                              
|              | 
|10.6*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on March 29, 2006 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on April 4, 2006).                                               
|              | 
|10.7*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on March 31, 2006 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on April 6, 2006).                                               
|              | 
|10.8*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on April 13, 2006 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on April 19, 2006).                                              
|              | 
|10.9*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on April 18, 2006 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on April 28, 2006).                                              
|              | 
|10.10*        |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on April 25, 2006 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on May 1, 2006).                                                 
|              | 
|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.                                                                                                                              
|              | 
|99.1*         |  | Press release dated February 23, 2006, announcing the appointment of Mr. Kenneth T. Myers as President and Chief Executive Officer of the Company (incorporated by reference to Exhibit 99.1 to
the Current Report on Form 8-K filed by the Company on March 1, 1006)

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|* | Such exhibits are incorporated by reference.
|- | --------------------------------------------

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



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