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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 June 30, 2005, 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 an
accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    YES ̈NO  x



The number of shares outstanding of the Registrants Common Stock as of August 5, 2005 was 35,191,311.



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##### Table of Contents

DIGITAL LIGHTWAVE, INC.



QUARTERLY
REPORT ON FORM 10-Q

For the Period Ended June 30, 2005



INDEX



|              |  |                                                                                                                  |  |     
|------------- |  | ---------------------------------------------------------------------------------------------------------------- |  | ----
|              |  |                                                                                                                  |  | Page
|              |  | PART I. FINANCIAL INFORMATION                                                                                    |  |     
|              |  |                                                                                                                 
|Item 1.       |  | Consolidated Condensed Financial Statements:                                                                     |  |     
|              |  |                                                                                                                 
|              |  | Consolidated Condensed Balance Sheets  June 30, 2005 (Unaudited) and December 31, 2004                          |  | 1   
|              |  |                                                                                                                 
|              |  | Consolidated Condensed Statements of Operations (Unaudited)  Three Months Ended June 30, 2005 and June 30, 2004 |  | 2   
|              |  |                                                                                                                 
|              |  | Consolidated Condensed Statements of Operations (Unaudited)  Six Months Ended June 30, 2005 and June 30, 2004   |  | 3   
|              |  |                                                                                                                 
|              |  | Consolidated Condensed Statements of Cash Flows (Unaudited)  Six Months Ended June 30, 2005 and June 30, 2004   |  | 4   
|              |  |                                                                                                                 
|              |  | Notes to Consolidated Condensed Financial Statements (Unaudited)                                                 |  | 5   
|              |  |                                                                                                                 
|Item 2.       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                            |  | 13  
|              |  |                                                                                                                 
|Item 3.       |  | Quantitative and Qualitative Disclosures About Market Risk                                                       |  | 21  
|              |  |                                                                                                                 
|Item 4.       |  | Controls and Procedures                                                                                          |  | 22  
|              |  |                                                                                                                 
|              |  | PART II. OTHER INFORMATION                                                                                       |  |     
|              |  |                                                                                                                 
|Item 1.       |  | Legal Proceedings                                                                                                |  | 22  
|              |  |                                                                                                                 
|Item 2.       |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                      |  | 22  
|              |  |                                                                                                                 
|Item 3.       |  | Defaults Upon Senior Securities                                                                                  |  | 22  
|              |  |                                                                                                                 
|Item 4.       |  | Submission of Matters to a Vote of Security Holders                                                              |  | 22  
|              |  |                                                                                                                 
|Item 5.       |  | Other Information                                                                                                |  | 22  
|              |  |                                                                                                                 
|Item 6.       |  | Exhibits and Reports on Form 8-K                                                                                 |  | 22  
|              | 
|SIGNATURES    |  | 23                                                                                                              
|              | 
|EXHIBIT INDEX |  | 24                                                                                                              



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##### Table of Contents

PART I



FINANCIAL INFORMATION



Item 1.Consolidated Condensed Financial Statements



DIGITAL LIGHTWAVE, INC.



CONSOLIDATED CONDENSED BALANCE SHEETS

(In thousands, except share data)



|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|----------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                                      |  | June 30, 2005 |          |   | December 31,2004 |  
|                                                                                                                                                      |  | (Unaudited)   |          |   |                  |  
|ASSETS                                                                                                                                                |  |               |          |   |                  |   |          |  
|Current assets:                                                                                                                                       |  |               |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                                             |  | $             | 182      |   |                  | $ | 809      |  
|Accounts receivable, less allowance of $145 and $564 in 2005 and 2004, respectively                                                                   |  |               | 2,206    |   |                  |   | 2,069    |  
|Notes receivable                                                                                                                                      |  |               |         |   |                  |   | 366      |  
|Inventories, net                                                                                                                                      |  |               | 6,091    |   |                  |   | 5,488    |  
|Prepaid expenses and other current assets                                                                                                             |  |               | 1,134    |   |                  |   | 783      |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Total current assets                                                                                                                                  |  |               | 9,613    |   |                  |   | 9,515    |  
|Property and equipment, net                                                                                                                           |  |               |         |   |                  |   | 2,690    |  
|Other assets                                                                                                                                          |  |               | 37       |   |                  |   | 349      |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Total assets                                                                                                                                          |  | $             | 9,650    |   |                  | $ | 12,554   |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)                                                                                                        |  |               |          |   |                  |   |          |  
|Current liabilities:                                                                                                                                  |  |               |          |   |                  |   |          |  
|Accounts payable and accrued liabilities                                                                                                              |  | $             | 8,267    |   |                  | $ | 6,289    |  
|Notes payable to related party                                                                                                                        |  |               | 40,360   |   |                  |   | 31,435   |  
|Notes payable - current portion                                                                                                                       |  |               | 3,295    |   |                  |   | 3,711    |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Total current liabilities                                                                                                                             |  |               | 51,922   |   |                  |   | 41,435   |  
|Other long-term liabilities                                                                                                                           |  |               | 344      |   |                  |   | 265      |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Total liabilities                                                                                                                                     |  |               | 52,266   |   |                  |   | 41,700   |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Stockholders 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 35,191,311 and 34,183,204 shares in 2005 and 2004,
respectively |  |               | 4        |   |                  |   | 3        |  
|Additional paid-in capital                                                                                                                            |  |               | 87,175   |   |                  |   | 86,133   |  
|Accumulated deficit                                                                                                                                   |  |               | (129,795 | ) |                  |   | (115,282 | )
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Total stockholders deficit                                                                                                                           |  |               | (42,616  | ) |                  |   | (29,146  | )
|                                                                                                                                                      |  |               |          |   |                  |   |          |  
|Total liabilities and stockholders deficit                                                                                                           |  | $             | 9,650    |   |                  | $ | 12,554   |  
|                                                                                                                                                      |  |               |          |   |                  |   |          |  



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 June 30, |           
|                                                                        |  | 2005                        |            |   | 2004 |  
|Net sales                                                               |  | $                           | 2,670      |   |      | $ | 5,796      |  
|Cost of goods sold                                                      |  |                             | 986        |   |      |   | 2,553      |  
|                                                                        |  |                             |            |   |      |   |            |  
|Gross profit                                                            |  |                             | 1,684      |   |      |   | 3,243      |  
|                                                                        |  |                             |            |   |      |   |            |  
|Operating expenses:                                                     |  |                             |            |   |      |   |            |  
|Engineering and development                                             |  |                             | 2,904      |   |      |   | 1,681      |  
|Sales and marketing                                                     |  |                             | 2,027      |   |      |   | 2,259      |  
|General and administrative                                              |  |                             | 915        |   |      |   | 899        |  
|Impairment of long-lived assets                                         |  |                             | 2,988      |   |      |   |           |  
|                                                                        |  |                             |            |   |      |   |            |  
|Total operating expenses                                                |  |                             | 8,834      |   |      |   | 4,839      |  
|                                                                        |  |                             |            |   |      |   |            |  
|Operating loss                                                          |  |                             | (7,150     | ) |      |   | (1,596     | )
|Other loss, net                                                         |  |                             | (940       | ) |      |   | (67        | )
|                                                                        |  |                             |            |   |      |   |            |  
|Loss before income taxes                                                |  |                             | (8,090     | ) |      |   | (1,663     | )
|Benefit from income taxes                                               |  |                             |           |   |      |   |           |  
|                                                                        |  |                             |            |   |      |   |            |  
|Net loss                                                                |  | $                           | (8,090     | ) |      | $ | (1,663     | )
|                                                                        |  |                             |            |   |      |   |            |  
|Per share of common stock:                                              |  |                             |            |   |      |   |            |  
|Basic and Diluted net loss per share                                    |  | $                           | (0.23      | ) |      | $ | (0.05      | )
|                                                                        |  |                             |            |   |      |   |            |  
|Weighted average common shares and common equivalent shares outstanding |  |                             | 35,179,118 |   |      |   | 32,278,334 |  
|                                                                        |  |                             |            |   |      |   |            |  



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 OPERATIONS

(Unaudited)

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



|                                                                        |  |                           |            |   |      |   |            |  
|----------------------------------------------------------------------- |  | ------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                        |  | Six Months Ended June 30, |           
|                                                                        |  | 2005                      |            |   | 2004 |  
|Net sales                                                               |  | $                         | 5,535      |   |      | $ | 10,189     |  
|Cost of goods sold                                                      |  |                           | 2,557      |   |      |   | 4,805      |  
|                                                                        |  |                           |            |   |      |   |            |  
|Gross profit                                                            |  |                           | 2,978      |   |      |   | 5,384      |  
|                                                                        |  |                           |            |   |      |   |            |  
|Operating expenses:                                                     |  |                           |            |   |      |   |            |  
|Engineering and development                                             |  |                           | 5,479      |   |      |   | 3,193      |  
|Sales and marketing                                                     |  |                           | 4,697      |   |      |   | 4,034      |  
|General and administrative                                              |  |                           | 2,541      |   |      |   | 1,800      |  
|Restructuring charges                                                   |  |                           |           |   |      |   | 40         |  
|Impairment of long-lived assets                                         |  |                           | 2,988      |   |      |   |           |  
|                                                                        |  |                           |            |   |      |   |            |  
|Total operating expenses                                                |  |                           | 15,705     |   |      |   | 9,067      |  
|                                                                        |  |                           |            |   |      |   |            |  
|Operating loss                                                          |  |                           | (12,727    | ) |      |   | (3,683     | )
|Other loss, net                                                         |  |                           | (1,786     | ) |      |   | (447       | )
|                                                                        |  |                           |            |   |      |   |            |  
|Loss before income taxes                                                |  |                           | (14,513    | ) |      |   | (4,130     | )
|Benefit from income taxes                                               |  |                           |           |   |      |   |           |  
|                                                                        |  |                           |            |   |      |   |            |  
|Net loss                                                                |  | $                         | (14,513    | ) |      | $ | (4,130     | )
|                                                                        |  |                           |            |   |      |   |            |  
|Per share of common stock:                                              |  |                           |            |   |      |   |            |  
|Basic and Diluted net loss per share                                    |  | $                         | (0.42      | ) |      | $ | (0.13      | )
|                                                                        |  |                           |            |   |      |   |            |  
|Weighted average common shares and common equivalent shares outstanding |  |                           | 34,801,233 |   |      |   | 31,943,775 |  
|                                                                        |  |                           |            |   |      |   |            |  



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



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DIGITAL LIGHTWAVE, INC.



CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)



|                                                                        |  |                           |         |   |      |   |         |  
|----------------------------------------------------------------------- |  | ------------------------- | ------- | - | ---- | - | ------- | -
|                                                                        |  | Six Months Ended June 30, |        
|                                                                        |  | 2005                      |         |   | 2004 |  
|Cash flows from operating activities:                                   |  |                           |         |   |      |   |         |  
|Net loss                                                                |  | $                         | (14,513 | ) |      | $ | (4,130  | )
|Adjustments to reconcile net loss to cash used in operating activities: |  |                           |         |   |      |   |         |  
|Depreciation and amortization                                           |  |                           | 879     |   |      |   | 1,205   |  
|Provision for uncollectible accounts                                    |  |                           |        |   |      |   | 33      |  
|Provision for excess and obsolete inventory                             |  |                           | (308    | ) |      |   |        |  
|Compensation expense for stock option grants                            |  |                           | 16      |   |      |   |        |  
|Gain on settlement of debt and accrued litigation                       |  |                           | (106    | ) |      |   | (593    | )
|Impairment of long-lived assets                                         |  |                           | 2,988   |   |      |   |        |  
|Loss on forgiveness of debt                                             |  |                           | 374     |   |      |   |        |  
|Loss on disposal of property                                            |  |                           | 2       |   |      |   | 34      |  
|Restructuring charges                                                   |  |                           |        |   |      |   | 40      |  
|Changes in operating assets and liabilities:                            |  |                           |         |   |      |   |         |  
|Increase in accounts receivable                                         |  |                           | (137    | ) |      |   | (5,096  | )
|(Increase) decrease in inventories                                      |  |                           | (900    | ) |      |   | 3,062   |  
|Increase in prepaid expenses and other assets                           |  |                           | (357    | ) |      |   | (980    | )
|Increase in accounts payable and accrued expenses                       |  |                           | 3,057   |   |      |   | 893     |  
|Decrease in accrued litigation charge                                   |  |                           |        |   |      |   | (5,802  | )
|                                                                        |  |                           |         |   |      |   |         |  
|Net cash used in operating activities                                   |  |                           | (9,005  | ) |      |   | (11,334 | )
|                                                                        |  |                           |         |   |      |   |         |  
|Cash flows from investing activities:                                   |  |                           |         |   |      |   |         |  
|Decrease in restricted cash and cash equivalents                        |  |                           |        |   |      |   | 602     |  
|Purchases of property and equipment                                     |  |                           | (263    | ) |      |   | (102    | )
|                                                                        |  |                           |         |   |      |   |         |  
|Net cash (used in) provided by investing activities                     |  |                           | (263    | ) |      |   | 500     |  
|                                                                        |  |                           |         |   |      |   |         |  
|Cash flows from financing activities:                                   |  |                           |         |   |      |   |         |  
|Proceeds from notes payable - related party                             |  |                           | 8,925   |   |      |   | 11,215  |  
|Payments/settlements on notes payable - other                           |  |                           | (310    | ) |      |   | (734    | )
|Proceeds from sale of common stock, net of expense                      |  |                           | 26      |   |      |   | 91      |  
|                                                                        |  |                           |         |   |      |   |         |  
|Net cash provided by financing activities                               |  |                           | 8,641   |   |      |   | 10,572  |  
|                                                                        |  |                           |         |   |      |   |         |  
|Net decrease in cash and cash equivalents                               |  |                           | (627    | ) |      |   | (262    | )
|Cash and cash equivalents at beginning of period                        |  |                           | 809     |   |      |   | 312     |  
|                                                                        |  |                           |         |   |      |   |         |  
|Cash and cash equivalents at end of period                              |  | $                         | 182     |   |      | $ | 50      |  
|                                                                        |  |                           |         |   |      |   |         |  
|Other supplemental disclosures:                                         |  |                           |         |   |      |   |         |  
|Cash paid for interest                                                  |  | $                         |        |   |      | $ | 100     |  
|                                                                        |  |                          
|Non-cash Transactions:                                                  |  |                           |         |   |      |   |         |  
|See Note 7 - Non-Cash Transactions                                      |  |                           |         |   |      |   |         |  



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



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##### Table of Contents

DIGITAL LIGHTWAVE, INC.



NOTES TO
CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(Unaudited)



1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Business and Basis of Presentation



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



The accompanying
unaudited consolidated condensed financial statements of Digital Lightwave, Inc. and its subsidiaries (the Company, Digital Lightwave, us, we, our, etc.) have been prepared in accordance
with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements. In the opinion of management, these statements include all adjustments, consisting of normal and recurring adjustments, considered necessary for a fair presentation of results for
such periods. The results of operations for the six- month period ending June 30, 2005, are not necessarily indicative of results which may be achieved for the full fiscal year or for any future period. The unaudited interim financial statements
should be read in conjunction with the financial statements and notes thereto contained in Digital Lightwaves Annual Report on Form 10-K for the year ended December 31, 2004.



Operational Matters



The Company continues to have insufficient short-term resources for the payment of its current liabilities. During the first six months of 2005, 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. The Company has used the financing
provided by Optel to fund (i) the satisfaction of substantially all of its outstanding debt and liabilities owed to creditors other than Optel, and (ii) the Companys short-term working capital needs.



As of August 5, 2005, we owed Optel approximately $41.1 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):
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $2.0 million of accrued and unpaid interest as of September 16, 2004, plus any interest that accrues on such $2.0 million in accrued and unpaid interest and any
interest that accrues on $27.0 million in outstanding principal is due and payable on demand at any time after September 16, 2005;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Interest that accrues from September 17, 2005, to December 31, 2005, due and payable on demand at any time after December 31, 2005; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | $27.0 million of principal due and payable on demand at any time after December 31, 2005.
| | - |  | -----------------------------------------------------------------------------------------



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##### Table of Contents

| |  |  | 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
$14.1 million from Optel on the following terms (the Short-Term Notes):
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $12.5 million plus accrued interest currently payable on demand; and
| | - |  | ----------------------------------------------------------------------------------



| |  |  | $1.6 million plus accrued interest payable on demand at any time after September 30, 2005.
| | - |  | ------------------------------------------------------------------------------------------



On February 10, 2005, at a special meeting of our stockholders, the conversion feature of the Secured Convertible Promissory Note was
approved by our stockholders. Accordingly, all or any portion of such debt is convertible into our common stock at the option of Optel at any time. The conversion price is based upon the volume-weighted average trading price of our common stock
during the five-day period preceding the date of any conversion.



All of the
foregoing transactions dated May 11, 2005 and prior 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, we 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 August 5, 2005, the aggregate outstanding principal and accrued interest under the Secured Convertible
Promissory Note was approximately $30.4 million, and the Applicable Conversion Price was approximately $0.261. Accordingly, on August 5, 2005, Optel had the right to convert the Secured Convertible Promissory Note into an aggregate of 114,327,936
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.



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



On March 15, 2005, Optel established an irrevocable letter of credit in the amount of $6.0 million on our behalf and naming MC Test Service, Inc. as beneficiary. 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. The letter of credit expires on December 30,
2005.



We have entered into preliminary discussions with Optel to restructure
the Short-Term Notes by extending the maturity date of such debt, to arrange for additional short-term working capital and to obtain additional financing through guarantees and letters of credit to secure vendor obligations. If we do not reach an
agreement to restructure the Short-Term Notes and obtain additional financing from Optel, we will be unable to meet our obligations to Optel and our other creditors, and in an attempt to collect payment, our 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 additional financing, it
expects that it will not have sufficient cash to fund its working capital and capital expenditure requirements for the near term. Optel currently is and continues to be the principal source of financing for the Company. Further, the Company has not
identified any funding source other than Optel that would be prepared to provide current or future financing to the Company.



The Company cannot assure that it will be able to obtain adequate financing, that it will achieve profitability or, if it achieves profitability that the profitability
will be sustainable or that it will continue as a going concern. As a result, our independent registered public accounting firm has included an explanatory paragraph for a going concern in its report for the year ended December 31, 2004, that was
included in our Annual Report on Form 10-K filed on March 30, 2005.



Effective
as of June 8, 2004, the Company entered into a settlement agreement (the Mediation Settlement Agreement) with CIT Technologies Corporation (CIT), which resolves and settles certain disputes between the Company and CIT. Under
the Mediation Settlement Agreement, CIT received $5.2 million in cash, 2,500,000 shares of common stock of the Company and certain equipment subject to the original lease agreements between the Company and CIT. Further, CIT dismissed the lawsuit it
filed in April 2003. CIT was previously the Companys largest unsecured creditor and had been seeking damages in excess of $15.6 million. (See Note 4  Legal Proceedings)



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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. The Companys impairment analysis as of June 30, 2005, 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, in the
second quarter of 2005, the Company recorded a total non-cash impairment charge for the remaining balance of its long-lived assets which included $2.8 million and $200,000 on its property and equipment and other assets, respectively. During the six
months ended June 30, 2004, no impairment charges were recorded as there were no events which occurred that required a measurement for impairment during that period.



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:



|                                 |  |                           |      |   |      |   |      |  
|-------------------------------- |  | ------------------------- | ---- | - | ---- | - | ---- | -
|                                 |  | Six Months Ended June 30, |     
|(In thousands)                   |  | 2005                      |      |   | 2004 |  
|Beginning balance                |  | $                         | 546  |   |      | $ | 678  |  
|Adjustment to warranty provision |  |                           | 353  |   |      |   | 113  |  
|Cost of warranty services        |  |                           | (260 | ) |      |   | (245 | )
|                                 |  |                           |      |   |      |   |      |  
|Ending balance                   |  | $                         | 639  |   |      | $ | 546  |  
|                                 |  |                           |      |   |      |   |      |  



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.



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



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



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



The Company assesses collection based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. Collateral
is not requested from customers. If it is determined that collection of an account receivable is not reasonably assured, the amount of the account receivable is deferred and revenue 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 six-month periods ended June 30, 2005
and 2004, 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 108,727,880 and 435,043 for the three months ended June 30, 2005 and 2004, respectively. The total incremental shares from common stock equivalents were 108,727,880 and 1,549,627 for the six months ended June 30, 2005 and
2004, respectively. The total incremental shares from common stock equivalents at June 30, 2005 represent shares that are issuable pursuant to the conversion feature of the Secured Convertible Promissory Note held by Optel Capital, LLC. Total
outstanding stock options of 7,775,257 shares for the six months ended June 30, 2005 were excluded from the computation, as the inclusion of such would be anti-dilutive. 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 Ended June 30,
|                                                |  | 2005                        |  | 2004      
|Basic:                                          |  |                             |  |           
|Weighted average common shares outstanding      |  | 35,179,118                  |  | 32,278,334
|Total basic                                     |  | 35,179,118                  |  | 32,278,334
|                                                |  |                             |  |           
|Diluted:                                        |  |                             |  |           
|Incremental shares for common stock equivalents |  |                            |  |          
|                                                |  |                             |  |           
|Total dilutive                                  |  | 35,179,118                  |  | 32,278,334
|                                                |  |                             |  |           



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|                                                |  |                           |  |           
|----------------------------------------------- |  | ------------------------- |  | ----------
|                                                |  | Six Months Ended June 30,
|                                                |  | 2005                      |  | 2004      
|Basic:                                          |  |                           |  |           
|Weighted average common shares outstanding      |  | 34,801,233                |  | 31,943,775
|Total basic                                     |  | 34,801,233                |  | 31,943,775
|                                                |  |                           |  |           
|Diluted:                                        |  |                           |  |           
|Incremental shares for common stock equivalents |  |                          |  |          
|                                                |  |                           |  |           
|Total dilutive                                  |  | 34,801,233                |  | 31,943,775
|                                                |  |                           |  |           



Stock Based Compensation



At June 30, 2005, the Company had two stock-based employee compensation
plans. The Company accounts for the plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in
net loss, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The stock-based compensation recorded in 2005 resulted from options issued to non-employee
contractors. The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of Financial Accounting Standards Board (FASB) Statement No. 148, Accounting for
Stock-Based Compensation, to stock-based employee compensation:



|                                                                                                                  |  |                            |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|----------------------------------------------------------------------------------------------------------------- |  | -------------------------- | ------ | - | ------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                                                                  |  | Three Months EndedJune 30, |        |   | Six Months Ended June 30, |  
|(In thousands, except per-share data)                                                                             |  | 2005                       |        |   | 2004                      |   |        | 2005 |  |   | 2004    |  
|Net loss, as reported                                                                                             |  | $                          | (8,090 | ) |                           | $ | (1,663 | )    |  | $ | (14,513 | ) |  | $ | (4,130 | )
|Add: Stock-based employee compensation included in reported net income, net of related tax effects                |  |                            | 4      |   |                           |   |       |      |  |   | 16      |   |  |   |       |  
|Deduct: Total stock - based employee compensation expense determined under fair value based method for all awards |  |                            | (716   | ) |                           |   | (855   | )    |  |   | (1,454  | ) |  |   | (1,846 | )
|                                                                                                                  |  |                            |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Pro forma net loss                                                                                                |  | $                          | (8,802 | ) |                           | $ | (2,518 | )    |  | $ | (15,951 | ) |  | $ | (5,976 | )
|                                                                                                                  |  |                            |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Loss per share:                                                                                                   |  |                            |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Basic & Diluted-as reported                                                                                       |  | $                          | (0.23  | ) |                           | $ | (0.05  | )    |  | $ | (0.42   | ) |  | $ | (0.13  | )
|Basic & Diluted-pro forma                                                                                         |  | $                          | (0.25  | ) |                           | $ | (0.08  | )    |  | $ | (0.46   | ) |  | $ | (0.19  | )



During the quarter ended June 30,
2005, the Company granted options to purchase an aggregate of 90,000 shares of the Companys common stock at a weighted average exercise price of $0.93 per share. These options, which generally vest quarterly over three years, were granted to
employees and Directors under the Digital Lightwave, Inc. 2001 Stock Option Plan.



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New Accounting Pronouncements



In December 2004, the FASB issued Statement on Financial Accounting Standard (SFAS) No. 123 (Revised 2004) Share-Based
Payment (No. 123R). SFAS No. 123R addresses all forms of share-based payment (SBP) awards, including shares issued under employee stock purchase plans, stock options, restricted stock and stock appreciation rights. SFAS
No. 123R will require the Company to expense SBP awards with compensation cost for SBP transactions measured at fair value. The FASB originally stated a preference for a lattice model because it believed that a lattice model more fully captures the
unique characteristics of employee stock options in the estimate of fair value, as compared to the Black-Scholes model that the Company currently uses for its footnote disclosure. The FASB decided to remove its explicit preference for a lattice
model and not require a single valuation methodology. SFAS No. 123R requires the Company to adopt the new accounting provisions either prospectively or retrospectively beginning in the first quarter of 2006. The Company has not yet determined either
the method or the impact of applying the various provisions of SFAS No. 123R.



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 will improve
financial reporting by clarifying those 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 Company does not believe that the adoption of SFAS No. 151 will have a significant effect on its financial statements.



In December 2004, FASB issued SFAS No. 153, Exchanges of Non-monetary Assets, an
amendment of APB Opinion No. 29. This statement is effective for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. This statement eliminates the exception to fair value for exchanges of similar productive assets
and replaces it with a general exception for exchange transactions that do not have commercial substance  that is, transactions that are not expected to result in significant changes in the cash flows of the reporting entity. The Company does
not believe that the adoption of SFAS No. 153 will have a significant effect on its financial statements.



2. INVENTORIES



Inventories are
summarized as follows:



|                |  |              |       |                  |   |      
|--------------- |  | ------------ | ----- | ---------------- | - | -----
|(In thousands)  |  | June 30,2005 |       | December 31,2004
|Raw materials   |  | $            | 4,061 |                  | $ | 3,036
|Work-in-process |  |              | 309   |                  |   |     
|Finished goods  |  |              | 1,721 |                  |   | 2,452
|                |  |              |       |                  |   |      
|                |  | $            | 6,091 |                  | $ | 5,488
|                |  |              |       |                  |   |      



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



On May 11, 2004, the Company and Jabil entered into a settlement agreement to resolve and settle certain disputes between the Company and Jabil, and Jabil agreed to continue to provide manufacturing services to the Company. As previously
reported, on February 27, 2003, Jabil terminated the manufacturing services agreement and on March 19, 2003, commenced an arbitration proceeding against the Company seeking damages in excess of $6.8 million. On December 5, 2003, the Company entered
into a manufacturing services letter agreement with Jabil specifying the terms under which Jabil would provide the Company with certain manufacturing services. The manufacturing services letter agreement expired on December 30, 2003, and the term of
such letter agreement was extended through December 31, 2004. Jabil continued to provide manufacturing services during the six months ended June 30, 2005. (See Note 3  Legal Proceedings)



Effective as of January 21, 2005, the Company entered into an agreement with MC Test Service,
Inc. (MC) to also 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.



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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



CIT Technologies Corporation



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



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



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



Jabil Circuit, Inc.



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



On May 11, 2004, Jabil and the Company entered into a settlement agreement (the
Settlement Agreement), which resolved and settled certain and all previous disputes between Jabil and the Company. Pursuant to the Settlement Agreement, the Company executed promissory notes (the Jabil Notes) totaling
approximately $5.2 million in favor of Jabil for unpaid accounts, notes and certain inventory for which the Company had not paid. Further, the Company also placed additional purchase orders with Jabil approximately $1.1 million and made cash
payments to Jabil approximating $1.4 million in conjunction with new purchase orders and as initial payments under the Jabil Notes. Under the Settlement Agreement, the Company and Jabil agreed to dismiss the two lawsuits filed by Jabil in 2003, and
Jabil agreed to continue to provide manufacturing services to the Company through December 31, 2004.



Jabil continued to provide manufacturing services during the six months ended June 30, 2005. During the six months ending June 30, 2005, the Company made scheduled payments under the Jabil Notes. The Jabil Notes
mature on December 31, 2005, and bear interest at a rate of 6% per annum. As of June 30, 2005, the aggregate principal amount outstanding under the Jabil Notes was approximately $3.1 million and is reported in the balance sheet as current
liabilities, notes payable. Accrued and unpaid interest approximated $246,000 as of June 30, 2005. On July 22, 2005, the Company initiated a discussion with Jabil to renegotiate the terms of the outstanding Jabil Notes. In conjunction with this
on-going renegotiation, the Company has not paid the July 1, 2005 scheduled payment of $150,000.



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.



4. COMMITMENTS



At June 30, 2005, the Company had non-cancelable purchase order commitments to purchase certain inventory items totaling approximately $1.8 million, with approximately $1.7 million of those purchase order commitments
placed with MC Test Service, Inc. and approximately $38,000 placed with Jabil in conjunction with contract manufacturing services.



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5. REVOLVING CREDIT FACILITY



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



At
June 30, 2004, there was approximately $1.4 million of letters of credit outstanding under this facility collateralized by approximately $1.4 million of the Companys cash and cash equivalents, which were classified as restricted as of June 30,
2004. The Company currently has no additional borrowing capacity under this facility and accordingly has no outstanding balance.The Agreement expired on April 15, 2005.



6. RELATED PARTY TRANSACTIONS



Note Receivable



On February 15, 2005, in conjunction with a severance agreement between the Company and James R. Green, the Companys Chief Executive Officer, the Company agreed to forgive the entire amount of a note receivable
from Mr. Green of approximately $374,000, including approximately $7,700 of accrued interest. Further, the Company agreed to release all collateral held as security against such note, including a second lien on Mr. Greens residence. The costs
associated with the forgiveness of the note and the severance agreement were reported as general and administrative expenses in the quarter ended March 31, 2005.



The loan to Mr. Green originated in February 2001 in the amount of $200,000, had a stated interest rate of the prime rate plus one percent
and was payable on demand or, if earlier, from the proceeds of any sale of Mr. Greens stock holdings in the Company or on the date of termination of Mr. Greens employment. The loan was collateralized by Mr. Greens stock holdings in
the Company and any future cash bonuses.



In April 2002, Mr. Green borrowed an
additional $175,000 from the Company. The loan was combined with the previous note of $200,000 plus accrued interest of approximately $16,000 into one note with a principal balance of approximately $391,000, and was classified in notes receivable.
The note bore a rate of interest of 8% per annum, was payable on demand or, if earlier, from the proceeds of any sale of Mr. Greens stock holdings in the Company or on the date of termination of Mr. Greens employment. The loan was
collateralized by Mr. Greens stock holdings in the Company, any future cash bonuses and a second lien on Mr. Greens residence.



Effective August 1, 2003, $50,000 a year of Mr. Greens annual salary was used to repay the April 2002 note discussed above. The repayment was deducted
proportionally each pay period and was applied first to accrued interest. As of December 31, 2004, the outstanding balance, reflecting a voluntary principal prepayment of $25,000 made during the fourth quarter of 2002 and regular monthly payments
beginning August 2003, was approximately $366,000 exclusive of accrued interest of approximately $10,300.



Notes Payable



As described in Note 1 under the paragraph entitled Operational Matters, since February 2003 and through August 5, 2005, the Company has borrowed approximately $42.0 million from Optel, an entity
controlled by the Companys largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan, of which approximately $41.1 million in principal and $4.2 million in accrued and unpaid interest remain outstanding.



Also as described in Note 1 under the paragraph entitled Operational Matters,
Optel has provided additional working capital financing in the form of letters of credit totaling approximately $7.4 million, with vendors of the Company named as beneficiaries, and a guarantee of certain obligations of the Company up to
approximately $1.88 million under a guarantee agreement.



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7. NON-CASH TRANSACTIONS



During the six months ended June 30, 2005, Optel elected to convert a total of $1.0 million of the Secured Convertible Promissory Note into 981,258 shares of common
stock of the Company, reducing accrued interest payable by $1.0 million and increasing additional paid-in capital by the same amount. The number of shares issued increased common stock by $98.00.



During the six months ended June 30, 2005, the Company forgave the notes receivable
outstanding balance of $374,000 from Mr. James R. Green, the Companys former Chief Executive Officer, as part of his severance arrangements (see Note 6Related Party Transactions).



During the six months ended June 30, 2004, the Company completed litigation settlements
representing $14.2 million of accrued litigation liabilities reported at December 31, 2003. Related to the CIT settlement, the Company paid $5.2 million in cash and recorded a non-cash deferred gain of $3.7 million, and an increase of $4.7 million
to additional paid-in capital related to the issuance of 2,500,000 shares of common stock to CIT. The Company paid approximately $400,000 in cash related to certain other litigation settlements (see Note 3  Legal Proceedings).



Further, the Jabil settlement, also completed in the six months ending June 30, 2004,
resulted in a $320,000 reduction in accounts payable and accrued expenses and a net increase of approximately $100,000 to notes payable (see Note 2  Inventories).



8. SUBSEQUENT EVENTS



As described in Note 1 under the paragraph entitled Operational Matters, on July 14, 2005, the Company borrowed an additional $700,000 from Optel to fund its
ongoing working capital needs. The loan is evidenced by a separate secured promissory note, bears a rate of interest of 10.0% per annum and is secured by a security interest in substantially all of the Companys assets.



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



FORWARD LOOKING STATEMENTS



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



This information should be read in conjunction with (i) the
consolidated condensed financial statements and notes thereto included in Item 1of Part I of this quarterly report on Form 10-Q, (ii) the consolidated financial statements and notes thereto, as well as the accompanying Managements Discussion
and Analysis of Results of Operations, for the years ended December 31, 2004 and 2003 included in our Annual Reports on Form 10-K.



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OVERVIEW



Executive Summary



The Company has insufficient short-term resources for the payment of its current liabilities. During the six months ended June 30, 2005, 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. Our ability to meet cash requirements and maintain sufficient liquidity over the next 12
months is dependent on our ability to obtain additional financing from funding sources which may include, but may not be limited to, Optel. If the Company is not able to obtain additional financing, it expects that it will not have sufficient cash
to fund its working capital and capital expenditure requirements for the near term. Optel currently is and continues to be the principal source of financing for the Company. Further, the Company has not identified any funding source other than Optel
that would be prepared to provide current or future financing to the Company.



The Company cannot assure that it will be able to obtain adequate financing, that it will achieve profitability or, if it achieves profitability that the profitability will be sustainable or that it will continue as a going concern.



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 six months ended June 30, 2005, two customers accounted for approximately 18% and 17%
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. It generally obtains purchase orders for immediate shipment. The Company does not expect to carry substantial backlog from quarter to quarter. Our sales during a particular quarter are highly dependent upon orders placed by
customers during that quarter. Most of our operating expenses are fixed and cannot be easily reduced in response to decreased revenues. Variations in the timing of revenues could cause significant variations in results of operations from quarter to
quarter and result in continuing quarterly losses. The deferral of any large order from one quarter to another would negatively affect the results of operations for the earlier quarter. The Company must obtain orders during each quarter for shipment
in that quarter to achieve revenue and profit objectives.



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.



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



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



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



On November 5, 2002 we acquired certain assets related to the OTS product line of Tektronix, Inc. Since the acquisition, we have integrated this technology into our NIC product line. The value of these assets has been
substantially written off.



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;
| | - |  | ------------------------------------------



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



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



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



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



We estimate the amount of potential future product returns related to current period product
revenue. We consider many factors when making our estimates, including analyzing historical returns, current economic trends, changes in customer demand and acceptance of our products to evaluate the adequacy of the sales returns and other
allowances. Our estimate for the provision for sales returns and other allowances as of June 30, 2005, was approximately $285,000.



We also estimate the collectability of our accounts receivable. 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. This reserve was reduced by approximately
$545,000 during the six months ended June 30, 2005 as a result of an anticipated product return and corresponding write-off of an account receivable that had aged beyond 120 days. Our accounts receivable balance as of June 30, 2005, was $2.2
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 $6.1 million as of June 30, 2005, net of our
estimated reserve for excess and obsolete inventory of $15.9 million.



We
estimate the impairment of long-lived assets. We monitor events and changes in circumstances that could indicate carrying amounts of long-lived assets may not be recoverable. These events and circumstances include any decrease in the



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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. As of June 30, 2005, a review of the carrying value of our long-lived assets and the probability of recovering such value indicated
that an additional $3.0 million impairment charge was required which represented an impairment of our remaining long-lived assets.



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
June 30, 2005 was approximately $639,000.



We estimate the amount of
liability the Company may incur as a result of pending litigation. As of June 30, 2005, the Company was not aware of any pending litigation, claims or assessments. Accordingly, there is no accrual for pending litigation at June 30, 2005.



RESULTS OF OPERATIONS



The following is a discussion of significant changes in the results of operations of the
Company which occurred in the quarter and six months ended June 30, 2005 compared to the quarter and six months ended June 30, 2004. The following sets forth certain financial data as a percent of net sales:



|                                |  |                                                     |    |  |                                                        |    |  |      |    |  |      |   
|------------------------------- |  | --------------------------------------------------- | -- |  | ------------------------------------------------------ | -- |  | ---- | -- |  | ---- | --
|                                |  | Percent of Net Sales for the Quarter Ended June 30, |    |  | Percent of Net Sales for the Six Months Ended June 30, |   
|                                |  | 2005                                                |    |  | 2004                                                   |    |  | 2005 |    |  | 2004 |   
|Net sales                       |  | 100                                                 | %  |  | 100                                                    | %  |  | 100  | %  |  | 100  | % 
|Cost of goods sold              |  | 37                                                  |    |  | 44                                                     |    |  | 46   |    |  | 47   |   
|                                |  |                                                     |    |  |                                                        |    |  |      |    |  |      |   
|Gross profit (loss)             |  | 63                                                  |    |  | 56                                                     |    |  | 54   |    |  | 53   |   
|                                |  |                                                     |    | 
|Operating expenses:             |  |                                                     |    |  |                                                        |    |  |      |    |  |      |   
|Engineering and development     |  | 109                                                 |    |  | 29                                                     |    |  | 99   |    |  | 31   |   
|Sales and marketing             |  | 76                                                  |    |  | 39                                                     |    |  | 85   |    |  | 40   |   
|General and administrative      |  | 34                                                  |    |  | 16                                                     |    |  | 46   |    |  | 18   |   
|Restructuring charges           |  |                                                    |    |  |                                                       |    |  |     |    |  |     |   
|Impairment of long-lived assets |  | 112                                                 |    |  |                                                       |    |  | 54   |    |  |     |   
|                                |  |                                                     |    |  |                                                        |    |  |      |    |  |      |   
|Total operating expenses        |  | 331                                                 |    |  | 84                                                     |    |  | 284  |    |  | 89   |   
|                                |  |                                                     |    |  |                                                        |    |  |      |    |  |      |   
|Operating loss                  |  | (268                                                | )  |  | (28                                                    | )  |  | (230 | )  |  | (36  | ) 
|                                |  |                                                     |    | 
|Other loss, net                 |  | (35                                                 | )  |  | (1                                                     | )  |  | (32  | )  |  | (4   | ) 
|                                |  |                                                     |    |  |                                                        |    |  |      |    |  |      |   
|Loss before income taxes        |  | (303                                                | )  |  | (29                                                    | )  |  | (262 | )  |  | (40  | ) 
|Benefit from income taxes       |  |                                                    |    |  |                                                       |    |  |     |    |  |     |   
|                                |  |                                                     |    |  |                                                        |    |  |      |    |  |      |   
|Net Loss                        |  | (303                                                | )% |  | (29                                                    | )% |  | (262 | )% |  | (40  | )%
|                                |  |                                                     |    |  |                                                        |    |  |      |    |  |      |   



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Net Sales



Net sales for the quarter ended June 30, 2005, decreased $3.1 million, or 54%, to $2.7 million from $5.8 million for the quarter ended June 30, 2004. The sales decrease
related primarily to decreased volume reflecting the impact of more stringent credit policies applied by the Company, particularly with international customers. International sales for the quarter ended June 30, 2005, were approximately $600,000, or
22% of net sales, as compared to approximately $2.3 million, or 40% of net sales, for the quarter ended June 30, 2004.



Net sales for the six months ended June 30, 2005, decreased $4.7 million, or 46%, to $5.5 million from $10.2 million for the six months ended June 30, 2004. The sales
decrease related primarily to decreased volume reflecting the impact of more stringent credit policies applied by the Company, particularly with international customers. International sales for the six months ended June 30, 2005, were approximately
$1.4 million, or 25% of net sales, as compared to approximately $3.9 million, or 38% of net sales, for the six months ended June 30, 2004.



Cost of Goods Sold



Cost of goods sold for the quarter ended June 30, 2005 totaled approximately $1.0 million, or 37% of net sales, as compared to $2.6 million, or 44% of net sales, for the quarter ended June 30, 2004. For the quarter
ended June 30, 2005, cost of goods sold was lower due to the lower comparable net sales volume for the period. Cost of goods sold during this period favorably benefited from use of approximately $200,000 of materials which were previously deemed
excess and obsolete inventory and were fully reserved for as well as resale of refurbished trade-in units, which have lower cost value than newly built units. Excluding these transactions, normalized cost of goods sold was approximately $1.2
million, or 43% of net sales. During the quarter ended June 30, 2004, the Company recognized a benefit of approximately $600,000 as part of the legal settlement with Jabil Circuit, Inc., whereby inventory that was written off at December 31, 2003
was shipped in the period, which reduced cost of sales by that amount. This benefit was offset by an inventory adjustment of approximately $600,000.



Cost of goods sold for the six months ended June 30, 2005 totaled approximately $2.6 million, or 46% of net sales, as compared to $4.8 million, or 47% of net sales, for
the six months ended June 30, 2004. During the six months ended June 30, 2005, cost of goods was lower due to the lower comparable net sales volume in the period. Cost of goods sold during this period favorably benefited from use of approximately
$200,000 of materials which were previously deemed excess and obsolete inventory and were fully reserved for as well as resale of refurbished trade-in units, which have lower cost value than newly built units. For the six months ended June 30, 2004,
the Company recognized a benefit of approximately $600,000 resulting from the settlement with Jabil Circuit, Inc. as described above, offset by an inventory adjustment of approximately $600,000.



Gross Profit



Gross profit for the second quarter ended June 30, 2005 declined by approximately $1.6 million to approximately $1.7 million, or 63% of net
sales, from $3.2 million, or 56% of net sales, for the quarter ended June 30, 2004. Gross profit for the second quarter of 2005 decreased reflecting the lower net sales volume. Gross profit for this period favorably benefited from use of
approximately $200,000 of materials which were previously deemed excess and obsolete inventory and were fully reserved for as well as resale of refurbished trade-in units, which have lower cost value than newly built units. Excluding these
transactions, normalized gross profit was approximately $1.5 million, or 57% of net sales. Gross profit for the second quarter of 2004 was impacted by a benefit of approximately $600,000 resulting from the settlement with Jabil Circuit, Inc.,
whereby inventory that was written off at December 31, 2003 was shipped in the period, which increased gross profit by that amount. This benefit was offset by an inventory adjustment of approximately $600,000.



Gross profit for the six-month period ended June 30, 2005 decreased by approximately $2.4
million to $3.0 million, or 54% of net sales, from $5.4 million, or 53% of net sales, for the six months ended June 30, 2004. During the six months ended June 30, 2005, the decrease in gross profit was primarily due to the lower net sales volume.
Gross profit for this period favorably benefited from use of approximately $200,000 of materials which were previously deemed excess and obsolete inventory and were fully reserved for as well as resale of refurbished trade-in units, which have lower
cost value than newly built units. Gross profit for the six-month period ended June 30, 2004 was impacted by a benefit of approximately $600,000 resulting from the settlement with Jabil Circuit, Inc., offset by an inventory adjustment of
approximately $600,000.



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



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expenses for the quarter ended June 30, 2005 increased by approximately $1.2 million to $2.9 million from approximately
$1.7 million for the quarter ended June 30, 2004. Engineering and development expenses for the six months ended June 30, 2005 increased by approximately $2.3 million to $5.5 million from $3.2 million for the six months ended June 30, 2004. This
increase was primarily due to additional engineers hired in 2005 and increased product development costs reflecting the Companys implementation of controlled spending initiatives to further the development of technologies and corresponding new
products.



Sales and Marketing



Sales and marketing expenses principally include salaries, commissions, travel, tradeshows,
promotional materials, depreciation of demonstration units, and warranty expenses. Sales and marketing expenses for the quarter ended June 30, 2005 were $2.0 million, a decrease of approximately $300,000 from $2.3 million for the same period ended
June 30, 2004. Sales and marketing expenses for the six months ended June 30, 2005 totaled $4.7 million, an increase of approximately $700,000 from $4.0 million for the six-month period ending June 30, 2004. The decrease from the second quarter of
2004 was primarily due to the decrease in depreciation reflecting 34% of gross demonstration and loaner units fully depreciated in the latter part of 2004. The increase in sales and marketing expenses during the six months ended June 30, 2005
compared to the same period in 2004 was primarily attributable to an increase in staff, travel and a comparative increase in warranty cost partially offset by a decrease in depreciation reflecting 34% of gross demonstration and loaner units fully
depreciated in the latter part of 2004.



General and Administrative



General and administrative expenses principally include salaries,
professional fees, facility rentals, compensation and information systems related to general management functions. General and administrative expenses for the quarter ended June 30, 2005 and June 30, 2004 remained unchanged. For the six months ended
June 30, 2005, general and administrative expenses increased approximately by $700,000 to $2.5 million from $1.8 million for the six-month period ended June 30, 2004.



The increase in spending during the six months ended June 30, 2005 represented one-time expenditures, including severance and debt
forgiveness costs, of approximately $445,000 relating to the resignation of the Companys former Chief Executive Officer James R. Green in February 2005, and approximately $78,000 in expenses for the Special Meeting of Stockholders held during
the six months ended June 30, 2005. Other increases during the six months ended June 30, 2005 included additional spending on staff and outside professional fees.



Impairment of Long-Lived Assets



The Companys impairment analysis as of June 30, 2005, 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, in the second quarter of 2005, the Company recorded a total non-cash impairment charge for the remaining balance of its long-lived assets which include $2.8 million and $200,000 on its property and
equipment and other assets, respectively. During the three and six months ended June 30, 2004, no impairment charges were recorded as there were no events which occurred that required a measurement for impairment during those periods.



Other Loss, net



Other loss, net for the quarter ended June 30, 2005, was $940,000 as compared to other loss,
net of $67,000 for the quarter ended June 30, 2004. The decrease of approximately $900,000 was primarily attributable to the increase of $400,000 in interest expense reflecting increased debt levels. During the quarter ended June 30, 2004, other
loss, net included a $312,000 charge for disposal of assets as well as a forgiveness of debt associated with certain vendor settlements, including Jabil Circuit, Inc. for approximately $200,000 and settlements resulting in debt forgiveness for
various trade accounts payable of $300,000.



Other loss, net for the six
months ended June 30, 2005, was $1.8 million, an increase of $1.3 million compared to other loss, net, of $447,000 for the six months ended June 30, 2004.The increase of approximately $1.3 million is primarily the result of approximately
$800,000 increase in interest expense reflecting increased debt levels. During the six months ended June 30, 2004, other loss, net included $256,000 million charge for disposal of assets as well as a forgiveness of debt associated with certain
vendor settlements, including Jabil Circuit, Inc. for approximately $200,000 and settlements resulting in debt forgiveness for various trade accounts payable of approximately $500,000.



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Provision for Income Taxes



No provision for income taxes was made for the three- and six-month periods ended June 30, 2005 and 2004 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 June 30, 2005 was approximately $8.1
million or $0.23 per diluted share compared with net loss of approximately $1.7 million or $0.05 per diluted share for the quarter ended June 30, 2004, for the reasons discussed above. Net loss for the six months ended June 30, 2005
approximated $14.5 million or $0.42 on a per diluted share basis compared to a net loss for the six months ended June 30, 2004 of $4.1 million or $0.13 per diluted share, for the reasons stated above.



LIQUIDITY AND CAPITAL RESOURCES



As of June 30, 2005, the Companys unrestricted cash and cash equivalents totaled
approximately $182,000, a decrease of approximately $627,000 from December 31, 2004. As of June 30, 2005, the Companys working capital deficit was $42.3 million as compared to a working capital deficit of $31.9 million at December 31, 2004.
The Company had an accumulated deficit of approximately $130.0 million as of June 30, 2005.



Beginning in the third quarter of 2001 and continuing through June 30, 2005, the Company experienced combined net losses of approximately $142.8 million. The Company expects to continue to incur operating losses
during the remainder of the fiscal year 2005. 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.



The Company continues to have insufficient short-term resources for the payment of its current liabilities. During the first six months of 2005, 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. The Company has used the financing provided by Optel to fund (i) the satisfaction of
substantially all of its outstanding debt and liabilities owed to creditors other than Optel, and (ii) the Companys short-term working capital needs.



As of August 5, 2005, we owed Optel approximately $41.1 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):
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $2.0 million of accrued and unpaid interest as of September 16, 2004, plus any interest that accrues on such $2.0 million in accrued and unpaid interest and any
interest that accrues on $27.0 million in outstanding principal is due and payable on demand at any time after September 16, 2005;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | Interest that accrues from September 17, 2005, to December 31, 2005, due and payable on demand at any time after December 31, 2005; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | $27.0 million of principal due and payable on demand at any time after December 31, 2005.
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | 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
$14.1 million from Optel on the following terms (the Short-Term Notes):
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $12.5 million plus accrued interest currently payable on demand; and
| | - |  | ----------------------------------------------------------------------------------



| |  |  | $1.6 million plus accrued interest payable on demand at any time after September 30, 2005.
| | - |  | ------------------------------------------------------------------------------------------



On February 10, 2005, at a special meeting of our stockholders, the conversion feature of the Secured Convertible Promissory Note was
approved by our stockholders. Accordingly, all or any portion of such debt is convertible into our common stock at the option of Optel at any time. The conversion price is based upon the volume-weighted average trading price of our common stock
during the five-day period preceding the date of any conversion.



All of the
foregoing transactions dated May 11, 2005 and prior 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, we 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 August 5, 2005, the aggregate outstanding principal and accrued interest under the Secured Convertible
Promissory Note was approximately $30.4 million, and the Applicable Conversion Price was approximately $0.261. Accordingly, on August 5, 2005, Optel had the right to convert the Secured Convertible Promissory Note into an aggregate of 114,327,936
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.



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



On March 15, 2005, Optel established an irrevocable letter of credit in the amount of $6.0 million on our behalf and naming MC Test Service, Inc. as beneficiary. 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. The letter of credit expires on December 30, 2005.



We have entered into preliminary discussions with Optel to restructure the Short-Term Notes
by extending the maturity date of such debt, to arrange for additional short-term working capital and to obtain additional financing through guarantees and letters of credit to secure vendor obligations. If we do not reach an agreement to
restructure the Short-Term Notes and obtain additional financing from Optel, we will be unable to meet our obligations to Optel and our other creditors, and in an attempt to collect payment, our 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 additional financing, it expects that it will
not have sufficient cash to fund its working capital and capital expenditure requirements for the near term. Optel currently continues to be the principal source of financing for the Company. Further, the Company has not identified any funding
source other than Optel that would be prepared to provide current or future financing to the Company.



The Company cannot assure that it will be able to obtain adequate financing, that it will achieve profitability or, if it achieves profitability that the profitability will be sustainable or that it will continue as a
going concern. As a result, our independent registered public accounting firm has included an explanatory paragraph for a going concern in its report for the year ended December 31, 2004, that was included in our Annual Report on Form 10-K filed on
March 30, 2005.



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Operating Activities



Net cash used by operating activities for the six months ended June 30, 2005 was approximately $9.0 million. This was primarily the result of loss from operations of
$14.5 million. The net loss from operations was favorably adjusted for a $3.0 million impairment charge, $374,000 forgiveness of a related party note receivable, $879,000 of depreciation and amortization; and offset by a decrease in the provision
for excess and obsolete inventory of approximately $374,000 and the gain on debt settlement of approximately $106,000. An increase in accounts payable and accrued expenses of approximately $3.1 million provided net cash during the six months ended
June 30, 2005. Increases in inventories of $900,000, accounts receivable of $137,000, and an increase in prepaid expenses and other assets of $358,000 used operating cash during the six months ended June 30, 2005. The cash provided by accounts
payable and accrued expenses totaling approximately $3.1 million resulted primarily from unpaid trade accounts payable of $1.1 million; conversion of debt to stock of $1.0 million, which was applied first to accrued interest; and, from accrued and
unpaid interest expenses of approximately $916,000.



Investing
Activities



Net cash used for investing activities for the six months
ended June 30, 2005 was approximately $263,000. This was primarily the result of the purchase of property and equipment to further the development of technologies and corresponding new products.



Financing Activities



Net cash provided by financing activities for the six months ended June 30, 2005 was approximately $8.6 million. This was primarily the
result of proceeds of $8.9 million from borrowings from Optel, offset by payments of $310,000 made on notes payable, primarily to Jabil Circuit, Inc. in conjunction with the settlement agreement made with Jabil in May 2004 (see Note 2 
Inventories).



Revolving Credit Facility



In April 2002, the Company entered into a Revolving Credit and Security Agreement (the
Agreement) with Wachovia Bank (the Bank). The terms of the Agreement provide the Company with a $27.5 million line of credit at LIBOR plus 0.7% collateralized by the Companys cash and cash equivalents and short-term
investments. The advance rate varied between 80% and 95% and was dependent upon the composition and maturity of the available collateral. An availability fee of 0.10% per annum was payable quarterly based on the Average Available Principal Balance
(as defined in the Agreement) for such three months. The Agreement had an initial term of three years. The Agreement could have been terminated by the Company at any time upon at least fifteen days prior written notice to the Bank, and the Bank had
the right to terminate the Agreement at any time, without notice upon or after the occurrence of an event of default. The company currently has no additional borrowing capacity under this facility and accordingly has no outstanding balance. The
Agreement expired on April 15, 2005. At June 30, 2004, there were approximately $1.4 million of letters of credit outstanding under this facility secured by approximately $1.4 million of the Companys cash and cash equivalents which were
classified as restricted as of June 30, 2004.



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.



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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 (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of June 30, 2005. Based on this
evaluation, our principal executive officer and principal financial officer concluded that, as of June 30, 2005, our disclosure controls and procedures were not effective in ensuring that (1) information to be disclosed in reports we file under the
Exchange Act is recorded, processed, summarized and reported within the time periods specified by the rules and forms promulgated under the Exchange Act and (2) information required to be disclosed in reports filed under the Exchange Act is
accumulated and communicated to the principal executive officer and 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, we will initiate corrective actions to address internal control deficiencies, and 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 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 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.



As of August 5, 2005, the aggregate outstanding
principal and accrued interest under the Secured Convertible Promissory Note was approximately $30.4 million, and the Applicable Conversion Price was approximately $0.261. Accordingly, on August 5, 2005, Optel had the right to convert the Secured
Convertible Promissory Note into an aggregate of 114,327,936 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.



Item 3.Defaults Upon Senior Securities.



Not applicable.



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



The information required by this Item is set forth in Part II, Item 4 of the Companys Quarterly Report on Form 10-Q for the three months ended March 30, 2005. Such
information is incorporated herein by reference.



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 24 of this report.



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##### Table of Contents

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/ ROBERT F. HUSSEYInterim President and Chief Executive Officer(Principal Executive Officer)Date: August 12, 2005By:

/s/ ROBERT F. HUSSEYChief Accounting Officer(Principal Financial Officer)Date: August 12, 2005




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##### Table of Contents

EXHIBIT INDEX



|              |  |                                                                                                                                                                                                                                                                                                      
|------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                                                                                                                                                                          
|10.1*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on April 14, 2005 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on April 15, 2005).                                                                              
|              | 
|10.2*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on April 28, 2005 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on May 2, 2005).                                                                                 
|              | 
|10.3*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on May 12, 2005 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on May 18, 2005).                                                                                  
|              | 
|10.4*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on May 26, 2005 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on June 2, 2005).                                                                                  
|              | 
|10.5*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on June 15, 2005 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on June 20, 2005).                                                                                
|              | 
|10.6*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on June 29, 2005 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on July 5, 2005).                                                                                 
|              | 
|10.7*         |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on July 14, 2005 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on July 15, 2005).                                                                                
|              | 
|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*         |  | Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing dated April 29, 2005. (incorporated by reference to Item 3.01 of the Current Report on Form
8-K filed by the Company on May 5, 2005).                                                            
|              | 
|99.2*         |  | Press Release dated May 6, 2005, announcing the delisting of the Companys securities from The Nasdaq Stock Market and the Companys request for a hearing to appeal the delisting
(incorporated by reference to Exhibit 99.1 to the Current Report on Form 8-K filed by the Company on May 6, 2005).
|              | 
|99.3*         |  | Press Release dated June 2, 2005, announcing the delisting of the Companys securities from The Nasdaq Stock Market (incorporated by reference to Exhibit 99.1 to the Current Report on
Form 8-K filed by the Company on June 3, 2005).                                                              
|              | 
|99.4*         |  | Press Release dated June 8 2005, announcing that the Companys common stock has been approved for quotation on the OTC Bulletin Board (incorporated by reference to Exhibit 99.1 to the
Current Report on Form 8-K filed by the Company on June 8, 2005).                                            

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

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



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