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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

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



For the quarterly period ended September 30, 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



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



The number of shares outstanding of the Registrants Common Stock as of November 4, 2004, was 35,204,425.



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##### Table of Contents

DIGITAL LIGHTWAVE, INC.



QUARTERLY
REPORT ON FORM 10-Q

For the Period Ended September 30, 2005



INDEX



|              |  |                                                                                                                            |  |     
|------------- |  | -------------------------------------------------------------------------------------------------------------------------- |  | ----
|              |  |                                                                                                                            |  | Page
|              |  | PART I. FINANCIAL INFORMATION                                                                                              |  |     
|              |  |                                                                                                                           
|Item 1.       |  | Consolidated Condensed Financial Statements:                                                                               |  |     
|              |  |                                                                                                                           
|              |  | Consolidated Condensed Balance Sheets  September 30, 2005 (Unaudited) and December 31, 2004                               |  | 1   
|              |  |                                                                                                                           
|              |  | Consolidated Condensed Statements of Operations (Unaudited)  Three Months Ended September 30, 2005 and September 30, 2004 |  | 2   
|              |  |                                                                                                                           
|              |  | Consolidated Condensed Statements of Operations (Unaudited)  Nine Months Ended September 30, 2005 and September 30, 2004  |  | 3   
|              |  |                                                                                                                           
|              |  | Consolidated Condensed Statements of Cash Flows (Unaudited)  Nine Months Ended September 30, 2005 and September 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                                      |  | 14  
|              |  |                                                                                                                           
|Item 3.       |  | Quantitative and Qualitative Disclosures About Market Risk                                                                 |  | 23  
|              |  |                                                                                                                           
|Item 4.       |  | Controls and Procedures                                                                                                    |  | 23  
|              |  |                                                                                                                           
|              |  | PART II. OTHER INFORMATION                                                                                                 |  |     
|              |  |                                                                                                                           
|Item 1.       |  | Legal Proceedings                                                                                                          |  | 23  
|              |  |                                                                                                                           
|Item 2.       |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                                |  | 24  
|              |  |                                                                                                                           
|Item 3.       |  | Defaults Upon Senior Securities                                                                                            |  | 24  
|              |  |                                                                                                                           
|Item 4.       |  | Submission of Matters to a Vote of Security Holders                                                                        |  | 24  
|              |  |                                                                                                                           
|Item 5.       |  | Other Information                                                                                                          |  | 24  
|              |  |                                                                                                                           
|Item 6.       |  | Exhibits and Reports on Form 8-K                                                                                           |  | 24  
|              | 
|SIGNATURES    |  | 25                                                                                                                        
|              | 
|EXHIBIT INDEX |  | 26                                                                                                                        



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##### Table of Contents

PART I



FINANCIAL INFORMATION



|Item 1. | Consolidated Condensed Financial Statements
|------- | -------------------------------------------



DIGITAL LIGHTWAVE, INC.



CONSOLIDATED CONDENSED BALANCE SHEETS

(In thousands, except share data)



|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|----------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                                      |  | September 30,2005 |          |   | December 31,2004 |  
|                                                                                                                                                      |  | (Unaudited)       |          |   |                  |  
|ASSETS                                                                                                                                                |  |                   |          |   |                  |   |          |  
|Current assets:                                                                                                                                       |  |                   |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                                             |  | $                 | 671      |   |                  | $ | 809      |  
|Accounts receivable, less allowance of $145 and $564 in 2005 and 2004, respectively                                                                   |  |                   | 3,733    |   |                  |   | 2,069    |  
|Notes receivable                                                                                                                                      |  |                   |         |   |                  |   | 366      |  
|Inventories, net                                                                                                                                      |  |                   | 4,381    |   |                  |   | 5,488    |  
|Prepaid expenses and other current assets                                                                                                             |  |                   | 643      |   |                  |   | 783      |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Total current assets                                                                                                                                  |  |                   | 9,428    |   |                  |   | 9,515    |  
|Property and equipment, net                                                                                                                           |  |                   |         |   |                  |   | 2,690    |  
|Other assets                                                                                                                                          |  |                   | 37       |   |                  |   | 349      |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Total assets                                                                                                                                          |  | $                 | 9,465    |   |                  | $ | 12,554   |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|                                                                                                                                                      |  |                  
|LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)                                                                                                        |  |                   |          |   |                  |   |          |  
|Current liabilities:                                                                                                                                  |  |                   |          |   |                  |   |          |  
|Accounts payable and accrued liabilities                                                                                                              |  | $                 | 9,196    |   |                  | $ | 6,289    |  
|Notes payable to related party                                                                                                                        |  |                   | 44,580   |   |                  |   | 31,435   |  
|Notes payable - current portion                                                                                                                       |  |                   | 61       |   |                  |   | 3,711    |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Total current liabilities                                                                                                                             |  |                   | 53,837   |   |                  |   | 41,435   |  
|Other long-term liabilities                                                                                                                           |  |                   | 324      |   |                  |   | 265      |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Total liabilities                                                                                                                                     |  |                   | 54,161   |   |                  |   | 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                                                                                                                            |  |                   | 87,179   |   |                  |   | 86,133   |  
|Accumulated deficit                                                                                                                                   |  |                   | (131,879 | ) |                  |   | (115,282 | )
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Total stockholders deficit                                                                                                                           |  |                   | (44,696  | ) |                  |   | (29,146  | )
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Total liabilities and stockholders deficit                                                                                                           |  | $                 | 9,465    |   |                  | $ | 12,554   |  
|                                                                                                                                                      |  |                   |          |   |                  |   |          |  



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



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DIGITAL LIGHTWAVE, INC.



CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(Unaudited)

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



|                                                                 |  |                                 |            |   |      |   |            |  
|---------------------------------------------------------------- |  | ------------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                 |  | Three Months EndedSeptember 30, |           
|                                                                 |  | 2005                            |            |   | 2004 |  
|Net sales                                                        |  | $                               | 4,898      |   |      | $ | 2,492      |  
|Cost of goods sold                                               |  |                                 | 2,429      |   |      |   | 923        |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Gross profit                                                     |  |                                 | 2,469      |   |      |   | 1,569      |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Operating expenses:                                              |  |                                 |            |   |      |   |            |  
|Engineering and development                                      |  |                                 | 2,424      |   |      |   | 1,975      |  
|Sales and marketing                                              |  |                                 | 2,050      |   |      |   | 3,582      |  
|General and administrative                                       |  |                                 | 598        |   |      |   | 964        |  
|Impairment of long-lived assets                                  |  |                                 |           |   |      |   |           |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Total operating expenses                                         |  |                                 | 5,072      |   |      |   | 6,521      |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Operating loss                                                   |  |                                 | (2,603     | ) |      |   | (4,952     | )
|Other income, net                                                |  |                                 | 520        |   |      |   | 2,862      |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Loss before income taxes                                         |  |                                 | (2,083     | ) |      |   | (2,090     | )
|Benefit from income taxes                                        |  |                                 |           |   |      |   |           |  
|                                                                 |  |                                 |            |   |      |   |            |  
|Net loss                                                         |  | $                               | (2,083     | ) |      | $ | (2,090     | )
|                                                                 |  |                                 |            |   |      |   |            |  
|Per share of common stock:                                       |  |                                 |            |   |      |   |            |  
|Basic and diluted net loss per share                             |  | $                               | (0.06      | ) |      | $ | (0.06      | )
|                                                                 |  |                                 |            |   |      |   |            |  
|Weighted average common and common equivalent shares outstanding |  |                                 | 35,191,317 |   |      |   | 34,169,531 |  
|                                                                 |  |                                 |            |   |      |   |            |  



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)



|                                                                 |  |                                |            |   |      |   |            |  
|---------------------------------------------------------------- |  | ------------------------------ | ---------- | - | ---- | - | ---------- | -
|                                                                 |  | Nine Months EndedSeptember 30, |           
|                                                                 |  | 2005                           |            |   | 2004 |  
|Net sales                                                        |  | $                              | 10,433     |   |      | $ | 12,681     |  
|Cost of goods sold                                               |  |                                | 4,985      |   |      |   | 5,728      |  
|                                                                 |  |                                |            |   |      |   |            |  
|Gross profit                                                     |  |                                | 5,448      |   |      |   | 6,953      |  
|                                                                 |  |                                |            |   |      |   |            |  
|Operating expenses:                                              |  |                                |            |   |      |   |            |  
|Engineering and development                                      |  |                                | 7,903      |   |      |   | 5,168      |  
|Sales and marketing                                              |  |                                | 6,748      |   |      |   | 7,616      |  
|General and administrative                                       |  |                                | 3,139      |   |      |   | 2,764      |  
|Restructuring charges                                            |  |                                |           |   |      |   | 40         |  
|Impairment of long-lived assets                                  |  |                                | 2,988      |   |      |   |           |  
|                                                                 |  |                                |            |   |      |   |            |  
|Total operating expenses                                         |  |                                | 20,778     |   |      |   | 15,588     |  
|                                                                 |  |                                |            |   |      |   |            |  
|Operating loss                                                   |  |                                | (15,330    | ) |      |   | (8,635     | )
|Other income (expense), net                                      |  |                                | (1,266     | ) |      |   | 2,415      |  
|                                                                 |  |                                |            |   |      |   |            |  
|Loss before income taxes                                         |  |                                | (16,596    | ) |      |   | (6,220     | )
|Benefit from income taxes                                        |  |                                |           |   |      |   |           |  
|                                                                 |  |                                |            |   |      |   |            |  
|Net loss                                                         |  | $                              | (16,596    | ) |      | $ | (6,220     | )
|                                                                 |  |                                |            |   |      |   |            |  
|Per share of common stock:                                       |  |                                |            |   |      |   |            |  
|Basic and diluted net loss per share                             |  | $                              | (0.48      | ) |      | $ | (0.19      | )
|                                                                 |  |                                |            |   |      |   |            |  
|Weighted average common and common equivalent shares outstanding |  |                                | 34,932,690 |   |      |   | 32,691,107 |  
|                                                                 |  |                                |            |   |      |   |            |  



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



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DIGITAL LIGHTWAVE, INC.



CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)



|                                                                        |  |                                |         |   |      |   |         |  
|----------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------- | -
|                                                                        |  | Nine Months EndedSeptember 30, |        
|                                                                        |  | 2005                           |         |   | 2004 |  
|Cash flows from operating activities:                                   |  |                                |         |   |      |   |         |  
|Net loss                                                                |  | $                              | (16,596 | ) |      | $ | (6,220  | )
|Adjustments to reconcile net loss to cash used in operating activities: |  |                                |         |   |      |   |         |  
|Depreciation and amortization                                           |  |                                | 879     |   |      |   | 1,789   |  
|Loss on disposal of property                                            |  |                                | 2       |   |      |   | 37      |  
|Loss on forgiveness of debt                                             |  |                                | 374     |   |      |   |        |  
|Provision for uncollectible accounts                                    |  |                                |        |   |      |   | 1,299   |  
|Provision for excess and obsolete inventory                             |  |                                | (475    | ) |      |   | (53     | )
|Impairment of long-lived assets                                         |  |                                | 2,988   |   |      |   |        |  
|Restructuring charges                                                   |  |                                |        |   |      |   | 40      |  
|Compensation expense for stock option grants                            |  |                                | 19      |   |      |   |        |  
|Settlement of accounts payable and accrued litigation                   |  |                                |        |   |      |   | (386    | )
|Gain on settlement of debt                                              |  |                                | (1,742  | ) |      |   | (259    | )
|Changes in operating assets and liabilities:                            |  |                                |         |   |      |   |         |  
|Increase in accounts receivable                                         |  |                                | (1,664  | ) |      |   | (3,239  | )
|Decrease in inventories                                                 |  |                                | 978     |   |      |   | 3,001   |  
|(Increase) decrease in prepaid expenses and other assets                |  |                                | 132     |   |      |   | (293    | )
|Increase in accounts payable and accrued expenses                       |  |                                | 3,966   |   |      |   | 1,414   |  
|Decrease in accrued litigation charge                                   |  |                                |        |   |      |   | (5,802  | )
|Decrease in deferred gain debt settlement                               |  |                                |        |   |      |   | (3,701  | )
|                                                                        |  |                                |         |   |      |   |         |  
|Net cash used in operating activities                                   |  |                                | (11,139 | ) |      |   | (12,373 | )
|                                                                        |  |                                |         |   |      |   |         |  
|Cash flows from investing activities:                                   |  |                                |         |   |      |   |         |  
|Decrease in restricted cash and cash equivalents                        |  |                                |        |   |      |   | 602     |  
|Purchases of property and equipment                                     |  |                                | (262    | ) |      |   | (134    | )
|                                                                        |  |                                |         |   |      |   |         |  
|Net cash (used in) provided by investing activities                     |  |                                | (262    | ) |      |   | 468     |  
|                                                                        |  |                                |         |   |      |   |         |  
|Cash flows from financing activities:                                   |  |                                |         |   |      |   |         |  
|Proceeds from notes payable - related party                             |  |                                | 13,145  |   |      |   | 13,365  |  
|Payments/settlements on notes payable - other                           |  |                                | (1,908  | ) |      |   | (1,287  | )
|Proceeds from sale of common stock, net of expense                      |  |                                | 26      |   |      |   | 100     |  
|                                                                        |  |                                |         |   |      |   |         |  
|Net cash provided by financing activities                               |  |                                | 11,263  |   |      |   | 12,178  |  
|                                                                        |  |                                |         |   |      |   |         |  
|Net increase (decrease) in cash and cash equivalents                    |  |                                | (138    | ) |      |   | 273     |  
|Cash and cash equivalents at beginning of period                        |  |                                | 809     |   |      |   | 312     |  
|                                                                        |  |                                |         |   |      |   |         |  
|Cash and cash equivalents at end of period                              |  | $                              | 671     |   |      | $ | 585     |  
|                                                                        |  |                                |         |   |      |   |         |  
|Other supplemental disclosures:                                         |  |                                |         |   |      |   |         |  
|Cash paid for interest                                                  |  | $                              |        |   |      | $ |        |  
|                                                                        |  |                               
|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 nine-month period ended September 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. As of September 30, 2005,
the Company had certain secured promissory notes in the amount of approximately $16.3 million plus accrued interest in the amount of approximately $900,000 that became due and payable on or before September 30, 2005 and which are now payable on
demand to 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. In addition, as of September 30, 2005, accrued
interest of approximately $3.7 million became due and payable and is now payable on demand, and all of the other outstanding debt owed by the Company to Optel in the principal amount of approximately $28.3 million plus accrued interest in the amount
of approximately $129,000 will become due and payable on demand by Optel after December 31, 2005. If the Company is not able to obtain financing, it expects that it will not have sufficient cash to fund its working capital and capital
expenditure requirements for the near term and will not have the resources required for the payment of its current liabilities when they become due. During the first nine months of 2005, the Company has addressed this shortfall by obtaining
financing from Optel. 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.



Optel currently is and continues to be the principal
source of financing for the Company. The Company has not identified any funding source other than Optel that would be prepared to provide current or future financing to the Company. The Company cannot assure that it will be able to obtain adequate
financing, that it will achieve profitability or, if it achieves profitability that the profitability will be sustainable or that it will continue as a going concern. As a result, our independent registered public accounting firm has included an
explanatory paragraph for a going concern in its report for the year ended December 31, 2004, that was included in our Annual Report on Form 10-K filed on March 30, 2005.



As of November 4, 2005, we owed Optel approximately $44.6 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:



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##### Table of Contents

| |  |  | 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 now due and payable on demand any time after September 16, 2005;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Interest that accrues from September 17, 2005, to December 31, 2005, is 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 $17.6 million from Optel on the following terms (the Short-Term Notes):
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $16.3 million plus accrued interest is currently payable on demand; and
| | - |  | -------------------------------------------------------------------------------------



| |  |  | $1.3 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 disinterested 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. Further, as part of the conversion features approved by the disinterested stockholders, the Company is required to file a registration statement covering the offer and
sale by Optel of the shares of common stock issuable upon conversion and to keep the registration statement effective until the date that is two years after the date that such registration statement is declared effective.



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



On March 11, 2005, 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 November 4, 2005, the aggregate outstanding principal and accrued interest under the Secured Convertible Promissory Note was approximately $31.1 million, and the Applicable Conversion Price was
approximately $0.173. Accordingly, on November 4, 2005, Optel had the right to convert the Secured Convertible Promissory Note into an aggregate of 179,304,866 shares of common stock. Further, conversion by Optel of all or any portion of the
Secured Convertible Promissory Note could significantly dilute the ownership interests of our other stockholders and give Optel and Dr. Zwan even greater control over the Company. If Optel converted all of the indebtedness evidenced by the
Secured Convertible Promissory Note, including principal and accrued interest, into shares of common stock on November 4, 2005 at a conversion price of $0.173 per share, Optel and other entities controlled by the Companys largest
stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan, would control, in the aggregate, approximately 89.4% of the then outstanding shares of common stock after giving effect to the conversion.



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 was 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.



On August 31, 2005, the Company and Jabil entered
into a Settlement Agreement and Mutual Release (the Settlement



6



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Agreement) relating to an earlier Settlement Agreement (the 2004 Settlement) that the Company and Jabil entered into effective as of
May 11, 2004. In connection with the 2004 Settlement, the Company executed and delivered to Jabil a purchase order, a promissory note in the original principal amount of approximately $3.0 million, and a second promissory note in the original
principal amount of approximately $2.2 million.



In connection with the
Settlement Agreement, and in view of the fact that the Companys current manufacturing needs have changed, Jabil and the Company agreed to amicably settle all outstanding principal and interest financial obligations between them relating to the
2004 Settlement. Under the terms of the Settlement Agreement, Jabil returned to the Company approximately $810,000 in parts inventory and work-in-progress materials that had been purchased by the Company and warehoused at Jabil for Jabils use
in the on-going manufacturing of the Companys finished goods.



Pursuant
to the Settlement Agreement, the Company paid Jabil $1.9 million (the Settlement Payment) on August 31, 2005. The Company and Jabil exchanged mutual releases subject to specified exclusions and the Company picked up leftover parts
inventory and work-in-progress materials in Jabils possession on September 9, 2005.



The Company has entered into discussions with Optel to restructure the Short-Term Notes and the Secured Convertible Promissory Note by extending the maturity date of such debt, to arrange for additional short-term
working capital and to continue guarantees through letters of credit to secure vendor obligations. If the Company does not reach an agreement to restructure the Short-Term Notes and the Secured Convertible Promissory Note, continue its guarantees
through letters of credit and obtain additional financing from Optel, 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.



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 3 Legal Matters)



Impairment of Long-Lived Assets



Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be
recoverable. During the nine months ended September 30, 2005, the Companys impairment analysis calculated in accordance with the guidelines set forth in SFAS 144, indicated future cash flows from the Companys operations were
insufficient to cover the carrying value of the Companys long-lived assets. Therefore, the Company calculated an impairment using the probability-weighted approach with an average life of five (5) years, and a risk-free rate of interest
of 3%. As a result, during the nine months ended September 30, 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 nine months ended September 30, 2004, no impairment charges were recorded because 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:



|                                 |  |                                |      |   |      |   |      |  
|-------------------------------- |  | ------------------------------ | ---- | - | ---- | - | ---- | -
|                                 |  | Nine Months EndedSeptember 30, |     
|(In thousands)                   |  | 2005                           |      |   | 2004 |  
|Beginning balance                |  | $                              | 546  |   |      | $ | 678  |  
|Adjustment to warranty provision |  |                                | 595  |   |      |   | 258  |  
|Cost of warranty services        |  |                                | (449 | ) |      |   | (393 | )
|                                 |  |                                |      |   |      |   |      |  
|Ending balance                   |  | $                              | 692  |   |      | $ | 543  |  
|                                 |  |                                |      |   |      |   |      |  



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Revenue Recognition



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



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



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



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



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



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



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



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



Computation of Net Loss Per Share



Basic net loss per share is based on the weighted average number of common shares outstanding during the periods presented. For the nine-month periods ended
September 30, 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 136,027,632 and 101,207 for the three months ended September 30, 2005 and 2004, respectively. The total incremental



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##### Table of Contents

shares from common stock equivalents were 136,215,891 and 318,339 for the nine months ended September 30, 2005 and 2004, respectively. The total
incremental shares from common stock equivalents for the nine months ended September 30, 2005 included 188,259 from outstanding stock options and 136,027,632 shares that were issuable pursuant to the conversion feature of the Secured
Convertible Promissory Note held by Optel Capital, LLC. Total outstanding stock options of 7,161,422 shares for the nine months ended September 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 EndedSeptember 30,
|                                                |  | 2005                            |  | 2004      
|Basic:                                          |  |                                 |  |           
|Weighted average common shares outstanding      |  | 35,191,317                      |  | 34,169,531
|Total basic                                     |  | 35,191,317                      |  | 34,169,531
|                                                |  |                                 |  |           
|Diluted:                                        |  |                                 |  |           
|Incremental shares for common stock equivalents |  |                                |  |          
|                                                |  |                                 |  |           
|Total dilutive                                  |  | 35,191,317                      |  | 34,169,531
|                                                |  |                                 |  |           
|                                                | 
|                                                |  | Nine Months EndedSeptember 30, 
|                                                |  | 2005                            |  | 2004      
|Basic:                                          |  |                                 |  |           
|Weighted average common shares outstanding      |  | 34,932,690                      |  | 32,691,107
|Total basic                                     |  | 34,932,690                      |  | 32,691,107
|Diluted:                                        |  |                                 |  |           
|Incremental shares for common stock equivalents |  |                                |  |          
|                                                |  |                                 |  |           
|Total dilutive                                  |  | 34,932,690                      |  | 32,691,107
|                                                |  |                                 |  |           



Stock Based Compensation



At September 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 because all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The stock-based compensation recorded in 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 EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|(In thousands, except per-share data)                                                                           |  | 2005                            |        |   | 2004                           |   |        | 2005 |  |   | 2004    |  
|Net loss, as reported                                                                                           |  | $                               | (2,083 | ) |                                | $ | (2,090 | )    |  | $ | (16,596 | ) |  | $ | (6,220 | )
|Add: Stock-based employee compensation included in reported net loss, net of related tax effects                |  |                                 | 3      |   |                                |   |       |      |  |   | 19      |   |  |   |       |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards |  |                                 | (176   | ) |                                |   | (872   | )    |  |   | (1,630  | ) |  |   | (2,715 | )
|                                                                                                                |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Pro forma loss                                                                                                  |  | $                               | (2,256 | ) |                                | $ | (2,962 | )    |  | $ | (18,207 | ) |  | $ | (8,935 | )
|                                                                                                                |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Loss per share:                                                                                                 |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Basic and diluted-as reported                                                                                   |  | $                               | (0.06  | ) |                                | $ | (0.06  | )    |  | $ | (0.48   | ) |  | $ | (0.19  | )
|Basic and diluted-pro forma                                                                                     |  | $                               | (0.07  | ) |                                | $ | (0.09  | )    |  | $ | (0.52   | ) |  | $ | (0.27  | )



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During the quarter ended September 30, 2005, the Company granted options to purchase an aggregate of 525,000 shares
of the Companys common stock at a weighted average exercise price of $0.26 per share. These options, which vest quarterly over three years, were granted to employees and directors under the Digital Lightwave, Inc. 2001 Stock Option Plan.



New Accounting Pronouncements



In 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)  |  | September 30,2005 |       | December 31,2004
|Raw materials   |  | $                 | 3,292 |                  | $ | 4,209
|Work-in-process |  |                   | 239   |                  |   | 164  
|Finished goods  |  |                   | 850   |                  |   | 984  
|                |  |                   |       |                  |   |      
|                |  | $                 | 4,381 |                  | $ | 5,357
|                |  |                   |       |                  |   |      



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On August 31, 2005, the Company and Jabil amicably ended their manufacturing service relationship and all monies and
inventories were exchanged as described herein.



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



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



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.



On August 31, 2005, the Company and Jabil entered into a
Settlement Agreement and Mutual Release (the Settlement Agreement) relating to an earlier Settlement Agreement (the 2004 Settlement) that the Company and Jabil entered into effective as of May 11, 2004. In connection
with the 2004 Settlement, the Company executed and delivered to Jabil a purchase order, a promissory note in the original principal amount of approximately $3.0 million, and a second promissory note in the original principal amount of approximately
$2.2 million.



In connection with the Settlement Agreement, and in view of the
fact that the Companys current manufacturing needs have changed, Jabil and the Company have agreed to amicably settle all outstanding principal and interest financial obligations between them relating to the 2004 Settlement. Under the terms of
the Settlement Agreement, Jabil returned to the Company approximately $810,000 in parts inventory and work-in-progress materials that had been purchased by the Company and warehoused at Jabil for Jabils use in the on-going manufacturing of the
Companys finished goods.



Pursuant to the Settlement Agreement, the
Company paid Jabil $1.9 million (the Settlement Payment) on August 31, 2005. The Company and Jabil exchanged mutual releases subject to specified exclusions and the Company picked up leftover parts inventory and work-in-progress
materials in Jabils possession on September 9, 2005.



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 MATTERS



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



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



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##### Table of Contents

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



Jabil Circuit,
Inc.



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



Effective as of May 11, 2004, the Company entered into a settlement agreement (the 2004 Settlement) with Jabil, which resolves and settles certain and all disputes between Jabil and the Company. Pursuant to the 2004
Settlement, the Company executed promissory notes (the Jabil Notes) totaling approximately $5.2 million in favor of Jabil for unpaid accounts and certain inventory for which the Company had not paid. Further, the Company also placed
additional purchase orders with Jabil for 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 2004 Settlement, 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.



As of September 30, 2004, the combined value of notes payable to Jabil are reported in the balance sheet as current and long term
portions of those notes payable approximating $1.2 million and $3.0 million, respectively. As a result of the 2004 Settlement, the Company realized a gain from debt forgiveness of approximately $0.5 million, of which $0.2 million has been recognized
in the nine months ended September 30, 2004, as other income. The remaining $0.3 million is included as part of the restructured Jabil Notes, was reported in the balance sheet as a component of debt, and was amortized monthly as a reduction to
interest expense through December 31, 2005.



On August 31, 2005, the
Company and Jabil entered into a Settlement Agreement and Mutual Release (the Settlement Agreement) relating to an earlier Settlement Agreement (the 2004 Settlement) that the Company and Jabil entered into effective as of
May 11, 2004. In connection with the 2004 Settlement, the Company executed and delivered to Jabil a purchase order, a promissory note in the original principal amount of approximately $3.0 million, and a second promissory note in the original
principal amount of approximately $2.2 million.



In connection with the
Settlement Agreement, and in view of the fact that the Companys current manufacturing needs have changed, Jabil and the Company have agreed to amicably settle all outstanding principal and interest financial obligations between them relating
to the 2004 Settlement. Under the terms of the Settlement Agreement, Jabil returned to the Company approximately $810,000 in parts inventory and work-in-progress materials that had been purchased by the Company and warehoused at Jabil for
Jabils use in the on-going manufacturing of the Companys finished goods.



Pursuant to the Settlement Agreement, the Company paid Jabil $1.9 million (the Settlement Payment) on August 31, 2005. The Company and Jabil exchanged mutual releases subject to specified exclusions and the Company picked
up leftover parts inventory and work-in-progress materials in Jabils possession on September 9, 2005.



Other



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



4. COMMITMENTS



At September 30, 2005, the Company had non-cancelable purchase order commitments to purchase certain inventory items totaling approximately $3.6 million, with approximately $3.0 million of those purchase order
commitments placed with MC Test Service, Inc. in conjunction with contract manufacturing services.



12



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



6. RELATED PARTY TRANSACTIONS



Notes Receivable



On February 15, 2005, in conjunction with a severance agreement between the Company and
James R. Green, the Companys former 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 mortgage 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.



Notes
Payable



As described above in Note 1 under the paragraph entitled
Operational Matters, since February 2003 and through the date of this report, the Company has borrowed approximately $44.6 million from Optel, an entity controlled by the Companys largest stockholder and current chairman of the
board of directors, Dr. Bryan J. Zwan. In addition to the approximately $44.6 million in principal, there is approximately $5.2 million in accrued and unpaid interest which remains outstanding.



Also as described above 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.



7. NON-CASH TRANSACTIONS



During the nine months ended September 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 nine months ended
September 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).



Also during the nine months ended September 30,
2005, pursuant to the Settlement Agreement, the Company paid Jabil $1.9 million on the remaining notes which consisted of $3.1 million of principal and $300,000 of accrued interest. The Company realized a total non-cash gain of $1.7 million, which
included a $1.5 million of debt settlement gain on the current notes as well as $200,000 remaining deferred gain on settlement of the restructured Jabil Notes (see Note 3  Legal Matters).



13



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##### Table of Contents

During the nine months ended September 30, 2004, the Company completed litigation settlements representing $14.2
million of accrued litigation liabilities reported at December 31, 2003. Related to the CIT settlement, the Company paid $5.2 million in cash and 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 Matters).



Further, the Jabil settlement, also completed in the nine months ended September 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).



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



FORWARD LOOKING STATEMENTS



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



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



OVERVIEW



Executive Summary



The Company has insufficient short-term resources for the payment of its current liabilities. As of September 30, 2005, the Company had certain secured promissory
notes in the amount of approximately $16.3 million plus accrued interest in the amount of approximately $900,000 that became due and payable on or before September 30, 2005 and which are now payable on demand to Optel at any time. In addition,
as of September 30, 2005, accrued interest of approximately $3.7 million became due and payable and is now payable on demand, and all of the other outstanding debt owed by the Company to Optel in the principal amount of approximately $28.3
million plus accrued interest in the amount of approximately $129,000 will become due and payable on demand by Optel after December 31, 2005. If the Company is not able to obtain financing, it expects that it will not have sufficient cash to
fund its working capital and capital expenditure requirements for the near term and will not have the resources required for the payment of its current liabilities when they become due. During the nine months ended September 30, 2005, the
Company addressed this shortfall by obtaining financing from Optel. The Companys ability to meet cash requirements and maintain sufficient liquidity over the next 12 months is dependent on the Companys ability to obtain additional
financing from funding sources which may include, but may not be limited to, Optel. Optel currently is and continues to be the principal source of financing for the Company. The Company has not identified any funding source other than Optel that
would be prepared to provide current or future financing to the Company.



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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 nine months ended
September 30, 2005, two customers accounted for approximately 15.4% and 14.5% of total sales, respectively. No other customers accounted for more than 10% of sales.



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



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



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



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



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



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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.



Critical Accounting Policies



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



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



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



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



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



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



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



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



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



We also estimate the collectability of our accounts receivables. We consider many factors when making our estimates, including analyzing accounts receivable and
historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the reserve for uncollectible accounts. This reserve was reduced by
approximately $545,000 during the nine months ended September 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
September 30, 2005 was $3.7 million, net of our estimated reserve for uncollectible accounts of approximately $145,000.



We estimate the amount of excess and obsolete inventory. When evaluating the reserve for excess and obsolete inventory, we consider many factors, including analyzing
current and expected sales trends, the amount of current parts on hand, the current market value of parts on hand and the viability and technical obsolescence of our products. The assumptions made relative to expected sales trends are subjective in
nature and have a material impact on the estimate of the reserve requirement. Should future sales trends, in total or by product line, fluctuate from that used in our estimates, this reserve could be overstated or understated. Our inventory balance
was $4.4 million as of September 30, 2005, net of our estimated reserve for excess and obsolete inventory of $15.8 million.



We estimate the impairment of long-lived assets. We monitor events and changes in circumstances that could indicate carrying amounts of long-lived assets may not be
recoverable. These events and circumstances include decrease in market price of a long-lived asset, change in the manner in which a long-lived asset is used, changes in legal factors and a current-period operating loss or cash flow loss combined
with a history of operating losses or cash flow losses or a forecast that demonstrates continuing losses associated with the use of long-lived assets. When such an event or changes in circumstance occur, we assess the recoverability of long-lived
assets by determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows. We recognize impairments when there is an excess of the assets carrying value over the fair value as estimated using a
discounted expected future cash flows model. In estimating undiscounted expected future cash flows, we must make judgments and estimates related to future sales and profitability. Should future sales trends or profitability be significantly less
than that forecasted, our impairment could be understated. During the nine months ending September 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 the Companys remaining long-lived assets.



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We estimate the amount of our warranty reserve. We consider many factors when making our estimate, including historical
trends, the number of products under warranty, the costs of replacement parts and the expected reliability of our products. We believe that our accrued warranty reserve is sufficient to meet our responsibilities for potential future warranty work on
products sold. Our accrued warranty reserve as of September 30, 2005 was approximately $692,000.



We estimate the amount of liability the Company may incur as a result of pending litigation. As of September 30, 2005, all previously reported litigation and disputes have been settled and resolved. Accordingly,
there is no accrual for pending litigation at September 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 nine months ended September 30, 2005 compared to the quarter and nine months ended September 30, 2004. The following sets forth certain
financial data as a percent of net sales:



|                                |  |                                                         |    |  |                                                             |    |  |      |    |  |      |   
|------------------------------- |  | ------------------------------------------------------- | -- |  | ----------------------------------------------------------- | -- |  | ---- | -- |  | ---- | --
|                                |  | Percent of Net Sales for theQuarter Ended September 30, |    |  | Percent of Net Sales for theNine Months Ended September 30, |   
|                                |  | 2005                                                    |    |  | 2004                                                        |    |  | 2005 |    |  | 2004 |   
|Net sales                       |  | 100                                                     | %  |  | 100                                                         | %  |  | 100  | %  |  | 100  | % 
|Cost of goods sold              |  | 50                                                      |    |  | 37                                                          |    |  | 48   |    |  | 45   |   
|                                |  |                                                         |    |  |                                                             |    |  |      |    |  |      |   
|Gross profit                    |  | 50                                                      |    |  | 63                                                          |    |  | 52   |    |  | 55   |   
|                                |  |                                                         |    | 
|Operating expenses:             |  |                                                         |    |  |                                                             |    |  |      |    |  |      |   
|Engineering and development     |  | 49                                                      |    |  | 79                                                          |    |  | 76   |    |  | 41   |   
|Sales and marketing             |  | 42                                                      |    |  | 144                                                         |    |  | 65   |    |  | 60   |   
|General and administrative      |  | 12                                                      |    |  | 39                                                          |    |  | 30   |    |  | 22   |   
|Restructuring charges           |  |                                                        |    |  |                                                            |    |  |     |    |  |     |   
|Impairment of long-lived assets |  |                                                        |    |  |                                                            |    |  | 29   |    |  |     |   
|                                |  |                                                         |    |  |                                                             |    |  |      |    |  |      |   
|Total operating expenses        |  | 103                                                     |    |  | 262                                                         |    |  | 200  |    |  | 123  |   
|                                |  |                                                         |    |  |                                                             |    |  |      |    |  |      |   
|Operating loss                  |  | (53                                                     | )  |  | (199                                                        | )  |  | (148 | )  |  | (68  | ) 
|                                |  |                                                         |    | 
|Other income (loss), net        |  | 11                                                      |    |  | 115                                                         |    |  | (12  | )  |  | 19   |   
|                                |  |                                                         |    |  |                                                             |    |  |      |    |  |      |   
|Loss before income taxes        |  | (42                                                     | )  |  | (84                                                         | )  |  | (160 | )  |  | (49  | ) 
|Benefit from income taxes       |  |                                                        |    |  |                                                            |    |  |     |    |  |     |   
|                                |  |                                                         |    |  |                                                             |    |  |      |    |  |      |   
|Net Loss                        |  | (42                                                     | )% |  | (84                                                         | )% |  | (160 | )% |  | (49  | )%
|                                |  |                                                         |    |  |                                                             |    |  |      |    |  |      |   



Net Sales



Net sales for the three months ended September 30, 2005 increased $2.4 million, or 97%,
to $4.9 million from $2.5 million for the three months ended September 30, 2004. The increase in sales was primarily a result of a $2.5 million, or 143%, increase in new customer sales of NIC and NAA products for the three months ended
September 20, 2005 compared to the same period in 2004. International sales for the three months ended September 30, 2005 were approximately $2.5 million, or 51% of net sales, as compared to approximately $1.2 million, or 48% of net sales,
for the three months ended September 30, 2004.



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Net sales for the nine months ended September 30, 2005 decreased $2.2 million, or 18%, to $10.4 million from $12.7
million for the nine months ended September 30, 2004. The sales decrease related primarily to decreased volume reflecting the impact of more stringent credit policies applied by the Company. International sales for the nine months ended
September 30, 2005 were approximately $3.9 million, or 37% of net sales, as compared to approximately $5.1 million, or 40% of net sales, for the nine months ended September 30, 2004.



Cost of Goods Sold



Cost of goods sold for the three months ended September 30, 2005 totaled approximately $2.4 million, or 50% of net sales, as compared
to $923,000, or 37% of net sales, for the three months ended September 30, 2004. The increase in cost of goods sold for the three months ended September 30, 2005, reflected the corresponding increase in product shipments for the period.
During the three months ended September 30, 2004, the Company recognized a benefit of $139,000 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. Excluding inventory adjustments, cost of goods sold was approximately $1.1 million, or 43% of net sales, for the three months ended September 2004.



Cost of goods sold for the nine months ended September 30, 2005 totaled approximately
$5.0 million, or 48% of net sales, as compared to $5.7 million, or 45% of net sales, for the nine months ended September 30, 2004. The decrease in cost of goods reflected the decrease in sales volumes for the period. During the nine months
ended September 30, 2004, the Company recognized a benefit of $756,000 resulting from the settlement with Jabil Circuit, Inc. as described above, offset by an inventory adjustment of $571,000. Excluding charges for inventory adjustments and
reserves, cost of goods sold was approximately $5.9 million, or 47% of net sales, for the nine months ended September 30, 2004.



Gross Profit



Gross profit for the three months ended September 30, 2005 increased by approximately $900,000 to approximately $2.5 million, or 50% of net sales, from a gross profit of $1.6 million, or 63% of net sales, for the
three months ended September 30, 2004. Gross profit for the three months ended September 30, 2005 reflected the increase in sales volumes for the period. Gross profit for the three months ended September 30, 2004 was affected by a
benefit of $139,000 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. Excluding inventory adjustments,
gross profit is approximately $1.4 million, or 57% of net sales, for the three months ended September 30, 2004.



Gross profit for the nine months ended September 30, 2005 decreased by approximately $1.5 million to approximately $5.4 million, or 52% of sales, from a gross profit
of $7.0 million for the nine months ended September 30, 2004. The decrease in gross profit for the three months ended September 30, 2005, reflected the decrease in sales volumes for the period. Gross profit in 2004 was impacted by a
benefit of approximately $756,000 resulting from the settlement with Jabil Circuit, Inc., offset by a corresponding inventory adjustment of $571,000. Excluding charges for inventory adjustments and reserves, gross profit was approximately $6.8
million, or 53% of net sales for the nine months ended September 30, 2004.



Engineering and Development



Engineering and development
expenses principally include salaries for engineering and development personnel, depreciation of production and development assets, outside consulting fees and other development expenses. Engineering and development expenses for the three months
ended September 30, 2005 increased by approximately $449,000 to $2.4 million from approximately $2.0 million for the three months ended September 30, 2004. The increase in spending during the three months ended September 30, 2005,
reflected additional investment in product development through the increase in the engineering staff and planned controlled spending initiatives to further the development of technologies and corresponding new products.



Engineering and development expenses for the nine months ended September 30, 2005
increased by approximately $2.7 million to $7.9 million from $5.2 million for the nine months ended September 30, 2004. This increase in expenses during the nine months ended September 30, 2005 reflected the additional investment in
product development through increases in engineering staff and use of contract engineering services as well as planned controlled spending initiatives to further the development of technologies and corresponding new products.



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Sales and Marketing



Sales and marketing expenses principally include salaries, commissions, travel, tradeshows, and promotional materials, depreciation of demonstration units, bad debt and
warranty expenses. Sales and marketing expenses for the three months ended September 30, 2005 were $2.1 million, a decrease of approximately $1.5 million over the three months ended September 30, 2004, spending of $3.6 million. This
decrease over the same period in 2004 was primarily attributable to a decrease in the bad debt reserve and corresponding non-cash expense of approximately $1.3 million. The bad debt reserve was increased during the three months ended
September 30, 2004, due to slower than anticipated collections of international sales from the first half of 2004.



Sales and marketing expenses for the nine months ended September 30, 2005, totaled $6.7 million, a decrease of approximately $870,000 from $7.6 million for the nine
months ended September 30, 2004. The decrease over the comparable period in 2004 was primarily a result of a decrease in the bad debt reserve and corresponding non-cash expense of approximately $1.3 million. This decrease in bad debt expense
was partially offset by increases in additional staff in sales and marketing; increased cost for parts used in warranty repair; and additional warranty provisions recorded during the nine months ended September 30, 2005.



General and Administrative



General and administrative expenses principally include salaries, other compensation,
professional fees, facility rentals and information systems related to general management functions. General and administrative expenses for the three months ended September 30, 2005 decreased by approximately $366,000 to $598,000 from $964,000
for the three months ended September 30, 2004. The decrease in spending for the period was primarily attributable to no depreciation resulting from fully impaired assets, decreases in the annual premium of directors and officers insurance,
contract services and legal fees.



General and administrative expenses for the
nine months ended September 30, 2005, increased by approximately $376,000 to $3.1 million from $2.8 million for the nine months ended September 30, 2004. The increase in spending was primarily a result of a $446,000 severance and debt
forgiveness costs relating to the resignation of the Companys former Chief Executive Officer, James R. Green, during the nine months ended September 30, 2005.



Impairment of Long-Lived Assets



The Companys impairment analysis as of September 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 risk-free rate of interest of 3%. As a result, during the nine months ended September 30, 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 nine months ended September 20, 2004, no impairment charge was recorded because there were no events which occurred that required a measurement for impairment
during that period.



Other Income and Expense, net



Other income, net, for the three months ended September 30, 2005 was $520,000 as
compared to other income, net, of $2.9 million for the three months ended September 30, 2004. The decrease of approximately $2.4 million was primarily attributable to the $1.6 million gain in the forgiveness of debt associated with Jabil
Circuit, Inc., offset by $1.1 million of interest expense during the three months ended September 30, 2005, compared to $3.7 million gain in the forgiveness of debt associated with a vendor settlement with CIT Technologies Corporation
(CIT), offset by approximately $670,000 of interest expense during the three months ended September 30, 2004.



Other expense, net, for the nine months ended September 30, 2005 totaled $1.3 million, a decrease of $3.7 million as compared to other income, net, of $2.4 million
for the nine months ended September 30, 2004.The decrease in other income, net, was the result of $1.2 million increase in interest expense reflecting increased debt levels and a $2.9 million decrease in the gain realized from the
forgiveness of debt with certain vendors. During the nine months ended September 30, 2005, the Company realized $1.6 million gain from the forgiveness of debt with Jabil Circuit, Inc., compared to approximately $4.5 million gain from various
vendors, of which $3.7 million was from the CIT settlement during the third quarter of 2004.



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Provision for Income Taxes



No provision for income taxes was made for the three- and nine-month periods ending September 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 three months
ended September 30, 2005 was approximately $2.1 million, or $0.06 per diluted share, compared to net loss of approximately $2.1 million or $0.06 per diluted share for the three months ended September 30, 2004, for the reasons discussed
above. Net loss for the nine months ended September 30, 2005 approximated $16.6 million or $0.48 per diluted share basis compared to a net loss for the nine months ended September 30, 2004 of $6.0 million, or $0.19 per diluted share, for
the reasons stated above.



LIQUIDITY AND CAPITAL RESOURCES



As of September 30, 2005, the Companys unrestricted cash and cash equivalents
totaled approximately $671,000, a decrease of approximately $138,000 from December 31, 2004. As of September 30, 2005, the Companys working capital deficit was $44.4 million as compared to a working capital deficit of $31.9 million
at December 31, 2004. The Company had an accumulated deficit of approximately $131.9 million at September 30, 2005.



Beginning in the third quarter of 2001 and continuing through September 30, 2005, the Company experienced combined net losses of approximately $144.9 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, the Companys 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 product release schedules and attaining forecasted sales objectives.



The Company continues to have insufficient short-term resources for the payment of its current liabilities. During the nine months ended
September 30, 2005, the Company addressed this shortfall by obtaining financing from Optel. 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 November 4, 2005, the Company owed Optel approximately $44.6 million in principal plus accrued interest thereon, which debt is secured by a first priority security interest in substantially all of the
Companys 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 now due and payable on demand at any time after September 16, 2005;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Interest that accrues from September 17, 2005, to December 31, 2005, is 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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| |  |  | 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 $17.6 million from Optel on the following terms (the Short-Term Notes):
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $16.3 million plus accrued interest is currently payable on demand; and
| | - |  | -------------------------------------------------------------------------------------



| |  |  | $1.3 million plus accrued interest payable on demand at any time after September 30, 2005.
| | - |  | ------------------------------------------------------------------------------------------



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



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



On March 11, 2005, the Company issued 981,258 shares of common stock to Optel in connection with Optels conversion of $1.0 million of the indebtedness
outstanding under the Secured Convertible Promissory Note. As of November 4, 2005, the aggregate outstanding principal and accrued interest under the Secured Convertible Promissory Note was approximately $31.1 million, and the Applicable
Conversion Price was approximately $0.173 Accordingly, on November 4, 2005, Optel had the right to convert the Secured Convertible Promissory Note into an aggregate of 179,304,866 shares of common stock. Further, conversion by Optel of all or
any portion of the Secured Convertible Promissory Note could significantly dilute the ownership interests of the Companys stockholders, and give Optel and Dr. Zwan even greater control over the Company. If Optel converted all of the
indebtedness evidenced by the Secured Convertible Promissory Note, including principal and accrued interest, into shares of common stock on November 4, 2005 at a conversion price of $0.173 per share, Optel and other entities controlled by the
Companys largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan, would control, in the aggregate, approximately 89.4% of the then outstanding shares of common stock after giving effect to the
conversion.



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 was 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 the Companys behalf and naming MC Test Service, Inc. as beneficiary. MC Test Service, Inc. provides
outsourced manufacturing services to the Company. With the letter of credit in place, MC Test Service, Inc. has extended to the Company regular payment terms to pay for purchased production material. The letter of credit expires on December 30,
2005.



On August 31, 2005, the Company and Jabil entered into a Settlement
Agreement and Mutual Release (the Settlement Agreement) relating to an earlier Settlement Agreement (the 2004 Settlement) that the Company and Jabil entered into effective as of May 11, 2004. In connection with the 2004
Settlement, the Company executed and delivered to Jabil a purchase order, a promissory note in the original principal amount of approximately $3.0 million, and a second promissory note in the original principal amount of approximately $2.2 million.



In connection with the Settlement Agreement, and in view of the fact that the
Companys current manufacturing needs have changed, Jabil and the Company have agreed to amicably settle all outstanding principal and interest financial obligations between them relating to the 2004 Settlement. Under the terms of the
Settlement Agreement, Jabil returned to the Company approximately $810,000 in parts inventory and work-in-progress materials that had been purchased by the Company and warehoused at Jabil for Jabils use in the on-going manufacturing of the
Companys finished goods.



Pursuant to the Settlement Agreement, the
Company paid Jabil $1.9 million (the Settlement Payment) on August 31, 2005. The Company and Jabil exchanged mutual releases subject to specified exclusions and the Company picked up leftover parts inventory and work-in-progress
materials in Jabils possession on September 9, 2005.



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



The Companys ability to meet cash requirements and maintain sufficient liquidity over the next 12 months is dependent on its ability to obtain additional financing from funding sources which may include, but may
not be limited to, Optel. As of September 30, 2005, the Company had certain secured promissory notes in the amount of approximately $16.3 million plus accrued interest in the amount of approximately $900,000 that became due and payable on or
before September 30, 2005 and which are now payable on demand to Optel at any time. In addition, as of September 30, 2005, accrued interest of approximately $3.7 million became due and payable and is now payable on demand, and all of the
other outstanding debt owed by the Company to Optel in the amount of approximately $28.3 million plus accrued interest in the amount of approximately $129,000 will become due and payable on demand by Optel after December 31, 2005. If the
Company is not able to obtain financing, it expects that it will not have sufficient cash to fund its working capital and capital expenditure requirements for the near term and will not have the resources required for the payment of its current
liabilities when they become due. Optel currently continues to be the principal source of financing for the Company. The Company has not identified any funding source other than Optel that would be prepared to provide current or future financing to
the Company.



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



Operating Activities



Net cash used by operating activities for the nine months ended September 30, 2005 was approximately $11.1 million. This was primarily the result of loss from
operations of $16.6 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 $1.7 million
gain on settlement of debt, and a decrease in the provision for excess and obsolete inventory of approximately $475,000. The cash provided by accounts payable and accrued expenses totaled approximately $4.0 million resulted primarily from accrued
but unpaid interest expenses of $1.7 million; from unpaid trade accounts payable of approximately $1.0 million; and from the conversion of debt to stock of $1.0 million, which was applied first to accrued interest. Usage of on-hand inventory and
increase in prepaid expenses and other assets provided operating cash of $978,000 and $132,000, respectively. Accounts receivable used operating cash of approximately $1.7 million on net sales of approximately $10.4 million, as new customer billings
outpaced cash collections.



Investing Activities



Net cash used in investing activities for the nine months ended September 30, 2005 was
approximately $262,000. 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 nine months ended September 30, 2005 was approximately $11.3 million. This was primarily the result of proceeds of
$13.1 million from borrowings from Optel, offset by payments of $1.9 million made on notes payable to Jabil Circuit, Inc. in conjunction with scheduled payments as well as the Settlement Agreement (see Note 2  Inventories).



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Revolving Credit Facility



In April 2002, the Company entered into a Revolving Credit and Security Agreement (the Agreement) with Wachovia Bank (the
Bank). The Agreement expired on April 15, 2005. 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 is dependent upon the composition and maturity of the available collateral. An availability fee of 0.10% per annum is payable quarterly based on the Average Available Principal
Balance (as defined in the Agreement) for such three months. The Agreement 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 September 30, 2004, there were approximately $1.4 million of letters of credit outstanding under this facility
secured by approximately $1.4 million of the Companys cash and cash equivalents which were classified as restricted at September 30, 2004. As stated above and in Note 5  Revolving Credit Facility, the Agreement expired
April 15, 2005 and the Company has no borrowing capacity under this facility and accordingly no outstanding balance under this Agreement.



Legal Proceedings



The Company has no current litigation; however, 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.



|Item 4. | Controls and Procedures.
|------- | ------------------------



Our principal executive officer and principal financial officer evaluated the effectiveness of our disclosure controls and procedures pursuant to the Securities Exchange
Act of 1934, as amended (the Exchange Act), as defined in Rules 13a- 15(e) and 15d-15(e) under the Exchange Act, as of September 30, 2005. Based on this evaluation, our principal executive officer and principal financial officer
concluded that, as of September 30, 2005, our disclosure controls and procedures are not sufficiently effective pursuant to the future requirements of the Sarbanes-Oxley Act of 2002 to ensure that (1) information to be disclosed in reports
we file under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the rules and forms promulgated under the Exchange Act and (2) information required to be disclosed in reports filed under the
Exchange Act is accumulated and communicated to the principal executive officer and principal financial officer as appropriate to allow timely decisions regarding required disclosure. There were no changes in the Companys internal control over
financial reporting that occurred during the Companys last fiscal quarter that have materially affected or are reasonably likely to materially affect, the Companys internal control over financial reporting.In conjunction with our
procedures to implement the documentation and internal control requirements of the Sarbanes-Oxley Act of 2002 for companies of our size, we will initiate corrective actions necessary to address internal control deficiencies, and thereafter we will
continue to evaluate the effectiveness of our disclosure controls and internal controls and procedures on an ongoing basis, taking corrective action as appropriate.



PART II

OTHER INFORMATION



|Item 1. | Legal Proceedings.
|------- | ------------------



The Company has no current, pending, or threatened litigation that could have a material adverse effect on the Companys



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



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



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



Pursuant to the terms of the Secured Convertible Promissory Note, all or any portion of the debt is convertible into the Companys common stock at the option of Optel at any time. The conversion price is based upon the volume-weighted
average trading price of the Companys common stock during the five-day period preceding the date of any conversion. Further, as part of the conversion features approved by the disinterested stockholders at a special meeting of the stockholders
held on February 11, 2005, the Company is required to file a registration statement covering the offer and sale by Optel of the shares of common stock issuable upon conversion and to keep the registration statement effective until the date that
is two years after the date that such registration statement is declared effective.



As of November 4, 2005, the aggregate outstanding principal and accrued interest under the Secured Convertible Promissory Note was approximately $31.1 million, and the Applicable Conversion Price was approximately $0.173. Accordingly,
on November 4, 2005, Optel had the right to convert the Secured Convertible Promissory Note into an aggregate of 179,304,866 shares of common stock. Further, conversion by Optel of all or any portion of the Secured Convertible Promissory Note
could significantly dilute the ownership interests of our other stockholders, and give Optel and Dr. Zwan even greater control over the Company. If Optel converted all of the indebtedness evidenced by the Secured Convertible Promissory Note,
including principal and accrued interest, into shares of common stock on November 4, 2005 at a conversion price of $0.173 per share, Optel and other entities controlled by the Companys largest stockholder and current chairman of the board
of directors, Dr. Bryan J. Zwan, would control, in the aggregate, approximately 89.4% of the then outstanding shares of common stock after giving effect to the conversion.



|Item 3. | Defaults Upon Senior Securities.
|------- | --------------------------------



Not applicable.



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



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 26 of this report.



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SIGNATURES



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



Digital Lightwave, Inc.(Registrant)By:

/s/ ROBERT F. HUSSEYChief Executive Officer and President(Principal Executive Officer)Date: November 10, 2005By:

/s/ ROBERT F. HUSSEYChief Accounting Officer(Principal Financial Officer)Date: November 10, 2005




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EXHIBIT INDEX



|               |  |                                                                                                                                                                                                                                
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                    
|10.1*          |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on August 12, 2005 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on August 18, 2005).      
|               | 
|10.2*          |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on August 31, 2005 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on September 7, 2005).    
|               | 
|10.3*          |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on September 14, 2005 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on September 20, 2005).
|               | 
|10.4*          |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on September 29, 2005 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by the
Company on October 4, 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.                                                                                        

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

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



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