The following discussion should be read in conjunction with our Consolidated Financial Statements and Notes thereto.

Recent Accounting Pronouncements

See Note 1 to the Consolidated Financial Statements for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on results of operations and financial condition, which is incorporated herein by reference.

Critical Accounting Policies and Estimates

General

Management's discussion and analysis of our financial condition and results of operations are based on our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, bad debts, inventories, asset impairments, income taxes, contingencies, and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values for assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Revenue Recognition

We follow SEC Staff Accounting Bulletin (SAB) No. 104, "Revenue Recognition in Financial Statements" for recognizing revenue. Specifically, we recognize revenues upon the shipment of our products to our customers provided that we have received a purchase order, the price is fixed, the collection of the resulting receivable is reasonably assured and transfer of title and risk of loss has occurred. Subsequent to the sale of our products, we have no obligation to provide any modification or customization, upgrades, enhancements, or post-contract customer support.

Stock-based Compensation Expense

On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment," ("SFAS 123(R)") which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors including stock options and purchases under our Employee Stock Purchase Plan based on estimated fair values. We adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of our fiscal year. Our Consolidated Financial Statements for the year ended December 31, 2007 and 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, our Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our Consolidated Statement of Operations. Prior to the adoption of SFAS 123(R), we accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123). As stock-based compensation expense recognized in the Consolidated Statement of Operations for the fiscal year 2007 and 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The estimated average forfeiture rates for the years ended December 31, 2007 and 2006, of approximately 6% and 10%, respectively, were based on historical forfeiture experience. In our pro forma information required under SFAS 123 for the periods prior to fiscal 2006, we accounted for forfeitures as they occurred. See Note 2 to the Consolidated Financial Statement for a further discussion on stock-based compensation.

Allowance for Doubtful Accounts

Allowances are provided for estimated returns. Provisions for return allowances are recorded at the time revenue is recognized based on our historical returns, current economic trends and changes in customer demand. Such allowances are adjusted periodically to reflect actual and anticipated experience. Material differences may result in the amount and timing of our revenue for any period if management made different judgments or utilized different estimates.

Inventory

Inventories are stated at the lower of cost or market, with cost being determined using standard cost, which approximates actual cost on a first-in, first-out basis. Market value is determined as the lower of replacement cost or net realizable value. Provisions are made for excess and obsolete inventory based on historical usage and management's estimates of future demand. Inventory reserves, once established, are only reversed upon sale or disposition of related inventory.

Valuation of Long-Lived Assets

We review the valuation of long-lived assets and assess the impairment of the assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable due to: significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of our use of the assets or the strategy for the overall business; and significant negative industry or economic trends. When we determine that the carrying value of long-lived assets may not be recoverable based on the existence of one or more of the above indicators of impairment, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. We did not record any asset impairment charge for the years ended December 31, 2007, 2006, and 2005, respectively.

We estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our Consolidated Balance Sheets. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in our Statements of Operations. To date, we have recorded a full allowance against our deferred tax assets as we believe it is more likely than not that such benefit will not be realized.

Overview

We were founded in December 1995 and commenced operations to design, manufacture and market fiber optic interconnect products, which we call our connectivity products, or what we previously called our OPMS products. We have broadened our connectivity product line to include attenuators, PLC, and fused fiber products. In early 1999, we started forming a new product line based in part on our proprietary technology. We started selling our optical passive products, or what we previously called our DWDM products, and other wavelength management products in July 2000. Since introduction, sales of Optical Passive products have fluctuated with the overall market for these products.

We market and sell our products predominantly through our direct sales force. From our inception through December 31, 2007, we derived a substantial portion of our revenues from our connectivity product line. Our optical passive products contributed as a percentage of revenue 34%, 39% and 33% for the years ended December 31, 2007, 2006 and 2005, respectively. In the years ended December 31, 2007, 2006 and 2005, our top 10 customers comprised 58%, 61%, and 57% of our revenues, respectively. One customer accounted for 17% of our revenues in 2007. Two customers accounted for 15% and 10% of our revenue in 2006. One customer accounted for 10% of our revenues in 2005.

Our cost of revenues consists of raw materials, components, direct labor, manufacturing overhead and production start-up costs. We expect that our cost of revenues as a percentage of revenues will fluctuate from period to period based on a number of factors including:

o changes in manufacturing volume;

o costs incurred in establishing additional manufacturing lines and facilities;

o inventory write-downs and impairment charges related to manufacturing assets;

o mix of products sold;

o changes in our pricing and pricing by our competitors;

o mix of sales channels through which our products are sold; and

o mix of domestic and international sales.

Research and development expenses consist primarily of salaries and related personnel expenses, fees paid to outside service providers, materials costs, test units, facilities, overhead and other expenses related to the design, development, testing and enhancement of our products. We expense our research and development costs as they are incurred. We believe that a significant level of investment for product research and development is required to remain competitive. We expect research and development expenses may increase as we intend to continue to invest in our research and product development efforts during 2008.

General and administrative expenses consist primarily of salaries and related expenses for executive, finance, administrative, accounting and human resources personnel, insurance and professional fees for legal and accounting support. We expect general and administrative expenses will increase in absolute dollar to support our revenue growth, higher insurance premiums, and costs associated with compliance with new laws and regulations.

In December 2005, we accelerated options to purchase up to 1.9 million shares of our common stock held by employees at the director level and above, including executive officers. The purpose of the accelerated vesting was to enable the Company to avoid recognizing any non-cash compensation expense associated with these options in future periods. As a result of the acceleration, we expect to avoid recognition of up to approximately $1.5 million of compensation expense over the course of the original vesting periods, including approximately $0.7 million and $0.4 million in 2007 and 2006, respectively.

Stock-based compensation expenses recognized under SFAS 123(R) were $0.4 million and $0.3 million for the year ended December 31, 2007 and 2006, respectively. These expenses were determined by the Binomial Lattice valuation model, and they are related to employee stock options and stock purchases through our employee stock purchase plan. As of December 31, 2007, total unrecognized compensation costs related to unvested stock options was $0.6 million, which is expected to be recognized as an expense over a weighted average period of approximately 2 years. Subsequent to the adoption of SFAS 123(R), we have not made any changes in the type of incentive equity instruments or added any performance conditions to the incentive options.

We own 98.5% of the outstanding common stock of Alliance Fiber Optic Products, Ltd (formally named Transian Technology Ltd. Co.), a Taiwan corporation. This majority owned subsidiary is engaged in design and manufacturing of our products.

In December 2000, we established a subsidiary, Alliance Fiber Optic Products, in the People's Republic of China, which we have developed as a manufacturing facility. We commenced production at this facility in the third quarter of 2003.

Results of Operations

The following table sets forth the relationship between various components of operations, stated as a percentage of revenues, for the periods indicated.

--------------------------------------------------------------------------------
                                    Years Ended December 31,
                                 -------------------------------
                                     2007       2006        2005
                                 --------   --------    --------
Revenues                           100.0%     100.0% .    100.0%

Cost of revenues                     68.5       72.3        78.1
                                 --------   --------    --------
  Gross profit                       31.5       27.7        21.9

Operating expenses:
   Research and development           9.5       11.5        16.4
   Sales and marketing                7.0        8.4        10.4
   General and administrative        10.2       11.5        14.3
                                 --------   --------    --------
     Total operating expenses        26.7       31.4        41.1

Income (loss) from operations         4.8      (3.7)      (19.2)
Interest and other income, net        5.2        6.2         6.7
                                 --------   --------    --------
Net income (loss)                   10.0%       2.5%     (12.5%)
                                 --------   --------    --------

Results of Operations

Comparison of Fiscal Year 2007 and Fiscal Year 2006

Revenues. Revenues were $33.8 million and $26.8 million for the years ended December 31, 2007 and 2006, respectively. Connectivity products revenue increased to $22.5 million in 2007 from $16.4 million in 2006 primarily due to increased volume shipments of our products. Optical passive products revenue increased to $11.3 million in 2007 from $10.4 million in 2006, primarily due to the increased acceptance of our products by our customers which resulted in higher volume shipments partially offset by lower average selling prices.

Cost of Revenues. Cost of revenues in fiscal year 2007 increased to $23.2 million from $19.4 million in fiscal year 2006. Cost of revenues as a percentage of net revenues decreased to 68.5% in fiscal year 2007 from 72.3% in fiscal year 2006. The increase of cost of revenues in 2007 was due to increased volume of products sold.

Gross Profit. Our 2007 gross profit was $10.6 million, or 31.5% of revenues, compared with a 2006 gross profit of $7.4 million, or 27.7% of revenues. The gross profit in 2007 for connectivity products increased to $8.0 million from $4.9 million in 2006. The gross profit in 2007 for optical passive products increased to $2.8 million from $2.5 million in 2006. Higher utilization of our factories as a result of increased volume shipments of our products resulted in an improved gross margin for the year ended December 31, 2007. We expect our gross profit as a percentage of revenues to continue to improve with higher production volumes, which we anticipate will result in improved absorption of overhead expenses. However, our average selling prices are declining, which will negatively impact our gross profit and may offset any benefits from improved absorption.

Research and Development Expenses. Research and development expenses increased to $3.2 million in fiscal year 2007 from $3.1 million in fiscal year 2006. As a percentage of revenues, research and development expenses decreased to 9.5% in 2007 from 11.5% in 2006 and the decrease was a result of increased revenue. The increase in absolute dollars was primarily due to increased headcount in Taiwan and increased material expenses. We expect research and development expenses on our product development efforts may increase as we intend to continue to invest in our research and product development efforts.

Sales and Marketing Expenses. Sales and marketing expenses remained flat at $2.3 million in fiscal years 2007 and 2006. As a percentage of revenues, sales and marketing expenses decreased to 7.0% in 2007 from 8.4% in 2006. We expect sales and marketing expenses will remain relatively flat due in part to continued emphasis on expense control.

General and Administrative Expenses. General and administrative expenses increased to $3.5 million in fiscal year 2007 from $3.1 million in fiscal year 2006. The increase was primarily due to an increase in compensation and employee benefits resulting from our growth. As a percentage of revenues, general and administrative expenses decreased to 10.2% in 2007 from 11.5% in 2006. We expect general and administrative expenses will increase due to higher costs associated with compliance with laws and regulations such as the Sarbanes-Oxley Act of 2002 and the regulations promulgated thereunder.

Interest and Other Income, Net. Interest and other income, net, was $1.8 million and $1.7 million for the years ended December 31, 2007 and 2006, respectively. These amounts consisted primarily of interest income, which fluctuated based on cash balances and changes in interest rates. The increase in 2007 was due to higher interest income.

Income Taxes. There was no income tax benefit in the years ended December 31, 2007 and 2006.

As of December 31, 2007, we had approximately $38.5 million and $20.4 million of net operating loss carryforwards for federal and state tax purposes, respectively, which will expire in 2021 for federal and in 2011 for state purposes, if not utilized. We have provided a full valuation allowance against our net deferred tax assets because realization of our deferred tax assets is uncertain due to our history of losses.

Comparison of Fiscal Year 2006 and Fiscal Year 2005

Revenues. Revenues were $26.8 million and $21.0 million for the years ended December 31, 2006 and 2005, respectively. Connectivity products revenue increased to $16.4 million in 2006 from $14.1 million in 2005 primarily due to increased volume shipments of our products. Optical passive products revenue increased to $10.4 million in 2006 from $6.9 million in 2005 primarily due to the increased acceptance of our products by our customers which resulted in higher volume shipments partially offset by lower average selling prices.

Cost of Revenues. Cost of revenues in fiscal year 2006 increased to $19.4 million from $16.4 million in fiscal year 2005. Cost of revenues as a percentage of net revenues decreased to 72.3% in fiscal year 2006 from 78.1% in fiscal year 2005. The increase of cost of revenues in 2006 was due to increased volume of products sold.

Gross Profit. Our 2006 gross profit was $7.4 million, or 27.7% of revenues, compared with a 2005 gross profit of $4.6 million, or 21.9% of revenues. The gross profit in fiscal year 2006 for connectivity products increased to $4.9 million from $4.5 million in 2005 and was also due to higher revenue. The gross profit in fiscal year 2006 for optical passive products increased to $2.5 million from $0.1 million in 2005 due to higher revenue from increased volume of shipments.

Research and Development Expenses. Research and development expenses decreased to $3.1 million in 2006 from $3.4 million in 2005. As a percentage of revenues, research and development expenses decreased to 11.5% in 2006 from 16.4% in 2005. The decrease was primarily due to reduced headcount in the United States and reduced material expenses.

Sales and Marketing Expenses. Sales and marketing expenses increased to $2.3 million in 2006 from $2.2 million in 2005. As a percentage of revenues, sales and marketing expenses decreased to 8.4% in 2006 from 10.4% in 2005. The increase in absolute dollars was due to higher commissions and professional fees as result of higher revenue

General and Administrative Expenses. General and administrative expenses increased to $3.1 million in 2006 from $3.0 million in 2005. As a percentage of revenues, general and administrative expenses decreased to 11.5% in 2006 from 14.3% in 2005. The increase in absolute dollars was primarily due to stock-based compensation expense resulting from the adoption of FAS 123R and other costs associated with being a public company.

Stock-Based Compensation. Total stock-based compensation was $0.3 million in the year ended December 31, 2006. Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123(R), determined by the Binomial Lattice valuation model as comparison, and this amount represents stock-based compensation expense related to employee stock options. There was no stock-based compensation expense in fiscal 2005 because the deferred compensation balance was fully amortized as of December 31, 2004.

Income Taxes. There was no income tax benefit in the years ended December 31, 2006 and 2005, respectively.

As of December 31, 2006, we had approximately $40.7 million and $22.4 million of net operating loss carryforwards for federal and state tax purposes, respectively, which will expire in 2021 for federal and in 2011 for state purposes, if not utilized.

Liquidity and Capital Resources

Comparison of Fiscal Year 2007 and Fiscal Year 2006

Net cash provided by operating activities was $5.3 million and $2.1 million in 2007 and 2006, respectively. The increase in our cash provided by operations in 2007 was primarily due to our net income of $3.4 million, an increase in accounts payable of $1.6 million, and an increase in accrued liabilities of $0.6 million which was offset by increase in accounts receivable of $1.3 million. The increase in our cash provided by operations in 2006 was primarily due to our net income of $0.7 million, an increase in accounts payable of $0.6 million, and an increase in accrued liabilities of $0.5 million which was offset by increase in accounts receivable of $0.5 million and increase in inventory of $0.8 million.

Cash used in investing activities was $5.8 million in 2007 and $1.1 million in 2006. In 2007, we spent $1.2 million to acquire property and equipment and $4.6 million was invested in short-term securities. In 2006, we spent $1.0 million to acquire property and equipment and $0.1 million was invested in short-term securities.

Cash generated by financing activities was $0.8 million in 2007, compared with $0.7 million in 2006. Cash generated by financing activities in 2007 and 2006 was comprised of proceeds from the exercise of options to purchase shares of our common stock, common stock issued through our Employee Stock Purchase Plan, and borrowings under mortgage and equipment loans.

At December 31, 2007, we had a letter of credit with a financial institution for $0.4 million. We pledged $0.4 million of our short-term investments as collateral for the letter of credit. Between November 2004 and September 2007, we entered into two mortgage loans of $0.7 million total with an interest rate of 3.20% and three equipment loans of $0.7 million total with an interest rate of 3.68% in Taiwan. The loans are secured by the building and equipment we own in Taiwan.

Our principal source of liquidity as of December 31, 2007 consisted of $36.5 million in cash and cash equivalents and interest bearing marketable securities. Of this amount, $16.4 million was held in auction rate securities collateralized by student loans and substantially guaranteed by the U.S. Department of Education. Subsequent to year end, six auctions have failed to totaling $8.1 million related to these securities. Continued auction failures could adversely impact our liquidity as we may not be able to sell these securities when we want to and may have to hold them until maturity between 2032 and 2046.

We believe that our current cash, cash equivalents and short-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, our future growth, including potential acquisitions, may require additional funding. If cash generated from operations is insufficient to satisfy our long-term liquidity requirements, we may need to raise capital through additional equity or debt financings, additional credit facilities, strategic relationships or other arrangements. If additional funds are raised through the issuance of securities, these securities could have rights, preferences and privileges senior to holders of common stock, and the terms of any debt facility could impose restrictions on our operations. The sale of additional equity or debt securities could result in additional dilution to our stockholders, and additional financing may not be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain additional financing, we may be required to reduce our research and development and marketing expenses. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish our rights to certain of our technologies or products. Our failure to raise capital when needed could harm our business, financial condition and operating results.

Net cash provided by operating activities was $2.1 million in 2006 and net cash used in operating activities was $1.8 million in 2005. The increase in our cash provided by operations in 2006 was primarily due to recording net income in 2006 versus a net loss in 2005, which was partially offset by higher accounts receivable and inventories. The higher accounts receivable and inventories were due to increase in sales in 2006.

Cash used in investing activities was $1.1 million in 2006 and $3.4 million in 2005. In 2006, we spent $1.0 million to acquire property and equipment and $0.1 million was invested in short-term securities. In 2005, we spent $0.7 million to acquire property and equipment and $2.7 million was invested in short-term securities.

Cash generated by financing activities was $0.7 million in 2006 compared with $0.6 million in 2005. Cash generated by financing activities in 2006 and 2005 . . .