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

The following are the significant changes in our critical accounting estimates during the 12 months ended December 31, 2008, as compared to what was previously disclosed in Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2007.

Effective January 1, 2008, we adopted the provisions of Statement of Financial Accounting Standards ("FAS") No. 157, "Fair Value Measurements" ("FAS 157") and FAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" Including an amendment of FASB Statement No. 115" ("FAS 159"). As permitted by FAS 159, we have elected the fair value option for our ARS as of December 1, 2008. In conjunction with the adoption of FAS 159, the Company accounted for its unrealized loss on its ARS of $2.6 million in earnings in the year ended December 31, 2008. There is no cumulative effect of a change in accounting principle as a result of adoption of FAS 159 as there was no other comprehensive income/loss from ARS before the adoption of FAS 159.

We adopted a new reserve for allowance for doubtful accounts policy effective October 1, 2008. Management considers the new policy to represent more accurate estimates of doubtful accounts. As the result of the change in policy, we estimate the allowance for uncollectible trade receivable accounts by the specific identification method.

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.

We believe the following critical accounting policies affect management's more significant judgments and estimates used in the preparation of our Consolidated Financial Statements:

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", or 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, 2008 and 2007 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 2008 and 2007 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, 2008 and 2007, of approximately 4% and 6%, 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.

Allowances are provided for estimated returns and potential uncollectable trade receivable. 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, 2008 and 2007, respectively.

Income Taxes

The Company adopted the provisions of FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes" on January 1, 2007. FIN 48 prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The Company has determined the impact of the adoption of FIN 48 is insignificant to the Company's consolidated financial position, results of operations and cash flows.

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, 2008, we derived a substantial portion of our revenues from our connectivity product line. Our optical passive products contributed as a percentage of revenue 37% and 34% for the years ended December 31, 2008 and 2007, respectively. In the years ended December 31, 2008 and 2007, our top 10 customers comprised 62% and 58% of our revenues, respectively. One customer accounted for 16% and 17% of our revenues in 2008 and 2007, respectively. 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 2009.

Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in marketing, sales and technical support functions, as well as the costs associated with trade shows, promotional activities and travel expenses. We intend to continue to invest amounts similar to our spending levels in 2008 in our sales and marketing efforts, both domestically and internationally, in order to increase market awareness and to generate sales of our products. However, we cannot be certain that our expenditures will result in higher revenues. In addition, we believe our future success depends upon establishing successful relationships with a variety of key customers.

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 remain relatively flat due in part to continued emphasis on expense control.

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 $0.3 million and $0.7 million in 2008 and 2007, respectively.

Stock-based compensation expenses recognized under SFAS 123(R) were $0.2 million and $0.4 million for the year ended December 31, 2008 and 2007, 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, 2008, total unrecognized compensation costs related to stock purchase was $37,500, which is expected to be recognized as an expense over a weighted average period of approximately 4 months. 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.

Explanatory Note

The amount reported on our Condensed Consolidated Statement of Operations on Form 10-K under the captions "Income tax" ($199,000) and "Year ended net income" ($4,066,000) differs by approximately $79,000 from the corresponding amount previously reported in our press release issued on January 28, 2009 ("Press Release"). Subsequent to the issuance of our Press Release, we determined that our estimated California state income tax was not accurate due to the impact of a change in tax laws in California. We recorded a income tax expense of $79,000 as of December 31, 2008. Consequently, it decreased the year ended net income by $79,000.

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,
                                 --------------------------
                                        2008           2007
                                 ------------    ----------
Revenues                               100.0%        100.0%

Cost of revenues                         68.6          68.5
                                 ------------    ----------
  Gross profit                           31.4          31.5

Operating expenses:
   Research and development               8.6           9.5
   Sales and marketing                    6.2           7.0
   General and administrative             9.0          10.2
                                 ------------    ----------
     Total operating expenses            23.8          26.7

Income from operations                    7.6           4.8
Interest and other income, net            3.4           5.2
                                 ------------    ----------
Net income before tax                    11.0          10.0
Income tax                                0.5             -
                                 ------------    ----------

Net income                              10.5%         10.0%
                                 ------------    ----------

Results of Operations

Comparison of Fiscal Year 2008 and Fiscal Year 2007

Revenues. Revenues were $38.8 million and $33.8 million for the years ended December 31, 2008 and 2007, respectively. Connectivity products revenue increased to $24.5 million in 2008 from $22.5 million in 2007 primarily due to increased volume shipments of our products. Optical passive products revenue increased to $14.3 million in 2008 from $11.3 million in 2007, 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 2008 increased to $26.6 million from $23.2 million in fiscal year 2007. Cost of revenues as a percentage of net revenues increased to 68.6% in fiscal year 2008 from 68.5% in fiscal year 2007. The increase of cost of revenues in 2008 was due to increased volume of products sold.

Gross Profit. Gross profit for the year ended December 31, 2008 was $12.2 million, or 31.4% of revenues, compared with gross profit of $10.6 million, or 31.5% of revenues in fiscal year 2007. The connectivity products gross profit was $8.0 million for each of 2008 and 2007. The gross profit in 2008 for optical passive products increased to $3.8 million from $2.8 million in 2007. 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, 2008. We expect our gross profit as a percentage of revenues to remain the same as in 2008. However, our average selling prices are declining, which we believe will negatively impact our gross profit and may offset any benefits from improved absorption.

Research and Development Expenses. Research and development expenses increased to $3.3 million in fiscal year 2008 from $3.2 million in fiscal year 2007. As a percentage of revenues, research and development expenses decreased to 8.6% in 2008 from 9.5% in 2007 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.

General and Administrative Expenses. General and administrative expenses remained flat at $3.5 million in fiscal years 2008 and 2007. As a percentage of revenues, general and administrative expenses decreased to 9.0% in 2008 from 10.2% in 2007. We expect general and administrative expenses will remain relatively flat due in part to continued emphasis on expense control.

Stock-Based Compensation. Total stock-based compensation was $0.2 million and $0.4 million for the years ended December 31, 2008 and 2007, respectively. 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 these amounts represent stock-based compensation expenses related to employee stock options.

Interest and Other Income, Net. Interest and other income, net, was $1.3 million and $1.8 million for the years ended December 31, 2008 and 2007, respectively. These amounts consisted primarily of interest income, which fluctuated based on cash balances and changes in interest rates. The decrease in 2008 was due to lower interest income because of lower rates. The amounts also included a loss of $2.6 million to reduce the value of our ARS investments classified as trading securities, offet by a gain of $2.6 million from the estimated fair value of the ARS Right as of December 31, 2008.

Provision for Taxes. Our effective alternative minimum tax, or AMT, rate was 20% for federal and 6.7% for state in fiscal 2008. The tax expense was the result of estimated income tax accruals for fiscal 2008 and $50,000 AMT tax expenses for fiscal 2007.

Under a new California tax law, effective retroactively to the beginning of 2008, our net operating loss deduction was suspended for 2008 and 2009. Beginning in 2008, the carryforward period for NOLs is extended from 10 to 20 years. Beginning in 2011, we will be permitted to carry back NOLs for two years. Carrybacks will be limited to 50% of NOLs for 2011 and 75% for 2012. Full carrybacks will be allowed beginning in 2013. In addition, our utilization of tax credits is limited to 50% of tax liability in 2008 and 2009 as a result of the new law.

As of December 31, 2008, we had approximately $35.9 million and $20.4 million of net operating loss carryforwards for federal and state tax purposes, respectively, which will expire in 2022 for federal and in 2014 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.

Liquidity and Capital Resources

Comparison of Fiscal Year 2008 and Fiscal Year 2007

Net cash provided by operating activities was $4.4 million and $5.3 million in 2008 and 2007, respectively. The decrease in our cash provided by operations in 2008 was primarily due to an increase in inventory of $0.6 million, a decrease in accounts payable of $1.0 million and a decrease in accrued liabilities of $0.2 million, which was offset by an increase in net income of $0.7 million and a decrease in accounts receivable of $0.7 million. 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.

Cash provided by investing activities was $2.2 million in 2008 and cash used in investing activities was $5.8 million in 2007. In 2008, we spent $1.2 million to acquire property and equipment and the net proceeds from sale and maturity of short-term securities were $3.4 million. In 2007, we spent $1.2 million to acquire property and equipment and $4.6 million was invested in short-term securities.

Cash generated by financing activities was $0.4 million in 2008, compared with $0.8 million in 2007. Cash generated by financing activities in 2008 and 2007 was comprised of proceeds from the exercise of options to purchase shares of our common stock and common stock issued through our Employee Stock Purchase Plan. Cash generated by financing activities in 2007 was also comprised of borrowings under mortgage and equipment loans.

Our principal source of liquidity as of December 31, 2008 consisted of $24.0 million in cash and cash equivalents and interest bearing marketable securities. We also hold $16.3 million in ARS and associated Rights which are not saleable by us at the date hereof. Accordingly, we do not consider the ARS as sources of liquidity at this time. 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.

Contractual Obligations

Our long-term debt obligations are for principal and interest on mortgage and equipment loans from financial instruments in Taiwan.

In July 2004, we moved into our corporate headquarters in Sunnyvale, California. The lease has a six-year term commencing on July 22, 2004.

In Taiwan, we lease a total of approximately 38,800 square feet in one facility located in Tu-Cheng City, Taiwan. This lease expires at various times from December 2008 to January 2009. In December 2000, the Company purchased approximately 8,200 square feet of space immediately adjacent to the leased facility for $0.8 million, bringing the total square footage to approximately 47,000 square feet.

In July 2007, we renewed the lease for our 62,000 square foot facility in the Shenzhen area of China, which will expire in July 2012. In February 2007, we entered into a lease for an 8,200 square feet facility in Shenzhen, which lease will expire in January 2012.

The following summarizes our contractual obligations at December 31, 2008 (in thousands):

                                              Payments Due by Period
                              ------------------------------------------------------
                                         Less than                        More than
                                Total      1 year   1-3 years  4-5 years   5 years
                              ---------- ---------- ---------- ---------- ----------
Contractual Obligations
Long-Term Debt Obligations     $   583    $   149     $  220     $  167      $  47
Operating Lease Obligations      1,526        780        701         45          -
                              -------- - -------- - -------- - -------- - -------- -
Total                         $  2,109     $  929     $  921     $  212      $  47
                              -------- - -------- - -------- - -------- - -------- -

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements, as such term is defined in rules promulgated by the Securities and Exchange Commission, that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, . . .