Optelecom-NKF, Inc., developer of Siqura® advanced Internet Protocol (IP) video network solutions, is a global supplier of advanced video surveillance solutions, including IP cameras, video servers/codecs, network video recorders, fiber transmission equipment, video management and video analytics software. We deliver complete solutions for traffic monitoring and security of airports, seaports, casinos, prisons, utilities, public transit, city centers, hospitals, and corporate campuses.

Optelecom-NKF is committed to providing its customers with expert technical advice and support in addition to products that are developed and tested for professional and mission critical applications. All Optelecom-NKF IP surveillance solutions are marketed under the Siqura® name.

Our corporate headquarters is in Germantown, Maryland, USA, with European corporate offices in Gouda, the Netherlands, and sales offices or support covering Latin America, France, Spain, the UK, Germany, Italy, Dubai, and Singapore.

Optelecom-NKF provides competitively priced, highly reliable, top quality equipment and solutions, along with technical advice and support. All products are developed and tested for real applications, particularly those that need to operate in challenging environmental conditions and across large distances between individual transmission sites. We are ISO 9001:2000 certified and dedicated to the ongoing improvement of our products and processes, applying a high level of quality monitoring to increase customer satisfaction.

We sell our products worldwide through direct sales, commercial integrators and resellers. Management expects the primary sales channel to continue to be commercial integrators. In addition, several vendors incorporate the Company's products in their product offerings allowing the Company to penetrate markets we do not address directly.

The Company continues to focus its resources on developing additional IP products, sales and distribution channels. Service and technical support programs are in place to attract and maintain a large network of integration companies. The Company primarily attracts new customer contacts through participation in trade shows in both the security and traffic markets. Our web site (www.optelecom-nkf.com) has enabled the convenient and rapid dissemination of information required by our distribution channel personnel and other interested parties to gather information necessary to select our equipment.

The Company has expanded its focus to identify prospects that have a requirement for complete IP-video solutions including the Company's video codecs, Ethernet network equipment, network video recorders and video management software as well as a broad range of pre and post sales services such as design, detailed engineering and training. Internal training programs have been implemented and additional personnel hired to expand the in-depth knowledge of our worldwide sales and support offices.

We strive to continue improving our position as a leading producer and supplier of powerful, intelligent network video solutions by providing reliable and profitable products and services that enable customers around the world to reduce their total cost of ownership and enhance the effectiveness of their applications. Products for these markets are classified into the two broad categories of Video over IP and Video over Fiber.

Video over IP solutions are represented by the Siqura product line. The Siqura product line includes video servers / codecs, IP cameras, Ethernet switches, recording and storage equipment. Also, to bring together all these hardware components, Siqura software solutions, Operator Office™ and the Optelecom-NKF SDK, help the user consolidate a complete video network under one, easy-to-use management platform.

The Video over Fiber product line is comprised of the MC Series and the 9000 Series. The MC Series is designed for most common fiber applications and is recognized for its exceptional price-performance ratio. The 9000 Series is designed for the more complex and demanding Video over Fiber applications. The availability of 18 different wavelengths (CWDM technology) and the unique concept of using "option modules" are the core elements behind the versatility of the 9000 Series. The 9000 Series is about customization: wavelength availability and system functionality facilitate a wide range of fiber network configuration possibilities.

In addition to our two primary product categories of IP and Fiber Optics the Company operates an Electro Optics (EO) group focused on Interferometric Fiber Optic Gyro coils and manufacturing innovative optical devices under contract, primarily to government and defense industry customers.

Effect of Recent Market Conditions and Uncertain Macroeconomic Environment on our Business

Through the first nine months of fiscal 2008, our financial performance included higher levels of revenue and gross profit compared to the first nine months of 2007. We achieved 13% revenue growth during the first nine months of 2007 while gross profit increased from $17.5 million to $20.3. During the later part of 2008, however, our business began to experience the effects of worsening macroeconomic conditions, further aggravated by customer specific challenges and disruptions in the financial and credit markets globally. As economic conditions worsen globally, the effects on our business spread across our customer segments and geographies. Revenue was $11.8 million for the fourth quarter of 2008, representing a 10% decrease from our results in the fourth quarter of 2007.

Significant uncertainty around current macroeconomic and industry conditions persists, particularly the effect these conditions and any sustained lack of liquidity in the capital markets may have upon the capital spending of our customers. We are uncertain of the impact this may have on the spending or financial position of our customers. We can not be certain how long these conditions will continue and the magnitude of their effects on our business and results of operations. Consequently, these conditions have negatively affected our business and made our forecasting and planning more difficult. While we expect the near term market conditions to be challenging, we continue to believe in our longer term market opportunities. As a result, we intend to continue to invest in our business, prioritizing spending related to product development and sales efforts.

During this period of uncertainty, we plan to balance our strategy of continued investment for the long-term and manage our workforce and operating costs carefully to ensure that they are aligned with our business and market opportunities. To that end, during the fourth quarter of fiscal 2008, we

effected a targeted staff reduction which resulted in a restructuring charge of approximately $525 thousand in severance costs.

RESULTS OF OPERATIONS

Revenue for 2008 was $45.2 million, an increase of 6% when compared to 2007. Information regarding the Company's U.S. and international based operations is included in the following table. For the purposes of this table and the following discussion, revenue classified as U.S. based includes Canada, Mexico, Latin America, and South America:

                                         2008                                    2007
(Dollars in thousands)     U.S.      International     Total       U.S.      International     Total
Revenue                  $ 14,854    $       30,311   $ 45,165   $ 15,427    $       27,076   $ 42,503
Less: Cost of Goods         6,471            11,467     17,938      6,527            10,925     17,452
Sold

Gross Profit             $  8,383    $       18,844   $ 27,227   $  8,900    $       16,151   $ 25,051
Less: Operating             9,627            15,147     24,774      9,341            12,805     22,146
Expenses

(Loss) Income from       $ (1,244 )  $        3,697   $  2,453   $   (441 )  $        3,346   $  2,905
Operations

Our international operations include the impact from foreign currency translation. On average, the Dollar was weaker in 2008 compared to 2007. The result of a weakening Dollar as it relates to our consolidated financial results is that we translated Euro and Pound Sterling sales and related expenses at proportionally higher U.S. Dollar equivalents.

Overall, 2008 revenue and profits were driven by our international business. Revenue in our European based operations increased 12% to $30.3 million while international operating expenses increased 18% during the year. This results in an 11% increase in international operating profits which totaled $3.7 million in 2008. After considering the impact of foreign exchange rates the international revenue increase would have been 5% while the operating expenses would have increased 11%. Our strongest region is Northern Europe representing almost 37% of the Company's worldwide revenue.

Revenue in our U.S. based operations was down slightly at $14.9 million in 2008. U.S. operating expenses increased 3% during the year. The result is an increased U.S. loss from operations in 2008 totaling $1.2 million. In the U.S., the largest portion of our business is on the East coast. The Mid-Atlantic, Northeast and Southeast collectively represent about 68% of the total U.S. business.

Revenue by product category in the recent two year period was:

                    (Dollars in thousands)     2008       2007
                    Fiber Optic              $ 29,891   $ 31,107
                    IP Video                   14,539     10,305
                    Electro Optics                735      1,091

                    Total Revenue            $ 45,165   $ 42,503

The Company made significant progress in a transition to accommodate an industry-wide shift from video transmission over fiber optics to video over IP/Ethernet based solutions. Fiber Optic products sales in 2008 were down 4% to $29.9 million. This decline is attributed to the market shift away from Fiber Optic and toward IP Video products which accelerated toward the end of 2008. In recent years, the Company has invested heavily in IP Video products. The result is an increase of 41% in IP related revenue in 2008 over 2007. This includes strong demand and growth in sales of our Codecs, Cameras, and NVR's.

Gross profit in 2008 was $27.2 million and 60% of sales. After considering the impact of foreign exchange rates this is an increase of $1.0 million versus 2007 when gross profit margins were slightly

lower at 59%. The current year increase is directly attributable to the growth in revenues in our international operations and efficiency realized in our manufacturing process.

Our operating expense increased during 2008 to $24.8 million from $22.1 million in 2007. The current year increase of $2.6 million includes additional personnel and costs in the sales and marketing function totaling $1.3 million and in the engineering function totaling $863 thousand. These increased costs are part of the Company's effort to transition its products and related sales effort toward the IP Video market, specifically the Siqura product suite. The increase in operating expenses in 2008 also includes a $525 thousand fourth quarter charge for severance accruals as we completed a reduction in force at year-end. The reduction was initiated to eliminate costs in mature product areas while continuing to allow for critical investments in our growing Video over IP products.

OTHER INCOME (EXPENSE)

Other expense declined in 2008 to $1.0 million compared to a total of $1.2 million in 2007. Substantially all of our other expense is from interest expense and foreign exchange losses. Interest expense on long term notes was $734 thousand in 2008 and $1.1 million in 2007 as we paid down our bank term debt and interest rates declined during the recent year. Our foreign exchange loss in 2008 was $262 thousand compared to $108 thousand in 2007 as a result of larger than normal foreign exchange rate fluctuations in the past year.

In June 2008, the Company implemented a new European holding company structure in the Netherlands. The restructuring included the transfer of our Dutch operating subsidiary (Optelecom-NKF B.V.) from the U.S. parent company to the new European holding company. Consideration for the transfer included an intercompany noted receivable to the U.S. parent and a corresponding note payable from the European holding company. The impact from the fluctuations in foreign exchange on the intercompany note payable is included in other income (expense).

Additionally, there is an impact from the fluctuations in foreign exchange on both the 7.3 million Euro-based Subordinated Note and related accrued interest residing on the U.S. parent company's books issued to Draka Holding, N.V. as part of the consideration during the acquisition of NKF. Prior to the aforementioned restructuring, the foreign exchange impact was included in comprehensive income (loss) as the note was identified as a hedge against the investment in NKF. As a result of that investment being transferred to the European holding company, the impact from the change in foreign exchange on the Subordinated Note and related accrued interest is now included in other income (expense).

INCOME TAXES

The provision for income taxes in 2008 was $3.2 million compared to $388 thousand in 2007. The higher tax expense in 2008 was attributed primarily to the Company's decision to record a full valuation allowance of our U.S. deferred tax assets. In evaluating the Company's ability to recover its deferred tax assets, we considered all available positive and negative evidence, including past operating results, the reversal of temporary differences, the forecasts of future taxable income and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income. Based on the weight of the positive and negative evidence and the information available, management concluded that it is not more likely than not that its US deferred tax assets will be realized and therefore recorded a valuation allowance of $3.0 million as of December 31, 2008. This one time charge does not impact the Company's liquidity, cash or core operations in the fourth quarter of 2008. The valuation allowance recorded against the deferred tax assets was $3.0 million and resulted from tax assets accumulated over a period of years in our U.S. operations. These deferred tax assets are still available for tax purposes to offset potential U.S. tax expense in the future. As a result of the write-down of deferred tax assets, we will no longer record income tax credits against potential U.S. operating losses beginning January 1, 2009. Excluding the

write-down our tax expense for 2008 was $347 thousand and comparable to the $388 thousand recorded in 2007. The effective tax rate excluding this charge is 24% in 2008 compared to 23% in 2007.

Impact of Inflation

Inflation did not have a significant effect on the operations of the Company during 2008 or 2007, and we do not expect it to have a significant effect during 2009.

FINANCIAL CONDITION

Total assets were $47.1 million at December 31, 2008, a decrease of $2.8 million from year-end 2007. The decline is primarily from the write-down of deferred tax assets of $3.0 million. At December 31, 2008, the Company had cash on hand of $5.7 million. The cash is held in our international business in Euros and the amount reported is impacted by changes in foreign exchange rates. The increase in cash was $628 thousand as compared to December 31, 2007, and primarily resulted from our international operations generating positive cash flow from operations.

Inventory balances increased during 2008 with increased sales in our IP Video product line. Also, the Company continued to keep additional inventory on hand which was used to provide greater in-stock items to meet the delivery needs of our customers. The following shows the composition of inventory for the past two years:

                   (Dollars in thousands)        2008      2007
                   Production materials         $ 4,164   $ 3,187
                   Work in process                  745       801
                   Finished goods                 1,552     1,976
                   Allowance for obsolescence      (679 )    (750 )

                   Total inventories, net       $ 5,782   $ 5,214

Total liabilities at year-end 2008 were $26.0 million, a $905 thousand decline from year-end 2007. The decline is primarily driven by a reduction in debt of $2.5 million offset by smaller increases in several areas including accounts payable, other current liabilities and taxes payable. This decrease in debt is primarily from a decline in our bank line of credit subsequent to our financial restructuring at June 30, 2008, combined with reductions in notes payable as we continued to make monthly principal payments during the year on our bank term debt.

In June 2008, the Company implemented a new European holding company structure in the Netherlands which provides a more flexible corporate structure. The Company established a new Dutch entity that is a subsidiary of the U.S. parent company and holds all of the Company's international subsidiaries. The new structure is intended to facilitate enhanced management of international operations and improvements in cash management and income tax planning. The Company and its bank also agreed on an extension of the due date on the senior term facility from March 2009 to September 2009 with an opportunity for an additional extension through March 2011 if certain criteria are met by the Company. The balance and interest rate on the term debt were not changed in the restructuring, however, the debt is now included in the European holding company rather than the U.S. parent company.

The Company's stockholders' equity decreased from $23.1 million at December 31, 2007, to $21.2 million at December 31, 2008, a decline of 8%. This decrease is from a net loss of $1.8 million in 2008 driven by the full valuation allowance recorded against its deferred tax assets during the fourth quarter of 2008. The full valuation allowance against total deferred tax assets was somewhat offset by operating profits during the year. Within our stockholders equity, the additional paid-in capital increased by $718 thousand as a result of stock compensation expense while the accumulated other comprehensive gain declined $872 thousand from unrecognized foreign exchange loss between the Euro and U.S. Dollar during 2008.

LIQUIDITY AND CAPITAL RESOURCES

The Company's operating activities provided positive cash flow of $3.7 million in 2008. This is because $1.8 million net loss during 2008 was more than offset by approximately $4.7 million in non cash expenses and a net increase in changes in assets and liabilities of $803 thousand. The $4.7 million in non cash expenses includes $1.7 million in depreciation and amortization, $670 thousand in stock based compensation expense and a $2.3 million decline in the balance of deferred tax assets in 2008. The $803 thousand of changes in assets and liabilities is due to an increase in the balance of accounts payable and other accrued expenses which is somewhat offset by increased balances in accounts receivable and inventory at year-end 2008.

Cash used in investing activities consists predominately of capital expenditures. In 2008 the Company decreased its spending for capital expenditures by $550 thousand compared to an increase in capital expenditures of $1.0 million during 2007. The Company's capital expenditures include a portion which is discretionary in the short term. This portion generally relates to technology systems, expanding product capabilities and improving infrastructure.

During 2008, cash used in financing activities was $2.5 million compared to $1.3 million used in 2007. The current year use of cash is from $1.5 million of payments on our notes payable and $1.0 million of payments against our line of credit in the U.S. The reduction of our line of credit was immediately subsequent to our June 2008 corporate restructuring.

Under its current banking facility, the Company has the ability to borrow up to $5.0 million, provided there are sufficient accounts receivable and inventory. This facility allows the Company to borrow in either U.S. Dollars or Euros. The borrowing base under the facility is between 60% - 85% of the eligible commercial billed accounts receivable and 30% of eligible related inventory. The revolving line of credit carries interest at the rate of LIBOR plus a margin that can range from 1.75% to 2.75% depending on the Company's leverage position. As of December 31, 2008, the Company had no outstanding borrowings on its bank line-of-credit, which is a $1.0 million decrease from the prior year-end. The largest amount outstanding on this bank line-of-credit during the year ended December 31, 2008, was $1.7 million. The Company is required by the bank to comply with certain financial covenants, including maintaining a maximum senior debt coverage ratio and a minimum fixed charge coverage ratio. The Company was in compliance with the financial covenants at December 31, 2008. Failure to meet the financial and other restrictive covenants contained in our debt facilities could limit our ability to engage in activities that may be in our long-term best interests, and our failure to comply with those covenants could result in an event of default which, if not cured or waived, could result in the acceleration of all of our debt.

We plan to finance our future working capital needs with our operating cash flow and use of our line-of-credit as needed. In the event these sources become insufficient to meet funding needs, the Company may be required to scale back sales and marketing expenses, product research and development costs, and overhead costs. Additionally, the Company would pursue an increase in its line of credit, additional debt or equity financing, and/or make dividend payments from its European operations. Dividends from international operations could result in an increased tax liability and tax expense to the Company.

The current economic environment is marked by significant instability with limited availability of credit in the business sector. With a global slowdown and reduced spending, continued weakness is expected as the job markets weaken and consumer confidence is low. Businesses are reporting declines in orders as a result of stricter lending standards. The manufacturing index reported a meaningful drop as the current year progressed and manufacturers reduced orders. This level indicates a contraction in the manufacturing sector that is consistent with a recession.

The Company experienced a net loss in 2008 and if losses were to continue the liquidity of our business could be adversely impacted. This may result in a reduction in our ability to secure additional financing opportunities. If we are able to secure additional financing under these circumstances the cost could be prohibitive. Our net operating losses were primarily from U.S. operations, which have experienced negative operating cash flow in certain recent periods.

We continue to work toward refinancing our senior and subordinated debt obligations which come due in September 2009 and March 2010, respectively. The Company is actively pursuing a senior credit facility from a Bank to finance some or all of this outstanding debt. However, there is no guarantee that senior bank financing will be available for all or part of our outstanding debt. As a result, the Company may need to pursue non-Bank financing which could result in significantly higher financing costs going forward.

NEW ACCOUNTING STANDARDS

In December 2007, the Financial Accounting Standards Board issued Statement
141 (revised 2007), Business Combinations (Statement 141R) to change how an entity accounts for the acquisition of a business. Statement 141R replaces existing Statement 141 in its entirety. Statement 141R carries forward the existing requirements to account for all business combinations using the acquisition method (formerly called the purchase method). In general, Statement 141R requires acquisition-date fair value measurement of identifiable assets acquired, liabilities assumed, and noncontrolling interests in the acquiree. Statement 141R eliminates the current cost-based purchase method under Statement 141. Statement 141R is effective for fiscal years and interim periods within those fiscal years beginning on or after December 15, 2008. Early adoption is prohibited. The Company adopted Statement 141R effective January 1, 2009 and will apply its provisions prospectively. The adoption of Statement 141R will have no material impact on the Company's financial statements.

Statement 141R amends the goodwill impairment test requirements in Statement
142. For a goodwill impairment test as of a date after the effective date of Statement 141R, the value of the reporting unit and the amount of implied goodwill, calculated in the second step of the test, will be determined in accordance with the measurement and recognition guidance on accounting for business combinations under Statement 141R. This change could effect the determination of what amount, if any, should be recognized as an impairment loss for goodwill recorded before the effective date of Statement 141R. This accounting will be required when Statement 141R becomes effective (January 1, 2009 for the Company) and applies to goodwill related to acquisitions accounted for originally under Statement 141 as well as those accounted for under Statement 141R.

The Company has $14.6 million of goodwill at December 31, 2008, related to a previous business combination. The Company has not determined what effect, if any, Statement 141R will have on the results of its impairment testing subsequent to December 31, 2008.

In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements-An Amendment of ARB No. 51" ("SFAS 160"). SFAS 160 establishes new accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008. As the Company has no noncontrolling interest in a subsidiary, it does not believe the adoption of this statement will have a material effect on its financial condition, results of operations and cash flows.

In March 2008, the FASB issued SFAS No. 161, "Disclosures About Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133" ("SFAS 161"). SFAS 161 expands quarterly disclosure requirements in SFAS No. 133 about an entity's derivative instruments and hedging activities. SFAS 161 is effective for fiscal years beginning after November 15, 2008. As the Company has no derivative instruments and does not currently participate in any hedging activities, it does not

believe the adoption of this statement will have a material effect on its . . .