RESULTS OF OPERATIONS

You should read this discussion together with the consolidated financial statements and other financial information elsewhere in this Form 10-K.

Overview

PECO II, Inc. was organized in 1988 for the purpose of acquiring the assets of ITT's communications power product business. Today, we provide solutions to our telecommunications customers through a variety of products and services in order to meet their cost, quality, productivity and capacity challenges. As part of this process, we design and manufacture communications specific power products. We also provide on-site E&I, systems integration,

installation, maintenance, and monitor services to our customers. Our power systems provide a primary supply of power to support the infrastructure of communications service providers, including local exchange carriers, long distance carriers, wireless service providers, internet service providers and broadband access providers. Our power distribution equipment directs this power to specific customer communications equipment. Our systems integration business provides complete built-to-order communications systems assembled and installed pursuant to customer specifications and incorporating other manufacturers' products.

Market conditions remain uncertain and difficult. In the recent past, several of our customers have engaged in mergers, acquisitions and divestitures, such as SBC acquiring AT&T, AT&T acquiring Bell South and Cingular, Alltel acquiring Western Wireless, and Sprint acquiring NEXTEL. Also, both Sprint Nextel and Alltel spun off their local wireline businesses to focus on their core wireless businesses. Recently Verizon has concluded its purchase of Alltel, AT&T has announced its intention to acquire Centennial, and Century Tel is planning to merge with Embarq. Currently, major wireline companies are focusing their capital expenditure spending on FTTC (fiber to the curb) and FTTN (fiber to the node) for both broadband and video services distribution, while wireless companies are focusing their capital expenditure spending on migration of acquired systems to the standards of the acquiring carrier, integrating networks, improving area coverage, deploying 3G data services and have begun to announce plans to deploy WIMAX and LTE networks.

While the telecommunications market is extremely volatile, capital expenditure spending has expanded by the mid single digits in 2008 and analysts, given the economic uncertainty, are unsure regarding capital expenditure levels for 2009. The current economic environment is causing many companies to forecast a downturn in spending in the near future. Notwithstanding this possible slowdown, we believe that our capabilities, combined with our market position, will afford us the opportunity to take market share even in a slowing economy.

In 2008, we targeted the capital expenditure growth in the wireless market. We successfully ramped the midsized power products, which serve the wireless base station market, including both cabinet and hut applications. The midsized product platforms are standardized at 3 wireless operators. We believe our market share grew in 2008 given the overall product business revenue growth year over year.

Our R&D investment extended beyond traditional cell site applications. In June, we introduced our new small power platform at the NXTcomm08 trade show in Las Vegas. The Quantum™ Power System positions us as a player in the shelf power market segment and the fast growing outside plant broadband market. According to industry analyst Skyline Marketing, the size of this power market segment in the United States is estimated to be $269 million in 2008, reaching $450 million by 2011.

The Quantum platform is a 48-volt DC power system that combines high-density rectifiers, distribution and control in a sleek, low-profile shelf for optimized value to telecom carriers deploying FTTN and traditional wireline architectures. Designed for the harsh outside plant environment, the Quantum system's small footprint makes it ideal for cabinets where rack space is at a premium.

The Quantum Power System has several distinctive features that optimize the user experience. Our innovative QuickLoadÔ feature enables the technician to rapidly configure the system. The system controller features a technician-friendly input control device and a display that can easily be read in difficult outdoor conditions. The rectifiers include our unique I-ViewÔ faceplate indicators that report rectifier current and load-sharing status.

During the third quarter, we continued to develop features for the Quantum Power System. New developments included additional distribution options and configurations that enabled the product to be deployed in more diverse applications. First orders and subsequent installations for the Quantum Power System were received from a major wireline carrier. The Quantum system will be deployed in two applications to power different network elements. Additionally, systems were quoted to 10 other customers during the third quarter. Lastly, we augmented our field sales team by adding a seasoned veteran in the Tier II and nontraditional service provider markets resulting in a marked increase in quoting opportunities over the last four weeks of the third quarter with the trend continuing into the first half of the fourth quarter.

We also introduced the high-capacity 5069HC BDFB (battery distribution fuse bay) in September 2008. The 5069HC is a modular power distribution solution offering 66% improvement in current capacity. The 5069HC features an industry-leading 1000 Amps per panel, enabling telecom power engineers to significantly lower the cost of powering and cabling new high-power network elements such as routers, optical equipment and broadband delivery systems. The 5069HC also achieved NEBS certification during the quarter.

During the third quarter 2008, we achieved TL9000 recertification. The certification process included evaluation of our core business processes based on TL9000 Quality Management System Requirements Release 4.0, an upgrade over previous assessments. The TL9000 standard defines the telecommunications quality system requirements for the design development, production, delivery, installation and maintenance of products and services.

Our Services group focused on hardening our solution portfolio to meet the power needs of our Tier I customer base. The revenue decline in 2008 was driven by reduced spending at two of our major customers. During the fourth quarter of 2008, we were notified of a contract renewal with a major Tier I customer. This renewal included a major expansion of work to be performed by us.

Our Services division continues to provide multi-vendor engineering and installation services for all major power product brands. This capability is both respected and valued in the marketplace. Our strong power E&I services reputation has provided many opportunities for introducing new power products as well as a real user feedback channel on deployed products. This feedback continues to aid us with designing and improving products to meet the industry evolving needs.

Looking forward, we will continue to focus our efforts on delivering the service solutions our customers have come to expect from working with PECO II. This dedication has enabled us to minimize customer turnover. We will continue to expand our Services footprint on those opportunities that make the best utilization of our current available resources, and/or those that position us for success as our industry matures to the next level.

Critical Accounting Policies and Estimates

In preparing our financial statements and accounting for the underlying transactions and balances, we applied the accounting policies disclosed in the Notes to the Consolidated Financial Statements. Preparation of our financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Although we believe our estimates and assumptions are reasonable, they are based on information presently available and actual results may differ significantly from those estimates.

We consider the estimates discussed below as critical to an understanding of our financial statements because they place the most significant demands on management's judgment about the effect of matters that are inherently uncertain, and the impact of different estimates or assumptions is material to our financial condition or results of operations. Specific risks for these critical accounting estimates are described in the following paragraphs. The impact and any associated risks related to these estimates are discussed throughout this discussion and analysis where such estimates affect reported and expected financial results.

For a detailed discussion of the application of these and other accounting policies, see Note 1 to the Consolidated Financial Statements. Management has discussed the development and selection of the critical accounting policies and the related disclosure included herein with the Audit Committee of the Board of Directors.

Revenue Recognition

Product revenues are recognized when customer orders are completed and shipped, title passes to the customer and collection is reasonably assured. Product sales sometimes include multiple items including services such as installation. In such instances, product revenue is not recognized until installation is complete and the product is made available for customer use. Services revenues on engineering and installation contracts and the costs for services performed are primarily recorded as the work progresses on a percentage of completion basis. Management believes that all relevant criteria and conditions are considered when recognizing sales.

Impairment of Long-Lived Assets

We assess the impairment of long-lived assets, which include intangible assets, goodwill, and plant and equipment, whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered important that could trigger an impairment review include, but are not limited to, the following:

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Sustained underperformance relative to expected historical or projected future operating results;

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Changes in the manner of use of the assets, their physical condition or the strategy for the Company's overall business;

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Negative industry or economic trends;

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Declines in stock price of an investment for a sustained period;

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The Company's market capitalization relative to net book value;

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A more-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit, or a long-lived asset will be sold or otherwise disposed of, significantly before the end of its previously estimated useful life;

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A significant decrease in the market price of a long-lived asset;

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A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset, including an adverse action or assessment by a regulator;

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An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset;

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A current period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset;

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Unanticipated competition; and

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A loss of key personnel.

Goodwill and indefinite-lived intangibles are required to be evaluated for impairment on an annual basis, or more frequently if impairment indicators arise, using a fair-value-based test that compares the fair value of the asset to its carrying value. Fair values are typically calculated using discounted expected future cash flows using a risk-adjusted discount rate.

Product and Services Goodwill

Goodwill represents the excess of the purchase price paid over the value of net tangible and identifiable intangible assets of businesses acquired. Goodwill is not amortized, but instead is tested for impairment on an annual basis or more frequently if impairment indications arise.

During the fourth quarter of each year, the Company performs the annual impairment test. During 2007, the Company recognized an impairment charge of $4.4 million related to the product segment goodwill. The impairment charge was due to the decline in the PECO II stock price in 2007, combined with the continued weakness in carrier spending for the wireless segment, the product goodwill recognized as part of the Delta acquisition is fully impaired. During 2008, the Company recognized an impairment charge of $1.5 million related to the services segment goodwill. The impairment charge was due to the continued weakness in carrier spending for the wireless segment, the services goodwill recognized as part of previous acquisitions is fully impaired.

Inventory Valuation

Inventories are stated at the lower of cost or market with cost determined by the first-in, first-out method. Inventory costs consist of purchased product, internal and external manufacturing costs, and freight. Management regularly reviews inventory for obsolescence or excessive quantities and records an allowance accordingly. Various factors are considered in making this determination, including recent usage history, forecasted usage and market conditions.

We continually review the inventory for obsolescence or excessive quantities and accrue accordingly. At a minimum, all part numbers are reviewed quarterly. We identify potential obsolete or excess inventory by identifying parts with no usage for a year and excess parts greater than the last twelve month usage or two times future six month requirements, whichever is greater. Management reviews the inventory identified as potentially obsolete or excess to determine the appropriate allowance.

Deferred Taxes

We record income taxes under the asset and liability method. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our deferred tax assets.

Our ability to realize deferred tax assets is primarily dependent on the future taxable income of the taxable entity to which the deferred tax asset relates. We evaluate all available evidence to determine whether it is more likely than not that some portion or the entire deferred income tax asset will not be realized.

Share-Based Compensation

Determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. The assumptions used in calculating the fair value of share-based payment awards represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be different in the future.

Under the fair value recognition provisions, we recognize stock-based compensation expense net of an estimated forfeiture rate and only recognize compensation expense for those shares expected to vest over the requisite service period of the award. If our actual forfeiture rate is materially different from our estimate, our stock-based compensation expense could be significantly different from what we have recorded in the current period.

Results of Operations

The following table shows, for the periods indicated, selected items and the percentage of net sales from our consolidated statement of operations.

                                                       Year Ended December 31,
                                                   2008                       2007
 Net sales:
   Product                                 $ 31,554        75.6 %     $ 26,683        71.2 %
   Services                                  10,189        24.4 %       10,774        28.8 %
                                             41,743       100.0 %       37,457       100.0 %
 Cost of goods sold:
   Product                                   26,552        63.6 %       23,113        61.7 %
   Services                                   8,307        19.9 %        8,556        22.8 %
   Asset impairments                              -           -           (453 )      (1.2 % )
   Obsolete inventory write-off               2,146         5.1 %          399         1.1
                                             37,005        88.6 %       31,615        84.4 %

 Gross margin                                 4,738        11.4 %        5,842        15.6 %

 Operating expenses:
   Research, development and engineering      2,353         5.6 %        2,296         6.1 %
   Selling, general and administrative        8,512        20.4 %        8,506        22.7 %
   Impairment of goodwill                     1,503         3.6 %        4,426        11.8 %
   Impairment of idle facility                  200         0.5 %          220         0.6 %
                                             12,568        30.1 %       15,448        41.2 %
 Loss from operations                        (7,830 )     (18.7 % )     (9,606 )     (25.6 % )
 Interest income, net                           171         0.4 %          416         1.1 %
 Loss before income taxes                    (7,659 )     (18.3 % )     (9,190 )     (24.5 % )
 Income tax expense                             (45 )     ( 0.1 % )        (43 )     ( 0.1 % )
 Net loss                                  $ (7,704 )     (18.4 % )   $ (9,233 )     (24.6 % )

Net Sales. Net sales increased $4.3 million, or 11.4%, to $41.7 million for the year ended December 31, 2008 from $37.5 million for the year ended December 31, 2007. This increase was driven primarily by taking market share in the wireless cell site market. The lead times that customers require to deliver product to meet their needs is being shortened. The Company focuses its responsiveness capability on meeting these shortened intervals with a high degree of reliability. We believe that the product revenue growth in 2008 is directly attributed to the execution of this strategy. Additionally, during the fourth quarter of 2008, we were awarded new services work with a major service provider, which positions the services business for growth in 2009.

Net sales in our product segment increased by $4.9 million, with the result being $31.6 million for the year ended December 31, 2008 as compared to $26.7 million for year ended December 31, 2007. This increase, as previously discussed, was primarily driven by taking market share with reliable responsiveness to delivery dates. New products, defined as those sold within the first 18 months of product introduction, accounted for 29% of our total product revenues in 2008. As of December 31, 2008, our product backlog, which represents total dollar volume of firm sales orders not yet recognized as revenue, had decreased to $1.9 million from $3.8 million at December 31, 2007.

Net sales in our services segment decreased by $0.6 million, resulting in $10.2 million for year ended December 31, 2008 as compared with $10.8 million for year ended December 31, 2007. The decrease in revenues was primarily driven by one key customer's delayed rollout of its 2008 program as discussed in our First Quarter 2008 Form 10-Q. As of December 31, 2008, our services backlog, which represents total dollar volume of firm sales orders not yet recognized as revenue, was $0.6 million, or flat with the year ended December 31, 2007.

Gross Margin. Gross margin dollars decreased to $4.7 million in 2008 as compared to a $5.8 million in 2007. Gross margin as a percentage of net sales decreased to 11.4% in 2008 as compared to 15.6% in 2007. This decrease included a charge of $2.1 million for obsolete and slow-moving inventory. This charge resulted from the completion of our strategic outsourcing initiative combined with product rationalization of our Legacy products. Adjusting for the obsolescence charges noted above, gross margins for 2008 were slightly better than 2007.

The product gross margin decreased to $2.9 million in 2008 as compared to $3.6 million in 2007. Product gross margin, as a percentage of product sales, decreased to 9.1% in 2008, compared to 13.6% in 2007, which included the impacts of the obsolescence charges noted above.

The services segment gross margin decreased to $1.9 million in 2008 as compared with the $2.2 million in 2007. Services gross margin as a percentage of services sales was 18.5% in 2008 as compared to 20.6% in 2007. This decrease reflected the impact of the first quarter 2008 revenue decline incurred as a result of one key customer's delay in its rollout of its 2008 program.

Research, Development and Engineering. Research, development and engineering expense increased slightly to $2.4 million in 2008 from $2.3 million in 2007, representing an increase of $0.1 million. As a percentage of net product sales, research, development and engineering expense decreased to 7.5% in 2008 from 8.6% in 2007. The decrease, as a percentage of revenues, reflected productivity increases realized as we continued our focus on process improvements throughout the business. The increase in overall spend was primarily attributed to the cost of bringing our new small power products to the market.

Selling, General and Administrative. Selling, general and administrative expense remained flat at $8.5. As a percentage of net sales, selling, general and administrative expense decreased to 20.4% in 2008 from 22.7% in 2007. The decrease, as a percentage of revenues, reflected the productivity increases realized as we continued our focus on process improvements throughout the business.

Interest Income. Interest income, net, was $171 thousand in 2008 compared to $416 thousand in 2007. Of this amount, interest expense was $14 thousand in 2008 compared to $22 thousand in 2007, while interest income decreased to $185 thousand in 2008 compared to $438 thousand in 2007. The decrease in interest income, net, in the current year was due primarily to less income from investments from reduced interest-earning balances and reductions of effective interest rates.

Income Taxes. As a result of our significant continued operating losses in recent years, we have not been subject to significant income taxes and have a 100% valuation allowance for our net deferred tax assets. As such, our effective income tax rate was a negative 0.6% in 2008 compared to an effective rate of negative 0.5% in 2007.

Liquidity and Capital Resources

Our primary liquidity needs for the foreseeable future will be for working capital and operations. As of December 31, 2008, available cash and cash equivalents approximated $5.8 million. Based on available funds and current plans, we believe that our available cash, borrowings and amounts generated from operations, will be sufficient to meet our cash requirements for the next 12 months. The assumptions underlying this belief include, among other things, that there will be no material adverse developments in the business or market in general. There can be no assurances however that those assumed events will occur. If management's plans are not achieved, there may be further negative effects on the results of operations and cash flows, which could have a material adverse effect on the Company.

Working capital was $12.4 million at December 31, 2008, which represented a working capital ratio of 2.5 to 1, compared to $16.5 million at December 31, 2007. Our investment in inventories and accounts receivables was $12.9 million and $15.1 million at December 31, 2008 and 2007, respectively. Our capital expenditures were $0.07 million and $0.02 million in 2008 and 2007, respectively. Our budgeted capital expenditures for 2009 are $0.1 million as we remain focused on conserving cash. Accounts receivable days sales outstanding stood at 46 days at December 31, 2008, as compared to 48 days at December 31, 2007. The improvement in accounts receivable days sales outstanding was primarily the result of more customers taking advantage of discounts, which increased 0.1% as a percent of sales over 2007. Another factor was that more invoicing and payments were processed electronically, which increases the time to process and pay. At December 31, 2008, inventory days on hand, which represents gross inventory excluding impairments or reserves, was 145 days, as compared to 268 days on hand at December 31, 2007. The Company has invested in certain tools to assist in forecasting levels of required inventory to meet its customer requirements. These tools were implemented throughout 2008 and have resulted in a significant reduction in required inventory.

Cash flows used for operating activities were $3.0 million in 2008, compared to 2007 which had cash flows provided by operating activities of $559 thousand. This was primarily from the net loss, an increase in accounts receivable and a decrease in accounts payable and other liabilities, offset by reductions in inventory and other non-cash charges. There was $144 thousand of cash used for investing activities, which was primarily from the issuance of the note receivable, offset by the sale of equipment sold as a result of outsourcing. Cash provided by financing activities was $1.0 million.

We have an available line of credit agreement with National City Bank for borrowing up to $3.5 million. The line of credit requires certain amounts be restricted in an identified collateral account based on the outstanding balance due. As of December 31, 2008, there is an outstanding balance of $834 on the line of credit. As such, the portion of the deposit account collateralized is reflected as restricted cash in the accompanying balance sheet as of December 31, 2008.

We believe that cash and cash equivalents, anticipated cash flow from operations, and our credit facilities will be sufficient to fund our working capital and capital expenditure requirements for at least the next 12 months. We do not currently plan to pay dividends.

From February 13, 2007, to May 22, 2008, we had not been in compliance with The Nasdaq Stock Market's Marketplace Rule 4310(c)(4), which requires the Company to maintain a $1.00 per share minimum bid price. In an effort to regain compliance, our shareholders approved, and on May 7, 2008, we executed, a 1-for-10 reverse stock split. On May 22, 2008, we received a decision that Nasdaq would continue the listing of our common shares on The Nasdaq Stock Market. Although our common shares are currently in compliance with the Nasdaq Stock Market's continued listing standards, we cannot assure you that we will continue to meet all continued listing standards in the future.

We have operating leases covering certain office facilities, and equipment that expire at various dates through 2009. Future minimum annual lease payments required during the years ending in 2009 through 2011 under non-cancelable operating leases having an original term of more than one year are $221 thousand, $114 thousand and $4 thousand, respectively.

Impact of New Accounting Standards

Recently adopted and recently issued accounting pronouncements and their effects on the Company's consolidated financial statements are described in Note 1, "Summary of Significant Accounting Policies," in Item 8.

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