The following discussion should be read along with the unaudited condensed consolidated financial statements included in this Form 10-Q, as well as the Company's 2008 Annual Report on Form 10-K filed with the Securities and Exchange Commission, including Management's Discussion and Analysis of Financial Condition and Results of Operations.

RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2009 COMPARED TO THE THREE MONTHS ENDED JUNE 30, 2008

The results of our international operations include the impact from foreign currency translation in the quarter. On average, the U.S. Dollar was stronger in the second quarter of 2009 compared to the same period in 2008. The result of a strengthening U.S. Dollar impacted our results on a consolidated basis because the Company translates Euro and Pound Sterling sales and related expenses at proportionally lower U.S. Dollar equivalents in its financials.

REVENUE

Revenue for the second quarter of 2009 was $10.0 million, a decrease of 12% compared to the second quarter of 2008. Excluding the impact of foreign exchange rates, revenue decreased approximately 3% in the second quarter of 2009 when compared to 2008. The ongoing global economic crisis caused some businesses and governments to defer or cancel purchases in the current period which contributed to our decline in sales. 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. or domestic based includes Canada, Japan, Mexico, Central and South America.

                                        2009                                    2008
(Dollars in
thousands)                U.S.      International     Total       U.S.      International     Total
Revenue                 $  3,102   $         6,908   $ 10,010   $  3,701   $         7,637   $ 11,338
Less: Cost of Goods
Sold                       1,191             2,771      3,962      1,684             2,984      4,668
Gross Profit            $  1,911   $         4,137   $  6,048   $  2,017   $         4,653   $  6,670
Less: Operating
Expenses                   2,344             3,446      5,790      3,044             3,737      6,781
(Loss) Income from
Operations              $   (433 ) $           691   $    258   $ (1,027 ) $           916   $   (111 )

Second quarter 2009 revenue decreased 10% in our international operations compared to the second quarter of 2008. Our international operations represented 69% of the Company's total revenue in the current period. International revenue includes the negative impact from foreign currency exchange rates of approximately $983 thousand in the second quarter of 2009 as the U.S. Dollar strengthened against the Euro and the Pound Sterling. Excluding the change in foreign exchange rates our international revenue increased approximately 3%. As a result of the lower level of reported revenue, our international based operations had a decline in income from operations to $691 thousand for the second quarter of 2009 compared to income from operations of $916 thousand in 2008.

Our U.S. based sales declined $599 thousand or 16% in the current quarter. The decline is primarily from the deferral of orders within our top 10 domestic customers. Outside these 10 largest customers our orders in the current quarter were comparable in the second quarter 2009 to the second quarter 2008. The U.S. business had a loss from operations of $433 thousand in the second quarter of 2009 compared to a loss of $1.0 million in 2008. The decline in the U.S. based loss is from a $700 thousand reduction in operating expenses combined with an increase in the gross profit margin from 54% to 62% in the second quarter of 2009. The improvement in our U.S. gross profit margin was the result of inventory adjustments during the second quarter of 2008 combined with improved overall efficiency in the U.S. manufacturing facility.

Information regarding the Company's revenue by product category is included in the following table:

                          Three Months Ending     Three Months Ending
(Dollars in thousands)       June 30, 2009           June 30, 2008
Fiber Optic              $               6,246   $               7,017
IP Video                                 3,522                   4,196
Electro Optics                             242                     125
Total Revenue            $              10,010   $              11,338

In the second quarter of 2009, sales of Fiber Optic products were down 11% to $6.2 million while IP Video revenue decreased $674 thousand to $3.5 million. The decline in Fiber Optic and IP video sales during the period led to a 12% decline in total revenue and includes the negative impact of $983 thousand foreign currency translation. The Company continues to focus its product development efforts on IP products in 2009 to address an overall market shift. The Company does not believe the decline in IP product sales in the second quarter of 2009 is reflective of the long term trend in the market.

Seasonality affects our revenues to the extent that normal contracting activities are affected by capital budgets. We are also impacted in areas with colder climates as some outdoor projects are planned to avoid the winter months. This seasonality has resulted in generally lower levels of revenue in the first half of the year when compared to revenue in the second half of the year.

GROSS PROFIT

Consolidated gross profit was $6.0 million or 60% of revenues for the quarter ended June 30, 2009, compared to $6.7 million or 59% of revenues in 2008. The gross profit percentage was 1% higher in the second quarter of 2009 and is slightly higher than the Company's ongoing target. Gross profit was down $622 thousand and 9% in total as a result of the decline in revenue.

The gross profit margin in our domestic business was 62% in the second quarter of 2009 compared to 54% in the second quarter of 2008. The U.S. gross profit margin increased in the second quarter due to improved overall efficiency in the U.S. manufacturing facility despite lower than expected sales volume in the quarter. The gross profit margin in our international business was 60% in the second quarter of 2009 compared to 61% in the second quarter of 2008 with the impact primarily driven by lower sales volume. Lower revenue levels can result in relatively higher costs of goods sold on a per unit basis as the costs for personnel in direct labor positions and other fixed overhead costs are spread over a smaller revenue base.

OPERATING EXPENSE

Consolidated operating expenses were $5.8 million for the quarter ended June 30, 2009, compared to $6.8 million in 2008. The overall decrease was $1.0 million representing a 15% reduction in operating expenses in the second quarter of 2009. The decrease in operating expense is due to foreign currency exchange rates as the U.S. Dollar strengthened against the Euro. Excluding the change in foreign exchange rates our operating expenses decreased approximately 8% and $510 thousand. The remaining decline in operating expenses is due to a $350 thousand charge in the second quarter of 2008 from a refinancing, a reduction in force at year-end 2008 and internal cost control measures implemented during the first six months of 2009 as the Company works to control its operating expenses in a difficult economic environment.

INCOME TAX EXPENSE

The provision for income taxes in the three months ended June 30, 2009 was $243 thousand compared to a benefit of $281 thousand in the second quarter of 2008. The increase in the effective tax rate for the second quarter of 2009 is attributed to current year losses in the U.S. which are not benefited due to a full valuation allowance on the deferred tax assets. In the second quarter of 2008, a non recurring benefit was recorded for restructuring of international operations, which decreased the effective tax rate for the period.

RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2009 COMPARED TO THE SIX MONTHS ENDED JUNE 30, 2008

The results of our international operations include the impact from foreign currency translation in the quarter. On average, the U.S. Dollar was stronger in the first six months of 2009 compared to 2008. The result of a strengthening U.S. Dollar impacted our results on a consolidated basis because the Company translates Euro and Pound Sterling sales and related expenses at proportionally lower U.S. Dollar equivalents in its financials.

REVENUE

Revenue for the first six months of 2009 was $18.6 million, a decrease of 15% compared to the first six months of 2008. Excluding the impact of foreign exchange rates, revenue decreased approximately 6% in the first six months of 2009 when compared to 2008. The current global economic crisis caused some businesses and governments to defer or cancel purchases in the current period which contributed to our decline in U.S. and International sales. 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. or domestic based includes Canada, Japan, Mexico, Central and South America.

                                        2009                                    2008
(Dollars in
thousands)                U.S.      International     Total       U.S.      International     Total
Revenue                 $  5,595   $        13,001   $ 18,596   $  6,976   $        14,897   $ 21,873
Less: Cost of Goods
Sold                       2,480             5,352      7,832      2,999             5,745      8,744
Gross Profit            $  3,115   $         7,649   $ 10,764   $  3,977   $         9,152   $ 13,129
Less: Operating
Expenses                   4,448             7,007     11,455      5,404             7,324     12,728
(Loss) Income from
Operations              $ (1,333 ) $           642   $   (691 ) $ (1,427 ) $         1,828   $    401

Revenue for the first six months of 2009 decreased 13% in our international operations when compared to the first six months of 2008. Our international operations represented 70% of the Company's total revenue in the current period. International revenue includes the negative impact from foreign currency exchange rates of approximately $1.9 million in the first six months of 2009 as the U.S. Dollar strengthened against the Euro and the Pound Sterling. As a result of the reported reduction in revenue, our international based operations had a decline in income from operations to $642 thousand for the first six months of 2009 compared to income from operations of $1.8 million in 2008.

Our U.S. based sales declined $1.4 million or 20% in the first six months of 2009. The decline is from a reduction of $823 thousand in fiber optic based product sales and slower than expected sales in IP products. Our IP revenue declined $723 thousand in the first six months of 2009. The U.S. business had a loss from operations of $1.3 million in the first six months of 2009 compared to a loss of $1.4 million in 2008. The small decrease in the U.S. based loss from operations is due to a reduction of $956 thousand in U.S. operating expenses in the first six months of 2009 which includes intercompany charges from the US to our international operations.

Information regarding the Company's revenue by product category is included in the following table:

                          Six Months Ending     Six Months Ending
(Dollars in thousands)      June 30, 2009         June 30, 2008
Fiber Optic              $            11,647   $            14,699
IP Video                               6,436                 6,826
Electro Optics                           513                   348
Total Revenue            $            18,596   $            21,873

In the first six months of 2009, sales of Fiber Optic products were down 21% to $11.6 million while IP Video revenue decreased 6% to $6.4 million. The Company has planned for a market shift toward IP Video products as it invested in the development of these new products in the current and prior periods. The decline in Fiber Optic sales during the period was in line with an overall trend away from these products in the market but this trend accelerated in 2009. The decline in IP product sales were significantly less than the decline in Fiber Optic sales in the first six months of 2009. However this decline is primarily due to the impact of foreign currency translation.

Seasonality affects our revenues to the extent that normal contracting activities are affected by capital budgets. We are also impacted in areas with colder climates as some outdoor projects are planned to avoid the winter months. This seasonality has resulted in generally lower levels of revenue in the first half of the year when compared to revenue in the second half of the year.

GROSS PROFIT

Consolidated gross profit was $10.8 million or 58% of revenues for the six months ended June 30, 2009, compared to $13.1 million or 60% of revenues in 2008. The gross profit percentage was 2% lower in 2009 which is in line with the Company's ongoing target. Gross profit was down a total of $2.4 million and 18% primarily because of the decrease in revenue combined with slightly lower profit margins in our U.S. and international businesses. Lower revenue levels result in relatively higher costs of goods sold on a per unit basis as the costs for personnel in direct labor positions and other fixed costs are spread over a smaller revenue base.

The gross profit margin in our domestic business was 56% in the first six months of 2009 compared to 57% in the first six months of 2008. The U.S. gross profit margin declined in the current period due to the U.S. manufacturing facility not operating at full capacity during the first quarter of 2009 as a result of lower than expected sales volume. The gross profit margin in our international business was 59% in the first six months of 2009 compared to 61% in the first six months of 2008, again with the impact primarily driven by lower sales volume.

OPERATING EXPENSE

Consolidated operating expenses were $11.5 million for the six months ended June 30, 2009, compared to $12.7 million in 2008. The overall decrease was $1.2 million representing a 10% reduction in operating expenses in the first half of 2009. The decrease in operating expense is somewhat due to foreign currency exchange rates as the U.S. Dollar improved against the Euro. Excluding the change in foreign exchange rates our operating expenses decreased approximately 3% and $338 thousand.

The remaining decline in operating expenses is due to a $350 thousand one time charge in the second half of 2008 from a refinancing combined with a reduction in force at year-end 2008 and a number of internal cost control measures implemented during 2009 as the Company works to control its operating expenses in a difficult economic environment.

OTHER EXPENSE, NET

Other expense, net declined from $498 thousand in the first six months of 2008 to $433 thousand in the current six months. The Company's other expense includes interest expense, net of interest income, and foreign exchange transaction (losses)/gains from notes payable. The notes payable include a U.S. Dollar senior term loan which resides on the foreign holding company's books, a Euro-based subordinated note that resides on the parent company's books, and a U.S. Dollar intercompany note payable that resides on the foreign holding company's books. The improvement in other expense, net in the first six months of 2009 is the result of several factors including a decline in the overall interest rate environment and reduced debt levels from payments on our senior term loan.

INCOME TAX EXPENSE

The benefit for income taxes in the first six months of 2009 was $232 thousand compared to a benefit of $269 thousand in the first six months of 2008. The tax benefit in 2009 was attributed to a loss before tax of $1.1 million in the current period compared to a loss of $97 thousand in the first six months of 2008. The tax benefit in the first six months of 2009 is primarily recorded in the Company's international operations.

In the fourth quarter of 2008 the Company recorded a full valuation allowance against our net U.S. deferred tax assets. In the first six months of 2009 we continued to provide a full valuation allowance against net U.S. deferred tax assets and therefore we did not record the impact of income tax benefits against U.S. operating losses and other deferred tax assets in 2009. These deferred tax assets are still available for tax purposes to offset potential U.S. tax expense in the future. As of June 30, 2009, and December 31, 2008, the Company had a valuation allowance of $3.2 and $3.0 million, respectively, related to its U.S. deferred tax assets, which consisted principally of research and development tax credits, foreign tax credits and net operating loss carryforwards.

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

The Company's stockholders' equity decreased from $21.2 million at December 31, 2008 to $20.7 million at June 30, 2009. The decrease in total stockholders' equity resulted from an $892 thousand net loss in the first six months of 2009 combined with a $48 thousand decrease in accumulated other comprehensive income. The decrease in accumulated other comprehensive income is primarily from the impact of foreign exchange rates. At June 30, 2009, the exchange rate for the Euro to the U.S. Dollar was 1.40 compared to 1.41 at December 31, 2008.

The total assets of the Company were $42.7 million at June 30, 2009, compared to $47.1 million at December 31, 2008, a decline of 9%. The Company had a decline in cash of $2.8 million, a decline in accounts receivable of $834 thousand, and a decline in inventory of $240 thousand. The reduced cash level is the result of lower profit from operating activities in the first half of 2009 combined with payment of accrued expenses and payment of principal on loans during the period. The decrease in accounts receivable is attributable to the reduction in sales levels during 2009 compared to the later part of 2008. The decline in inventory is also due to reduced sales levels along with an initial effort by the Company to decrease general levels of inventory.

The Company's total liabilities decreased in the first six months of 2009 to $22.1 million at June 30, 2009 compared to $26.0 million at December 31, 2008. This decrease is primarily from declines in our level of debt totaling $705 thousand, a decrease in accounts payable of $1.2 million and a decrease in taxes payable of $927 thousand. We also had small declines in commission payable, deferred tax liabilities and other liabilities. The decline in debt is from the recurring monthly payments on our senior bank debt, the decline in accounts payable is due to additional cash payments on accrued expenses and the reduction in taxes payable is from actual tax payments made during 2009.

The Company has outstanding debt totaling $14.8 million at June 30, 2009. The $14.8 million is all due within nine months of June 30, 2009 and is therefore all classified as current. The debt includes a senior term loan with a bank for $2.7 million with a balloon payment in December 2009 and a subordinated note and related deferred interest totaling $12.1 million due in March 2010. We also have a line of credit which expires on December 31, 2009 that has no current outstanding balance at June 30, 2009.

On July 21, 2009, the Company entered into an amended financing agreement with its bank. Pursuant to the amendment, the bank agreed to extend the term of the line available to the Company until December 31, 2009. This agreement included certain changes in the borrowing base, interest rate and financial covenants. The change in the borrowing base is stated as the greater of eligible collateral less the outstanding principal amount of the Senior Term Loan, or the lesser of $1.0 million or the aggregate sum of eligible collateral. At June 30, 2009, eligible collateral was calculated at $4.4 million. Therefore, under the amended financing agreement the Company would have had $1.7 million available on its bank line of credit.

The balance of our subordinated debt obligation totals $12.1 million. The Company continues to work through its options for refinancing this debt. These options include discussions to refinance the US banking facility or financing with a combination of U.S. and international bank funding. In the current credit environment, however, the availability of senior financing is constrained. Therefore, the Company began negotiations with the current holder of the subordinated debt to consider extending the due date at a potentially higher interest rate. We are also making preparations for accessing mezzanine or alternate financing options if this should be necessary.

The Company needs to secure additional financing to meet these obligations and is working to secure such financing. However, the current economic environment is marked by limited availability of credit in the business sector and we may be required to pursue refinancing of the debt on less than favorable terms. Further, uncertainty about current and future global economic conditions may continue to cause businesses and governments to defer or cancel purchases. If demand for our products continues to decline, it will adversely impact our financial results and negatively impact our ability to secure additional financing. There can be no assurance that additional financing will be available in a timely manner or on acceptable terms. If we are unable to extend or refinance the subordinated debt and default on repayment of the subordinated debt, Seller would have claims against Optelecom-NKF, Inc. and its subsidiaries, subject to the rights of the bank holding our senior debt. The subordinated note is secured by a 35% interest in our European holding company. If we default on repayment of the subordinated debt, this 35% interest in our European holding company would be available to the subordinated debt holder, subject to the rights of the bank holding our senior debt. Should this collateral prove insufficient to satisfy the obligation then additional collateral or payments to the holder could be required.

The Company provides reserves for accounts receivable, inventory obsolescence and warranty against product defects. For the three months ended June 30, 2009, the Company had $85 thousand of additional expense related to the accounts receivable reserve, $50 thousand of additional expense related to the inventory obsolescence reserve and additional expense of $20 thousand related to the warranty reserve.

Cash used in our operating activities was $1.6 million for the first six months of 2009 compared to cash provided of $2.2 million in the same period for 2008. Our cash from operations is the result of our net income, adjusted for depreciation, amortization and other non-cash items, and changes in our operating assets and liabilities. Cash used in operating activities during the first six months of 2009 is primarily a result of a net loss of $892 thousand, a decline in accounts payable and accrued expenses of $1.2 million, a reduction in taxes payable totaling $928 thousand and a reduction in other liabilities of $936 thousand.

Cash used in investing activities was $408 thousand for the six months ended June 30, 2009 and $464 thousand for the same period of 2008. Cash used in investing activities is entirely from capital expenditures in the current and prior periods. Cash used in financing activities was $746 thousand during the first six months of 2009 compared to cash provided during the first six months of 2008 totaling $995 thousand. The current period includes payments of $751 thousand on notes payable.

FORWARD LOOKING INFORMATION

Statements in this Form 10-Q that are in the future tense, and all statements accompanied by terms such as "believe," "project," "expect," "estimate," "assume," "intend," "anticipate," and variations or similar terms are intended to be "forward-looking statements" as defined by federal securities law. Forward-looking statements are based upon assumptions, expectations, plans and projections that are believed valid when made, but that are subject to the risks and uncertainties identified under Risk Factors in the company's annual report on Form 10-K for the year ended December 31, 2008, that may cause actual results to differ materially from those expressed or implied in the forward-looking statements. The Company intends that all forward-looking statements made will be subject to safe harbor protection of the federal securities laws pursuant to
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Forward-looking statements are based upon, among other things, the company's assumptions with respect to:

†        future revenue;

†        expected sales levels and cash flows;

†        debt payments and related interest rates;

†        fluctuations in foreign currency amounts and rates;

†        performance issues with key distributors and suppliers;

†        product development and performance and the successful execution of
internal plans;

†        trends in the markets for our products;

†        successful negotiation of major contracts;

†        effective tax rates and timing and amounts of tax payments;

†        acquisitions or divestitures of businesses;

†        the results of any audit or appeal process with the Internal Revenue
Service;

†        anticipated costs of capital investments; and

†        the ability to obtain future financing.

You should consider the limitations on, and risks associated with, forward-looking statements and not unduly rely on the accuracy of predictions contained in such forward-looking statements. As noted above, these forward-looking statements speak only as of the date when they are made. The Company does not undertake any obligation to update forward-looking statements to reflect events, circumstances, changes in expectations, or the occurrence of unanticipated events after the date of those statements. Moreover, in the future, the Company, through senior management, may make forward-looking statements that involve the risk factors and other matters described in this Form 10-Q as well as other risk factors subsequently identified. This includes those identified in the Company's filings with the Securities and Exchange Commission on Form 10-K, Form 10-Q and Form 8-K.