Summary of CLEARFIELD, INC.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cautionary Statement Regarding Forward-Looking Information

Statements made in this Annual Report on Form 10-K, in the Company's other SEC filings, in press releases and in oral statements, that are not statements of historical fact are "forward-looking statements." Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results or performance of the Company to be materially different from the results or performance expressed or implied by such forward-looking statements. The words "believes," "expects," "anticipates," "seeks" and similar expressions identify forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date the statement was made. The risks and uncertainties that could cause actual results to differ materially and adversely from the forward-looking statements include those risks described in Part I, Item 1A. "Risk Factors."

Overview of Business: The Company sells highly configurable fiber management and connectivity products to broadband service providers serving the FTTP, FTTB, FTT-Cell site markets in the U.S. and in certain limited markets outside the U.S., currently countries in the Caribbean, Central America and South America. The Company's sales channels include direct to customer, through distribution (channel) partners, and to original equipment suppliers who private label its products. The Company's products are sold by its sales employees and independent sales representatives.

Critical Accounting Policies: In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our revenues, income or loss from operations and net income or loss, as well as on the value of certain assets and liabilities on our balance sheet. We believe that there are several accounting policies that are critical to an understanding of our historical and future performance, as these policies affect the reported amounts of revenues, expenses and significant estimates and judgments applied by management. While there are a number of accounting policies, methods and estimates affecting our financial statements, areas that are particularly significant include:

· Accounting for income taxes; and
· Valuation and evaluating impairment of long-lived assets and goodwill.

Income Taxes We account for income taxes in accordance with Accounting Standards Codification ("ASC") 740, under which deferred income taxes are recognized based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of enacted tax laws. Deferred income tax provisions and benefits are based on changes to the assets or liabilities from year to year. In providing for deferred taxes, we consider tax regulations of the jurisdictions in which we operate, estimates of future taxable income, and available tax planning strategies. If tax regulations, operating results, or the ability to implement tax-planning strategies vary, adjustments to the carrying value of deferred tax assets and liabilities may be required. A valuation allowance is recorded when it is more likely than not that a deferred tax asset will not be realized. The recorded valuation allowance is based on significant estimates and judgments and if the facts and circumstances change the valuation allowance could materially change.

In accounting for uncertainty in income taxes, we recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more likely than not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. The Company recognizes interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense.

As of September 30, 2012, the Company had U.S. federal and state net operating loss (NOL) carry-forwards of approximately $23,340,000 and $21,270,000, respectively. The U.S. federal NOL carry forward amounts expire in fiscal years 2020 through 2028 if not utilized. The state NOL carry forward amounts expire in fiscal year 2013 through 2022 if not utilized. In fiscal year 2009, the Company completed an Internal Revenue Code Section 382 analysis of the loss carry-forwards and determined that all of the Company's loss carry-forwards were utilizable and not restricted under Section 382. The Company has not updated its
Section 382 analysis subsequent to 2009 and does not believe there have been any events subsequent to 2009 that would impact the analysis.

As part of the process of preparing our financial statements, we are required to estimate our income tax liability in each of the jurisdictions in which we do business. This process involves estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We must then assess the likelihood that these deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not more likely than not or unknown, we must establish a valuation allowance.

Prior to 2011, a valuation allowance had been recorded which required the Company to evaluate its future taxable income after consideration of positive and negative evidence. If the valuation allowance is reduced, the Company would record an income tax benefit in the period in which that determination is made. If the valuation allowance is increased, the Company would record additional income tax expense,

Consequently, during the fourth quarter of fiscal year 2011 and 2012, the Company reversed a portion of its valuation allowance in consideration of all available positive and negative evidence, including our historical operating results, current financial condition, and potential future taxable income. The reduction in the valuation allowance in the fourth quarter of fiscal year 2012 resulted in a non-cash income tax benefit of $3,518,000 million. We recorded an income tax benefit of $3,324,000 for the year ended September 30, 2012, compared to an income tax benefit $2,316,000 for the year ended September 30, 2011.

Our future potential taxable income was evaluated based on both historical profitability as well as anticipated operating results for future years. Based upon the assessment of all available evidence, the Company reversed $3,518,000 million of additional valuation allowance for the year ended September 30, 2012, which was recorded as a one-time income tax benefit. As of September 30, 2012, the Company's only remaining valuation allowance of approximately $975,000 relates to state net operating loss carry forwards we do not expect to utilize. The Company will continue to assess the assumptions used to determine the amount of our valuation allowance and may adjust the valuation allowance in future periods based on changes in assumptions of estimated future income and other factors. If the remaining valuation allowance is reduced, we would record an income tax benefit in the period the valuation allowance is reduced. If the remaining valuation allowance is increased, we would record additional income tax expense.

The Company files income tax returns in the U.S. Federal jurisdiction, and various state jurisdictions. Based on its evaluation, the Company has concluded that it has no significant unrecognized tax benefits. With limited exceptions, the Company is no longer subject to U.S. federal and state income tax examinations for fiscal years ending prior to 1998. We are generally subject to U.S. federal and state tax examinations for all tax years since 1998 due to our net operating loss carryforwards and the utilization of the carryforwards in years still open under statute. In 2007 the Company changed its fiscal year to September 30.

Impairment of Long-Lived Assets and Goodwill The Company's long-lived assets at September 30, 2012 consisted of property, plant and equipment, patents and goodwill. The Company reviews the carrying amount of its property, plant and equipment and patents if events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. When this review indicates the carrying amount of an asset or asset group exceeds the sum of the future undiscounted cash flows expected to be generated by the assets, the Company recognizes an asset impairment charge against operations for the amount by which the carrying amount of the impaired asset exceeds its fair value.

Determining fair values of property, plant and equipment and patents using a discounted cash flow method involves significant judgment and requires the Company to make significant estimates and assumptions, including long-term projections of cash flows, market conditions and appropriate discount rates. Judgments are based on historical experience, current market trends, consultations with external valuation specialists and other information. If facts and circumstances change, the use of different estimates and assumptions could result in a materially different outcome. The Company generally develops these forecasts based on recent sales data for existing products, planned timing of new product launches, and estimated expansion of the FTTP market.

The Company reviews the carrying amount of goodwill annually in the fourth quarter of each fiscal year and more frequently if events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. If the carrying amount of a reporting unit exceeds its fair value, the Company measures the possible goodwill impairment loss based on an allocation of the estimate of fair value of the reporting unit to all of the underlying assets and liabilities of the reporting unit, including any previously unrecognized intangible assets. The excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. An impairment loss is recognized to the extent that a reporting unit's recorded goodwill exceeds the implied fair value of goodwill. The Company utilizes a market capitalization approach for testing its goodwill, whereby a significant reduction in our market capitalization or in the carrying amount of net assets of a reporting unit could result in an impairment charge. This test for the period ended September 30, 2012 resulted in no change to goodwill from the prior period. During the prior quarter ends, there were no triggering events that indicated impairment existed and there were no adjustments to goodwill. An impairment loss would be based on significant estimates and judgments and if the facts and circumstances change a potential impairment could have a material impact.

No impairment of long-lived assets or goodwill has occurred during the years ended September 30, 2012 or 2011, respectively.

Results of Operations

Year ended September 30, 2012 compared to year ended September 30, 2011

Revenues for the fiscal year 2012 increased 6% to $37,474,000 from revenue of $35,193,000 in 2011. Revenue growth was experienced from existing clients as well as from the development of new accounts within the telecommunications industry. The growth in revenue includes gains from within Tier 3 Carriers, as well as from an emerging presence associated with Tier 2 Carriers who have a national footprint. The increase in revenue includes the gains in product sales to engineering contractors providing Engineer, Furnish and Installation (EF&I) services to telco and cable broadband operators. Revenues derived from distributor arrangements increased as additional distributors are now representing the Company as compared to the prior year. In addition, revenue gains were also gained in our build-to-print market serving OEM customers. These revenue increases in fiscal 2012 were offset by lower revenues to system integrators in the comparable period in fiscal 2011. Revenues were positively affected by deployments associated with the American Recovery and Reinvestment Act (stimulus funds) in both periods.

As a result of the above factors, revenues in fiscal year 2012 to commercial data networks and broadband service providers were 87% of sales, or $32,553,000, while revenues associated with build-to-print manufacturing for original equipment manufacturers outside of the telecommunications market were 13% of sales, or $4,921,000, for fiscal 2012. For fiscal year 2011, revenues to commercial data networks and broadband service providers were 87% of sales, or $30,633,000, while revenues associated with build-to-print manufacturing for original equipment manufacturers outside of the telecommunications market were 13% of sales, or $4,560,000.

Cost of sales for the fiscal year 2012 was $22,188,000, an increase of $1,654,000, or 8% from the $20,534,000 in fiscal year 2011. Gross margin was 40.8% in fiscal year 2012, as compared to 41.7% for fiscal year 2011. Gross profit increased 4%, or $627,000, from $14,658,000 for fiscal year 2011 to $15,286,000 for fiscal year 2012. The year-over-year increase in cost of goods and gross profit is a result of increased revenue.

Selling, general and administrative expense for fiscal year 2012 was $11,011,000 compared to $10,942,000 for fiscal year 2011, relatively unchanged between periods. Selling expense, which includes engineering and marketing expense, was $7,458,000 in fiscal year 2012 versus $6,600,000 in fiscal 2011, and increase of $858,000. Selling and engineering expenses increased $708,000, mainly as a result of additional headcount and associated expenses, while marketing expenses increased $150,000, mainly as a result of higher marketing and trade show costs in fiscal 2012. Offsetting these increases was a decrease in general and administrative expenses. General and administrative expenses were $3,553,000 in fiscal 2012 versus $4,342,000 in fiscal year 2011, a decrease of $789,000, mainly due to a decrease of $729,000 in incentive compensation related to the achievement of objectives in fiscal 2012.

Income from operations for fiscal year 2012 was $4,275,000 compared to $3,716,000 for fiscal year 2011. This increase is due to the increase in revenue and a decrease in incentive compensation expense for fiscal year 2012.

Interest income in fiscal year 2012 was $102,000 compared to $110,000 for the fiscal year 2011. The decrease is a result of declining interest rates resulting in lower returns on our investments. The Company invests its excess cash primarily in FDIC-backed bank certificates of deposit and money market accounts.

The Company recorded no other income in fiscal 2012, compared to $26,000 in fiscal year 2011. This is attributable to rental income from our Aberdeen, SD facility which was sold in June 2011 at which time the rental arrangement ended.

Income taxes for fiscal year 2012 was a benefit of $3,324,000. The total valuation allowance reversed during fiscal year 2012 was approximately $5,100,000. The valuation allowance reversed in the fourth quarter was $3,518,000 and was included in the income tax benefit for the year. Income taxes for fiscal year 2011 was a benefit of $2,316,000. In fiscal year 2011, the Company reversed approximately $3,920,000 of its valuation allowance. The valuation allowance reversed in the fourth quarter of fiscal year 2011 was $2,481,000 and was included in the income tax benefit for the year. Additional components of the fiscal 2011 net income tax benefit included deferred tax amortization of goodwill of $75,000, federal alternative minimum tax of $67,000, and various state taxes of $24,000.

Net income for fiscal year 2012 was $7,701,000 or $0.62 per share for basic and $0.60 for diluted, compared to $6,167,000 or $0.51 per basic and $0.48 per diluted share for the year 2011. The increase in net income was primarily due to our increased strategic investment of sales and marketing programs, continued product acceptance that drove increased revenue, and the reversal of a portion of the valuation allowance related to deferred tax assets.

Liquidity and Capital Resources

As of September 30, 2012, our principal source of liquidity was our cash and cash equivalents and short-term investments. Those sources total $14,785,000 at September 30, 2012, compared to $13,130,000, at September 30, 2011. Our excess cash is invested mainly in certificates of deposit backed by the FDIC and money market accounts. The majority of our funds are insured by the FDIC. Investments considered long-term are $4,572,000 at September 30, 2012, compared to $2,707,000 at September 30, 2011. We believe the combined balances of short-term cash and investments along with long-term investments provide a more accurate indication of our available liquidity. At September 30, 2012, the Company had combined balances of short-term cash and investments and long term investments of $19,357,000 as compared to $15,837,000 at September 30, 2011. We have no long-term debt obligations at September 30, 2012 or 2011, respectively.

Operating Activities

Net cash generated from operations for the fiscal year ended September 30, 2012 totaled $3,826,000. Cash provided by operations included net income of $7,701,000, which included non-cash expenses for depreciation and amortization of $405,000, stock-based compensation of $471,000, and losses on disposal of assets of $24,000, along with a non-cash gain from deferred taxes of $3,437,000. Changes in working capital items providing cash included a decrease in accounts receivable of $206,000 reflecting lower sales levels in the fourth quarter of 2012. Changes in working capital items using cash include increases in inventory of $213,000, an increase in other current assets of $307,000, and a decrease in accounts payable and accrued expenses of $1,023,000. Changes in accounts payable and accrued expenses reflect a decrease to employee compensation accruals of $639,000 related to incentive payments.

Net cash generated from operations for the fiscal year ended September 30, 2011 totaled $5,297,000. Cash provided by operations included net income of $6,167,000, which included non-cash expenses for depreciation of $359,000, stock-based compensation of $535,000, and gains on disposals of assets of $44,000, mainly related to the sale of the Aberdeen, SD facility, along with a non-cash gain from deferred taxes of $2,407,000. Changes in working capital items providing cash included an increase in accounts receivable of $16,000 reflecting a lower number of days outstanding due to early payment terms with several customers. Changes in working capital using cash include increases to inventory of $1,244,000 due to higher stocking levels required to meet increased demand and accounts payable and accrued expenses of $1,958,000. Included within this amount are employee compensation accruals increasing by $1,700,000 mainly due to incentive payments related to fiscal 2011, and an accounts payable increase of $251,000.

Investing Activities

For the fiscal year ended September 30, 2012, we used $591,000 in cash for the purchase of equipment and patents. Included in this amount were purchases for manufacturing and engineering equipment in the amount of $295,000, IT equipment and software purchases of $129,000, and additional patent cost of $40,000. During the same period we purchased $11,942,000 of FDIC-backed certificates of deposit and sold approximately $2,819,000 of FDIC-backed certificates of deposit. The result is a net decrease in cash from investing activities of $9,714,000 in fiscal year 2012 as compared to fiscal year 2011. The Company intends to continue to invest in the necessary and appropriate manufacturing equipment to help maintain a competitive position in manufacturing capability but has no material commitments for capital expenditures for fiscal year 2013.

For the fiscal year ended September 30, 2011, we used $746,000 in cash for the purchase of equipment. Included in this amount were purchases for manufacturing equipment in the amount of $375,000 and IT equipment and software purchases of $120,000. During the same period we purchased $1,887,000 of FDIC-backed certificates of deposit and sold approximately $2,332,000 of FDIC-backed certificates of deposit. In fiscal year 2011 we received proceeds from the sale of assets in the amount of $719,000. The majority of these proceeds were from the sale of the Aberdeen facility which accounted for approximately $660,000 of the proceeds. The result is a net increase in cash from investing activities of $418,000 in fiscal year 2011 as compared to fiscal year 2010.

Financing Activities

For the fiscal year ended September 30, 2012, we received $143,000 from employees' participation and purchase of stock through our Employee Stock Purchase Plan (ESPP) and $142,000 from the issuance of stock as a result of employees and directors exercising stock options. The net cash received from financing activities was $285,000.

For the fiscal year ended September 30, 2011 we received $88,000 from employees' participation and purchase of stock through our Employee Stock Purchase Plan (ESPP), $180,000 from the issuance of stock as a result of employees and directors exercising stock options and $12,000 from excess tax benefits from the exercise of stock options. The net cash received from financing activities was $280,000.

The Company has current cash and cash equivalents and investments with a maturity of less than one year that total $14,785,000 which we believe provides a strong financial position and along with cash flow from operations will be sufficient to meet its working capital and investment requirements for beyond the next 12 months. The Company intends on utilizing its available cash and assets primarily for its continued organic growth, as well as potential future strategic transactions. However, future growth, organically or through acquisition, may require the Company to raise capital through additional equity or debt financing. There can be no assurance that any such financing would be available on commercially acceptable terms.

Recent Accounting Pronouncements:

From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board or other standard setting bodies that may have an impact on the Company's accounting and reporting. The Company believes that such recently issued accounting pronouncements and other authoritative guidance for which the effective date is in the future either will not have an impact on its accounting or reporting or that such impact will not be material to its financial position, results of operations, and cash flows when implemented.