UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

_________________

FORM 10-Q

(Mark One)

þ	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
	OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
	OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                 to                

Commission File Number 0-31857

ALLIANCE FIBER OPTIC PRODUCTS, INC.

(Exact name of registrant as specified in its charter)

Delaware	77-0554122
(State or other jurisdiction of	(I.R.S. employer
Incorporation or organization)	identification number)

275 Gibraltar Drive, Sunnyvale, California 94089

(Address of Principal Executive Offices)

(408) 736-6900

(Registrant's telephone number including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act). Large Accelerated Filer  o Accelerated Filer  o Non-Accelerated Filer  þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

On November 3, 2006, 40,378,748 shares of the registrant’s Common Stock, $0.001 par value per share, were outstanding.

ALLIANCE FIBER OPTIC PRODUCTS, INC.

FORM 10-Q

QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

INDEX

	Page
PART I: FINANCIAL INFORMATION	1
ITEM 1: FINANCIAL STATEMENTS	1
Condensed Consolidated Balance Sheets at September 30, 2006 (Unaudited)
and December 31, 2005	1
Condensed Consolidated Statements of Operations for the
Three and Nine Months Ended September 30, 2006 and 2005 (Unaudited)	2
Condensed Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 2006 and 2005 (Unaudited)	3
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	4
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	14
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	20
ITEM 4: CONTROLS AND PROCEDURES	21
PART II: OTHER INFORMATION	22
ITEM 1A: RISK FACTORS	22
ITEM 6: EXHIBITS	33
SIGNATURE	33

i

PART I: FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

ALLIANCE FIBER OPTIC PRODUCTS, INC.
Condensed Consolidated Balance Sheets
(In thousands, except share data)

	September 30, 2006			December 31, 2005
Assets		(Unaudited)
Current assets:
Cash and cash equivalents	$	3,884		$	2,714
Short-term investments		25,942			26,693
Accounts receivable, net		3,872			3,570
Inventories, net		4,812			3,670
Prepaid expense and other current assets		799			634
Total current assets		39,309			37,281
Property and equipment, net		4,057			4,564
Other assets		152			105
Total assets	$	43,518		$	41,950
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable	$	3,159		$	2,342
Accrued expenses		2,532			2,355
Current portion of bank loan		73			73
Total current liabilities		5,764			4,770
Other long-term liabilities
Bank loan		425			484
Other long-term liabilities		378			375
Total long term liabilities		803			859
Total liabilities		6,567			5,629
Commitments and contingencies (Note 7)
Stockholders' equity:
Common stock, $0.001 par value: 250,000,000 shares authorized;
40,272,849 and 39,719,351 shares issued and outstanding at
September 30, 2006 and December 31, 2005, respectively		40			40
Additional paid-in-capital		109,261			108,867
Accumulated deficit		(72,466	)		(72,466	)
Accumulated other comprehensive income (loss)		116			(120	)
Stockholders' equity		36,591			36,321
Total liabilities and stockholders' equity	$	43,5180		$	41,950

        The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

1

ALLIANCE FIBER OPTIC PRODUCTS, INC.
Condensed Consolidated Statements of Operations
(Unaudited, in thousands, except per share data)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2006		2005			2006			2005
Revenues	$	7,573	$	5,269		$	19,046		$	15,453
Cost of revenues		5,402		4,141			13,907			12,293
Gross profit		2,171		1,128			5,139			3,160
Operating expenses:
Research and development		815		784			2,282			2,618
Sales and marketing		543		519			1,684			1,653
General and administrative		789		756			2,272			2,219
Total operating expenses		2,147		2,059			6,238			6,490
Income(loss) from operations		24		(931	)		(1,099	)		(3,330	)
Interest and other income, net		334		373			1,103			1,240
Net income (loss)		358		(558	)		4			(2,090	)
Net income (loss) per share:
Basic	$	0.01	$	(0.01	)	$	0.00		$	(0.05	)
Diluted	$	0.01	$	(0.01	)	$	0.00		$	(0.05	)
Shares used in computing net income (loss) per share:
Basic
		40,205		39,405			40,023			39,228
Diluted
		43,728		39,405			43,545			39,228

        The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

2

ALLIANCE FIBER OPTIC PRODUCTS, INC.
Condensed Consolidated Statements of Cash Flows
(Unaudited, in thousands, excpet share data)

	Nine Months Ended September 30,
	2006			2005
Cash flows from operating activities:
Net Income(loss)	$	4		$	(2,090	)
Adjustments to reconcile net loss to net cash used
in operating activities:
Depreciation and amortization		993			1,223
Disposal of property and equipment		34			52
Amortization of stock-based compensation		192			--
Provision for inventory obsolescence		384			(249	)
Changes in assets and liabilities:
Accounts receivable		(302	)		(692	)
Inventories		(1,526	)		831
Prepaid expenses and other current assets		(212	)		(15	)
Accounts payable		817			(363	)
Accrued expenses		(177	)		(277	)
Other long-term liabilities		3			(33	)
Net cash provided by (used in) operating activities		564			(1,613	)
Cash flows from investing activities:
Purchase of short-term investments		(10,693	)		(11,147	)
Proceeds from sales and maturities of short-term investments		11,465			9,778
Purchase of of property and equipment		(496	)		(592	)
Net cash provided by or (used in) investing activities		276			(1,961	)
Cash flows from financing activities:
Proceeds from issuance of common stock under ESPP		200			210
Proceeds from the exercise of common stock options		194			74
Proceeds of bank borrowings		--			172	)
Repayment of bank borrowings		(54	)		(33	)
Net cash provided by financing activities		340			423
Effect of exchange rate changes on cash and cash equivalents		(10	)		(303	)
Net increase or (decrease) in cash and cash equivalents		1,170			(3,454	)
Cash and cash equivalents at beginning of period		2,714			7,499
Cash and cash equivalents at end of period	$	3,884		$	4,045

        The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

3

ALLIANCE FIBER OPTIC PRODUCTS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Summary of Significant Accounting Policies

The Company

        Alliance Fiber Optic Products, Inc. (the “Company”) was incorporated in California on December 12, 1995 and reincorporated in Delaware on October 19, 2000. The Company designs, manufactures and markets fiber optic components for communications equipment manufacturers. The Company’s headquarters are located in Sunnyvale, California, and it has operations in Taiwan and China.

Basis of presentation

        The condensed consolidated financial information as of September 30, 2006 included herein is unaudited, has been prepared by the Company in accordance with generally accepted accounting principles in the United States of America, and reflects all adjustments, consisting only of normal recurring adjustments, which in the opinion of management are necessary to state fairly the Company's consolidated financial position, results of its consolidated operations, and consolidated cash flows for the periods presented.

         The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates, and such differences may be material to the financial statements.

        These financial statements should be read in conjunction with the Company's audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2005. The results of operations for the three and nine months ended September 30, 2006 are not necessarily indicative of the results to be expected for any future periods.

Revenue Recognition

        The Company recognizes revenue upon shipment of its products to its customers, provided that the Company has received a purchase order, the price is fixed, collection of the resulting receivable is reasonably assured and transfer of title and risk of loss has occurred. Subsequent to the sale of its products, the Company has no obligation to provide any modification or customization upgrades, enhancements or post contract customer support.

        Allowances are provided for estimated returns. A provision for estimated sales return allowances is recorded at the time revenue is recognized based on historical returns, current economic trends and changes in customer demand. Such allowances are adjusted periodically to reflect actual and anticipated experience. Such adjustments, which are recorded against revenue in the period, could be material.

Cash and Cash Equivalents

        The Company considers all highly liquid instruments with a maturity of three months or less when purchased to be cash equivalents. Cash equivalents consist primarily of market rate accounts, municipal bonds, and highly rated commercial paper that are stated at cost, which approximates fair value.

4

Concentrations of Risk

        The Company's dense wavelength division multiplexing ("DWDM") related products contributed revenues of $2.9 million and $7.0 million for the three and nine months ended September 30, 2006, respectively and $1.4 million and $5.1 million for the three and nine months ended September 30, 2005, respectively. In the nine months ended September 30, 2006 and September 30, 2005, the Company's top 10 customers comprised 58.1% and 58.2% of its revenues, respectively. For the nine months ended September 30, 2006, one customer accounted for 13.4% of total revenues. For the nine months ended September 30, 2005, one customers accounted for 11.0% of total revenues, respectively.

2. Recent Accounting Pronouncements

        In September 2006, the Financial Accounting Standards Board ("FASB") issued SFAS No. 157 ("FAS 157"), "Fair Value Measurements." Among other requirements, FAS 157 defines fair value and establishes a framework for measuring fair value and also expands disclosure about the use of fair value to measure assets and liabilities. FAS 157 is effective beginning the first fiscal year that begins after November 15, 2007. The Company is currently evaluating the impact of FAS 157 on our financial position and results of operations.

        In June 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109" ("FIN 48"). This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS No. 109, "Accounting for Income Taxes." This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact of adopting FIN 48 on the Consolidated Financial Statements.

        In March 2006, the FASB issued Statement of Financial Accounting Standard No. 156, "Accounting for Servicing of Financial Assets an amendment of FASB Statement No. 140". SFAS 156 amends SFAS Statement No.140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities", with respect to the accounting for separately recognized servicing assets and servicing liabilities. The Statement addresses the recognition and measurement of separately recognized servicing assets and liabilities and provides an approach to simplify efforts to obtain hedge-like (offset) accounting. SFAS 56 will be adopted January 1, 2007 as required by the statement. The Company does not believe adoption of SFAS 156 will have a material effect on its financial position, results of operations, or cash flows.

        In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments." SFAS No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. As of March 31, 2006, the Company did not have any hybrid financial instruments subject to the fair value election under SFAS No. 155. The Company is required to adopt SFAS No. 155 effective at the beginning of 2008. The Company does not believe adoption of SFAS 155 will have a material effect on its financial position, results of operations, or cash flows.

        Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the American Institute of Certified Public Accountants ("AICPA") and the SEC did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.

3. Stock-based Compensation

        Effective January 1, 2006, the Company adopted the provisions of FASB Statement No. 123 (revised 2004), "Share-Based Payment" and the Securities and Exchange Commission Staff Accounting Bulletin No. 107 (collectively, "Statement No. 123(R)"), which establish accounting for share-based payment ("SBP") awards exchanged for employee services and requires companies to expense the estimated fair value of these awards over the requisite employee service period.

        Prior to January 1, 2006, the Company accounted for stock-based compensation arrangements in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees". In addition, the Company complies with the disclosure provisions of SFAS No. 123, "Accounting for Stock-Based Compensation" and SFAS No. 148, "Accounting for Stock-Based Compensation, Transition and Disclosure." Equity instruments issued to non-employees are accounted for in accordance with the provisions of SFAS No. 123, SFAS 148 and EITF Issue No. 96-18, which require the award to be recorded at its fair value.

5

        Statement No. 123(R) requires companies to record compensation expense for stock options measured at fair value, on the date of grant, using an option-pricing model. The fair value of stock options is determined using the Binomial Lattice Model instead of the Black-Scholes Model previously utilized under Statement No. 123. The Company believes that the former represents a more likely projection of actual outcomes.

        The Company adopted the modified prospective transition method provided for under Statement No. 123(R) and, accordingly, has not restated prior period amounts. Under this transition method, compensation expense for the three and nine months ended September 30, 2006 includes compensation expense for all SBP awards granted prior to, but not yet vested as of, January 1, 2006 based on the grant date fair value estimated in accordance with the original provisions of Statement No. 123. Stock-based compensation expense for all SBP awards granted after January 1, 2006 is based on the grant date fair value estimated in accordance with the provisions of Statement No. 123(R). Stock-based compensation expense includes an estimate for forfeitures and is recognized over the expected term of the award on a straight-line basis. The Company evaluated the need to record a cumulative effect adjustment relating to estimated forfeitures for unvested previously issued awards, and the impact was not deemed to be material.

        As a result of adopting Statement No. 123(R), on January 1, 2006, the Company's income before income tax and net income for the three months ended September 30, 2006 was $358,000, or $83,000 lower than if it had continued to account for share-based compensation under APB Opinion 25. The Company's income before income tax and net income for the nine months ended September 30, 2006 was $4,000, or $192,000 lower than if it had continued to account for share-based compensation under Opinion 25. The adoption of Statement No. 123(R) did not impact basic and diluted income and loss per share for the three and nine months ended September 30, 2006.

        Statement No. 123(R) requires that the realized tax benefit related to the excess of the deductible amount over the compensation expense recognized be reported as a financing cash flow rather than as an operating cash flow, as required under previous accounting guidance. The Company does not recognize any tax benefit related to this based on Company's historical operating performance, lack of taxable income and the accumulated deficit.

        As of September 30, 2006, there was $0.4 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Company's various option plans. The cost is expected to be recognized over a period of 3.25 years.

        The following table presents the Company's pro forma net income and basic and diluted net income per share for the three and six months ended September 30, 2005 had compensation expense been determined in accordance with the fair value method of accounting at the grant dates for awards under the Company's various stock-based compensation plans:

6

	Three Months Ended	Nine Months Ended
	September 30, 2005	September 30, 2005
Net loss, as reported	$   (558)	$      (2,090)
Deduct: Total stock-based employee compensation
expense determined under the fair value method for
all awards, net of related taxes	$   (116)	$      (611)
Pro forma net loss	$   (674)	$      (2,701)
Net loss per share
Basic and Diluted - as reported	$   (0.01)	$      (0.05)
Basic and Diluted - pro forma	$   (0.02)	$      (0.07)
Shares used in EPS calculation (basic and diluted)	$   39,405	$      39,228

        For the three and nine months ended September 30, 2005, the fair value of SBP awards was estimated using the Black-Scholes valuation model, with the following weighted-average assumptions and fair values as follows:

	Three Months Ended	Nine Months Ended
	September 30, 2005	September 30, 2005
Volatility (percent)*	46.2	46.2
Expected term (in years)**	4	4
Risk-free interest rate (percent)***	4.04	3.87
Expected dividend rate (percent)	--	--
Weighted-average fair value per
option granted	N/A	N/A

* Volatility is measured using historical daily price changes of the Company's common stock over the expected life of the option

** The expected term represents the weighted average period the option is expected to be outstanding and is based primarily on the historical exercise behavior of employees.

*** The risk free interest rate is based on the U.S. Treasury zero-coupon yield with a maturity that approximates the expected life of the option.

N/A: There were no options granted during the period.

        For the three and nine months ended Septemebr 30, 2006, the fair value of SBP awards were estimated using the Binomial Lattice valuation model, with the following weighted-average assumptions and fair values as follows:

7

	Three Months Ended	Nine Months Ended
	September 30, 2006	September 30, 2006
Volatility (percent)*	36.7	36.7
Expected term (in years)**	4	4
Risk-free interest rate (percent)***	4.74	4.80
Expected dividend rate (percent)	--	--
Forfeiture rate (percent)****	10	10
Weighted-average fair value per
granted	$        0.71	$        0.71

* Volatility is projected using Industry Analysis forecasts for earnings, earnings per share, and stock price, and the Company's earning forecast.

** The expected term represents the weighted average period the option is expected to be outstanding and is based primarily on the historical exercise behavior of employees.

*** The risk free interest rate is based on the U.S. Treasury zero-coupon yield with a maturity that approximates the expected life of the option.

**** Forfeiture rate is the estimated percentage of options forfeited by employees by leaving or being terminated before vesting.

        At September 30, 2006, the Company had two stock-based compensation plans. They are: (a) 1997 Stock Option Plan and (b) 2000 Stock Incentive Plan, which are described below.

(a) 1997 Stock Option Plan

        In May 1997, the Company adopted its 1997 Stock Plan under which 3,000,000 shares of common stock were reserved for issuance to eligible employees, directors and consultants upon exercise of stock options and stock purchase rights. During the year ended December 31, 2000, an additional 5,200,000 shares were reserved for issuance under the 1997 Stock Plan. Incentive stock options are granted at a price not less than 100% of the fair market value of the Company's common stock and at a price of not less than 110% of the fair market value for grants to any person who owned more than 10% of the voting power of all classes of stock on the date of grant. Nonstatutory stock options are granted at a price not less than 85% of the fair market value of the common stock and at a price not less than 110% of the fair market value for grants to a person who owned more than 10% of the voting power of all classes of stock on the date of the grant. Options granted under the 1997 Stock Plan generally vest over four years and are exercisable for not more than ten years (five years for grants to any person who owned more than 10% of the voting power of all classes of stock on the date of the grant). In November 2000, the 1997 Stock Plan was replaced by the 2000 Stock Incentive Plan.

(b) 2000 Stock Incentive Plan

        In November 2000, the Company adopted its 2000 Stock Incentive Plan under which 1,500,000 shares of common stock were reserved for issuance to eligible employees, directors and consultants upon exercise of stock options and stock purchase rights. On January 1 of each year, beginning on January 1, 2001, the number of shares available for grant will automatically increase by the lesser of: (i) 1,700,000 shares; (ii) 5% of the fully diluted outstanding shares of stock on that date; or (iii) a lesser amount as may be determined by the Board of Directors. Incentive stock options are granted at a price not less than 100% of the fair market value of the Company's common stock and at a price of not less than 110% of the fair market value for grants to any person who owned more than 10% of the voting power of all classes of stock on the date of grant. Nonstatutory stock options are granted at a price not less than 85% of the fair market value of the common stock and at a price not less than 110% of the fair market value for grants to a person who owned more than 10% of the voting power of all classes of stock on the date of the grant. Options granted under the 2000 Stock Incentive Plan generally vest over four years and are exercisable for not more than ten years (five years for grants to any person who owned more than 10% of the voting power of all classes of stock on the date of the grant).

        The following information relates to the stock option activity for the nine months ended September 30, 2006:

8

	Nine Months Ended September 30, 2006
Options	Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life		Aggregate Intrinstc Value
Outstanding at December 31, 2005		4,840,383	$	1.12
Granted		100,000		1.33
Exercised		(270,850)		0.72
Forfeited		(144,500)		1.14
Outstanding at September 30, 2006		4,525,033	$	1.15		7.1 Years	$	1,603,303
Vested and expected to vest at September 30, 2006		4,466,779	$	1.15		7.1 Years	$	1,571,179
Exercisable at September 30, 2006		3,942,491	$	1.17		6.9 Years	$	1,282,061

        The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company's closing stock price on the last trading day of the third quarter of fiscal 2006 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on September 30, 2006. This amount changes based on the fair market value of the Company's stock. The total intrinsic value of options exercised for the three months ended September 30, 2006 and 2005 was $25,000 and $82,000, respectively. The total intrinsic value of options exercised for the nine months ended September 30, 2006 and 2005 was $327,000 and $161,000, respectively.

         No options were granted during the quarter ended September 30, 2005.

        The expected dividend rate is 0% for both three month periods ended September 30, 2006 and 2005 respectively.

        Cash received from option exercises during the three and nine months ended September 30, 2006 was $26,000 and $194,000, respectively, and is included within the financing activities section in the accompanying consolidated statements of cash flows.

Employee Stock Purchase Plan

        In November 2000, the Company adopted its 2000 Employee Stock Purchase Plan (the "Plan"). The Company reserved 1,500,000 shares of common stock for issuance under the Plan. On the first day of January each year beginning January 1, 2001, additional shares of common stock are reserved for issuance under the Plan as determined by the Board of Directors. The plan limits the annual increase to the lesser of 1% of the Company's issued and outstanding common stock or 1,000,000 shares. The Plan provides eligible employees with the opportunity to acquire shares of common stock at a price of 85% of the lower of the fair market value of the common stock on the first day of the offering period or the last day of the offering period, whichever is lower. The Plan is structured as a qualified employee stock purchase plan under Section 423 of the Internal Revenue Code of 1986. However, the Plan is not intended to be a qualified pension, profit sharing or stock bonus plan under Section 401(a) of the 1986 Code and is not subject to the provisions of the Employee Retirement Security Act of 1974. The Board may amend, suspend, or terminate the Plan at any time without notice.

9

The following information relates to the plan:

Additional Information About ESPP
Weighted average fair value per share of purchase	$	0.71
Total compensationn expense for ESPP	$	22,975
Total amount of cash received from the puchase of stock through ESPP	$	200,374
Total intrinsic value of ESPP stock purchased as September 30, 2006	$	223,598

4. Inventories, net (in thousands)

	September 30, 2006	December 31, 2005
Inventories
Finished goods	$   1,691	$      842
Work-in-process	1,872	1,579
Raw materials	1,249	1,249
	$   4,812	$   3,670

5. Net Loss Per Share

        Basic net loss per share is computed by dividing net loss for the period by the weighted average number of shares of common stock outstanding during the period. Diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of common and potential common equivalent shares outstanding during the period. The calculation of diluted net loss per share excludes potential common shares if the effect is anti-dilutive. Potential common shares are composed of shares of common stock subject to repurchase and common stock issuable upon the exercise of stock options. As the Company is in a net loss position, diluted net loss per share is the same as basic net loss per share for all periods presented as the effect of potential common shares would be anti-dilutive.

        The following table sets forth the computation of basic and diluted net loss per share for the periods indicated (in thousands, except per share data):

10

	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
Numerator
Net income (loss)	$	358	$	(558)	$	4	$	(2,090)
Denominator:
Shares used in computing net income (loss) per share:
Weighted average of common shares outstanding		40,205		39,405		40,023		39,228
Less: Weighted average of shares subject to repurchase		-		-		-		-
Basic		40,205		39,405		40,023		39,228
Diluted		43,728		39,405		43,545		39,228
Net income (loss) per share:
Basic	$	0.01	$	(0.01)	$	0.00	$	(0.05)
Diluted	$	0.01	$	(0.01)	$	0.00	$	(0.05)

        All outstanding stock options and shares subject to repurchase by the Company have been excluded from the calculation of diluted net loss per share as all such securities were anti-dilutive for all periods presented. The total number of shares excluded from the calculation of diluted net loss per share is as follows (in thousands):

	Nine Months Ended September 30,
	2006		2005
Options to purchase common stock and
shares subject to repurchase		1,002		4,057

6. Comprehensive Loss

        Comprehensive income (loss) is defined as the change in equity of a company during a period resulting from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners. The difference between net loss and comprehensive loss for the Company is due to foreign exchange translations adjustments and unrealized gain (loss) on available-for-sale securities.

        The components of comprehensive income (loss) are as follows (in thousands):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
Net income (loss)	$	358	$	(558)	$	4	$	(2,090)
Cumulative translation adjustments		42		(18)		18		(369)
Unrealized gain on short-term investments		9		(14)		22		30
Total comprehensive income (loss)	$	409	$	(590)	$	44	$	(2,429)

7. Commitments and Contingencies

Litigation:

        From time to time, the Company may be involved in litigation in the normal course of business. As of the date of these financial statements, the Company is not aware of any material legal proceedings pending or threatened against the Company.

11

Indemnification and Product Warranty:

        The Company indemnifies certain customers, suppliers and subcontractors for attorney fees and damages and costs awarded against these parties in certain circumstances in which products are alleged to infringe third party intellectual property rights, including patents, trade secrets, trademarks or copyrights. In all cases, there are limits on and exceptions to the potential liability for indemnification relating to intellectual property infringement claims. The Company cannot estimate the amount of potential future payments, if any, that it might be required to make as a result of these agreements. To date, the Company has not paid any claim or been required to defend any action related to indemnification obligations, and accordingly, the Company has not accrued any amounts for such indemnification obligations. However, the Company may record charges in the future as a result of these indemnification obligations.

        The Company generally warrants products against defects in materials and workmanship and non-conformance to specifications for varying lengths of time. If there is a material increase in customer claims compared with historical experience, or if costs of servicing warranty claims are greater than expected, the Company may record a charge against cost of revenues.

Operating Leases:

        The Company leases certain office space under long-term operating leases expiring at various dates through 2010.

The Company’s aggregate future minimum facility lease payments are as follows (in thousands):

Three months ending December 31, 2006	$	215
Years ending December 31:
2007		630
2008		602
2009		437
2010		238
Total	$	2,122

Letter of Credit:

        The Company had a letter of credit of $0.4 million outstanding as of September 30, 2006. The letter of credit is collateralized by short-term investments of $0.4 million.

8. Bank Loan

        In November 2004, the Company entered into a ten-year loan of $0.5 million with a lender in Taiwan. The loan has a fixed interest rate of 2.3% for the first year after which the loan has a variable interest rate equal to Taiwan's prime rate for the remaining years. The loan is secured by the Company's building in Taiwan. The net book value of the building was $0.6 million as of September 30, 2006.

Payments due under the bank loan as of September 30, 2006 are as follows (in thousands):

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Years ending December 31,
2006		22
2007		89
2008		89
2009		89
2010		66
2011 and after		210
Total payment		565
Less: Amounts representing interest		(67	)
Present value of net remaining payments		498
Less: current portion		(73	)
Long-term portion	$	425

9. Related Party Transactions

        As of September 30, 2006, Foxconn Holding Limited was a holder of 19.9% of the Company's common stock, based on share ownership information set forth in a Schedule 13G filed by Foxconn Holding Limited on January 4, 2002. The Company sells products and purchases raw materials from Hon Hai Precision Company Limited, who is the parent company of Foxconn Holding Limited, in the normal course of business. These transactions were made at prices and terms consistent with those with unrelated third parties. Sales of products to Hon Hai Precision Industry Company Limited were $31,000 and $0.4 million for the three and nine months ended September 30, 2006. Purchases of raw materials from Hon Hai Precision Company Limited were $0.6 million and $1.8 million for the three and nine months ended September 30, 2006. Amounts due from Hon Hai Precision Company Limited were $49,000 at September 30, 2006. Amounts due to Hon Hai Precision Company Limited were $0.5 million at September 30, 2006.

10. Geographic Segment Information

        The Company operates in a single industry segment. This industry segment is characterized by rapid technological change and significant competition.

        The following is a summary of the Company's revenues generated by geographic segments, revenues generated by product lines and identifiable assets located in these segments (in thousands):

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	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
Revenues
North America	$	5,393	$	4,109	$	13,613	$	11,623
Asia		1,727		1,002		4,175		3,290
Europe		453		158		1,258		540
	$	7,573	$	5,269	$	19,046	$	15,453

	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
Revenues
Optical path mulitplexing solution	$	4,699	$	3,901	$	12,010	$	10,327
Dense wave division multiplexer		2,874		1,368		7,036		5,126
	$	7,573	$	5,269	$	19,046	$	15,453

	September 30, 2006		December 31, 2005
Property and Equipment
United States	$	161	$	371
Taiwan		2,807		3,129
China		1,089		1,064
	$	4,057	$	4,564

ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        When used in this Report, the words "expects," "anticipates," "believes", "estimates," "plans," "intends," "could," "will," "may" and similar expressions are intended to identify forward-looking statements. These are statements that relate to future periods and include statements as to our operating results, revenues, sources of revenues, cost of revenues, gross profit, net operating losses, profitability, the amount and mix of anticipated investments, expenditures and expenses, our liquidity and the adequacy of our capital resources, exposure to interest rate or currency fluctuation, anticipated working capital and capital expenditures, reliance on our OPMS products, our cash flow, trends in average selling prices, our reliance on the commercial success of our DWDM-related products, plans for future products and enhancements of existing products, features, benefits and uses of our products, demand for our products, our success being tied to relationships with key customers, industry trends and market demand, acquisitions of complementary businesses, products or technologies, our efforts to protect our intellectual property, potential indemnification agreements, increases in the number of possible license offers and patent infringement claims, our competitive position, sources of competition, consolidation in our industry, our international strategy, inventory management, our plans for a reverse stock split, our employee relations, the adequacy of our internal controls, the effect of recent and changing accounting pronouncements and our critical accounting policies, estimates, models and assumptions. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. These risks and uncertainties include, but are not limited to, those risks discussed elsewhere in this report, as well as risks related to the development of the metropolitan, last mile access, and enterprise networks, customer acceptance of our products, our ability to retain and obtain customers, industry-wide overcapacity and shifts in supply and demand for optical components and modules, our ability to meet customer demand and manage inventory, fluctuations in demand for our products, declines in average selling prices, development of new products by us and our competitors, increased competition, inability to obtain sufficient quantities of a raw material product, loss of a key supplier, integration of acquired businesses or technologies, financial stability in foreign markets, foreign currency exchange rates, interest rates, costs associated with being a public company, delisting from the Nasdaq Capital Market, failure to meet customer requirements, our ability to license intellectual property on commercially reasonable terms, economic stability, and the risks set forth below under Part II, Item 1A, "Risk Factors." These forward-looking statements speak only as of the date hereof. The Company expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in the Company's expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

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        This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's Annual Report on Form 10-K, its Consolidated Financial Statement and the notes thereto, for the year ended December 31, 2005.

        The following discussion should be read in conjunction with our Condensed Consolidated Financial Statements and Notes thereto.

Critical Accounting Policies and Estimates

Stock-based Compensation Expense

        On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment," ("SFAS 123(R)") which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan ("ESPP") based on estimated fair values. We adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of our fiscal year 2006. Our Consolidated Financial Statements as of and for the three and nine months ended September 30, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, our Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our Consolidated Statement of Operations. Prior to the adoption of SFAS 123(R), we accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123). As stock-based compensation expense recognized in the Consolidated Statement of Operations for the first quarter of fiscal 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The estimated average forfeiture rates for the three and nine months ended September 30, 2006, of approximately 10% were based on historical forfeiture experience. In our pro forma information required under SFAS 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred.

        Stock-based compensation expense recognized under SFAS 123(R) for the three and nine months ended September 30, 2006 was $83,000 and $192,000, respectively, determined by the Binomial Lattice valuation model, and represents stock-based compensation expense related to employee stock options. As of September 30, 2006, total unrecognized compensation costs related to unnvested stock options was $0.4 million, which is expected to be recognized as an expense over a weighted average period of approximately 3.25 years. Subsequent to the adoption of SFAS 123(R), we have not made any changes in the type of incentive equity instruments or added any performance conditions to the incentive options.

        Management's discussion and analysis of financial condition and results of operations is based on our Condensed Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, bad debts, inventories, asset impairments, income taxes, contingencies, and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values for assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

        For additional information regarding our critical accounting policies and estimates, see the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K, for the year ended December 31, 2005.

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Overview

        We were founded in December 1995 and commenced operations to design, manufacture and market fiber optic interconnect products, which we call our Optical Path Management Solution, or OPMS, products. We started selling our dense wavelength division multiplexing, or DWDM, and other wavelength management products in July 2000. Since introduction, sales of DWDM-related products have fluctuated with the overall market for these products.

        From our inception through September 30, 2006, we derived a substantial portion of our revenues from our OPMS product line, although revenues from our DWDM product line have increased as a percentage of revenues in the last few quarters. Revenues from our DWDM products represented 38.0% and 26.0% of total revenues for the three months ended September 30, 2006 and 2005, respectively, and 36.9% and 33.2% of total revenues for the nine months ended September 30, 2006 and 2005, respectively. We market and sell our products predominantly through our direct sales force.

        Our cost of revenues consists of raw materials, components, direct labor, manufacturing overhead and production start-up costs. We expect that our cost of revenues as a percentage of revenues will fluctuate from period to period based on a number of factors including:

     o   changes in manufacturing volume;

     o   costs incurred in establishing additional manufacturing lines and facilities;

     o   inventory write-downs and impairment charges related to manufacturing assets;

     o   mix of products sold;

     o   changes in our pricing and pricing from our competitors;

     o   mix of sales channels through which our products are sold; and

     o   mix of domestic and international sales.

        Research and development expenses consist primarily of salaries and related personnel expenses, fees paid to outside service providers, materials costs, test units, facilities, overhead and other expenses related to the design, development, testing and enhancement of our products. We expense our research and development costs as they are incurred. We believe that a significant level of investment for product research and development is required to remain competitive.

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

General and administrative expenses consist primarily of salaries and related expenses for executive, finance, administrative, accounting and human resources personnel, insurance and professional fees for legal and accounting support.

        In connection with the grant of stock options to employees and consultants, we recorded deferred stock-based compensation of approximately $26.8 million in stockholders' equity prior to our initial public offering, representing the difference between the estimated fair market value of our common stock and the exercise price of these options at the date of grant. Deferred stock-based compensation was being amortized using the graded vesting method, under which each option grant was separated into portions based on its vesting terms which resulted in acceleration of amortization expense for the overall award. The deferred stock-based compensation balance was fully amortized on an accelerated basis by December 1, 2004.

        In January 2004, we completed the purchase of the assets of Taiwan-based Ritek Corporation's photonic business unit in exchange for 1.7 million shares of our common stock. The total purchase price was $4.0 million, including $1.5 million in cash from Ritek. The unit is located in Hsin Chu Industrial Park, Taiwan.

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Results of Operations

        The following table sets forth the relationship between various components of operations, stated as a percentage of revenues for the periods indicated:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
Revenues		100.0%		100.0%		100.0%		100.0%
Cost of revenues		71.3		78.6		73.0		79.5
Gross profit		28.1		21.4		27.0		20.5
Operating expenses:
Research and development:		10.8		14.9		12.0		16.9
Sales and marketing:		7.2		9.9		8.9		10.7
General and administrative		10.4		14.3		11.9		14.4
Total operating expenses		28.4		39.1		32.8		42.0
Income(loss) from operations		0.3		(17.7)		(5.8)		(21.5)
Interest and other income, net		4.4		7.1		5.8		8.0
Net income (loss)		4.7%		(10.6%)		0.0%		(13.5%)

        Revenues. . . Revenues were $7.6 million and $5.3 million for the three months ended September 30, 2006 and 2005, respectively. Revenues increased 43.7% in the quarter ended September 30, 2006 from the same period in 2005 primarily due to increased volume shipments of our OPMS products for various premise cabling applications and increased sales into Fiber to the Home (FTTH) systems. The FTTH sales increase resulted from production demand from a video system customer. Revenues were $19.0 million and $15.5 million for the nine months ended September 30, 2006 and 2005, respectively. Revenues increased 23.3% in the nine months ended September 30, 2006 from the same period in 2005, primarily due to increased volume shipments of our OPMS and DWDM products of various applications including FTTH.

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        Cost of Revenues. Cost of revenues was $5.4 million and $4.1 million for the three months ended September 30, 2006 and 2005, respectively. Cost of revenues as a percentage of revenues decreased to 71.3% for the three months ended September 30, 2006 from 78.6% for the three months ended September 30, 2005. Cost of revenues was $13.9 million and $12.3 million for the nine months ended September 30, 2006 and 2005, respectively. Cost of revenues as a percentage of revenues decreased to 73.0% for the nine months ended September 30, 2006 from 79.6% for the nine months ended September 30, 2005. Cost of revenues for the period ended September 30, 2006 benefited from increased factory utilization and improved manufacturing overhead absorption as a result of increased volume shipments of our products.

        Gross Profit. Gross profit increased to $2.2 million, or 28.7% of revenues, for the three months ended September 30, 2006 from $1.1 million, or 21.4% of revenues, for the same period in 2005. Gross profit increased to $5.1 million, or 27.0% of revenues, for the nine months ended September 30, 2006 from $3.2 million, or 20.5% of revenues, for the same period in 2005. For the period ended September 30, 2006, higher utilization of our factories as a result of increased volume shipments of our products resulted in an improved gross margin. We expect our gross profit as a percentage of revenues to continue to improve in the near term due to higher production volumes, which we anticipate will result in improved absorption of overhead expenses. However, we expect that decreasing average selling prices will negatively impact our gross profit and may offset any benefits from improved absorption. We had approximately $2.1 million in DWDM-related net inventory and $2.7 million in OPMS-related net inventory on hand at September 30, 2006. Although we continue to take steps to attempt to manage future inventory levels, we may have to record additional inventory provisions in future periods if demand for our products decrease below our forecasted levels.

        Research and Development Expenses. . Research and development expenses remained at $0.8 million for the three months ended September 30, 2006 and for the same period in 2005. Research and development expenses decreased to $2.3 million for the nine months ended September 30, 2006 from $2.6 million for the same period in 2005. The decrease was primarily due to lower headcount related expenses. As a percentage of revenues, research and development expenses decreased to 10.8% in the three months ended September 30, 2006 from 14.9% for the same period in 2005. As a percentage of revenues, research and development expenses decreased to 12.0% in the nine months ended September 30, 2006 from 16.9% for the same period in 2005. We expect research and development expenses on our product development efforts may increase in the last quarter of 2005 as we intend to continue to invest in our research and product development efforts.

        Sales and Marketing Expenses. Sales and marketing expenses remained at $0.5 million for the three months ended September 30, 2006 and for the same period in 2005. Sales and marketing expenses remained at $1.7 million for the nine months ended September 30, 2006 and for the same period in 2005. As a percentage of revenues, sales and marketing expenses decreased to 7.2% in the three months ended September 30, 2006 from 9.9% for the same period in 2005. As a percentage of revenues, sales and marketing expenses decreased to 8.9% in the nine months ended September 30, 2006 from 10.7% for the same period in 2005. We expect sales and marketing expenses to decline slightly in the next quarter as a result of fewer trade show activities.

        General and Administrative Expenses. General and administrative expenses remained at $0.8 million for the three months ended September 30, 2006 and for the same period in 2005. General and administrative expenses increased to $2.3 million for the nine months ended September 30, 2006 from $2.2 million for the same period in 2005. As a percentage of revenues, general and administrative expenses decreased to 10.4% in the three months ended September 30, 2006 from 14.3% for the same period in 2005. As a percentage of revenues, general and administrative expenses decreased to 11.9% in the nine months ended September 30, 2006 from 14.4% for the same period in 2005. We expect general and administrative expenses will increase due to higher fees and costs associated with compliance with new laws and regulations such as the Sarbanes-Oxley Act of 2002 and the regulations promulgated thereunder.

        Stock-Based Compensation. Total stock based compensation increased to $83,000 for the three months ended September 30, 2006 from $0 for the same period in 2005. Total stock based compensation increased to $192,000 for the nine months ended September 30, 2006 from $0 for the same period in 2005. This increase was due to the adoption of SFAS No. 123R ("Accounting for Stock Based Compensation") as of January 2006. In 2005, the Company accelerated the vesting of options to purchase up to approximately 1.9 million shares. The Company's accounting policy requires the amortization of a larger proportion of deferred compensation expense during the early vesting periods of the option grants. The deferred compensation balance was fully amortized as of December 1, 2004. This resulted in no stock based compensation in the first quarter of 2005.

        Interest and Other Income, Net. . Interest and other income, net, was $0.3 million and $0.4 million for the three months ended September 30, 2006 and 2005, respectively. Interest and other income, net, was $1.1 million and $1.2 million for the nine months ended September 30, 2006 and 2005, respectively.

18

Liquidity and Capital Resources

        At September 30, 2006, we had cash and cash equivalents of $3.9 million and short-term investments of $25.9 million.

        Net cash provided by operating activities was $564,000 for the nine months ended September 30, 2006. The cash provided was primarily due to depreciation expenses of $1.0 million and a $0.4 million inventory provision, which was partially offset by $1.5 million increase in inventory. Accounts receivable increased by $0.3 million and prepaid expenses and other assets increased by $0.2 million offset by a $0.8 million increase in accounts payable and a $0.2 million increase in accrued expenses. Net cash used in operating activities was $1.6 million for the nine months ended September 30, 2005, and was primarily due to a net loss of $2.1 million.

        Net cash provided by investing activities was $0.3 million for the nine months ended September 30, 2006. This resulted from $0.8 million in net proceeds from sales of short-term investments offset by $0.5 million spending on equipment. Cash used in investing activities was $2.0 million for the nine months ended September 30, 2005. In the nine months ended September 30, 2005, we spent a net $1.4 million for the purchase of short-term securities, and we used $0.6 million for property and equipment.

        Cash provided by financing activities was $0.3 million and $0.4 million for the nine months ended September 30, 2006 and 2005, respectively, and was comprised of proceeds from exercise of options to purchase common stock and common stock issued through our Employee Stock Purchase Plan. Cash provided for the nine months ended September 30, 2005 also included net proceeds from borrowings under an equipment loan of $0.2 million offset by repayment of bank borrowings.

        We believe that our current cash, cash equivalents and short-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, our future growth, including any potential acquisitions, may require additional funding. If cash generated from operations is insufficient to satisfy our long-term liquidity requirements, we may need to raise capital through additional equity or debt financings, additional credit facilities, strategic relationships or other arrangements. If additional funds are raised through the issuance of securities, these securities could have rights, preferences and privileges senior to holders of common stock, and the terms of any debt facility could impose restrictions on our operations. The sale of additional equity or debt securities could result in additional dilution to our stockholders, and additional financing may not be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain additional financing, we may be required to reduce the scope of our planned product development and marketing efforts. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish our rights to certain of our technologies or products. Our failure to raise capital when needed could harm our business, financial condition and operating results.

Contractual Obligations

	Payments Due by Period
	Total		Less than 1 Year		1-3 Years		3-5 Years		More than 5 Year
					(In thousa	nds)
Longterm debt obligations	$	565	$	89	$	178	$	128	$	170
Operating lease obligations		2,122		696		1,080		346		--
Total	$	2,687	$	785	$	1,258	$	474	$	170

         In November 2004, the Company entered into a ten-year loan of $0.5 million with a lender in Taiwan. The loan has a fixed interest rate of 2.3% for the first year after which the loan has a variable interest rate equal to Taiwan's prime rate for the remaining years. The loan is secured by the Company's building in Taiwan. The net book value of the building was $0.6 million as of September 30, 2006.

        Our corporate headquarters are in Sunnyvale, California where we lease the facilities from a third party. The lease has a six-year term commencing on July 22, 2004, the facility is 34,800 square feet and the current monthly rent is approximately $32,000.

        In December 2000, we purchased approximately 8,200 square feet of space immediately adjacent to our leased facility in Tu-Cheng City, Taiwan for $0.8 million. In August 2002, we entered into a lease for 62,000 square foot facility in the Shenzhen area of China, which will expire in July 2007.

        Additionally, in February 2006, we entered into a new lease for a total of 21,600 square feet facility located in Hu-Kou, Taiwan. This lease will expire in January 2009.

Off-balance Sheet Arrangements

As of September 30, 2006, we did not have any off-balance sheet arrangements.

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ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Sensitivity

        We currently maintain our funds primarily in money market funds and highly liquid marketable securities. We do not have any derivative financial instruments. As of September 30, 2006, $4.1 million, or 15% of our investments, had maturities of less than three months. We will continue to invest a significant portion of our existing cash in interest bearing, investment grade securities, with maturities of less than 12 months pending their need for other uses. We do not believe that our investments, in the aggregate, have significant exposure to interest rate risk and we do not believe that a 10% change in interest rates will have a significant impact on our investments or interest income.

Exchange Rate Sensitivity

        We currently have operations in the United States, Taiwan and China. The functional currency of our subsidiaries in Taiwan and China are the local currencies, and we are subject to foreign currency exchange rate fluctuations associated with the translation to United States dollars. Though some expenses are incurred by our Taiwan and China operations, substantially all of our sales are made in United States dollars; hence, we have minimal exposure to foreign currency rate fluctuations relating to sales transactions. We do not believe that a hypothetical change of 10% in the foreign currency exchange rates would have a material impact on our financial results.

        While we expect our international revenues to continue to be denominated predominately in United States dollars, an increasing portion of our international revenues may be denominated in foreign currencies in the future. In addition, we plan to continue to expand our overseas operations. As a result, our operating results may become subject to significant fluctuations based upon changes in exchange rates of certain currencies in relation to the United States dollar. We will analyze our exposure to currency fluctuations and may engage in financial hedging techniques in the future to attempt to minimize the effect of these potential fluctuations; however, exchange rate fluctuations may adversely affect our financial results in the future.

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ITEM 4: CONTROLS AND PROCEDURES

        (a) Evaluation of disclosure controls and procedures. We maintain "disclosure controls and procedures," as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act"), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Acting Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Our disclosure controls and procedures have been designed to meet reasonable assurance standards. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Chief Executive Officer and Acting Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective to ensure that material information relating to us, including our consolidated subsidiaries, is made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared.

        (b) Changes in internal controls. There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with the evaluation described in Item 3(a) above that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II: OTHER INFORMATION

ITEM 1A: RISK FACTORS

        We have a history of losses, expect future losses and may not be able to generate sufficient revenues in the future to achieve and sustain profitability.

        We had net income of approximately $0.4 million in the third quarter of fiscal 2006. We incurred net losses of approximately $0.6 million in the third quarter of fiscal 2005. Although we generated a profit in the second and third quarters, we may not be able to sustain profitability in the future. Although our cash and cash equivalents increased from previous two quarters, we could find our cash flows to be negative again in the future as we continue to invest in our business. As of September 30, 2006, we had an accumulated deficit of approximately $72.5 million.

        Although we continue to experience fluctuating demand for our products, we are hopeful that demand for our products will increase in the future. If this happens, we expect we will incur significant and increasing expenses for expansion of our manufacturing operations, research and development, sales and marketing, and administration, and in developing direct sales and distribution channels. Given the rate at which competition in our industry intensifies and the fluctuations in demand for our products, we may not be able to adequately control our costs and expenses or achieve or maintain adequate operating margins. As a result, to achieve and maintain profitability, we will need to generate and sustain substantially higher revenues while maintaining reasonable cost and expense levels. We may not be able to achieve and sustain profitability on a quarterly or an annual basis.

        Our quarterly and annual financial results have historically fluctuated due primarily to introduction of, demand for, and sales of our products, and future fluctuations may cause our stock price to decline.

        We believe that period-to-period comparisons of our operating results are not a good indication of our future performance. Our quarterly operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a number of factors. For example, the timing and expenses associated with product introductions and establishing additional manufacturing lines and facilities, changes in manufacturing volume, declining average selling prices of our products, the timing and extent of product sales, the mix of domestic and international sales, the mix of sales channels through which our products are sold, the mix of products sold and significant fluctuations in the demand for our products have caused our operating results to fluctuate in the past. Because we incur operating expenses based on anticipated revenue trends, and a high percentage of our expenses are fixed in the short term, any delay in generating or recognizing revenues or any decrease in revenues could significantly harm our quarterly results of operations. Other factors, many of which are more fully discussed in other risk factors below, may also cause our results to fluctuate. Many of the factors that may cause our results to fluctuate are outside of our control. If our quarterly or annual operating results do not meet the expectations of investors and securities analysts, the trading price of our common stock could significantly decline.

        Our Optical Path Management Solution (OPMS) products have historically represented a substantial portion of our revenues, and if we are unsuccessful in commercially selling our DWDM-related products, our business will be seriously harmed.

        Sales of our OPMS products accounted for over 62.0% of our revenues in the quarter ended September 30, 2006 and a substantial portion of our historical revenues. We expect to substantially depend on these products for our near-term revenues. Any significant decline in the price of, or demand for, these products, or failure to increase their market acceptance, would seriously harm our business. In addition, we believe that our future growth and a significant portion of our future revenues will depend on the commercial success of our DWDM-related products, which we began shipping commercially in July 2000. Demand for these products have fluctuated over the past few years as demand declined sharply starting in mid fiscal 2001 and then increased beginning in 2003. If demand for these products does not continue to increase and our target customers do not continue to adopt and purchase our DWDM-related products, our revenues may decline further and we may have to write-off additional inventory that is currently on our books.

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        We are experiencing fluctuations in market demand due to overcapacity in our industry and an economy that is stymied by international terrorism, war and political instability.

        The United States economy has experienced and continues to experience significant fluctuations in consumption and demand since 2001. During the past few years, telecommunication companies have periodically decreased their spending which has resulted in excess inventory, overcapacity and a decrease in demand for our products. We may experience periodic decreases in the demand for our products due to a weak domestic and international economy as the fiber optics industry copes with the effects of oversupply of products, international terrorism, war and political instability. Even if the general economy experiences a recovery, the activity of the United States telecommunications industry may lag behind the recovery of the overall United States economy.

        If we cannot attract more optical communications equipment manufacturers to purchase our products, we may not be able to increase or sustain our revenues.

        Our future success will depend on our ability to migrate existing customers to our new products and our ability to attract additional customers. Some of our present customers are relatively new companies. The growth of our customer base could be adversely affected by:

     o     customer unwillingness to implement our products;

     o     any delays or difficulties that we may incur in completing the development and introduction of our planned products or product enhancements;

     o     the success of our customers;

     o     excess inventory in the telecommunications industry;

     o     new product introductions by our competitors;

     o     any failure of our products to perform as expected; or

     o     any difficulty we may incur in meeting customers' delivery requirements or product specifications.

        The fluctuations in the economy have affected the telecommunications industry. Telecommunications companies have cut back on their capital expenditure budgets, which has and may continue to further decrease demand for equipment and parts, including our products. This decrease has had and may continue to have an adverse effect on the demand for fiber optic products and negatively impact the growth of our customer base.

        We are exposed to risks and increased expenses and business risk as a result of new Restriction on Hazardous Substances (RoHS) directives.

        Following the lead of the European Union, or EU, various governmental agencies have either already put into place or are planning to introduce regulations that regulate the permissible levels of hazardous substances in products sold in various regions of the world. For example, the RoHS directive for EU took effect on July 1, 2006. Consequently, many suppliers of products sold into the EU countries have required their suppliers to be compliant with the new directive. Many of our customers have adopted this approach and have required our full compliance. Though we have devoted a significant amount of resources and effort planning and executing our RoHS program, it is possible that some portion of our products might be incompatible with such regulations. In such events, we could experience the following consequences: loss of revenue, damaged reputation, diversion of resources, monetary penalties, and legal action.

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        The market for fiber optic components is increasingly competitive, and if we are unable to compete successfully our revenues could decline.

        The market for fiber optic components is intensely competitive. We believe that our principal competitors are the major manufacturers of optical components and integrated modules, including vendors selling to third parties and business divisions within communications equipment suppliers. Our principal competitors in the components market include Avanex Corp., DiCon Fiberoptics, Inc., JDS Uniphase Corp., Oplink Communications Inc., Stratos International, Inc. and Tyco Electronics Corporation. We believe that we primarily compete with diversified suppliers for the majority of our product line and to a lesser extent with niche companies that offer a more limited product line. Competitors in any portion of our business may also rapidly become competitors in other portions of our business. In addition, our industry has recently experienced significant consolidation, and we anticipate that further consolidation will occur. This consolidation has further increased competition.

        Many of our current and potential competitors have significantly greater financial, technical, marketing, purchasing, manufacturing and other resources than we do. As a result, these competitors may be able to respond more quickly to new or emerging technologies and to changes in customer requirements, to devote greater resources to the development, promotion and sale of products, to negotiate lower prices on raw materials and components, or to deliver competitive products at lower prices.

        Several of our existing and potential customers are also current and potential competitors of ours. These companies may develop or acquire additional competitive products or technologies in the future and subsequently reduce or cease their purchases from us. In light of the consolidation in the optical networking industry, we also believe that the size of suppliers will be an increasingly important part of a purchaser's decision-making criteria in the future. We may not be able to compete successfully with existing or new competitors, and we cannot ensure that the competitive pressures we face will not result in lower prices for our products, loss of market share, or reduced gross margins, any of which could harm our business.

        New and competing technologies are emerging due to increased competition and customer demand. The introduction of products incorporating new or competing technologies or the emergence of new industry standards could make our existing products noncompetitive. For example, there are technologies for the design of wavelength division multiplexers that compete with the technology that we incorporate in our products. If our products do not incorporate technologies demanded by customers, we could lose market share causing our business to suffer.

        If we fail to effectively manage our operations, specifically given the past history of sudden and dramatic downturn in demand for our products, our operating results could be harmed.

        We rapidly expanded our operations domestically and internationally in the final two quarters of 2000. We had to carefully manage and re-evaluate this expansion given the sudden and dramatic downturn in demand for our products experienced in 2001 and 2002. Additionally, we implemented a reduction in force to reduce employees during the second, third and fourth quarters of 2002 to match our operations to this decreased demand for our products. As of September 30, 2006, we had a total of 44 full-time employees in Sunnyvale, California, 363 full-time employees in Taiwan, and 260 full-time employees in China. Matching the scale of our operations with demand fluctuations, combined with the challenges of expanding and managing geographically dispersed operations, has placed, and will continue to place, a significant strain on our management and resources. To manage the expected fluctuations in our operations and personnel, we will be required to:

     o     improve existing and implement new operational, financial and management controls, reporting systems and procedures;

     o     hire, train, motivate and manage additional qualified personnel, especially if we experience a significant increase in demand for our products;

     o     effectively expand or reduce our manufacturing capacity, attempting to adjust it to customer demand; and

     o     effectively manage relationships with our customers, suppliers, representatives and other third parties.

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        In addition, we will need to coordinate our domestic and international operations and establish the necessary infrastructure to implement our international strategy. If we are not able to manage our operations in an efficient and timely manner, our business will be severely harmed.

        Our success also depends, to a large degree, on the efficient and uninterrupted operation of our facilities. We have expanded our manufacturing facilities in Taiwan and manufacture many of our products there. Our facility in China also houses a substantial portion of our manufacturing operations. There is significant political tension between Taiwan and China. If there is an outbreak of hostilities between Taiwan and China, our manufacturing operations may be disrupted or we may have to relocate our manufacturing operations. Tensions between Taiwan and China may also affect our facility in China. Relocating a portion of our employees could cause temporary disruptions in our operations and divert management's attention.

        Because of the time it takes to develop fiber optic components, we incur substantial expenses for which we may not earn associated revenues.

        The development of new or enhanced fiber optic products is a complex and uncertain process. We may experience design, manufacturing, marketing and other difficulties that could delay or prevent the development, introduction or marketing of new products and enhancements. Development costs and expenses are incurred before we generate revenues from sales of products resulting from these efforts. Our total research and development expenses were approximately $0.8 million for the three months ended September 30, 2006 and 2005, respectively. Our total research and development expenses were approximately $2.3 million and $2.6 million for the nine months ended September 30, 2006 and 2005, respectively. We expect that our research and development expense may increase in the last quarter of 2006 as we intend to continue to invest in our research and product development efforts. Any such increase could have a negative impact on our earnings in future periods.

        If we are unable to develop new products and product enhancements that achieve market acceptance, sales of our fiber optic components could decline, which could reduce our revenues.

        The communications industry is characterized by rapidly changing technology, frequent new product introductions, changes in customer requirements, evolving industry standards and, more recently, significant variations in customer demand. Our future success depends on our ability to anticipate market needs and develop products that address those needs. As a result, our products could quickly become obsolete if we fail to predict market needs accurately or develop new products or product enhancements in a timely manner. Our failure to predict market needs accurately or to develop new products or product enhancements in a timely manner will harm market acceptance and sales of our products. If the development or enhancement of these products or any other future products takes longer than we anticipate, or if we are unable to introduce these products to market, our sales will not increase. Even if we are able to develop and commercially introduce them, these new products may not achieve the widespread market acceptance necessary to provide an adequate return on our investment.

        Current and future demand for our products depends on the continued growth of the Internet and the communications industry, which is experiencing rapid consolidation, realignment, oversupply of product inventory and fluctuating demand for fiber optic products.

        Our future success depends on the continued growth of the Internet as a widely used medium for communications and commerce, and the growth of optical networks to meet the increased demand for capacity to transmit data, or bandwidth. If the Internet does not continue to expand as a medium for communications and commerce, the need to significantly increase bandwidth across networks and the market for fiber optic components may not continue to develop. If this growth does not continue, sales of our products may continue to decline, which would adversely affect our revenues. Our customers have experienced an oversupply of inventory due to fluctuating demand for their products that has resulted in inconsistent demand for our products. Future demand for our products is uncertain and will depend heavily on the continued growth and upgrading of optical networks, especially in the metropolitan, last mile, and enterprise access segments of the networks.

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        Inconsistent spending by telecommunication companies over the past three years has resulted in fluctuating demand for our products. The rate at which communication service providers and other fiber optic network users have built new fiber optic networks or installed new systems in their existing fiber optic networks has fluctuated in the past and these fluctuations may continue in the future. These fluctuations may result in reduced demand for new or upgraded fiber optic systems that utilize our products and therefore, may result in reduced demand for our products. Declines in the development of new networks and installation of new systems have resulted in the past in a decrease in demand for our products, an increase in our inventory, and erosion in the average selling prices of our products.

        The communications industry is experiencing consolidation and realignment, as industry participants seek to capitalize on the rapidly changing competitive landscape developing around the Internet and new communications technologies such as fiber optic networks. As the communications industry consolidates and realigns to accommodate technological and other developments, our customers may consolidate or align with other entities in a manner that results in a decrease in demand for our products.

        The optical networking component industry has in the past, is now, and may in the future experience declining average selling prices, which could cause our gross margins to decline.

        The optical networking component industry has in the past experienced declining average selling prices as a result of increasing competition and greater unit volumes as communication service providers continue to deploy fiber optic networks. Average selling prices are currently decreasing and may continue to decrease in the future in response to product introductions by competitors, price pressures from significant customers, greater manufacturing efficiencies achieved through increased automation in the manufacturing process and inventory build-up due to decreased demand. Average selling price declines may contribute to a decline in our gross margins, which could harm our results of operations.

        We will not attract new orders for our fiber optic components unless we can deliver sufficient quantities of our products to optical communications equipment manufacturers.

        Communications service providers and optical systems manufacturers typically require that suppliers commit to provide specified quantities of products over a given period of time. If we are unable to commit to deliver quantities of our products to satisfy a customer's anticipated needs, we will lose the order and the opportunity for significant sales to that customer for a lengthy period of time. In addition, we would be unable to fill large orders if we do not have sufficient manufacturing capacity to enable us to commit to provide customers with specified quantities of products. However, if we build our manufacturing capacity and inventory in excess of demand, as we have done in the past, we may produce excess inventory that may have to be reserved or written off.

        We depend on a limited number of third parties to supply key materials, components and equipment, such as ferrules, optical filters and lenses, and if we are not able to obtain sufficient quantities of these items at acceptable prices, our ability to fill orders would be limited and our operating results could be harmed.

        We depend on third parties to supply the raw materials and components we use to manufacture our products. To be competitive, we must obtain from our suppliers, on a timely basis, sufficient quantities of raw materials and components at acceptable prices. We obtain most of our critical raw materials and components from a single or limited number of suppliers and generally do not have long-term supply contracts with them. As a result, our suppliers could terminate the supply of a particular material or component at any time without penalty. Finding alternative sources may involve significant expense and delay, if these sources can be found at all. Difficulties in obtaining raw materials or components in the future may delay or limit our product shipments, which could result in lost orders, increase our costs, reduce our control over quality and delivery schedules and require us to redesign our products. If a supplier became unable or unwilling to continue to manufacture or ship materials or components in required volumes, we would have to identify and qualify an acceptable replacement. A delay or reduction in shipments or any need to identify and qualify replacement suppliers would harm our business. All of our graded index, or GRIN, lenses, which are incorporated into substantially all of our filter-based DWDM products, is obtained from one supplier, Nippon Sheet Glass. Nippon Sheet Glass is the only known supplier of GRIN lenses.

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        Because we experience long lead times for materials and components, we may not be able to effectively manage our inventory levels, which could harm our operating results.

        Because we experience long lead times for materials and components and are often required to purchase significant amounts of materials and components far in advance of product shipments, we may not effectively manage our inventory levels, which could harm our operating results. Alternatively, if we underestimate our raw material requirements, we may have inadequate inventory, which could result in delays in shipments and loss of customers. If we purchase raw materials and increase production in anticipation of orders that do not materialize or that shift to another quarter, we will, as we have in the past, have to carry or write off excess inventory and our gross margins will decline. Both situations could cause our results of operations to be below the expectations of investors and public market analysts, which could, in turn, cause the price of our common stock to decline. The time our customers require to incorporate our products into their own can vary significantly and generally exceeds several months, which further complicates our planning processes and reduces the predictability of our forecasts. Even if we receive these orders, the additional manufacturing capacity that we add to meet our customer's requirements may be underutilized in a subsequent quarter.

        We are exposed to risks and increased expenses as a result of laws requiring companies to evaluate internal controls over financial reporting.

        Section 404 of the Sarbanes-Oxley Act of 2002 requires our management to perform assessment of control by December 31, 2007, and our independent auditors to attest to the effectiveness of our internal controls over financial reporting beginning with our year ending December 31, 2008. We have implemented an ongoing program to perform the system and process evaluation and testing we believe to be necessary to comply with these requirements, however, we cannot assure you that we will be successful in our efforts. This legislation is relatively new and neither companies nor accounting firms have significant experience in complying with its requirements. As a result, we expect to incur increased expense and to devote additional management resources to Section 404 compliance. In the event that our chief executive officer, acting chief financial officer or independent registered public accounting firm determine that our internal controls over financial reporting are not effective as defined under Section 404, investor perceptions of our Company may be adversely affected and could cause a decline in the market price of our stock.

        Changes to financial accounting standards may affect our results of operations and cause us to change our business practices.

        We prepare our financial statements to conform to generally accepted accounting principles, or GAAP, in the United States. These accounting principles are subject to interpretation by the American Institute of Certified Public Accountants, the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in those policies can have a significant effect on our reported results and may affect our reporting of transactions completed before a change is announced. Changes to those rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business. For example, accounting policies affecting many aspects of our business, including rules relating to employee stock option grants, have recently been revised or are under review. The Financial Accounting Standards Board and other agencies have finalized changes to U.S. generally accepted accounting principles that require us, starting in our first quarter of 2006, to record a charge to earnings for employee stock option grants and other equity incentives. We may have significant and ongoing accounting charges resulting from option grant and other equity incentive expensing that could reduce our overall net income. While the implementation of this standard did not have material impact on the Company's financial statements at September 30, 2006, it may in the future. In addition, since we historically have used equity-related compensation as a component of our total employee compensation program, the accounting change could make the use of equity-related compensation less attractive to us and therefore make it more difficult to attract and retain employees.

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        We depend on key personnel to operate our business effectively in the rapidly changing fiber optic components market, and if we are unable to hire and retain appropriate management and technical personnel, our ability to develop our business could be harmed.

        Our success depends to a significant degree upon the continued contributions of the principal members of our technical sales, marketing, engineering and management personnel, many of whom perform important management functions and would be difficult to replace. We particularly depend upon the continued services of our executive officers, particularly Peter Chang, our President and Chief Executive Officer; David Hubbard, our Vice President, Sales and Marketing; Wei-shin Tsay, our senior Vice President of Product Development; Anita Ho, our Acting Chief Financial Officer and Corporate Controller; and other key engineering, sales, marketing, finance, manufacturing and support personnel. In addition, we depend upon the continued services of key management personnel at our Taiwanese subsidiary. None of our officers or key employees is bound by an employment agreement for any specific term, and may terminate their employment at any time. In addition, we do not have "key person" life insurance policies covering any of our employees.

        Our ability to continue to attract and retain highly skilled personnel will be a critical factor in determining whether we will be successful in the future. We may have difficulty hiring skilled engineers at our manufacturing facilities in the United States, Taiwan, and China. If we are not successful in attracting, assimilating or retaining qualified personnel to fulfill our current or future needs, our business may be harmed.

        If we are not able to achieve acceptable manufacturing yields and sufficient product reliability in the production of our fiber optic components, we may incur increased costs and delays in shipping products to our customers, which could impair our operating results.

        Complex and precise processes are required for the manufacture of our products. Changes in our manufacturing processes or those of our suppliers, or the inadvertent use of defective materials, could significantly reduce our manufacturing yields and product reliability. Because the majority of our manufacturing costs are relatively fixed, manufacturing yields are critical to our results of operations. Lower than expected production yields could delay product shipments and impair our operating results. We may not obtain acceptable yields in the future.

        In some cases, existing manufacturing techniques, which involve substantial manual labor, may not allow us to cost-effectively meet our production goals so that we maintain acceptable gross margins while meeting the cost targets of our customers. We may not achieve adequate manufacturing cost efficiencies.

        Because we plan to introduce new products and product enhancements, we must effectively transfer production information from our product development department to our manufacturing group and coordinate our efforts with those of our suppliers to rapidly achieve volume production. In our experience, our yields have been lower during the early stages of introducing new product to manufacturing. If we fail to effectively manage this process or if we experience delays, disruptions or quality control problems in our manufacturing operations, our shipments of products to our customers could be delayed.

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        Because the qualification and sales cycle associated with fiber optic components is lengthy and varied, it is difficult to predict the timing of a sale or whether a sale will be made, which may cause us to have excess manufacturing capacity or inventory and negatively impact our operating results.

        In the communications industry, service providers and optical systems manufacturers often undertake extensive qualification processes prior to placing orders for large quantities of products such as ours, because these products must function as part of a larger system or network. This process may range from three to six months and sometimes longer. Once they decide to use a particular supplier's product or component, these potential customers design the product into their system, which is known as a design-in win. Suppliers whose products or components are not designed in are unlikely to make sales to that customer until at least the adoption of a future redesigned system. Even then, many customers may be reluctant to incorporate entirely new products into their new systems, as this could involve significant additional redesign efforts. If we fail to achieve design-in wins in our potential customers' qualification processes, we will lose the opportunity for significant sales to those customers for a lengthy period of time.

        In addition, some of our customers require that our products be subjected to standards-based qualification testing, which can take up to nine months or more. While our customers are evaluating our products and before they place an order with us, we may incur substantial sales and marketing and research and development expenses, expend significant management efforts, increase manufacturing capacity and order long lead-time supplies. Even after the evaluation process, it is possible a potential customer will not purchase our products. In addition, product purchases are frequently subject to unplanned processing and other delays, particularly with respect to larger customers for which our products represent a very small percentage of their overall purchase activity. Accordingly, our revenues and operating results may vary significantly and unexpectedly from quarter to quarter.

        If our customers do not qualify our manufacturing lines for volume shipments, our optical networking components may be dropped from supply programs and our revenues may decline.

        Customers generally will not purchase any of our products, other than limited numbers of evaluation units, before they qualify our products, approve our manufacturing process and approve our quality assurance system. Our existing manufacturing lines, as well as each new manufacturing line, must pass through various levels of approval with our customers. For example, customers may require that we be registered under international quality standards. Our products may also have to be qualified to specific customer requirements. This customer approval process determines whether the manufacturing line achieves the customers' quality, performance and reliability standards. Delays in product qualification may cause a product to be dropped from a long-term supply program and result in significant lost revenue opportunity over the term of that program.

        Our fiber optic components are deployed in large and complex communications networks and may contain defects that are not detected until after our products have been installed, which could damage our reputation and cause us to lose customers.

        Our products are designed for deployment in large and complex optical networks. Because of the nature of these products, they can only be fully tested for reliability when deployed in networks for long periods of time. Our fiber optic products may contain undetected defects when first introduced or as new versions are released, and our customers may discover defects in our products only after they have been fully deployed and operated under peak stress conditions. In addition, our products are combined with products from other vendors. As a result, should problems occur, it may be difficult to identify the source of the problem. If we are unable to fix defects or other problems, we could experience, among other things:

     o     loss of customers;

     o     damage to our reputation;

     o     failure to attract new customers or achieve market acceptance;

     o     diversion of development and engineering resources; and

     o     legal actions by our customers.

        The occurrence of any one or more of the foregoing factors could cause our net loss to increase.

        The market for fiber optic components is new and unpredictable, characterized by rapid technological changes, evolving industry standards, and significant changes in customer demand, which could result in decreased demand for our products, erosion of average selling prices, and could negatively impact our revenues.

        The market for fiber optic components is new and characterized by rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. Because this market is new, it is difficult to predict its potential size or future growth rate. Widespread adoption of optical networks, especially in the metropolitan, last mile, and enterprise access segments of the networks, is critical to our future success. Potential end-user customers who have invested substantial resources in their existing copper lines or other systems may be reluctant or slow to adopt a new approach, such as optical networks. Our success in generating revenues in this emerging market will depend on:

     o     the education of potential end-user customers and network service providers about the benefits of optical networks; and

     o     the continued growth of the metropolitan, last mile, and enterprise access segments of the communications network.

        If we fail to address changing market conditions, sales of our products may decline, which would adversely impact our revenues.

        We may be unable to successfully integrate acquired businesses or assets with our business, which may disrupt our business, divert management's attention and slow our ability to expand the range of our proprietary technologies and products.

        To expand the range of our proprietary technologies and products, we may acquire complementary businesses, technologies or products, if appropriate opportunities arise. We may be unable to identify other suitable acquisitions at reasonable prices or on reasonable terms, or consummate future acquisitions or other investments, any of which could slow our growth strategy. We may have difficulty integrating the acquired products, personnel or technologies of any company or acquisition that we may make. Similarly, we may not be able to attract or retain key management, technical or sales personnel of any other companies that we acquire or from which we acquire assets. These difficulties could disrupt our ongoing business, distract our management and employees and increase our expenses.

        If our common stock is not relisted on the Nasdaq Global Market, we will be subject to certain provisions of the California General Corporation Law that may affect our charter documents and result in additional expenses.

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        Beginning at the commencement of trading on November 8, 2002, the listing of our common stock was transferred from the Nasdaq Global Market to the Nasdaq Capital Market. As a result, we may become subject to certain sections of the California General Corporation Law that will affect our charter documents if our common stock is not returned to being listed on the Nasdaq Global Market. A recent Delaware decision has called into question the applicability of the California General Corporation Law to Delaware corporations. However, if the California General Corporation Law applies to our Company, we will not be able to continue to have a classified board or continue to eliminate cumulative voting by our stockholders. In addition, certain provisions of our Certificate of Incorporation that call for supermajority voting may need to be approved by stockholders every two years or be eliminated. Also, in the event of a reorganization, stockholders will have dissenting stockholder rights under both California and Delaware law. Any of these changes will result in additional expense as we will have to comply with certain provisions of the California General Corporation Law as well as the Delaware General Corporation Law. We included these provisions in our charter documents in order to delay or discourage a change of control or changes in our management. Because of the California General Corporation Law, we may not be able to avail ourselves of these provisions.

        If we are unable to maintain our listing on the Nasdaq Capital Market, the price and liquidity of our common stock may decline.

        There can be no assurance that we will be able to satisfy all of the quantitative maintenance criteria for continued listing on the Nasdaq Capital Market, including a continued minimum bid price of $1.00 per share. If the closing bid price of our common stock falls and remains below $1.00 for 30 consecutive days as it has for significant periods of time in the past, our common stock may not remain listed on the Nasdaq Capital Market. If we fail to maintain continued listing on the Nasdaq Capital Market and must move to a market with less liquidity, our financial condition could be harmed and our stock price would likely decline. If we are delisted, it could have a material adverse effect on the market price of, and the liquidity of the trading market for our common stock.

        Many companies that face delisting as a result of closing bid prices that are below the Nasdaq Capital Market's continued listing standards seek to maintain the listing of their securities by effecting reverse stock splits. However, reverse stock splits do not always result in a sustained closing bid price per share. We continue to consider the merits of implementing a reverse split and to evaluate other courses of action.

        If we fail to protect our intellectual property rights, competitors may be able to use our technologies, which could weaken our competitive position, reduce our revenues or increase our costs.

        The fiber optic component market is a highly competitive industry in which we, and most other participants, rely on a combination of patent, copyright, trademark and trade secret laws, confidentiality procedures and licensing arrangements to establish and protect proprietary rights. The competitive nature of our industry, rapidly changing technology, frequent new product introductions, changes in customer requirements and evolving industry standards heighten the importance of protecting proprietary technology rights. Since the United States Patent and Trademark Office keeps patent applications confidential until a patent is issued, our pending patent applications may attempt to protect proprietary technology claimed in a third party patent application. Our existing and future patents may not be sufficiently broad to protect our proprietary technologies as policing unauthorized use of our products is difficult and we cannot be certain that the steps we have taken will prevent the misappropriation or unauthorized use of our technologies, particularly in foreign countries where the laws may not protect our proprietary rights as fully as United States laws. Our competitors and suppliers may independently develop similar technology, duplicate our products, or design around any of our patents or other intellectual property. If we are unable to adequately protect our proprietary technology rights, others may be able to use our proprietary technology without having to compensate us, which could reduce our revenues and negatively impact our ability to compete effectively.

        Litigation may be necessary to enforce our intellectual property rights or to determine the validity or scope of the proprietary rights of others. As a result of any such litigation, we could lose our proprietary rights and incur substantial unexpected operating costs. Any action we take to protect our intellectual property rights could be costly and could absorb significant management time and attention. In addition, failure to adequately protect our trademark rights could impair our brand identity and our ability to compete effectively.

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        We may be subject to intellectual property infringement claims that are costly to defend and could limit our ability to use some technologies in the future.

        Our industry is very competitive and is characterized by frequent intellectual property litigation based on allegations of infringement of intellectual property rights. Numerous patents in our industry have already been issued, and as the market further develops and participants in our industry obtain additional intellectual property protection, litigation is likely to become more frequent. From time to time, third parties may assert patent, copyright, trademark and other intellectual property rights to technologies or rights that are important to our business. In addition, we have and we may continue to enter into agreements to indemnify our customers for any expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. Any litigation arising from claims asserting that our products infringe or may infringe the proprietary rights of third parties, whether the litigation is with or without merit, could be time-consuming, resulting in significant expenses and diverting the efforts of our technical and management personnel. We do not have insurance against our alleged or actual infringement of intellectual property of others. These claims could cause us to stop selling our products, which incorporate the challenged intellectual property, and could also result in product shipment delays or require us to redesign or modify our products or to enter into licensing agreements. These licensing agreements, if required, would increase our product costs and may not be available on terms acceptable to us, if at all.

        Although we are not aware of any intellectual property lawsuits filed against us, we may be a party to litigation regarding intellectual property in the future. We may not prevail in any such actions, given their complex technical issues and inherent uncertainties. Insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed. If there is a successful claim of infringement or we fail to develop non-infringing technology or license the proprietary rights on a timely basis, our business could be harmed.

        If we fail to increase sales of our products to optical communications equipment manufacturers outside of North America, growth of our business may be harmed.

        For the three and nine months ended September 30, 2006, sales to customers located outside of North America were 28.7% and 28.4% of our revenues, respectively. In order to expand our business, we must increase our sales to customers located outside of North America. We have limited experience in marketing and distributing our products internationally and in developing versions of our products that comply with local standards. Our international sales will be limited if we cannot establish relationships with international distributors, establish additional foreign operations, expand international sales channels, hire additional personnel and develop relationships with international communications equipment manufacturers. Even if we are able to successfully continue international operations, we may not be able to maintain or increase international market demand for our products.

        Outbreaks of diseases pose a risk to the our business.

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        In the past, outbreaks of Severe Acute Respiratory Syndrome, or SARS, and of the bird flu have developed into an international health concern, especially in Asia. We have manufacturing facilities located in Taiwan and China. A new outbreak of disease such as SARS or the bird flu among our employees in Asia could disrupt our Asian manufacturing operations for an extended period of time, which could limit our ability to supply our products to our customers in sufficient quantities on a timely basis. A shutdown of our Asian facilities due to fear of spread of infection or because of a quarantine could result in our inability to supply our customers. If we are unable to fulfill demand for our products, our relationships with our customers would be harmed and our revenues could be impacted. We also rely on companies in Asia for many of the components necessary to manufacture our products. If our suppliers experience a significant disruption in their businesses as a result of outbreaks, we may not be able to obtain the parts necessary to make our products, which could negatively impact our revenues. In addition, if any of our customers experiences a significant disruption in their business as a result of outbreaks, they may delay or cancel purchases of our products, which could harm our business. Also, certain of our key employees travel to Asia to oversee our Asian operations and to meet with our suppliers and customers. If any of our key employees are infected with diseases such as SARS or the bird flu on such a trip or if these employees are quarantined when they return to the United States, our business could be negatively impacted. These conditions and uncertainties make it difficult for us, our suppliers and our customers to accurately forecast and plan future business activities.

        Because our manufacturing operations are located in active earthquake fault zones in California and Taiwan, and our Taiwan location is susceptible to the effects of a typhoon, we face the risk that a natural disaster could limit our ability to supply products.

        Three of our primary manufacturing operations are located in Sunnyvale, California, Tu-Cheng City, Taiwan, and Hu-Kou City, Taiwan, all active earthquake fault zones. These regions have experienced large earthquakes in the past and may likely experience them in the future. In September 2001, a typhoon hit Taiwan causing businesses, including our manufacturing facility, and the financial markets to close for two days. Because the majority of our manufacturing operations are located in Taiwan, a large earthquake or typhoon in Taiwan could disrupt our manufacturing operations for an extended period of time, which would limit our ability to supply our products to our customers in sufficient quantities on a timely basis, harming our customer relationships.

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ITEM 6: EXHIBITS

Exhibits

Exhibit Number	Title
31.1	Rule 13a-14(a) certification of Chief Executive Office
31.2	Rule 13a-14(a) certification of Acting Chief Financial Officer
32.1*	Statement of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350).
32.2*	Statement of Acting Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350).
___________________

* In accordance with Item 601(b)(32)(ii) of Regulation S-K and SEC Release Nos. 33-8238 and 34-47986, Final Rule: Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed “filed” for purpose of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.

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SIGNATURE

        In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

      Dated: November 13, 2006

ALLIANCE FIBER OPTIC PRODUCTS, INC.

By           /s/ Anita K. Ho                                        

               Anita K. Ho

      Acting Chief Financial Officer and Corporate Controller

      (Principal Financial and Accounting Officer and Duly

      Authorized Signatory)