-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Ko1Ire+G1dEo+0jUzT45067vKRsY7gXutYIq781Uwf0mai3VQrK5IiriJaWxzDq2 vJCKhLMPg1NI3C6yZ16KAQ== 0000950124-06-006417.txt : 20061103 0000950124-06-006417.hdr.sgml : 20061103 20061103133251 ACCESSION NUMBER: 0000950124-06-006417 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20060930 FILED AS OF DATE: 20061103 DATE AS OF CHANGE: 20061103 FILER: COMPANY DATA: COMPANY CONFORMED NAME: MRV COMMUNICATIONS INC CENTRAL INDEX KEY: 0000887969 STANDARD INDUSTRIAL CLASSIFICATION: SEMICONDUCTORS & RELATED DEVICES [3674] IRS NUMBER: 061340090 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-11174 FILM NUMBER: 061185938 BUSINESS ADDRESS: STREET 1: 20415 NORDHOFF ST CITY: CHATSWORTH STATE: CA ZIP: 91311 BUSINESS PHONE: 8187730900 MAIL ADDRESS: STREET 1: 20415 NORDHOFF ST CITY: CHATSWORTH STATE: CA ZIP: 91311 10-Q 1 v24739e10vq.htm FORM 10-Q e10vq
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 
FORM 10-Q
(Mark One)
     
þ   Quarterly report under 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
for the transition period from                      to                     
Commission file number 0-25678
 
(MRV LOGO)
MRV COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)
     
Delaware   06-1340090
(State or other jurisdiction   (I.R.S. Employer
incorporation or organization)   identification No.)
20415 Nordhoff Street, Chatsworth, CA 91311
(Address of principal executive offices, Zip Code)
Registrant’s telephone number, including area code: (818) 773-0900
     Indicate by check mark, whether the issuer (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. (Check one):
Large accelerated filer o     Accelerated filer þ     Non-accelerated filero
     Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ
     As of October 15, 2006, there were 125,250,964 shares of common stock, $.0017 par value per share, outstanding.
 
 

 

 

MRV Communications, Inc.
Form 10-Q, September 30, 2006
Table of Contents
             
        Page
        Number
  Financial Information     3  
 
            
  Financial Statements:     3  
 
            
 
  Condensed Statements of Operations (unaudited) for the three and nine months ended September 30, 2006 and 2005     4  
 
            
 
  Condensed Balance Sheets as of September 30, 2006 (unaudited) and December 31, 2005     5  
 
            
 
  Statements of Cash Flows (unaudited) for the nine months ended September 30, 2006 and 2005     6  
 
            
 
  Notes to Financial Statements     7  
 
            
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     18  
 
            
  Quantitative and Qualitative Disclosures About Market Risk     44  
 
            
  Controls and Procedures     45  
 
            
  Other Information     47  
 
            
  Risk Factors     47  
 
            
  Exhibits     54  
 
            
 
  Signatures     55  
 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32.1
     As used in this Report, “we”, “us,” “our,” “MRV” or the “Company” refer to MRV Communications, Inc. and its consolidated subsidiaries.

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PART I — FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
          The condensed financial statements included herein have been prepared by MRV, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations, although MRV believes that the disclosures are adequate to make the information presented not misleading. It is suggested that these condensed financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in MRV’s latest annual report on Form 10-K.
          In the opinion of MRV, these unaudited statements contain all adjustments (consisting of normal recurring adjustments) necessary to present fairly the financial position of MRV Communications, Inc. as of September 30, 2006, and the results of its operations and its cash flows for the three and nine months then ended.
          The results reported in these condensed financial statements should not be regarded as necessarily indicative of results that may be expected for any subsequent period or for the entire year.

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MRV Communications, Inc.
Condensed Statements of Operations
(In thousands, except per share data)
                                 
    Three Months Ended   Nine Months Ended
    Sept. 30,   Sept. 30,   Sept. 30,   Sept. 30,
    2006   2005   2006   2005
            (Unaudited)        
Revenue
   $ 89,616     $ 65,875     $ 253,843     $ 192,529  
Cost of goods sold
     60,962       46,157       172,621       129,414  
           
Gross profit
     28,654       19,718       81,222       63,115  
 
                                
Operating costs and expenses:
                                
Product development and engineering
     7,331       6,133       20,983       18,951  
Selling, general and administrative
     20,991       15,762       63,602       52,342  
Goodwill impairment
     —       —       52       —  
           
Total operating costs and expenses
     28,322       21,895       84,637       71,293  
           
Operating income (loss)
     332       (2,177 )     (3,415 )     (8,178 )
 
                                
Interest expense
     (819 )     (767 )     (2,608 )     (3,268 )
Other income, net
     1,646       1,117       3,312       1,833  
           
Income (loss) before taxes
     1,159       (1,827 )     (2,711 )     (9,613 )
 
                                
Provision for taxes
     943       1,317       3,397       4,111  
           
Net income (loss)
   $ 216     $ (3,144 )   $ (6,108 )   $ (13,724 )
           
 
                                
Earnings (loss) per share:
                                
Basic
   $ 0.00     $ (0.03 )   $ (0.05 )   $ (0.13 )
Diluted
   $ 0.00     $ (0.03 )   $ (0.05 )   $ (0.13 )
Weighted average number of shares:
                                
Basic
     125,202       104,437       119,394       104,312  
Diluted
     126,365       104,437       119,394       104,312  
The accompanying notes are an integral part of these condensed financial statements.

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MRV Communications, Inc.
Condensed Balance Sheets
(In thousands, except par values)
                 
    September 30,   December 31,
At:   2006   2005
    (Unaudited)        
Assets
                
Current assets:
                
Cash and cash equivalents
   $ 81,177     $ 67,984  
Short-term marketable securities
     34,809       —  
Time deposits
     773       1,475  
Accounts receivable, net
     87,513       92,466  
Inventories
     70,399       42,216  
Deferred income taxes
     873       873  
Other current assets
     11,374       7,828  
       
Total current assets
     286,918       212,842  
Property and equipment, net
     14,042       14,065  
Goodwill
     35,251       33,656  
Deferred income taxes
     136       136  
Other assets
     4,605       4,478  
       
 
   $ 340,952     $ 265,177  
       
Liabilities and stockholders’ equity
                
Current liabilities:
                
Short-term obligations
   $ 23,352     $ 30,378  
Accounts payable
     52,796       45,372  
Accrued liabilities
     29,993       29,272  
Deferred revenue
     6,974       6,076  
Other current liabilities
     3,651       2,230  
       
Total current liabilities
     116,766       113,328  
Convertible notes
     23,000       23,000  
Other long-term liabilities
     7,029       6,694  
Minority interest
     5,192       5,151  
Commitments and contingencies
                
 
Stockholders’ equity:
                
Preferred stock, $0.01 par value:
                
Authorized — 1,000 shares; no shares issued or outstanding
     —       —  
Common stock, $0.0017 par value:
                
Authorized — 160,000 shares
                
Issued — 126,590 shares in 2006 and 105,849 shares in 2005
                
Outstanding — 125,237 shares in 2006 and 104,496 shares in 2005
     213       177  
Additional paid-in capital
     1,230,458       1,156,209  
Accumulated deficit
     (1,037,517 )     (1,031,409 )
Treasury stock — 1,353 shares in 2006 and 2005
     (1,352 )     (1,352 )
Accumulated other comprehensive loss
     (2,837 )     (6,621 )
       
Total stockholders’ equity
     188,965       117,004  
       
 
   $ 340,952     $ 265,177  
   
The accompanying notes are an integral part of these condensed balance sheets.

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MRV Communications, Inc.
Statements of Cash Flows
(In thousands)
                 
For the nine months ended September 30:   2006   2005
    (Unaudited)
Cash flows from operating activities:
                
Net loss
   $ (6,108 )   $ (13,724 )
Adjustments to reconcile net loss to net cash used in operating activities:
                
Depreciation and amortization
     4,064       5,543  
Share-based compensation expense
     2,476       162  
Provision for doubtful accounts
     582       578  
Deferred income taxes
     —       1,604  
Gain on disposition of property and equipment
     (80 )     (6 )
Gain on sale of equity method investment
     (50 )     —  
Minority interests’ share of income
     42       19  
Impairment of goodwill
     52       —  
Changes in operating assets and liabilities:
                
Time deposits
     704       325  
Accounts receivable
     9,362       (1,108 )
Inventories
     (26,387 )     (10,358 )
Other assets
     (3,232 )     (1,724 )
Accounts payable
     5,307       3,934  
Accrued liabilities
     (174 )     (1,009 )
Deferred revenue
     668       833  
Other current liabilities
     853       1,920  
       
Net cash used in operating activities
     (11,921 )     (13,011 )
 
                
Cash flows from investing activities:
                
Purchases of property and equipment
     (3,891 )     (2,296 )
Proceeds from sale of property and equipment
     100       56  
Proceeds from sale of equity method investment
     114       —  
Proceeds from maturity (purchase) of investments
     (34,809 )     5,099  
Purchase of minority interest
     (50 )     (90 )
       
Net cash provided by (used in) investing activities
     (38,536 )     2,769  
 
                
Cash flows from financing activities:
                
Net proceeds from issuance of common stock
     71,810       543  
Borrowings on short-term obligations
     78,475       42,472  
Payments on short-term obligations
     (87,346 )     (40,430 )
Borrowings on long-term obligations
     —       593  
Payments on long-term obligations
     (234 )     (65 )
Other long-term liabilities
     609       1,221  
       
Net cash provided by financing activities
     63,314       4,334  
 
                
Effect of exchange rate changes on cash and cash equivalents
     336       (1,232 )
       
Net increase (decrease) in cash and cash equivalents
     13,193       (7,140 )
 
                
Cash and cash equivalents, beginning of period
     67,984       77,226  
   
Cash and cash equivalents, end of period
   $ 81,177     $ 70,086  
   
The accompanying notes are an integral part of these financial statements.

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MRV Communications, Inc.
Notes To Financial Statements
September 30, 2006
1.   Earnings (Loss) Per Share and Stockholders’ Equity
     Earnings (Loss) Per Share
          Basic earnings (loss) per share is computed using the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed using the weighted average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares primarily consist of employee stock options and warrants and the shares associated with MRV’s outstanding 5% Convertible Notes issued in June 2003 (“2003 Notes”).
          Statements of Financial Accounting Standards (“SFAS”) No. 128, “Earnings per Share,” requires that employee equity share options, nonvested shares and similar equity instruments granted by the Company be treated as potential common shares outstanding in computing diluted earnings per share. Diluted shares outstanding include the dilutive effect of in-the-money options, which is calculated based on the average share price for each period using the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that would be realized and recorded in additional paid-in capital if the deduction for the award would reduce taxes payable are assumed to be used to repurchase shares.
          For the three months ended September 30, 2006, the 1.2 million share difference between the basic and diluted weighted average shares outstanding related to the dilutive effect of stock options and warrants under the treasury stock method. Outstanding stock options and warrants to purchase 6.3 million and 11.7 million shares as of September 30, 2006 were not included in the computation of diluted loss per share for the three and nine months ended September 30, 2006, respectively, and outstanding stock options and warrants to purchase 10.7 million shares as of September 30, 2005 were not included in the computation of diluted loss per share for the three and nine months ended September 30, 2006 because such stock options and warrants were considered anti-dilutive. Shares associated with the 2003 Notes were not included in the computation of diluted loss per share as they were anti-dilutive.
     Stockholders’ Equity
          In March 2006, MRV completed a private placement of approximately 19.9 million shares of its common stock at $3.75 per share for gross proceeds of approximately $74.5 million with a group of institutional investors. The net proceeds to MRV were approximately $69.9 million. MRV intends to use the net proceeds for working capital, general corporate purposes and in its efforts to support its recent growth in revenues. MRV may also use a portion of the net proceeds, currently intended for general corporate purposes, to acquire or invest in technologies, products or services that complement its business.
2.   Share-Based Compensation
          Effective January 1, 2006, MRV adopted the provisions of SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), which requires the measurement and recognition of compensation expense for all share-based payment awards made to MRV’s employees and directors including employee stock option awards based on estimated fair values. MRV previously applied the provisions of Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” and related Interpretations and provided the required pro forma disclosures under SFAS No. 123, “Accounting for Stock-Based Compensation.”

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     Pro forma Information for Periods Prior to the Adoption of SFAS No. 123(R)
          Prior to the adoption of SFAS No. 123(R), MRV provided the disclosures required under SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosures.” For the nine months ended September 30, 2005, MRV recorded $162,000 of share-based compensation expense, under SFAS No. 123, for the issuance of 100,000 shares to employees. No additional share-based compensation expense was reflected in MRV’s results of operations for the three and nine month periods ended September 30, 2005 as all options were granted with an exercise price equal to the market value of the underlying common stock on the date of grant. Forfeitures of awards were recognized as they occurred. Previously reported amounts have not been restated.
          The pro forma information for the three and nine months ended September 30, 2005 was as follows (in thousands, except per share data):
                 
    Three Months   Nine Months
    Ended   Ended
    Sept. 30, 2005   Sept. 30, 2005
       
Net loss, as reported
   $ (3,144 )   $ (13,724 )
Add: SFAS No. 123 based compensation expense included in reported net loss
     —       162  
Deduct: Total SFAS No. 123 based compensation expense determined under fair value method for all awards
     (1,005 )     (5,382 )
       
Net loss, pro forma
   $ (4,149 )   $ (18,944 )
       
 
                
Earnings per share:
                
Basic and diluted net loss per share – as reported
   $ (0.03 )   $ (0.13 )
Basic and diluted net loss per share – pro forma
   $ (0.04 )   $ (0.18 )
     Impact of the Adoption of SFAS No. 123(R)
          MRV adopted SFAS No. 123(R) using the modified prospective transition method beginning January 1, 2006. Accordingly, during the three and nine month periods ended September 30, 2006, MRV recorded share-based compensation expense for awards granted prior to but not yet vested as of January 1, 2006 as if the fair value method required for pro forma disclosure under SFAS No. 123 were in effect for expense recognition purposes adjusted for estimated forfeitures. For these awards, MRV has continued to recognize compensation expense using the straight-line amortization method. For share-based awards granted on and after January 1, 2006, MRV has recognized compensation expense based on the estimated grant date fair value method required under SFAS No. 123(R). For these awards, MRV has also recognized compensation expense using a straight-line amortization method. As SFAS No. 123(R) requires that share-based compensation expense be based on awards that are ultimately expected to vest, estimated share-based compensation for the three and nine month periods ended September 30, 2006 has been reduced for estimated forfeitures. The impact on MRV’s results of operations of recording share-based compensation under SFAS No. 123(R), rather than had it continued to account for share-based compensation under APB No. 25, for the three and nine month periods ended September 30, 2006 was as follows (in thousands, except per share data):

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    Three Months   Nine Months
    Ended   Ended
    Sept. 30, 2006   Sept. 30, 2006
       
Cost of goods sold
   $ 83     $ 231  
Product development and engineering
     190       579  
Selling, general and administrative
     589       1,666  
       
Total share-based compensation expense
   $ 862     $ 2,476  
       
 
                
Impact on:
                
Income (loss) before taxes
   $ (862 )   $ (2,476 )
Net income (loss)
     (862 )     (2,476 )
Basic and diluted net income (loss) per share
   $ (0.01 )   $ (0.02 )
          The weighted average grant date fair value of awards, as determined under SFAS No. 123(R), granted during the three and nine month periods ended September 30, 2006 was $1.49 and $1.60 per share, respectively. The total fair value of shares vested during the three and nine month periods ended September 30, 2006 was $596,000 and $2.3 million, respectively. For the three and nine months ended September 30, 2006, the windfall tax benefit realized from exercised stock options and similar awards was immaterial. As of September 30, 2006, the total unrecorded deferred share-based compensation balance for unvested shares, net of expected forfeitures, was $6.4 million which is expected to be amortized over a weighted-average period of 2.6 years.
     Valuation Assumptions
          As of September 30, 2006 and 2005, the fair value of share-based awards for employee stock option awards was estimated using the Black-Scholes option pricing model. The following weighted average assumptions were used for determining the fair value of options granted:
                                 
    Three Months Ended   Nine Months Ended
    Sept. 30,   Sept. 30,   Sept. 30,   Sept. 30,
    2006   2005   2006   2005
     
Risk-free interest rate
     4.7 %     4.1 %     4.8 %     3.9 %
Dividend yield
     0.0 %     0.0 %     0.0 %     0.0 %
Volatility
     80.5 %     70.1 %     81.5 %     65.6 %
Expected life
     3.7 yrs     4.0 yrs     3.2 yrs     4.0 yrs
          The Black-Scholes model requires the use of highly subjective and complex assumptions, including the option’s expected life and the price volatility of the underlying stock. MRV has used historical volatility to derive the expected volatility assumption, since sufficient implied volatility data was not available and future volatility is expected to approximate historical volatility.

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     Share-Based Payment Award Activity
          The following table summarizes equity share-based payment award activity for the nine month period ended September 30, 2006:
                                 
                    Wtd. Avg.    
            Wtd. Avg.   Remaining   Aggregate
            Exercise   Contractual   Intrinsic
    Shares   Price   Term   Value
    (in 000’s)           (in years)   (in 000’s)
Outstanding, beginning of period
     11,433     $ 3.18                  
Granted
     2,265     $ 2.96                  
Exercised
     (883 )   $ 2.20                  
Cancelled and forfeited
     (1,108 )   $ 4.62                  
       
Outstanding, end of period
     11,707     $ 3.07       7.1     $ 6,390  
           
Vested & Expected to Vest, end of period
     11,192     $ 3.09       7.0     $ 6,191  
       
Exercisable, end of period
     5,929     $ 3.46       5.5     $ 4,237  
          The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on the company’s closing stock price of $2.76 at September 30, 2006, which would have been received by award holders had all award holders exercised their awards that were in-the-money as of that date.
          The following table summarizes certain stock option exercise activity during the periods presented (in thousands):
                                 
    Three Months Ended   Nine Months Ended
    Sept. 30,   Sept. 30,   Sept. 30,   Sept. 30,
    2006   2005   2006   2005
Total intrinsic value of stock options exercised
   $ 63     $ 51     $ 1,514     $ 356  
Cash received from stock options exercised
     43       44       1,943       543  
3.   Segment Reporting and Geographical Information
          MRV divides and operates its business based on three segments: the networking group, the optical components group and development stage enterprise group. The networking group designs, manufactures and distributes optical networking solutions and Internet infrastructure products. The optical components group designs, manufactures and distributes optical components and optical subsystems. The development stage enterprise group develops optical components, subsystems and networks and products for the infrastructure of the Internet. Segment information is therefore being provided on this basis.
          The accounting policies of the segments are the same as those described in the Summary of Significant Accounting Policies in MRV’s most recent Form 10-K. MRV evaluates segment performance based on revenues and operating expenses of each segment. As such, there are no separately identifiable segment assets nor are there any separately identifiable Statement of Operations data below operating income.

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          Business segment revenues were as follows (in thousands):
                                 
    Three Months Ended   Nine Months Ended
    Sept. 30,   Sept. 30,   Sept. 30,   Sept. 30,
    2006   2005   2006   2005
           
Networking group
   $ 68,524     $ 54,107     $ 190,282     $ 158,973  
Optical components group
     23,187       12,474       67,221       36,141  
Development stage enterprise group
     —       —       —       —  
           
 
     91,711       66,581       257,503       195,114  
Intersegment adjustment
     (2,095 )     (706 )     (3,660 )     (2,585 )
           
Total
   $ 89,616     $ 65,875     $ 253,843     $ 192,529  
           
          Revenues by groups of similar products were as follows (in thousands):
                                 
    Three Months Ended   Nine Months Ended
    Sept. 30,   Sept. 30,   Sept. 30,   Sept. 30,
    2006   2005   2006   2005
           
Network equipment
   $ 28,519     $ 21,676     $ 72,594     $ 62,555  
Network integration
     40,001       32,431       117,681       96,410  
Fiber optic components
     21,096       11,768       63,568       33,564  
           
Total
   $ 89,616     $ 65,875     $ 253,843     $ 192,529  
           
          Network equipment revenue primarily consists of MRV’s internally developed products, such as Metro Ethernet equipment, optical transport equipment, out-of-band network equipment, defense and aerospace network applications, the related service revenue and fiber optic components sold as part of the system solution. Network integration revenue primarily consists of value-added integration and support service revenue, related third-party product sales (including third-party product sales through distribution) and fiber optic components sold as part of the system solution. Fiber optic components revenue primarily consists fiber optic components, such as components for FTTP applications, fiber optic transceivers, discrete lasers and LEDs, that are not sold as part of MRV’s network equipment or network integration solutions.
          For the three and nine months ended September 30, 2006, MRV had one customer that accounted for 12% and 13% of revenues, respectively. For the three and nine months ended September 30, 2005, MRV had no single customer that accounted for 10% or more of revenues. As of September 30, 2006 and December 31, 2005, MRV had no single customer that accounted for 10% or more of accounts receivable. MRV does not track customer revenue by region for each individual reporting segment.
          Revenues by geographical region were as follows (in thousands):
                                 
    Three Months Ended   Nine Months Ended
    Sept. 30,   Sept. 30,   Sept. 30,   Sept. 30,
    2006   2005   2006   2005
           
Americas
   $ 28,277     $ 18,910     $ 84,776     $ 52,011  
Europe
     52,787       43,827       154,170       130,739  
Asia Pacific
     8,445       3,031       14,685       9,266  
Other regions
     107       107       212       513  
           
Total
   $ 89,616     $ 65,875     $ 253,843     $ 192,529  
           

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          Long-lived assets, consisting of property and equipment, by geographical region were as follows (in thousands):
                 
    Sep. 30,   Dec. 31,
At:   2006   2005
 
Americas
   $ 3,347     $ 2,013  
Europe
     6,927       6,639  
Asia Pacific
     3,768       5,413  
Other regions
     —       —  
   
Total
   $ 14,042     $ 14,065  
       
          Business segment operating income (loss) was as follows (in thousands):
                                 
    Three Months Ended   Nine Months Ended
    Sept. 30,   Sept. 30,   Sept. 30,   Sept. 30,
    2006   2005   2006   2005
     
Networking group
   $ 279     $ 2,062     $ (2,115 )   $ 1,407  
Optical components group
     455       (3,804 )     (190 )     (8,273 )
Development stage enterprise group
     (404 )     (435 )     (1,090 )     (1,312 )
       
 
     330       (2,177 )     (3,395 )     (8,178 )
Intersegment adjustment
     2       —       (20 )     —  
       
Total
   $ 332     $ (2,177 )   $ (3,415 )   $ (8,178 )
       
          Income (loss) before provision for income taxes was as follows (in thousands):
                                 
    Three Months Ended   Nine Months Ended
    Sept. 30,   Sept. 30,   Sept. 30,   Sept. 30,
    2006   2005   2006   2005
           
Domestic
   $ (2,618 )   $ (5,473 )   $ (12,675 )   $ (13,001 )
Foreign
     3,777       3,646       9,964       3,388  
       
Total
   $ 1,159     $ (1,827 )   $ (2,711 )   $ (9,613 )
       
4.   Cash and Cash Equivalents, Time Deposits and Marketable Securities
          MRV considers all highly liquid investments with an original maturity of 90 days or less to be cash equivalents. Investments with maturities of less than one year are considered short-term. Time deposits represent investments, which are restricted as to withdrawal or use based on maturity terms. Furthermore, MRV maintains cash balances and investments in what management believes are highly qualified financial institutions. At various times such amounts are in excess of federally insured limits.
          MRV accounts for its marketable securities, which are available for sale, under the provisions of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” because it expects to possibly sell some securities prior to maturity. The Company’s investments are subject to market risk, primarily interest rate and credit risk. The Company’s investments are managed by a limited number of outside professional managers within investment guidelines set by the Company. Such guidelines include security type, credit quality and maturity and are intended to limit market risk by restricting the Company’s investments to high quality debt instruments with relatively short-term maturities.

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          The original cost of MRV’s marketable securities approximated fair market value and consisted of the following security types (in thousands):
                 
    Sep. 30,   Dec. 31,
At:   2006   2005
 
Government issues
   $ 15,966     $ —  
Corporate issues
     18,843       —  
       
Total
   $ 34,809     $ —  
       
          Marketable securities mature at various dates through 2007. Purchases, sales and maturities of securities are presented in the accompanying Statements of Cash Flows.
5.   Inventories
          Inventories are stated at the lower of cost or market and consist of materials, labor and overhead. Cost is determined by the first-in, first-out method. Inventories consisted of the following (in thousands):
                 
    Sep. 30,     Dec. 31,  
At:   2006     2005  
 
Raw materials
   $ 13,050     $ 8,471  
Work-in process
     20,381       9,682  
Finished goods
     36,968       24,063  
       
Total
   $ 70,399     $ 42,216  
       
6.   Goodwill and Other Intangibles
          MRV adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” effective January 1, 2002. In accordance with SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized, but instead are measured for impairment at least annually, or when events indicate that impairment exists. Intangible assets that are determined to have definite lives continue to be amortized over their useful lives.
          The following table summarizes the changes in carrying value of goodwill during the periods presented (in thousands):
                                 
    Three Months Ended   Nine Months Ended
    Sept. 30,   Sept. 30,   Sept. 30,   Sept. 30,
    2006   2005   2006   2005
     
Beginning balance (1)
   $ 35,215     $ 34,155     $ 33,656     $ 37,747  
Purchase of Minority Interest
     —       —       39       90  
Impairment
     —       —       (52 )     —  
Foreign currency translation
     36       15       1,608       (3,667 )
       
Total
   $ 35,251     $ 34,170     $ 35,251     $ 34,170  
       
 
(1)   Reclassified to conform with 2006 presentation.

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7.   Restructuring Costs
          During the second quarter of 2001, LuminentOIC’s management approved and implemented a restructuring plan in order to adjust operations and administration as a result of the dramatic slowdown in the communications equipment industry generally and the optical components sector in particular. Major actions primarily involved the reduction of workforce totaling $1.3 million, the abandonment of certain assets, including closed and abandoned facilities, amounting to $12.8 million and the cancellation and termination of purchase commitments totaling $6.2 million. MRV has a remaining obligation totaling $239,000 for its fulfillment of a lease obligation on an abandoned facility that it expects to pay through cash on-hand through August 2007.
8.   Product Warranty and Indemnification
          Financial Accounting Standards Board (“FASB”) Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” requires that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation it assumes under that guarantee.
          The requirements of FIN 45 are applicable to MRV’s product warranty liability. As of September 30, 2006 and 2005, MRV’s product warranty liability recorded in accrued liabilities was $2.0 million and $2.5 million, respectively. The following table summarizes the activity related to the product warranty liability during the periods presented (in thousands):
                                 
    Three Months Ended   Nine Months Ended
    Sept. 30,   Sept. 30,   Sept. 30,   Sept. 30,
    2006   2005   2006   2005
     
Beginning balance
   $ 2,101     $ 2,495     $ 2,328     $ 2,456  
Cost of warranty claims
     (290 )     (379 )     (616 )     (1,257 )
Accruals for product warranties
     220       387       319       1,304  
       
Total
   $ 2,031     $ 2,503     $ 2,031     $ 2,503  
       
          MRV accrues for warranty costs as part of its cost of goods sold based on associated material product costs, technical support labor costs and associated overhead. The products sold are generally covered by a warranty for periods of one to two years.
          In the normal course of business to facilitate sales of its products, MRV indemnifies other parties, including customers, lessors and parties to other transactions with MRV, with respect to certain matters. MRV has agreed to hold the other party harmless against losses arising from a breach of representation or covenants, or out of intellectual property infringement or other claims made against certain parties. These agreements may limit the time within which an indemnification claim can be made and the amount of the claim. In addition, MRV has entered into indemnification agreements with its officers and directors, and MRV’s bylaws contain similar indemnification obligations to MRV’s agents.
          MRV cannot estimate the amount of potential future payments, if any, that it might be required to make as a result of these agreements. Over at least the last decade, MRV has not incurred any significant expense as a result of agreements of this type. Accordingly, MRV has not accrued any amounts for such indemnification obligations. However, there can be no assurances that MRV will not incur expense under these indemnification provisions in the future.

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9.   Comprehensive Income (Loss)
          The components of comprehensive income (loss) were as follows (in thousands):
                                 
    Three Months Ended   Nine Months Ended
    Sept. 30,   Sept. 30,   Sept. 30,   Sept. 30,
    2006   2005   2006   2005
           
Net income (loss)
   $ 216     $ (3,144 )   $ (6,108 )   $ (13,724 )
Unrealized gain (loss) from available-for-sale securities
     7       —       4       (7 )
Foreign currency translation
     (105 )     (1,274 )     3,780       (9,624 )
       
Total
   $ 118     $ (4,418 )   $ (2,324 )   $ (23,355 )
       
10.   Derivative Financial Instruments
          The Company, through certain foreign offices, has entered into foreign exchange and interest rate swap contracts. All derivatives are straight-forward and are held for purposes other than trading. The fair values of the derivatives are recorded in other current or non-current assets or liabilities in the accompanying balance sheet. No hedging relationship is designated for these derivatives held and they are marked to market through earnings. The fair value of these derivative instruments is based on quoted market prices. Cash flows from financial instruments are recognized in the statement of cash flows in a manner consistent with the underlying transactions.
          Foreign Exchange Contracts. Certain foreign offices of the Company enter into foreign exchange contracts to protect economically currency exchange risk related to purchase commitments denominated in foreign currencies other than their functional currency, primarily the U.S. dollar. These contracts cover periods commensurate with known or expected exposures, generally less than 12 months, and are principally unsecured foreign exchange contracts with carefully selected banks. The market risk exposure is essentially limited to risk related to currency rate movements. As of September 30, 2006, there were no outstanding foreign currency contracts and the realized gains and losses recorded were insignificant.
          Interest Rate Swaps. A foreign office of the Company manages its debt portfolio by utilizing interest rate swaps to achieve an overall desired position of fixed and floating rates. As of September 30, 2006 the Company had two interest rate swap contracts maturing in 2007 and 2008. Unrealized gains on these interest rate swaps for the three and nine months ended September 30, 2006 were $50,000 and $133,000, respectively, and unrealized losses for the three and nine months ended September 30, 2005 were $28,000 and $746,000, respectively, which have been recorded in interest expense. The fair value and the carrying value of these interest rate swaps were $801,000 and $882,000 at September 30, 2006 and December 31, 2005, respectively, and were recorded in other long-term liabilities.
11.   Supplemental Statement of Cash Flow Information (in thousands)
                 
For the nine months ended September 30:   2006   2005
 
Cash paid during the period for interest
   $ 2,372     $ 2,273  
Cash paid during the period for taxes
   $ 1,955     $ 2,913  

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12.   Recently Issued Accounting Pronouncements
          In November 2005, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” The amendments made by SFAS No. 151 clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The pronouncement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years after November 23, 2005. The adoption of this pronouncement on January 1, 2006, did not have a material effect on MRV’s financial condition, its results of operations or liquidity.
          In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections.” SFAS No. 154 replaces APB No. 20, “Accounting Changes,” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements,” and establishes retrospective application as the required method for reporting a change in accounting principle. SFAS No. 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of this pronouncement on January 1, 2006, did not have a material effect on MRV’s financial condition, its results of operations or liquidity.
          In December 2004, the FASB issued SFAS No. 123(R), which requires the measurement and recognition of compensation expense based on estimated fair value for all share-based payment awards including stock options, employee stock purchases under employee stock purchase plans, non-vested share awards (restricted stock) and stock appreciation rights. SFAS No. 123(R) supersedes our previous accounting under APB No. 25. In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107, which provides the Staff’s views regarding implementation issues related to SFAS No. 123(R).
          MRV adopted the provisions of SFAS No. 123(R) using the modified prospective transition method beginning January 1, 2006, the first day of the first quarter of 2006. In accordance with that transition method, MRV has not restated prior periods for the effect of compensation expense calculated under SFAS No. 123(R). MRV has selected the Black-Scholes option-pricing model as an appropriate method for determining the estimated fair value of all the Company’s awards as required by SFAS No. 123(R). Compensation expense for all share-based equity awards are being recognized on a straight-line basis over the vesting period of the award. The adoption of SFAS No. 123(R) also requires additional accounting related to income taxes and earnings per share as well as additional disclosure related to the cash flow effects resulting from share-based compensation. The adoption of SFAS No. 123(R) had a material impact on MRV’s condensed consolidated financial statements for the three and nine months ended September 30, 2006, and is expected to continue to materially impact MRV’s financial statements in the foreseeable future. See Note 2, “Share-Based Compensation” for more information on the impact of the new standard.
          In November 2005, the FASB issued FASB Staff Position (“FSP”) FAS No. 123 (R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards” (“FSP FAS 123(R)-3”). FSP FAS 123(R)-3 provides a practical exception when a company transitions to the accounting requirements in SFAS No. 123(R). SFAS No. 123(R) requires a company to calculate the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to adopting SFAS No. 123(R) (termed the APIC Pool), assuming the company had been following the recognition provisions prescribed by SFAS No. 123. MRV has elected to use the guidance in FSP FAS 123(R)-3 to calculate its APIC Pool. FSP FAS 123(R)-3 is effective immediately. The adoption of the FSP did not have a material effect on MRV’s financial condition, its results of operations or liquidity.

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          In July 2006, the FASB issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109.” FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes” and prescribes a recognition threshold and measurement attribute for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Additionally, FIN 48 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, with early adoption permitted. MRV is currently evaluating whether the adoption of FIN 48 will have a material effect on its financial condition, its results of operations or liquidity.
          In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for consistently measuring fair value under GAAP, and expands disclosures about fair value measurements. SFAS No. 157 is effective for the Company beginning January 1, 2008, and the provisions of SFAS No. 157 will be applied prospectively as of that date. MRV is currently evaluating whether the adoption of this statement will have a material effect on its financial condition, its results of operations or liquidity.
          In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R).” Among other items, SFAS No. 158 requires recognition of the overfunded or underfunded status of an entity’s defined benefit postretirement plan as an asset or liability in the financial statements, requires the measurement of defined benefit postretirement plan assets and obligations as of the end of the employer’s fiscal year, and requires recognition of the funded status of defined benefit postretirement plans in other comprehensive income. SFAS No. 158 is effective for fiscal years ending after December 15, 2006, and early application is encouraged. MRV is currently evaluating whether the adoption of this statement will have a material effect on its financial condition, its results of operations or liquidity.
          In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (“SAB”) No. 108 (SAB 108). Due to diversity in practice among registrants, SAB 108 expresses SEC staff views regarding the process by which misstatements in financial statements are evaluated for purposes of determining whether financial statement restatement is necessary. SAB 108 is effective for fiscal years ending after November 15, 2006, and early application is encouraged. The Company does not believe SAB 108 will have a material impact on its financial condition, its results of operations or liquidity.
13.   Reclassifications
          Certain prior year amounts have been reclassified to conform to the current year presentation.

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ITEM 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the Consolidated Condensed Financial Statements and Notes thereto included elsewhere in this Report. In addition to historical information, the discussion in this Report contains certain forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated by these forward-looking statements due to factors, including but not limited to, those set forth in the following and elsewhere in this Report. We assume no obligation to update any of the forward-looking statements after the date of this Report.
Overview
          We design, manufacture, sell, distribute, integrate and support communication equipment and services, and optical components. We conduct our business along three principal segments: the networking group, the optical components group and the development stage enterprise group. Our networking group provides equipment used by commercial customers, governments and telecommunications service providers, and includes switches, routers, physical layer products and console management products as well as specialized networking products for aerospace, defense and other applications including voice and cellular communication. Our optical components group designs, manufactures and sells optical communications components, primarily through our wholly owned subsidiary LuminentOIC, Inc. These components include fiber optic transceivers for metropolitan, access and Fiber-to-the-Premises, or FTTP, applications. Our development stage enterprise group seeks to develop new optical components, subsystems and networks and other products for the infrastructure of the Internet.
          We market and sell our products worldwide, through a variety of channels, which include a dedicated direct sales force, manufacturers’ representatives, value-added-resellers, distributors and systems integrators. We have operations in Europe that provide network system design, integration and distribution services that include products manufactured by third-party vendors, as well as our products. We believe such specialization enhances access to customers and allows us to penetrate targeted vertical and regional markets.
          We were organized in July 1988 as MRV Technologies, Inc., a California corporation and reincorporated in Delaware in April 1992, at which time we changed our name to MRV Communications, Inc.
          We generally recognize product revenue, net of sales discounts and allowances, when persuasive evidence of an arrangement exists, delivery has occurred and all significant contractual obligations have been satisfied, the fee is fixed or determinable and collection is considered probable. Products are generally shipped “FOB shipping point” with no right of return, except on rare occasions in which event our accounting is as described below. Sales of services and system support are deferred and recognized ratably over the contract period. Sales with contingencies, such as right of return, rotation rights, conditional acceptance provisions and price protection are rare and have historically been insignificant. We do not recognize such sales until the contingencies have been satisfied or the contingent period has lapsed. We generally warrant our products against defects in materials and workmanship for one to two year periods. The estimated costs of warranty obligations and sales returns and other allowances are recognized at the time of revenue recognition based on contract terms and prior claims experience. Gross profit is equal to our revenues less our cost of goods sold. Our cost of goods sold includes materials, direct labor and overhead. Cost of inventory is determined by the first-in, first-out method. Our operating costs and expenses generally consist of product development and engineering costs, or R&D, selling, general and administrative costs, or SG&A, and other operating related costs and expenses.

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          We evaluate segment performance based on the revenues and the operating expenses of each segment. We do not track segment data or evaluate segment performance on additional financial information. As such, there are no separately identifiable segment assets nor are there any separately identifiable Statement of Operations data below operating income (loss). The networking and optical components groups account for virtually all of our overall revenue.
          Our business involves reliance on foreign-based entities. Several of our divisions, outside subcontractors and suppliers are located in foreign countries, including Argentina, China, Denmark, Finland, France, Germany, Israel, Italy, Japan, Korea, the Netherlands, Norway, Russia, Singapore, South Africa, Switzerland, Sweden, Taiwan and the United Kingdom. For the nine months ended September 30, 2006 and 2005, foreign revenues constituted 67% and 73%, respectively, of our revenues. The vast majority of our foreign sales are to customers located in the European region. The remaining foreign sales are primarily to customers in the Asia Pacific region.
Critical Accounting Policies
          Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. 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.
          We believe that the estimates, assumptions and judgments involved in the accounting policies described below have the greatest potential impact on our financial statements, so we consider these to be our critical accounting policies. Because of the uncertainty inherent in these matters, actual results could differ from the estimates we use in applying the critical accounting policies. Certain of these critical accounting policies affect working capital account balances, including the policies for revenue recognition, allowance for doubtful accounts, inventory reserves and income taxes. These policies require that we make estimates in the preparation of our financial statements as of a given date. However, since our business cycle is relatively short, actual results related to these estimates are generally known within the six-month period following the financial statement date. Thus, these policies generally affect only the timing of reported amounts across two to three quarters.
          Within the context of these critical accounting policies, we are not currently aware of any reasonably likely events or circumstances that would result in materially different amounts being reported.
          Revenue Recognition. We generally recognize product revenue, net of sales discounts and allowances, when persuasive evidence of an arrangement exists, delivery has occurred and all significant contractual obligations have been satisfied, the fee is fixed or determinable and collection is considered probable. Products are generally shipped “FOB shipping point” with no right of return. Sales of services and system support are deferred and recognized ratably over the contract period. Sales with contingencies, such as right of return, rotation rights, conditional acceptance provisions and price protection are rare and insignificant and are deferred until the contingencies have been satisfied or the contingent period has lapsed. We generally warrant our products against defects in materials and workmanship for one to two year periods. The estimated costs of warranty obligations and sales returns and other allowances are recognized at the time of revenue recognition based on contract terms and prior claims experience. Our major revenue-generating products consist of fiber optic components, switches and routers, console management products, and physical layer products.
          Allowance for Doubtful Accounts. We make ongoing estimates relating to the collectability of our accounts receivable and maintain a reserve for estimated losses resulting from the inability of our customers to meet their financial obligations to us. In determining the amount of the reserve, we consider our historical level of credit losses and make judgments about the creditworthiness of significant customers based on ongoing credit evaluations. Since we cannot predict future changes in the financial stability of our customers, actual future losses from uncollectible accounts may differ from our estimates. If the financial condition of our customers were to deteriorate, resulting in their inability to make payments, a larger reserve may be required. In the event we determined that a smaller or larger reserve was appropriate, we would record a credit or a charge to selling and administrative expense in the period in which we made such a determination.

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          Inventory Reserves. We also make ongoing estimates relating to the market value of inventories, based upon our assumptions about future demand and market conditions. If we estimate that the net realizable value of our inventory is less than the cost of the inventory recorded on our books, we record a reserve equal to the difference between the cost of the inventory and the estimated net realizable market value. This reserve is recorded as a charge to cost of goods sold. If changes in market conditions result in reductions in the estimated market value of our inventory below our previous estimate, we would increase our reserve in the period in which we made such a determination and record a charge to cost of goods sold.
          Goodwill and Other Intangibles. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” we do not amortize goodwill and intangible assets with indefinite lives, but instead measure these assets for impairment at least annually, or when events indicate that impairment exists. We amortize intangible assets that have definite lives over their useful lives.
          Income Taxes. As part of the process of preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our Balance Sheets. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the Statement of Operations.
          Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. Management continually evaluates our deferred tax asset as to whether it is likely that the deferred tax assets will be realized. If management ever determined that our deferred tax asset was not likely to be realized, a write-down of that asset would be required and would be reflected in the provision for taxes in the accompanying period.
          Share-Based Compensation. As discussed in Note 2, “Share-Based Compensation” of Notes to Financial Statements included elsewhere in this report, the fair value of stock options is determined using the Black-Scholes valuation model. The assumptions used in calculating the fair value of share-based payment awards represent our best estimates. Our estimates may be impacted by certain variables including, but not limited to, stock price volatility, employee stock option exercise behaviors, additional stock option grants, estimates of forfeitures, and related tax impacts. See Note 2 for a further discussion on stock-based compensation and assumptions used.
Currency Rate Fluctuations
          Changes in the relative values of non-U.S. currencies to the U.S. dollar affect our results. We conduct a significant portion of our business in foreign currencies, including the euro, the Swedish krona, the Swiss franc and the Taiwan dollar. At September 30, 2006, currency changes resulted in assets and liabilities denominated in local currencies being translated into more dollars than at year-end 2005. We incurred approximately 42% of our operating expenses in currencies other than the U.S. dollar for the nine months ended September 30, 2006. In general, these currencies were weaker against the U.S. dollar for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005, so revenues and expenses in these countries translated into less dollars than they would have in the prior period. Additional discussion of foreign currency risk and other market risks is included in “Item 3. — Quantitative and Qualitative Disclosures About Market Risk” appearing elsewhere in this Report.

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Management Discussion Snapshot
          The following table sets forth, for the periods indicated, certain Statements of Operations data expressed as a percentage of revenues:
                                 
    Three Months Ended   Nine Months Ended
    Sept. 30,   Sept. 30,   Sept. 30,   Sept. 30,
    2006   2005   2006   2005
     
Revenue (1)
     100 %     100 %     100 %     100 %
           
Networking group
     76       82       75       83  
Optical components group
     26       19       26       19  
 
                                
Gross margin (2)
     32       30       32       33  
           
Networking group
     35       36       36       38  
Optical components group
     21       —       20       7  
 
                                
Operating costs and expenses (2)
     32       33       33       37  
           
Networking group
     34       33       37       37  
Optical components group
     19       31       20       30  
Development stage enterprise group
   NM   NM   NM   NM
 
                                
Operating income (loss) (2)
     0       (3 )     (1 )     (4 )
           
Networking group
     0       4       (1 )     1  
Optical components group
     2       (30 )     0       (23 )
Development stage enterprise group
   NM   NM   NM   NM
 
NM – not meaningful
(1)   Revenue information by segment includes intersegment revenue, primarily reflecting sales of fiber optic components to the networking group. No revenues were generated by the development stage enterprise group for the periods presented.
 
(2)   Statements of Operations data express percentages as a percentage of revenue. Statements of Operations data by segment express percentages as a percentage of applicable segment revenue. No revenues or corresponding gross profit were generated by the development stage enterprise group in 2006 or 2005.
          The following management discussion and analysis refers to and analyzes our results of operations among three segments as defined by our management. These three segments are the networking group, optical components group and development stage enterprise group, which includes all start-up activities.

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Three Months Ended September 30, 2006 (“2006”) Compared
To Three Months Ended September 30, 2005 (“2005”)
     Revenue
          The following table sets forth, for the periods indicated, certain revenue data from our Statements of Operations (dollars in thousands):
                                         
                                    % Change
                    $   %   Constant
For the three months ended Sept. 30:   2006   2005   Change   Change   Currency (2)
 
Networking group
   $ 68,524     $ 54,107     $ 14,417       27 %     26 %
Optical components group
     23,187       12,474       10,713       86       91  
Development stage enterprise group
     —       —       —       —       —  
     
 
     91,711       66,581       25,130       38       38  
Adjustments (1)
     (2,095 )     (706 )     (1,389 )   NM   NM
       
Total
   $ 89,616     $ 65,875     $ 23,741       36 %     36 %
       
NM – not meaningful
(1)   Adjustments represent the elimination of intersegment revenue in order to reconcile to consolidated revenues.
 
(2)   Percentage information in constant currencies in the table and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
          Revenues for 2006 increased $23.7 million, or 36%, to $89.6 million from $65.9 million for 2005. Geographically, revenues in the Americas increased $9.4 million, or 50%, to $28.3 million for 2006 from $18.9 million for 2005, which was largely due to shipments of our fiber optic components for FTTP deployments. Revenues in Europe increased $9.0 million, or 20%, to $52.8 million for 2006 from $43.8 million in 2005, which was primarily a result of increased revenue from our network integration and distribution activities in Italy. Revenues in Asia Pacific increased $5.4 million, or 179%, to $8.4 million for 2006 from $3.0 million for 2005, primarily because of a large order shipped to a tier-one customer in Japan for MRV’s optical transport products. Foreign currency fluctuations did not have a significant impact on the year-over-year change in our reported revenues.
          Networking Group. Our networking group provides two distinct groups of similar products and services: network equipment and network integration. Network equipment revenue primarily consists of MRV’s internally developed products, such as Metro Ethernet equipment, optical transport equipment, out-of-band network equipment, defense and aerospace network applications, the related service revenue and fiber optic components sold as part of the system solution. Network integration revenue primarily consists of value-added integration and support service revenue, related third-party product sales (including third-party product sales through distribution) and fiber optic components sold as part of the system solution. Revenues, including intersegment revenues, generated from our networking group increased $14.4 million, or 27%, to $68.5 million for 2006 as compared to $54.1 million for 2005. External network equipment revenues increased $6.8 million, or 32%, to $28.5 million for 2006 from $21.7 million for 2005, which was primarily because of a large order shipped to a tier-one customer in Japan for MRV’s optical transport products. External network integration revenues increased $7.6 million, or 23%, to $40.0 million for 2006 from $32.4 million for 2005, which was due primarily to increased revenue from our network integration and distribution activities in Italy. Foreign currency fluctuations did not have a significant impact on the year-over-year change in our reported revenues.

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          Optical Components Group. Our optical components group designs, manufactures and sells fiber optic components, such as components for FTTP applications, fiber optic transceivers, discrete lasers and LEDs that primarily consist of products manufactured by our wholly owned subsidiary, LuminentOIC. Revenues, including intersegment revenue, generated from our optical components group increased $10.7 million, or 86%, to $23.2 million for 2006 as compared to $12.5 million for 2005. Approximately 66% of optical components’ revenue related to shipments of optical components used by those customers in the early stages of deploying FTTP networks. FTTP networks use fiber optic cables, rather than copper cables, to deliver voice, video and high-speed data to customer premises. These networks can transmit voice, data and video signals at speeds and capacities far exceeding the traditional broadband services offered by telecommunication providers. FTTP deployment will allow communication providers to offer superior services at very competitive prices. Shipments of FTTP products for 2006 totaled approximately $15.2 million, compared to $7.4 million for 2005. Recent announcements suggest that FTTP deployments in North America made services available to approximately three million homes through 2005 and that continuing deployments are expected to make FTTP services available to at least an additional three million residences by the end of 2006 and a total of more than twenty million homes by 2010; however, the number of actual residential homes subscribing to such services is expected to be a fraction of the total deployments. We expect sales of FTTP products to continue to grow for the remainder of 2006 and beyond. However, this forward-looking statement may not come to pass if the actual deployments do not meet the expectations of industry announcements, if the orders we expect to receive do not materialize, are delayed or cancelled or if we are unable to ship the products as required. The effect of currency fluctuations did not have a significant impact on the year-over-year change in revenue.
          Development Stage Enterprise Group. No revenues were generated by this group for 2006 and 2005.
     Gross Profit
          The following table sets forth, for the periods indicated, certain gross profit data from our Statements of Operations (dollars in thousands):
                                         
                                    % Change
                    $   %   Constant
For the three months ended Sept. 30:   2006   2005   Change   Change   Currency (2)
 
Networking group
   $ 23,792     $ 19,711     $ 4,081       21 %     20 %
Optical components group
     4,860       7       4,853     NM   NM
Development stage enterprise group
     —       —       —       —       —  
             
 
     28,652       19,718       8,934       45       46  
Adjustments (1)
     2       —       2     NM   NM
 
Total
   $ 28,654     $ 19,718     $ 8,936       45 %     46 %
       
NM – not meaningful
(1)   Adjustments represent the elimination of intersegment revenue in order to reconcile to consolidated gross profit.
 
(2)   Percentage information in constant currencies in the table and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.

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          Gross profit increased $8.9 million, or 45%, to $28.7 million for 2006 from $19.7 million for 2005. Our gross margin increased to 32% for 2006, as compared to 30% for 2005. The increase in gross margin was primarily from the higher margins on fiber optic components which resulted from the efficiencies generated by higher volume manufacturing coupled with our transition of that volume manufacturing to our optical components facility in Taiwan and to third-party contract manufacturers in China, which we expect to continue to result in savings in direct labor costs in connection with manufacturing. The effect of currency fluctuations did not have a significant impact on the year-over-year change in our gross profit. Gross profit was negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which reduced gross profit by $83,000 for the recognition of share-based compensation expense in 2006.
          Networking Group. Gross profit for our networking group was $23.8 million for 2006 compared to $19.7 million for 2005, an increase of $4.1 million. Gross margins decreased to 35%, as compared to 36% for 2005. The decrease in gross margins in 2006 was the result of differences in the composition of the products we sold in each period. The effect of currency fluctuations did not have a significant impact on the year-over-year change in our gross profit. Gross profit was negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which reduced gross profit by $24,000 for the recognition of share-based compensation expense in 2006.
          Optical Components Group. Gross profit for 2006 was $4.9 million, compared to $7,000 for 2005, an increase of $4.9 million. Our optical components group gross margin increased to 21% for 2006, as compared to gross margin of 0% for 2005. The increase in gross margin in 2006 was primarily the result of increased revenue coupled with our transition of volume manufacturing to our optical components facility in Taiwan and to third-party contract manufacturers in China, which we expect to continue to result in savings in direct labor costs in connection with manufacturing. We will continue to assess the optimal cost structure within our operations, and attempt to adjust the cost structure as necessary. The effect of currency fluctuations did not have a significant impact on the year-over-year change in our gross profit. Gross profit was negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which reduced gross profit by $59,000 for the recognition of share-based compensation expense in 2006.
          Development Stage Enterprise Group. As we had no sales by this group, no gross margins were generated by this group for 2006 and 2005.
     Operating Costs and Expenses
          The following table sets forth, for the periods indicated, certain operating costs and expenses data from our Statements of Operations (dollars in thousands):
                                         
                                    % Change
                    $   %   Constant
For the three months ended Sept. 30:   2006   2005   Change   Change   Currency (1)
 
Networking group
   $ 23,513     $ 17,649     $ 5,864       33 %     33 %
Optical components group
     4,405       3,811       594       16       17  
Development stage enterprise group
     404       435       (31 )     (7 )     (7 )
 
Total
   $ 28,322     $ 21,895     $ 6,427       29 %     29 %
       
 
(1)   Percentage information in constant currencies in the table and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
          Operating costs and expenses were $28.3 million, or 32% of revenues, for 2006, compared to $21.9 million, or 33% of revenues, for 2005. Operating costs and expenses increased $6.4 million in 2006 compared to 2005. The effect of currency fluctuations did not have a significant impact on the year-over-year change in our operating costs and expenses. Operating costs and expenses were negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which increased product development and engineering expenses by $190,000 and selling, general and administrative expenses by $589,000 for the recognition of share-based compensation expense in 2006.

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          Networking Group. Operating costs and expenses for 2006 were $23.5 million, or 34% of revenues, compared to $17.6 million, or 33% of revenues, for 2005. Operating costs and expenses increased $5.9 million, or 33%, in 2006 compared to 2005. The increase in operating costs and expenses was primarily the result of increased sales and marketing expenses, particularly relating to the expansion of our North American sales organization, and share-based compensation expense. The effect of currency fluctuations did not have a significant impact on the year-over-year change in our operating costs and expenses. Operating costs and expenses were negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which increased product development and engineering expenses by $114,000 and selling, general and administrative expenses by $484,000 for the recognition of share-based compensation expense in 2006.
          Optical Components Group. Operating costs and expenses for 2006 were $4.4 million, or 19% of revenues, compared to $3.8 million, or 31% of revenues, for 2005. Operating costs and expenses increased $594,000, or 16%, in 2006 compared to 2005. Operating costs and expenses increased across all expense categories, but decreased significantly as a percentage of revenue, which benefited from the increased sales volume, particularly from FTTP products. The effect of currency fluctuations did not have a significant impact on the year-over-year change in our operating costs and expenses. Operating costs and expenses were negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which increased product development and engineering expenses by $76,000 and selling, general and administrative expenses by $105,000 for the recognition of share-based compensation expense in 2006.
          Development Stage Enterprise Group. Operating costs and expenses for 2006 were $404,000, compared to $435,000 for 2005. Operating costs and expenses decreased $31,000, or 7%, in 2006 compared to 2005. We attribute the decrease in operating costs and expenses to our cost saving efforts to align these costs with current development activities.
     Operating Income (Loss)
          The following table sets forth, for the periods indicated, certain operating income (loss) data from our Statements of Operations (dollars in thousands):
                                         
                                    % Change
                    $   %   Constant
For the three months ended Sept. 30:   2006   2005   Change   Change   Currency (2)
 
Networking group
   $ 279     $ 2,062     $ (1,783 )     (87 )%     (87 )%
Optical components group
     455       (3,804 )     4,259       (112 )     (114 )
Development stage enterprise group
     (404 )     (435 )     31       (7 )     (7 )
     
 
     330       (2,177 )     2,507       (115 )     (118 )
Adjustments (1)
     2       —       2     NM   NM
 
Total
   $ 332     $ (2,177 )   $ 2,509       (115 )%     (118 )%
       
NM – not meaningful
(1)   Adjustments represent the elimination of intersegment revenue in order to reconcile to consolidated operating income (loss).
          (2) Percentage information in constant currencies in the table and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.

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          We reported operating income of $332,000, or 0% of revenues, for 2006 compared to an operating loss of $2.2 million, or 3% of revenues, for 2005, an improvement in our results of $2.5 million in 2006 compared to 2005. This improvement in our results was primarily the result of the increase in our gross profit and the decrease of operating expenses as a percentage of revenue. The effect of currency fluctuations did not have a significant impact on the year-over-year change in our operating income (loss). In 2006, our operating income was negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which decreased our operating income by $862,000 for the recognition of share-based compensation expense.
          Networking Group. Our networking group reported operating income totaling $279,000 for 2006, compared to $2.1 million for 2005, a decrease of $1.8 million. This decrease was primarily the result of increased sales and marketing expenses, particularly relating to the expansion of our North American sales organization, and share-based compensation expense of $622,000, which we incurred as a consequence of the adoption of SFAS No. 123(R) on January 1, 2006. The effect of currency fluctuations did not have a significant impact on the year-over-year change in our operating income.
          Optical Components Group. Our optical components group reported operating income of $455,000, or 2% of revenues, for 2006, compared to an operating loss of $3.8 million, or 30% of revenues, for 2005. Our operating loss improved $4.3 million, or 112%, in 2006 compared to 2005. The improvement in our operating income (loss) was the result of the increased gross profit, partially offset by the increase in operating costs and expenses,. Our operating income (loss) was negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which decreased our operating income by $240,000 for the recognition of share-based compensation expense in 2006. The effect of currency fluctuations did not have a significant impact on the year-over-year change in our operating income (loss).
          Development Stage Enterprise Group. Our development stage enterprise group reported an operating loss of $404,000 for 2006 as compared to $435,000 for 2005. Our operating loss improved $31,000, or 7%, in 2006 compared to 2005. The improvement was the result of a reduction in spending for operating costs and expenses.
     Interest Expense and Other Income, Net
          Interest expense was $819,000 and $767,000 million for 2006 and 2005, respectively. Other income, net principally includes interest income on cash, cash equivalents and investments and gains (losses) on foreign currency transactions. Interest income was $1.4 million and $554,000 for 2006 and 2005, respectively, an increase of $886,000, or 160%. The increase in interest income was a result of higher yields on investments in 2006 compared to 2005 and incremental interest on the $69.9 million proceeds from the private placement of approximately 19.9 million shares of our common stock issued to a group of institutional investors, which was completed in March 2006. Realized income on foreign currency transactions were $169,000 and $592,000 in 2006 and 2005, respectively, a decrease of $423,000.
     Provision for Taxes
          The provision for income taxes for 2006 was $943,000 as compared to $1.3 million for 2005. Our income tax expense fluctuates based on the amount of income generated in the various jurisdictions where we conduct operations and pay income tax.

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Table of Contents

Nine Months Ended September 30, 2006 (“2006”) Compared
To Nine Months Ended September 30, 2005 (“2005”)
     Revenue
          The following table sets forth, for the periods indicated, certain revenue data from our Statements of Operations (dollars in thousands):
                                         
                                    % Change
                    $   %   Constant
For the nine months ended Sept. 30:   2006   2005   Change   Change   Currency (2)
 
Networking group
   $ 190,282     $ 158,973     $ 31,309       20 %     23 %
Optical components group
     67,221       36,141       31,080       86       90  
Development stage enterprise group
     —       —       —       —       —  
     
 
     257,503       195,114       62,389       32       35  
Adjustments (1)
     (3,660 )     (2,585 )     (1,075 )   NM   NM
 
Total
   $ 253,843     $ 192,529     $ 61,314       32 %     35 %
       
NM – not meaningful
(1)   Adjustments represent the elimination of intersegment revenue in order to reconcile to consolidated revenues.
 
(2)   Percentage information in constant currencies in the table and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
          Revenues for 2006 increased $61.3 million, or 32%, to $253.8 million from $192.5 million for 2005. Geographically, revenues in the Americas increased $32.8 million, or 63%, to $84.8 million for 2006 from $52.0 million for 2005, which was largely a consequence of shipments of our fiber optic components for FTTP deployments. Revenues in Europe increased $23.4 million, or 18%, to $154.2 million for 2006 from $130.7 million in 2005, which was primarily a result of increased revenue from our network integration and distribution activities in Italy. Revenues in Asia Pacific increased $5.4 million, or 58%, to $14.7 million for 2006 from $9.3 million for 2005, primarily from a large order shipped to a tier-one customer in Japan for MRV’s optical transport products. Foreign currency fluctuations had the effect of reducing the revenue increase by $6.7 million year-over-year on a constant currency basis.
          Networking Group. Revenues, including intersegment revenues, generated from our networking group increased $31.3 million, or 20%, to $190.3 million for 2006 as compared to $159.0 million for 2005. External network equipment revenues increased $10.0 million, or 16%, to $72.6 million for 2006 from $62.6 million for 2005, which was a consequence of a large order shipped to a tier-one customer in Japan for MRV’s optical transport products and the contributions of our expanded North American sales organization. External network integration revenues increased $21.3 million, or 22%, to $117.7 million for 2006 from $96.4 million for 2005, which was due primarily to increased revenue from our network integration and distribution activities in Italy. Foreign currency fluctuations had the effect of reducing the revenue increase by $5.4 million year-over-year on a constant currency basis.
          Optical Components Group. Revenues, including intersegment revenue, generated from our optical components group increased $31.1 million, or 86%, to $67.2 million for 2006 as compared to $36.1 million for 2005. Approximately 66% of optical components’ revenue related to shipments of optical components used by those customers in the early stages of deploying FTTP networks. Shipments of FTTP products for 2006 totaled approximately $44.5 million, compared to $20.6 million for 2005. Foreign currency fluctuations had the effect of reducing the revenue increase by $1.3 million year-over-year on a constant currency basis.
          Development Stage Enterprise Group. No revenues were generated by this group for 2006 and 2005.

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Table of Contents

     Gross Profit
          The following table sets forth, for the periods indicated, certain gross profit data from our Statements of Operations (dollars in thousands):
                                         
                                    % Change
                    $   %   Constant
For the nine months ended Sept. 30:   2006   2005   Change   Change   Currency (2)
 
Networking group
   $ 67,722     $ 60,412     $ 7,310       12 %     15 %
Optical components group
     13,520       2,703       10,817       400       409  
Development stage enterprise group
     —       —       —       —       —  
     
 
     81,242       63,115       18,127       29       32  
Adjustments (1)
     (20 )     —       (20 )   NM   NM
 
Total
   $ 81,222     $ 63,115     $ 18,107       29 %     32 %
       
NM – not meaningful
(1)   Adjustments represent the elimination of intersegment revenue in order to reconcile to consolidated gross profit.
 
(2)   Percentage information in constant currencies in the table and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
          Gross profit increased $18.1 million, or 29%, to $81.2 million for 2006 from $63.1 million for 2005. Our gross margin decreased to 32% for 2006, as compared to 33% for 2005. While MRV benefited from margin increases for optical components from efficiencies generated by higher volume manufacturing during 2006 coupled with our transition of that volume manufacturing to our optical components facility in Taiwan and to third-party contract manufacturers in China, such increases were offset, and our gross margin decreased primarily from the increase in sales of fiber optic components that yield lower gross margins than the company-wide average for all of our products. Foreign currency fluctuations had the effect of reducing the gross profit increase by $2.0 million year-over-year on a constant currency basis. Gross profit was negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which reduced gross profit by $231,000 for the recognition of share-based compensation expense in 2006.
          Networking Group. Gross profit for our networking group was $67.7 million for 2006 compared to $60.4 million for 2005, an increase of $7.3 million. Gross margin decreased to 36%, as compared to 38% for 2005. The decrease in gross margin in 2006 was the result of differences in the composition of the products we sold in each period. Foreign currency fluctuations had the effect of reducing the gross profit increase by $1.7 million year-over-year on a constant currency basis. Gross profit was negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which reduced gross profit by $72,000 for the recognition of share-based compensation expense in 2006.
          Optical Components Group. Gross profit for 2006 was $13.5 million, compared to $2.7 million for 2005, an increase of $10.8 million. Our optical components group gross margin increased to 20% for 2006, as compared to gross margin of 7% for 2005. The increase in gross margin in 2006 was primarily the result of increased revenue coupled with our transition of volume manufacturing to our optical components facility in Taiwan and to third-party contract manufacturers in China, which we expect to continue to result in savings in direct labor costs in connection with manufacturing. We will continue to assess the optimal cost structure within our operations, and attempt to adjust the cost structure as necessary. Foreign currency fluctuations had the effect of reducing the gross profit increase by $247,000 year-over-year on a constant currency basis. Gross profit was negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which reduced gross profit by $159,000 for the recognition of share-based compensation expense in 2006.
          Development Stage Enterprise Group. As we had no sales by this group, no gross margins were generated by this group for 2006 and 2005.

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Table of Contents

     Operating Costs and Expenses
          The following table sets forth, for the periods indicated, certain operating costs and expenses data from our Statements of Operations (dollars in thousands):
                                         
                                    % Change
                    $   %   Constant
For the nine months ended Sept. 30:   2006   2005   Change   Change   Currency (1)
 
Networking group
   $ 69,837     $ 59,005     $ 10,832       18 %     21 %
Optical components group
     13,710       10,976       2,734       25       26  
Development stage enterprise group
     1,090       1,312       (222 )     (17 )     (17 )
 
Total
   $ 84,637     $ 71,293     $ 13,344       19 %     21 %
       
     
(1)   Percentage information in constant currencies in the table and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
          Operating costs and expenses were $84.6 million, or 33% of revenues, for 2006, compared to $71.3 million, or 37% of revenues, for 2005. Operating costs and expenses increased $13.3 million in 2006 compared to 2005, but was down as a percentage of total revenue because of the increase in optical components revenue. Foreign currency fluctuations had the effect of reducing the increase in operating costs and expenses by $1.4 million year-over-year on a constant currency basis. Operating costs and expenses were negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which increased product development and engineering expenses by $579,000 and selling, general and administrative expenses by $1.7 million for the recognition of share-based compensation expense in 2006 compared to $162,000 of share-based compensation under SFAS No. 123 recorded in selling, general and administrative expenses for 2005.
          Networking Group. Operating costs and expenses for 2006 were $69.8 million, or 37% of revenues, compared to $59.0 million, or 37% of revenues, for 2005. Operating costs and expenses increased $10.8 million, or 18%, in 2006 compared to 2005. The increase in operating costs and expenses was the result of increased sales and marketing expenses, particularly relating to the expansion of our North American sales organization, and share-based compensation expense. Foreign currency fluctuations had the effect of reducing the increase in operating costs and expenses by $1.3 million year-over-year on a constant currency basis. Operating costs and expenses were negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which increased product development and engineering expenses by $352,000 and selling, general and administrative expenses by $1.4 million for the recognition of share-based compensation expense in 2006 compared to $162,000 of share-based compensation under SFAS No. 123 recorded in selling, general and administrative expenses for 2005.
          Optical Components Group. Operating costs and expenses for 2006 were $13.7 million, or 20% of revenues, compared to $11.0 million, or 30% of revenues, for 2005. Operating costs and expenses increased $2.7 million, or 25%, in 2006 compared to 2005. Operating costs and expenses increased across all expense categories, but decreased significantly as a percentage of revenue because of increased sales volume, particularly from FTTP products. Foreign currency fluctuations had the effect of reducing the increase in operating costs and expenses by $111,000 year-over-year on a constant currency basis. Operating costs and expenses were negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which increased product development and engineering expenses by $227,000 and selling, general and administrative expenses by $315,000 for the recognition of share-based compensation expense in 2006.
          Development Stage Enterprise Group. Operating costs and expenses for 2006 were $1.1 million, compared to $1.3 million for 2005. Operating costs and expenses decreased $222,000, or 17%, in 2006 compared to 2005. We attribute the decrease in operating costs and expenses to our cost saving efforts to align these costs with current development activities.

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     Operating Income (Loss)
          The following table sets forth, for the periods indicated, certain operating income (loss) data from our Statements of Operations (dollars in thousands):
                                         
                                    % Change
                    $   %   Constant
For the nine months ended Sept. 30:   2006   2005   Change   Change   Currency (2)
 
Networking group
   $ (2,115 )   $ 1,407     $ (3,522 )     (250 )%     (219 )%
Optical components group
     (190 )     (8,273 )     8,083       (98 )     (99 )
Development stage enterprise group
     (1,090 )     (1,312 )     222       (17 )     (17 )
     
 
     (3,395 )     (8,178 )     4,783       (58 )     (65 )
Adjustments (1)
     (20 )     —       (20 )   NM   NM
 
Total
   $ (3,415 )   $ (8,178 )   $ 4,763       (58 )%     (65 )%
       
NM – not meaningful
(1)   Adjustments represent the elimination of intersegment revenue in order to reconcile to consolidated operating income (loss).
 
(2)   Percentage information in constant currencies in the table and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
          We reported an operating loss of $3.4 million, or 1% of revenues, for 2006 compared to $8.2 million, or 4% of revenues, for 2005, an improvement in our results of $4.8 million in 2006 compared to 2005. This improvement in our results was primarily the result of the increase in our gross profit and the decrease of operating expenses as a percentage of revenue. Foreign currency fluctuations had the effect of reducing the decrease in our operating loss by $574,000 year-over-year on a constant currency basis. In 2006, our operating loss was negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which increased our operating loss by $2.5 million for the recognition of share-based compensation expense compared to $162,000 of share-based compensation under SFAS No. 123 recorded in 2005.
          Networking Group. Our networking group reported an operating loss of $2.1 million for 2006, compared to operating income of $1.4 million for 2005, a decrease of $3.5 million. This decrease was primarily the result of increased sales and marketing expenses, particularly relating to the expansion of our North American sales organization, and share-based compensation expense of $1.8 million, which we incurred as a consequence of the adoption of SFAS No. 123(R) on January 1, 2006 compared to $162,000 of share-based compensation under SFAS No. 123 recorded in 2005. Foreign currency fluctuations had the effect of reducing the decrease in our operating loss by $435,000 year-over-year on a constant currency basis.
          Optical Components Group. Our optical components group reported an operating loss of $190,000, or 0% of revenues, for 2006, compared to an operating loss of $8.3 million, or 23% of revenues, for 2005. Our operating loss improved $8.1 million, or 98%, in 2006 compared to 2005. The improvement in our operating loss was the result of the increased gross profit, partially offset by the increase in operating costs and expenses. Our operating income (loss) was negatively impacted by the adoption of SFAS No. 123(R) on January 1, 2006, which decreased our operating income by $701,000 for the recognition of share-based compensation expense in 2006. Foreign currency fluctuations had the effect of reducing the decrease in our operating loss by $138,000 year-over-year on a constant currency basis.
          Development Stage Enterprise Group. Our development stage enterprise group reported an operating loss of $1.1 million for 2006 as compared to $1.3 million for 2005. Our operating loss improved $222,000, or 17%, in 2006 compared to 2005. The improvement was the result of a reduction in spending for operating costs and expenses.

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     Interest Expense and Other Income, Net
          Interest expense was $2.6 million and $3.3 million for 2006 and 2005, respectively. Interest expense decreased in 2006 primarily from fluctuations in the fair value of certain interest rate swaps utilized by one of our foreign offices. Other income, net principally includes interest income on cash, cash equivalents and investments and gains (losses) on foreign currency transactions. Interest income was $3.5 million and $1.4 million for 2006 and 2005, respectively, an increase of $2.1 million, or 153%. The increase in interest income was the result of higher yields on investments in 2006 compared to 2005 and incremental interest on the $69.9 million proceeds from the private placement of approximately 19.9 million shares of our common stock issued to a group of institutional investors, which was completed in March 2006. Realized income (loss) on foreign currency transactions were $(357,000) and $104,000 in 2006 and 2005, respectively, a decrease of $461,000.
     Provision for Taxes
          The provision for income taxes for 2006 was $3.4 million, compared to $4.1 million for 2005. The decrease in tax expense in 2006 versus 2005 was primarily from the additional valuation allowance recognized against certain deferred income tax assets associated with foreign jurisdictions in 2005. The decrease was partially offset by an increase in the amount of income generated in certain of the various jurisdictions where we conduct operations and pay income tax.
Recently Issued Accounting Standards
          For a discussion of recently issued accounting standards relevant to our financial performance, see Note 12 of Notes to Financial Statements included elsewhere in this report.

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Liquidity and Capital Resources
          We had cash and cash equivalents of $81.2 million as of September 30, 2006, an increase of $13.2 million from the cash and cash equivalents of $68.0 million we had as of December 31, 2005. The increase in cash and cash equivalents was primarily the result of the net proceeds we received from the issuance and sale of our common stock in a private placement to institutional investors that we completed in March 2006. The increase in cash and cash equivalents was partially offset by our purchase of marketable securities, cash we used in our operations, the timing of cash collections from customers, cash we used to procure necessary raw materials and components to build our inventories for products we expect to ship in the future, cash we used to satisfy vendor obligations and net payments on short-term and long-term obligations. The following table illustrates our cash position, which we define as cash, cash equivalents, time deposits and short-term and long-term marketable securities, as it relates to our debt position, which we define as all short-term and long-term obligations including our 2003 Notes (dollars in thousands):
                 
    September 30,   December 31,
At:   2006   2005
 
Cash
                
Cash and cash equivalents
   $ 81,177     $ 67,984  
Short-term marketable securities
     34,809       —  
Time deposits
     773       1,475  
     
 
     116,759       69,459  
Debt
                
5% convertible notes due 2008
     23,000       23,000  
Short-term obligations (1)
     23,352       30,378  
Long-term debt
     120       284  
     
 
     46,472       53,662  
     
Excess cash versus debt
   $ 70,287     $ 15,797  
     
Ratio of cash versus debt (2)
     2.5:1       1.3:1  
 
(1)   Includes current maturities of long-term debt.
 
(2)   Determined by dividing total “cash” by total “debt,” in each case as reflected in the table.
     Working Capital
          Working capital means the difference between current assets and current liabilities at particular points in time. The following table illustrates our working capital position (dollars in thousands):
                 
    September 30,   December 31,
At:   2006   2005
 
Current assets
   $ 286,918     $ 212,842  
Current liabilities
     116,766       113,328  
       
Working capital
   $ 170,152     $ 99,514  
       
Current ratio (1)
     2.5:1       1.9:1  
 
(1)   Determined by dividing total “current assets” by total “current liabilities,” in each case as reflected in the table.

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          Current assets increased $74.1 million due primarily to increases in cash and cash equivalents, short-term marketable securities and inventories, partially offset by decreases in accounts receivables. The increase in cash and cash equivalents and short-term marketable securities was primarily the result of the net proceeds from our March 2006 private placement of our common stock. Fluctuations in current assets typically result from the timing of: shipments of our products to customers, receipts of inventories from and payments to our vendors, cash used for capital expenditures and the effects of changes in foreign currency.
          Current liabilities increased $3.4 million due primarily to the increase in accounts payable and other current liabilities, partially offset by the decrease in short-term obligations. Fluctuations in current liabilities typically result from the timing of: payments to our vendors for raw materials, timing of payments for accrued liabilities, such as payroll related expenses and interest on our short-term and long-term obligations, changes in deferred revenue, income tax liabilities and the effects of changes in foreign currencies.
     Cash Flow
          The following table sets forth, for the periods indicated, certain cash flow data from our Statements of Cash Flows (dollars in thousands):
                 
For the nine months ended September 30:   2006   2005
 
Net cash provided by (used in):
                
Operating activities
   $ (11,921 )   $ (13,011 )
Investing activities
     (38,536 )     2,769  
Financing activities
     63,314       4,334  
Effect of exchange rate changes on cash and cash equivalents
     336       (1,232 )
     
Net change in cash and cash equivalents
   $ 13,193     $ (7,140 )
       
          Cash Flows Related to Operating Activities. Cash used in operating activities was $11.9 million for the nine months ended September 30, 2006, compared to cash used in operating activities of $13.0 million for same period last year. Cash used in operating activities was a result of our net loss of $6.1 million, adjusted for non-cash items such as depreciation and amortization, additional allowances for doubtful accounts, share-based compensation expense, deferred income taxes and gains on the disposition of fixed assets. In 2006, decreases in accounts receivable and increases in accounts payable positively affected cash used in operating activities. In the same period, cash used in operating activities was negatively affected by increases in inventories and other assets. The decrease in accounts receivable resulted from the timing of customer payments and collection efforts. The increase in inventories was primarily the result of our purchase of raw materials and components for products we expect to ship in the future. Increases in accounts payable were the result of the timing of payments to our vendors. Cash used in operating activities for the prior period was the result of our net loss adjusted for non-cash items and changes in working capital.
          Cash Flows Related to Investing Activities. Cash used in investing activities was $38.5 million for the nine months ended September 30, 2006, compared to cash provided by investing activities totaling $2.8 million for the same period last year. Cash used in investing activities for 2006 was primarily the result of capital expenditures and the purchase of short-term marketable securities. As of September 30, 2006, we had no plans for major capital expenditures. Cash flows provided by investing activities for the prior period resulted from the maturity of short-term and long-term marketable securities, partially offset by cash used for capital expenditures.

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          Cash Flows Related to Financing Activities. Cash flows provided by financing activities were $63.3 million for the nine months ended September 30, 2006, as compared to cash flows provided by financing activities of $4.3 million for the same period last year. Cash provided by financing activities was primarily the result of net proceeds from our issuance of common stock, the exercise of employee stock options, and changes in other long-term liabilities, partially offset by net payments on short-term and long-term obligations. Cash flows provided by financing activities for the prior period represent the net proceeds from the exercise of employee stock options, changes in other long-term liabilities, and net cash received on short-term borrowings.
          In March 2006, we completed a private placement of approximately 19.9 million shares of our common stock at $3.75 per share for gross proceeds of approximately $74.5 million with a group of institutional investors. The net proceeds to us were approximately $69.9 million. The net proceeds will be used for working capital, general corporate purposes and in efforts to support our recent growth in revenues. We may also use a portion of the net proceeds, currently intended for general corporate purposes, to acquire or invest in technologies, products or services that complement our business.
     Off-Balance Sheet Arrangements
          We do not have transactions, arrangements and other relationships with unconsolidated entities that are reasonably likely to affect our liquidity or capital resources. We have no special purpose or limited purpose entities that provided off-balance sheet financing, liquidity or market or credit risk support, engaged in leasing, hedging, research and development services, or other relationships that expose us to liability that is not reflected on the face of the financials.
     Contractual Cash Obligations
          The following table illustrates our total contractual cash obligations as of September 30, 2006 (in thousands):
                                         
            Less than 1                   After 5
Cash Obligations   Total   Year   1 – 3 Years   4 – 5 Years   Years
 
Short-term obligations
   $ 23,080     $ 23,080     $ —     $ —     $ —  
Long-term debt
     392       272       120       —       —  
5% convertible notes due June 2008
     23,000       —       23,000       —       —  
Unconditional purchase obligations
     11,493       7,883       2,621       —       989  
Operating leases
     26,663       6,075       8,432       5,620       6,536  
           
Total contractual cash obligations
   $ 84,628     $ 37,310     $ 34,173     $ 5,620     $ 7,525  
       
          Our total contractual cash obligations as of September 30, 2006, were $84.6 million, of which, $37.3 million are due by September 30, 2007. These total contractual cash obligations primarily consist of short-term and long-term obligations, including our 5% convertible notes due in June 2008, operating leases for our equipment and facilities and unconditional purchase obligations for necessary raw materials. Historically, these obligations have been satisfied through cash generated from our operations or other avenues and we expect that this will continue to be the case.

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          We believe that our cash on hand and cash flows from operations will be sufficient to satisfy our current operations, capital expenditures and product development and engineering requirements for at least the next 12 months. However, we may choose to obtain additional debt or equity financing if we believe it appropriate. We are limited in the amount of debt financing we may obtain and the price per share of our common stock at which we may conduct equity financings without triggering an acceleration of, or obtaining a waiver from holders of, our 5% convertible notes due June 2008. For a discussion of these limitations and other restrictions of our 5% convertible notes due June 2008, see the discussion below under “Certain Factors That Could Affect Future Results – Our 2003 Notes Provide for Various Events of Default That Would Entitle the Holders to Require Us to Repay Upon a Holder’s Demand the Outstanding Principal Amount, Plus Accrued And Unpaid Interest” and under Item 1A of Part II of this Report “If Our Cash Flow Significantly Deteriorates in the Future, Our Liquidity and Ability to Operate Our Business Could Be Adversely Affected.” Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending to support development of new products and the expansion of sales and marketing efforts, the timing of new product introductions and enhancements to existing products and the market acceptance of our products.
Internet Access to Our Financial Documents
          We maintain a website at www.mrv.com. We make available, free of charge, either by direct access or a link to the SEC website, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC. Our reports filed with, or furnished to, the SEC are also available directly at the SEC’s website at www.sec.gov.
Certain Factors That Could Affect Future Results
You should carefully consider and evaluate all of the information in this Form 10-Q, including the risk factors listed below. The risks described below are not the only ones facing our company. Additional factors not now known to us or that we currently deem immaterial may also impair our business operations.
If any circumstances discussed in the following factors actually occur or occur again, our business could be materially harmed. If our business is harmed, the trading price of our common stock could decline.
Some of the statements contained in this report discuss future events or expectations, contain projections of results of operations or financial condition, changes in the markets for our products and services, or state other “forward-looking” information. MRV’s “forward-looking” information is based on various factors and was derived using numerous assumptions. In some cases, you can identify these “forward-looking statements” by words like “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of those words and other comparable words. You should be aware that these statements only reflect our current predictions and beliefs. These statements are subject to known and unknown risks, uncertainties and other factors, and actual events or results may differ materially. Important factors that could cause our actual results to be materially different from the forward-looking statements are disclosed throughout this report, particularly those immediately below and under the heading “Risk Factors” in Item 1A of Part II of this report. You should review these factors that could affect our future results and the risk factors in Item 1A of this report and the rest of this quarterly report in combination with the more detailed description of our business in our annual report on Form 10-K, which we filed with the Securities and Exchange Commission on March 6, 2006, for a more complete understanding of the risks associated with an investment in our securities. We undertake no obligation to revise or update any forward-looking statements.
          Our operating results could fluctuate significantly from quarter-to-quarter. Our operating results for a particular quarter are extremely difficult to predict. Our revenue and operating results could fluctuate substantially from quarter-to-quarter and from year-to-year. This could result from any one or a combination of factors such as:
  •   the cancellation or postponement of orders;
 
  •   the timing and amount of significant orders;

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  •   our success in developing, introducing and shipping product enhancements and new products;
 
  •   the mix of products we sell;
 
  •   software, hardware or other errors in the products we sell requiring replacements or increased warranty reserves;
 
  •   our annual reviews of goodwill and other intangibles that lead to impairment charges;
 
  •   new product introductions by our competitors;
 
  •   the timing of delivery and availability of components from suppliers;
 
  •   readiness of customer sites for installation;
 
  •   political stability in the areas of the world in which we operate in;
 
  •   changes in material costs;
 
  •   currency fluctuations;
 
  •   changes in accounting rules; and
 
  •   general economic conditions as well as changes in such conditions specific to our market segments.
          Moreover, the volume and timing of orders we receive during a quarter are difficult to forecast. From time to time, our customers encounter uncertain and changing demand for their products. Customers generally order based on their forecasts. If demand falls below these forecasts or if customers do not control inventories effectively, they may cancel or reschedule shipments previously ordered from us. Our expense levels during any particular period are based, in part, on expectations of future sales. If sales in a particular quarter do not meet expectations, our operating results could be materially adversely affected.
          Our success is dependent, in part, on the overall growth rate of the fiber optic components and networking industry. The Internet, or the industries that serve it, may not continue to grow, and even if it does or they do, we may not achieve increased growth. Our business, operating results or financial condition may be adversely affected by any decreases in industry growth rates. In addition, we can give no assurance that our results in any particular period will fall within the ranges for growth forecast by market researchers or securities analysts.
          Because of these and other factors, you should not rely on quarter-to-quarter comparisons of our results of operations as an indication of our future performance. It is possible that, in future periods, our results of operations will be below the expectations of public market analysts and investors. This failure to meet expectations could cause the trading price of our common stock to decline. Similarly, the failure by our competitors or customers to meet or exceed the results expected by their analysts or investors could have a ripple effect on us and cause our stock price to decline.
          Our markets are subject to rapid technological change, and to compete effectively, we must continually introduce new products that achieve market acceptance. The markets for our products are characterized by rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. We expect that new technologies will emerge as competition and the need for higher and more cost effective transmission capacity, or bandwidth, increases. Our future performance will depend on the successful development, introduction and market acceptance of new and enhanced products that address these changes as well as current and potential customer requirements. The introduction of new and enhanced products may cause our customers to defer or cancel orders for existing products. We have in the past experienced delays in product

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development and these delays may occur in the future. Therefore, to the extent that customers defer or cancel orders in the expectation of a new product release or there is any delay in development or introduction of our new products or enhancements of our products, our operating results would suffer. We also may not be able to develop the underlying core technologies necessary to create new products and enhancements, or to license these technologies from third parties. Product development delays may result from numerous factors, including:
  •   changing product specifications and customer requirements;
 
  •   difficulties in hiring and retaining necessary technical personnel;
 
  •   difficulties in reallocating engineering resources and overcoming resource limitations;
 
  •   difficulties with contract manufacturers;
 
  •   changing market or competitive product requirements; and
 
  •   unanticipated engineering complexities.
          The development of new, technologically advanced products is a complex and uncertain process requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. In order to compete, we must be able to deliver to customers products that are highly reliable, operate with its existing equipment, lower the customer’s costs of acquisition, installation and maintenance and provide an overall cost-effective solution. We may not be able to identify, develop, manufacture, market or support new or enhanced products successfully, if at all, or on a timely basis. Further, our new products may not gain market acceptance or we may not be able to respond effectively to product announcements by competitors, technological changes or emerging industry standards. Our failure to respond effectively to technological changes would significantly harm our business.
          Defects in our products resulting from their complexity or otherwise could hurt our financial performance. Complex products, such as those we offer, may contain undetected software or hardware errors when we first introduce them or when we release new versions. The occurrence of these errors in the future, and our inability to correct these errors quickly or at all, could result in the delay or loss of market acceptance of our products. It could also result in material warranty expense, diversion of engineering and other resources from our product development efforts and the loss of credibility with, and legal actions by, our customers, system integrators and end users. Any of these or other eventualities resulting from defects in our products could cause our sales to decline and have a material adverse effect on our business, operating results and financial condition.
          The long sales cycles for our products may cause revenues and operating results to vary from quarter-to-quarter, which could cause volatility in our stock price. The timing of our revenue is difficult to predict because of the length and variability of the sales and implementation cycles for our products. We do not recognize revenue until a product has been shipped to a customer, all significant vendor obligations have been performed and collection is considered probable. Customers often view the purchase of our products as a significant and strategic decision. As a result, customers typically expend significant effort in evaluating, testing and qualifying our products and our manufacturing process. This customer evaluation and qualification process frequently results in a lengthy initial sales cycle of, depending on the products, many months or more. In addition, some of our customers require that our products be subjected to lifetime and reliability testing, which also can take 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 to customize our products to the customer’s needs. We may also expend significant management efforts, increase manufacturing capacity and order long lead-time components or materials prior to receiving an order. Even after this evaluation process, a potential customer may not purchase our products. Even after acceptance of orders, our customers often change the scheduled delivery dates of their orders. Because of the evolving nature of the optical networking and network infrastructure markets, we cannot predict the length of these sales, development or delivery cycles. As a result, these long sales cycles may cause our net sales and

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operating results to vary significantly and unexpectedly from quarter-to-quarter, which could cause volatility in our stock price.
          Cost containment is critical to achieving positive cash flow from operations and profitability consistently. We are continuing efforts at strict cost containment and believe that such efforts are essential to achieving positive cash flow from operations in future quarters and maintaining profitability on a consistent basis, especially since the outlook for future quarters is subject to numerous challenges. Additional measures to contain costs and reduce expenses may be undertaken if revenues do not continue to improve. A number of factors could preclude us from consistently bringing costs and expenses in line with our revenues, such as our inability to forecast business activities accurately and decreases in our revenues. If we are not able to maintain an expense structure commensurate with our business activities and revenues, we may have inadequate levels of cash for operations or for capital requirements, which could significantly harm our ability to operate the business.
          Our business and future operating results are subject to a wide range of uncertainties arising out of the continuing threat of terrorist attacks and ongoing military action in the Middle East. Like other U.S. companies, our business and operating results are subject to uncertainties arising out of the continuing threat of terrorist attacks on the United States and ongoing military action in the Middle East, including the potential worsening or extension of the current global economic slowdown, the economic consequences of the war in Iraq or additional terrorist activities and associated political instability, and the impact of heightened security concerns on domestic and international travel and commerce. In particular, from these uncertainties, we are subject to:
  •   increased risks related to the operations of our manufacturing facilities in China;
 
  •   greater risks of disruption in the operations of our Asian contract manufacturers and more frequent instances of shipping delays; and
 
  •   the risk that future tightening of immigration controls may adversely affect the residence status of non-U.S. engineers and other key technical and other employees in our U.S. facilities or our ability to hire new non-U.S. employees in such facilities.
          We face risks in reselling the products of other companies. We distribute products manufactured by other companies. To the extent we succeed in reselling the products of these companies, or products of other vendors with which we may enter into similar arrangements, we may be required by customers to assume warranty and service obligations. While these suppliers have agreed to support us with respect to those obligations, if they should be unable, for any reason, to provide the required support, we may have to expend our own resources on doing so. This risk is exacerbated by the fact that the equipment has been designed and manufactured by others, and is thus subject to warranty claims, the magnitude of which we are currently unable to evaluate fully.
          Our 2003 Notes provide for various events of default that would entitle the holders to require us to repay upon a holder’s demand the outstanding principal amount, plus accrued and unpaid interest. On June 4, 2003, we completed the sale of $23 million principal amount of 2003 Notes to Deutsche Bank AG, London Branch in a private placement pursuant to Regulation D under the Securities Act of 1933. The 2003 Notes mature in June 2008. We will be considered in default of the 2003 Notes if any of the following events, among others, occurs:
  •   our default in payment of any principal amount of, interest on or other amount due under the 2003 Notes when and as due;
 
  •   the effectiveness of the registration statement, which registered for resale the shares of our common stock issuable upon conversion of the 2003 Notes, lapses for any reason or is unavailable to the holder of the 2003 Notes for resale of all of the shares issuable upon conversion, other than during allowable grace periods, for a period of five consecutive trading days or for more than an aggregate of ten trading days in any 365-day period;
 
  •   the suspension from trading or failure of our common stock to be listed on the Nasdaq Stock Market for a period of five consecutive trading days or for more than an aggregate of ten trading days in any 365-day period;

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  •   we or our transfer agent notify any holder of our intention not to issue shares of our common stock to the holder upon receipt of any conversion notice delivered in respect of a Note by the holder;
 
  •   we fail to deliver shares of our common stock to the holder within twelve business days of the conversion date specified in any conversion notice delivered in respect of a Note by the holder;
 
  •   we breach any material representation, warranty, covenant or other term or condition of the 2003 Notes or the Securities Purchase Agreement, or the Registration Rights Agreement relating to 2003 Notes and the breach, if curable, is not cured by us within ten days;
 
  •   failure by us for ten days after notice to comply with any other provision of the 2003 Notes in all material respects, which include abiding by our covenants not to;
  o   incur any form of unsecured indebtedness in excess of $17.0 million, plus obligations arising from accounts receivable financing transactions with recourse through our foreign offices, in the ordinary course of business and consistent with past practices;
 
  o   repurchase our common stock for an aggregate amount in excess of $5.0 million; pursuant to a stock purchase program that was approved by our Board of Directors and publicly announced on June 13, 2002;
 
  o   declare or pay any dividend on any of our capital stock, other than dividends of common stock with respect to our common stock;
  •   we breach provisions of the 2003 Notes prohibiting us from either issuing;
  o   our common stock or securities that are convertible into or exchangeable or exercisable for shares of our common at a per share price less than the conversion price per share of the 2003 Notes then in effect, except in certain limited cases;
 
  o   securities that are convertible into or exchangeable or exercisable for shares of our common stock at a price that varies or may vary with the market price of our common stock;
  •   we breach any of our obligations under any other debt or credit agreements involving an amount exceeding $3,000,000; or
 
  •   we become bankrupt or insolvent.
          If an event of default occurs, any holder of the 2003 Notes can elect to require us to pay the outstanding principal amount, together with all accrued and unpaid interest. Some of the events of default include matters over which we may have some, little or no control. If a default occurs and we do not pay the amounts payable under the 2003 Notes in cash (including any interest on such amounts and any applicable default interest under the 2003 Notes), the holders of the 2003 Notes may protect and enforce their rights or remedies either by suit in equity or by action at law, or both, whether for the specific performance of any covenant, agreement or other provision contained in the 2003 Notes. Any default under the 2003 Notes could have a material adverse effect on our business, operating results and financial condition or on the market price of our common stock.
          In the event of a change of control, holders of the 2003 Notes have the option to require immediate repayment of the 2003 Notes at a premium and this right could prevent a takeover otherwise favored by stockholders. In the event of our “Change of Control,” which essentially means someone acquiring or merging with us, each holder of 2003 Notes has the right to require us to redeem the 2003 Notes in whole or in part at a redemption price of 105% of the principal amount of the 2003 Notes, plus accrued and unpaid interest or if the amount is greater, an amount equal to the number of shares issuable upon conversion of the 2003 Notes based on the conversion price at the date the holder

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gives us notice of redemption, multiplied by the average of the weighted average prices of our common stock during the five days immediately proceeding that date. If a Change of Control were to occur, we might not have the financial resources or be able to arrange financing on acceptable terms to pay the redemption price for all the 2003 Notes as to which the purchase right is exercised. Further, the existence of this right in favor of the holders may discourage or prevent someone from acquiring or merging with us.
          We depend on third-party contract manufacturers and therefore could face delays harming our sales. We outsource the board-level assembly, test and quality control of material, components, subassemblies and systems relating to our networking products to third-party contract manufacturers. Though there are a large number of contract manufacturers that we can use for outsourcing, we have elected to use a limited number of vendors for a significant portion of our board assembly requirements in order to foster consistency in quality of the products and to achieve economies of scale. These independent third-party manufacturers also provide the same services to other companies. Risks associated with the use of independent manufacturers include unavailability of or delays in obtaining adequate supplies of products and reduced control of manufacturing quality and production costs. If our contract manufacturers failed to deliver needed components timely, we could face difficulty in obtaining adequate supplies of products from other sources in the near term. Our third party manufacturers may not provide us with adequate supplies of quality products on a timely basis, or at all. While we could outsource with other vendors, a change in vendors may require significant lead-time and may result in shipment delays and expenses. Our inability to obtain these products on a timely basis, the loss of a vendor or a change in the terms and conditions of the outsourcing would have a material adverse effect on our business, operating results and financial condition.
          We may lose sales if suppliers of other critical components fail to meet our needs. Our companies currently purchase several key components used in the manufacture of our products from single or limited sources. We depend on these sources to meet our needs. Moreover, we depend on the quality of the products supplied to us over which we have limited control. We have encountered shortages and delays in obtaining components in the past and expect to encounter shortages and delays in the future. If we cannot supply products because of a lack of components, or are unable to redesign products with other components in a timely manner, our business will be significantly harmed. We have no long-term or short-term contracts for any of our components. As a result, a supplier can discontinue supplying components to us without penalty. If a supplier discontinued supplying a component, our business may be harmed by the resulting product manufacturing and delivery delays.
          We may suffer losses as a result of entering into fixed price contracts. From time to time we enter into contracts with certain customers where the price we charge for particular products is fixed. Although our estimated production costs for these products are used to compute the fixed price for sale, if our actual production cost exceeds the estimated production cost as a result of our inability to obtain needed components timely or at all or for other reasons, we may incur a loss on the sale. Sales of material amounts of products on a fixed price basis where we have not accurately predicted the production costs could have a material adverse effect on our results of operations.
          Our inability to achieve adequate production yields for certain components we manufacture internally could result in a loss of sales and customers. We rely heavily on our own production capability for critical semiconductor lasers and light-emitting diodes used in our products. Because we manufacture these and other key components at our own facilities and these components are not readily available from other sources, any interruption of our manufacturing processes could have a material adverse effect on our operations. Furthermore, we have a limited number of employees dedicated to the operation and maintenance of our wafer fabrication equipment, the loss of any of whom could result in our inability to effectively operate and service this equipment. Wafer fabrication is sensitive to many factors, including variations and impurities in the raw materials, the fabrication process, performance of the manufacturing equipment, defects in the masks used to print circuits on the wafer and the level of contaminants in the manufacturing environment. We may not be able to maintain acceptable production yields or avoid product shipment delays. In the event adequate production yields are not achieved, resulting in product shipment delays, our business, operating results and financial condition could be materially adversely affected.
          If we fail to protect our intellectual property, we may not be able to compete. We rely on a combination of trade secret laws and restrictions on disclosure and patents, copyrights and trademarks to protect our intellectual property rights. We cannot assure you that our pending patent applications will be approved, that any patents that may be issued will protect our intellectual property or that third parties will

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not challenge any issued patents. Other parties may independently develop similar or competing technology or design around any patents that may be issued to us. We cannot be certain that the steps we have taken will prevent the misappropriation of our intellectual property, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. Any of this kind of litigation, regardless of the outcome, could be expensive and time consuming, and adverse determinations in any of this kind of litigation could seriously harm our business.
          We could in the future become subject to litigation regarding intellectual property rights, which could be costly and subject us to significant liability. From time to time, third parties, including our competitors, may assert patent, copyright and other intellectual property rights to technologies that are important to us. Over the years, we have received notices from third parties alleging possible infringement of patents with respect to certain features of our products or our manufacturing processes and in connection with these notices have been involved in discussions with the claimants, including IBM, Lucent, Ortel, Nortel, Rockwell, the Lemelson Foundation and Finisar. To date, our aggregate revenues potentially subject to the foregoing claims have not been material. However, these or other companies may pursue litigation with respect to these or other claims. The results of any litigation are inherently uncertain. In the event of an adverse result in any litigation with respect to intellectual property rights relevant to our products that could arise in the future, we could be required to obtain licenses to the infringing technology, to pay substantial damages under applicable law, to cease the manufacture, use and sale of infringing products or to expend significant resources to develop non-infringing technology. Licenses may not be available from third parties either on commercially reasonable terms or at all. In addition, litigation frequently involves substantial expenditures and can require significant management attention, even if we ultimately prevail. Accordingly, any infringement claim or litigation against us could significantly harm our business, operating results and financial condition.
          In the future, we may initiate claims or litigation against third parties for infringement of our proprietary rights to protect these rights or to determine the scope and validity of our proprietary rights or the proprietary rights of competitors. These claims could result in costly litigation and the diversion of our technical and management personnel. Necessary licenses of third-party technology may not be available to us or may be very expensive, which could adversely affect our ability to manufacture and sell our products. From time to time we may be required to license technology from third parties to develop new products or product enhancements. We cannot assure you that third-party licenses will be available to us on commercially reasonable terms, if at all. The inability to obtain any third-party license required to develop new products and product enhancements could require us to obtain substitute technology of lower quality or performance standards or at greater cost, either of which could seriously harm our ability to manufacture and sell our products.
          We are dependent on certain members of our senior management. We are substantially dependent upon Dr. Shlomo Margalit, our Chairman of the Board of Directors, Chief Technical Officer and Secretary, and Mr. Noam Lotan, our President and Chief Executive Officer. The loss of the services of either of these officers could have a material adverse effect on us. We have entered into employment agreements with Dr. Margalit and Mr. Lotan and are the beneficiary of a key man life insurance policy in the amount of $1.0 million on Mr. Lotan’s life. However, we can give no assurance that the proceeds from this policy will be sufficient to compensate us in the event of the death of Mr. Lotan, and the policy is not applicable in the event that he becomes disabled or is otherwise unable to render services to us. We no longer maintain a key man life insurance policy on Dr. Margalit.
          Our business requires us to attract and retain qualified personnel. Our ability to develop, manufacture and market our products, run our operations and our ability to compete with our current and future competitors depends, and will depend, in large part, on our ability to attract and retain qualified personnel. Competition for executives and qualified personnel in the networking and fiber optics industries is intense, and we will be required to compete for those personnel with companies having substantially greater financial and other resources than we do. To attract executives, we have had to enter into compensation arrangements, which have resulted in substantial deferred stock expense and adversely affected our results of operations. We may enter into similar arrangements in the future to attract qualified executives. If we should be unable to attract and retain qualified personnel, our business could be materially adversely affected.
          Environmental regulations applicable to our manufacturing operations could limit our ability to expand or subject us to substantial costs. We are subject to a variety of environmental regulations relating to the use, storage, discharge and disposal of hazardous chemicals used during our

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manufacturing processes. Further, we are subject to other safety, labeling and training regulations as required by local, state and federal law. Any failure by us to comply with present and future regulations could subject us to future liabilities or the suspension of production. In addition, these kinds of regulations could restrict our ability to expand our facilities or could require us to acquire costly equipment or to incur other significant expenses to comply with environmental regulations. We cannot assure you that these legal requirements will not impose on us the need for additional capital expenditures or other requirements. If we fail to obtain required permits or otherwise fail to operate within these or future legal requirements, we may be required to pay substantial penalties, suspend our operations or make costly changes to our manufacturing processes or facilities.
          Our headquarters are located in southern California, and certain of our manufacturing facilities are located in southern California and Taiwan, where disasters may occur that could disrupt our operations and harm our business. Our corporate headquarters are located in the San Fernando Valley of Southern California and some of our manufacturing facilities are located in Southern California and Taiwan. Historically, these regions have been vulnerable to natural disasters and other risks, such as earthquakes, fires and floods, which at times have disrupted the local economies and posed physical risks to our property.
          In addition, terrorist acts or acts of war targeted at the United States, and specifically Southern California, could cause damage or disruption to us, our employees, facilities, partners, suppliers, distributors and resellers, and customers, which could have a material adverse effect on our operations and financial results.
          If we fail to forecast component and material requirements for our manufacturing facilities accurately, we could incur additional costs or experience manufacturing delays. We use rolling forecasts based on anticipated product orders to determine our component requirements. It is very important that we accurately predict both the demand for our products and the lead times required to obtain the necessary components and materials. Lead times for components and materials that we order vary significantly and depend on factors such as specific supplier requirements, the size of the order, contract terms and current market demand for the components. For substantial increases in production levels, some suppliers may need nine months or more lead-time. If we overestimate our component and material requirements, we may have excess inventory, which would increase our costs. If we underestimate our component and material requirements, we may have inadequate inventory, which could interrupt our manufacturing and delay delivery of our products to our customers. Any of these occurrences would negatively impact our net sales.
          We are at risk of securities class action or other litigation that could result in substantial costs and divert management’s attention and resources. In the past, securities class action litigation has been brought against a company following periods of volatility in the market price of its securities. As a result of the volatility and potential volatility of our stock price, we may be the target of securities litigation in the future. Securities or other litigation could result in substantial costs and divert management’s attention and resources.
          The prevailing market price of our common stock may limit our ability to raise equity capital. Covenants in our Notes preclude us from issuing our common stock or securities that are convertible into or exchangeable or exercisable for shares of our common stock at a per share price less than the conversion price per share of the 2003 Notes then in effect, except in certain limited cases. The conversion price of our Notes currently in effect is $2.32 per share and the recent market prices of our common stock have at times been below the conversion price. During periods when the market price of our common stock is below $2.32 per share, we are limited in our ability to conduct an equity financing without triggering a default of our Notes or the need to seek a waiver from the holder, which may not be obtainable. A continuing inability to raise financial capital would limit our operating flexibility.
          It is an event of default under our Notes if our common stock were delisted from the Nasdaq stock market. We would be in default under our Notes, if our common stock is delisted from the Nasdaq Stock Market. In that case, each holder of Notes has the right to require us to repay the outstanding principal amount of the Notes, plus accrued and unpaid interest.
          Delaware law and our ability to issue preferred stock may have anti-takeover effects that could prevent a change in control, which may cause our stock price to decline. We are authorized to issue up to 1,000,000 shares of preferred stock. This preferred stock may be issued in one or more series, the terms of which may be determined at the time of issuance by our board of directors without

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further action by stockholders. The terms of any series of preferred stock may include voting rights (including the right to vote as a series on particular matters), preferences as to dividend, liquidation, conversion and redemption rights and sinking fund provisions. No preferred stock is currently outstanding. The issuance of any preferred stock could materially adversely affect the rights of the holders of our common stock, and therefore, reduce the value of our common stock. In particular, specific rights granted to future holders of preferred stock could be used to restrict our ability to merge with, or sell our assets to, a third party and thereby preserve control by the present management. We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which prohibit us from engaging in a business combination with an interested stockholder for a period of three years after the date of the transaction in which the person became an interested stockholder unless the business combination is approved in the manner prescribed under Section 203. These provisions of Delaware law also may discourage, delay or prevent someone from acquiring or merging with us, which may cause the market price of our common stock to decline.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risks
          Market risk represents the risk of loss that may impact our Consolidated Financial Statements through adverse changes in financial market prices and rates and inflation. Our market risk exposure results primarily from fluctuations in foreign exchange and interest rates. We manage our exposure to these market risks through our regular operating and financing activities and, in certain instances, through the use of derivative financial instruments. These derivative instruments are used to manage risks of volatility in interest and foreign exchange rate movements on certain assets, liabilities or anticipated transactions and creates a relationship in which gains or losses on derivative instruments are expected to counter-balance the losses or gains on the assets, liabilities or anticipated transactions exposed to such market risks.
          Interest Rates. We are exposed to interest rate fluctuations on our investments, short-term borrowings and long-term obligations. Our cash and short-term investments are subject to limited interest rate risk, and are primarily maintained in money market funds and bank deposits. Our variable-rate short-term borrowings are also subject to limited interest rate risk because of their short-term maturities. Our long-term obligations were entered into with fixed interest rates. As of September 30, 2006, through a foreign office, we had two interest rate swap contracts outstanding. The economic purpose of these interest rate swap contracts are utilized in an effort to protect our variable interest debt from significant interest rate fluctuations. Unrealized gains on these interest swap contracts for the nine months ended September 30, 2006 were approximately $133,000 and unrealized losses for the nine months ended September 30, 2005 were approximately $746,000, and have been included in Interest expense in the accompanying statements of operations.
          Foreign Exchange Rates. We operate on an international basis with a portion of our revenues and expenses being incurred in currencies other than the U.S. dollar. Fluctuation in the value of these foreign currencies in which we conduct our business relative to the U.S. dollar affect our results and will cause U.S. dollar translation of such currencies to vary from one period to another. We cannot predict the effect of exchange rate fluctuations upon future operating results. However, because we have revenues and expenses in each of these foreign currencies, the effect on our results of operations from currency fluctuations is reduced.
          Through certain foreign offices, and from time-to-time, we enter into foreign exchange contracts in an effort to protect economically currency exchange risk related to purchase commitments denominated in foreign currencies other than their functional currency, primarily the U.S. dollar. These contracts cover periods commensurate with known or expected exposures, generally less than 12 months. As of September 30, 2006, we did not have any foreign exchange contracts outstanding.
          Certain assets, including certain bank accounts and accounts receivables, exist in non-U.S. dollar-denominated currencies, which are sensitive to foreign currency exchange rate fluctuations. The non-U.S. denominated currencies are principally in the euro, the Swedish krona, the Swiss franc and the Taiwan dollar. Additionally, certain of our current and long-term liabilities are denominated in these foreign currencies. At September 30, 2006, currency changes resulted in assets and liabilities denominated in local currencies being translated into more dollars than at year-end 2005.
          We incurred approximately 42% of our operating expenses in currencies other than the U.S. dollar during the nine months ended September 30, 2006. In general, these currencies were weaker against the U.S. dollar for the nine months ended September 30, 2006 compared to the same period last year, so revenues and expenses in these countries translated into less dollars than they would have in 2005. For the first nine months of 2006, we had approximately:
  •   $17.8 million of operating expenses that were settled in the euro;
 
  •   $8.4 million of operating expenses that were settled in Swiss francs;
 
  •   $5.0 million of operating expenses that were settled in Swedish krona; and

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  •   $4.1 million of operating expenses settled in the Taiwan dollar.
          Had rates of these various foreign currencies been 10% higher relative to the U.S. dollar for the first nine months of 2006, our costs would have increased approximately:
  •   $1.8 million related to expenses settled in euros;
 
  •   $837,000 related to expenses settled in Swiss francs;
 
  •   $498,000 in expenses settled in Swedish kronas; and
 
  •   $413,000 in expenses settled in the Taiwan dollar.
          As of September 30, 2006, we held as part of our cash and cash equivalents $4.0 million of euros, $4.9 million of Swiss francs, $1.4 million of Swedish kronas and $1.3 million of Taiwan dollars. If rates of these foreign currencies were to move higher or lower by some percentage, it would have an equal effect on the relative U.S. dollar value of the balances we hold.
          Inflation. We believe that the relatively moderate rate of inflation in the United States over the past few years has not had a significant impact on our sales or operating results or on the prices of raw materials. However, in view of our recent expansion of operations in Taiwan, Israel and other countries, which have experienced greater inflation than the United States, there can be no assurance that inflation will not have a material adverse effect on our operating results in the future.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
          As of the end of the period covered by this report on Form 10-Q, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)) pursuant to Rule 13a-15 of the Exchange Act. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of the end of the period covered by the report on Form 10-Q, the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s Exchange Act filings.
Changes in Internal Controls
          We are in the process of upgrading and replacing information systems used by two of our subsidiaries to accumulate, track and store financial and other data used in the preparation of their financial statements that are consolidated with our and our other subsidiaries financial statements. During the three months ended September 30, 2006, one of these subsidiaries began to upgrade the software information system that it utilizes in all aspects of its operations in Taiwan. During the same period, the other subsidiary began to use the new system with respect to certain aspects of its US operations that relate to fulfillment of orders from its US customers with products manufactured by the other subsidiary in Taiwan or by third-party contract manufacturers in China, all of which ship directly to our subsidiary’s customers, a process called drop-shipping. While this new system was placed on line in the latter half of the quarter ended September 30, 2006, it was operated in parallel with our subsidiaries’ legacy systems which continued to provide the financial and other data that our subsidiaries used in preparing their financial statements for the quarter ended September 30, 2006. We expect that our subsidiaries will begin relying on the new information systems exclusively in the fourth quarter of 2006 and that our US subsidiary will begin using the new system in connection with its business activities in addition to those involving drop-shipping from Asian manufacturers in early 2007.

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          Except as described in the paragraph above, there have been no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or 15d-15 under the Exchange Act that occurred during the 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
          You should carefully consider and evaluate all of the information in this Form 10-Q in combination with the more detailed description of our business in our annual report on Form 10-K for the year ended December 31, 2005, which we filed with the Securities and Exchange Commission on March 6, 2006, for a more complete understanding of the risks associated with an investment in our securities. There have been material changes in the Risk Factors as previously disclosed in our annual report on Form 10-K for the year ended December 31, 2005 and such changes are reflected immediately below. The following risk factors, as well those contained in our annual report on Form 10-K for the year ended December 31, 2005 and elsewhere in this report are not the only ones facing our company. Additional risks not now known to us or that we currently deem immaterial may also impair our business operations.
Our Gross Margin May Fluctuate from Period to Period and Our Gross Margins for Optical Components and/or Networking Equipment May Be Adversely Affected by a Number of Factors.
          During the years ended December 31, 2005, 2004 and 2003, our gross margins were 32%, 34% and 31%, respectively, of total revenue, 36%, 38% and 35%, respectively, on sales from our networking group and 11%, 14% and 8%, respectively, on sales from our optical components group. Our gross margins also fluctuate from quarter to quarter. During the three months ended September 30, 2006 and 2005, our gross margins were 32% and 30%, respectively, of total revenue, 35% and 36%, respectively, on sales from our networking group and 21% and 0%, respectively, on sales from our optical components group. These yearly and quarterly fluctuations in our margins have been affected, and may continue to be affected, by numerous factors, including:
  •   increased price competition, including competition from low-cost producers in Asia;
 
  •   price reductions that we make, such as our recent marketing decision to reduce the price for our optical components to certain customers in an effort to secure long-term leadership in the market for FTTP components;
 
  •   decreases in average selling prices of our products which, in addition to competitive factors and pressures from, or accommodations made to, significant customers, result from factors such as overcapacity and the introduction of new and more technologically advanced products in the case of optical components and excess inventories, increased sales discounts and new product introductions in the case of networking equipment;
 
  •   the mix in any period or year of higher and lower margin products and services;
 
  •   sales volume during a particular period or year;
 
  •   charges for excess or obsolete inventory;
 
  •   changes in the prices or the availability of components needed to manufacture our products;
 
  •   the relative success of our efforts to reduce product manufacturing costs, such as the transition of our optical component manufacturing to our Taiwan facility or to low-cost third party manufacturers in China;
 
  •   our introduction of new products, with initial sales at relatively small volumes with resulting higher production costs; and
 
  •   increased warranty or repair costs.

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          We expect gross margins generally and for specific products to continue to fluctuate from quarter to quarter and year to year.
Our Business Has Been Adversely Impacted by the Worldwide Economic Slowdown and Related Uncertainties.
          Weaker economic conditions worldwide, particularly in the U.S. and Europe, have contributed to the current technology industry slowdown compared to levels before 2000 and impacted our business resulting in:
  •   reduced demand for our products, particularly fiber optic components;
 
  •   increased risk of excess and obsolete inventories;
 
  •   increased price competition for our products;
 
  •   excess manufacturing capacity under current market conditions; and
 
  •   higher overhead costs, as a percentage of revenues.
          We reported losses for the nine months ended September 30, 2006 and the years ended December 31, 2005, 2004 and 2003 and have not achieved profitability for a full year since 1997. We anticipate continuing to incur significant sales and marketing, product development and general and administrative expenses and, as a result, we will continue to need to contain expense levels and increase revenue levels to continue to achieve profitability in future fiscal quarters.
The Price of Our Shares May Continue to Be Highly Volatile.
          Historically, the market price of our shares has been extremely volatile. For example, during the three months ended September 30, 2006, the closing prices of our common stock as reported on the Nasdaq Global Market (formerly called the Nasdaq National Market) ranged from a high of $3.07 and a low of $2.25 per share, a 36% difference between the high and the low prices, and during the nine months ended September 30, 2006, the closing prices of our common stock as reported on the Nasdaq Global Market ranged from a high of $4.64 and a low of $2.05 per share, a 126% difference between the high and the low prices. The market price of our common stock is likely to continue to be highly volatile and could be significantly affected by factors such as:
  •   actual or anticipated fluctuations in our operating results;
 
  •   announcements of technological innovations or new product introductions by us or our competitors;
 
  •   changes of estimates of our future operating results by securities analysts;
 
  •   developments with respect to patents, copyrights or proprietary rights; and
 
  •   general market conditions and other factors.
          In addition, the stock market has experienced extreme price and volume fluctuations that have particularly affected the market prices for shares of the common stocks of technology companies in particular, and that have been unrelated to the operating performance of these companies. These factors, as well as general economic and political conditions, may materially adversely affect the market price of our common stock in the future. Similarly, the failure by our competitors or customers to meet or exceed the results expected by their analysts or investors could have a ripple effect on us and cause our stock price to decline. Additionally, volatility or a lack of positive performance in our stock price may adversely affect our ability to retain key employees, all of whom have been granted stock options.

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Sales of Substantial Amounts of Our Shares by Selling Stockholders Could Cause the Market Price of Our Shares to Decline.
          Under our registration statement that the SEC declared effective in June 2003, selling stockholders are offering for resale up to 9,913,914 shares of our common stock issuable upon conversion of our 2003 Notes. This represents approximately 7.9% of the outstanding shares of our common stock on October 15, 2006 (or 7.3% of the outstanding shares of our common stock on that date if pro forma effect were given to the full conversion of the 2003 Notes).
          Under our registration statement that the SEC declared effective in April 2006, selling stockholders are offering an additional 19,858,156 shares of our common stock. This represents approximately 15.9% of the outstanding shares of our common stock on October 15, 2006, and, when added to the shares being offered by the selling stockholders under our registration statement that the SEC declared effective in June 2003, approximately 23.8% of the outstanding shares of our common stock on October 15, 2006 (or 22.0% of the outstanding shares of our common stock on that date if pro forma effect were given on that date to the full conversion of the 2003 Notes).
          Sales of substantial amounts of these shares at any one time or from time to time, or even the availability of these shares for sale, could adversely affect the market price of our shares.
Our Business Is Intensely Competitive and the Evident Trend of Consolidations in Our Industry Could Make It More So.
          The markets for fiber optic components and networking products are intensely competitive and subject to frequent product introductions with improved price/performance characteristics, rapid technological change and the continual emergence of new industry standards. We compete and will compete with numerous types of companies including companies that have been established for many years and have considerably greater financial, marketing, technical, human and other resources, as well as greater name recognition and a larger installed customer base, than we do. This may give these competitors certain advantages, including the ability to negotiate lower prices on raw materials and components than those available to us. In addition, many of our large competitors offer customers broader product lines, which provide more comprehensive solutions than our current offerings. We expect that other companies will also enter markets in which we compete.
          Greater concentration of purchasing power and decreased demand for communications networking products and optical components in recent years have resulted in increased competitive pressures. We expect aggressive competitive tactics to continue, and perhaps become more severe. These tactics include:
  •   intense price competition in sales of new equipment, resulting in lower profit margins;
 
  •   discounting resulting from sales of used equipment or inventory that a competitor has written down or written off;
 
  •   early announcements of competing products and other extensive marketing efforts;
 
  •   competitors offering to repurchase our equipment from existing customers;
 
  •   customer financing assistance;
 
  •   marketing and advertising assistance; and
 
  •   intellectual property assertions and disputes.

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          Tactics such as those described above can be particularly effective in a concentrated base of potential customers such as communications service providers. Our service provider customers are under increasing competitive pressure to deliver their services at the lowest possible cost. This pressure may result in the pricing of communications networking equipment becoming a more important factor in customer decisions. This may favor larger competitors that can spread the effect of price discounts across a larger array of products and services and across a larger customer base than ours. If we are unable to offset any reductions in the average sales price for our products by a reduction in the cost of our products, our gross profit margins will be adversely affected. Our inability to compete successfully and maintain our gross profit margins would harm our business, financial condition and results of operations.
          There has been a trend toward industry consolidation for several years. Examples of such consolidation in our industries during 2006 are the pending acquisition of Lucent Technologies Inc. by Alcatel, an acquisition approved by Lucent’s stockholders in September 2006 and which is expected by the parties to close before the end of 2006, and the July 2006 closing of the acquisition of privately-held TelCove, Inc., a provider of metropolitan and regional communications services, by Level 3 Communications, Inc. We expect this trend toward industry consolidation to continue as companies attempt to strengthen or hold their market positions in an evolving industry. We believe that industry consolidation may provide stronger competitors that are better able to compete. This could have a material adverse effect on our business, operating results and financial condition.
We Face Risks from Our International Operations.
          International sales have become an increasingly important part of our operations. The following table sets forth the percentage of our total revenues from sales to customers in foreign countries for the periods identified:
                                         
    Nine Months    
    Ended Sept. 30,   Year Ended December 31,
    2006   2005   2005   2004   2003
     
Percentage of total revenue from foreign sales
     67 %     73 %     74 %     77 %     78 %
          We have offices in, and conduct a significant portion of our operations in and from Israel. Similarly, some of our development stage enterprises are located in Israel. We are, therefore, influenced by the political and economic conditions affecting Israel. Any major hostilities involving Israel, the interruption or curtailment of trade between Israel and its trading partners or a substantial downturn in the economic or financial condition of Israel could have a material adverse effect on our operations. LuminentOIC has a minority interest in a large manufacturing facility in the People’s Republic of China in which it manufactures passive fiber optic components and both LuminentOIC and we make sales of our products in the People’s Republic of China. The ongoing political tension between Taiwan and the People’s Republic of China could eventually lead to hostilities. Risks we face from international sales and the use of overseas manufacturing include:
  •   greater difficulty in accounts receivable collection and longer collection periods;
 
  •   the impact of recessions in economies outside the United States;
 
  •   unexpected changes in regulatory requirements;
 
  •   seasonal reductions in business activities in some parts of the world, such as during the summer months in Europe or in the winter months in Asia when the Chinese New Year is celebrated;
 
  •   difficulties in managing operations across disparate geographic areas;
 
  •   difficulties associated with enforcing agreements through foreign legal systems;
 
  •   the payment of operating expenses in local currencies, which exposes us to risks of currency fluctuations;

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  •   higher credit risks requiring cash in advance or letters of credit;
 
  •   potentially adverse tax consequences;
 
  •   unanticipated cost increases;
 
  •   unavailability or late delivery of equipment;
 
  •   trade restrictions;
 
  •   limited protection of intellectual property rights;
 
  •   unforeseen environmental or engineering problems; and
 
  •   personnel recruitment delays.
          The majority of our sales are currently denominated in U.S. dollars. As we conduct business in several different countries, through December 31, 2005 we benefited from sales made in currencies other than the U.S. dollar because of the weakness of the U.S. dollar in relation to the currencies in which these sales have been made. During the nine months ended September 30, 2006, this trend reversed, with the U.S. dollar becoming stronger against currencies of other countries in which we have done business than they were at December 31, 2005, resulting in increased operating expenses during the quarter when such currencies were translated into U.S. dollars and adversely affecting our operating results for the period. If this trend continues, our operating expenses will continue to increase. Moreover, continued strengthening of the U.S. dollar to such currencies could cause our products to become relatively more expensive in those countries, leading to a reduction in sales in that country.
          Through one of our foreign subsidiaries, we have entered into foreign exchange and interest rate swap contracts to protect against currency exchange risks related to purchase commitments denominated in foreign currencies other than their functional currency, primarily the U.S. dollar and to hedge exposure to interest rate fluctuations. Net unrealized gains (losses) from these activities during the nine months ended September 30, 2006 and 2005 amounted to $133,000 and $(746,000), respectively, and we could incur losses from these or other hedging activities in the future.
We May Be Harmed if We Again Pursue Acquisitions or in Doing So, We Do Not Successfully Complete Them.
          In the past, an important element of our strategy has been to review acquisition prospects that would complement our existing operations and products, augment our market coverage and distribution ability or enhance our technological capabilities. Since the end of 2000, we have not made any acquisitions of businesses or product lines. The networking and fiber optics components business is highly competitive and our failure to pursue future acquisitions could hamper our ability to enhance existing products and introduce new products on a timely basis. If we do choose to pursue acquisitions, they could have a material adverse effect on our business, financial condition and results of operations because of various factors, including the following:
  •   possible charges to operations for purchased technology and restructuring;
 
  •   potentially dilutive issuances of equity securities;
 
  •   incurrence of debt and contingent liabilities;
 
  •   incurrence of amortization expenses and impairment charges related to goodwill and other intangible assets and deferred stock expense;
 
  •   difficulties assimilating the acquired operations, technologies, products, management or employees, particularly if we acquire companies in countries where English is not widely spoken, the culture and political, monetary, economic, financial or monetary systems,

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      principles or controls are different from those of the U.S., Taiwan, Israel or countries in Europe where we currently have offices or significant operations;
 
  •   diversion of management’s attention to other business concerns;
 
  •   risks of entering markets in which we have no or limited prior experience;
 
  •   potential loss of key employees of acquired organizations; and
 
  •   difficulties in honoring commitments made to customers by management of the acquired entity prior to the acquisition.
          We can give no assurance as to whether we can successfully integrate the companies, products, technologies or personnel of any business that we might acquire in the future. Moreover, our efforts to pursue acquisitions could result in substantial expenses and adversely affect our operating results if the acquisition is not successfully consummated. For example, we incurred costs and expenses aggregating approximately $170,000 during the nine months ended September 30, 2006 in connection with our efforts to acquire a manufacturer of fiber optic components located in the Peoples’ Republic of China, all of which was charged to our operations for that period as a result of the termination of the contemplated transaction.
Changes to Financial Accounting Standards Have Adversely Affected Our Results Of Operations and May Adversely Affect Them in the Future and Cause Us to Change Our Business Practices.
          We prepare our financial statements to conform with 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 SEC 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 historical 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 GAAP that required us, in the nine months ended September 30, 2006, to record charges to our results of operations for employee stock option grants amounting to approximately $2.5 million. We expect to have significant and ongoing accounting charges resulting from option grants that could increase our net losses or reduce our net income if we achieve sustained profitability (of which there can be no assurance). 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 stock options or other equity-related compensation less attractive to us and therefore make it more difficult to attract and retain employees.
Legislative and Regulatory Actions and Higher Insurance Costs Have Impacted, and Are Likely to Impact Our Future Financial Position and Results of Operations.
          There have been regulatory changes, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq Stock Market rules implementing mandates from that Act, and other new regulations that have had an adverse impact on our financial position and results of operations. These regulatory changes and other legislative initiatives have caused increases in our general and administrative costs and new regulations and initiatives are likely to have an additional impact on our future financial position and results of operations. For example, in late July 2006, the SEC adopted sweeping changes to its rules requiring disclosure of executive and director compensation, related person transactions, director independence and other corporate governance matters, and security ownership of officers and directors. These rules will take effect for our annual reports and proxy statements that we file after December 15, 2006, which means that we must begin complying with them in the preparation of our Annual Report on Form 10-K for our year ending December 31, 2006 and our proxy statement for our 2007 annual meeting of stockholders. The new disclosure rules will also modify the disclosure requirements of the SEC’s Current Report on Form 8-K regarding certain employment arrangements and material amendments for our named executive officers. These Form 8-K disclosure changes go into effect

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in November 2006 and thus we will be required to comply with them before the end of 2006. The future financial impact on us of complying with these new rules and other legislative or regulatory requirements that may be implemented in the future are uncertain, but as was the case with prior legislative and regulatory initiatives enacted since 2002, it may be expected that our general and administrative costs will further increase. In addition, insurers are likely to increase rates as a result of high claims rates recently and our rates for our various insurance policies are likely to increase.
If Our Cash Flow Significantly Deteriorates in the Future, Our Liquidity and Ability to Operate Our Business Could Be Adversely Affected.
          We incurred net losses in 2005, 2004 and 2003 and during the nine months ended September 30, 2006. During those years, with the exception of the nine months ended September 30, 2006, our combined cash, cash equivalents, time deposits and short-term and long-term marketable securities decreased as well. While our combined cash, cash equivalents, time deposits and short-term and long-term marketable securities increased at September 30, 2006 by approximately $47.3 million since December 31, 2005, that was the result of the net proceeds we received from an institutional private placement of our common stock that we completed in March 2006. Had we not completed that financing, our combined cash, cash equivalents, time deposits and short-term and long-term marketable securities at September 30, 2006 would have again decreased from the level at December 31, 2005. Our combined cash, cash equivalents, time deposits and short-term and long-term marketable securities at September 30, 2006 decreased by approximately $4.5 million from the level at June 30, 2006. Although we generate cash from operations, we may continue to experience negative overall cash flow in future quarters. If our cash flow significantly deteriorates in the future, our liquidity and ability to operate our business could be adversely affected. For example, our ability to raise financial capital may be hindered due to our net losses and the possibility of future negative cash flow.
Claims on Indemnification Agreements under Which We Are Obligated Could Increase Our Expenses.
          In the normal course of business to facilitate sales of our products, we indemnify other parties, including customers, lessors and parties to other transactions with us, with respect to certain matters. We have agreed to hold the other party harmless against losses arising from a breach of representation or covenants, or out of intellectual property infringement or other claims made against certain parties. In addition, we have also entered into indemnification agreements with our officers and directors, and our bylaws contain similar indemnification obligations to our agents.
          We cannot estimate the amount of potential future payments, if any, that we might be required to make as a result of these agreements or whether our insurance will be applicable or sufficient to cover claims that may arise on matters for which we have provided indemnity. Over at least the last decade, we have not incurred any significant expense as a result of agreements of this type and according we have not accrued any amounts for such indemnification obligations. However, there can be no assurances that we will not incur expenses under these indemnification provisions in the future or that the amount of such expenses will not have a material adverse affect on our operations or financial condition.
One Customer Accounted for over 10 percent of Our Sales During the Three and Nine Months Ended September 30, 2006, Increasing Both Our Dependence on a Single Revenue Source and the Risk that Our Operations Will Suffer Materially If the Customer Stopped Ordering from Us or Substantially Reduced Its Business With Us.
          For the last several years and for the interim periods within those years, no customer has accounted for 10 percent or more of our revenues and accordingly we were not dependent on any single customer. For the three and nine months ended September 30, 2006, however, we had one customer that accounted for 12% and 13% of our total revenues, respectively. While our financial performance during these quarters benefited from the increased sales to that customer, because of the magnitude of our sales to that customer, our results would suffer if we lost that customer or it made a substantial reduction in orders unless we were able to replace the customer or orders with one or more of comparable size. In addition, our sales are made on credit and our results of operations would be adversely affected if this customer were to experience unexpected financial reversals resulting in it being unable to pay for our products.

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ITEM 6. EXHIBITS
     (a) Exhibits
     
No.   Description
 
    
10.2
  Letter Agreement dated July 18, 2006 by and among Huagong Tech Company Limited, registrant, Wuhan Huagong Genuine Optics Technology Co., Ltd. (“HG Genuine)” and Luminent, Inc. mutually terminating Framework Agreement(incorporated by reference to Exhibit 10.2 of MRV’s Form 10-Q for the quarter ended June 30, 2006 filed on August 2, 2006).
 
    
31.1
  Certification of the Chief Executive Officer required by Rule 13a-14(a) of the Exchange Act.
 
    
31.2
  Certification of the Chief Financial Officer required by Rule 13a-14(a) of the Exchange Act.
 
    
32.1
  Certifications pursuant to Rule 13a-14(b) and 18 U.S.C. Section 1350.

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SIGNATURES
          Pursuant to the requirements of the Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant certifies that it has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized on November 3, 2006.
         
 
  MRV COMMUNICATIONS, INC.    
 
        
 
  By: /s/ Noam Lotan
 
Noam Lotan 		   
 
  President and Chief Executive Officer    
 
        
 
  By: /s/ Kevin Rubin
 
Kevin Rubin 		   
 
  Chief Financial Officer and Compliance Officer    

55

EX-31.1 2 v24739exv31w1.htm EXHIBIT 31.1 exv31w1
 

Exhibit 31.1
CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER
REQUIRED BY RULE 13A-14(a) OF THE EXCHANGE ACT
I, Noam Lotan, certify that:
1. I have reviewed this Quarterly Report on Form 10-Q of MRV Communications, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
  a.   designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
 
  b.   designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States;
 
  c.   evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
 
  d.   disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
  a.   all significant deficiencies and material weakness in the design or operation of internal control our financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
 
  b.   any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
         
 
  Date: November 3, 2006    
 
        
 
  /s/ Noam Lotan
 
Noam Lotan 		   
 
  President and Chief Executive Officer    

56

EX-31.2 3 v24739exv31w2.htm EXHIBIT 31.2 exv31w2
 

Exhibit 31.2
CERTIFICATION OF THE CHIEF FINANCIAL OFFICER
REQUIRED BY RULE 13A-14(a) OF THE EXCHANGE ACT
I, Kevin Rubin, certify that:
1. I have reviewed this Quarterly Report on Form 10-Q of MRV Communications, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
  a.   designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
 
  b.   designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States;
 
  c.   evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
 
  d.   disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
  a.   all significant deficiencies and material weakness in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
 
  b.   any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
         
 
  Date: November 3, 2006    
 
        
 
  /s/ Kevin Rubin
 
Kevin Rubin 		   
 
  Chief Financial Officer and Compliance Officer    

57

EX-32.1 4 v24739exv32w1.htm EXHIBIT 32.1 exv32w1
 

Exhibit 32.1
CERTIFICATION PURSUANT TO
RULE 13A-14(B) AND 18 U.S.C. SECTION 1350
     In connection with the Quarterly Report of MRV Communications, Inc. (the “Company”) on Form 10-Q for the period ended September 30, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), each of the undersigned, in the capacities and on November 3, 2006, hereby certifies pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to his knowledge:
  1.   The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
 
  2.   The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
         
 
  MRV COMMUNICATIONS, INC.    
 
        
 
  By: /s/ Noam Lotan
 
 Noam Lotan 		   
 
  President and Chief Executive Officer    
 
        
 
  By: /s/ Kevin Rubin
 
 Kevin Rubin 		   
 
  Chief Financial Officer and Compliance Officer    

58

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