Avanex 10Q 2007 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended December 31, 2006

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

For the transition period from to

Commission file number 000-29175

AVANEX CORPORATION

(Exact name of Registrant as Specified in its Charter)

Delaware

94-3285348

(State or Other Jurisdiction of

Incorporation or Organization)

(I.R.S. Employer

Identification Number)

40919 Encyclopedia Circle

Fremont, California 94538

(Address of Principal Executive Offices including Zip Code)

(510) 897-4188

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 (the “Exchange Act”) 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 x NO ¨

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

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ¨ NO x

There were 208,525,520 shares of the Company’s Common Stock, par value $.001 per share, outstanding on January 31, 2007.

AVANEX CORPORATION

FORM 10-Q

TABLE OF CONTENTS


		Page No.
	PART I. FINANCIAL INFORMATION	3
Item 1.	Condensed Consolidated Financial Statements (Unaudited):	3
	Condensed Consolidated Balance Sheets as of December 31, 2006 and June 30, 2006	3
	Condensed Consolidated Statements of Operations for the Three months and Six months Ended December 31, 2006 and 2005	4
	Condensed Consolidated Statements of Cash Flows for the Six months Ended December 31, 2006 and 2005	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	23
Item 4.	Controls and Procedures	24
	PART II. OTHER INFORMATION	25
Item 1.	Legal Proceedings	25
Item 1A.	Risk Factors	26
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	39
Item 3.	Defaults Upon Senior Securities	39
Item 4.	Submission of Matters to a Vote of Security Holders	40
Item 5.	Other Information	41
Item 6.	Exhibits	41
Signatures

2 of 41

PART I — FINANCIAL INFORMATION

ITEM 1 — Financial Statements

AVANEX CORPORATION

Condensed Consolidated Balance Sheets

(In thousands, except share and par value data)

(Unaudited)


	December 31, 2006			June 30, 2006
Assets
Current assets:
Cash and cash equivalents	$	37,360		$	28,963
Restricted cash and investments		5,891			6,676
Short-term investments		14,638			38,696
Accounts receivable, net of of allowance for doubtful accounts of $55 and $0 at December 31, 2006 and June 30, 2006, respectively		34,587			26,768
Inventories, net		21,893			18,417
Due from related party		17,972			10,404
Other current assets		13,477			15,473
Total current assets		145,818			145,397
Property and equipment, net		6,064			5,668
Intangibles, net		1,749			3,246
Goodwill		9,408			9,408
Other assets		2,228			1,839
Total assets	$	165,267		$	165,558

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	47,998		$	38,276
Accrued compensation		7,581			6,872
Accrued warranty		1,742			1,799
Due to related party		4,750			4,475
Other accrued expenses and deferred revenue		9,472			4,467
Current portion of long-term obligations		976			823
Current portion of accrued restructuring		6,359			6,321
Total current liabilities		78,878			63,033

Long-term liabilities:
Accrued restructuring		11,122			13,252
Convertible notes		4,438			4,569
Other long-term obligations		11,446			11,366
Total liabilities		105,884			92,220

Stockholders’ equity:
Common stock, $0.001 par value, 450,000,000 and 300,000,000 shares authorized at December 31, 2006 and June 30, 2006, respectively; 207,568,597 and 204,361,846 shares outstanding at December 31, 2006 and June 30, 2006, respectively, net of 157,656 and 160,749 treasury shares at December 31, 2006 and June 30, 2006, respectively		208			204
Additional paid-in capital		747,955			742,951
Accumulated other comprehensive income		3,991			4,687
Accumulated deficit		(692,771	)		(674,504	)
Total stockholders’ equity		59,383			73,338
Total liabilities and stockholders’ equity	$	165,267		$	165,558

See accompanying notes.

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AVANEX CORPORATION

Condensed Consolidated Statements of Operations

(In thousands, except per share data)

(Unaudited)


	Three Months Ended						Six Months Ended
		December 31,						December 31,
	2006			2005			2006			2005
Net revenue:
Third parties	$	40,325		$	25,475		$	77,679		$	53,386
Related parties		15,298			10,650			28,835			23,972
Total net revenue		55,623			36,125			106,514			77,358

Cost of revenue:
Cost of revenue except for purchases from related parties		44,968			32,287			90,542			69,906
Purchases from related parties		159			920			164			2,408
Total cost of revenue		45,127			33,207			90,706			72,314
Gross profit		10,496			2,918			15,808			5,044

Operating expenses:
Research and development		5,832			5,452			11,457			12,579
Sales and marketing		3,891			2,783			7,439			6,571
General and administrative:
Third parties		9,148			3,694			14,810			7,423
Related parties		(73	)		147			(84	)		1,692
Amortization of intangibles		656			1,385			1,508			3,150
Restructuring		436			2,942			373			2,982
Gain on disposal of property and equipment		(28	)		(775	)		(48	)		(768	)
Total operating expenses		19,862			15,628			35,455			33,629
Loss from operations		(9,366	)		(12,710	)		(19,647	)		(28,585	)
Interest and other income		1,121			379			1,960			930
Interest and other expense		(308	)		(6,212	)		(580	)		(7,811	)
Net loss	$	(8,553	)	$	(18,543	)	$	(18,267	)	$	(35,466	)

Basic and diluted net loss per common share	$	(0.04	)	$	(0.13	)	$	(0.09	)	$	(0.24	)

Weighted-average number of shares used in computing basic and diluted net loss per common share		206,873			145,215			206,131			145,199

See accompanying notes.

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AVANEX CORPORATION

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)


	Six Months Ended
		December 31,
	2006			2005
Operating Activities:
Net loss	$	(18,267	)	$	(35,466	)
Adjustments to reconcile net loss to net cash used in operating activities:
Gain on disposal of property and equipment		(48	)		(775	)
Depreciation and amortization		1,330			3,295
Amortization of intangibles		1,507			3,150
Stock-based compensation		3,701			1,060
Provision for doubtful accounts and sales returns		51			387
Loss in connection with convertible notes modification		-			4,761
Non-cash interest expense		317			893
Write-down of excess and obsolete inventory		6,898			3,994
Reduction in fair value of investment		-			177
Changes in operating assets and liabilities:
Accounts receivable		(7,296	)		1,948
Inventories		(10,179	)		1,499
Other current assets		4,121			(190	)
Other assets		(434	)		(29	)
Due to/from related parties		(7,293	)		6,121
Accounts payable		8,866			6,803
Accrued compensation		474			(2,881	)
Accrued restructuring		(2,410	)		(15,391	)
Accrued warranty		(107	)		(583	)
Other accrued expenses and deferred revenues		3,338			(342	)
Total adjustments		2,836			13,897
Net cash used in operating activities		(15,431	)		(21,569	)

Investing Activities:
Purchases of investments		(220,713	)		(50	)
Maturities of investments		244,796			11,627
Decrease in restricted cash		785			1,269
Purchases of property and equipment		(1,552	)		(1,590	)
Proceeds from sale of property and equipment		106			2,285
Net cash provided by investing activities		23,422			13,541

Financing Activities:
Payments on capital lease obligations		(712	)		(1,274	)
Payments in connection with convertible notes modification		-			(4,075	)
Proceeds from issuance of common stock		858			501
Net cash provided by (used in) financing activities		146			(4,848	)

Effect of exchange rate changes on cash		260			(140	)

Net increase/(decrease) in cash and cash equivalents		8,397			(13,016	)
Cash and cash equivalents at beginning of period		28,963			26,811
Cash and cash equivalents at end of period	$	37,360		$	13,795

Supplemental Information:
Cash paid during the period for:
Interest expense	$	28		$	83
Non-cash investing and financing activities:
Conversion of senior convertible notes into common stock, net of discount of $96	$	449		$	-
Warrants-related charges	$	-		$	686

See accompanying notes.

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AVANEX CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1. Basis of Presentation

Avanex Corporation and its wholly-owned subsidiaries (collectively “Avanex,” “we” or the “Company”) design, manufacture and market fiber optic-based products, known as photonic processors, which are designed to increase the performance of optical networks. We sell our products to telecommunications system integrators and their network carrier customers. We were incorporated in October 1997 in California and reincorporated in Delaware in January 2000, and began making volume shipments of our products during the quarter ended September 30, 1999.

The accompanying unaudited condensed consolidated financial statements as of December 31, 2006 and 2005, and for the three months and six months ended December 31, 2006 and 2005 have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial statements and pursuant to the rules and regulations of the Securities and Exchange Commission, and include the accounts of Avanex. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the consolidated financial position at December 31 2006, the consolidated operating results for the three months and six months ended December 31, 2006, and the consolidated cash flows for the three months and six months ended December 31, 2006. The consolidated results of operations for the three months and six months ended December 31, 2006, are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year ending June 30, 2007.

The condensed consolidated balance sheet at June 30, 2006 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by GAAP for complete financial statements. These unaudited condensed financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes for the year ended June 30, 2006, contained in its Annual Report on Form 10-K filed with the Securities and Exchange Commission on September 28, 2006.

2. Stock-based Compensation

Determining Fair Value

Valuation and amortization method—The Company estimates the fair value of stock options granted using the Black-Scholes option-pricing formula and a single-option award approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period.

Expected Term—The Company’s expected term represents the period that the Company’s stock-based awards are expected to be outstanding and is determined based on the Staff Accounting Bulletin 107 simplified method.

Expected Volatility—The Company’s volatility factor is estimated using the Company’s stock price history.

Expected Dividend—The Black-Scholes valuation model calls for a single expected dividend yield as an input. The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends in the future.

Risk-Free Interest Rate—The Company bases the risk-free interest rate used in the Black-Scholes valuation method on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term. Where the expected term of the Company’s stock-based awards does not correspond with the term for which an interest rate is quoted, the Company performs a straight-line interpolation to determine the rate from the available term maturities.

Fair Value—Fair value of the Company’s stock options granted to employees for the three months and six months ended December 31, 2006 and 2005 was estimated using the following weighted-average assumptions:

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	Three Months Ended						Six Months Ended
	Three Months Ended						Six Months Ended
	December 31,						December 31,
	2006			2005			2006			2005

Option Plan Shares
Expected term (in years)		6.25			6.25			6.25			6.25
Volatility		80.0	%		78.0	%		80.5	%		77.5	%
Expected dividend		0	%		0	%		0	%		0	%
Risk-free interest rate		4.70	%		4.36	%		4.65	%		4.29	%
Weighted-average fair value	$	1.19		$	0.58		$	1.20		$	0.60

ESPP Shares
Expected term (in years)		1.00			1.00			1.00			1.00
Volatility		80.0	%		77.0	%		80.5	%		77.0	%
Expected dividend		0	%		0	%		0	%		0	%
Risk-free interest rate		4.86	%		3.92	%		4.86	%		3.92	%
Weighted-average fair value	$	2.75		$	1.81		$	2.75		$	1.81

Stock Compensation Expense

Under the provisions of Statement of Financial Accounting Standards (“SFAS”) 123(R) “Share-Based Payment,” effective July 1, 2005, we recorded $1.8 million and $618,000 of stock compensation expense in our consolidated statements of operations for the three months ended December 31, 2006 and 2005, and $3.7 million and $1.1 million for the six months ended December 31, 2006 and 2005, respectively.

At December 31, 2006 and 2005, the total compensation cost related to unvested stock-based awards granted to employees under the Company’s stock option plans but not yet recognized was approximately $4.5 million and $3.6 million, respectively, net of estimated forfeitures of $2.3 million and $263,000, respectively. This cost will be amortized on a straight-line basis over a weighted-average period of approximately 3.3 years and will be adjusted for subsequent changes in estimated forfeitures.

The amortization of stock compensation under SFAS 123(R) for the three months and six months ended December 31, 2006 and 2005 is based on the single-option approach.

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of the Company’s common stock for the 4.7 million options that were in-the-money at December 31, 2006 and for the 3.5 million options that were in-the-money at December 31, 2005. During the three months ended December 31, 2006 and 2005, the aggregate intrinsic value of options exercised under the Company’s stock option plans was $140,000 and $35,000, respectively. During the six months ended December 31, 2006 and 2005, the aggregate intrinsic value of options exercised under the Company’s stock option plans was $152,000 and $56,000, respectively. Intrinsic value was determined as of the date of option exercise.

Stock option activity under the Option Plans and the Director Plan was as follows:


	Number of Shares		Weighted- average Exercise Price
Beginning outstanding, July 1, 2006	12,688,341		$	4.84
Granted	2,442,250		$	1.66
Exercised	(175,461	)	$	1.01
Canceled	(1,903,707	)	$	4.83
Ending outstanding, December 31, 2006	13,051,423		$	4.31
Ending vested + expected to vest, December 31, 2006	11,484,236		$	4.67


Range of Exercise Prices	Number Outstanding as of December 31, 2006	Average Remaining Contractual Term, in Years	Weighted- average Exercise Price		Number Exercisable as of December 31, 2006	Weighted- average Exercise Price
$0.39 – $1.01	1,313,924	8.00	$	0.92	646,403	$	0.89
$1.03 – $1.59	1,356,700	8.69	$	1.24	174,211	$	1.21
$1.64 – $1.64	1,550,000	9.83	$	1.64	-	$	-
$1.70 – $2.19	2,131,947	8.11	$	2.05	1,090,220	$	2.16
$2.32 – $2.88	1,555,836	7.80	$	2.65	999,711	$	2.60
$2.95 – $3.95	2,145,703	6.87	$	3.60	1,953,703	$	3.64
$4.00 – $4.90	2,075,978	5.83	$	4.62	2,075,978	$	4.62
$4.99 – $115.81	886,335	4.36	$	22.72	886,335	$	22.72
$118.94 – $118.94	3,000	3.57	$	118.94	3,000	$	118.94
$139.25 – $139.25	32,000	3.69	$	139.25	32,000	$	139.25
	13,051,423	7.49	$	4.31	7,861,561	$	6.03

Restricted Stock Unit Activity

The Company issues new shares of common stock upon the vesting of restricted stock units. Restricted stock unit activity for the six months ended December 31, 2006 is summarized below:


	Number of Shares		Weighted- average Exercise Price		Weighted- average Remaining Term, in Years	Aggregate Intrinsic Value as of December 31, 2006
Beginning outstanding, July 1, 2006	4,073,502		$	0.001
Awarded	2,428,820		$	0.001
Released	(1,160,065	)	$	0.001
Forfeited	(506,874	)	$	0.001
Ending outstanding, December 31, 2006	4,835,383		$	0.001	1.59	$	9,141,000
Ending vested + expected to vest, December 31, 2006	3,804,838		$	0.001	1.46	$	7,187,000

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Aggregate intrinsic value is calculated as the difference between the exercise price of the shares and the quoted price of the Company’s common stock for the 4.8 million of outstanding restricted stock units at December 31, 2006, all of which were in-the-money. During the three months and six months ended December 31, 2006, the aggregate intrinsic value of restricted stock units vesting was $1.2 million and $2.1 million, respectively. Intrinsic value was determined as of the date the restricted stock unit vested.

Employee Stock Purchase Plan Activity

During the three months ended December 31, 2006 and 2005, no shares were issued in connection with the Company’s employee stock purchase plan (“ESPP”), and so the aggregate intrinsic value of options exercised under the Company’s ESPP was $0 for both periods. During the six months ended December 31, 2006 and 2005, the aggregate intrinsic value of options exercised under the Company’s ESPP was $94,000 and $54,000, respectively.

3. Inventories

Inventories consist of raw materials, work-in-process and finished goods and are stated at the lower of cost or market. Cost is computed on a standard basis, which approximates actual costs on a first-in, first-out basis. Inventories consisted of the following (in thousands):


	December 31,		June 30,
		2006		2006
Raw materials	$	8,161	$	6,114
Work-in-process		696		974
Finished goods		13,036		11,329
	$	21,893	$	18,417

In the three months ended December 31, 2006 and 2005, the Company recorded charges to cost of revenue for the write-down of excess and obsolete inventory of $3.4 million and $2.0 million, respectively, and for the six months ended December 31, 2006 and 2005, the Company recorded charges to cost of revenue for the write-down of excess and obsolete inventory of $6.9 million and $4.0 million,

4. Restructuring

A summary of the Company’s accrued restructuring expense and accrued restructuring liability is as follows (in thousands):

Three months ended December 31, 2006:


	Expense for Three Months Ended December 31, 2006			Balance September 30, 2006		Accrued		Paid			Recovered			Balance December 31, 2006
Non-acquisition Related
Severance benefits
Fiscal 2004 workforce reduction				$	536	$	-	$	(19	)	$	-		$	517
Fiscal 2005 workforce reduction		312			2,612		317		(376	)		-			2,553
Fiscal 2006 workforce reduction		(2	)		24		-		(22	)		(2	)		-
Total severance benefits		310			3,172		317		(417	)		(2	)		3,070
Abandonment of excess facilities		126			11,927		126		(703	)		-			11,350
Total non-acquisition related		436			15,099		443		(1,120	)		(2	)		14,420

Acquisition-related
Severance benefits					3,131		-		(70	)		-			3,061
Total restructuring	$	436		$	18,230	$	443	$	(1,190	)	$	(2	)	$	17,481

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Six months ended December 31, 2006:


	Expense for Six Months Ended December 31, 2006		Balance June 30, 2006		Accrued		Paid			Recovered			Balance December 31, 2006
Non-acquisition Related
Severance benefits
Fiscal 2004 workforce reduction	$	-	$	542	$	-	$	(25	)	$	-		$	517
Fiscal 2005 workforce reduction		314		2,828		320		(594	)		(1	)		2,553
Fiscal 2006 workforce reduction		5		62		-		(60	)		(2	)		-
Total severance benefits		319		3,432		320		(679	)		(3	)		3,070
Abandonment of excess facilities		54		12,708		126		(1,412	)		(72	)		11,350
Total non-acquisition related		373		16,140		446		(2,091	)		(75	)		14,420

Acquisition-related
Severance benefits		-		3,433		-		(372	)		-			3,061
Total restructuring	$	373	$	19,573	$	446	$	(2,463	)	$	(75	)	$	17,481

The accrued restructuring liability at December 31, 2006 is classified as follows (in thousands):


	Current		Non- current		TOTAL
Accrued severance and LOA		3,288		2,843	$	6,131

Abandonment of excess facilities		3,071		8,279		11,350
	$	6,359	$	11,122	$	17,481

Accrued severance will be paid out through December 2012. The liability related to abandoned facilities will be paid out through 2010.

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5. Investment in Paxera Corporation

In September 2005, Avanex acquired shares of preferred stock and warrants convertible into common stock of Paxera Corporation, a privately-held manufacturer of tunable lasers, in exchange for certain manufacturing equipment. Avanex assigned a fair value of $400,000 to the acquired shares of preferred stock and warrants. The fair value was based on a recent private round of preferred stock financing by Paxera, in which Paxera received cash from investors.

At various times during 2006, Avanex acquired additional shares of preferred stock and additional warrants convertible into common stock in exchange for $303,000 of product development services performed by Avanex.

In November 2006, Paxera was acquired by NeoPhotonics Corporation, a privately-held manufacturer of active and passive optical components. Avanex’s preferred shares and warrants in Paxera will be exchanged for shares of common and preferred stock in NeoPhotonics and $595,000 in cash for a combined value of $1.2 million.

Avanex recognized a gain of $515,000 during the three months ended December 31, 2006 in connection with this exchange. The gain is included in Interest and Other Income.

6. Warranties

In general, the Company provides a product warranty for one year from the date of shipment. The Company accrues for the estimated costs of product warranties during the period in which revenue is recognized. The Company estimates the costs of its warranty obligations based on its historical experience and expectation of future conditions. To the extent the Company experiences increased warranty claim activity or increased costs associated with servicing those claims, the Company’s warranty costs will increase resulting in decreases to gross profit. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.

Changes in the Company’s accrued product warranty liability are as follows (in thousands):


	Three Months Ended						Six Months Ended
		December 31,						December 31,
	2006			2005			2006			2005
Balance at beginning of period	$	1,745		$	5,243		$	1,799		$	5,268
Accrual for sales during the period		272			321			408			1,063
Cost of warranty repair		(271	)		(116	)		(405	)		(469	)
Adjustment to prior sales (including expirations and changes in estimates)		(4	)		(812	)		(60	)		(1,226	)
Balance at end of period	$	1,742		$	4,636		$	1,742		$	4,636

7. Net Loss per Share and Comprehensive Loss

The following table presents the calculation of basic and diluted net loss per share, and comprehensive loss (in thousands, except per share data):


	Three Months Ended						Six Months Ended
	Three Months Ended						Six Months Ended
		December 31,						December 31,
	2006			2005			2006			2005
Net loss	$	(8,553	)	$	(18,543	)	$	(18,267	)	$	(35,466	)
Basic and diluted weighted-average number of shares of common stock outstanding		206,873			145,215			206,131			145,199
Basic and dilued net loss per common share	$	(0.04	)	$	(0.13	)	$	(0.09	)	$	(0.24	)

Net loss	$	(8,553	)	$	(18,543	)	$	(18,267	)	$	(35,466	)
Unrealized gain on investments		-			119			25			177
Cumulative translation adjustment		(600	)		350			(721	)		205
Comprehensive loss	$	(9,153	)	$	(18,074	)	$	(18,963	)	$	(35,084	)

During the periods presented, the Company had securities outstanding that could potentially dilute basic earnings per share in the future, but were excluded from the computation of diluted net loss per share, as their effect would have been anti-dilutive. The anti-dilutive securities are as follows:

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	December 31, 2006	December 31, 2005
Employee stock options	13,051,423	16,328,166
Employee restricted stock units	4,835,383	-
8% convertible notes	5,555,556	38,888,889
Warrants attached to 8% convertible notes	8,737,689	8,677,689
Warrants granted to landlord	60,000	60,000
Warrants attached to March 2006 equity securities offering	7,222,500	-
	39,462,551	63,954,744

8. Consolidated Condensed Balance Sheet Detail

Other Accrued Expenses and Deferred Revenue

Other Accrued Expenses and Deferred Revenue consist of the following (in thousands):


	December 31,		June 30,
	2006		2006
Accrued liability to contract manufacturer	$	1,929	$	12
Accrued outside services		3,176		1,668
Deferred revenue		1,378		402
Other accrued liabilities		2,989		2,385

	$	9,472	$	4,467

9. Related Party Transactions

On July 31, 2003, in connection with the Company’s acquisition of Alcatel’s and Corning’s optical components businesses, Alcatel (now known as Alcatel Lucent) was issued 28% of the Company’s outstanding common stock and Corning was issued 17% of the Company’s common stock on a post-transaction basis. As of December 31, 2006 Alcatel Lucent ** owned 28,295,868 shares representing 14% of the outstanding shares of Avanex common stock and Corning owned zero shares. The Company sells products to and purchases raw materials and components from Alcatel Lucent in the regular course of business. Additionally, Alcatel Lucent provided certain administrative services to the Company.

Amounts sold to and purchased from related parties were as follows (in thousands):


	Three Months Ended December 31,					Six Months Ended December 31,
		2006**			2005*		2006**			2005*
Related party transactions
Sales to related parties	$	15,298		$	10,650	$	28,835		$	23,972
Purchases from related parties in cost of revenue		159			920		164			2,408
Administrative and transitional services purchased from related parties; starting December 31, 2005, amounts include facilities rent credits		(73	)		147		(84	)		1,692
Royalty income		-			-		-			190

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*	On December 31, 2005, Corning no longer owned shares in Avanex. As a result, we have only included transactions with Corning in the related party disclosure for the three months and six months ended December 31, 2005.

**	On November 30, 2006, the merger of Alcatel and Lucent was completed and the combined company was named “Alcatel Lucent”. As a result, we have included December 2006 transactions with Lucent in the related party disclosure for the three months and six months ended December 31, 2006.

Amounts due from and due to related parties (in thousands):


	December 31, 2006**		June 30, 2006
Due from related parties	$	17,972	$	10,404
Due to related parties		4,750		4,475

**	On November 30, 2006, the merger of Alcatel and Lucent was completed and the combined company was named “Alcatel Lucent”. As a result, we have included December 2006 transactions with Lucent in the related party disclosure.

As of January 31, 2007, Alcatel Lucent owned 28,295,868 shares of Avanex common stock representing approximately 14% of the outstanding shares of Avanex common stock.

10. Disclosures about Segments of an Enterprise

SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” establishes standards for the way public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. SFAS No. 131 also establishes standards for related disclosures about products and services, geographic areas and major customers.

The Company’s chief operating decision maker is considered to be the Company’s Chief Executive Officer (“CEO”). The CEO reviews the Company’s financial information presented on a consolidated basis substantially similar to the accompanying consolidated financial statements. Therefore, the Company has concluded that it operates in one segment, to manufacture and market photonic processors, and accordingly has provided only the required enterprise-wide disclosures.The Company has adopted a matrix management organizational structure whereby management of worldwide activities is on a functional basis.

Customers who represented 10% or more of our net revenue (including sales to each customer’s contract manufacturer) or accounts receivable were as follows:


	Three Months Ended December 31,		Six Months Ended December 31,
	2006	2005	2006	2005
Company A	27%	29%	29%	31%
Company B	21%	-	16%	-
Company C	10%	-	11%	-
Company D	10%	-	-	11%
	68%	29%	56%	42%

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Revenues by geographical area were as follows (in thousands):


	Three Months Ended December 31,				Six Months Ended December 31,
		2006		2005		2006		2005
		Amount		Amount		Amount		Amount
U.S.		39,224		21,388		76,509		48,099
France		12,047		14,429		21,418		28,614
Italy		4,352		308		8,587		645
	$	55,623	$	36,125	$	106,514	$	77,358

Long-lived assets by geographical area were as follows (in thousands):


	December 31, 2006		June 30, 2006
Property, plant and equipment:
U.S.	$	4,152	$	3,888
Non-U.S.		1,912		1,780
	$	6,064	$	5,668

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11. Litigation

On August 6, 2001, Avanex, certain of its officers and directors, and various underwriters in its initial public offering (“IPO”) were named as defendants in a class action filed in the United States District Court for the Southern District of New York, captioned Beveridge v. Avanex Corporation et al., Civil Action No. 01-CV-7256. This action and other subsequently filed substantially similar class actions have been consolidated into In re Avanex Corp. Initial Public Offering Securities Litigation, Civil Action No. 01 Civ. 6890. The consolidated amended complaint in the action generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in Avanex’s IPO. Plaintiffs have brought claims for violation of several provisions of the federal securities laws against those underwriters, and also against Avanex and certain of its directors and officers, seeking unspecified damages on behalf of a purported class of purchasers of Avanex’s common stock between February 3, 2000, and December 6, 2000. Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 40 investment banks and 250 other companies. All of these “IPO allocation” securities class actions currently pending in the Southern District of New York have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings as In re Initial Public Offering Securities Litigation, 21 MC 92. On October 9, 2002, the claims against Avanex’s directors and officers were dismissed without prejudice pursuant to a tolling agreement. The issuer defendants filed a coordinated motion to dismiss all common pleading issues, which the Court granted in part and denied in part in an order dated February 19, 2003. The Court’s order did not dismiss the Section 10(b) or Section 11 claims against Avanex. In June 2004, a stipulation of settlement for the claims against the issuer defendants, including Avanex, was submitted to the Court. On August 31, 2005, the Court granted preliminary approval of the settlement. On April 24, 2006, the Court held a fairness hearing in connection with the motion for final approval of the settlement. The Court did not issue a ruling on the motion for final approval at the fairness hearing. On December 5, 2006, the Court of Appeals for the Second Circuit reversed the Court’s October 2004 order certifying a class in six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceeding. Avanex is not one of the test cases and it is unclear what impact this will have on Avanex’s case. The settlement remains subject to a number of conditions, including final approval of the Court. If the settlement does not occur, and litigation against Avanex continues, Avanex believes it has meritorious defenses and intends to defend the action vigorously. Nevertheless, an unfavorable result in litigation may result in substantial costs and may divert management’s attention and resources, which could seriously harm our business, financial condition, results of operations or cash flow in a particular period.

12. Recent Accounting Pronouncements

In June 2006, FASB issued interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (FAS No. 109)” (“FIN 48”). This interpretation prescribes a recognition threshold and measurement attribute for tax positions taken or expected to be taken in a tax return. This interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The evaluation of a tax position in accordance with this interpretation is a two-step process. In the first step, recognition, it is determined whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The second step addresses measurement of a tax position that meets the more-likely-than-not criteria. The tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. Differences between tax positions taken in a tax return and amounts recognized in the financial statements will generally result in a) an increase in a liability for income taxes payable or a reduction of an income tax refund receivable, b) a reduction in a deferred tax asset or an increase in a deferred tax liability or c) both a and b. Tax positions that previously failed to meet the more- likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not recognition threshold should be de-recognized in the first subsequent financial reporting period in which that threshold is no longer met. Use of a valuation allowance as described in FAS No. 109 is not an appropriate substitute for the de-recognition of a tax position. The requirement to assess the need for a valuation allowance for deferred tax assets based on sufficiency of future taxable income is unchanged by this interpretation. This Interpretation is effective for fiscal years beginning after December 15, 2006. We do not believe that FIN 48 will have a material impact on our consolidated balance sheet and statement of operations.

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operations financial statements and the related financial statement disclosures. SAB 108 permits existing public companies to record the cumulative effect of initially applying this approach in the first year ending after November 15, 2006 by recording the necessary correcting adjustments to the carrying values of assets and liabilities as of the beginning of that year with the offsetting adjustment recorded to the opening balance of retained earnings. Additionally, the use of the cumulative effect transition method requires detailed disclosure of the nature and amount of each individual error being corrected through the cumulative adjustment and how and when it arose. We believe the adoption of SAB 108 will not have a material impact on our consolidated balance sheet and statement of operations.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Certain statements contained in this Quarterly Report on Form 10-Q that are not purely historical are “forward-looking statements” within the meaning of the federal securities laws, including, without limitation, statements regarding our anticipated cost of revenue, operating expenses, gross margins, anticipated savings from our restructuring and cost reduction plans, and statements regarding our expectations, beliefs, anticipations, commitments, intentions and strategies regarding the future. In some cases forward-looking statements can be identified by terms such as “may,” “could,” “would,” “might,” “will,” “should,” “expect,” “plan,” “intend,” “ forecast,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” or the negative of these terms or other comparable terminology. Actual results could differ from those projected in any forward-looking statements are made as of the date of this Form 10-Q and we assume no obligation to update the forward-looking statements, or to update the reasons why actual results could differ from those projected in the forward-looking statements.

The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and our audited consolidated financial statements and notes for the year ended June 30, 2006, included in our Annual Report on Form 10-K filed with the SEC on September 28, 2006.

Overview

We design, manufacture and market fiber optic-based products, known as photonic processors, which are designed to increase the performance of optical networks. We sell our products to telecommunications system integrators and their network carrier customers. We were incorporated in October 1997 in California and reincorporated in Delaware in January 2000, and began making volume shipments of our products during the quarter ended September 30, 1999.

We acquired the optical components businesses of Alcatel (now known as Alcatel Lucent) and Corning on July 31, 2003, in transactions accounted for as a purchase. In addition, we acquired certain assets of Vitesse Semiconductor’s Optical Systems Division on August 28, 2003, in a transaction accounted for as a purchase.

The telecommunications industry experienced a significant period of retraction following a dramatic slowdown in equipment spending in late 2001 through 2005. Like many of our competitors, we continue to be adversely affected by the downturn in the telecommunications industry, and restructuring and cost-cutting measures are a significant focus for us. Over the past several years, we have implemented various restructuring programs to realign resources in response to the changes in the industry and customer demand. In fiscal 2004, we assumed restructuring liabilities with fair values of $64.1 million at the date of acquisition through the acquisitions of the optical components businesses of Alcatel Lucent and Corning, which were included in the purchase price. Subsequent to these acquisitions, we have continued to restructure our organization, primarily through the downsizing of our workforce and the abandonment of excess facilities. As of December 31, 2006 our accrued restructuring liability was $17.5 million. Of that amount, $6.4 million is expected to be paid within the next 12 months.

The restructurings have resulted in, among other things, a significant reduction in the size of our workforce, consolidation of our facilities and increased reliance on outsourced, third-party manufacturing. In March 2005, we announced that we had opened an operations center in Thailand to centralize global manufacturing and operational overhead functions in a lower-cost region. In July 2005, we announced the opening of a development and marketing office in Shanghai, China. Although we have relocated most of our manufacturing operations to reduce our production costs, we expect to undertake additional actions to further reduce costs and improve our gross margins. However, there can be no assurance that our cost structure will not increase in the future or that we will be able to align our cost structure with our expectations.

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Net Revenue.The market for optical equipment continues to evolve and the volume and timing of orders is difficult to predict. A customer’s decision to purchase our products typically involves a commitment of its resources and a lengthy evaluation and product qualification process. This initial evaluation and product qualification process typically takes several months and includes technical evaluation, integration, testing, planning and implementation into the equipment design. Implementation cycles for our products, and the practice of customers in the communications industry to sporadically place orders with short lead times, may cause our net revenues, gross margins, operating results and the identity of our largest customers to vary significantly and unexpectedly from quarter to quarter.

A summary of our net revenues and other financial information by geographic location is found in Note 10 of Notes to Condensed Consolidated Financial Statements.

To date, a substantial proportion of our sales have been concentrated with a limited number of customers. Four customers (including sales to their contract manufacturers) accounted for an aggregate of 27%, 21%, 10% and 10% of our net revenue, respectively, for the three months ended December 31, 2006. One customer (including sales to its contract manufacturers) accounted for 29% of our net revenue for the three months ended December 31, 2005. We expect that a substantial portion of our sales will remain concentrated with a limited number of customers, although the level of customer concentration has been declining.

Cost of Revenue. Our cost of revenue consists of costs of components and raw materials, direct labor, warranty, manufacturing overhead, payments to our contract manufacturers and inventory write-offs for obsolete and excess inventory. We rely on a single or limited number of suppliers to manufacture some key components and raw materials used in our products, and we rely on the outsourcing of some turnkey solutions.

We write off the cost of inventory that we specifically identify and consider obsolete or in excess of future sales estimates. We define obsolete inventory as products that we no longer market, for which there is no demand, or inventory that will no longer be used in the manufacturing process. Excess inventory is generally defined as inventory in excess of projected usage, and is determined using management’s best estimate of future demand at the time, based upon information then available to us. For the three months and six months ended December 31, 2006, we recorded inventory write-downs to cost of revenue of $3.4 million and $6.9 million, respectively, and $2.0 million and $4.0 million for the three months and six months ended December 31, 2005, respectively.

Gross Margin. Gross margin represents revenue less cost of revenue. During the three months and six months ended December 31, 2006, gross margin increased to 19% and 15% of revenue, respectively, compared to a gross margin of 8% and 7% for the three months and six months ended December 31, 2005. The increase was due to a more profitable mix of products sold to our customers, manufacturing overhead cost reductions resulting from outsourcing most of our manufacturing to lower-cost contract manufacturers, and higher-priced newly introduced products.

Research and Development Expenses. Research and development expenses consist primarily of salaries and related personnel costs, fees paid to consultants and outside service providers, costs of allocated facilities, non-recurring engineering charges and prototype costs related to the design, development, testing, pre-manufacturing and significant improvement of our products. We expense our research and development costs as they are incurred. We believe that research and development is critical to our strategic product development objectives. We further believe that, in order to meet the changing requirements of our customers, we must continue to fund investments in several development projects in parallel.

Sales and Marketing Expenses. Sales and marketing expenses consist primarily of salaries and related personnel costs of employees in sales, marketing, customer service and application engineering functions, costs of allocated facilities and promotional and other marketing expenses.

General and Administrative Expenses. General and administrative expenses consist primarily of salaries and related personnel costs for executive, finance, accounting, legal and human resources personnel, costs of allocated facilities, recruiting expenses, professional fees, legal, accounting and consulting expenses incurred in connection with transactions that were not completed and other corporate expenses.

Amortization of Intangible Assets. A portion of the purchase price in a business combination is allocated to goodwill and intangibles. Goodwill is not amortized, but rather is assessed for impairment at least annually. Intangible assets with definite lives continue to be amortized over their estimated useful lives.

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Restructuring. Restructuring expense generally includes employee severance costs and the costs of excess facilities associated with formal restructuring plans.

Gain on Disposal of Property and Equipment.Gain on disposals includes gains incurred as a result of disposal of property, plant or equipment for an amount greater than the net book value.

Interest and Other Income. Interest income consist primarily of interest earned from the investment of our cash and cash equivalents, short-term investments and long-term investments. Other income consists primarily of a gain realized in connection with our investment in Paxera, Inc, a privately-held photonics company.

Interest and Other Expense. Interest and other expense consists primarily of interest expense associated with borrowings under our line of credit, senior secured convertible notes, capital lease obligations, equipment loans and foreign currency exchange rate loss.

Critical Accounting Policies and Estimates

The preparation of our consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, net revenues and expenses, and related disclosures. We believe our estimates and assumptions are reasonable; however, actual results and the timing of the recognition of such amounts could differ from these estimates. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition. Our revenue recognition policy complies with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition”. We recognize product revenue when persuasive evidence of an arrangement exists, the product has been shipped, risk of loss has been transferred, collectibility is reasonably assured, fees are fixed or determinable and there are no uncertainties with respect to customer acceptance. We record a provision for estimated sales returns and price adjustments in the same period as when the related revenues are recorded. These estimates are based on historical sales returns and adjustments, other known factors and our return policy. If future sales returns or price adjustment levels differ from the historical data we use to calculate these estimates, changes to the provision may be required. We generally do not accept product returns from customers; however, we do sell our products under warranty. The specific terms and conditions of our warranties vary by customer and region in which we do business; however, the warranty period is generally one year.

Allowance for Doubtful Accounts. In the last three years, our uncollectible accounts experience has been almost zero. When we become aware, subsequent to delivery, of a customer’s potential inability to meet its obligations, we record a specific allowance for doubtful accounts. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Such an allowance may be magnified due to the concentration of our sales to a limited number of customers. At December 31, 2006, we determined that an allowance of $55,000 was required due to the uncertainty of collections from one customer.

Excess and Obsolete Inventory. We write off the cost of inventory that we specifically identify and consider obsolete or excessive to fulfill future sales estimates. We define obsolete inventory as products that we no longer market for which there is no demand, or inventory that will no longer be used in the manufacturing process. Excess inventory is generally defined as inventory in excess of projected usage, and is determined using management’s best estimate of future demand at the time, based upon information then available to us.

In estimating excess inventory, we use a range of six-month to twelve-month demand forecast. In addition, we assess inventory on a quarterly basis and write-down those inventories which are obsolete or in excess of our forecasted usage to their estimated realizable value. Our estimates of realizable value are based upon our analysis including, but not limited to forecasted sales levels by product, expected product life cycle, product development plans and future demand requirements. Our marketing department plays a key role in our excess review process by providing updated sales forecasts, managing product rollovers and working with sub-contract manufacturing to maximize recovery of excess inventory. If actual market conditions are less favorable than our forecasts or actual demand from our customers is lower than our estimates, we maybe required to record additional inventory write downs. If actual market conditions are more favorable than anticipated, inventory previously written down may be sold resulting in lower cost of sales and higher income from operations than expected in that period.

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Stock-based Compensation Expense. We account for employee stock-based compensation costs in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment” (“SFAS 123(R)”) and Staff Accounting Bulletin No. 107, “Share-Based Payment” (“SAB 107”). We utilize the Black-Scholes option pricing model to estimate the fair value of employee stock-based compensation at the date of grant, which requires the input of highly subjective assumptions, including expected volatility and expected life. Historical volatility was used in estimating the fair value of our stock-based awards, and the expected life was estimated to be 6.25 years using the simplified method permitted under SAB 107. Further, as required under SFAS 123(R), we now estimate forfeitures for options granted that are not expected to vest. Changes in these inputs and assumptions can materially affect the measure of estimated fair value of our share-based compensation. The estimated fair value is charged to earnings on a straight-line basis over the vesting period of the underlying awards, which is generally four years. The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options having no vesting restrictions and being fully transferable. Accordingly, our estimate of fair value may not represent the value assigned by a third-party in an arms-length transaction. While our estimate of fair value and the associated charge to earnings materially impacts our results of operations, it has no impact on our cash position.

Goodwill.If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recorded in net income (loss). We operate in one segment, which we consider our sole operating unit. Measurement of the fair value of the reporting unit in our annual test for impairment is determined using the market capitalization approach. The capitalization approach focuses on the fair value of the enterprise, which was determined based on our current market capitalization, and goodwill was determined not to be impaired at December 31, 2006.

Impairment of Long-lived Assets.We evaluate the recoverability of long-lived assets in accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-lived Assets.” When events or changes in circumstances indicate that the carrying amount of long-lived assets may not be recoverable we recognize such impairment in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to such assets.

Warranties. In general, we provide a product warranty for one year from the date of shipment. We accrue for the estimated cost to provide warranty services at the time revenue is recognized. The specific terms and conditions of our warranties vary by customer and region in which we do business. Our estimate of costs to service our warranty obligations is based on historical experience and expectation of future conditions. To the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, our warranty costs will increase resulting in decreases to gross profit. Conversely, to the extent we experience decreased warranty claim activity, or decreased costs associated with servicing those claims, our warranty costs will decrease resulting in increases to gross profit. We periodically assess the adequacy of our recorded warranty liabilities and adjust the amounts as necessary.

Restructuring. During the past few years we have recorded significant accruals in connection with restructuring programs. Given the significance and complexity of restructuring activities, and the timing of the execution of such activities, the restructuring accrual process involves periodic reassessments of estimates made at the time the original decisions were made, including evaluating real estate market conditions for expected vacancy periods and sub-lease rents. Although we believe that these estimates accurately reflect the costs of the restructuring programs, actual results may differ, thereby requiring us to record additional provisions or reverse a portion of such provisions.

Contingencies. We are or have been subject to proceedings, lawsuits and other claims related to our initial public offering and other matters. We evaluate contingent liabilities including threatened or pending litigation in accordance with Statement of Financial Accounting Standards No. 5 (“SFAS 5”), “Accounting for Contingencies.” If the potential loss from any claim or legal proceedings is considered probable and the amount can be estimated, we accrue a liability for the estimated loss. Because of uncertainties related to these matters, accruals are based upon management’s judgment and the best information available to management at the time. As additional information becomes available, we reassess the potential liability related to its pending claims and litigation and may revise its estimates.

In addition to product warranties, we, from time to time, in the normal course of business, indemnify certain customers with whom we enter into contractual relationships. We have agreed to hold the other party harmless against third-party claims that our products, when used for their intended purpose, infringe the intellectual property rights of such third party or other claims made against certain parties. It is not possible to determine the maximum potential amount of liability under these indemnification obligations due to the limited history of prior indemnification claims and the unique facts and circumstances that are likely to be involved in each particular claim. The estimated fair value of these indemnification provisions is minimal. To date, we have not incurred any costs related to claims under these provisions, and no amounts have been accrued in the accompanying financial statements.

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Results of Operations

The following table sets forth, for the periods indicated, our Consolidated Statements of Operations, expressed as amounts in thousands and as percentages of net revenue. Our historical operating results are not necessarily indicative of our results for any future period.


	Three Months Ended December 31,										Six Months Ended December 31,

		Amounts					% of Revenue					Amounts					% of Revenue
		2006			2005		2006		2005			2006			2005		2006		2005
Net revenue	$	55,623		$	36,125		100	%	100	%	$	106,514		$	77,358		100	%	100	%
Cost of revenue		45,127			33,207		81	%	92	%		90,706			72,314		85	%	93	%
Gross profit		10,496			2,918		19	%	8	%		15,808			5,044		15	%	7	%
Operating expenses:
Research and development		5,832			5,452		10	%	15	%		11,457			12,579		11	%	16	%
Sales and marketing		3,891			2,783		7	%	8	%		7,439			6,571		7	%	8	%
General and administrative		9,075			3,841		16	%	11	%		14,726			9,115		14	%	12	%
Amortization of intangibles		656			1,385		1	%	4	%		1,508			3,150		1	%	4	%
Restructuring		436			2,942		1	%	8	%		373			2,982		0	%	4	%
Gain on disposal of property and equipment		(28	)		(775	)	(0	%)	(2	%)		(48	)		(768	)	(0	%)	(1	%)
Total operating expenses		19,862			15,628		36	%	43	%		35,455			33,629		33	%	43	%
Loss from operations		(9,366	)		(12,710	)	(17	%)	(35	%)		(19,647	)		(28,585	)	(18	%)	(37	%)
Interest and other income		1,121			379		2	%	1	%		1,960			930		2	%	1	%
Interest and other expense		(308	)		(6,212	)	(1	%)	(17	%)		(580	)		(7,811	)	(1	%)	(10	%)
Net loss	$	(8,553	)	$	(18,543	)	(15	%)	(51	%)	$	(18,267	)	$	(35,466	)	(17	%)	(46	%)

Net Revenue

Net revenue for the three months ended December 31, 2006 was $55.6 million, which represents an increase of $19.5 million, or 54%, from net revenue of $36.1 million for the three months ended December 31, 2005. The increase in net revenue was attributable to an overall increase in demand for our products from existing customers.

Net revenue for the six months ended December 31, 2006 was $106.5 million, which represents an increase of $29.1 million, or 38%, from net revenue of $77.4 million for the six months ended December 31, 2005. The increase in net revenue was attributable to an overall increase in demand for our products from existing customers.

To date, a substantial portion of our sales has been concentrated with a limited number of customers, although the level of concentration has been declining. For the three months and six months ended December 31, 2006 and 2005, sales to customers (including sales to each customer’s contract manufacturer) that each comprised 10% or more of net revenue were as follows:


	Three Months Ended December 31,				Six Months Ended December 31,
	2006		2005		2006		2005
Company A	27	%	29	%	29	%	31	%
Company B	21	%	-		16	%	-
Company C	10	%	-		11	%	-
Company D	10	%	-		-		11	%
	68	%	29	%	56	%	42	%

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While we have substantially diversified our customer base, we expect that a substantial portion of our sales will remain concentrated with a limited number of customers. Sales to our major customers vary significantly from period to period, and we do not have the ability to predict sales to these customers.

Net revenue from customers outside the United States accounted for $16.4 million and $14.7 million of total net revenue, or 29% and 41%, for the three months ended December 31, 2006 and 2005, respectively, and accounted for $30.0 million and $29.3 million of total net revenue, or 28% and 38%, for the six months ended December 31, 2006 and 2005, respectively.

Cost of Revenue and Gross Margin

Cost of revenue for the three months ended December 31, 2006 was $45.1 million, compared to $33.2 million for the three months ended December 31, 2005, an increase of $11.9 million. The increase was due to increased product shipments partially offset by reduced cost of goods as a percentage of revenue. The reduction in this percentage of revenue was due to the outsourcing of most of our manufacturing to contract manufacturers, which reduced our direct labor and manufacturing overhead costs.

Cost of revenue for the six months ended December 31, 2006 was $90.7 million, compared to $72.3 million for the six months ended December 31, 2005, an increase of $18.4 million. The increase was due to increased product shipments partially offset by reduced cost of goods as a percentage of revenue.

For the three months ended December 31, 2006 and 2005, we sold inventory previously written-off with original costs totaling $156,000 and $22,000, respectively, due to unforeseen demand for such inventory. For the six months ended December 31, 2006 and 2005, we sold inventory previously written-off with original costs totaling $357,000 and $270,000, respectively. As a result, cost of revenue associated with the sale of this inventory was zero. The selling price of the finished goods that included these components was similar to the selling price of products that did not include components that were written-off. These items were subsequently used and sold because customers ordered products that included these components in excess of our estimates.

Cost of revenue as a percentage of net revenue improved from the three months and six months ended December 31, 2005 to the three months and six months ended 2006 due to a number of factors. Manufacturing overhead as a percentage of net revenue decreased as we outsourced our manufacturing to contract manufacturers in lower-cost regions. Also, direct manufacturing costs as a percentage of net revenue decreased due to the lower cost of direct labor in these lower cost regions and improvement in our supply chain management. These favorable factors were partially offset by higher write-offs of excess and obsolete inventory which increased from $2.0 million and $4.0 million for the three months and six months ended December 31, 2005, respectively, to $3.4 million and $6.9 million for the three months and six months ended December 31, 2006, respectively. Consequently, our gross margin percentage improved from 8% and 7% for the three months and six months ended December 31, 2005, respectively, to 19% and 15% for the three months and six months ended December 31, 2006, respectively.

The increase in inventory write-downs was due to excess inventory resulting from lower demand than we had previously expected for some of our products. For the three and six months ended December 31, 2006 we incurred expenses of $528,000 and $1.9 million, respectively, resulting from the contractual repurchase of obsolete inventory from our contract manufacturers. For the three months and six months ended December 31, 2006, we also recorded a charge of $221,000 and $1.6 million, respectively, to cost of revenue in connection with book-to-physical inventory adjustments.

Our gross margins are and will be primarily affected by changes in mix of products sold, manufacturing volume, changes in sales prices, product demand, inventory write-downs, sales of previously written-off inventory, warranty costs, and product yields.

Research and Development

Research and development expenses increased $380,000 to $5.8 million for the three months ended December 31, 2006 from $5.5 million for the three months ended December 31, 2005. The increase was primarily due to increase in headcount at our development center in Shanghai. In addition, the lower research and development expenses last year were due to government research reimbursements received by our San Donato site. As a percentage of net revenue, research and development expenses decreased to 10% for the three months ended December 31, 2006 from 15% for the three months ended December 31, 2005. For the six months ended December 31, 2006, research and development expenses decreased $1.1 million to $11.5 million from $12.6 million for the six months ended December 31, 2005. The decrease was primarily

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due to a reduction in headcount expense in the US as we transitioned our research and development capability to a new facility in Shanghai, China. As a percentage of net revenue, research and development expenses decreased to 11% from 16% for the same period last year. We expect our research and development expenses to maintain at current levels as a percentage of net revenue in the current fiscal year, although there can be no assurance that our research and development expenses will not increase in the future.

Sales and Marketing

For the three months ended December 31, 2006, sales and marketing expenses increased $1.1 million to $3.9 million from $2.8 million for the three months ended December 31, 2005. As a percentage of net revenue, sales and marketing expenses decreased to 7% for the three months ended December 31, 2006 from 8% for the three months ended December 31, 2005. For the six months ended December 31, 2006, sales and marketing expenses increased $868,000 to $7.4 million from $6.6 million for the six months ended December 31, 2005. As a percentage of net revenue, sales and marketing expenses decreased to 7% from 8% for the same period last year. The increase in sales and marketing expense was primarily due to annual salary increases and increased sales commission as a result of higher revenue. We expect our sales and marketing expenses to maintain at current levels as a percentage of net revenue in the current fiscal year, although there can be no assurance that our sales and marketing expenses will not increase in the future.

General and Administrative

General and administrative expenses were $9.1 million for the three months ended December 31, 2006, an increase of $5.2 million from expenses of $3.8 million for the three months ended December 31, 2005. As a percentage of net revenue, general and administrative expenses increased to 16% in the three months ended December 31, 2006 from 11% in the three months ended December 31, 2005. General and administrative expenses were $14.7 million for the six months ended December 31, 2006, an increase of $5.6 million from expenses of $9.1 million for the six months ended December 31, 2005. As a percentage of net revenue, general and administrative expenses increased to 14% in the six months ended December 31, 2006 from 12% in the six months ended December 31, 2005. The increase in general and administrative expenses for the three and six months ended December 31, 2006 from the same period in the prior year was primarily driven by legal, accounting and consulting due diligence fees of $2.1 million related to a potential acquisition in which Avanex decided not to proceed further in the three months ended December 31, 2006, increased share-based compensation expenses of $947,000, unanticipated increase in audit fees of $750,000 related to the year-end audit, unanticipated increase of $800,000 in consulting fees related to Sarbanes-Oxley compliance and other year-end financial close activities, and general increase in employee salaries related to annual salary increases. We expect our general and administrative expenses to decrease in subsequent quarters primarily as a result of decreases in legal, accounting and consulting due diligence fees. Despite our continued efforts to reduce the level of our general and administrative expenses, there can be no assurance that our general and administrative expenses will not increase in the future.

Amortization of Intangible Assets

Amortization of intangible assets decreased by $729,000 to $656,000 for the three months ended December 31, 2006, from $1.4 million for three months ended December 31, 2005. For the six months ended December 31, 2006, amortization of intangible assets decreased by $1.7 million to $1.5 million from $3.2 million in the year earlier period. These decreases were primarily attributable to the fact that certain specific intangible assets had become fully amortized. These intangible assets were purchased in the acquisitions of the optical components businesses of Alcatel Lucent, Corning and Vitesse in fiscal 2004.

Restructuring

Over the past several years, we have implemented various restructuring programs to realign resources in response to the changes in our industry and customer demand, and we continue to assess our current and future operating requirements accordingly.

For the three month periods ended December 31, 2006 and 2005, restructuring expenses were $436,000 and $2.9 million, respectively and for the six month periods ended December 31, 2006 and 2005, restructuring expenses were $373,000 and $3.0 million, respectively. The reduction in restructuring expenses resulted primarily from our not having initiated restructuring programs during the three and six month periods ended December 31, 2006.

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Stock-based Compensation

Stock-based compensation expense was $1.8 million in the three months ended December 31, 2006, compared to $618,000 in the year earlier period. For the six month period ended December 31, 2006, stock-based compensation expense was $3.7 million, compared to $1.1 million in the year earlier period. These increases were primarily due to the expense associated with the issuance of restricted stock units for the three months and six months ended December 31, 2006. See Note 2 of Notes to Condensed Consolidated Financial Statements.

Gain on disposal of property and equipment

Gain or loss on disposal of property and equipment for the three months and six months ended December 31, 2006 was $28,000 and $48,000, respectively. Gain or loss on disposal of property and equipment for the three months and six months ended December 31, 2005 was $775,000 and $768,000, respectively.

Interest and Other Income

Interest and other income increased by $742,000 to $1.1 million in the three months ended December 31, 2006 from $379,000 in the three months ended December 31, 2005. Interest and other income increased by $1.0 million to $2.0 million in the six months ended December 31, 2006 from $930,000 in the six months ended December 31, 2005. This increase was primarily due to a $515,000 gain realized in the three months ended December 31, 2006 in connection with our investment in Paxera, Inc, a privately-held photonics company as discussed in Note 5 of Notes to Condensed Consolidated Financial Statements.

Interest and Other Expense

Interest and other expense decreased by $5.9 million to $308,000 in the three months ended December 31, 2006 from $6.2 million in the three months ended December 31, 2005. Interest and other expense decreased by $7.2 million to $580,000 for the six months ended December 31, 2006 from $7.8 million in the six months ended December 31, 2005. These decreases were primarily due to incurring a $4.5 million loss in connection with modifications to our 8% senior convertible notes in November 2005, and interest expense on higher principal balances of our borrowings in the three and six month periods ended December 31, 2005.

Liquidity and Capital Resources

In February 2000, we received net proceeds of approximately $238.0 million from the initial public offering of our common stock and a concurrent sale of stock to corporate investors. Subsequent to our initial public offering, we have financed our operations through the sale of equity securities, issuance of convertible notes and warrants, bank borrowings, equipment lease financing and acquisitions. Financing activities for prior fiscal years are summarized in the annual report on Form 10-K as filed with the SEC on September 28, 2006.

As of December 31, 2006, Avanex had cash and cash equivalents of $37.4 million and short-term investments of $14.6 million for an aggregate of $52.0 million, excluding restricted cash of $5.9 million.

As of June 30, 2006, Avanex had cash and cash equivalents of $29.0 million and short-term investments of $38.7 million for an aggregate of $67.7 million, excluding restricted cash of $6.7 million.

Net cash used in operating activities of $15.4 million for the six months ended December 31, 2006 was due primarily to a net loss of $18.3 million, an increase of $10.2 million in inventories, an increase of $7.3 million in accounts receivable and an increase of $7.3 million in related party receivables, partially offset by an increase in accounts payable of $8.9 million, an increase of $3.3 million in other accrued expenses and deferred revenues, and non-cash charges including stock-based compensation of $3.7 million, inventory write-downs of $6.9 million and other changes to working capital.

Net cash provided by investing activities during the six months ended December 31, 2006 was $23.4 million, which was primarily the result of net maturities of short-term investments of $24.1 million and a decrease in restricted cash of $785,000, partially offset by capital expenditures of $1.6 million.

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Net cash provided by financing activities was $146,000 during the six months ended December 31, 2006, which was the result of proceeds generated through the sale of common stock of $858,000 upon exercise of stock options and the sale of common stock through the Employee Stock Purchase Plan, partially offset by payments on capital lease obligations of $712,000.

Recent Accounting Pronouncements

In June 2006, FASB issued interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (FAS No. 109)” (“FIN 48”). This interpretation prescribes a recognition threshold and measurement attribute for tax positions taken or expected to be taken in a tax return. This interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The evaluation of a tax position in accordance with this interpretation is a two-step process. In the first step, recognition, it is determined whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The second step addresses measurement of a tax position that meets the more-likely-than-not criteria. The tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. Differences between tax positions taken in a tax return and amounts recognized in the financial statements will generally result in a) an increase in a liability for income taxes payable or a reduction of an income tax refund receivable, b) a reduction in a deferred tax asset or an increase in a deferred tax liability or c) both a and b. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not recognition threshold should be de-recognized in the first subsequent financial reporting period in which that threshold is no longer met. Use of a valuation allowance as described in FAS No. 109 is not an appropriate substitute for the de-recognition of a tax position. The requirement to assess the need for a valuation allowance for deferred tax assets based on sufficiency of future taxable income is unchanged by this interpretation. This Interpretation is effective for fiscal years beginning after December 15, 2006. We do not believe that FIN 48 will have a material impact on our consolidated balance sheet and statement of operations.

In September 2006, the United States Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 establishes an approach that requires quantification of financial statement errors based on the effects of each of the company’s balance sheet and statement of operations financial statements and the related financial statement disclosures. SAB 108 permits existing public companies to record the cumulative effect of initially applying this approach in the first year ending after November 15, 2006 by recording the necessary correcting adjustments to the carrying values of assets and liabilities as of the beginning of that year with the offsetting adjustment recorded to the opening balance of retained earnings. Additionally, the use of the cumulative effect transition method requires detailed disclosure of the nature and amount of each individual error being corrected through the cumulative adjustment and how and when it arose. We believe the adoption of SAB 108 will not have a material impact on our consolidated balance sheet and statement of operations.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. The objectives of our investment activities are preservation and safety of principal; maintenance of adequate liquidity to meet cash flow requirements; attainment of a competitive market rate of return on investments; minimization of risk on all investments; and avoidance of inappropriate concentrations of investments.

We place our investments with high quality credit issuers in short-term and long-term securities and maturities can range from overnight to 36 months. The average maturity of the portfolio will not exceed 18 months. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity. We do not have any derivative financial instruments. Accordingly, we do not believe that our investments have significant exposure to interest rate risk.

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The following table summarizes average interest rate and fair market value of the short-term securities and restricted cash and investments held by Avanex (in thousands), which were classified as available-for-sale at December 31, 2006 and June 30, 2006:


	December 31, 2006	June 30, 2006
Amortized cost	$20,529	$ 45,210
Fair market value	$20,529	45,372
Average interest rate	5.31%	3.09%

The interest rate on our outstanding $5 million principal amount convertible notes due 2008 is fixed at 8.0%. Accordingly, we believe that we have an insignificant interest rate risk exposure on this security.

Exchange Rate Risk

Our international business is subject to normal international business risks including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and foreign exchange rate volatility. Accordingly, our future results could be materially adversely affected by changes in these or other factors.

We have operations in the United States, China, Thailand, France and Italy. Accordingly, we have sales and expenses that are denominated in currencies other than the U.S. dollar. As a result, currency fluctuations between the U.S. dollar and the currencies in which we do business could cause foreign currency translation gains or losses that we would recognize in the period incurred. A 10% fluctuation in the dollar at December 31, 2006 would have led to an additional profit of approximately $4.8 million (dollar strengthening), or an additional loss of approximately $4.8 million (dollar weakening) on our net dollar position in outstanding assets and liabilities. We cannot predict the effect of exchange rate fluctuations on our future operating results because of the variability of currency exposure and the potential volatility of currency exchange rates. Currently, we do not hedge our exposure to translation gains and losses related to foreign currency net asset exposures.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures

Management, including our principal executive officer and principal financial officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as of December 31, 2006.

As discussed in more detail in our 2006 Form 10-K, as of June 30, 2006, our management concluded that we did not maintain effective controls over the following:

•

Company-level controls. The finance group continued to experience turnover such that there was insufficient familiarity with historical accounting entries, and the supervision of the accounting processes was not effective. In addition, during fiscal 2006, we transitioned the majority of our manufacturing operations to contract manufacturers, and these transitions contributed to a number of accounting errors that required post-close journal entries during our year-end close process. Also, controls were not in place to adequately restrict access to the accounting systems. In addition, our assessments related to the risk of financial fraud were not completed until after year end and certain controls in the assessment process were found to be ineffective.

•

Preparation and review procedures over account reconciliations and related journal entries. The controls over the preparation and review of account reconciliations and related journal entries both in our Fremont and Nozay facilities were initially inadequate and led to a lack of control over our closing and reporting processes, which were corrected in the audit process.

•

Controls over accounts receivable and warranty reserves. Accounts receivable reserves did not initially adequately consider our recent collection performance and warranty reserves initially did not adequately consider our recent performance in the contract manufacturing environment and were corrected in the audit process.

•

Controls over inventory. Inadequate controls around our inventory values, including transactions with our contract manufacturer and inter-company shipments, resulted in errors in our ending inventory in both the Fremont and Nozay facilities, which required adjustment in the audit process. Accounting records were not adjusted to physical counts in a timely manner, and inventory reserves did not initially adequately consider recent historical performance, which were corrected in the audit process.

•

Controls over pension accounting. Lack of personnel with the requisite level of knowledge of our French subsidiary’s pension plan initially resulted in errors in accounting for our pension obligation, which were corrected in the audit process.

•

Controls over stock-based compensation. Lack of personnel with the requisite level of knowledge of stock-based compensation accounting initially resulted in errors in the recorded expense, which were corrected in the audit process.

Based upon that evaluation, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures were not effective as of December 31, 2006 because we have not completed the remediation of the material weaknesses discussed in Item 9A of our Annual Report on Form 10-K for the year ended June 30, 2006 (“2006 Form 10-K”) and the material weakness described below.

During the six month period ended December 31, 2006, we began remediating the material weaknesses described in our 2006 Form 10-K. However, as of December 31, 2006 we have not completed the remediation of any of these material weaknesses.

Changes in internal controls over financial reporting

Our management is treating outstanding material weaknesses, as well as the control environment, seriously and has implemented or intends to implement the following actions to remediate them:

•

Enhancement of controls over the accounting close process; increase in the supervision of the accounting department; increase in the automation and integration of our accounting systems; reduction of our dependency on consultants; quarterly review of access rights to the accounting systems and implementation of controls designed to reduce the risk of financial fraud;

•

Implementation of enhanced preparation and review procedures over account reconciliations and related journal entries;

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•

Implementation of additional controls and improved analysis to evaluate accounts receivable and warranty reserves fully considering historical experience;

•

Implementation of enhanced quarterly controls over the recording of inventory values and transactions, the reconciliation of physical counts of inventory, and the detailed review of inventory reserves;

•

Implementation of improved review procedures over the accounting for our French subsidiary’s pension plan;

•

Implementation of improved review procedures over stock-based compensation accounting; and

•

Implementation of improved review procedures over revenue recognition.

During the three months ended December 31, 2006, management concluded that there was a material weakness resulting from design deficiencies in controls over revenue recognition from drop shipments to international customers resulting in a more than remote likelihood that a material misstatement of our annual or interim financial statements would not be prevented or detected. These control deficiencies existed during the period of migration from the SAP system used by our Nozay facility to a common integrated SAP platform used by all of Avanex. Management believes that the transition to the common SAP platform is now substantially complete.

Part II – OTHER INFORMATION

ITEM 1 LEGAL PROCEEDINGS

From time to time, we are subject to various legal proceedings that arise from the normal course of business activities. In addition, from time to time, third parties assert patent or trademark infringement claims against us in the form of letters and other forms of communication. We do not believe that any of these legal proceedings or claims is likely to have a material adverse effect on our consolidated results of operations, financial condition or cash flows. However, it is possible that an unfavorable resolution of one or more such proceedings could in the future materially affect our future results of operations, cash flows or financial position in a particular period.

IPO Class Action Lawsuit

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ITEM 1A. RISK FACTORS

In addition to the other information contained in this Quarterly Report on Form 10-Q, we have identified the following risks and uncertainties that may have a material adverse affect on our business, financial condition or results of operations. Investors should carefully consider the risks described below before making an investment decision. The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently believe are immaterial may also impair our business operations. Our business could be harmed by any of these risks. The trading price of our common stock could decline due to any of these risks and investors may lose all or part of their investment. This section should be read in conjunction with the Consolidated Financial Statements and Notes thereto, and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in this Form 10-Q.

I. Financial and Revenue Risks.

We have a history of negative cash flow and losses, which is likely to continue if we are unable to increase our revenues and further reduce our costs.

We have never been profitable. We have experienced operating losses in each quarterly and annual period since our inception in 1997, and we may continue to incur operating losses for the foreseeable future. As of December 31, 2006, we had an accumulated deficit of $692.8 million. Also, for the fiscal year ended June 30, 2006 and each of our prior fiscal years, we had negative operating cash flow, and we may incur negative operating cash flow in future periods. There can be no assurance that our business will become profitable in the future or that additional losses and negative cash flows from operations will not be incurred, which could have a material adverse affect on our financial condition.

Due to insufficient cash generated from operations, we have funded our operations primarily through the sale of equity securities, debt securities, bank borrowings, equipment lease financings, acquisitions and other strategic transactions. Although we implemented cost reduction programs during the past several years, we continue to have significant fixed expenses, and we expect to continue to incur considerable manufacturing, sales and marketing, product development and administrative expenses. If we fail to generate higher revenues and increase our gross margins while containing our costs and operating expenses, our financial position will be harmed significantly.

If we do not reduce costs and improve our gross margins, our financial condition and results of operations will be adversely impacted.

Our ability to achieve profitability depends on our ability to control costs and expenses in relation to sales and to increase our gross margin. During the three months and six months ended December 31, 2006, our gross margin percentage was positive 19% and 15%, respectively. During the fiscal years ended June 30, 2006, 2005 and 2004, our gross margin percentage was positive 5%, negative 3% and negative 25%, respectively. Despite our continued efforts to improve our gross margins, there can be no assurance that our gross margins will not decrease in the future.

We are working to minimize fixed costs through the extensive use of contract manufacturing and the relocation of most of our manufacturing operations into a central facility in Bangkok, Thailand. While this is an accepted model of manufacturing in many electronic industries, the use of this model is relatively untested within the optical industry. As such, we may face execution issues working with our contract manufacturers, including difficulties managing our supply chain and deliveries to our customers. From a financial viewpoint, should these difficulties occur, we could see negative impacts to revenue, gross margin and inventory levels.

In addition, over our limited operating history, the average selling prices of our existing products have decreased and this trend may continue. However, our overall product mix has shifted toward products with higher levels of integration, which we typically sell at higher unit prices. Future price decreases may be due to a number of factors, including competitive pricing pressures, rapid technological change and sales discounts. Therefore, to improve our gross margin, we must develop and introduce new products and product enhancements on a timely basis and reduce our costs of production. Moreover, as our average selling prices decline, we must increase our unit sales volume, or introduce new products, to maintain or increase our revenues. If our average selling prices decline more rapidly than our costs of production, our gross margin will decline, which would adversely impact our business, financial condition and results of operations. If we are unable to continue to generate positive gross margins our cash flows from operations would be negatively impacted, and we would be unable to achieve profitability.

We may not realize the anticipated benefits from our restructuring efforts.

As part of our cost reduction efforts, over the past several years we have implemented various restructuring programs to realign our resources in response to the changes in the industry and customer demand. These efforts have included

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transferring most of our manufacturing operations to lower-cost contract manufacturers. Our past restructuring programs may have a material effect on our financial position in the future as we pay severance to employees and rent for excess facilities. We may initiate future restructuring actions, which are likely to result in additional expenses that could affect our results of operations or financial position. There can be no assurance that we will realize the benefits we anticipate from our current or future restructuring programs or that such programs will reduce our operating expenses and improve our cost structure.

We may have difficulty obtaining additional capital.

Our balance of cash, cash equivalents and unrestricted short-term investments decreased from $67.7 million at June 30, 2006 to $52.0 million at December 31, 2006. There can be no assurance that our business will be profitable in the future. If these trends continue in the future, it could have an adverse affect on our financial condition. It may be difficult for us to raise additional capital. In addition, the holders of the notes issued in the May 2005 private placement have imposed certain restrictive covenants, including limits on our future indebtedness and limits on our ability to incur future liens and to make certain restricted payments. If adequate capital is not available to us as required, or is not available on favorable terms, our business and financial condition would be adversely affected.

Our future revenues and operating results are inherently unpredictable, and as a result, we may fail to meet the expectations of securities analysts or investors, which could cause our stock price to decline.

Our revenues and operating results have fluctuated significantly from quarter-to-quarter in the past, and may continue to fluctuate significantly in the future. Factors that are likely to cause these fluctuations, some of which are outside of our control, include, without limitation, the following:

•

the current economic environment and other developments in the telecommunications industry, including the severe business setbacks of customers or potential customers and the current perceived oversupply of communications bandwidth;

•

the mix of our products sold;

•

our ability to control expenses;

•

fluctuations in demand for and sales of our products, which will depend upon the speed and magnitude of the transition to an all-optical network, the acceptance of our products in the marketplace, and the general level of spending on infrastructure projects in the telecommunications industry;

•

cancellations of orders and shipment rescheduling;

•

changes in product specifications required by customers for existing and future products;

•

satisfaction of contractual customer acceptance criteria and related revenue recognition issues;

•

our ability to maintain appropriate manufacturing capacity through our contract manufacturers;

•

our ability to successfully complete a transition to an outsourced manufacturing model;

•

the ability of our outsourced manufacturers to timely produce and deliver subcomponents, and possibly complete products in the quantity and of the quality we require;

•

the current practice of companies in the telecommunications industry of sporadically placing large orders with short lead times;

•

our ability to comply with new rules and regulations

•

competitive factors, including the introduction of new products and product enhancements by competitors and potential competitors, pricing pressures, and the competitive environment in the markets into which we sell our photonic processing solutions and products, including competitors with substantially greater resources than we have;

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•

our ability to effectively develop, introduce, manufacture, and ship new and enhanced products in a timely manner without defects;

•

the availability and cost of components for our products;

•

new product introductions that may result in increased research and development expenses and sales and marketing expenses that are incurred in one quarter, with revenues, if any, that are not recognized until a subsequent quarter;

•

the unpredictability of customer demand and difficulties in meeting such demand;

•

revisions to our estimated reserves and allowances, as well as other accounting provisions or charges;

•

costs associated with, and the outcome of, any litigation to which we are, or may become, a party; and

•

customer perception of our financial condition and resulting effects on our orders and revenue.

A high percentage of our expenses, including those related to manufacturing, engineering, sales and marketing, research and development, and general and administrative functions, are fixed in the short term. As a result, if we experience delays in generating and recognizing revenue, our quarterly operating results are likely to be seriously harmed.

Due to these and other factors, we believe that quarter-to-quarter comparisons of our operating results may not be meaningful. Our results for one quarter should not be relied upon as any indication of our future performance. It is possible that in future quarters our operating results may be below the expectations of public market analysts or investors. If this occurs, the price of our common stock would likely decrease.

A lack of effective internal control over financial reporting could result in an inability to accurately report our financial results, which could lead to a loss of investor confidence in our financial reports and have an adverse effect on our stock price.

Effective internal controls are necessary for us to provide reliable financial reports. If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed. We have in the past discovered, and may in the future discover, deficiencies in our internal controls. For example, as more fully described in Item 9A “Controls and Procedures,” in our Form 10-K as filed with the SEC on September 28, 2006, our management concluded that as of June 30, 2006 we did not maintain effective internal controls over the following:

•

Company level controls;

•

Preparation and review procedures over account reconciliations and related journal entries;

•

Controls over accounts receivable and warranty reserves;

•

Controls over inventory;

•

Controls over pension accounting; and

•

Controls over stock-based compensation.

Our management determined that these control deficiencies were considered material weaknesses that could result in a material misstatement to annual or interim financial statements that would not be prevented or detected. As a result, our management concluded that our internal control over financial reporting was not effective as of June 30, 2006 using the criteria set forth in the Internal Control-Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (“COSO”). In addition, as described in Part 1, Item 4 above, during the three months ended December 31, 2006, management concluded that there was a material weakness related to revenue recognition from drop shipments to international customers, which could also result in a material misstatement to annual or interim financial statements that would not be prevented or detected.

A failure to implement and maintain effective internal control over financial reporting, including a failure to implement corrective actions to address the control deficiencies identified above, could result in a material misstatement of our financial statements or otherwise cause us to fail to meet our financial reporting obligations. This, in turn, could result in a loss of investor confidence in the accuracy and completeness of our financial reports, which could have an adverse effect on our business and operating results and our stock price, and we could be subject to stockholder litigation.

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We incur increased costs as a result of being a public company.

As a public company, we incur significant legal, accounting and other expenses.In addition, the Sarbanes-Oxley Act of 2002, as well as rules subsequently implemented by the Securities and Exchange Commission and Nasdaq, has required changes in corporate governance practices of public companies. These rules and regulations have increased our legal and financial compliance costs and made some activities more time consuming and costly. In addition, we incur additional costs associated with our public company reporting requirements. We also expect these rules and regulations to make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. As a result, it may be more difficult for us to attract and retain qualified persons to serve on our board or as an executive.

Our stock price is highly volatile.

The trading price of our common stock has fluctuated significantly since our initial public offering in February 2000, and is likely to remain volatile in the future. For example, since the beginning of fiscal 2006, our common stock has closed as low as $0.62 and as high as $3.29 per share. The trading price of our common stock could be subject to wide fluctuations in response to many events or factors, including the following:

•

quarterly variations in our operating results;

•

significant developments in the businesses of telecommunications companies;

•

changes in financial estimates by securities analysts;

•

changes in market valuations or financial results of telecommunications-related companies;

•

announcements by us or our competitors of technology innovations, new products, or significant acquisitions, strategic partnerships or joint ventures;

•

any deviation from projected growth rates in revenues;

•

any loss of a major customer or a major customer order;

•

the ability to meet our debt obligations;

•

additions or departures of key management or engineering personnel;

•

any deviations in our net revenue or in losses from levels expected by securities analysts;

•

activities of short sellers and risk arbitrageurs;

•

future sales of our common stock or the availability of additional financing;

•

volume fluctuations, which are particularly common among highly volatile securities of telecommunications-related companies; and

•

material weaknesses in internal controls.

In addition, the stock market has experienced volatility that has particularly affected the market prices of equity securities of many high technology companies, which often has been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of our common stock. As long as we continue to depend on a limited customer base and a limited number of products, there is substantial risk that our quarterly results will fluctuate.

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In July 2003, we issued an aggregate of 56,844,376 shares of our common stock to Alcatel Lucent and Corning Incorporated in connection with our acquisitions of the optical components businesses of Alcatel Lucent and Corning. In connection with these acquisitions, we entered into a stockholders’ agreement with Alcatel Lucent and Corning. Pursuant to the stockholders’ agreement, we registered 56,844,376 shares of common stock on behalf of Alcatel Lucent and Corning in July 2004. As of January 31, 2007, Alcatel Lucent owned shares of Avanex common stock representing 14% of the outstanding shares of Avanex common stock, and as of that date, Corning no longer held shares of Avanex common stock. Previously, certain restrictions on transfer applied to Alcatel Lucent making it more difficult for it to sell its shares of Avanex common stock. After January 1, 2007, however, Alcatel Lucent was no longer subject to such selling restrictions. If Alcatel Lucent or our other stockholders, including our convertible note holders, sell substantial amounts of our common stock in the public market, it could cause the market price of our common stock to fall, and could make it more difficult for us to raise capital through public offerings or other sales of our capital stock.

If the investors in our May 2005 financing (certain terms of which were amended in November 2005) continue to convert their notes or exercise their warrants, it will continue to have a dilutive effect upon our stockholders.

In May 2005 we issued notes and warrants to certain institutional investors, and in November 2005 certain terms of such convertible note financing were amended. Pursuant to the terms of the amended and restated notes, the holders of such notes may convert the notes into shares of common stock at any time prior to their maturity at a conversion price of $0.90 per share, subject to broad-based anti-dilution provisions. The anti-dilution provisions also provide for an adjustment for stock splits and certain other situations specified in the notes. Subject to certain conditions, at any time after May 19, 2007, we can automatically convert all of the outstanding notes into common stock if the weighted average price of the common stock of Avanex equals or exceeds 175% of the conversion price for a specified period. The warrants are exercisable for a term of 3 years at an exercise price of $1.13 per share, subject to broad-based anti-dilution provisions similar to the provisions set forth in the notes. If the institutional investors convert the notes or exercise the warrants, we will issue shares of our common stock and such issuances will be dilutive to our stockholders. For example, since January 2006, we have issued approximately 33.3 million shares of common stock upon conversion of $30.0 million principal amount of notes and approximately 1.2 million shares upon exercise of warrants. If the institutional investors were to convert the remaining unconverted notes in full at the current conversion price we would be obligated to issue an additional 5.6 million shares of common stock, and if such investors were to exercise the warrants in full at the current exercise price we would be obligated to issue 8.3 million shares of common stock, for an aggregate of 13.9 million shares of Avanex common stock. These 13.9 million shares represent approximately 6% of the outstanding shares of common stock (assuming such conversion and exercise) as of January 31, 2007. Because the conversion price of the notes and the exercise price of the warrants may be adjusted from time to time in accordance with the provisions of the notes and the warrants, the number of shares that could actually be issued may be greater than the amount described above. In addition, if such institutional investors or our other stockholders sell substantial amounts of our common stock in the public market during a short period of time, our stock price may decline significantly.

In addition, in March 2006 we issued warrants to purchase initially up to an aggregate of 7.2 million shares of common stock to certain institutional investors that are exercisable for a term of 4 years at an exercise price of $2.73 per share, subject to broad-based anti-dilution provisions. If the institutional investors exercise the warrants, we will issue shares of our common stock and such issuances will be dilutive to our stockholders. Because the exercise price of the warrants may be adjusted from time to time in accordance with the provisions of the warrants, the number of shares that could actually be issued may be greater than the amount described above.

II. Market and Competitive Risks.

Market conditions in the telecommunications industry may significantly harm our financial position.

In the past several years, there has been a significant reduction in spending in the telecommunications industry. Certain large telecommunications companies who were customers or potential customers of ours have suffered severe business setbacks and face uncertain futures. There is currently a perception that an oversupply of communications bandwidth exists. This perceived oversupply, coupled with the current economic environment, may lead to the continuation of lower telecommunications spending, and our customers may continue to cancel, defer or significantly reduce their orders for our products.

We sell our products primarily to a few large customers in the telecommunications industry. Four customers (including sales to their contract manufacturers) accounted for an aggregate of 27%, 21%, 10% and 10% of our net revenue, respectively, for the three months ended December 31, 2006. We expect that the majority of our revenues will continue to depend on

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sales of our products to a small number of customers. If current customers do not continue to place significant orders, or if they cancel or delay current orders, we may not be able to replace those orders. In addition, any negative developments in the business of existing customers could result in significantly decreased sales to these customers, which could seriously harm our revenues and results of operations. We have experienced, and in the future we may experience, losses as a result of the inability to collect accounts receivable, as well as the loss of ongoing business from customers experiencing financial difficulties. If our customers fail to meet their payment obligations, we could experience reduced cash flows and losses in excess of amounts reserved. Because of our reliance on a limited number of customers, any decrease in revenues from, or loss of, one or more of these customers without a corresponding increase in revenues from other customers would harm our operating results.

Except for Alcatel Lucent, our customers are under no obligation to buy significant quantities of our products, and may cancel or delay purchases with minimal advance notice to us.

Our customers typically purchase our products pursuant to individual purchase orders. While we have executed long-term contracts with some of our customers, and may enter into additional long-term contracts with other customers in the future, these contracts do not obligate our customers to buy significant quantities of our products, except for our supply agreement and frame purchase agreement with Alcatel Lucent, which will expire in October 2007. Our customers may cancel, defer or decrease purchases without significant penalty and with little or no advance notice. Further, certain of our customers have a tendency to purchase our products near the end of a fiscal quarter. Cancellation or delays of such orders may cause us to fail to achieve that quarter’s financial and operating goals. Decreases in purchases, cancellations of purchase orders, or deferrals of purchases may significantly harm our business, particularly if they are not anticipated.

We experience intense competition with respect to our products.

We believe that our principal competitors in the optical systems and components industry include Bookham Technology, CyOptics, DiCon Fiberoptics, Eudyna, Finisar, Fujitsu, Furukawa, Hitachi Cable, JDS Uniphase, NEC, Oplink Communications, Opnext, Optium, Intel, and Sumitomo. We may also face competition from companies that expand into our industry in the future.

Some of our competitors have longer operating histories and significantly greater financial, technical, marketing and other resources than we have. As a result, some of these competitors are able to devote greater resources to the development, promotion, sale, and support of their products. In addition, our competitors that have larger market capitalization or cash reserves are better positioned than we are to acquire other companies in order to gain new technologies or products that may displace our product lines. Consolidation in the optical systems and components industry could intensify the competitive pressures that we face because these consolidated competitors may have longer operating histories and significantly greater financial, technical, marketing and other resources than we have.

Some existing customers and potential customers, as well as suppliers and potential suppliers, are also our competitors. These customers and suppliers may develop or acquire additional competitive products or technologies in the future, which may cause them to reduce or cease their purchases from us or their supply to us, as the case may be. Further, these customers may reduce or discontinue purchasing our products if they perceive us as a serious competitive threat with regard to sales of products to their customers. Additionally, suppliers may reduce or discontinue selling materials to us if they perceive us as a serious competitive threat with regard to sales of products to their customers. As a result of these factors, we expect that competitive pressures will intensify and may result in price reductions, reduced margins and loss of market share.

Competition in the optical systems and components industry has contributed to substantial price-driven competition. As a result, sales prices for specific products have decreased over time at varying rates, in some instances significantly. Price pressure is exacerbated by the rapid emergence of new technologies and the evolution of technical standards, which can greatly diminish the value of products relying on older technologies and standards. In addition, the current economic and industry environment in the telecommunications sector has resulted in pressure to reduce prices for our products, and we expect pricing pressure to continue for the foreseeable future, which may continue to adversely affect our operating results. Reduced spending by our customers has caused and may continue to cause increased price competition, resulting in a decline in the prices we charge for our products. If our customers and potential customers continue to constrain their spending, or if the prices we charge continue to decline, our revenues and margins may be adversely affected.

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We will lose market share and may not be successful if our customers do not qualify our products to be designed into their products and systems or if our customers significantly delay purchasing our products.

In the telecommunications industry, service providers and optical systems manufacturers often undertake extensive qualification processes prior to placing orders for large quantities of products such as ours, because these products must function as part of a larger system or network. Once they decide to use a particular supplier’s product or component, these potential customers design the product into their system, which is known as a “design-in” win. Suppliers whose products or components are not designed in are unlikely to make sales to that company until the adoption of a future redesigned system at the earliest, which could occur several years after the last design-in win. If we fail to achieve design-in wins in potential customers’ qualification processes, we may lose the opportunity for significant sales to such customers for a lengthy period of time.

The long sales cycles for sales of our products to customers may cause operating results to vary from quarter to quarter, which could continue to cause volatility in our stock price, and may prevent us from achieving profitability.

The period of time between our initial contact with certain of our customers and the receipt of an actual purchase order from such customers often spans a time period of six to nine months, and sometimes longer. During this time, customers may perform, or require us to perform, extensive and lengthy evaluation and testing of our products and our manufacturing processes before purchasing our products. While our customers are evaluating our products before they place an order with us, we may incur substantial sales and marketing and research and development expenses, expend significant management efforts, increase manufacturing capacity and order long-lead-time supplies. For example, one of our largest customers required us to perform extensive and lengthy evaluation and testing of a proposed product. After such extensive work, we failed to be designed-in for that product. If we increase capacity and order supplies in anticipation of an order that does not materialize, our gross margins will decline and we will have to carry and write off excess inventory. Even if we receive an order, if we are required to add additional manufacturing capacity in order to service the customer’s requirements, such manufacturing capacity may be underutilized in a subsequent quarter, especially if an order is delayed or cancelled. Either situation could cause our results of operations to be below the expectations of investors or public market analysts, which could, in turn, cause the price of our common stock to decline.

If the communications industry does not continue to evolve and grow steadily, our business may not succeed.

Future demand for our products is uncertain and will depend to a great degree on the speed of the widespread adoption of optical networks. If the transition occurs too slowly or ceases altogether, the market for our products and the growth of our business will be significantly limited.

Our future success depends on the continued growth and success of the telecommunications industry, including the continued growth of the Internet as a widely used medium for commerce and communication and the continuing demand for increased bandwidth over communications networks. If the Internet does not continue to expand as a widespread communication medium and commercial marketplace, the need for significantly increased bandwidth across networks and the market for optical transmission products may not develop. As a result, it would be unlikely that our products would achieve commercial success.

The rate at which telecommunications service providers and other optical network users have built new optical networks or installed new systems in their existing optical networks has fluctuated in the past, and these fluctuations may continue in the future. Sales of our components depend on sales of fiber optic telecommunications systems by our systems-level customers, which are shipped in quantity when telecommunications service providers add capacity. Systems manufacturers compete for sales in each capacity deployment. If systems manufacturers that use our products in their systems do not win a contract, their demand for our products will decline, reducing our future revenues. Similarly, a telecommunications service provider’s delay in selecting systems manufacturers for a deployment could delay our shipments and revenues.

III. Acquisition Risks.

Acquisitions and investments may adversely affect our business.

We regularly review acquisition and investment prospects that would complement our existing product offerings, augment our market coverage, secure supplies of critical materials or enhance our technological capabilities. Acquisitions or investments have resulted in, and in the future could result in, a number of financial consequences, including without limitation:

•

potentially dilutive issuances of equity securities;

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•

reduced cash balances and related interest income;

•

higher fixed expenses, which require a higher level of revenues to maintain gross margins;

•

the incurrence of debt and contingent liabilities;

•

restructuring actions, which could result in charges that have a material effect on our results of operations and our financial position;

•

loss of customers, suppliers, distributors, licensors or employees of the acquired company;

•

amortization expenses related to intangible assets; and

•

one-time write-offs of large amounts.

Acquisitions may involve numerous other risks, such as integration and operational risks. In addition, to the extent that any potential acquisitions are not completed, we are required to expense the frequently significant legal, accounting, consulting and other costs of pursuing these transactions in the period in which the activity ceases, which could adversely affect our operating results and may not be anticipated.

IV. Operations and Research and Development Risks.

We have a limited operating history, which makes it difficult to evaluate our prospects and our operations.

We are in the optical systems and components industry. We were first incorporated in October 1997. Because of our limited operating history, we have limited insight into trends that may emerge in our industry and affect our business. The revenue and income potential of the optical systems and components industry, and our business in particular, are unproven. As a result of our limited operating history, we have limited financial data that can be used to evaluate our business. Our prospects must be considered in light of the risks, expenses and challenges we might encounter because we are in a new and rapidly evolving industry.

We face various risks related to our manufacturing operations that may adversely affect our business.

We may experience delays, disruptions or quality control problems in our manufacturing operations or the manufacturing operations of our third party manufacturers, and, as a result, product shipments to our customers could be delayed beyond the shipment schedules requested by our customers, which would negatively affect our business. Furthermore, even if we are able to timely deliver products to our customers, we may be unable to recognize revenue because of our revenue recognition policies. In the past, we have experienced disruptions in the manufacture of some of our products due to changes in our manufacturing processes, which resulted in reduced manufacturing yields, delays in the shipment of our products and deferral of revenue recognition. Any disruptions in the future could adversely affect our revenues, gross margins and results of operations. Changes in our manufacturing processes or those of our third party manufacturers, or the inadvertent use of defective materials by our third party manufacturers or us, could significantly reduce our manufacturing yields and product reliability. Lower than expected manufacturing yields could delay product shipments and further impair our gross margins. These operational issues included capacity constraints at our contract manufacturers, raw materials shortages, logistics issues and manufacturing yield issues for some of our new products.

We may need to develop new manufacturing processes and techniques that will involve higher levels of automation to improve our gross margins and achieve the targeted cost levels of our customers. If we fail to effectively manage this process or if we experience delays, disruptions or quality control problems in our manufacturing operations, our shipments of products to our customers could be delayed.

We face risks related to our concentration of research and development efforts on a limited number of key industry standards and technologies, and our future success depends on our ability to develop and successfully introduce new and enhanced products that meet the needs of our customers in a timely manner.

In the past, we have concentrated our research and development efforts on a limited number of technologies that we believed had the best growth prospects. If we are unable to develop commercially viable products using these technologies, or these technologies do not become generally accepted, our business will likely suffer.

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The markets for our products are characterized by rapid technological change, frequent new product introduction, changes in customer requirements, and evolving industry standards. Our future performance will depend upon the successful development, introduction and market acceptance of new and enhanced products that address these changes. We may not be able to develop the underlying core technologies necessary to create new or enhanced products, or to license or otherwise acquire these technologies from third parties. Product development delays may result from numerous factors, including:

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changing product specifications and customer requirements;

•

difficulties in hiring and retaining necessary technical personnel;

•

difficulties in reallocating engineering resources and overcoming resource limitations;

•

changing market or competitive product requirements;

•

unanticipated engineering complexities, and

•

failure to compete with new product releases by our competitors.

Our industry has increased its focus on products that transmit voice, video and data traffic over shorter distances and are offered at lower cost than the products that we offer to our telecommunications customers for transmission of information over longer distances. If we are unable to develop products that meet the requirements of potential customers of these products, our business will suffer.

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. We cannot assure that we will be able to identify, develop, manufacture, market or support new or enhanced products successfully, or on a timely basis. In addition, the introduction of new and enhanced products may cause our customers to defer or cancel orders for existing products. To the extent customers defer or cancel orders for existing products due to the expectation of a new product release or if there is any delay in development or introduction of our new products or enhancements of our products, our operating results would suffer. Further, we cannot assure that our new products will gain market acceptance or that we will be able to respond effectively to competitive products, technological changes or emerging industry standards. Any failure to respond to technological change would significantly harm our business.

If we are unable to forecast component and material requirements accurately or if we are unable to commit to deliver sufficient quantities of our products to satisfy customers’ needs, our results of operations will be adversely affected.

Our customers typically require us to commit to delivering certain quantities of our products to them (in guaranteed safety stock, guaranteed capacity or otherwise) without committing themselves to purchase such products, or any quantity of such products. Therefore, wide variations between estimates of our customers’ needs and their actual purchases may result in:

•

a surplus and potential obsolescence of inventory, materials and capacity, if estimates of our customers’ requirements are greater than our customers’ actual need; or

•

a lack of sufficient products to satisfy our customers’ needs, if estimates of our customers’ requirements are less than our customers’ actual needs.

We use a rolling three-month to twelve-month demand forecast based on anticipated and historical product orders to determine our component and material requirements. In addition, due to increased outsourcing, our procurement lead times have lengthened, which can result in higher inventory levels and greater risk of excess and obsolete inventory. 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. It is very difficult to develop accurate forecasts of product demand, especially given the current uncertain conditions in the telecommunications industry. Order cancellations and lower order volumes by our customers have in the past created excess inventories. For example, the inventory write-offs taken in the years ended, June 30, 2006, June 30, 2005, and June 30, 2004, were primarily the result of our inability to anticipate decreases in demand for certain of our products and variations in product mix ordered by our customers. For the three months and six months ended December 31, 2006, we recorded write-downs of $3.4 million and $6.9 million, respectively, for excess and obsolete

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inventory. If we fail to accurately predict both the demand for our products and the lead times required to obtain the necessary components and materials in the future, we could incur additional excess and obsolete inventory write-offs. 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 affect our results of operations.

Network carriers and telecommunication system integrators historically have required that suppliers commit to provide specified quantities of products over a given period of time. If we are unable to commit to deliver sufficient quantities of our products to satisfy a customer’s anticipated needs, we may lose the opportunity to make significant sales to that customer over a lengthy period of time. In addition, we may be unable to pursue large orders if we do not have sufficient manufacturing capacity to enable us to provide customers with specified quantities of products. If we cannot deliver sufficient quantities of our products, we may lose business, which could adversely impact our business, financial condition, and results of operations.

If our customers do not qualify our manufacturing processes they may not purchase our products, and our operating results could suffer.

Certain of our customers will not purchase our products prior to qualification of our manufacturing processes and approval of our quality assurance system. The qualification process determines whether the manufacturing line meets the quality, performance and reliability standards of our customers. These customers may also require that we, and any manufacturer that we may use, be registered under international quality standards, such as ISO 9001. In August 2000, we successfully passed the ISO 9001 registration audit and received formal registration of our quality assurance system at our Fremont California facility, and we have passed subsequent reviews as well. In addition, in fiscal year 2006 our Bangkok, Shanghai, Nozay, San Donato and New York sites obtained TL-9000 certification. Delays in obtaining customer qualification of our manufacturing processes or approval of our quality assurance system may cause a product to be removed from a long-term supply program and result in significant lost revenue opportunity over the term of that program.

We depend upon a limited number of contract manufacturers to manufacture a majority of our products, and our dependence on these manufacturers may result in product delivery delays, may harm our operations or have an adverse effect upon our business.

We rely on a limited number of outsourced manufacturers to manufacture a substantial majority of our components, subassemblies and finished products. In particular, one contract manufacturer, Fabrinet, currently manufactures products the sale of which constitutes a significant majority of our net revenue. We intend to develop further our relationships with these manufacturers so that they will eventually manufacture many of our high volume key components and subassemblies, and possibly a substantial portion of our finished products, in the future. The qualification of these independent manufacturers under quality assurance standards is an expensive and time-consuming process. Our independent manufacturers have a limited history of manufacturing optical subcomponents, and have no history of manufacturing our products on a turnkey basis. Any interruption in the operations of these manufacturers, or any deficiency in the quality or quantity of the subcomponents or products built for us by these manufacturers, could impede our ability to meet our scheduled product deliveries to our customers. Operational issues could result such as capacity constraints at our contract manufacturers, raw materials shortages, logistics issues and manufacturing yield issues for some of our new products. As a result, we may lose existing or potential customers.

We have limited experience in working with outsourced manufacturers, and do not have contracts in place with many of these manufacturers. As a result, we may not be able to effectively manage our relationships with these manufacturers. If we cannot effectively manage our manufacturing relationships, or if these manufacturers fail to deliver components in a timely manner, we could experience significant delays in product deliveries, which may have an adverse effect on our business and results of operations. Increased reliance on outsourced manufacturing, and the ultimate disposition of our manufacturing capacity in the future, may result in impairment expense relating to our long-lived assets in future periods, which would have an adverse impact on our business, financial condition and results of operations. In addition, for a period of time as we transfer production of certain products to these third party manufacturers and as our customers qualify such third party manufacturers, we incur fixed and variable costs at both locations.

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Our products may have defects that are not detected until full deployment of a customer’s network, which could result in a loss of customers and revenue and damage to our reputation.

Our products are designed to be deployed in large and complex optical networks and must be compatible with existing and future components of such networks. Our products can only be fully tested for reliability when deployed in networks for long periods of time. Our products may not operate as expected, and our customers may discover errors, defects, or incompatibilities in our products only after they have been fully deployed and are operating under peak stress conditions. If we are unable to fix errors or other problems, we could experience:

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loss of customers or customer orders;

•

loss of or delay in revenues;

•

loss of market share;

•

loss or damage to our brand and reputation;

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inability to attract new customers or achieve market acceptance;

•

diversion of development resources;

•

increased service and warranty costs;

•

legal actions by our customers; and

•

increased insurance costs.

We may be required to indemnify our customers against certain liabilities arising from defects in our products, which liabilities may also include the following costs and expenses:

•

costs and expenses incurred by our customers or their customers to fix the problems; or

•

costs and expenses incurred by our customers or their customers to replace our products, or their products which incorporate our products, with other product solutions.

While we carry insurance policies covering this type of liability, these policies may not provide sufficient protection should a claim be asserted. To date, product defects have not had a material negative effect on our business, financial condition or results of operations; however, we cannot be certain that they will not have a material negative effect on us in the future.

We depend on key personnel to manage our business effectively, and if we are unable to hire, retain, or motivate qualified personnel, our ability to sell our products could be harmed.

Our future success depends, in part, on certain key employees and on our ability to attract and retain highly skilled personnel. We recently hired a new Senior Vice President and Chief Financial Officer and a new Senior Vice President of Manufacturing and Operations. In addition, we recently made other significant changes in our executive management teams, and there can be no assurance that these changes will be successful. The loss of the services of any of our key personnel, the inability to attract or retain qualified personnel, or delays in hiring required personnel, particularly engineering, sales or marketing personnel, may seriously harm our business, financial condition and results of operations. None of our officers or key employees has an employment agreement for a specific term, and these employees may terminate their employment at any time. For example, several of our executive officers left Avanex since the beginning of fiscal 2005, including three chief financial officers, our vice president of sales and our chief operating officer. We do not have key person life insurance policies covering any of our employees. Our ability to continue to attract and retain highly skilled personnel will be a critical factor in determining whether we will be successful in the future. Competition for highly skilled personnel is frequently intense, especially in the San Francisco Bay Area. We may not be successful in attracting, assimilating or retaining qualified personnel to fulfill our current or future needs.

In addition, we implemented restructuring programs designed to attempt to improve our financial performance. Among other things, we moved substantially all of our manufacturing operations to lower cost locations. As a result, our headcount in the United States and Europe has been substantially reduced and may be reduced further in the future. To date, such actions have not resulted in substantial work stoppages. Decreases in labor productivity, however, whether formalized by a work stoppage, or strike, or decreased productivity due to morale issues could have an adverse effect on our business and operating results.

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We face various risks that could prevent us from successfully manufacturing, marketing and distributing our products internationally.

As a result of the opening of our operations center in Thailand and our research and development office in Shanghai, we expanded our international operations, including expansion of overseas product manufacturing, and we may continue to expand internationally in the future. Further, we have increased international sales and intend to further increase our international sales and the number of our international customers. We have also initiated significant restructuring programs overseas, and may initiate additional restructuring programs overseas in the future. Our international operations have required and will continue to require significant management attention and financial resources. For instance, we have incurred, and may continue to incur, startup costs to open our operations center in Thailand and our research and development office in Shanghai, and may incur costs in transferring operations to Thailand. We may not be able to maintain international demand for our products. We currently have limited experience in manufacturing, marketing and distributing our products internationally, particularly from our new operations center in Thailand. In addition, international operations are subject to inherent risks, including, without limitation, the following:

•

greater difficulty in accounts receivable collection and longer collection periods;

•

difficulties inherent in managing operations and employees in remote foreign operations;

•

difficulties and costs of staffing and managing foreign operations with personnel who have expertise in optics;

•

import or export licensing and product certification requirements;

•

tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries;

•

potential adverse tax consequences;

•

seasonal reductions in business activity in some parts of the world;

•

burdens of complying with a wide variety of foreign laws and regulations, particularly with respect to taxes, intellectual property, license requirements, employment matters and environmental requirements;

•

the impact of recessions in economies outside of the United States;

•

unexpected changes in regulatory or certification requirements for optical systems or networks; and

•

political and economic instability, terrorism and war.

Historically our international revenues and expenses have been denominated predominantly in U.S. dollars; however, as a result of the acquisitions of the optical components businesses of Alcatel Lucent and Corning, a portion of our international revenues and expenses are now denominated in foreign currencies. Therefore, fluctuations in the value of foreign currencies could have a negative impact on the profitability of our global operations, which would seriously harm our business, financial condition and results of operations.

V. Intellectual Property and Litigation Risks.

Current and future litigation against us could be costly and time consuming to defend.

We are regularly subject to legal proceedings and claims that arise in the ordinary course of business. Litigation may result in substantial costs and may divert management’s attention and resources, which may seriously harm our business, financial condition, results of operations and cash flows.

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We may be unable to protect our proprietary technology, which could significantly impair our ability to compete.

We rely on a combination of patent, copyright, trademark and trade secret laws, confidentiality agreements and other contractual restrictions on disclosure to protect our intellectual property rights. We also rely on confidentiality agreements with our employees, consultants and corporate partners, and controlled access to and distribution of our technology, documentation and other confidential information. We have numerous patents issued or applied for in the United States and abroad, of which some may be jointly filed or owned with other parties. Further, we license certain intellectual property from third parties, including Alcatel Lucent and Corning, that is critical to our business, and we also license intellectual property to other parties. We cannot assure you that any patent applications or issued patents will protect our proprietary technology, or that any patent applications or patents issued will not be challenged by third parties. Further, we cannot assure you that parties from whom we license intellectual property will not violate their agreements with us; that their patent applications, patents and other intellectual property will protect our technology, products and business; or that their patent applications, patents and other intellectual property will not be challenged by third parties. Our intellectual property also consists of trade secrets, requiring more monitoring and control mechanisms to protect. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our products is difficult, and we cannot be certain that the steps we take will prevent misappropriation or unauthorized use of our technology. Further, other parties may independently develop similar or competing technology or design around any patents that may be issued or licensed to us.

We use various methods to attempt to protect our intellectual property rights. However, we cannot be certain that the steps we have taken will prevent the misappropriation of our intellectual property. In particular, the laws in foreign countries may not protect our proprietary rights as fully as the laws in the United States.

We face risks with regard to our third-party intellectual property licenses.

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 a necessary third-party license required to develop new products and product enhancements could require us to substitute technology of lower quality or performance standards, or of greater cost, either of which could prevent us from operating our business. For example, Alcatel Lucent currently holds patent cross licenses with various third parties that may be necessary for us to operate our business. We cannot guarantee that we will be able to obtain these patent licenses from these third parties, or that we will be able to obtain these licenses on favorable terms. If we are not able to obtain licenses from these third parties, then we may be subject to litigation to defend against infringement claims from these third parties. Further, Alcatel Lucent has cross licenses with various third parties, which when combined with their own intellectual property, may permit these thirds parties to compete with us.

We may become subject to litigation or claims from or against third parties regarding intellectual property rights, which could divert resources, cause us to incur significant costs, and restrict our ability to utilize certain technology.

We may become a party to litigation in the future to protect our intellectual property or we may be subject to litigation to defend against infringement claims of others. These claims and any resulting lawsuit, if successful, could subject us to significant liability for damages and invalidation of our proprietary rights. These lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation also could force us to do one or more of the following:

•

stop selling, incorporating or using our products that use the challenged intellectual property;

•

obtain from the owner of the infringed intellectual property right a license to sell or use the relevant technology, which license may not be available on reasonable terms, or at all;

•

redesign the products that use the technology; or

•

indemnify certain customers against intellectual property claims asserted against them.

If we are forced to take any of these actions, our business may be seriously harmed. Although we carry general liability insurance, our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed. We may in the future initiate claims or litigation against third parties for infringement of our proprietary rights in order 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.

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VI. Other Risks.

Our business and future operating results may be adversely affected by events that are outside of our control.

Our business and operating results are vulnerable to interruption by events outside of our control, such as earthquakes, fire, power loss, telecommunications failures and uncertainties arising out of terrorist attacks throughout the world, including the continuation or potential worsening of the current global economic environment, the economic consequences of additional military action and associated political instability, and the effect of heightened security concerns on domestic and international travel and commerce. We cannot be certain that the insurance we maintain against fires, floods and general business interruptions will be adequate to cover our losses for such events in any particular case.

In addition, we handle hazardous materials as part of our manufacturing activities and are subject to a variety of governmental laws and regulations related to the use, storage, recycling, labeling, reporting, treatment, transportation, handling, discharge and disposal of such hazardous materials. Although we believe that our operations conform to presently applicable environmental laws and regulations, we may incur costs in order to comply with current or future environmental laws and regulations, including costs associated with permitting, investigation and remediation of hazardous materials and installation of capital equipment relating to pollution abatement, production modification and/or hazardous materials management. In addition, we currently sell products that incorporate firmware and electronic components. The additional level of complexity created by combining firmware and electronic components with our optical components requires that we comply with additional regulations, both domestically and abroad, related to power consumption, electrical emissions and homologation. Any failure to successfully obtain the necessary permits or comply with the necessary laws and regulations could have a material adverse effect on our operations.

Certain provisions of our certificate of incorporation and bylaws and Delaware law, as well as our 8% senior secured convertible notes, could delay or prevent a change of control of us.

Certain provisions of our certificate of incorporation and bylaws and Delaware law may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions allow us to issue preferred stock with rights senior to those of our common stock and impose various procedural and other requirements that could make it more difficult for our stockholders to effect certain corporate actions.

In addition, Alcatel Lucent owned shares of Avanex common stock representing 14% of the outstanding shares of Avanex common stock as of January 31, 2007. Pursuant to the stockholders’ agreement entered into by Avanex and Alcatel Lucent, Alcatel Lucent is generally required to vote on all matters as recommended by the board of directors of Avanex, except for proposals relating to certain acquisition transactions between Avanex and certain competitors of Alcatel Lucent. The concentration of ownership of our shares of common stock, combined with the voting requirements contained in the stockholders’ agreement, could have the effect of delaying or preventing a change of control or otherwise discourage a potential acquirer from attempting to obtain control of us, unless the transaction is approved by our board of directors.

Finally, certain provisions of our 8% senior secured convertible notes may discourage, delay or prevent a merger or acquisition because, upon a change of control (as defined in the notes), the holders of the notes will have certain redemption rights.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The annual meeting of stockholders was held on November 3, 2006. All matters voted on were approved. The results are as follows:

PROPOSAL I

The following individuals were elected to the Board of Directors to serve a three-year term as Class I directors:


	For	Authority Withheld
Greg Dougherty	174,831,847	6,312,411
Jo S. Major, Jr.	177,584,232	3,560,026

In addition, the terms of office of the following directors continued after the meeting: Vinton Cerf, Joel A. Smith III, and Susan Wang.

PROPOSAL II

The proposal to approve the elimination of the floor price limitations from the anti-dilution provisions of certain warrants to purchase common stock:


For	Against	Abstained	Non Votes
64,128,910	11,992,716	499,158	104,523,474

PROPOSAL III

The proposal to amend the Certificate of Incorporation to increase the number of authorized shares of common stock from 300 million to 450 million:


For	Against	Abstained	Non Votes
165,058,414	15,655,138	430,706	0

PROPOSAL IV

The proposal to approve an amendment to Avanex’s 1999 Director Option Plan to increase the number of shares of common stock underlying the initial option grant for new non-employee directors from 40,000 to 80,000 and to provide for an automatic annual grant of 10,000 restricted stock units to non-employee directors:


For	Against	Abstained	Non Votes
62,422,372	13,822,541	375,871	104,523,474

PROPOSAL V

The proposal to ratify the appointment of Deloitte & Touche LLP as Avanex’s independent registered public accounting firm for the fiscal year ending June 30, 2007:


For	Against	Abstained	Non Votes
179,058,082	1,414,747	671,429	0

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ITEM 5. OTHER INFORMATION

Not applicable.

ITEM 6. EXHIBITS


10.1		Offer of Employment between Marla Sanchez and the Registrant, effective October 27, 2006.

10.2		1999 Director Option Plan (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed November 9, 2006).

10.3		Form of Restricted Stock Unit Agreement Under 1999 Director Option Plan (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed November 15, 2006).

10.4		Amendment of Warrants (incorporated by reference to Item 1.01 to the Registrant’s Current Report on Form 8-K filed November 9, 2006).

31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


AVANEX CORPORATION (Registrant)

By:		/s/ MARLA SANCHEZ
		Marla Sanchez Senior Vice President and Chief Financial Officer (Duly Authorized Officer and Principal Financial Officer)
Date:		February 6, 2007

By:		/s/ A.A. RILEY
		A.A. Riley Vice President Finance (Principal Accounting Officer)
Date:		February 6, 2007

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. freshman Good

Avanex (AVNX) Inactive 10-Q2007 Q2 Quarterly report

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