Optelecom-nkf (OPTC) 10-Q 2006 Q1 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

For Quarterly Period Ended March 31, 2006
Commission File No. 0-8828

OPTELECOM-NKF, INC.

(Exact Name of Registrant as
Specified in its Charter)

DELAWARE
(State or other jurisdiction of incorporation or organization)

52-1010850
(IRS employer identification number)

12920 CLOVERLEAF CENTER DRIVE, GERMANTOWN, MARYLAND 20874
(Address of principal executive offices) (Zip code)

Registrant’s telephone number, including area code:(301) 444-2200.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yesþ Noo

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

Large Accelerated Filero      Accelerated Filero      Non-accelerated Filerþ

Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yeso Noþ

At May 9, 2006, the registrant had outstanding 3,479,574 shares of Common Stock, $0.03 Par Value.

OPTELECOM-NKF, INC.

FORM 10-Q

TABLE OF CONTENTS

	PAGE
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)
Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005		3
Consolidated Statements of Income and Comprehensive Income for the three months ended March 31, 2006 and 2005		4
Consolidated Statements of Cash Flows for the three months ended March 31, 2006 and 2005		5
Notes to Consolidated Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		13
Item 3. Quantitative and Qualitative Disclosures About Market Risk		15
Item 4. Controls and Procedures		16
PART II — OTHER INFORMATION		17
Item 1.  Legal Proceedings		17
Item 1.A Risk Factors		17
SIGNATURES		22

2

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements.

OPTELECOM-NKF, INC.

CONSOLIDATED BALANCE SHEETS
AS OF MARCH 31, 2006 and DECEMBER 31, 2005
(Unaudited)

	March 31, 2006				December 31, 2005
ASSETS
CURRENT ASSETS
Cash and cash equivalents	$	2,618,728			$	3,046,353
Accounts and contracts receivable, net of allowance for doubtful accounts of $560,050 and $554,469		7,930,772				6,731,373
Inventories, net		4,322,521				4,212,652
Deferred tax asset—current		516,079				820,830
Prepaid expenses and other current assets		718,501				640,050
Total current assets		16,106,601				15,451,258
Property and equipment, at cost less accumulated depreciation of $5,580,630 and $5,338,966		2,557,724				2,677,865
Deferred tax asset—non-current		939,888				589,010
Intangible assets, net of accumulated amortization of $680,182 and $623,705		7,983,140				7,719,737
Goodwill		12,463,388				12,430,037
Other assets		134,415				—
TOTAL ASSETS	$	40,185,156			$	38,867,907
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES
Accounts payable	$	2,219,000			$	2,235,665
Accrued payroll		1,714,215				1,616,988
Commissions payable		275,990				539,352
Current portion of capitalized leases		72,021				72,021
Current portion of notes payable		1,570,478				1,592,978
Accrued warranty reserve		350,543				308,570
Taxes Payable		710,161				568,147
Other current liabilities		1,009,063				1,393,945
Total current liabilities		7,921,471				8,327,666
Notes payable		15,389,368				15,794,050
Deferred tax liability		2,349,723				2,353,500
Capitalized leases		96,705				115,880
Other liabilities		650,759				523,118
				��
Total liabilities		26,408,026				27,114,214
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS’ EQUITY
Common stock, $0.03 par value—shares authorized, 15,000,000; issued and outstanding, 3,423,468 and 3,301,414 shares as of March 31, 2006 and December 31, 2005, respectively		102,704				99,042
Additional paid-in capital		13,406,237				12,255,978
Accumulated other comprehensive loss		(1,513,023	)			(1,818,350	)
Treasury stock, 162,672 shares, at cost		(1,265,047	)			(1,265,047	)
Retained earnings		3,046,259				2,482,070
Total stockholders’ equity		13,777,130				11,753,693
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	40,185,156			$	38,867,907

     See notes to unaudited condensed consolidated financial statements.

3

OPTELECOM-NKF, INC.

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
FOR THE THREE MONTHS ENDED MARCH 31,
(Unaudited)

	2006			2005
Revenues	$	9,515,447		$	5,486,914
Cost of goods sold		3,864,403			2,486,247
Gross profit		5,651,044			3,000,667
Operating expenses:
Engineering		1,113,199			564,215
Selling and marketing		1,911,820			1,032,321
General and administrative		1,360,780			1,093,970
Amortization of intangibles		96,485			—
Total operating expenses		4,482,284			2,690,506
Income from operations		1,168,760			310,161
Other income (expense), net		(305,458	)		(90,815	)
Income before income taxes		863,302			219,346
Provision for income taxes		299,113			68,538
Net income	$	564,189		$	150,808
Basic earnings per share	$	0.17		$	0.05
Diluted earnings per share	$	0.16		$	0.05
Weighted average common shares outstanding—basic		3,339,784			3,193,575
Weighted average common shares outstanding—diluted		3,543,450			3,282,336
Net income	$	564,189		$	150,808
Foreign currency translation		305,327			(37,643	)
Comprehensive income	$	869,516		$	113,165

     See notes to unaudited condensed consolidated financial statements.

4

OPTELECOM-NKF, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31,
(Unaudited)

	2006			2005
Cash Flows From Operating Activities:
Net income	$	564,189		$	150,808
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	250,463				144,766
Accounts receivable provision	(5,581		)		(357	)
Change in allowance for inventory obsolescence reserve	(43,974		)		20,628
Stock based compensation	184,843				8,025
Deferred rent	6,752				10,334
Deferred tax asset	(48,595		)		(93,732	)
Change in assets and liabilities:
Accounts and contracts receivable	(1,126,895		)		411,931
Inventories	(122,642		)		(14,849	)
Prepaid expenses and other current assets	(72,452		)		(191,656	)
Other assets	(134,415		)		—
Accounts payable and accrued expenses	(255,407		)		(202,481	)
Other current liabilities	(137,902		)		1,118,563
Net cash (used in) provided by operating activities	(930,454		)		1,361,980
Cash Flows From Investing Activities:
Capital expenditures	(130,108		)		(9,642	)
Goodwill and intangibles	(56,990		)		—
Investment in NKF	—				(16,267,291	)
Net cash used in investing activities	(187,098		)		(16,276,933	)
Cash Flows From Financing Activities:
Borrowings on notes payable	—				14,454,534
Payments on notes payable and capital leases		(469,952	)		—
Proceeds from issuance of common stock	10,576				226,134
Proceeds from exercise of stock options	958,503				91,250
Net cash provided by financing activities	499,127				14,771,918
Effect of exchange rates on cash and cash equivalents	(190,800		)		(37,643	)
Net decrease in cash and cash equivalents	(427,625		)		(180,678	)
Cash and cash equivalents—beginning of period	3,046,353				2,918,959
Cash and cash equivalents—end of period	$	2,618,728		$	2,738,281
Supplemental Disclosures of Cash Flow Information:
Cash paid during the period for interest	$	166,262		$	—
Cash paid during the period for income taxes	$	208,940		$	39,500

     See notes to unaudited condensed consolidated financial statements.

5

OPTELECOM-NKF, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements, including the accounts of Optelecom-NKF, Inc. and its wholly owned subsidiaries (collectively referred to as “we”, “the Company” or the “Registrant”), have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures, normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to those rules, although the Company believes that the disclosures made are adequate to make the information presented not misleading.

     In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments and reclassifications (all of which are of a normal recurring nature) that are necessary for fair presentation for the periods presented. The results for the interim periods presented herein are not necessarily indicative of the results to be expected for future quarters or the fiscal year as a whole. It is suggested that these financial statements be read in conjunction with the financial statements and the notes thereto included in the Company’s latest annual report to the Securities and Exchange Commission on Form 10-K for the year ended December 31, 2005.

2.Acquisition of NKF Electronics

     On March 8, 2005, Optelecom-NKF, Inc. (the “Company”) completed the acquisition of NKF Electronics, B.V. a private company with limited liability, incorporated in the Netherlands (“NKF”), pursuant to the terms and conditions of the Share Purchase Agreement dated March 8, 2005 (the “Purchase Agreement”) by and among the Company, NKF, Draka Holding, N.V., a limited liability company, incorporated in the Netherlands (“Draka”), and NKF Vastgoed B.V., a private company with limited liability, incorporated in the Netherlands, a direct wholly-owned subsidiary of Draka (“Vastgoed” together with Draka – the “Sellers”). NKF, which is included exclusively in the Communication Products Division(CPD), focuses on business opportunities in the worldwide optical communication equipment marketplace. The acquisition was undertaken to give the Company a strong position in this market through expanded and diversified revenue streams, enhanced research and development capabilities, and a more extensive sales and service organization, addressing the world-wide marketplace for the products of both companies.

     The acquisition was accounted for using the purchase method of accounting, as required by Statement of Financial Accounting Standard No. 141, “Business Combinations” and has been included in the operations of the Company since the date of acquisition. Unaudited pro forma results of operations are as follows. The amounts are shown as if the acquisition had occurred at the beginning of the three month periods ended March 31, 2005:

	March 31, 2005
Proforma revenues ($000’s)	$	8,220
Proforma net income ($000’s)	$	25
Proforma earnings per share – basic	$	0.01
Proforma earning per share – diluted	$	0.01

     This information is not necessarily indicative of the operational results that would have occurred if the acquisition had been consummated on the dates indicated nor is it necessarily indicative of future operating results or financial position of the combined enterprise. The unaudited proforma combined condensed financial information does not reflect any adjustments to conform accounting practices or to reflect any cost savings or other synergies anticipated as a result of the acquisition.

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3.Inventories

     Inventories consist of the following:

	March 31, 2006			December 31, 2005
Production materials	$	2,761,499		$	2,573,578
Work in process		467,827			498,885
Finished goods		1,483,392			1,574,360
Allowance for obsolescence		(390,197	)		(434,171	)
Total inventories, net	$	4,322,521		$	4,212,652

4.Notes Payable

     Notes payable consist of the following:

	March 31, 2006			December 31, 2005
Senior term facility with a bank due February 2009	$	8,049,854		$	8,624,848
Subordinated note due March 2010		8,864,992			8,694,680
Other		45,000			67,500
	$	16,959,846		$	17,387,028
Less: Current portion		(1,570,478	)		(1,592,978	)
Total notes payable		15,389,368			15,794,050

     As described above, on March 8, 2005, the Company completed the acquisition of NKF, pursuant to the terms and conditions of the Purchase Agreement. The purchase price for the acquisition, following the final purchase price adjustment, was approximately 18.3 million Euros ($24.4 million USD),which consists of a cash payment of 11 million Euros ($14.5 million USD) and a 6% subordinated note for the remainder.

     The cash portion of the purchase price was funded by a $14.6 million USD senior term facility provided by a Bank, consisting of a 4.1 million Euro based term loan ($5.4 million USD) and a $9.2 million USD based term loan. Both term loans carry interest at the rate of LIBOR plus a margin which can range from 2.25% to 3.25%. The variability in the margin is a function of the Company’s leverage position which is calculated as Total Senior Debt divided by EBITDA. As of March 31, 2006, the interest rate on this facility was 7.94 %. The term loans are subject to a seventy two month amortization which is payable over four years with a balloon payment due in month 48. Principal and interest are payable on a monthly basis.

     The subordinated note accrues interest at a rate of 6% per annum and is due and payable in full on March 8, 2010.

     As of March 31, 2006, the Company has a bank revolving line-of-credit provided under its current banking facility. This facility allows the Company to borrow in either USD or Euros with a maximum amount not to exceed $5 million USD. The Company’s borrowing base under the facility is equal to between 60% — 85% of the eligible commercial billed accounts receivable and 30% of eligible related inventory.

     The revolving line-of-credit carries interest at the rate of LIBOR plus a margin which can range from 1.75% to 2.75%, depending on the Company’s leverage position. As of March 31, 2006, the Company had no borrowings outstanding on its bank line-of-credit.

     The Company is required to comply with certain financial ratios including maintaining a minimum current ratio, a maximum debt to worth ratio, a maximum funded debt to EBITDA ratio and a maximum tangible net worth ratio. The Company was in compliance with all of these covenants at March 31, 2006.

7

5.Earnings Per Share

     Basic earnings per share is computed using the weighted average number of common shares outstanding. Diluted earnings per share is computed using the weighted average number of shares outstanding and the treasury stock computation method for stock options and warrants, provided they are not antidilutive. The following is a reconciliation of the basic and diluted earnings per share:

	Three Months Ended March 31,
	2006		2005
Basic Earnings per Share:
Net income	$	564,189	$	150,808
Weighted average common shares — basic		3,339,784		3,193,575
Basic earnings per share	$	0.17	$	0.05
Diluted Earnings per Share:
Net income	$	564,189	$	150,808
Weighted average common shares — basic		3,339,784		3,193,575
Assumed conversion of:
Stock options		203,666		88,761
Weighted average common shares — diluted		3,543,450		3,282,336
Diluted earnings per share	$	0.16	$	0.05

6.Share-based Compensation

     On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004),Share-based Payment(SFAS 123R), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. The Company adopted SFAS 123R using the modified prospective transition method, thereby recognizing compensation costs in its operating results for the three months ended March 31, 2006 for all awards granted after January 1, 2006 and for all existing awards for which the requisite service was not rendered as January 1, 2006. In accordance with the modified prospective transition method, the Company’s prior period operating results have not been restated to reflect the impact of SFAS 123R. Share-based compensation expense recognized under SFAS 123R for the three months ended March 31, 2006 was $174,443 or $0.05 for both basic and diluted earnings per share. As of March 31, 2006, total unamortized compensation expense related to non-vested share-based compensation was $779,037 and is expected to be recognized over a weighted period of three years.

     Prior to the adoption of SFAS 123R, the Company accounted for share-based awards in accordance with Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, (APB 25) and related interpretations, which provided that the compensation expense relative to the Company’s employee stock options be measured based on the intrinsic value of the stock option. Under the intrinsic value method, no share-based compensation expense had been recognized in the Company’s operating results because the exercise price of the Company’s stock options granted to employees and directors equaled the fair market value of the underlying stock at the date of grant. In accordance with Statement of Financial Accounting Standards No. 123,Accounting for Stock-Based Compensation(SFAS 123) and Statement of Financial Accounting Standards No. 148,Accounting for Stock-Based Compensation-Transition and Disclosure (SFAS 148), the Company provided pro forma information regarding net earnings and net earnings per share as if compensation costs for the Company’s share-based awards had been determined in accordance with the fair value method prescribed therein.

8

     The following table illustrates the effect on net income and net earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation for the three months ended March 31, 2005:

	Three Months
	Ended March 31,
	2005
Net income, as reported	$	150,808
Less: Stock-based employee compensation costs, net of income tax, as if fair value method had been applied		(249,174	)
Net loss, pro forma	$	(98,366	)
Net earnings (loss) per share:
Basic, as reported	$	0.05
Basic, pro-forma	$	(0.03	)
Diluted, as reported	$	0.05
Diluted, pro-forma	$	(0.03	)

Stock Option Plans

     The 2002 Incentive Stock Option Plan provides for up to 776,600 shares available for grant. The options may be granted to officers (including officers who are directors), other key employees and consultants to the Company. There were 293,205 options available for future grant at March 31, 2006. The exercise price of each option is the fair market value of the stock at the grant date. Options are 25% exercisable at the grant date, 75% exercisable one year from the grant date and fully exercisable two years from the grant date. Options expire five years from the date of grant and, in most cases, upon termination of employment.

     A summary of stock option activity for the Incentive Stock Option Plan during the three months ended March 31, 2006 and 2005 is as follows:

	2006					2005
				Weighted					Weighted
				Average					Average
				Exercise					Exercise
	Shares			Price		Shares			Price
Outstanding, January 1		381,766		$	8.27		301,326		$	6.88
Granted		48,376			14.09		109,972			9.05
Exercised		(103,033	)		8.26		(18,825	)		4.85
Canceled		(2,150	)		5.35		(8,775	)		13.07
Outstanding, March 31		324,959		$	9.16		383,698		$	7.46
Exercisable options, March 31		211,950		$	8.03		252,017		$	6.76

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     The following table summarizes information about stock options outstanding at March 31, 2006 under this plan:

	Options Outstanding						Options Exercisable
			Weighted		Weighted				Weighted
			average		average				average
	Number		remaining		exercise		Number		exercise
Range of exercise price	outstanding		life in years		price		exercisable		price
$1.44 to $8.99		66,400		1.56	$	4.13		65,125	$	4.09
$9.05 to $9.05		74,041		3.77		9.05		49,817		9.05
$9.15 to $9.17		475		3.51		9.15		300		9.15
$9.19 and above		184,043		3.78		11.02		96,708		10.15
		324,959		3.32	$	9.16		211,950	$	8.03

     The 2001 Nonqualified Director Stock Option Plan provides for up to 88,000 shares available for grant. Under this plan, each non-employee director who attends a Board of Directors meeting is granted an option to purchase 1,000 shares of common stock at fair market value on the date of such Board meeting. The options are exercisable upon grant and expire five years thereafter. There were no options available for future grant at March 31, 2006.

     A summary of stock option activity for the Nonqualified Director Stock Option Plan during the three months ended March 31, 2006 and 2005 is as follows:

	2006					2005
				Weighted				Weighted
				Average				Average
				Exercise				Exercise
	Shares			Price		Shares		Price
Outstanding, January 1		84,000		$	9.41		56,000	$	8.77
Granted		4,000			19.24		8,000		8.56
Exercised		(18,077	)		5.94		0		0.00
Canceled		0			0.00		0		0.00
Outstanding, March 31		69,923		$	10.87		64,000	$	8.74
Exercisable options, March 31		69,923		$	10.87		64,000	$	8.74

     The following table summarizes information about stock options outstanding at March 31, 2006 under this plan:

	Options Outstanding						Options Exercisable
			Weighted		Weighted				Weighted
			average		average				average
	Number		remaining		exercise		Number		exercise
Range of exercise price	outstanding		life in years		price		exercisable		price
$2.41 to $8.72		9,500		3.66	$	8.57		9,500	$	8.57
$8.81 to $10.00		21,000		3.60		9.42		21,000		9.42
$10.20 to $10.82		22,000		3.36		10.44		22,000		10.44
$11.50 and above		17,423		4.06		14.40		17,423		14.40
		69,923		3.65	$	10.87		69,923	$	10.87

     The weighted average fair value of stock options granted under these plans during the three months ended March 31, 2006 and 2005 was $15.19 and $9.02, respectively. The total intrinsic value of stock options exercised during the three months ended March 31, 2006 and 2005 was $1.6 million and $88.8 thousand, respectively.

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7.Income Taxes

     During the three months ended March 31, 2006, stock options for the purchase of 121,110 shares of common stock were exercised. The exercise of these stock options generated an income tax deduction equal to the excess of the fair market value over the exercise price of $1,376,000. In accordance with SFAS 123(R) the Company will not recognize a deferred tax asset with respect to the excess stock compensation deductions until those deductions actually reduce their income tax liability. As such the Company has not recorded a deferred tax asset of $504,000 related to the net operating losses resulting from the exercise of these stock options in the accompanying financial statements. At such time the Company utilizes these net operating losses to reduce income tax payable, the tax benefit will be recorded as an increase to additional paid in capital.

8.Business Unit Information

     The Company manages its operations in two segments: the Communication Products Division (CPD) which develops, manufactures and sells optical fiber-based data communications equipment to both commercial and government customers; and the Electro-Optics (EO) Technology Unit which is focused on Interferometric Fiber Optic Gyro coils and the manufacture of innovative optical devices under contract, primarily to government and defense industry customers. Revenues represent shipments and services provided to third parties. Contract costs and operating expenses directly traceable to individual segments were deducted from revenues to arrive at income from operations. Identifiable assets by segment are those assets that are used in the Company’s operations in each segment.

	Quarter Ended March 31, 2006
	Communication		Electro -Optics
	Products		Technology
	Division		Unit			Total
Revenues	$	9,350,871	$	164,576		$	9,515,447
Depreciation and amortization		250,463		—			250,463
Income (loss) from operations		1,176,293		(7,533	)		1,168,760
Assets		39,954,956		230,200			40,185,156
Capital expenditures		130,108		—			130,108

	Quarter Ended March 31, 2005
	Communication		Electro -Optics
	Products		Technology
	Division		Unit			Total
Revenues	$	5,279,871	$	207,043		$	5,486,914
Depreciation and amortization		144,766		—			144,766
Income from operations		343,032		(32,871	)		310,161
Assets		39,581,782		143,644			39,725,426
Capital expenditures		36,426		—			36,426

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     Information regarding the Company’s domestic and foreign operations as follows (in 000’s):

	Quarter Ended March 31, 2006				Quarter Ended March 31, 2005
			Long Lived				Long Lived
	Revenues		Assets		Revenues		Assets
United States	$	2,912	$	3,207	$	2,379	$	2,201
Netherlands		789		21,459		391		20,521
Spain		247		24		496		36
United Kingdom		1,463		2		1,190		17
Other		4,104		22		1,031		12
Total	$	9,515	$	24,714	$	5,487	$	22,787

     We believe the increase in most worldwide regions is a direct result of the synergies created through the NKF acquisition. We believe this acquisition has positioned us as a leading world-wide independent producer of fiber optic-based communications solutions for video surveillance, traffic monitoring, and business video systems, and has resulted in expanded and diversified revenue streams and a more extensive sales and service organization.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

          The statements contained in this Quarterly Report on Form 10-Q that are not purely historical should be considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 and Section 21E of the Securities Exchange Act of 1934, including, without limitations, statements regarding the Company’s expectations, hopes, beliefs, anticipations, commitments, intentions and strategies regarding the future. Forward-looking statements include, but are not limited to, statements contained in “Item 2- Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s business and strategies, product markets, sales, marketing, customer support and service, research and development, manufacturing, competition, backlog, employees, financial performance, revenue and expense levels in the future and the sufficiency of our existing assets to fund future operations and capital spending needs. Actual results could differ from those projected in any forward-looking statements for the reasons, among others, detailed under “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. The fact that some of the risk factors may be the same or similar to the Company’s past filings means only that the risks are present in multiple periods. We believe that many of the risks detailed in our filings are part of doing business in the industry in which we compete and will likely be present in all periods reported. The fact that certain risks are endemic to the industry does not lessen the significance of the risk. The 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 should be read in conjunction with the Financial Statements and Notes thereto.

OVERVIEW

          The Company currently maintains its corporate offices in the Germantown, Maryland, manufacturing facilities and sales offices both in the U.S. and the Netherlands along with additional sales offices in England, Spain, France and Singapore. The Company manages its operations under two business segments: the Communication Products Division (CPD) and the Electro-optics Technology unit (EO).

          The Communication Products Division is focused on the development, manufacture and sale of optical fiber-based data communication equipment and IP(Internet Protocol)/Ethernet-based products to both commercial and government clients worldwide. The Electro-optics Technology unit develops and manufactures innovative optical devices under contract, primarily to government and defense industry customers.

          Fiber optic communications equipment is the main element of the Company’s product offerings. Technology development is constantly and rapidly improving the capability to transmit at increasing data rates over ever greater distances with fiber-based communication systems and, in our markets of security/surveillance and Intelligent Transportation Systems, a fairly rapid transition to video communication systems based on IP/Ethernet network technology is occurring. We believe we are well-positioned to participate in this market transition, with a strong and growing product suite that will address the full range of IP/Ethernet applications.

          In the Electro-optics Technology unit, emphasis has been placed on fabrication of precision-wound coils of optical fiber used as the sensing elements of fiber optic gyroscopes. The Electro-optics unit also produces precision wound coils for applications ranging from optical fiber dispensers used in remote vehicle control systems to precision optical fiber coils for communications systems

     We design, develop, manufacture and market communications systems employing both fiber optic and IP-Ethernet based technology for traffic monitoring, security / surveillance, and business video systems. Over the past two years, we have aggressively pursued several operational objectives including: 1) the expansion of a distribution network both in the United States and abroad; 2) realization of manufacturing and process improvements; 3) development of products with advanced and unique capabilities; and 4) the comprehensive upgrade of our computer networks, operating systems and core financial, sales and manufacturing software platforms.

     Additionally, on March 8, 2005, we completed the acquisition of NKF, which effectively doubled the size of our operations and revenue. We believe this acquisition has resulted in expanded and diversified revenue streams, enhanced research and development capabilities, and a more extensive sales and service organization.

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     We believe the successful execution of these initiatives along with increased demand in our core markets has enabled us to improve significantly our financial condition in the past few years, as evidenced by increasing levels of profitability and positive cash flow. We intend to continue during the remainder of 2006 to work at broadening our sales channels, sustaining gross profit margins and controlling costs.

REVENUES

     Consolidated revenues for the quarter ended March 31, 2006 of $9,515,447 were $4,028,533 or 73% higher than the first quarter of 2005. Revenue for CPD increased by $4,071,000 or 77%. $2.6 million of this increase reflects NKF’s revenue for a full quarter in 2006 versus 23 days of quarter one of 2005. The additional $1.4 million increase is the result of the expansion of our sales network and additional product line offerings. EO unit revenues decreased by $42,467 or 21% primarily as a result of a $71,322 decrease in coil winding revenues and a $28,855 increase in contract services revenues from 2005 to 2006.

Gross Profit

     Consolidated gross profit was $5,651,044 or 59% of revenues for the quarter ended March 31, 2006, compared to $3,000,667 or 55% of revenues for the first quarter of 2005. CPD’s gross profit was $5,658,577 for the first quarter of 2006, compared to $2,990,751 in the first quarter of 2005. Gross profit for CPD as a percent of revenue was 60% and 55%, respectively, for the three months ended March 31, 2006 and 2005. The increase of $2,652,738 or 89% was due primarily to higher sales levels as a result of the purchase of NKF. The gross profit of the EO unit decreased from $9,916 in the first quarter of 2005 to a loss of $7,533 in the first quarter of 2006, primarily as a result of lower coil winding revenues realized in 2006.

OPERATING EXPENSES

     Consolidated operating expenses were $4,482,284 for the quarter ended March 31, 2006 compared to $2,690,506 in 2005. This increase of $1,791,778 or 66% is primarily due to the acquisition of NKF with proportional increases in all individual components of operating expense.

     Engineering expenses increased from $564,215 in the first quarter of 2005 to $1,113,199 for the first quarter of 2006 due primarily to the increase of $517,121 in recognition of a full quarter of NKF engineering expense. Selling and marketing expenses increased from $1,032,321 in the first quarter of 2005 to $1,911,820 for the first quarter of 2006. Of the $879,499 increase over last year, NKF represented $764,272. General and administrative costs increased from $1,093,970 in the first quarter of 2005 to $1,360,780 in the first quarter of 2006. Of the $266,810 increase over prior year, the additional expenses associated with NKF’s represented $260,231. Increases in NKF expenses mentioned herein are primarily the difference between recognition of a full quarter expenses in 2006 vs twenty three days expense in the first quarter of 2005. The Company’s management expects operating expenses to increase as revenues continue to grow and the Company develops and delivers new products to the marketplace.

Other Income (Expense)

Other income (expense), net for the quarters ended March 31, 2006 and 2005 consisted of net interest expense of $282,427 and $90,815, respectively. This increase is attributed to the incurrence of debt related to the acquisition of NKF in March 2005.

Financial Condition

The Company’s stockholders’ equity increased from $11.8 million at December 31, 2005 to $13.7 million at March 31, 2006 due primarily to the recording of net income, the exercise of stock options by employees, the purchase of shares pursuant to the employee stock purchase plan, and the impact of recognizing stock compensation expense for the award of stock options following the adoption of SFAS 123R.

     Other key components of the Company’s financial condition include accounts receivable, inventories, fixed assets and current liabilities. The Company’s current ratio has increased to 2.02 at March 31, 2006 compared to 1.86 at December 31, 2005. This increase is attributed to a significant decrease in other current liabilities resulting from the payment of accrued taxes and accrued commissions, and a $1.2 million increase in accounts receivable.

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     Accounts receivable increased $1.2 million from $6.7 million at December 31, 2005 to $7.9 million at March 31, 2006 primarily due to booking of a large contract in the United Kingdom at the end of the first quarter.

     The inventory increase from $4.2 million at December 31, 2005 to $4.3 million at March 31, 2006 was the result of preparing for anticipated customer needs that did not materialize.

     During the first quarter of 2006 fixed asset additions were $139,000, compared to $10,000 in the first quarter of 2005. During 2006, as the Company’s profitability continued to improve over prior year levels, capital spending has increased in order to improve and expand on engineering and manufacturing capabilities. The Company does not currently have any capital asset purchase commitments.

     The Company’s current liabilities decreased $0.4 million from $8.3 million at December 31, 2005 to $7.9 million at March 31, 2006 primarily as a result of a decrease in accrued expense component of other current liabilities.

LIQUIDITY AND CAPITAL RESOURCES

     Cash used in operating activities was $930,458 for the first three months of 2006, compared to cash provided of $1.4 million in the first three months of the prior year. Our cash from operations is the result of our net income, adjusted for depreciation, amortization and other non-cash items, and changes in our operating assets and liabilities. As noted above, we increased our inventory levels in order to have items on hand to meet the delivery needs of our customers. Should this market continue to increase, we expect to continue to increase inventory levels to meet this need. While the increase in inventories was not the only item that impacted our operating cash flows, it was one significant component.

     Cash used in investing activities was $187,098 million for the first quarter of 2006 and $16.3 million for the same period of 2005. The decrease is primarily attributable to the purchase in March 2005 of NKF discussed above.

     During the first quarter of 2005, financing activities provided $14.8 million in cash compared to $499,127 provided by financing activities during the first three months of 2006. The current year decrease resulted primarily from the borrowings on bank notes and subordinated notes relating to the NKF acquisition in 2005. Additionally, there was a significant increase in the proceeds from the exercise of stock options and common stock issued from the employee stock purchase plan.

     As of March 31, 2006, the Company has a bank revolving line-of-credit provided under its current banking facility. This facility allows the Company to borrow in either USD or Euros with a maximum amount not to exceed $5 million USD. The revolving line-of-credit carries interest at the rate of LIBOR plus a margin which can range from 1.75% to 2.75%, depending on the Company’s leverage position. The Company’s borrowing base under the facility is equal to between 60% — 85% of the eligible commercial billed accounts receivable and 30% of eligible related inventory. As of March 31, 2006, the Company had no borrowings outstanding on its bank line-of-credit.

     Under its banking facility, we are required to comply with certain financial ratios, including maintaining a minimum current ratio, a maximum debt to worth ratio, a maximum funded debt to EBITDA ratio and a maximum tangible net worth ratio. The Company was in compliance with all of these covenants at March 31, 2006.

     Our future working capital needs will be financed by our operating cash flow and, if needed, use of our line-of-credit. In the event that these sources become insufficient to meet funding needs, the Company may be required to scale back or eliminate product research and development and overhead costs. Additionally, the Company would look to increase its line of credit and/or pursue equity financing. The Company’s strategy will focus on identifying new products that meet the demands of our core markets, expanding our distribution channels and implementing processes which will increase manufacturing efficiencies.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

     For quantitative and qualitative disclosures about market risk, see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” of our annual report on Form 10-K for the year ended December 31, 2005, and Part II — Other Information Item 1A. Risk Factors herein. Our exposures to market risk have not changed materially since December 31, 2005.

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Item 4. Controls and Procedures.

Evaluation of disclosure controls and procedures

     As of March 31, 2006, under the direction and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company reviewed and evaluated the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2006.

Changes in internal controls

     In connection with the evaluation by management, including the Chief Executive Officer and Chief Financial Officer, of our internal controls over financial reporting, pursuant to Exchange Act Rule 13a-15(d), no changes during the quarter ended March 31, 2006 were identified that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION

Item 1. Legal Proceedings.

     On August 2, 2005, a legal action was filed in the Circuit Court for Montgomery County, Maryland, by a registered securities broker against the Company and Richard Alpert, its investor relations consultant. The lawsuit arose out of allegedly libelous statements made in connection with a complaint for violations filed at the direction of the Company against the securities dealer with the National Association of Securities Dealers (“NASD”). The plaintiff was seeking $10,000,000 in consequential and punitive damages. The Company vigorously defended the lawsuit. On March 6, 2006, a Motion to Dismiss was granted in favor of the Company dismissing the entire action. The applicable appeal period for the Order granting the Motion to Dismiss has not yet expired. It is the opinion of the Company’s corporate counsel that the lawsuit is frivolous and without legal basis in fact or law. Management has been informed that the chances of a verdict adverse to its interests are minimal and that this legal action should not have any material adverse effect on its business, financial condition or results of operations.

     From time to time, the Company is involved in other legal proceedings and litigation arising in the ordinary course of business. As of the date of this report, except as described above, the Company is not a party to any litigation or other legal proceeding that, in the opinion of management, could have a material adverse effect on the Company’s business, financial condition or results of operations.

Item 1A. Risk Factors.

Fluctuations in financial performance could harm our long-term growth strategy

     The Company has experienced and may, in the future, continue to experience fluctuations in our quarterly and annual operating results. Factors that may cause operating results to vary include, but are not limited to, changing technology, new product transitions, delays in new product introductions, competition, shortages of system components, changes in the mix of products and services sold and timing of investments in additional personnel, facilities and research and development. As a result of the impact of these and other factors, past financial performance should not be considered to be a reliable indicator of the future performance in any particular fiscal period. We are somewhat limited in our ability to reduce expenses quickly in response to any revenue shortfalls. Therefore, the Company’s business, financial condition, and operating results could be adversely affected if increased revenues are not achieved. If we fail to manage or anticipate our future growth effectively our business will suffer

The Company’s sales and dependence on major customers

     For the three months ended March 31, 2006, approximately 24% of our revenues were accounted for by sales to five commercial customers. This is similar to the year ended 2005 when five customers represented 16% of our revenues. In the event of a reduction, delay or cancellation of orders from one or more significant customers or if one or more significant customers selects products from one of our competitors for inclusion in future product generations, our business, financial condition and operating results could be materially and adversely affected. There can be no assurance that current customers will continue to place orders with us, that orders by existing customers will continue at current or historical levels or that we will be able to obtain orders from new customers. The loss of one or more of our current significant customers could materially and adversely affect business, financial condition and operating results.

Any failure to remain competitive would harm Optelecom-NKF’s operating results.

     The markets in which the Company sells its products are highly competitive and characterized by rapidly changing technologies. The Company faces competition from established domestic and international competitors and the threat of future competition from new and emerging companies. To remain competitive in both the current and future business climates, the Company believes it must maintain a substantial commitment to research and development. Our future success will depend in part upon our ability to enhance our current products and to develop and introduce new products that keep pace with technological developments and emerging industry standards and that address the increasingly sophisticated needs of our customers. There can be no assurance that we will be successful in developing and marketing such products or producing enhancements that meet these changing demands, or that we will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these products or that our new products and product enhancements will adequately meet the demands of the marketplace and achieve market acceptance. Our inability to develop and introduce new products or product enhancements in a timely manner or our failure to achieve market acceptance of a new product could have a material adverse effect our business, financial condition and operating results and our efforts to remain competitive.

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Competition

     We face intense and increasing competition from a large number of competitors, some of which are larger than the Company and have larger product development, research and sales staffs. We believe that the products developed in 2004 and 2005 and the products currently being developed will position us to compete effectively through 2006 and well into 2007.

Although Optelecom and NKF expect that the merger will result in benefits, those benefits may not be realized

     Achieving the maximum benefits of our merger with NKF will depend in part on the integration of technology, operations and personnel. The continued integration of Optelecom and NKF will be a complex, time consuming and expensive process and may disrupt the Company’s business if not completed in a timely and efficient manner. The challenges involved in this integration include the following:

• Coordinating manufacturing operations in a rapid and efficient manner;

• Combining product offerings and product lines effectively and quickly;

• Integrating sales efforts so that customers can do business easily with the combined company;

• Bringing together the companies’ marketing efforts so that the industry receives useful information about the merger;

• Coordinating research and development activities to enhance introduction of new products and technologies; and

• Persuading employees that Optelecoms’s and NKF’s business cultures are compatible.

     It is not certain that Optelecom and NKF can be successfully integrated in a timely manner or at all or that any of the anticipated benefits will be realized. Failure to do so could materially harm the business and operating results of the combined company. Also, neither Optelecom nor NKF can assure you that the growth rate of the combined company will equal the historical growth rate experienced by Optelecom and NKF.

     The recent acquisition of NKF also increased the Company’s risks relating to foreign currency risk exposure, increased financing costs as a result of increased borrowings to effectuate the transaction and increased debt. While management believes that the transaction will be accretive, if it is not, we may be required to pursue equity financing to refinance the acquisition debt and enter into foreign currency hedges to reduce the exchange rate risk. Management believes that the individuals that it retained at NKF will continue the successful operations in the future and continue the effective management of NKF.

Optelecom borrowed $23.1 million of senior and subordinated notes in connection with its acquisition of NKF.

     In connection with the acquisition of NKF, the Company borrowed $23.1 million of senior and subordinated notes. The issuance of these notes substantially increased its principal payment obligations and it may not have enough cash to repay the notes when due. By incurring new indebtedness, the related risks that it now faces could intensify. The degree to which it is leveraged could materially and adversely affect its ability to successfully obtain financing for working capital, acquisitions or other purposes and could make it more vulnerable to industry downturns and competitive pressures.

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Future Capital Needs; Uncertainty Of Additional Funding

     We believe that our existing capital resources, including an existing $5,000,000 bank line-of-credit and future operating cash flows, will generate the funds needed for our long-term cash requirements.

     If our growth rate should exceed expectations, or if we should fail to generate the anticipated operating cash flows, we would be required to seek additional funding. In those circumstances, the Company would look to increase its line of credit and/or pursue equity financing. There can be no assurance that additional financing will be available in a timely manner or on acceptable terms. If issuing equity securities raises additional funds, further dilution to existing stockholders will result. If adequate funds are not available when needed, we may be required to delay, scale back or eliminate product research and development and overhead costs.

If the Company fails to attract and retain key personnel, its business could suffer.

     The Company’s future depends, in part, on its ability to attract and retain key personnel. It may not be able to hire and retain such personnel at compensation levels consistent with its existing compensation and salary structure. Its future also depends on the continued contributions of its executive management team and other key management and technical personnel, each of whom would be difficult to replace. The loss of service from these or other executive officers or key personnel or the inability to continue to attract qualified personnel could have a material adverse effect on the Company’s business.

     On March 8, 2005, the Company essentially doubled in size. This event and the Company’s implementation of a new global growth strategy lead to some restructuring within the organization. The Company’s CFO was promoted to Executive Vice President and COO for North American operations and in addition to his new responsibilities will continue to serve as CFO until a replacement is found. The Company also hired a new Vice President of Sales and Marketing. While this restructuring will allow the Company to better align responsibilities and further expand and strengthen the management team, the Company faces general business risks associated with any transition in roles and responsibilities.

Our common stock price is volatile, we have never paid dividends and our stock is subject to future dilution.

     Our Common Stock currently trades on the NASDAQ Small Cap Market. The securities markets have from time-to-time experienced significant price and volume fluctuations that were unrelated to our operating performance. In addition, the market prices of the common stock of many publicly traded technology companies have in the past been, and can in the future be expected to be, especially volatile. Announcements of technological innovations or new products of the Company or our competitors, developments or disputes concerning proprietary rights, publicity regarding products under development by the Company or our competitors, regulatory developments in both the United States and foreign countries, and economic and other external factors, as well as period-to-period fluctuations in our operating and product development results, may have a significant impact on the market price of our Common Stock.

     We have not paid any cash dividends since our inception and we do not anticipate paying any cash dividends in the foreseeable future. In addition, dilution will occur upon the exercise of outstanding stock options. Additionally, further dilution could be significant if we decide to complete a future equity financing if we experience additional requirements to fund operations.

The Company faces risks related to its international operations and revenue.

     The Company’s customers are located throughout the world. In addition, with the acquisition of NKF, it has significant offshore operations, including manufacturing, sales and customer support operations. Its operations outside North America are primarily located in the Netherlands.

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          The Company’s international presence exposes it to certain risks, including the following:

• Its ability to comply with customs, import/export and other trade compliance regulations of the countries in which it does business, together with any unexpected changes in such regulations;

• difficulties in establishing and enforcing its intellectual property rights;

• tariffs and other trade barriers;

• political, legal and economic instability in foreign markets, particularly in those markets in which it maintains manufacturing and research facilities;

• difficulties in staffing and management;

• language and cultural barriers;

• seasonal reductions in business activities in the countries where its international customers are located;

• integration of foreign operations;

• longer payment cycles;

• greater difficulty in accounts receivable collection;

• currency fluctuations; and

• potential adverse tax consequences.

          Net revenue from customers outside North America accounted for 56%, 24%, and 15% of the Company’s total net revenue in 2005, 2004, and 2003, respectively. The Company expects that revenue from customers outside North America will continue to account for a significant portion of its total net revenue. Lower sales levels that typically occur during the summer months in Europe and some other overseas markets may materially and adversely affect its business. In addition, sales of many of its customers depend on international sales and consequently further expose it to the risks associated with such international sales.

If the Company fails to manage its exposure to worldwide financial markets successfully, its operating results could suffer.

          The Company is exposed to financial market risks, including changes in interest rates and foreign currency exchange rates. It does not use derivative financial instruments to manage these risks. A substantial portion of the Company’s net revenue, expense and capital purchasing activities are transacted in U.S. dollars. However, some of these activities are conducted in other currencies, primarily European currencies. A significant change in interest rates or an unfavorable movement in the European currencies compared to the U.S. Dollar would impact the Company’s operations.

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The Company faces risk from the potential impact of being classified as an “Accelerated Filer”.

     The Company is currently classified by the Securities and Exchange Commission (“Commission”) as a non-accelerated filer and therefore the mandatory compliance date for the management report on internal control over financial reporting requirement and the related registered public accounting firm report requirement under Section 404 of the Sarbanes-Oxley Act of 2002 was to be December 31, 2007. A non-accelerated filer is defined by the Commission as a public company with public float less than $75 million. It is likely that on June 30, 2006, the Company’s measurement date for the fiscal year ending December 31, 2006, the Company will exceed the $75 million mark and thus be classified as an accelerated filer. This reclassification will accelerate the mandatory compliance date to December 31, 2006, and redirect some of management’s focus and funding for the current year.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

          None.

Item 3. Defaults Upon Senior Securities.

          None.

Item 4. Submission of Matters to a Vote of Security Holders.

          None.

Item 5. Other Information.

          None.

Item 6. Exhibits.

2.1	Share Purchase Agreement dated March 8, 2005, by and among Optelecom, Inc., NKF Electronics B.V., Draka Holding, N.V. and NKF Vastgoed B.V. (incorporated by reference from Form 8-K filed March 11, 2005)
3.1	Certificate of Incorporation, as amended (incorporated by reference from Form 10-K filed March 31, 1998 and Form 8-K filed April 19, 2005)
3.2	By-Laws (Incorporated by reference from Form 10-K filed March 31, 1998)
10.1	Employment Agreement — Edmund Ludwig (Incorporated by reference from Form 10-K filed March 31, 2006)
10.2	Employment Agreement — James Armstrong (Incorporated by reference from Form 10-K filed March 31, 2006)
10.3	Employment Agreement — Thomas Overwijn (Incorporated by reference from Form 10-K filed March 31, 2006)
10.4	Subordinated Promissory Note dated March 8, 2005 (incorporated by reference from 8-K filed March 11, 2005)
10.5	Financing and Security Agreement date March 8, 2005 by and among Optelecom, Europe Limited, NKF B.V., and Inc., Optelecom UK Electronics I bena Manufacturers and Limited, Optelecom S.L., NKF Traders Trust Electronics, Company (incorporated by reference from 8-K filed March 11, 2005)
10.6	Facility lease by and among Optelecom — NKF Inc., and Guardian Realty Mgt — filed herewith.
31.1	Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act — filed herewith.
31.2	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act — filed herewith.
32	Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

     Other exhibits required by this item are incorporated by reference to the Company’s December 31, 2005 Form 10-K.

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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.

	OPTELECOM-NKF, INC.
Date: May 15, 2006	/s/ Edmund Ludwig
	Edmund Ludwig,
	Director, President and Chief Executive Officer
Date: May 15, 2006	/s/ James Armstrong
	James Armstrong,
	Executive VP, CFO, Chief Operating Officer North American Operations

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