UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

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 September 30, 2004

OR

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

For the transition period from                      to                    

Commission file number: 0-28734

ADVANCED FIBRE COMMUNICATIONS, INC.

1465 North McDowell Boulevard
Petaluma, California 94954

Telephone: (707) 794-7700

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

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No o

At October 29, 2004, there were 88,902,059 shares of common stock outstanding.

ADVANCED FIBRE COMMUNICATIONS, INC.
REPORT ON FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

Table of Contents

1

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ADVANCED FIBRE COMMUNICATIONS, INC.

See accompanying notes to condensed consolidated financial statements.

2

ADVANCED FIBRE COMMUNICATIONS, INC.

See accompanying notes to condensed consolidated financial statements.

3

See accompanying notes to condensed consolidated financial statements.

4

Note 1 Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted for interim financial information in the United States and pursuant to the rules and regulations of the Securities and Exchange Commission. While these financial statements reflect all adjustments of a normal and recurring nature which are, in the opinion of management, necessary to present fairly the results of the interim period, they do not include all information and footnotes required by generally accepted accounting principles for complete financial statements. These financial statements and notes should be read in conjunction with the financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2003.

The unaudited condensed consolidated financial statements include Advanced Fibre Communications, Inc. and its subsidiaries, or AFC. Significant intercompany transactions and accounts have been eliminated.

We operate on 13-week fiscal quarters ending on the last Saturday of each fiscal period. For presentation purposes only, the fiscal periods are shown as ending on the last day of the month of the respective fiscal period. The results of operations for the three and nine months ended September 30, 2004 are not necessarily indicative of the operating results for the full year.

Note 2 Pro Forma Fair Value Information

We account for equity-based compensation plans with employees and non-employee members of the board of directors using the intrinsic value method under Accounting Principles Board, or APB, Opinion No. 25, Accounting for Stock Issued to Employees. As of September 30, 2004, executive officers held 1.8 million of the 15.5 million total outstanding options held by employees and board of directors.

We follow the disclosure requirements of Statement of Financial Accounting Standards, or SFAS, No. 123, Accounting for Stock-Based Compensation and SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. We use the Black-Scholes option-pricing model to calculate the disclosure requirements. The Black-Scholes option-pricing model was developed for use in estimating the value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of subjective assumptions including the expected stock price volatility. AFC uses projected data for expected volatility and expected lives of its stock options based on historical and other economic data trended into future years. AFC’s stock options have characteristics significantly different from those of traded options, and changes in the subjective input assumptions can materially affect the estimate. In management’s opinion, the existing valuation models do not provide a reliable measure of fair value of AFC’s stock options.

5

If compensation cost for our stock-based compensation plans had been determined in accordance with the fair value approach set forth in SFAS No. 123, net income and earnings per share would have been reduced to the approximate pro forma amounts as follows (in thousands, except per share data):

The fair value of option grants in the three and nine months ended September 30, 2004 and 2003 were estimated on the date of grant using the Black-Scholes option-pricing model assuming no dividend yield and with the following assumptions:

Pro forma compensation costs related to the Employee Stock Purchase Plan, or ESPP, were estimated for the fair value of the employees’ purchase rights, as of the date of grant, using the Black-Scholes option-pricing model assuming no dividend yield and with the following assumptions:

The ESPP was suspended following the July 31, 2004 purchase under the ESPP pending the merger with Tellabs, Inc., or Tellabs. See Note 3 Pending Merger for further information.

6

Note 3 Pending Merger

On May 20, 2004, AFC and Tellabs announced a definitive merger agreement under which Tellabs would acquire AFC through a two-step merger. Under the original agreement, AFC stockholders would have received 1.55 shares of Tellabs common stock and $7.00 cash for each AFC share. Following AFC’s announcement of its second quarter financial results and business updates, Tellabs’ board of directors requested Tellabs to further evaluate AFC’s business and financial outlook. Discussion between the two companies followed, and both companies’ boards of directors agreed to revise the conditions of closing to increase the likelihood that the merger would be completed on terms that would be fair to the stockholders of both companies. Accordingly, AFC and Tellabs amended and restated the merger agreement on September 7, 2004. A copy of the merger agreement, as amended and restated, was included in an attachment to a Current Report on Form 8-K we filed on September 8, 2004. Under the terms of the amended transaction, AFC stockholders will receive .504 shares of Tellabs common stock and $12.00 cash, without interest, for each AFC share. The transaction is subject to certain closing conditions, including approval by AFC’s stockholders. We have scheduled a special meeting of AFC stockholders for November 30, 2004 to vote on the proposed merger. AFC stockholders of record, as of the close of business on October 25, 2004 will be entitled to vote at the special stockholders meeting. Assuming that the required vote is obtained and all other closing conditions are satisfied, the merger is expected to close soon thereafter. We have incurred merger-related costs of approximately $4 million related to investment banking, legal, accounting and other fees, which were expensed in the nine months period ended September 30, 2004. We have a commitment to pay additional investment banking fees upon consummation of the merger, in an amount based on the value of the merger consideration when the merger was first publicly announced, when the merger agreement was signed or when the merger is completed, whichever is greater of all consideration paid directly or indirectly by Tellabs. The remaining commitment, calculated as of the signing of the merger agreement, totals $6.9 million. Also see Note 14 Pending Litigation for a matter related to the merger.

Note 4 Acquisition

On February 20, 2004, we completed the acquisition of North American Access, or NAA, a business unit of Marconi Communications, Inc., a subsidiary of Marconi Corporation plc. We acquired 100% of the business interests of NAA. We accounted for the acquisition as a purchase in accordance with the guidance in SFAS No. 141, Business Combinations. The purchase consideration for NAA consisted of $240.9 million in cash, $5.2 million in acquisition-related expenses, $32.1 million in liabilities assumed and a $2 million credit for working capital adjustment. Our results of operations for the three and nine months ended September 30, 2004 include those of NAA beginning as of February 20, 2004. We have incurred $3.5 million in integration costs related to this acquisition during the nine months ended September 30, 2004.

This acquisition enables us to offer a more robust portfolio of fiber-based access network solutions. We view the products from NAA to be complementary to our own, particularly NAA’s fiber-to-the-curb offering and our Fiber-to-the-Premises, or FTTP, solution. We believe that synergies among our products enable us to serve a broader base of customers, from the smallest independent operating company to the largest regional Bell operating company.

7

We engaged third party appraisers to value the acquired tangible and intangible assets. The amount assigned to goodwill was increased by $0.2 million as of September 30, 2004 for additional legal and auditing fees incurred. Following is a condensed balance sheet disclosing the finalized fair values of the assets acquired and liabilities assumed as of the date of acquisition (in thousands):

The allocation of the purchase price to intangible assets included:

•		In-process research and development, or in-process R&D, of $14 million, which was expensed during the three months ended March 31, 2004 at the time of the acquisition;
•		Completed technology of $20 million, projected to be amortized over the weighted average useful lives ranging from four to seven years based on revenues from products containing the technology;
•		Order backlog of $0.3 million, which was capitalized at the time of acquisition and expensed during the three months ended March 31, 2004 as inventory shipped;
•		Customer relationships of $61.9 million, projected to be amortized over the next nine years; and
•		Goodwill of $133.9 million, which will not be amortized but is deductible for tax purposes over 15 years.

Our methodology for allocating the purchase price to in-process R&D was determined based on valuations performed by an independent third party. We acquired three in-process R&D projects:

•		Project A, estimated to be 62% complete as of the acquisition date, with $1.4 million in estimated costs to complete;
•		Project B, estimated to be 71% complete as of the acquisition date, with $1.3 million in estimated costs to complete; and
•		Project C, estimated to be 68% complete as of the acquisition date, with $4.3 million in estimated costs to complete.

A 15% risk-adjusted rate was used to value these projects, resulting in a valuation of $14 million. We expensed the $14 million upon acquisition because technological feasibility for these projects had not been established and no future alternative uses existed.

We consider the acquired business to be part of our access solutions for segment reporting purposes. We operate as one business segment and our chief operating decision maker continues to review and make operating decisions based on consolidated results.

The consolidated financial statements include the operating results of NAA from the date of acquisition. The pro forma condensed consolidated statements of operations for the acquisition of NAA are presented below, assuming the transaction was consummated at the beginning of AFC’s fiscal year 2004 and 2003 for comparative purposes.

8

These pro forma amounts do not purport to be indicative of the results that would have been actually obtained if the acquisition occurred as of the beginning of the period presented or that may be obtained in the future:

Note 5 Accounts Receivable

Accounts receivable are comprised of the following (in thousands):

9

Note 6 Income Taxes

As of September 30, 2004, we had recorded an income tax receivable of $218.6 million based on the filing of our tax returns for 2003. Our returns were filed in accordance with a Private Letter Ruling that we received from the Internal Revenue Service. The ruling addressed the tax treatment of settling with borrowed shares the two hedge contracts on 10.6 million Cisco Systems, Inc., or Cisco, shares that matured in 2003. The cash proceeds received from the settlement were approximately $690 million. Because we used borrowed shares rather than our existing Cisco shares to settle the hedge contracts, we believe that current law allows the deferral of taxes on the gains attributable to the hedge contracts until the new Cisco stock loans are settled. The total tax liability related to the gains on the Cisco stock and hedge contracts, assuming no deferral, would have been approximately $265 million. During 2003, we paid estimated federal and state taxes net of applicable credits on the full amount of the gains because of concern that the tax authorities could challenge the tax deferral position. Payments of these taxes were accounted for on the balance sheet at the time. In response to our request, the Internal Revenue Service issued a Private Letter Ruling that was favorable to deferring taxes on the settlement of the hedge contracts with borrowed shares. Although a Private Letter Ruling from the Internal Revenue Service is not conclusive of all issues, based upon the strength of the ruling, we filed federal and state income tax returns requesting refunds that totaled $218.6 million.

We received a $201.7 million federal tax refund, which will be recorded in the three months ending December 31, 2004. We expect to receive a state tax refund of approximately $16 million sometime in the three months ending December 31, 2004. A deferred tax liability of $210.2 million has been recorded based on taxes that will be due on the hedge contract gains upon termination of our Cisco stock loans. The balance sheet reports a net deferred tax liability of $182.6 million, which is net of the deferred tax assets. We intend to maintain the stock loans for an extended period of time; however, there is no assurance that we will be able to do so.

Both the three and nine month periods ended September 30, 2004 included a $15.9 million tax benefit relating to a tax reserve adjustment. The adjustment is related to multiple tax matters, and the reserves were established several years ago. The statute of limitations has now expired on these issues and the tax reserves have been adjusted accordingly.

Note 7 Inventories

Inventories are valued at the lower of cost or market, with cost computed on a first-in, first-out basis, and consist of the following (in thousands):

Note 8 Cisco Stock Loan Fees

During 2003, we borrowed 10.6 million shares of Cisco stock to settle the hedge contracts on our Cisco stock. In connection with borrowing the Cisco shares under the stock loans, we pay quarterly borrowing fees and a fee adjustment based on the average daily price of Cisco stock. The majority of the borrowing fees is expensed based on the average share price of Cisco stock during each quarter. A portion of the borrowing fees is expensed on a straight-line basis over the lives of the loans. We expensed a total of $0.4 million and $1 million, respectively, in borrowing fees during the three and nine months ended September 30, 2004.

10

Provisions in the Cisco stock loans contain “make-whole” fee arrangements. The make-whole fees would provide the lender with the discounted net present value of a portion of future borrowing fees. The make-whole fees are triggered if we assign the loans to another lender, or terminate and enter into a similar transaction with another lender, or if we are acquired by Cisco. The make-whole fees are calculated based on the net present value, discounted at 10% per annum, of a portion of future borrowing fees due up to and including the seventh year. Based on the arithmetic average closing price of Cisco’s stock for the three months ended September 30, 2004, the make-whole fee would be $2.4 million.

Note 9 Accrued Liabilities

Accrued liabilities are comprised of the following (in thousands):

Note 10 Warranty Reserve

Warranty reserve activity for the nine months ended September 30, 2004, consisted of the following (in thousands):

A provision for estimated warranty costs is established at the time of sale and adjusted periodically based on historical trends in warranty claims and expected material and labor costs to provide warranty service. We evaluate the overall reasonableness and adequacy of the warranty reserve provision at the end of each quarter. During the nine months ended September 30, 2004, we reversed a total of $1.8 million in unused warranty reserve related to a range of products resulting from changes in estimates.

11

Note 11 Accumulated Other Comprehensive Income

The following table presents the components of accumulated other comprehensive income (in thousands):

Note 12 Net Income Per Share

The shares and net income amounts used in the computation of basic and diluted net income per share for the three and nine months ended September 30, 2004 and 2003 are as follows (in thousands, except per share data):

Options to purchase 9,428,708 and 5,237,170 shares of common stock during the three months ended September 30, 2004 and 2003, respectively, were excluded from the computation of diluted net income per share. Options to purchase 6,966,893 and 6,888,633 shares of common stock during the nine months ended September 30, 2004 and 2003, respectively, were excluded from the computation of diluted net income per share. The exercise prices for these options were greater than the respective average market price of the common shares, and inclusion would be anti-dilutive.

Note 13 Securities Litigation Settlement Costs

During the three months ended September 30, 2004, we settled an arbitration proceeding with a former insurer and received $6.4 million in cash. Prior to the settlement, we were notified in April 2004 that we had won an arbitration proceeding with the former insurer and on June 30, 2004, we were notified of the final award. The former insurer provided us with coverage in 1998 when several lawsuits were brought against AFC and certain

12

former directors and officers relating to securities litigation. The former insurer refused to pay approximately $5 million in 2002 under an excess liability policy related to the covered defense costs and settlement of the class action securities lawsuit and two individual, non-class actions which were related to the consolidated securities class actions. As a result, we commenced arbitration proceedings in 2003. We were awarded approximately $5.8 million in compensatory damages and interest. In the decision, the arbitrators found the conduct of the insurer to be in bad faith, such that we were entitled to apply for attorneys’ fees and arbitration fees incurred. We recorded the $5.8 million award for the compensatory damages and interest as a reduction to operating expenses during the three months ended June 30, 2004 because the original defense costs and settlements we incurred were charged to operating expense during 2002. The former insurer appealed the final award; however, we subsequently settled with them for $6.4 million. The $0.6 million received above the $5.8 million recorded in the three months ending June 30, 2004 represented attorneys’ fees and arbitration fees. The $0.6 million was recorded as a reduction to operating expenses during the three months ended September 30, 2004 because the original defense costs and settlements we incurred were charged to operating expense during 2002.

Note 14 Pending Litigation

On June 1, 2004, a complaint was filed on behalf of a putative class of AFC stockholders against AFC, certain of its current officers and directors, and Tellabs, in the Court of Chancery in the State of Delaware in and for New Castle County. The complaint alleges that the individual defendants breached their fiduciary duties to AFC’s public stockholders by acting to cause or facilitate the merger of Tellabs and AFC for inadequate consideration, and that each of the defendants, including AFC and Tellabs, acted to aid and abet the alleged breaches of fiduciary duty. In particular, plaintiff alleges that the merger consideration for AFC’s public stockholders is unfair and inadequate because, according to the plaintiff, “(a) the intrinsic value of the stock of AFC is materially in excess of the $21.24 per share being proposed, giving due consideration to the possibilities of growth and profitability of AFC in light of its business, earnings and earnings power, present and future; (b) the $21.24 per share price is inadequate and offers an inadequate premium to the public shareholders of AFC; and (c) the $21.24 per share price is not the result of any structure[d] auction process by which AFC sought to obtain the best deal possible for its shareholders.” The plaintiff seeks to enjoin the merger, and if the merger is consummated, to rescind the transaction. The plaintiff also asserts claims for unspecified compensatory and/or rescissory damages, and an award of costs, including attorneys’ fees. AFC believes that these claims are without merit and intends to vigorously defend itself in this action.

13

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

This report contains “forward-looking statements.” In some cases, you can identify these statements by terms such as “may”, “intend”, “might”, “expect”, “believe”, “seek”, “anticipate”, “estimate”, “predict”, “potential”, “target”, “goals”, “projects”, “plan”, “should”, “could”, “would”, or similar expressions intended to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. We discuss many of these risks and uncertainties in greater detail under the heading “Risk Factors That Might Affect Future Operating Results and Financial Condition” of this Quarterly Report on Form 10-Q. These risks and uncertainties may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. These factors are not intended to be an all-encompassing list of risks and uncertainties that may affect the operations, performance, development and results of our business. You should not place undue reliance on these forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions as of the date of this report. We are under no duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results or to changes in our expectations.

The following discussion should be read in conjunction with the financial statements and notes included in this report and the financial statements and notes in our Annual Report on Form 10-K for the year ended December 31, 2003. Copies of our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K and any amendments to those reports filed or furnished to the SEC are accessible, free of charge, at our Internet Website http://www.afc.com. Information on our Website is not part of this report. Copies of these reports are also available without charge by contacting the Investor Relations Department, c/o Advanced Fibre Communications, Inc., P.O. Box 751239, Petaluma, California 94975-1239.

Overview

AFC sells access solutions to telecommunications companies in the U.S. and international marketplaces. AFC is the largest U.S. wireline equipment manufacturer dedicated solely to the access network. We market our products through our direct sales force and indirectly through distributors and sales representatives. We sell our products primarily to service providers who install our equipment as part of their access networks. Our customers in the U.S. are generally incumbent local exchange carriers, or ILECs, which include independent operating companies, or IOCs, and regional Bell operating companies, or RBOCs. In international markets, our customers are primarily incumbent local service providers. We have continued to expand our portfolio of innovative access solutions and expand our presence within key customer accounts despite a challenging business environment. We offer a comprehensive portfolio of carrier-class, standards-based solutions to carriers that satisfy the demand for such leading technologies and architectures as packetized voice, Fiber-to-the-Premises, or FTTP, Fiber-to-the-Curb, or FTTC, video, and digital subscriber line, or DSL. Addressing these technologies, we offer the following solutions:

•		AdvancedVoiceSM, which provides both legacy and packet-based voice solutions;
•		AFC FiberDirectSM, innovative FTTP and FTTC offerings that enable carriers to deploy a high-capacity all-fiber network;
•		TelcoVideoSM, a solution that delivers advanced voice, high-speed Internet, video and other entertainment services; and
•		UniversalDSLSM, which delivers DSL technology in multiple deployment options and configurations.

Our suite of access solutions incorporates elements of our core product portfolio, which includes AccessMAX^TM, DISC*S^TM, Telliant^TM , PremMAX^TM , AFC’s network management system, Panorama^TM, professional services and plant cabinets and technologies. On February 20, 2004, we acquired North American Access, or NAA, a business unit of Marconi Communications, Inc., a subsidiary of Marconi Corporation plc. NAA’s DISC*S products were added to AFC’s product line and include:

•		DISC*S Digital Loop Carrier, a scaleable next generation digital loop carrier, or NGDLC, providing plain old telephone service, or POTS, and broadband services;
•		DISC*S HD, a high density version of the DISC*S NGDLC platform;

14

•		DISC*S MX, a FTTC platform that supports a “triple play” of consumer voice, Internet and video; and
•		The Deep Fiber HFC, a broadband FTTC architecture that incorporates radio frequency return capability into the DISC*S fiber in the loop platform.

The NAA acquisition completed during the first quarter of 2004 supports our business strategy to expand our optical access portfolio, and enhance our ability to serve the demands and requirements of large telecommunications carriers. The acquisition enables us to offer a more robust portfolio of fiber-based access network solutions. We view the products from NAA to be complementary to our own, particularly NAA’s DISC*S FTTC offering with our FTTP solution. We believe that synergies among our product lines enable us to serve a broader base of customers, from the smallest IOCs to the largest RBOCs. Our results of operations for the nine months ended September 30, 2004 include those of NAA beginning as of February 20, 2004. With the acquisition, we added 255 employees.

On May 20, 2004, AFC and Tellabs, Inc., or Tellabs, announced a definitive merger agreement under which Tellabs would acquire AFC through a two-step merger. Under the original agreement, AFC stockholders would have received 1.55 shares of Tellabs common stock and $7.00 cash for each AFC share. Following AFC’s announcement of its second quarter financial results and business updates, Tellabs’ board of directors requested Tellabs to further evaluate AFC’s business and financial outlook. Discussion between the two companies followed, and both companies’ boards of directors agreed to revise the conditions of closing to increase the likelihood that the merger would be completed on terms fair to the stockholders of both companies. Accordingly, AFC and Tellabs amended and restated the merger agreement on September 7, 2004. A copy of the merger agreement, as amended and restated, was included in an attachment to a Current Report on Form 8-K we filed on September 8, 2004. Under the terms of the amended transaction, AFC stockholders will receive .504 shares of Tellabs common stock and $12.00 cash, without interest, for each AFC share. The transaction is subject to certain closing conditions and approval by AFC’s stockholders. We have scheduled a special meeting of AFC stockholders for November 30, 2004 to vote on the merger. AFC stockholders of record, as of the close of business on October 25, 2004 will be entitled to vote at the special stockholders meeting. Assuming that the required vote is obtained and all other closing conditions are satisfied, the merger is expected to close soon thereafter.

Factors Influencing Our Results of Operations. Our results of operations have been and will continue to be influenced by a variety of factors, including:

Pending Merger with Tellabs. In reaching its determination to recommend the adoption of the merger agreement, as amended and restated on September 7, 2004, and the merger with Tellabs, the AFC board of directors consulted with various advisors and considered various material factors. Among those factors considered were:

•		Enhanced strategic position of AFC by combining with Tellabs’ substantial resources and experience in servicing RBOCs, Tellabs’ complementary product lines, and Tellabs’ international distribution platform, which are expected to provide AFC with a stronger competitive position and greater opportunity for growth;
•		AFC’s business, financial condition and prospects on a stand-alone basis as compared to a combined company with a more diversified product line, greater resources and experience required to serve RBOCs and other large customers effectively, expanded distribution channels and increased size and scope as a supplier in an increasingly consolidated telecommunications market; and
•		Tellabs’ business, financial condition and prospects.

Customer Demands. Our operating results reflect our ability to offer products that meet the needs of our customers. In view of reduced overall industry spending, our ability to grow revenue is significantly affected by the degree to which carriers will devote their resources to the introduction of new products and technologies in the access network. While we see growth in our broadband business, we are seeing a decline in POTS demand. We have experienced an increased level of interest from our customers and potential customers worldwide in both DSL and FTTP solutions. FTTP continues to become a more significant part of our product offering and orders for FTTP are exceeding our forecasts. Our goal is to be the leading supplier of advanced voice and broadband solutions in the access market.

From a regulatory standpoint, we believe the Federal Communications Commission’s, or FCC’s, Triennial Review Order encourages long-term investment in broadband networks and migration to FTTP-based services by reducing the incumbent carriers’ unbundling obligations for broadband facilities. The Court of Appeals for

15

the D.C. Circuit upheld those portions of the FCC’s Order when they were challenged on appeal. In addition, the U.S. Supreme Court denied cert petitions from the competitive carriers and some States challenging the D.C. Circuit Court of Appeals’ decision. The FCC, moreover, has taken several steps since the release of the Triennial Review Order to further reduce or eliminate unbundling obligations for incumbent carriers’ broadband facilities. The FCC on reconsideration decided to treat primarily residential fiber-to-Multi-Dwelling Units (fiber-to-MDUs) and FTTC the same as fiber-to-the-home (FTTH), which means there is no unbundling obligation for greenfield deployments using these deep fiber architectures. In addition, the FCC used its forbearance authority to hold that where broadband unbundling is eliminated under Section 251 of the Federal Communications Act (as it is for FTTH, FTTC and fiber-to-MDUs), then the separate unbundling obligation imposed on the RBOCs under Section 271 of the Federal Communications Act will not be applied.

Investment in New Technology. We expect to continue making investments in new technologies to support existing and new product needs of our customers. FTTP has been part of our product development roadmap since 2001, and we retain ownership of all technology developed in our FTTP research and development efforts, whether or not in connection with a specific FTTP development project. We are incurring costs and expenses associated with preparation for the deployment of our FTTP systems and we are generating revenues from the FTTP systems.

As an example of FTTP deployment, in January 2004, we signed a multiyear agreement with Verizon Communications, Inc., or Verizon, to be the primary FTTP project vendor in providing the central office and premises electronics, also known as the active elements of FTTP technology. As part of our contract with Verizon, we supply currently developed FTTP equipment.

The FTTP systems are comprised of various components. Our revenue and profitability are affected by the timing and mix of components in the deployment of FTTP systems and mix of customers. One component of the FTTP systems, the Single Family Optical Network Terminal, or ONT, will be sold at a negative gross profit margin until volume increases and unit costs decline. An ONT is deployed at a residence as a network interface device for connecting fiber to services in the home. Although revenue could increase as a result of expected increased shipments of ONTs towards the end of the year, gross margins are expected to decrease since we expect that sales of ONTs at negative margins will constitute a larger portion of revenue than in previous periods. We expect that the amount of ONTs shipped over the next year will have a significant impact on near term gross profit margins and overall financial results. We anticipate an operating loss during the fourth quarter of 2004 as a result of the ONT negative margins, coupled with increasing operating expenses, primarily due to research and development initiatives and planned year end employee hiring, and Tellabs merger-related transaction costs. We have an active remediation program in place to address the profitability of the ONT component. Over the next year we expect design cost reductions, component price reductions and increased production volumes to improve gross margins compared with initial FTTP shipments. The other components of the FTTP systems are expected to sell at a profit to customers.

In our work with large customers such as RBOCs, our agreements may contain provisions for performance compensation payments, or PCPs, which are tied to key milestones related to the availability of product releases containing certain product features. Completion of such milestones requires timely and successful R&D efforts, and on converting the results of those R&D efforts into usable, cost effective products. R&D efforts involve large and complicated projects, which rely in part on the work of third parties over which we have limited control, and on which there can be no assurance of success. For example, our agreement with Verizon to provide FTTP systems has several provisions requiring PCPs for failure to meet key milestones by specified dates. While we have met a number of these milestones on time, we have also failed to meet some milestones in a timely manner. We failed to achieve a February 23, 2004 milestone for delivery of a product release, which triggered a PCP of $2 million. We subsequently provided the required product release on March 8, 2004. We also did not meet a June 30, 2004 milestone for delivery of a product release, which triggered a PCP of $1 million. We subsequently provided the required product release for this milestone on July 21, 2004. We did not incur any penalties during the three months ended September 30, 2004.

In mid-June 2004 Verizon informed us that it believes our failure to deliver product features by specified milestone dates, for which we have paid a PCP in the amount of $2 million to Verizon in the three months ended March 31, 2004, and our failure to subsequently deliver some of these product features in accordance with our corrective plans, constitute a default and a breach of our obligations under our agreement with Verizon. Verizon has reserved all of its legal rights and remedies under the agreement, which include termination of the agreement without the required advance notice, pursuing claims against AFC for costs and other damages caused by the breach and

16

canceling previously placed orders. We believe that the FTTP project with Verizon is still intact and note that Verizon has continued to order a range of products, including FTTP systems, following its notice of default. As indicated above, we did not meet the product release milestone on June 30, 2004 (which Verizon anticipated in its mid-June letter to us) for which we accrued a $1 million PCP to Verizon and subsequently paid in the three months ending December 31, 2004. The accrual was treated as a reduction to revenue during the three months ended June 30, 2004. We could experience an offset to revenues and reduced net income in future quarters due to penalties imposed under such agreements as a result of failures to comply with strict contractual terms.

Telecommunications Industry Conditions. Our results of operations have been adversely affected by the downturn in the telecommunications industry and worldwide economies over the last several years. Spending on communications equipment and services remains at significantly lower levels as compared to pre-2001 sales levels. On an ongoing basis, we attempt to balance our operating expenses with lower overall revenue levels associated with the industry downturn and reduced capital spending. We focus on cost controls while we continue to invest in research and development activities that will keep us in a strong position to take advantage of sales opportunities when industry conditions improve and demand recovers. Although the current economic environment for our industry remains challenging, we believe we have positioned our business for success over the long-term.

Acquisition of NAA. The acquisition of NAA impacts our future results of operations. Revenues will increase as a result of the new DISC*S products, although we expect gross profit for these products will be lower than historical gross profit margins. The acquisition will also result in higher operating expenses. In connection with closing the acquisition, we wrote off $14 million for in-process research and development during the three months ended March 31, 2004. Over the next nine years, we will amortize costs stemming from acquired intangible assets. We also expect that interest income will be lower in the future as a result of liquidating a portion of our marketable securities to pay for the acquisition. We anticipate that we will obtain benefits from consolidating our supply chain over time. Our ability to successfully operate the NAA business and integrate NAA’s products and employees with our existing business may materially affect our future results of operations.

In connection with the acquisition, BellSouth Communications, Inc., or BellSouth, became a customer and accounted for 29% of our revenues in the nine months ended September 30, 2004. We will continue to incur costs associated with supporting and growing our relationship with BellSouth.

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. Applying GAAP requires our judgment in determining the appropriateness of acceptable accounting principles and methods of application in diverse and complex economic activities. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of revenues, expenses, assets and liabilities, and related disclosure of contingent assets and liabilities. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the year ended December 31, 2003 in the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” We base our estimates on historical experience and other assumptions we believe are reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities, which may not be readily apparent from other sources.

In addition to the critical accounting policies and estimates referred to above, we have identified the following additional critical accounting policies and estimates:

Pre-production costs related to long-term supply arrangements. We follow Emerging Issues Task Force Issue No. 99-5 Accounting for Pre-Production Costs Related to Long-Term Supply Arrangements and Statement of Financial Accounting Standards No. 2 Accounting for Research and Development Costs in accounting for pre-production costs related to long-term supply arrangements. We expense to research and development expense in the period incurred any pre-production design and development costs of products to be sold in long-term supply arrangements. We own the molds, dies and tools used in producing products for long-term supply agreements. Therefore, we expense to research and development as incurred any pre-production design and development costs

17

of molds, dies and tools to be used in such agreements. We have no long-term supply agreements wherein a contractual guarantee for reimbursement exists, and therefore have no assets on the books related to such costs.

Workers’ Compensation. We are partially self-insured for worker’s compensation. Accruals for losses are made based on our claims experience and actuarial assumptions followed in the insurance industry, including provisions for incurred but not reported losses. We rely on data provided by third party consultants as support for our accrual, and we review the accrual on a quarterly basis for adequacy. Actual losses could differ from accrued amounts. See Note 9, Accrued Liabilities, for the amounts accrued as of September 30, 2004 and December 31, 2003. During 2004, we reviewed the reserve and determined the need to increase the accrual rate based on current rates of claims. Determining the amount of the reserve includes some uncertainty due to the difficulty in determining the likelihood, volume and extent of claims in the future.

We believe the application of our accounting policies and estimates accurately reflects our financial condition and results of operations in the consolidated financial statements, and provides the basis for comparability between periods. We believe our accounting policies and estimates are reasonable and appropriate for our business.

Results of Operations

Comparison of the three and nine months ended September 30, 2004 and 2003
Revenues increased in 2004 as a result of the acquisition of NAA and sales to the acquired customer base. We incurred costs associated with the NAA acquisition, amortization of intangible assets, the pending Tellabs merger and leased facility write-offs. These costs were offset by an arbitration award for securities litigation settlement costs and a tax benefit from a tax reserve adjustment.

Revenues. Revenues were $119.6 million in the three months ended September 30, 2004; a 40% increase from the $85.2 million recorded in the three months ended September 30, 2003. Revenues were $331 million in the nine months ended September 30, 2004; a 33% increase from the $248.7 million recorded in the nine months ended September 30, 2003. NAA’s stand-alone revenues were approximately $52 million and $118 million, respectively, for the three months ended September 30, 2004, and the period from the February 20 acquisition date through September 30, 2004. The majority of NAA’s revenues were earned from U.S. customers.

Sales to U.S. customers increased 45% to $107.6 million in the three months ended September 30, 2004, compared with $74.1 million in the three months ended September 30, 2003. Sales to U.S. customers accounted for 90% of revenues in the three months ended September 30, 2004, and 87% in the three months ended September 30, 2003. Sales to U.S customers were also affected by an adjustment to the return reserve associated with the expiration of a sales and distribution contract in 2004.

Sales to U.S. customers increased 39% to $295.9 million in the nine months ended September 30, 2004, compared with $212.4 million in the nine months ended September 30, 2003. Sales to U.S. customers accounted for 89% of revenues in the nine months ended September 30, 2004, and 85% in the nine months ended September 30, 2003. Sales to U.S customers were also affected by an adjustment to the return reserve associated with the expiration of a sales and distribution contract in 2004.

Sales to international customers increased 8% to $12 million in the three months ended September 30, 2004, compared with $11.1 million in the three months ended September 30, 2003. Sales to international customers accounted for 10% of revenues in the three months ended September 30, 2004, and 13% in the three months ended September 30, 2003.

Sales to international customers decreased 3% to $35.1 million in the nine months ended September 30, 2004, compared with $36.3 million in the nine months ended September 30, 2003. Sales to international customers accounted for 11% of revenues in the nine months ended September 30, 2004, and 15% in the nine months ended September 30, 2003.

BellSouth, and Sprint North Supply Company, or Sprint, accounted for 36.7% and 21%, respectively, of revenues in the three months ended September 30, 2004. Sprint and Alltel Communications Products, Inc., or Alltel, accounted for 37.3% and 12.5%, respectively, of revenues in the three months ended September 30, 2003.

18

BellSouth and Sprint accounted for 29% and 23.6%, respectively, of revenues in the nine months ended September 30, 2004. Sprint and Alltel accounted for 33.7% and 13%, respectively, of revenues in the nine months ended September 30, 2003. No other customer accounted for 10% or more of revenues in any of these periods. We continue to depend on a small number of large customers for the majority of our sales. Although Alltel continues to purchase products from us, our contract with them, which did not include purchase commitments, expired by its terms as of September 6, 2004. We are currently in negotiations with Alltel for a new sales and distribution contract. Sales to our top five customers accounted for 73% of revenues in the nine months ended September 30, 2004, an increase from 65% in the same period a year ago.

Sprint and Alltel are distribution subsidiaries of Sprint Corporation and Alltel Corporation, respectively. These subsidiaries distribute our products to their respective affiliates for deployment in their own networks and also resell our products to third party IOC customers. Historically, we believe that products representing approximately 20% to 35% of our sales to Sprint and Alltel have been sold to IOC customers.

We have failed to meet various key milestones in a timely manner under our agreement with Verizon for which we have paid or accrued $3 million in penalties in the nine months ended September 30, 2004. These penalty payments were accounted for as a corresponding reduction in revenue in the quarter they were incurred. Our future revenues, gross profit and net income will be affected by our ability to meet key milestones and avoid penalty payments under our agreement.

Gross Profit. Gross profit as a percentage of revenues decreased to 37.8% in the three months ended September 30, 2004, from 47.7% in the three months ended September 30, 2003. Gross profit for the three months ended September 30, 2004 was $45.2 million. The acquired NAA business accounted for approximately $18 million of gross profit during that period. Gross profit as a percentage of revenues decreased to 42.5% in the nine months ended September 30, 2004, from 48.8% in the nine months ended September 30, 2003. Gross profit for the nine months ended September 30, 2004 was $140.7 million. The acquired NAA business accounted for approximately $39 million of gross profit during that period. Margin for the three and nine month periods ended September 30, 2004 decreased primarily due to product and customer mix, and increased reserves.

For both the three and nine month periods ended September 30, 2004, gross profit declined as a result of FTTP product sales with lower margins, including initial sales of the Single Family ONTs at negative margins, and sales of lower margin DISC*S products. Gross profit was impacted by an increase in the reserve for excess and obsolete inventory, primarily for TransMAX^TM inventory, and for returns associated with the expiration of a sales and distribution contract. We have continued our supply chain management and cost reduction efforts. The resulting standard cost savings partially offset the decreases in 2004 gross profit. We believe gross profit will continue to be impacted by sales of ONTs at negative margins. We are working on significant cost reductions for this component that we anticipate realizing in 2005. We expect design cost reductions, component price reductions and increased production volumes to improve gross margins compared with initial FTTP shipments.

During the three and nine months ended September 30, 2004, gross profit was affected by increases in reserves of $8.3 million and $15.3 million, respectively. These were offset by utilization of $7 million and $21.7 million, respectively, of reserves during the three and nine months ended September 30, 2004. These reserves were for excess and obsolete inventory, returned materials, demonstration inventory, purchase commitments and warranty. During the nine months ended September 30, 2004, the reserve increases reflected offsets due to the reversal of $1.8 million in unused warranty reserve from changes in estimates and $1 million in purchase commitments reserve due to revised estimates.

Research and Development. Research and development expenses increased 43% to $21.2 million in the three months ended September 30, 2004, and represented 18% of revenues, compared with 17% of revenues in the three months ended September 30, 2003. For the three months ended September 30, 2004, the acquired NAA business accounted for approximately $5 million of total research and development expense. Research and development expenses increased 23% to $61.6 million in the nine months ended September 30, 2004, and represented 19% of revenues, compared with 20% of revenues in the nine months ended September 30, 2003. For the period February 20, 2004 through September 30, 2004, NAA accounted for approximately $12 million of total research and development expense.

19

The increase in research and development expense for the three months ended September 30, 2004 as compared to the three months ended September 30, 2003 was primarily attributable to:

	•		Compensation, primarily due to acquiring NAA’s engineering employees in February 2004 and hiring additional engineers to support FTTP development;
	•		Employee benefits, primarily due to a higher number of engineering employees;
	•		Hiring and relocation fees for new engineering employees;
	•		Higher depreciation expense resulting from the addition of NAA’s engineering equipment;
	•		Outside services related to testing new products, such as FTTP; and
	•		Loss on fixed asset write-off.

These increases were partially offset by a decrease in engineering materials during the three months ended September 30, 2004. Product development life cycles were more advanced as compared to the prior year, and required reduced amounts of materials.

The increase in research and development expense for the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003 was primarily attributable to:

	•		Compensation, primarily due to acquiring NAA’s engineering employees in February 2004 and hiring additional engineers to support FTTP development;
	•		Employee benefits, primarily due to a higher number of engineering employees and an increase to the workers’ compensation accrual;
	•		Outside services related to testing new products, such as FTTP;
	•		Engineering materials for new product development;
	•		Hiring and relocation fees for new engineering employees;
	•		Higher depreciation expense resulting from the addition of NAA’s engineering equipment; and
	•		Leased facility write-off.

The nine months ended September 30, 2003 also included charges for severance and facility closures from a workforce reduction initiated in April 2003 and a loss on disposal of fixed assets.

We believe rapidly evolving technology and competition in our industry necessitates the continued commitment of our resources to research and development to remain competitive. We plan to continue to support the development of new products and features, while seeking to carefully manage associated costs through expense controls.

Sales and Marketing. Sales and marketing expenses increased 14% to $10.7 million in the three months ended September 30, 2004, and represented 9% of revenues, compared with 11% of revenues in the three months ended September 30, 2003. For the three months ended September 30, 2004, the acquired NAA business accounted for approximately $2 million of total sales and marketing expense. Sales and marketing expenses increased 16% to $35.2 million in the nine months ended September 30, 2004, and represented 11% of revenues, compared with 12% of revenues in the nine months ended September 30, 2003. For the period February 20, 2004 through September 30, 2004, NAA accounted for approximately $5 million of total sales and marketing expense.

The increase in sales and marketing expense for the three months ended September 30, 2004 as compared to the three months ended September 30, 2003 was primarily attributable to:

	•		Compensation, largely due to acquiring NAA’s sales and marketing employees in February 2004;
	•		Distributor commissions on higher international sales; and
	•		Higher costs associated with the Supercom trade show.

Partially offsetting these increases was a decrease in advertising costs as a result of reducing our branding campaign in anticipation of the Tellabs merger.

The increase in sales and marketing expense for the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003 was primarily attributable to:

20

	•		Compensation, largely due to acquiring NAA’s sales and marketing employees in February 2004 and severance payments;
	•		Employee benefits, primarily due to a higher number of sales and marketing employees and an increase to the workers’ compensation accrual;
	•		Commissions on domestic sales;
	•		Higher costs associated with the Supercom trade show and increased participation in other trade shows; and
	•		Travel and entertainment expenses largely due to acquiring NAA’s sales and marketing employees in February 2004.

The nine months ended September 30, 2003 also included charges for severance and facility closures from a workforce reduction initiated in April 2003 and a loss on disposal of fixed assets.

We believe we have aligned sales and marketing expenses with current results of operations. We plan to continue to monitor sales and marketing expenses in view of our expected future operating results.

General and Administrative. General and administrative expenses increased 33% to $8.6 million in the three months ended September 30, 2004, and represented 7% of revenues, compared to 8% of revenues in the three months ended September 30, 2003. For the three months ended September 30, 2004, the acquired NAA business accounted for approximately $1 million of total general and administrative expense. General and administrative expenses increased 40% to $29.9 million in the nine months ended September 30, 2004, and represented 9% of revenues, compared to 9% of revenues in the nine months ended September 30, 2003. For the period February 20, 2004 through September 30, 2004, NAA accounted for approximately $3 million of total general and administrative expense.

The increase in general and administrative expense for the three months ended September 30, 2004 as compared to the three months ended September 30, 2003 was primarily attributable to:

	•		Outside services, accounting and auditing fees primarily arising from compliance with the Sarbanes-Oxley Act of 2002;
	•		Compensation, largely due to acquiring NAA’s general and administrative employees in February 2004, annual raises and severance payments;
	•		Tellabs merger related costs;
	•		Depreciation resulting from increased asset base; and
	•		Legal expenses related to the inclusion of NAA business matters and increased patent work.

These costs were partially offset by lower performance-based compensation as a result of not meeting internal goals, lower bad debt expense, and a reduction in litigation costs as a result of settling cases in process during 2003.

The increase in general and administrative expense for the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003 was primarily attributable to:

	•		Tellabs merger related costs;
	•		Outside services, accounting and auditing fees arising from compliance with the Sarbanes-Oxley Act of 2002 and work on various projects;
	•		Compensation, largely due to acquiring NAA’s general and administrative employees in February 2004, annual raises and severance payments; and
	•		Employee benefits, primarily due to a higher number of general and administrative employees and an increase to the workers’ compensation accrual.

These costs were partially offset by lower performance-based compensation as a result of not meeting internal goals and lower bad debt expense in 2004. The nine months ended September 30, 2003 also included a leased facility write-off and severance costs arising from the workforce reduction initiated in April 2003.

21

We believe we have aligned general and administrative expenses with current results of operations. We plan to continue to monitor general and administrative expenses in view of our expected future operating results.

Securities Litigation Settlement Costs. During the three months ended September 30, 2004, we settled an arbitration proceeding with a former insurer and received $6.4 million in cash. Prior to the settlement, we were notified in April 2004 that we had won an arbitration proceeding with the former insurer and on June 30, 2004, we were notified of the final award. The former insurer provided us with coverage in 1998 when several lawsuits were brought against AFC and certain former directors and officers relating to securities litigation. The former insurer refused to pay approximately $5 million in 2002 under an excess liability policy related to the covered defense costs and settlement of the class action securities lawsuit and two individual, non-class actions which were related to the consolidated securities class actions. As a result, we commenced arbitration proceedings in 2003. We were awarded approximately $5.8 million in compensatory damages and interest. In the decision, the arbitrators found the conduct of the insurer to be in bad faith, such that we were entitled to apply for attorneys’ fees and arbitration fees incurred. We recorded the $5.8 million award for the compensatory damages and interest as a reduction to operating expenses during the three months ended June 30, 2004 because the original defense costs and settlements we incurred were charged to operating expense during 2002. The former insurer appealed the final award; however, we subsequently settled with them for $6.4 million. The $0.6 million received above the $5.8 million recorded in the three months ending June 30, 2004 represented attorneys’ fees and arbitration fees. The $0.6 million was recorded as a reduction to operating expenses during the three months ended September 30, 2004 because the original defense costs and settlements we incurred were charged to operating expense during 2002.

Amortization of Intangibles. In connection with the acquisition of intangible assets from NAA, we amortized $3.7 million of completed technology during the three months ended September 30, 2004. In connection with the acquisition of intangible assets from AccessLan Communications, Inc., or AccessLan, we amortized $0.3 million of deferred compensation, non-compete agreements and completed technology during the three months ended September 30, 2004. During the three months ended September 30, 2003, we amortized $0.3 million of deferred compensation, non-compete agreements and completed technology arising from the AccessLan acquisition.

In connection with the acquisition of intangible assets from NAA, we amortized $9.4 million of completed technology during the nine months ended September 30, 2004. In connection with the acquisition of intangible assets from AccessLan, we amortized $0.9 million of deferred compensation, non-compete agreements and completed technology during the nine months ended September 30, 2004. During the nine months ended September 30, 2003, we amortized $1.8 million of deferred compensation, non-compete agreements and completed technology arising from the AccessLan acquisition. We expect to continue amortizing the NAA intangibles through 2013 and the AccessLan intangibles through 2005.

Integration Costs. In connection with integrating NAA into AFC, we incurred $1 million and $3.5 million, respectively, in the three and nine months ended September 30, 2004, for consultants, accounting services, travel and other related costs. In connection with integrating with Tellabs, we incurred $54 thousand and $0.1 million, respectively, in the three and nine months ended September 30, 2004 for consultants and travel related costs.

In-Process Research and Development. For the nine months ended September 30, 2004, we recognized a $14 million write-off for technology that had not yet reached technological feasibility, had no alternative future use and for which successful development was uncertain. The write-off was in connection with the acquisition of NAA on February 20, 2004.

Other Income. Other income decreased to $2.2 million in the three months ended September 30, 2004, from $2.9 million in the three months ended September 30, 2003. The decrease was primarily due to liquidating a portion of the marketable securities portfolio and cash equivalents to pay for the NAA acquisition and the related decrease in interest income earned on the remaining securities.

Other income decreased to $7 million in the nine months ended September 30, 2004, from $10.1 million in the nine months ended September 30, 2003. The decrease was primarily due to liquidating a portion of the marketable securities portfolio and cash equivalents to pay for the NAA acquisition and the related decrease in interest income earned on the remaining securities. The decrease was also the result of settling the Cisco hedge contracts in 2003.

22

The gains generated by the hedge contracts more than offset the Cisco share losses in 2003, resulting in unrealized gains.

Income Taxes. The effective tax was 40% for the three months ended September 30, 2004 compared with the effective tax rate of 25% for the three months ended September 30, 2003. The 40% tax is based on a revision of the forecasted earnings for the remainder of the year. The effective tax rate was a benefit of 36% for the nine months ended September 30, 2004 compared with the effective tax rate of 25% for the nine months ended September 30, 2003. Both the three and nine month periods ended September 30, 2004 included a $15.9 million tax benefit relating to a tax reserve adjustment. The adjustment is related to multiple tax matters, and the reserves were established several years ago. The statute of limitations has now expired on these issues and the tax reserves have been adjusted accordingly. The rate in 2004 is attributable to several factors including reduced tax-exempt income resulting from liquidating a portion of the marketable securities portfolio for the cash purchase of NAA, a revision of the forecasted earnings for the remainder of the year, and certain costs related to the Tellabs merger, a portion of which is non-deductible for tax purposes. The lower rate in 2003 was primarily the result of investing the proceeds from the Cisco hedge contract settlements in 2003 in tax-exempt marketable securities.

Goodwill

We allocated the NAA and AccessLan purchase prices based on valuations performed by third party appraisal firms. Goodwill is measured as the excess of the cost of acquisition over the sum of the amounts assigned to identifiable assets acquired less liabilities assumed. The amount assigned to goodwill was increased by $0.2 million as of September 30, 2004 for additional legal and auditing fees incurred in connection with the NAA acquisition. We perform goodwill impairment tests on an annual basis and between annual tests when circumstances warrant. We performed an annual impairment test during the three months ending September 30, 2004 and determined there was no impairment. As of September 30, 2004, $133.9 million in goodwill is attributable to the NAA acquisition, and $55.9 million in goodwill is attributable to the AccessLan acquisition.

Summary of Certain Significant Items

AFC management takes certain significant items into consideration when evaluating internal performance and results of operations. We exclude certain significant items from our GAAP results of operations for budgeting purposes, reviewing business performance and making investment decisions. We exclude these items because we believe the resulting amounts provide a more consistent and useful basis for comparison between periods. Significant items excluded from our GAAP results of operations include (in thousands):

23

Three Months Ended September 30, 2004

•		$4 million in amortization of intangible assets acquired in the NAA and AccessLan acquisitions.
•		$0.5 million in investment banking, legal, accounting and other costs expensed related to the pending merger with Tellabs;
•		$25 thousand for facility write-offs stemming from a workforce reduction initiated in April 2003;
•		$(0.6) million from an arbitration proceeding settlement treated as a reduction to operating expenses; and
•		$(15.9) million for a tax benefit relating to a tax reserve adjustment.

Three Months Ended September 30, 2003

•

$0.3 million in amortization of intangible assets acquired in the AccessLan acquisition.

Nine Months Ended September 30, 2004

•		$10.3 million in amortization of intangible assets acquired in the NAA and AccessLan acquisitions;
•		$4 million in investment banking, legal, accounting and other costs expensed related to the pending merger with Tellabs;
•		$1.8 million for leased facility write-offs due in part to a workforce reduction initiated in April 2003;
•		$14 million for in-process research and development costs written off upon the acquisition of NAA;
•		$(6.4) million from an arbitration award treated as a reduction to operating expenses; and
•		$(15.9) million for a tax benefit relating to a tax reserve adjustment.

Nine Months Ended September 30, 2003

•		$1.8 million in amortization of intangible assets acquired in the AccessLan acquisition;
•		$5.5 million in expenses due in part from severance and facility closures from a workforce reduction initiated in April 2003; and
•		$1.4 million in unrealized gains on our Cisco securities holdings and related hedge contracts.

Liquidity and Capital Resources

Liquidity and capital resources refers to the ability to generate cash to meet existing and known or reasonably likely future cash requirements in the short-term and foreseeable future. Our forecasts take into account financial resource needs, working capital and capital expenditure requirements, and operating lease obligations. We believe our existing cash and marketable securities and cash flows from operating and financing activities are adequate to support our financial needs in both the short-term and the foreseeable future.

Cash, Cash Equivalents and Marketable Securities

The following table summarizes our cash, cash equivalents and marketable securities (in thousands):

Cash and cash equivalents. The $8.4 million decrease was primarily the result of paying $240.9 million in cash to acquire NAA, $5.2 million in cash for related acquisition costs, a $2 million investment in a privately held company, and paying a $2 million cash PCP to Verizon for failing to timely achieve a product release milestone. Partially offsetting these decreases were the movement of $210.2 million from other marketable securities into shorter-term cash equivalents and $6.9 million in interest income during the nine months ended September 30, 2004.

24

Cisco marketable securities. The $56.5 million decrease was the result of market price volatility. At September 30, 2004, we owned 10.6 million shares of Cisco common stock. We acquired these shares as a result of an investment in privately held Cerent Corporation, which was merged with Cisco in 1999. In 2000, we entered into two three-year hedge contracts, pledging all of our Cisco stock to secure the obligations under these contracts. In 2003, the hedge contracts matured, and we entered into stock loan agreements with a lender, borrowing 10.6 million shares of Cisco stock to settle the hedge contracts. The fair market value of the Cisco stock loans is reflected as a current liability.

As of September 30, 2004, we had recorded an income tax receivable of $218.6 million based on the filing of our tax returns for 2003. Our returns were filed in accordance with a Private Letter Ruling that we received from the Internal Revenue Service. The ruling addressed the tax treatment of settling with borrowed shares the two hedge contracts on 10.6 million Cisco shares that matured in 2003. The cash proceeds received from the settlement were approximately $690 million. Because we used borrowed shares rather than our existing Cisco shares to settle the hedge contracts, we believe that current law allows the deferral of taxes on the gains attributable to the hedge contracts until the new Cisco stock loans are settled. The total tax liability related to the gains on the Cisco stock and hedge contracts, assuming no deferral, would have been approximately $265 million. During 2003, we paid estimated federal and state taxes net of applicable credits on the full amount of the gains because of concern that the tax authorities could challenge the tax deferral position. Payments of these taxes were accounted for on the balance sheet at the time. In response to our request, the Internal Revenue Service issued a Private Letter Ruling that was favorable to deferring taxes on the settlement of the hedge contracts with borrowed shares. Although a Private Letter Ruling from the Internal Revenue Service is not conclusive of all issues, based upon the strength of the ruling, we filed federal and state income tax returns requesting refunds that totaled $218.6 million.

We received a $201.7 million federal tax refund, which will be recorded in the three months ending December 31, 2004. We expect to receive a state tax refund of approximately $16 million sometime in the three months ending December 31, 2004. A deferred tax liability of $210.2 million has been recorded based on taxes that will be due on the hedge contract gains upon termination of our Cisco stock loans. The balance sheet reports a net deferred tax liability of $182.6 million, which is net of the deferred tax assets. We intend to maintain the stock loans for an extended period of time; however, there is no assurance that we will be able to do so.

In connection with borrowing the Cisco shares under the stock loans, we pay borrowing fees and a fee adjustment based on the average daily price of Cisco stock. The majority of the borrowing fees is expensed based on the average share price of Cisco stock during each quarter. A portion of the borrowing fees is expensed on a straight-line basis over the lives of the loans. We expect to incur approximately $1.4 million annually in borrowing fees, before taxes, to pursue our tax position.

Provisions in the Cisco stock loans contain “make-whole” fee arrangements. The make-whole fees would provide the lender with the discounted net present value of a portion of future borrowing fees. The make-whole fees are triggered if we assign the loans to another lender, or terminate and enter into a similar transaction with another lender, or we are acquired by Cisco. The make-whole fees are calculated based on the net present value, discounted at 10% per annum, of a portion of future borrowing fees due up to and including the seventh year. Based on the arithmetic average closing price of Cisco’s stock for the three months ended September 30, 2004, the make-whole fee would be $2.4 million.

Other marketable securities. The $213.6 million decrease was primarily the result of liquidating securities for cash required to purchase NAA.

Restricted cash equivalents and marketable securities. $20.4 million in restricted tax-exempt cash equivalents and marketable securities is held as collateral to back a three-year bond posted for a U.S. customer contract. The bond expires in January 2005 and guarantees our performance under the contract. The current earnings rate on these cash equivalents and marketable securities is approximately 1.195%. $3.1 million in restricted taxable cash equivalents is held as collateral for our standby letters of credit facility with our bank. The current earnings rate on these cash equivalents is approximately 1.7%. $1 million of this amount is held as collateral for a letter of credit issued to a third party that provides AFC’s workers’ compensation insurance. These restricted cash equivalents and marketable securities are recorded in other assets on the balance sheets.

25

Cash Flows

The following table summarizes our cash flows (in thousands):

Operating activities in the nine months ended September 30, 2004 provided cash, primarily due to net income offset by increases in inventories as a result of a combination of FTTP inventory build up, actual versus forecasted sales, customers’ expectations of shortened delivery timeframes and a transition to a new contract manufacturer. Non-cash activity included an increase in deferred income taxes offset by a decrease in current income taxes, depreciation and amortization, the write-off of in-process research and development and an increase in reserves for returns, rebates and credits. The nine months ended September 30, 2003 included the non-cash effect of the proceeds from the settlement of the Cisco hedge contracts. Investing activities in the nine months ended September 30, 2004 used cash primarily as a result of paying $246.1 million in cash and associated costs to acquire NAA. This was partially offset by sales and maturities of marketable securities exceeding purchases. The nine months ended September 30, 2003 used cash primarily due to purchases of marketable securities exceeding sales and maturities. Financing activities in the nine months ended September 30, 2004 provided cash as a result of stock option exercises, as did the prior year comparable period.

Performance Metrics

The following table summarizes certain performance metrics (in thousands, except days sales outstanding, or DSO, and inventory turns):

The decrease in DSO as of September 30, 2004 was the result of improved collection efficiency and revenues arising as a result of products acquired from NAA.

Inventory turns during the three months ended September 30, 2004 decreased primarily due to the increase in cost of revenues and increases in inventories. Inventories increased as a result of a combination of FTTP inventory build up, actual versus forecasted sales, customers’ expectations of shortened delivery timeframes and a transition to a new contract manufacturer.

The decrease in working capital as of September 30, 2004 was primarily the result of acquiring NAA for $240.9 million in cash and $5.2 million in associated costs, the decrease in market value of our Cisco securities and an increase in net deferred tax liabilities.

Borrowings

We maintain an uncommitted bank facility for the issuance of commercial and standby letters of credit. At September 30, 2004 we had $2.4 million in letters of credit outstanding under this facility, including $0.5 million issued as a five-year deposit on one of our leased facilities.

26

We maintain agreements with two banks under which we may enter into foreign exchange contracts up to $40 million. There are no borrowing provisions or financial covenants associated with these facilities. At September 30, 2004, there were no foreign exchange contracts outstanding.

Workforce Reduction

In April 2003, we announced a reduction in our workforce to reduce expenses and align our cost structure with our revised business outlook. The major components of the reduction included severance and employee related expenses, and consolidation of excess leased facilities. The following table summarizes expenditures from December 31, 2003 through September 30, 2004 related to the workforce reduction (in thousands):

The remaining expenditures relating to the consolidation of excess leased facilities will be paid through 2009.

Stock Repurchases

We did not make any stock repurchases during the three months ended September 30, 2004.

Contractual Obligations

The following table summarizes our known contractual obligations as of September 30, 2004 that will affect our liquidity and cash flows in future periods (in thousands):

We do not have contractual obligations related to:

•		Long-term debt obligations;
•		Capital lease obligations; or
•		Significant other long-term liabilities.

27

The Cisco stock loan obligations are repayable with 10.6 million shares of Cisco stock. There is no contractual dollar obligation under the loan agreements. We intend to settle the loans using the 10.6 million Cisco shares we own. For purposes of the contractual obligations disclosure only, we used Cisco’s share price of $18.40 as of September 24, 2004 to determine the hypothetical value of the loan obligations assuming the loans are settled in 2010.

We have purchase agreements with contract manufacturers. Under these agreements, the maximum liability for purchase commitments at September 30, 2004 was $91.8 million, of which $1 million was accrued on the balance sheet.

In 2001, we vacated an engineering facility in Largo, Florida and entered into a sublease agreement for the entire space. Our lease term continues through 2007, while the sublease agreement extends through the end of 2004. We accrued $1.5 million to short-term and long-term liabilities for this operating lease in 2001. The amount represents the present value of the loss we expect to incur for the ongoing shortfall between our sublease income and operating lease obligation. If the sublessee does not renew their lease agreement with us, and we are unable to enter into another sublease agreement through the March 31, 2007 term of the lease obligation, the amount of the ultimate loss based on the lease could increase by up to $1 million before tax.

We sublease three of our facilities. The total future minimum lease payments above have not been reduced by $15 million of future sublease payments to be received under non-cancelable subleases.

The Cisco stock loans borrowing fees are partially based on Cisco’s average share price at the end of each quarter. For purposes of the contractual obligations disclosure, we used the $20.13 arithmetic average of Cisco’s share closing price during our third fiscal quarter to determine the hypothetical value of the borrowing fees assuming the loans are settled in 2010.

Based on past performance and current expectations, we believe that our cash and cash equivalents, marketable securities and cash generated from operating and financing activities will be adequate to support our financial resource needs, working capital and capital expenditure requirements, and operating lease obligations, for at least the next 12 months.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that are material to investors.

Risk Factors That Might Affect Future Operating Results and Financial Condition

You should carefully consider the following risk factors and the other information included in this Quarterly Report on Form 10-Q before investing in our common stock. Our business and results of operations could be seriously impaired by any of the following risks. The trading price of our common stock could decline due to any of these risks and investors could lose part or all of their investment. In addition, if our pending merger with Tellabs is completed, the combined company will face additional risks. For information about these risks, refer to the Form S-4 registration statement and amendments thereto, filed with the SEC by Tellabs (SEC File No. 333-116794), including the disclosures under the heading “Risk Factors.” Listed below are risk factors specific to AFC.

Risks related to the pending merger transaction:

The value of Tellabs shares to be received by our stockholders will fluctuate.

Upon consummation of the merger, each share of our common stock will be converted into the right to receive 0.504 shares of Tellabs common stock and $12.00 in cash, without interest. The number of shares of Tellabs common stock to be issued pursuant to the merger for each share of our common stock is fixed. The market price of Tellabs common stock when the merger is completed may fluctuate significantly from its market price at the

28

date of the proxy statement/ prospectus and at the date of the special meeting of AFC stockholders. Future fluctuations in the price of Tellabs common stock may be the result of various factors, including:

•		Changes in the business, operations or prospects of Tellabs or AFC;
•		General market and economic conditions; and
•		Litigation and/or regulatory developments.

Many of these factors are beyond Tellabs’ control. At the time of the special meeting, AFC stockholders will not know the exact market value of the Tellabs common stock that will be issued in connection with the merger. The value of the merger consideration to be received by AFC stockholders will fluctuate with changes in the price of Tellabs common stock. We urge our stockholders to obtain current market quotations for Tellabs and AFC common stock.

Tellabs and AFC will incur significant transaction and merger-related integration costs in connection with the merger.

Tellabs and AFC expect to incur costs associated with consummating the merger and integrating the operations of the two companies, as well as $22.5 million in transaction fees. The estimated $10.3 million of transaction costs incurred by Tellabs will be included as a component of the purchase price for purposes of purchase accounting. The amount of transaction fees expected to be incurred is a preliminary estimate and subject to change. Tellabs is in the early stages of assessing the magnitude of the integration costs that will be required and, therefore, is unable to provide an estimate of these costs at this time. Additional unanticipated costs may be incurred in the integration of the businesses of Tellabs and AFC. Although Tellabs and AFC expect that the elimination of duplicative costs, as well as the realization of other efficiencies related to the integration of the businesses, may offset incremental transaction, merger-related costs over time, we cannot give any assurance that this net benefit will be achieved in the near term, or at all.

We will be subject to business uncertainties and contractual restrictions while the merger is pending.

Uncertainty about the effect of the merger on employees and customers may have an adverse effect on AFC and consequently on the combined company. These uncertainties may impair our ability to attract, retain and motivate key personnel until the merger is consummated, and could cause customers, distributors and others that deal with us to defer purchases or other decisions concerning AFC, or to seek to change existing business relationships with us. Employee retention may be particularly challenging during the pendency of the merger, as employees may experience uncertainty about their future roles with the combined company. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the combined company, the combined company’s business could be seriously harmed. In addition, the merger agreement restricts us from making certain acquisitions and taking other specified actions until the merger occurs or the merger agreement terminates. These restrictions may prevent us from pursuing attractive business opportunities that may arise prior to the completion of the merger or termination of the merger agreement. See the section titled “The Merger Agreement — Covenants” of Tellabs’ Amendment No. 2 to Form S-4 for a description of the restrictive covenants applicable to AFC.

Failure to complete the merger will subject us to financial risks and could cause our stock price to decline.

If the merger is not completed for any reason, we will be subject to a number of material risks, including:

•		Under the merger agreement, we could be required to pay Tellabs up to $10 million as reimbursement of expenses relating to the merger, and a termination fee of $44.45 million if either party terminates the merger agreement where the AFC board of directors has withdrawn, qualified, amended or modified its recommendation of the merger adversely to Tellabs or if we sign a letter of intent, agreement in principle, acquisition agreement or similar agreement for or consummate another acquisition transaction within 12 months of the termination. These fees could deter another interested party from seeking to negotiate such a transaction with AFC after termination;
•		As a result of investors’ expectations regarding the merger, our stock price may decline to the extent that our shares are trading at a higher level than they might have been in the absence of the merger;

29

•		Customers, suppliers and others may believe that we cannot compete effectively in the marketplace without the merger;
•		Costs related to the merger, such as legal and accounting fees and a portion of our investment banking fees, must be paid even if the merger is not completed;
•		The benefits that we expect to realize from the merger would not be realized, and we may have foregone attractive business opportunities as a result of the covenants in the merger agreement; and
•		The diversion of management attention and the possible disruption of our relationships with employees, customers and other business partners between the signing of the merger agreement and its termination, may make it difficult for our company to regain its financial and market position if the merger does not occur.

Risks related to AFC’s business and results of operations:

A number of factors could cause our operating results to fluctuate significantly and cause volatility in our stock price.

Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate in the future due to a variety of factors, many of which are outside our control. These factors include, but are not limited to:

•		Telecommunications market conditions and general economic conditions;
•		The level of capital spending and financial strength of our customers;
•		Changes in revenues, cost of revenues and gross margins resulting from changes in our sales and distribution mix;
•		Changes in revenues, cost of revenues and gross margins resulting from variations in the mix of products sold;
•		Our ability to successfully reduce the cost of certain FTTP components to achieve positive gross profit margins;
•		Our ability to successfully introduce new technologies and products ahead of our competitors;
•		Introductions or announcements of new products by our competitors;
•		The timing, size and mix of the orders we receive;
•		Adequacy of supplies for key components and assemblies;
•		Financial strength of our customers and vendors;
•		Our ability to effectively and efficiently produce and ship orders promptly on a price-competitive basis;
•		Our ability to accurately forecast and execute our strategy and operating plans;
•		Our ability to integrate and operate acquired businesses and technologies; and
•		Changes in accounting rules, such as expensing employee stock option grants.

Any of these factors could result in a significant negative impact on our operating results. Volatility in the price of our common stock may occur as the result of operating results not meeting the expectations of the investment community. In such event, the market price of our common stock could significantly decline. A significant market price decline could result in litigation. Litigation could be costly, lengthy and divert management’s attention and resources from our core business operations.

We rely on a limited number of customers for a substantial portion of our revenues. If we lose one or more of our significant customers or experience a decrease in the level of sales to any of these customers, our revenues and net income could decline.

BellSouth and Sprint accounted for 36.7% and 21%, respectively, of revenues in the three months ended September 30, 2004. Sprint and Alltel accounted for 37.3% and 12.5%, respectively, of revenues in the three months ended September 30, 2003. BellSouth and Sprint accounted for 29% and 23.6%, respectively, of revenues in the nine months ended September 30, 2004. Sprint and Alltel accounted for 33.7% and 13%, respectively, of revenues in the nine months ended September 30, 2003. No other customer accounted for 10% or more of revenues in any of these periods. Sales to our top five customers accounted for 73% of revenues in the nine months ended September 30, 2004, an increase from 65% in the same period a year ago. We anticipate that results of operations in any given period will continue to depend to a great extent on sales to a small number of large accounts. This dependence may increase due to our strategy of growing several large accounts. There can be no assurance that significant existing customers will continue to purchase products from us at current levels, if at all.

30

In the event that a significant existing customer merges with another company, there can be no assurance that such customer will continue to purchase our products. The loss of one or more significant existing customers or a decrease in the level of purchases from these customers could result in a decrease in revenues and net income, an increase in excess and obsolete inventory, and increase our dependency on our remaining significant customers. Although Alltel continues to purchase products from us, our contract with them, which did not include purchase commitments, expired by its terms as of September 6, 2004. We are currently in negotiations with Alltel for a new sales and distribution contract, but can give no assurance if or when we will enter into a new contract.

Sprint and Alltel are distribution subsidiaries of Sprint Corporation and Alltel Corporation, respectively. These subsidiaries distribute our products to their respective affiliates for deployment in their own networks and resell our products to third party IOC customers. Historically, we believe that products representing approximately 20% to 35% of our sales to Sprint and Alltel have been sold to IOC customers.

In mid-June 2004 Verizon informed us that it believes our failure to deliver product features by specified milestone dates, for which we have paid a PCP in the amount of $2 million to Verizon in the three months ended March 31, 2004, and our failure to subsequently deliver some of these product features in accordance with our corrective plans, constitute a default and a breach of our obligations under our agreement with Verizon. Verizon has reserved all of its legal rights and remedies under the agreement, which include termination of the agreement without the required advance notice, pursuing claims against AFC for costs and other damages caused by the breach and canceling previously placed orders. Further, the breach allegation and any resulting termination of the contract or claim against AFC could hurt our reputation and our standing with other RBOCs. We believe that the FTTP project with Verizon is still intact and note that Verizon has continued to order a range of products, including FTTP systems, following its notice of default. As indicated above, we did not meet the product release milestone on June 30, 2004 (which Verizon anticipated in its mid-June letter to us) for which we accrued a $1 million PCP payment to Verizon and subsequently paid in the three months ending December 31, 2004. The accrual was treated as a reduction to revenue during the three months ended June 30, 2004. We could experience an offset to revenues and reduced net income in future quarters due to penalties imposed under such agreements as a result of failures to comply with strict contractual terms.

Significant portions of our revenues are generated through sales of the AccessMAX family of products and a decline in demand for these products would result in decreases in revenues and net income.

Significant portions of our revenues are derived from our AccessMAX product family. Any decrease in market demand for AccessMAX products would result in decreased revenues and lower net income. Factors that could affect demand for our products include price competition, regulatory uncertainty, technological change and new product introductions or announcements by our competitors.

Recent and future acquisitions may compromise our operations and financial results.

We recently completed the acquisition of NAA. We have limited experience in acquiring and integrating companies. The merger agreement with Tellabs currently restricts AFC from pursuing additional acquisitions of companies, products and technologies, which in the past has been, and may in the future be, part of our efforts to enhance our existing product solutions, introduce new product solutions and fulfill changing customer requirements.

Acquisitions could adversely affect our operating results in the short-term. The NAA acquisition, and acquisitions in general, involve numerous risks including disruption of our business, exposure to unknown liabilities of the acquired company, and failure to successfully integrate the operations, products, technologies or personnel of the acquired company. We may not realize the anticipated benefits of our acquisition of NAA, such as increased market share and sales or successful development and market acceptance of new products. The acquired products and technologies in the NAA acquisition for example, or in other future acquisitions, may not result in sufficient revenues to offset the expenses associated with the acquisition.

Goodwill arising from acquisitions may become impaired and result in significant impairment write downs charged to our operating results. As of September 30, 2004, we had $189.8 million in goodwill related to the

31

acquisitions of NAA in February 2004 and AccessLan in 2002. The effect of an impairment write down could harm our business, financial condition and results of operations.

We operate in a rapidly changing competitive and economic environment. If we are unable to adapt quickly to these changes, our business and results of operations could be seriously harmed.

The telecommunications equipment market is characterized by rapid change and converging technology, the full scope and nature of which is difficult to predict. We believe that technological and regulatory change will continue to attract new entrants to the access market. Industry consolidation among our competitors may increase their financial resources, enabling them to reduce their prices. This could require us to either reduce our product prices or risk losing market share. Moreover, industry consolidation may result in stronger competitors that are better able to compete as sole-source suppliers for their customers.

Some of our competitors have broader product portfolios and market share, and may not be as susceptible to downturns in the telecommunications industry. These competitors’ offerings compete directly with our product solutions and provide comprehensive ranges of other products.

Our principal established competitors include Alcatel and Lucent. Some of our competitors enjoy superior name recognition in the market or have more extensive financial, marketing and technical resources than we do. We expect to face increased competition with our established and newly launched product solutions, from both established and emerging competitors.

Continued growth in the access market is highly dependent on a strong level of capital investments in broadband access solutions and a positive regulatory environment for larger ILEC customers. Future reductions in capital expenditures by companies in the telecommunications industry, including some of our customers, could seriously harm our revenues, net income and cash flows.

Our revenues depend on the capital spending programs and financial capabilities of our customers and ultimately on the demand for new telecommunications services from end users.

Our customers are public carriers and, in the U.S., include ILECs, IOCs and RBOCs. Our ability to generate future revenues depends upon the capital spending patterns and financial capabilities of our customers, continued demand by our customers for our product solutions and services, and end user demand for advanced telecommunications services. The financial problems affecting the telecommunications industry in general could continue to cause a slowdown in our sales and result in slower payments or in customer payment defaults. Further, there can be no assurance that carriers, foreign governments or other customers will pursue infrastructure upgrades that will necessitate the implementation of advanced product solutions such as ours. Infrastructure improvements may be delayed or prevented by a variety of factors including cost, regulatory obstacles, the lack of consumer demand for advanced telecommunications services and alternative approaches to service delivery. The economic slowdown impacting the telecommunications industry has affected customers’ capital spending patterns for deploying new services and we cannot provide assurance as to when, or if, capital spending will improve.

Failure to develop and introduce new product solutions that meet changing customer requirements and address technological advances would limit our future revenues.

The telecommunications equipment market is characterized by rapidly changing technology, changes in end user requirements, and frequent new product introductions and enhancements. Our success will depend upon our ability to accurately forecast market trends, enhance our product solutions through the timely development of new technology, develop and introduce new feature enhancements, and implement ongoing cost reductions. We must commit significant resources to develop new product solutions before knowing whether our investments will result in solutions the market will accept. Market acceptance of our product solutions may be significantly reduced or delayed if we fail or are late to respond to new technological developments, or if we experience delays in product development.

The introduction of products embodying new technologies or the emergence of new industry standards can render our existing products obsolete or unmarketable. Competitors’ new products, product enhancements, services or

32

technologies that replace or shorten the life cycle of our products could impair the competitiveness of our product solutions.

Our future operating results will be impacted by whether new products and solutions, including AdvancedVoice, AFC FiberDirect, TelcoVideo, UniversalDSL and DISC*S are widely deployed by operators, the actual timing and quantity of orders for our solutions, growth in demand for broadband services, and our ability to gain market share and experience growth. In January 2004, we signed a multiyear agreement with Verizon, to be the primary FTTP project vendor in providing the central office and premises electronics, also known as the active elements of FTTP technology. We are incurring costs and expenses associated with preparation for the deployment of our FTTP systems and we are generating revenues from the FTTP systems. Our revenues and expenses are affected by the degree to which Verizon invests in FTTP systems and the timing of any such investment.

The FTTP systems are comprised of various components. Our revenue and profitability are affected by the timing and mix of components in the deployment of FTTP systems and mix of customers. One component of the FTTP systems, the Single Family ONT, or ONT, will be sold at a negative gross profit margin until volume increases and unit costs decline. An ONT is deployed at a residence as a network interface device for connecting fiber to services in the home. Although revenue could increase as a result of expected increased shipments of ONTs towards the end of the year, gross margins are expected to decrease since we expect that sales of ONTs at negative margins will constitute a larger portion of revenue than in previous periods. We expect that the amount of ONTs shipped over the next year will have a significant impact on near term gross profit margins and overall financial results. We anticipate an operating loss during the fourth quarter of 2004 as a result of the ONT negative margins, coupled with increasing operating expenses, primarily due to research and development initiatives and planned year end employee hiring, and Tellabs merger-related transaction costs. We have an active remediation program in place to address the profitability of the ONT component. Failure to achieve adequate positive gross profit margins on the ONT component will have an adverse affect on overall gross profit margins, operating income and net income.

Further, we have failed to meet various key milestones in a timely manner under our agreement with Verizon for which we have paid or accrued a total of $3 million in penalties in the nine months ended September 30, 2004. These penalty payments were accounted as a corresponding reduction in revenue in the quarter they are incurred. Our future revenues, gross profit and net income will be affected by the degree to which Verizon invests in FTTP systems, the mix of products ordered, the timing of any such investment and our ability to meet key milestones and avoid penalty payments under our agreement.

We may be unable to secure necessary components and support because we depend upon a limited number of third party manufacturers and support organizations, and in some cases we rely upon sole or limited-source suppliers.

Our growth and ability to meet customer demands are dependent on our ability to obtain timely deliveries of components from our suppliers. We currently purchase certain key components from sole or limited-source vendors. Most of our component purchases are on a purchase order basis without guaranteed supply arrangements. Some of our sole and limited-source vendors allocate parts to multiple telecommunications equipment manufacturers based on market demand for components and equipment. This may result in shortages of certain key components sold to us. In the event of a disruption in supply, we may not be able to identify an alternative source in a timely manner, at favorable prices or of acceptable quality. Such a failure could limit our ability to meet scheduled deliveries to our customers and increase our expenses. This could reduce our gross profit margin and net income. For example, during the three months ended June 30, 2004, a shortage of components used in the manufacture of our FTTP system negatively impacted our ability to ship product and recognize revenue.

We have purchase agreements with contract manufacturers, or CMs, which allow us to negotiate volume discounts and help assure us of a steady supply of components. The agreements require the CMs to purchase component parts to be used in manufacturing our products and authorize them to make purchases in accordance with agreed upon lead times. We provide CMs with forecasts of our expected needs and we issue purchase orders covering a certain period of time for specific quantities. As customers increasingly demand shorter delivery timeframes, the difficulty of accurately forecasting component mix and quantity needs creates additional risk. If we overestimate our requirements, the CMs may assess cancellation penalties or we may have excess or obsolete inventory. If we underestimate our requirements, the CMs may have inadequate inventory, which could interrupt manufacturing of our products. Both situations could reduce our gross profit margin and net income.

33

We cannot be assured that CMs will allocate sufficient resources to the timely completion of our orders in accordance with our quality standards. Qualifying a new CM is costly and time consuming and could result in significant interruptions in the supply of our products.

We may be unable to sell customer-specific inventory, which could result in lower gross profit margins and net income.

Some of our customers’ order specifications require us to design and build systems and purchase parts that are unique to a customer. In many cases, we forecast and purchase components in advance and allocate resources to design and manufacture the systems. If our customers’ requirements change or if we experience delays or cancellation of orders, we may be unable to cost-effectively rework system configurations or return parts to inventory as available-for-sale. Write downs and accruals for unrealizable inventory negatively impact our gross profit margins and net income.

Failure or inability to protect our intellectual property would adversely affect our ability to compete, which could result in decreased revenues.

We seek to protect our technology through a combination of copyrights, trademarks, trade secret laws, contractual obligations and patents. These intellectual property protection measures may not be sufficient to prevent wrongful misappropriation of our technology. These measures will not prevent competitors from independently developing technologies that are substantially equivalent or superior to our technology. The laws of many foreign countries do not protect our intellectual property rights to the same extent as the laws of the U.S. Failure or inability to protect proprietary information could result in loss of our competitive advantage, loss of customer orders and decreased revenues. Furthermore, policing the unauthorized use of our products is difficult. Litigation may be necessary in the future to enforce our intellectual property rights. Litigation could result in substantial costs and diversion of management resources, while not guaranteeing a successful result.

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

We have been subject to several intellectual property disputes in the past, and due to the intensely competitive nature of our industry, we expect to continue being subject to infringement claims and other intellectual property disputes. As a result, we may be subject to additional litigation and may be required to defend against claimed infringements of the rights of others or to determine the scope and validity of the proprietary rights of others. Litigation could be expensive, lengthy and divert management’s attention and resources from core business operations. Adverse determinations could result in the loss of our proprietary rights, or prevent us from manufacturing or selling our products. They may also subject us to significant liabilities and require that we seek licenses from third parties. In such case, we cannot be assured that licenses will be available on commercially reasonable terms, if at all, from any third party that asserts intellectual property claims against us. Any inability to obtain third party licenses required to develop new products or product enhancements could require us to obtain substitute technology of lower quality or performance standards or at greater cost, any of which could seriously impair our competitiveness.

We must attract, retain and motivate key technical and management personnel in order to sustain or grow our business.

Our success depends in large part on our ability to attract and retain key technical and management personnel. Despite the economic slowdown, competition for some specific skill sets remains intense. The process of identifying and attracting key employees is often a lengthy and costly process. Our key employees generally do not have employment agreements. The Financial Accounting Standards Board’s exposure draft to expense stock options could adversely affect our policy of issuing stock options to all employees. This could have a direct effect on our ability to retain key employees. There can be no assurance that we will succeed in retaining key employees. We expect continued challenges in recruiting, assimilating, motivating and retaining the key technical and management personnel necessary to effectively manage our operations.

34

Our products are complex and may contain undetected errors that could result in significant unexpected expenses.

Our products are complex, and despite extensive testing, may contain undetected defects or errors. These issues may only become apparent after products are shipped, when product features are introduced or as new versions are released. The occurrence of any defects, errors or failures could result in delays or cancellation of orders, product returns, warranty costs or legal actions by our customers or our customers’ end users. Any of these issues could reduce revenues, gross profit margin and net income.

We are subject to numerous and changing regulations and industry standards. If our products do not meet these regulations or are not compatible with these standards, our ability to sell our products could be seriously harmed.

Our products must comply with a significant number of voice and data regulations and standards, which vary between U.S. and international markets. Our ability to sell products would be impaired if we fail to ensure our systems are compliant with evolving standards and regulations in a timely manner. Testing to ensure compliance and interoperability requires significant investments of time and money. Additionally, our selling ability would be impaired if we fail to obtain compliance on new features or fail to maintain interoperability with equipment from other companies. As a result, we could experience customer contract penalties, delayed or lost customer orders, decreased revenues and reduced net income.

In our work with large customers such as RBOCs, our agreements may contain provisions for PCPs that are tied to key milestones related to the availability of product releases containing certain product features. Completion of such milestones requires timely and successful R&D efforts, and on converting the results of those R&D efforts into usable, cost effective products. R&D efforts involve large and complicated projects, which rely in part on the work of third parties over which we have limited control, and on which there can be no assurance of success. For example, our agreement with Verizon to provide FTTP systems has several provisions requiring PCPs for failure to meet key milestones or provide product features by specified dates. FTTP has been part of our product development roadmap since 2001, and the majority of the product supplied under the contract is currently developed FTTP equipment. While we have met a number of these milestones on time, we have also failed to meet some milestones. We have paid or accrued a total of $3 million in PCPs to Verizon for two milestones during the nine months ended September 30, 2004. These penalty payments were accounted as a corresponding reduction in revenue in the quarter they are incurred. We could experience an offset to revenues and reduced net income in future quarters due to penalties imposed under such agreements as a result of failures to comply with strict contractual terms.

We have maintained compliance with ISO 9001 since we were first certified in 1997, and TL 9000 since we were first certified for hardware, software and services in 2000. TL 9000 contains all ISO 9001 requirements as well as other telecommunications industry requirements. There can be no assurance that we will maintain these certifications. The failure to maintain TL 9000 certification may adversely impair the competitiveness of our products.

Government actions will continue to have a direct impact on the telecommunications industry and our business. From a regulatory standpoint, we believe the Federal Communications Commission’s, or FCC’s, Triennial Review Order encourages long-term investment in broadband networks and migration to FTTP-based services by reducing the incumbent carriers’ unbundling obligations for broadband facilities. The Court of Appeals for the D.C. Circuit upheld those portions of the FCC’s Order when they were challenged on appeal. In addition, the U.S. Supreme Court denied cert petitions from the competitive carriers and some States challenging the D.C. Circuit Court of Appeals’ decision. The FCC, moreover, has taken several steps since the release of the Triennial Review Order to further reduce or eliminate unbundling obligations for incumbent carriers’ broadband facilities. The FCC on reconsideration decided to treat primarily residential fiber-to-Multi-Dwelling Units (fiber-to-MDUs) and FTTC the same as fiber-to-the-home (FTTH), which means there is no unbundling obligation for greenfield deployments using these deep fiber architectures. In addition, the FCC used its forbearance authority to hold that where broadband unbundling is eliminated under Section 251 of the Federal Communications Act (as it is for FTTH,

35

FTTC and fiber-to-MDUs), then the separate unbundling obligation imposed on the RBOCs under Section 271 of the Federal Communications Act will not be applied.

The 1996 Telecommunications Act imposed additional regulations that affect telecommunications services, including changes to pricing, access by competitive vendors and other broad changes to data and telecommunications networks and services. These changes have had a major impact on the pricing and availability of services, and may affect the deployment of future services. There can be no assurance that any future legislative and regulatory changes will not have a material adverse effect on our products’ competitiveness. Moreover, uncertainty regarding future legislation and governmental policies combined with emerging new competition may also affect the demand for our product solutions.

We face risks associated with international markets and distribution channels.

International sales accounted for 11% and 15% of our revenues in the nine months ended September 30, 2004 and 2003, respectively. International sales have fluctuated in absolute dollars and are expected to continue to fluctuate in future periods.

Access to international markets is often difficult to achieve due to trade barriers and established relationships between government-owned or government-controlled carriers and traditional local equipment vendors. We rely on a number of third party distributors and sales representatives to market and sell our products outside of the U.S. There can be no assurance that third party distributors or sales representatives will provide the support and effort necessary to effectively service our international markets. In some cases, our gross profit margins have been lower for sales through third party and indirect distribution channels than for sales through our direct sales efforts. Increased sales through our third party and indirect distribution channels could reduce our overall gross profit margin and net income.

Although we have attempted to minimize our exposure to taxation in foreign countries, any income or other taxes imposed may increase our overall effective tax rate, thereby adversely impacting our competitiveness in those countries. We currently intend that any earnings of our foreign subsidiaries remain permanently invested in these entities to facilitate the potential expansion of our business. Our cash flows could be adversely affected to the extent that these earnings are actually or deemed repatriated, resulting in the imposition of additional U.S. federal and state income taxes.

We must comply with various country-specific standards and regulations to compete in international markets. Our product solutions may be incompatible with the legacy infrastructure of some international markets. If our existing international customers adopt network standards incompatible with those supported by our product solutions, we could experience a loss of revenues and lowered net income. Any inability to obtain or maintain local regulatory approval could delay or prevent entrance into certain markets. These factors could result in delays or loss of customer orders, decreased revenues and lower net income.

Economic risks that may impact our international sales include the inability to collect receivables from customers due to a country’s economic collapse and resulting currency exchange controls. This would negatively impact our cash flow and result in receivable write-offs.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We have a Cisco shares liability for 10.6 million shares of Cisco common stock borrowed and outstanding at September 30, 2004. The following table shows the changes in fair value of the Cisco shares liability arising from a hypothetical 20% increase or decrease in Cisco’s stock price. Based on the $18.40 closing price at September 24, 2004, the last trading day of our third fiscal quarter, the amounts were (in thousands):

36

We have a Cisco shares asset for 10.6 million shares of Cisco common stock as of September 30, 2004. The following table shows the changes in fair value of the Cisco shares arising from a hypothetical 20% increase or decrease in Cisco’s stock price. Based on the $18.40 closing price at September 24, 2004, the amounts were (in thousands):

We have foreign currency sales to two international customers. When circumstances warrant, we hedge foreign currency risk on certain accounts receivable and accounts payable with forward contracts that generally expire within 60 days. These forward currency contracts are not designated as hedges and changes in the fair value of the forward contracts are recognized immediately in earnings.

At September 30, 2004, we held a $3.3 million investment in a privately held company. The investment represents 2% ownership of the company on a fully diluted basis. The company designs and manufactures telecommunications equipment. We began investing in the company in 1999. We maintain this investment on a cost basis and do not have the ability to exercise significant influence over the company’s operations. Our investment carries risk because the products of this company have been in general release for a limited time. This company is also subject to risks resulting from uncertain standards for new products and competition. If these products fail to generate customer interest, the value of the company would likely decline and could result in impairment of our investment. Additionally, macroeconomic conditions and an industry capital spending slowdown are affecting the availability of venture capital funding, and the valuations of private companies. We could lose our entire investment in this company and be required to record a charge to operations for any loss. Our ability to earn a return on this investment is largely dependent on the occurrence of an initial public offering, merger, or sale of the company.

At September 30, 2004, we held a $2 million investment in a privately held company. The investment represents 7% ownership of the company on a fully diluted basis. The company is a supplier of optical components. We maintain this investment on a cost basis and do not have the ability to exercise significant influence over the company’s operations. Our investment carries risk because the products of this company are specialized and have a limited market. We could lose our entire investment in this company and be required to record a charge to operations for any loss. Our ability to earn a return on this investment is largely dependent on the occurrence of an initial public offering, merger, or sale of the company.

Item 4. Controls and Procedures

AFC maintains “disclosure controls and procedures,” as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, or the Exchange Act. These disclosure controls and procedures are designed to ensure that information required to be disclosed by AFC in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms. They are also designed to ensure that such information is accumulated and communicated to AFC’s management, including our Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating AFC’s disclosure controls and procedures, we recognized that no matter how well conceived and operated, disclosure controls and procedures can provide only reasonable, not absolute, assurance that their objectives are met. Additionally, we evaluated the cost-benefit relationship in the design of our disclosure controls and procedures. Their design is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

Subject to the limitations noted above, our management, with the participation of our CEO and CFO, has evaluated the effectiveness of the design and operation of AFC’s disclosure controls and procedures as of the end of the fiscal quarter covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the CEO and CFO have concluded that AFC’s disclosure controls and procedures provided reasonable assurance that the objectives of the control systems for which they were designed were effective.

37

There were no changes in our internal control over financial reporting identified in connection with the foregoing evaluation that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

38

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On June 1, 2004, a complaint was filed on behalf of a putative class of AFC stockholders against AFC, certain of its current officers and directors, and Tellabs, in the Court of Chancery in the State of Delaware in and for New Castle County. The complaint alleges that the individual defendants breached their fiduciary duties to AFC’s public stockholders by acting to cause or facilitate the merger of Tellabs and AFC for inadequate consideration, and that each of the defendants, including AFC and Tellabs, acted to aid and abet the alleged breaches of fiduciary duty. In particular, plaintiff alleges that the merger consideration for AFC’s public stockholders is unfair and inadequate because, according to the plaintiff, “(a) the intrinsic value of the stock of AFC is materially in excess of the $21.24 per share being proposed, giving due consideration to the possibilities of growth and profitability of AFC in light of its business, earnings and earnings power, present and future; (b) the $21.24 per share price is inadequate and offers an inadequate premium to the public shareholders of AFC; and (c) the $21.24 per share price is not the result of any structure[d] auction process by which AFC sought to obtain the best deal possible for its shareholders.” The plaintiff seeks to enjoin the merger, and if the merger is consummated, to rescind the transaction. The plaintiff also asserts claims for unspecified compensatory and/or rescissory damages, and an award of costs, including attorneys’ fees. AFC believes that these claims are without merit and intends to vigorously defend itself in this action.

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

Not applicable.

Item 3. Defaults Upon Senior Securities

Not applicable.

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

Not applicable.

Item 5. Other Information

Not applicable.

Item 6. Exhibits

39

SIGNATURE

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.

	ADVANCED FIBRE COMMUNICATIONS, INC.
Date: November 3, 2004	By:	/s/ Keith E. Pratt
		Name:	Keith E. Pratt
		Title:	Chief Financial Officer, Senior Vice President, Finance and Administration and Assistant Secretary (Duly Authorized Signatory and Principal Financial Officer)

40

Index of Exhibits

41