STRATOS INTERNATIONAL INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q


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

		For the quarterly period ended October 31, 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 0-30869

STRATOS INTERNATIONAL, INC.

(Exact name of Registrant as specified in its charter)


Delaware		36-4360035
(State or Other Jurisdiction of		(I.R.S. Employer Identification No.)
Incorporation or Organization)


7444 West Wilson Avenue		60706
Chicago, Illinois 60706
(Address of Principal Executive Offices)		(Zip Code)

(708) 867-9600
(Registrant’s Telephone Number, Including Area Code)

Not Applicable

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last
Report)

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 Securities Exchange Act of 1934).

Yes o No x

As of December 14, 2004, there were 14,159,123 shares of the registrant’s common stock, par value $0.01 per share, outstanding.

PART I
FINANCIAL INFORMATION

Item 1. Financial Statements.

STRATOS INTERNATIONAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)


	April 30,			October 31,
	2004			2004
				(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	15,501		$	27,388
Short-term investments		21,488			9,247
Accounts receivable, less allowance		12,544			10,703
Inventories:
Finished products		2,831			2,852
Work in process		1,042			902
Materials		12,091			13,117

		15,964			16,871
Recoverable income taxes		4,176			4,212
Prepaid expenses		1,326			1,235

Total current assets		70,999			69,656
Other assets:
Goodwill and other indefinite lived assets		6,110			6,110
Intangible assets, net of amortization		14,665			14,036
Assets held for sale		4,441			2,988
Other		5,879			6,043

		31,095			29,177
Property, plant and equipment		91,530			89,678
Less allowances for depreciation		64,574			65,848

		26,956			23,830

Total assets	$	129,050		$	122,663

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	8,422		$	7,044
Other current liabilities		7,373			8,153
Current portion of long-term debt		2,230			1,766

Total current liabilities		18,025			16,963
Long-term debt, less current portion		801			—
Deferred income taxes		445			445
Redeemable preferred stock		5,000			5,000
Shareholders’ equity:
Preferred stock – Series B		—			—
Common stock		143			142
Additional paid-in capital		319,212			318,629
Accumulated deficit		(210,633	)		(215,201	)
Unearned compensation		(3,809	)		(2,796	)
Foreign currency translation adjustments		114			(271	)
Cost of shares in treasury		(248	)		(248	)

Total shareholders’ equity		104,779			100,255

Total liabilities and shareholders’ equity	$	129,050		$	122,663

See notes to condensed consolidated financial statements.

-1-

STRATOS INTERNATIONAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(in thousands, except per share amounts)


	Three Months Ended						Six Months Ended
	October 31,						October 31,
	2003			2004			2003			2004
Revenue:
Net sales	$	7,111		$	18,181		$	13,682		$	39,204
License fees and royalties		113			1,493			619			4,276

Total		7,224			19,674			14,301			43,480
Costs and expenses:
Costs of sales		8,020			12,439			15,498			26,253
Research and development		1,807			2,422			4,697			4,828
Sales and marketing		1,327			2,610			2,845			5,419
General and administrative		3,775			6,267			6,473			11,501

Total costs and expenses		14,929			23,738			29,513			48,001

Loss from operations		(7,705	)		(4,064	)		(15,212	)		(4,521	)
Investment income, net		184			65			423			129

Loss before income taxes		(7,521	)		(3,999	)		(14,789	)		(4,392	)
Provision for income taxes		—			—			—			—

Net loss		(7,521	)		(3,999	)		(14,789	)		(4,392	)
Preferred stock dividend requirements		—			(88	)		—			(175	)

Net loss attributable to common shareholders	$	(7,521	)	$	(4,087	)	$	(14,789	)	$	(4,567	)

Net loss per share attributable to common shareholders, basic and diluted:
Net loss	$	(1.02	)	$	(0.30	)	$	(2.00	)	$	(0.33	)
Preferred stock dividend requirements		—			—			—			(0.01	)

Net loss per share attributable to common shareholders	$	(1.02	)	$	(0.30	)	$	(2.00	)	$	(0.34	)

Weighted average number of common shares outstanding:
Basic and diluted		7,392			13,549			7,378			13,542

See notes to condensed consolidated financial statements.

-2-

STRATOS INTERNATIONAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(in thousands)


	Six Months Ended
	October 31,
	2003			2004
Operating activities:
Net loss	$	(14,789	)	$	(4,392	)
Adjustments to reconcile net loss to net cash used in operating activities:
Provision for depreciation and amortization		2,584			3,642
Gain on sale of assets held for sale		(1,305	)		—
Change in operating assets and liabilities		2,784			427

Net cash used in operating activities		(10,726	)		(323	)
Investing activities:
Purchases of property, plant and equipment		(1,815	)		(346	)
Purchases of short-term investments		(28,503	)		(3,747	)
Sales of short-term investments		13,679			15,988
Proceeds from sale of property, plant and equipment		—			186
Proceeds from sale of assets held for sale		4,381			1,450

Net cash from (used in) investing activities		(12,258	)		13,531
Financing activities:
Repayments on long-term borrowings		(1,959	)		(1,265	)
Net proceeds from exercise of stock options		138			119
Dividends on preferred stock		—			(175	)
Treasury stock transactions		(217	)		—

Net cash used in financing activities		(2,038	)		(1,321	)

Net increase (decrease) in cash and cash equivalents		(25,022	)		11,887
Cash and cash equivalents at beginning of period		43,649			15,501

Cash and cash equivalents at end of period	$	18,627		$	27,388

See notes to condensed consolidated financial statements.

-3-

STRATOS INTERNATIONAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

October 31, 2004
(All amounts in thousands, except share and per share data)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. Certain items included in these statements are based on management’s estimates. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six month periods ended October 31, 2004 are not necessarily indicative of the results that may be expected for the fiscal year ending April 30, 2005. This unaudited quarterly information should be read in conjunction with the audited consolidated financial statements and related notes for the fiscal year ended April 30, 2004 included in the Company’s Annual Report on Form 10-K, as amended, filed with the Securities and Exchange Commission.

Comprehensive loss consists of net loss and foreign currency translation adjustments and totaled $7,517 and $4,384 for the second quarters of fiscal 2004 and 2005 and $14,870 and $4,777 for the six months ended October 31, 2003 and 2004.

2. Stock-Based Compensation

In the first quarter of fiscal 2004, the Company adopted Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation. The provisions of SFAS No. 148 did not have a material impact on the Company’s financial position or results of operations. The Company will continue to account for stock-based compensation plans using the intrinsic value method described in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. All stock options granted by the Company are granted at market price and thus no compensation expense is recorded in the Company’s results of operations. Under SFAS No. 148, the Company is required to report quarterly and year to date pro forma net loss and loss per share as if the Company had accounted for its stock options plans under the fair value method. The following table shows the Company’s pro forma net loss and loss per share as if the Company had recorded the fair value of stock options as compensation expense.

STRATOS INTERNATIONAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)


	Three Months Ended						Six Months Ended
	October 31,						October 31,
(Dollars in thousands, except per share amounts)	2003			2004			2003			2004
Reported net loss attributable to common shareholders	$	(7,521	)	$	(4,087	)	$	(14,789	)	$	(4,567	)
Stock-based compensation, net of tax		(609	)		(213	)		(1,205	)		(483	)
Pro forma net loss		(8,130	)		(4,300	)		(15,994	)		(5,050	)
Reported basic and diluted net loss per share attributable to common shareholders		(1.02	)		(0.30	)		(2.00	)		(0.34	)
Pro forma basic and diluted net loss per share attributable to common shareholders		(1.10	)		(0.32	)		(2.17	)		(0.37	)

No stock options were issued during the six months ended October 31, 2004.

3. Business Combinations

In November 2003, the Company acquired Sterling Holding Company (“Sterling”), a privately-held company based in Mesa, Arizona that designs and manufactures Radio Frequency (“RF”) and microwave interconnect products via its two operating units, Trompeter Electronics, Inc. and Semflex, Inc. The Company completed this merger on November 6, 2003, following approval by both Company and Sterling shareholders. At closing, Sterling became a wholly-owned subsidiary of the Company, with Sterling shareholders receiving 6,082,000 shares of the Company’s common stock, which represented approximately 82% of the Company’s total shares outstanding immediately prior to the consummation of the merger. Of such amount, 608,189 shares were placed in escrow to provide indemnification to the Company with respect to certain matters provided for in the merger agreement. These shares were released from escrow and distributed after the end of the second quarter. Company common shares issued in this transaction were valued at $5.09 a share, the closing price on July 2, 2003, the day the merger was announced. The Company also issued 50,000 shares of Series B redeemable preferred stock with a face value of $5,000 and a contingent value of up to an additional $6,250 based on certain events, including the future performance of the Company’s common share price. The total purchase consideration was $38,755, consisting of common and preferred shares of Company stock valued at $35,957 and $2,798 of acquisition related costs.

The primary reasons for the acquisition included Stratos’ desire to expand the size of its business, Stratos’ belief that Sterling’s electronic interconnect operations would be a positive addition to Stratos’ existing product lines, and Stratos’ goal of acquiring profitable operations. Sterling’s historical operating results, future operating forecasts and the fair value of Sterling’s assets less liabilities assumed, contributed to the determination of the purchase price and the recognition of goodwill.

STRATOS INTERNATIONAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The Sterling acquisition was accounted for using the purchase method of accounting and the results of operations of Sterling have been included in the Company’s consolidated financial statements from the date of acquisition.

The allocation of the purchase price to the net assets acquired was as follows:


Assets acquired:
Cash	$	10,918
Accounts receivable		5,312
Inventories		7,785
Developed technology		3,185
Computer software		700
Company trade names		2,700
Customer relationships		10,800
Deferred income taxes		7,572
Property, plant and equipment		8,489
Other		3,099

Total assets		60,560
Liabilities assumed:
Accounts payable		1,430
Accrued expenses		3,673
Dividend payable		12,000
Deferred income taxes		8,112

Total liabilities		25,215

Net assets acquired		35,345
Goodwill		3,410

Purchase price	$	38,755

Cash paid, including transaction costs	$	2,798
Stock consideration		35,957

Total purchase price	$	38,755

Independent valuation specialists identified $17,385 of intangible assets in the acquisition of Sterling. These intangible assets and their associated useful lives are as follows (in thousands):


	Amount		Useful Life
Patents and related technology	$	3,185	14.25 years
Developed software		700	5.00 years
Tradenames		2,700	Indefinite
Customer relationships		10,800	12.50 years

	$	17,385

STRATOS INTERNATIONAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Goodwill and other indefinite lived assets at October 31, 2004 and April 30, 2004 are comprised of goodwill of $3,410 and tradenames of $2,700 related to the Sterling acquisition.

Had the acquisition been made as of May 1, 2003, unaudited pro forma sales and operating results are estimated to have been as follows:


							Pro forma
	Stratos			Sterling			Adjustments			Consolidated
Net sales:
Six months ended October 31, 2003	$	13,682		$	17,364		$	—		$	31,046
Net loss:
Six months ended October 31, 2003		(14,789	)		(4,579	)		(997	)		(20,365	)
Net loss per share, basic and diluted:
Six months ended October 31, 2003		(2.00	)		(0.63	)		(0.13	)		(2.76	)

The pro forma adjustments represent additional depreciation related to the step-up in value of fixed assets and amortization of intangibles acquired.

The pro forma results reported above are not necessarily indicative of future results.

Under current tax regulations, the goodwill related to the acquisition of Sterling cannot be deducted for federal and state income tax purposes.

4. Intangible Assets

Amortizable intangible assets were comprised of the following:


	October 31, 2004						April 30, 2004
	Gross						Gross
	Carrying		Accumulated				Carrying		Accumulated
Amortizable Intangible Assets	Amount		Amortization		Net		Amount		Amortization		Net
	(in thousands)
Customer relationships	$	10,800	$	864	$	9,936	$	10,800	$	432	$	10,368
Patents and related technology		4,085		452		3,633		4,039		325		3,714
Developed software		700		233		467		700		117		583

Total amortized intangible assets	$	15,585	$	1,549	$	14,036	$	15,539	$	874	$	14,665

Amortization for intangible assets was $355 and $684 for the three and six months ended October 31, 2004. Annual expense for intangible assets subject to amortization is expected to approximate $1,500 for each of the next five years.

5. Restructuring Charges

During prior fiscal years the Company recorded restructuring charges related to the consolidation and elimination of various operating units. These charges included excess and obsolete inventory, goodwill and fixed asset impairment, personnel, rentals for limited use

STRATOS INTERNATIONAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

facilities and legal costs related to the restructuring of operations. The Company terminated 95 employees in fiscal 2004 during the restructuring of operations, including both production and administrative personnel.

Accruals relating to restructuring charges and the subsequent activity are summarized as follows:


	Balance		2005		Utilized through		Balance
	April 30, 2004		Charges		October 31, 2004		October 31, 2004
Employee costs	$	240	$	—	$	101	$	139
Limited-use facility rental		738		—		535		203

	$	978	$	—	$	636	$	342

6. Income Taxes

The Company has recorded a valuation allowance of $65,200 against deferred income tax assets primarily associated with tax loss carry forwards through April 30, 2004 because the significant operating losses experienced in recent years establishes a presumption that realization of these income tax benefits does not meet a “more likely than not” standard. We have continued to experience operating losses during the six months ended October 31, 2004, and an additional valuation reserve of $1,600 was recorded, which eliminated the tax benefit attributable to the net loss incurred in the first six months of fiscal 2005.

We have net operating loss carryforwards of approximately $165,000 that are available to offset taxable income in the future. The net operating loss carry forwards will expire in 2022 through 2025.

7. Long-Term Debt

Long-term debt consists of a note payable for the purchase of computer software and hardware in connection with the implementation of a new information technology system in fiscal 2002. At October 31, 2004, the remaining principal payments totaling $1,766 are considered current because such payments are due within one year of the balance sheet date.

The note is supported by a letter of credit in the amount of $2,700 that expires on August 1, 2005.

8. Assets Held For Sale

Assets held for sale at October 31, 2004 represents real property and machinery and equipment that is no longer in use and is being actively marketed for sale. Management expects to complete these sales transactions within a one-year period. The Company recorded a charge

STRATOS INTERNATIONAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

of $619 in fiscal 2004 to adjust the carrying value of assets held for sale to their estimated net realizable value. The Company used independent appraisals or realtors’ letters of opinion of value to determine the estimated net realizable value of assets held for sale.

9. Loss Per Share


	Three Months Ended						Six Months Ended
	October 31,						October 31,
	2003			2004			2003			2004
Numerator – net loss attributable to common shareholders	$	(7,521	)	$	(4,087	)	$	(14,789	)	$	(4,567	)

Denominator:
Denominator for basic and diluted loss per share – weighted-average shares outstanding		7,392			13,549			7,378			13,542

Basic and diluted loss per share	$	(1.02	)	$	(0.30	)	$	(2.00	)	$	(0.34	)

The effect of outstanding stock options and unvested restricted stock awards have not been considered in the determination of dilutive weighted average shares outstanding because their effect would be antidilutive.

10. Sale of a Business

Effective May 23, 2003, the Company sold the assets and business of its wholly-owned subsidiary, Bandwith Semiconductor LLC, located in Hudson, New Hampshire. The Company realized a net gain of approximately $1,200, which is reflected as a reduction of general and administrative expenses in the condensed consolidated statement of operations for the six months ended October 31, 2003.

11. Litigation

The Company and certain of its directors and executive officers have been named as defendants in purported class action lawsuits filed in the United States District Court, Southern District of New York. The first of these lawsuits, filed on July 25, 2001, is captioned Kucera v. Stratos Lightwave, Inc. et.al. No. 01 CV 6821. Three other similar lawsuits have also been filed against the Company and certain of its directors and executive officers. The complaints also name as defendants the underwriters for the Company’s initial public offering. The complaints are substantially identical to numerous other complaints filed against other companies that went public during the time of the Company’s IPO. The complaints generally allege, among other things, that the registration statement and prospectus from the Company’s June 26, 2000 initial public offering failed to disclose certain alleged actions by the underwriters for the offering. The complaints charge the Company and two or three of its directors and executive officers with violations of Sections 11 and 15 of the Securities Act of 1933, as amended, and/or Section 10(b) and Section 20(a) to the Security Exchange Act of 1934, as amended. The complaints also allege claims solely against the underwriting defendants under Section 12(a)(2) of the Securities Act of 1933, as amended.

STRATOS INTERNATIONAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

In 2003, the Company agreed to a Memorandum of Understanding, which reflects a settlement of these class actions as between the purported class action plaintiffs, the Company and the defendant officers and directors, and the Company’s liability insurer. Under the terms of the Memorandum of Understanding, the Company’s liability insurers will pay certain sums to the plaintiffs, with the amount dependent upon the plaintiffs’ recovery from the underwriters in the IPO class actions as a whole. The plaintiffs will dismiss with prejudice their claims against the Company and its officers and directors, and the Company will assign to the plaintiffs certain claims that it may have against the underwriters. The plaintiffs have filed with the court a motion for preliminary approval of the settlement, which, if granted, will lead to the mailing of class-wide notices of the settlement and a hearing date for approval of the settlement. The issuers filed a statement joining in the plaintiffs’ motion for preliminary approval of the settlement. The underwriter defendants have opposed the motion, and the court has not ruled on it.

In February 2002, the Company acquired Tsunami Optics, Inc. The acquisition agreement contemplated a potential earn-out payment of up to $18 million in common stock if certain financial targets were achieved following the acquisition. In June 2002, Catherine Lego, as representative of the former Tsunami shareholders, filed a lawsuit against the Company alleging, among other things, that the Company breached the acquisition agreement by refusing to allow Tsunami to operate as a separate subsidiary, firing the Tsunami executives that it believed were necessary to operate the business and thereby making it impossible for Tsunami to achieve the targets required to receive any earnout payments. The complaint also alleged fraud and violations of federal securities laws in connection with the acquisition of Tsunami. Plaintiffs are seeking $38 million in damages or the rescission of the acquisition agreement. The Company filed a counterclaim against Ms. Lego and several other shareholders and officers of Tsunami which alleges fraud, breach of contract and violations of federal securities laws. The counterclaim seeks compensatory and punitive damages.

In April 2004, the Court entered an order in favor of the Company to dismiss with prejudice 11 of 13 counts of the plaintiffs’ complaint. The alleged damages sought for the plaintiffs’ two remaining claims (breach of contract and rescission) remain unchanged at $38 million. The Company believes that the plaintiffs’ remaining claims are without merit and intends to vigorously defend against these claims. The court also denied the plaintiff’s motion to dismiss the Company’s counterclaims of fraud and violations of federal securities law and granted the plaintiff’s motion to dismiss the allegation of breach of contract. Trial of this action commenced on December 1, 2004, and is expected to conclude in December 2004.

In August 2002, James Campbell, the former CEO of Tsunami, filed a lawsuit against the Company alleging wrongful termination in breach of his employment contract, fraud and age discrimination. Campbell’s claims were subsequently amended to include intentional infliction of emotional distress. Campbell seeks unspecified damages, punitive damages and attorney’s fees. The Company believes that this lawsuit is without merit and intends to vigorously defend against these claims. An August 2004 trial date was originally set but was vacated, and a new trial date has not been set.

STRATOS INTERNATIONAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

In March 2003, Alcatel USA filed suit against the Company and others, seeking unspecified damages and alleging breach of contract, breach of warranty, negligent misrepresentation, fraud and conspiracy in connection with Alcatel’s purchase of certain goods from the defendants over a period spanning 2000 and 2001. The Company asserted certain counterclaims against Alcatel relating to the same type of goods at issue in Alcatel’s complaint. In April 2004, Alcatel and the Company executed a written settlement agreement resolving all disputes. Pursuant to the terms of the written settlement agreement, the parties executed mutual releases and the case was dismissed with prejudice on August 13, 2004.

The Company is a plaintiff in a lawsuit relating to its intellectual property rights against Picolight, Inc. (District of Delaware). In this action, the Company alleges that optoelectronic products sold by the defendant infringe numerous of the Company’s patents and is seeking monetary damages and injunctive relief. The defendant has asserted an affirmative defense and filed counterclaims and contends that the patents are invalid, unenforceable and/or not infringed by the products sold by the defendant. Picolight has asserted an antitrust counterclaim based on the alleged unenforceability of the Company’s patents. If successful, the defendant is seeking attorneys’ fees and costs in connection with the lawsuit. The Company intends to pursue this lawsuit and defend against the counterclaims vigorously. On November 24, 2003, a jury returned a verdict finding that Picolight infringed six of the Company’s patents. The case is currently in the inequitable conduct phase and we are awaiting the judge’s ruling. The third phase on validity is dependent on the outcome of the inequitable conduct phase, and would be followed by the damages phase.

During the second quarter of fiscal year 2005 the Company settled a patent infringement case and as a result of this settlement the Company received approximately $1.4 million, which was recorded as license fees and royalties in the consolidated statement of operations.

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

You should read the following discussion together with our consolidated financial statements and notes to those financial statements, which are included in this report. This report contains forward-looking statements made pursuant to the safe harbor provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended. The words “anticipates,” “intends,” “expects,” “could,” “should,” “plans,” “believes,” “estimates,” or words or phrases of similar import generally identify forward-looking statements. You are cautioned that forward-looking statements are subject to risks, trends and uncertainties that could cause actual results, performance or achievements to differ materially from those expressed in any forward-looking statements. Important factors that could cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by those statements include, but are not limited to the following: (i) the continuation of the current economic climate and its effect on our business; (ii) our ability to meet analyst and investor expectations; (iii) the long-term growth of the communications industry and its use of our technologies; (iv) our ability to develop and market new products and technology and to make enhancements to existing products and technology on a successful and timely basis; (v) our and our customers’ ability to comply with evolving domestic and international government regulations; (vi) expenditures associated with redesigning products to comply with evolving industry standards or alternative technologies that become the industry standard; (vii) our dependence on sales to the military/aerospace industry; (viii) our ability to develop and manage relationships with large customers that comprise, and will comprise, a significant percentage of our net sales, respectively; (ix) the length of sales cycles, which vary by product and customer, and the effect that this length has on net sales and operating expenses; (x) the lack of long-term customer contracts and its effect on customers’ ability to reduce, cancel and defer orders on short notice without significant penalty; (xi) the effect on gross margins of an inability to reduce manufacturing costs or increase sales of higher margin products; (xii) the impact of competitive products; (xiii) our reliance on a limited number of suppliers and the effect of underestimating or overestimating the need for certain supplies; (xiv) our ability to attract and retain qualified personnel; (xv) the effect of defects in our products; (xvi) the effect of compliance with environmental laws and other legal requirements; (xvii) the effect of economic, political and regulatory risks associated with international operations, including acts of terrorism directed against the United States or U.S. affiliated targets; (xviii) our ability to complete and integrate acquisitions, strategic alliances and joint ventures; (xix) our ability to secure and defend intellectual property rights and, when appropriate, license required technology; (xx) adverse outcomes of pending, threatened or future litigation, including suits related to intellectual property matters; (xxi) volatile market prices for securities of technology-related companies; (xxii) the effect of provisions in our organizational documents and Delaware law that may delay or prevent the acquisition of Stratos or may decrease the value of Stratos common stock; (xxiii) our ability to integrate Stratos and Sterling; (xxiv) the continued costs associated with the acquisition of Sterling; and (xxv) impact on our earnings of application of the purchase method of accounting in connection w ith the Sterling merger. Because forward-looking statements are subject to assumptions and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. Shareholders are cautioned not to place undue reliance on such statements, which speak only as of the date of this document or the date of any document incorporated by

reference. All subsequent written and oral forward-looking statements concerning the matters addressed in this document and attributable to the Company or any person acting on the Company’s behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. Except to the extent required by applicable law or regulation, the Company undertakes no obligation to release publicly any revisions or updates to such forward-looking statements to reflect events or circumstances after the date of this document or to reflect the occurrence of unanticipated events.

See the cautionary statements included as Exhibit 99 to this quarterly report for a more detailed discussion of the foregoing and other factors that could cause actual results to differ materially from those included in the forward-looking statements and that, among others, should be considered in evaluating our outlook.

Overview

In November 2003, the Company acquired Sterling Holding Company (“Sterling”), a privately-held company based in Mesa, Arizona that designs and manufactures Radio Frequency (“RF”) and microwave interconnect products via its two operating units, Trompeter Electronics, Inc. and Semflex, Inc. At closing, Sterling became a wholly-owned subsidiary of the Company, with Sterling shareholders receiving 6,082,000 shares of the Company’s common stock, which represented approximately 82% of the Company’s total shares outstanding immediately prior to the consummation of the merger. Of such amount, 608,189 shares were placed in escrow to provide indemnification to the Company with respect to certain matters provided for in the merger agreement. These shares were released from escrow and distributed after the end of the second quarter. Company common shares issued in this transaction were valued at $5.09 a share, the closing price on July 2, 2003, the day the merger was announced. The Company also issued 50,000 shares of Series B redeemable preferred stock with a face value of $5.0 million and a contingent value of up to an additional $6.25 million based on certain events, including the future performance of the Company’s share price. The total purchase consideration was $38.8 million, consisting of common and preferred shares of Company stock valued at $36.0 million and $2.8 million of acquisition related costs.

In connection with the transaction, the Company expanded its Board of Directors to nine members. The new board was comprised of four members of the Company’s Board at the time of the closing of the merger, four members from Sterling’s Board, and an additional director chosen by Sterling.

On May 19, 2004, we announced that our Board of Directors had decided to explore various strategic alternatives to maximize shareholder value, including a possible sale of the Company. In connection with that decision, our Board of Directors has formed a committee and has retained CIBC World Markets Corp. as its exclusive financial advisor. There can be no assurance that a transaction will result involving the Company.

On November 5, 2004, the Company announced that James W. McGinley resigned effective that date, as President and Chief Executive Officer and director of the Company. In addition, the Company announced that Brian J. Jackman had resigned as a director of the Company effective the same date. As a result, the Board currently has seven members.

We develop, manufacture and sell optical, RF, and microwave components and subsystems for various applications and multiple end markets. These subsystems are designed for use in storage, data networking, metro and wide area telecom networks, military, aerospace, video, government security, oil and gas, and other industrial markets and applications. We plan to continue to diversify our end markets and expand our product offerings through internal and, possibly, external growth. Our products are compatible with the various standards used in these applications, including Gigabit Ethernet, Fast Ethernet, Fibre Channel, and synchronous optical network (“SONET”), and other standards dictated by the application of our products.

Our net sales are derived from the sale of optical components and subsystems to original equipment manufacturers (“OEMs”) and local resellers, and from the sale of RF and microwave components to telecom service providers, OEMs, military and government users, and distributors and resellers. Our net sales have fluctuated from period to period due to customer demand for our products, the size and timing of customer orders, our ability to deliver in the relevant period and any canceled, delayed or rescheduled orders in the relevant period. We determine inventory reserves in light of the rapid technological change experienced in our industry on a product-by-product basis. While it is likely that obsolescence due to rapid technological change will continue, the timing and amount of this obsolescence cannot be predicted with certainty.

The average unit prices of many of our products generally decrease as the products mature in response to factors such as increased competition, the introduction of new products and increased unit volumes. We anticipate that average selling prices of many of our products will continue to decline in future periods, although the timing and degree of the declines cannot be predicted with any certainty. We must continue to develop and introduce new products that incorporate features that can be sold at higher average selling prices, on a timely basis. There can be no assurance that we will be able to introduce new products to offset the anticipated decrease in the average selling prices of our products.

License fees and royalties represent payments received from licensees of our patented technology, which is also used by us in our optical, RF and microwave product lines. These license agreements generally provide for up-front payments and/or future fixed payments or ongoing royalty payments based on a percentage of sales of the licensed products. The timing and amounts of these payments is beyond our control. Accordingly, the amount received in any given period is expected to vary significantly. The duration of all of these license agreements extends until the expiration of the licensed patents, which in most cases is greater than ten years. We will consider entering into similar agreements in the future. However, we are not able to predict whether we will enter into any additional licenses in the future and, if so, the amount of any license fees or royalties.

Our cost of sales consists of materials, salaries and related expenses for manufacturing personnel and manufacturing overhead. We purchase several key components used in the manufacture of our products from a limited number of suppliers. We have periodically experienced shortages and delivery delays for these materials. In some circumstances, we maintain an inventory of limited source components to decrease the risk of shortage. If we overestimate our requirements, we may have excess inventory of these components. The majority of our products are designed and manufactured in our own facilities. In the future we may expand the volume of products manufactured by third parties. In order to remain

competitive, we must continually reduce our manufacturing costs through design and engineering innovations and increases in manufacturing efficiencies. There can be no assurance that we will be able to reduce our manufacturing costs.

Some of our critical components used in production of certain of our products are purchased from a key supplier, which has been acquired by a competitor of the Company. If this supplier increases prices, reduces quantities available to us or ceases to supply us, our business and results of operations may be significantly harmed.

Research and development expenses consist primarily of salaries and related expenses for design engineers, scientists and other technical personnel, depreciation of test and prototyping equipment, and tooling. Research and development expenses also consist of materials and operating expenses related to major product development projects. We charge all research and development expenses to operations as incurred.

We market and sell our products domestically and internationally through our direct sales force, local resellers and manufacturers’ representatives. Specifically, we have established relationships with resellers and manufacturers’ representatives in North America, Europe, South America, Asia and various other countries.

The Company sells through a team of representative distributors and direct sales professionals across North America, Europe and Asia. The Company’s sales teams are organized into three groups including Stratos Lightwave (active and passive components and subsystems), Trompeter (RF interconnect products) and Semflex (microwave cable and cable assemblies). The Company maintains three sales organizations to capture the strong brand identity each has developed in its respective marketplace.

The marketing group is responsible for developing marketing strategies and programs that support the sale of the Company’s products and enhance its reputation in the industry. These strategies and programs include (i) ongoing interaction with customers for the development of new products and technical support, (ii) advertising and other promotional activities in industry trade journals and publications targeting design engineers, (iii) participation in major trade show events and conferences in the communications network industry to promote the Company’s broad lines of active and passive optical, and RF and microwave components and subsystems, (iv) public relations covering new products, applications and design wins, (v) market research to support R&D investment and investor relations activity, (vi) corporate branding to create a consistent message across the Stratos Lightwave, Trompeter and Semflex brands, and (vii) interaction with our customers in industry associations and standards committees to promote and further enhance active and passive interconnection technologies, and increase the Company’s visibility as an industry expert.

We believe our ability to deliver value-added customer service and technical support is essential to our business. Our sales force and design engineers work closely with our customers through the design and manufacturing process. We also provide extensive technical support to our customers after the design and qualification process is complete. We intend to strengthen our current customer relationships by continuing to deliver a high level of value-added service and technical support and leveraging our reputation for high quality products and service to establish relationships with new customers.

Sales and marketing expenses consist primarily of personnel costs, including sales commissions, travel costs, outside marketing and consulting services, and product marketing and promotion costs. We expect to continue to make significant expenditures for sales and marketing services.

General and administrative expenses consist primarily of personnel costs for our administrative and financial groups, as well as legal, accounting, information technology and other professional fees. We expect to continue to make significant expenditures for general and administrative services.

Critical Accounting Policies

Accounts Receivable

We sell products primarily to various OEMs and distributors. Sales to these customers have varying degrees of collection risk associated with them. Management assesses collection risk and the related allowance for doubtful accounts based on the aging of accounts, historical experience and the customer’s financial condition.

Inventory Reserves

It is our policy to reserve 100% of the value of inventory we specifically identify and consider obsolete or excessive for fulfilling future sales estimates. We define obsolete inventory as inventory that will no longer be used in the manufacturing process or items that have potential quality problems. Excess inventory is defined as inventory in excess of one to two years’ projected usage depending upon the product. Excess inventory is determined using our best estimate of future demand at the time, based upon information then available to us. In general, our policy is to scrap inventory determined to be obsolete shortly after the determination is made and to keep excess inventory for a reasonable amount of time before it is discarded. Occasionally, changed circumstances in the marketplace present us with an opportunity to sell inventory that was previously determined to be excessive and reserved for. If this occurs, we vigorously pursue such opportunities.

Impairment of Long-Lived Assets

We review the carrying value of our long-lived assets if the facts and circumstances, such as significant declines in sales, earnings or cash flows or material adverse changes in the business climate suggest that they may be impaired. If this review indicates that long-lived assets will not be recoverable, as determined based on the estimated undiscounted cash flows of the long-lived asset, impairment is measured by comparing the carrying value of the long-lived

asset to fair value. Fair value is determined based on quoted market values, discounted cash flows or appraisals. If an asset is considered held for sale, we adjust the carrying value of the underlying assets to fair value, as determined based on the estimated net realizable proceeds of the assets.

Revenue Recognition

Revenue from product sales, is recognized when a customer order is established, the price is determined, title passes (which occurs upon shipment) and collectibility is reasonably assured. On rare occasions, we may ship products to a customer FOB destination and transfer of ownership occurs at the customer’s place of business. Our product sales do not include any obligations for installation, training or other post shipment obligations. We do not issue any guarantees or provide warranties for our products. We handle returns by replacing, repairing or issuing credit for defective products when returned. We establish a reserve for returns based on any known and anticipated returns and accordingly adjust revenue, accounts receivable and inventories.

Customer Returns

It is our policy to establish a reserve for customer returns based on any known returns and anticipated returns based on past experience and accordingly adjust revenue, accounts receivable and inventories.

Customer demand is a changing dynamic. Occasionally, we have and will receive requests from customers to accept the return of merchandise for which they had previously accepted delivery. Although we have no obligation to do so, each such request is evaluated in light of contemplated future business from that customer. We will continue to consider these requests in the future, however, we are not able to predict the amount of any such returns.

Research and Development

All expenses relative to the development of a new product, prior to its introduction into production, are considered research and development expenses. In addition, the costs of the engineering effort to do significant redesign to enhance product performance that results essentially in a new product are also considered to be research and development expenses. Because the true manufacturability of our products is not obvious until a period of volume production has occurred, initial production is considered a part of the development process. During this phase, a portion of the scrap expense and yield loss is considered development expense. A product continues to be considered under development until it matures to the point where its production yields (volumes) are consistent with other mature products and any related engineering effort is predominately dedicated to customer applications and/or quality support.

Results of Operations

The following table sets forth certain statement of operations data as a percentage of net sales for the periods indicated:


	Three Months Ended October 31,										Change
	2004					2003					$			%
	(dollars in millions)
Revenue:
Net sales	$	18,181		100.0	%	$	7,111		100.0	%	$	11,070			155.7	%
License fees and royalties		1,493		8.2			113		1.6			1,380			1,221.2

Total revenue		19,674		108.2			7,224		101.6			12,450			172.3
Costs and expenses:
Cost of sales		12,439		68.4			8,020		112.8			4,419			55.1
Research and development		2,422		13.3			1,807		25.4			615			34.0
Sales and marketing		2,610		14.4			1,327		18.7			1,283			96.7
General and administrative		6,267		34.5			3,775		53.1			2,492			66.0

Total costs and expenses		23,738		130.6			14,929		210.0			8,809			59.0

Loss from operations		(4,064	)	(22.4	)		(7,705	)	(108.4	)		3,641			47.3
Investment income, net		65		0.4			184		2.6			(119	)		(64.7	)

Loss before income taxes		(3,999	)	(22.0	)		(7,521	)	(105.8	)		3,522			46.8
Provision for income taxes		—		—			—		—			—			—

Net loss	$	(3,999	)	(22.0	)%	$	(7,521	)	(105.8	)%	$	3,522			46.8	%

Three Months Ended October 31, 2004 and 2003

Net Sales. Net sales for the second quarter of fiscal 2005 increased to $18.2 million from $7.1 million a year ago. Of the $11.1 million increase in the second quarter, $6.0 million was from an increase in net sales to the military/governmental end market, $2.2 million from an increase to the telecom/metro end market, and $3.7 million is from an increase in net sales to other end markets. These increases were offset in part by an $800,000 decrease in net sales in the data networking end market. Included in the amounts above is $10.6 million in sales from product lines acquired in the merger with Sterling.

Excluding the sales attributable to the product lines acquired from Sterling, sales increased $488,000 (6.9%) in the three months ended October 31, 2004 over the comparable period last year. The increase in sales was due to an increase in customer demand for our products in most of our end markets.

On November 5, 2004 the Company announced that revenues for the three months ended October 31, 2004 would be lower than expected, due to anticipated returns of a specific product sold to one major customer. As a result of certain quality problems experienced with the product, the Company decided to accept the returns and rework the parts and the quality issue

has been resolved to the customer’s satisfaction. Returns of $1.5 million related to this matter were recorded in the three months ended October 31, 2004. However, the customer has identified additional source(s) for this product and competition will likely create downward pricing pressure.

License Fees and Royalties. License fees increased to $1.5 million in the three months ended October 31, 2004 from $113,000 in the three months ended October 31, 2003. This increase is primarily attributable to $1.4 million of license fee income associated with the settlement of a patent infringement case. License fees consist of both fixed schedule payments and contingent payments based on sales volumes of licensed products.

Cost of Sales and Gross Margins. Cost of sales increased to $12.4 million in the three months ended October 31, 2004 from $8.0 million in the three months ended October 31, 2003. Gross margin as a percentage of net sales improved to 31.6% in the three months ended October 31, 2004 from negative 12.8% in the three months ended October 31, 2003. Approximately, 13.6 percentage points of the 44.4% increase was due to the decrease in prime costs and manufacturing costs, 22.6 percentage points was due to product lines acquired in the merger with Sterling, and 9.2 percentage points was due to the reduction in the charges for obsolete and slow moving inventory that were recognized in the second quarter of fiscal 2004. These factors were offset by 1.0 percentage point for the reduction in sales of inventory previously considered excess and fully reserved.

Research and Development. Research and development expenses increased to $2.4 million in the three months ended October 31, 2004 from $1.8 million in the three months ended October 31, 2003. The increase of $600,000 was due primarily to a $400,000 increase in costs of personnel dedicated to research and development and $200,000 increase in material and overhead cost related to major product development. The above amounts include $165,000 of research and development expenses attributable to the product lines acquired from Sterling.

Sales and Marketing. Sales and marketing expenses increased to $2.6 million in the three months ended October 31, 2004 from $1.3 million for the three months ended October 31, 2003. This $1.3 million increase was due to increases of $1.4 million in sales and marketing salaries, fringe benefits, bonuses and commissions, offset by a decrease of $100,000 in field sales operating costs supporting our sales. The above amounts include $1.4 million of sales and marketing expenses attributable to the product lines acquired from Sterling.

General and Administrative. General and administrative expenses increased to $6.3 million in the three months ended October 31, 2004 from $3.8 million in the comparable period last year. This increase of $2.5 million resulted from an increase of $600,000 in corporate salaries, fringe benefits and bonuses and a $1.9 million increase in general expenses. The amounts above include $1.2 million of general and administrative expenses attributable to the product lines acquired from Sterling.

Investment Income, Net. Investment income, net of investment expense, decreased to $65,000 in the three months ended October 31, 2004 from $184,000 in the three months ended October 31, 2003. Investment income consists of earnings on the short-term investment of excess cash balances. The decrease of this income in the three months ended October 31, 2004

reflect less cash being invested on a short-term basis as well as lower prevailing interest rates during the period.

Income Taxes. The Company has recorded a valuation allowance of $65.4 million against deferred income tax assets primarily associated with tax loss carry forwards through July 31, 2004 because the significant operating losses experienced in recent years establishes a presumption that realization of these income tax benefits does not meet a “more likely than not” standard. We have continued to experience operating losses during the three months ended October 31, 2004, and an additional valuation allowance of $1.4 million was recorded, which eliminated the tax benefit attributable to the net loss incurred in the second quarter of fiscal 2005.

Six Months Ended October 31, 2004 and 2003


	Six Months Ended October 31,										Change
	2004					2003					$			%
	(dollars in millions)
Revenue:
Net sales	$	39,204		100.0	%	$	13,682		100.0	%	$	25,522			186.5	%
License fees and royalties		4,276		10.9			619		4.5			3,657			590.8

Total revenue		43,480		110.9			14,301		104.5			29,179			204.0
Costs and expenses:
Cost of sales		26,253		67.0			15,498		113.3			10,755			69.4
Research and development		4,828		12.3			4,697		34.3			131			2.8
Sales and marketing		5,419		13.8			2,845		20.8			2,574			90.5
General and administrative		11,501		29.3			6,473		47.3			5,028			77.7

Total costs and expenses		48,001		122.4			29,513		215.7			18,488			62.6

Loss from operations		(4,521	)	(11.5	)		(15,212	)	(111.2	)		10,691			70.3
Investment income, net		129		0.3			423		3.1			(294	)		69.5

Loss before income taxes		(4,392	)	(11.2	)		(14,789	)	(108.1	)		10,397			70.3
Provision for income taxes		—		—			—		—			—			—

Net loss	$	(4,392	)	(11.2	)%	$	(14,789	)	(108.1	)%	$	10,397			70.3	%

Net sales for the six month period ended October 31, 2004 increased $25.5 million over the same period a year ago to $39.2 million from $13.7 million. The increase represents a $9.8 million increase in net sales to the military/governmental end market, a $4.8 million increase in the net sales to the telecom/metro end market, a $3.8 million increase in net sales to the data networking end market, a $100,000 increase in the net sales into the storage end market, and $7 million is from an increase in net sales to other end markets. Included in the amounts above is $21.1 million in net sales from product lines acquired in the merger with Sterling.

Excluding the sales attributable to the product lines acquired from Sterling, sales increased $4.4 million (32.1%) in the six months ended October 31, 2004 over the comparable period last year. The increase in sales was due to an increase in customer demand for our products throughout our end markets. Our total sales order backlog decreased to $12.3 million as of October 31, 2004 from $13.0 million as of April 30, 2004. Although we realized a slight

decrease in our backlog since the end of fiscal 2004, we experienced an increase in backlog in all our end markets over the comparable period in fiscal 2004.

License Fees and Royalties. License fees increased to $4.3 million in the six months ended October 31, 2004 from $619,000 in the six months ended October 31, 2003. This increase is primarily attributable to $3.9 million of license fee income associated with the settlement of two patent infringement cases. License fees consist of both fixed schedule payments and contingent payments based on sales volumes of licensed products.

Cost of Sales and Gross Margins. The gross margin increased to 33% for the six months ended October 31, 2004 from negative 13.3% in the comparable period last year. Approximately 15.8 percentage points of the 46.3% increase was due to the decrease in prime costs and manufacturing costs, 21.6 percentage points was due to product lines acquired in the merger with Sterling, 10.4 percentage points was due to the reduction in the charges for obsolete and slow moving inventory and 2.8 percentage points was due to reduction of the cost of severance pay relating to restructuring of operations. These factors were offset by 4.3 percentage points for the sale of inventory previously considered excess and fully reserved.

Cost of sales was increased approximately $140,000 and $1.5 million in the six months ended October 31, 2004 and 2003, respectively, for obsolete and excess inventory.

Research and Development. Research and development expenses increased to $4.8 million in the six months ended October 31, 2004 from $4.7 million in the six months ended October 31, 2003. The increase of $100,000 was the result of increases in personnel costs dedicated to research and development and in material and overhead costs related to major product development. The above amounts include $287,000 of research and development expenses attributable to the product lines acquired from Sterling.

Sales and Marketing. Sales and marketing expenses increased to $5.4 million in the six months ended October 31, 2004 from $2.8 million in the comparable period last year. This $2.6 million increase was due to an increase in sales and marketing salaries, fringe benefits, bonuses and commissions. The above amounts include $2.8 million of sales and marketing expenses attributable to the product lines acquired from Sterling.

General and Administrative. General and administrative expenses increased to $11.5 million in the six months ended October 31, 2004 from $6.5 million in the comparable period last year. This $5 million increase was due to $500,000 in legal fees for the settlement of litigation as described in License Fees and Royalties above, $1.2 million increase in salaries, fringe benefits and bonuses and a $3.3 million increase in general expenses. The amounts above include $2.3 million of general and administrative expenses attributable to the product lines acquired from Sterling.

Investment Income, Net. Investment income, net of investment expense, decreased to $129,000 in the six months ended October 31, 2004 from $423,000 in the comparable period last year. Investment income consists of earnings on the short-term investment of excess cash balances, and the decreases of this income in the six months ended October 31, 2004 reflect the reduction of excess cash balances as well as lower prevailing interest rates during the period.

Income Taxes. The Company has recorded a valuation allowance of $65.2 million against deferred income tax assets primarily associated with tax loss carry forwards through April 30, 2004 because the significant operating losses experienced in recent years establishes a presumption that realization of these income tax benefits does not meet a “more likely than not” standard. We have continued to experience operating losses during the six months ended October 31, 2004, and an additional valuation allowance of $1,600 was recorded, which eliminated the tax benefit attributable to the net loss incurred in the first six months of fiscal 2005.

We have net operating loss carry forwards of approximately $165 million that are available to offset taxable income in the future. The net operating loss carry forwards will expire in 2022 through 2025.

Liquidity and Capital Resources

Net cash used in operating activities totaled $323,000 for the six months ended October 31, 2004. The use of cash in operating activities resulted primarily from a net loss, the decrease of accounts payable and accrued expenses, and an increase in inventory, offset in part by a decrease in accounts receivable. Net cash used in operating activities totaled $10.7 million for the six months ended October 31, 2003. The use of cash in operating activities resulted primarily from a net loss offset in part by decreases in accounts receivable and inventories and increases in accounts payable and accrued expenses.

We operate in markets that have experienced a severe economic downturn during the past several years and, as a result, many of our customers may, from time to time, stretch their payment terms. Days sales in accounts receivable was 53 days at October 31, 2004 compared to 57 days at April 30, 2004.

Net cash from investing activities totaled $13.5 million in the six months ended October 31, 2004, including a $12.2 million decrease in short-term investments, $200,000 in proceeds from the sale of fixed assets and $1.4 million of proceeds from the sale of assets held for sale, offset by $350,000 for the purchase of equipment and facilities. Net cash used in investing activities totaled $12.3 million in the six months ended October 31, 2003, including $1.8 million for the purchase of equipment and facilities, a $14.8 million increase in short-term investments, partially offset by $4.3 million of proceeds from the sale of assets held for sale.

Net cash used in financing activities was $1.3 million in the six months ended October 31, 2004, including a $1.25 million repayment on borrowings and $175,000 of dividends on preferred stock, offset in part by $120,000 of proceeds from exercise of stock options. Net cash used in financing activities was $2.0 million in the six months ended October 31, 2003, including a $2.0 million repayment on borrowings and $200,000 in treasury stock transactions, offset in part by $200,000 of proceeds from exercise of stock options.

As of October 31, 2004, our principal source of liquidity was approximately $36.6 million in cash, cash equivalents and short-term investments.

Sterling provided $4.1 million of net positive cash flow during the six months ended October 31, 2004.

Our future capital requirements will depend on a number of factors, including our ability to generate increased sales and our ability to manage operating expenses. The continued diversification of our end markets and expansion of our product offerings through internal and, possibly, external growth could materially change our level of cash and cash equivalents. This diversification may require the Company to seek equity or debt financing. Our only cash commitments are (i) the repayment of long-term debt of approximately $1.8 million and (ii) the payment of cumulative cash dividends on the Series B Preferred Stock on terms specified in the Certificate of Designation for such stock ($350,000 annually). We also are obligated to redeem all shares of Series B Preferred Stock in accordance with the terms of the Certificate of Designation for such stock no later than 60 days following the occurrence of certain events relating to the Company’s achievement of $250 million in annual revenue or $500 million in market capitalization. In addition, if a change of control of the Company occurs, the Series B Preferred Stock becomes redeemable for an aggregate of $5 million, subject to upward adjustment under certain circumstances relating to market price of the Company’s Common Stock. We believe that our current cash balances will be sufficient to meet our cash needs for working capital, capital expenditures, the Series B Preferred Stock dividend and repayments of long-term debt for the next 12 months. The settlement of, or an adverse result in, current and future litigation may, however, significantly affect our cash position and capital requirements. To the extent that the Company needs to or deems it advisable to seek equity or debt financing in connection with any of the foregoing, no assurance can be given that such financing will be available, or that it will be available on favorable terms.

The severe economic downturn in our markets during the past several years may continue in the remainder of fiscal 2005, during which we may experience significant decreases in net sales and incur net losses, offset to a certain extent by net profits generated by Sterling. We expect the difficult industry conditions to continue for at least the next 6 to 12 months and they may continue for a longer period. Any continued or further decline in demand for our customers’ products or in general economic conditions would likely result in further reduction in demand for our products and our business, operating results and financial condition would suffer.

Further, in order to propel overall industry growth and to encourage interoperability of supplier components, subsystems, systems and networks, various industry standards have evolved and are evolving which provide customers the opportunity to choose between vendors who have form, fit and function compatible products that are essentially interchangeable as second or third sources. As customers manage their supply chains more efficiently, pricing pressure increases on vendors, such as the Company, reducing gross margins for similar products.

In response to these conditions, we have implemented personnel reductions, shut down certain facilities, disposed of certain assets and put in place other cost reduction programs; however, since many of our costs are fixed in the near term, we expect to continue to incur significant manufacturing, research and development, sales and marketing and administrative expenses. Consequently, we will need to generate higher revenues while containing costs and operating expenses if we are to return to profitability. If our efforts to increase our revenues and contain our costs are not successful, we will continue to incur net losses.

We are also examining and pursuing opportunities for improving gross margins and cash flow. The merger with Sterling combined two companies with brands that are well-respected by segments of the telecommunications, military, video and broadcast customer base that seek solutions to difficult problems at the electrical side of the high-performance, high-bandwidth interface which are solved by products offered by Stratos. We believe that these products, when combined with superior customer service, provide the potential for improving gross margins and cash flows.

Off-Balance Sheet Arrangements

We are not party to any transactions, arrangements and other relationships with unconsolidated entities or other persons that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

The Company is subject to certain market risks, including foreign currency and interest rates. Although our Stratos U.K. subsidiary enters into transactions in currencies other than its functional currency, foreign currency exposures arising from these transactions are not material to us. The primary foreign currency exposure arises from the translation of our net equity investment in our foreign subsidiary to U.S. dollars. We generally view our investment in our foreign subsidiary with a functional currency other than the U.S. dollar as long-term. The primary currency to which we are exposed is the pound sterling.

The Company does not have exposure to interest rate risk related to its debt obligation because the interest rate is fixed. The Company’s market risk is the potential loss of income from the reduction in interest rates from the renewal of short-term investments. The Company has experienced such reductions in these rates during fiscal year 2004 and the first six months of fiscal 2005.

Item 4. Controls and Procedures.

As of the end of the period covered by this report, our management, including our Chief Financial Officer and the two other Executive Vice Presidents, carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Based upon that evaluation, our Chief Financial Officer and the two other Executive Vice Presidents concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in our filings with the SEC.

There has been no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the period covered by this quarterly report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time, the Company becomes involved in various lawsuits and legal proceedings that arise in the normal course of business. The Company believes that the resolution of these lawsuits and legal proceedings will not have a significant effect on the Company’s business, financial condition or results of operations.

targets required to receive any earnout payments. The complaint also alleged fraud and violations of federal securities laws in connection with the acquisition of Tsunami. Plaintiffs are seeking $38 million in damages or the rescission of the acquisition agreement. The Company filed a counterclaim against Ms. Lego and several other shareholders and officers of Tsunami which alleges fraud, breach of contract and violations of federal securities laws. The counterclaim seeks compensatory and punitive damages.

In August 2004, Federal Insurance Company, issuer of the Directors’ and Officers’ Insurance policy for the company, filed suit against the Company and others in the United States District Court, Northern District of Illinois. The Complaint for Declaratory Judgment has been filed to deny coverage to the Company, under its Director and Officer policy, for the Lego and Campbell lawsuits. The suit was filed in response to the Company’s submission of a claim for insurance coverage for the Lego and Campbell lawsuits and the tender of defense costs to the insurer for reimbursement. Federal does not seek damages from the Company and the Company disputes denial of the coverage. This action is scheduled for trial in June 2005.

filed counterclaims and contends that the patents are invalid, unenforceable and/or not infringed by the products sold by the defendant. Picolight has asserted an antitrust counterclaim based on the alleged unenforceability of the Company’s patents. If successful, the defendant is seeking attorneys’ fees and costs in connection with the lawsuit. The Company intends to pursue this lawsuit and defend against the counterclaims vigorously. On November 24, 2003, a jury returned a verdict finding that Picolight infringed six of the Company’s patents. The case is currently in the inequitable conduct phase and we are awaiting the judge’s ruling. The third phase on validity is dependent on the outcome of the inequitable conduct phase, and would be followed by the damages phase.

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

(b) The Company’s registration statement on Form S-1 filed under the Securities Act of 1933, Commission File No. 333-34864, was declared effective by the Commission on June 26, 2000. As adjusted for the 1-for-10 reverse stock split in October, 2002, a total of 1,006,250 shares of our common stock were registered pursuant to this registration statement. The managing underwriters for the offering were Lehman Brothers, CIBC World Markets, U.S. Bancorp Piper Jaffray, Robert W. Baird & Co., Tucker Anthony Cleary Gull, and Fidelity Capital Markets, a division of National Financial Services Corporation.

The Company sold these shares at an initial public offering price of $210.00 per share. The aggregate underwriting discount paid in connection with the offering was $14,791,875.

The net proceeds from the offering, after deducting the underwriting discount and the estimated offering expenses to be paid by the Company, were approximately $195 million. Uses of proceeds to date include $135.2 million for general corporate purposes and the purchase of equipment and facilities, payments of $17.1 million in connection with various acquisitions, repayment of $2.7 million of advances from a Methode Electronics Inc. (“Methode”) subsidiary, and $333,000 for repayment of a note assumed in connection with the acquisition of our Stratos Ltd. subsidiary. The remainder of the proceeds will be used for general corporate purposes, including working capital, capital expenditures, and research and development. Pending these uses, the remaining net proceeds have been invested in short-term interest bearing, investment grade marketable securities.

Other than the repayment of advances from a Methode subsidiary described above and the payment of the additional purchase price in connection with our Stratos Lightwave-Florida acquisition which was paid to two of our officers (and the payment of salaries and expense reimbursements to employees in the ordinary course of business), none of the net proceeds of the offering have been paid, directly or indirectly, to any director or officer of the Company or any of their associates, to any persons owning 10 percent or more of our common stock, or to any affiliate of the Company.

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

There were no matters submitted to a vote of security holders during the three month period ended October 31, 2004.

Item 6. Exhibits.


Exhibit
Number		Description of Document
2.1		Agreement and Plan of Merger, dated as of July 2, 2003, as amended as of August 19, 2003 and October 31, 2003, among Stratos Lightwave, Inc., Sleeping Bear Merger Corp. and Sterling Holding Company (12)

3.1		Restated Certificate of Incorporation of Registrant (13)

3.2		Bylaws of Registrant (1)

3.3		Certificate of Designation of Series A Junior Participating Preferred Stock, included as Exhibit A to Exhibit 4.3

3.4		Certificate of Designation for Series B Preferred Stock (11)

4.1		Specimen certificate representing the common stock (1)

4.2		Specimen Certificate representing the Series B Preferred Stock (13)

4.3		Rights Agreement, dated as of March 23, 2001, between Stratos International, Inc. and Mellon Investor Services LLC (2)

4.4		First Amendment, dated as of July 2, 2003, to Rights Agreement, dated as of March 23, 2001, between Stratos Lightwave, Inc. and Mellon Investor Services LLC, as Rights Agent. (10)

4.5		Registration Rights Agreement, dated as of July 2, 2003, among Stratos Lightwave, Inc., Citicorp Venture Capital Ltd., the William N. and Carol A. Stout Trust dated November 24, 1998 and the William N. and Carol A. Stout Charitable Remainder Unit Trust (11)

4.6		Standstill Agreement, dated as of July 2, 2003, between Stratos Lightwave, Inc. and Citicorp Venture Capital Ltd. (11)

10.1		Form of Indemnity Agreement between Registrant and Registrant’s directors and officers (1)

10.2		Stratos Lightwave, Inc. 2000 Stock Plan, as amended and restated (3)

10.3		Agreement and Plan of Reorganization, dated January 22, 2002, by and among the Registrant, Tundra Acquisition Corp. and Tsunami Optics, Inc. (4)

10.4		Stratos Lightwave, Inc. 2002 Stock Plan for Acquired Companies (5)

10.5		Agreement and Plan of Reorganization, dated March 18, 2002, by and among the Registrant, Polar Acquisition Corp. and Paracer, Inc. (6)

10.6		Management Retention Agreement between the Registrant and James McGinley (7)

10.7		Management Retention Agreement between the Registrant and David Slack (7)

10.8		Management Retention Agreement between the Registrant and Richard Durrant (7)

10.9		Stratos Lightwave, Inc. Severance Plan (7)

10.10		Agreement and Plan of Merger, dated as of July 2, 2003, as amended as of August 19, 2003 and October 31, 2003, among Stratos Lightwave, Inc., Sleeping Bear Merger Corp. and Sterling Holding Company (11)

10.11		Amendment to Management Retention Agreement between the Registrant and James McGinley (8)

10.12		Amendment to Management Retention Agreement between the Registrant and David Slack (8)

10.13		Amendment to Management Retention Agreement between the Registrant and Richard Durrant (8)

10.14		Amendment to Stratos Lightwave, Inc. Severance Plan (8)

10.15		Stratos Lightwave, Inc. 2003 Stock Plan (10)

10.16		Stratos Lightwave, Inc. 2003 Employee Stock Purchase Plan (10)

10.17		Employment, Confidentiality and Noncompete Agreement, dated as of November 3, 1997, by and between Trompeter Electronics, Inc. and Joe Norwood (13)

10.18		Salary Continuation Agreement, dated as of October 18, 2000, by and between Trompeter Electronics, Inc. and Joe Norwood (13)

10.19		Amendment to Salary Continuation Agreement, dated as of July 26, 2004, by and between Trompeter Electronics, Inc. and Joe Norwood (13)

10.20		Salary Continuation Agreement, dated as of August 10, 2004, by and between Trompeter Electronics,


Exhibit
Number		Description of Document
		Inc. and Joe Norwood (13)

10.21		Amendment to Management Retention Agreement between the Registrant and James McGinley (13)

31.1		Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer*

31.2		Rule 13a-14(a)/15d-14(a) Certification of Executive Officer*

31.3		Rule 13a-14(a)/15d-14(a) Certification of Executive Officer*

32.1		Section 1350 Certification of Chief Financial Officer*

32.2		Section 1350 Certification of Executive Officer*

32.3		Section 1350 Certification of Executive Officer*

99		Cautionary Statements*

(1)		Incorporated by reference to the Registrant’s Registration Statement on Form S-1 effective June 26, 2000.

(2)		Incorporated by reference to the Registrant’s Form 8-K dated March 22, 2001.

(3)		Incorporated by reference to the Registrant’s Annual Report on Form 10-K for the year ended April 30, 2001.

(4)		Incorporated by reference to the Registrant’s Form 8-K dated February 4, 2002.

(5)		Incorporated by reference to the Registrant’s Registration Statement on Form S-8 dated January 31, 2002.

(6)		Incorporated by reference to the Registrant’s Form 8-K dated March 28, 2002.

(7)		Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended October 31, 2002.

(8)		Incorporated by reference to the Registrant’s Annual Report on Form 10-K for the fiscal year ended April 30, 2003.

(9)		Incorporated by reference to the Registrant’s Form 8-A/A filed August 7, 2003.

(10)		Incorporated by reference to the Registrant’s Form S-4/A effective September 29, 2003.

(11)		Incorporated by reference to the Registrant’s Form 8-K dated November 6, 2003.

(12)		Incorporated by reference to the Quarterly Report on Form 10-Q for the quarter ended October 31, 2003.

(13)		Incorporated by reference to the Registrant’s Form 10-K/A filed August 30, 2004.

* Filed or furnished herewith

EXHIBIT INDEX


Exhibit
Number		Description of Document
2.1		Agreement and Plan of Merger, dated as of July 2, 2003, as amended as of August 19, 2003 and October 31, 2003, among Stratos Lightwave, Inc., Sleeping Bear Merger Corp. and Sterling Holding Company (12)

3.1		Restated Certificate of Incorporation of Registrant (13)

3.2		Bylaws of Registrant (1)

3.3		Certificate of Designation of Series A Junior Participating Preferred Stock, included as Exhibit A to Exhibit 4.3

3.4		Certificate of Designation for Series B Preferred Stock (11)

4.1		Specimen certificate representing the common stock (1)

4.2		Specimen Certificate representing the Series B Preferred Stock (13)

4.3		Rights Agreement, dated as of March 23, 2001, between Stratos International, Inc. and Mellon Investor Services LLC (2)

4.4		First Amendment, dated as of July 2, 2003, to Rights Agreement, dated as of March 23, 2001, between Stratos Lightwave, Inc. and Mellon Investor Services LLC, as Rights Agent. (10)

4.5		Registration Rights Agreement, dated as of July 2, 2003, among Stratos Lightwave, Inc., Citicorp Venture Capital Ltd., the William N. and Carol A. Stout Trust dated November 24,19/98 and the William N. and Carol A. Stout Charitable Remainder Unit Trust (11)

4.6		Standstill Agreement, dated as of July 2, 2003, between Stratos Lightwave, Inc. and Citicorp Venture Capital Ltd. (11)

10.1		Form of Indemnity Agreement between Registrant and Registrant’s directors and officers (1)

10.2		Stratos Lightwave, Inc. 2000 Stock Plan, as amended and restated (3)

10.3		Agreement and Plan of Reorganization, dated January 22, 2002, by and among the Registrant, Tundra Acquisition Corp. and Tsunami Optics, Inc. (4)

10.4		Stratos Lightwave, Inc. 2002 Stock Plan for Acquired Companies (5)

10.5		Agreement and Plan of Reorganization, dated March 18, 2002, by and among the Registrant, Polar Acquisition Corp. and Paracer, Inc. (6)

10.6		Management Retention Agreement between the Registrant and James McGinley (7)

10.7		Management Retention Agreement between the Registrant and David Slack (7)

10.8		Management Retention Agreement between the Registrant and Richard Durrant (7)

10.9		Stratos Lightwave, Inc. Severance Plan (7)

10.10		Agreement and Plan of Merger, dated as of July 2, 2003, as amended as of August 19, 2003 and October 31, 2003, among Stratos Lightwave, Inc., Sleeping Bear Merger Corp. and Sterling Holding Company (11)

10.11		Amendment to Management Retention Agreement between the Registrant and James McGinley (8)

10.12		Amendment to Management Retention Agreement between the Registrant and David Slack (8)

10.13		Amendment to Management Retention Agreement between the Registrant and Richard Durrant (8)

10.14		Amendment to Stratos Lightwave, Inc. Severance Plan (8)

10.15		Stratos Lightwave, Inc. 2003 Stock Plan (10)

10.16		Stratos Lightwave, Inc. 2003 Employee Stock Purchase Plan (10)

10.17		Employment, Confidentiality and Noncompete Agreement, dated as of November 3, 1997, by and between Trompeter Electronics, Inc. and Joe Norwood (13)

10.18		Salary Continuation Agreement, dated as of October 18, 2000, by and between Trompeter Electronics, Inc. and Joe Norwood (13)

10.19		Amendment to Salary Continuation Agreement, dated as of July 26, 2004, by and between Trompeter Electronics, Inc. and Joe Norwood (13)

10.20		Salary Continuation Agreement, dated as of August 10, 2004, by and between Trompeter Electronics, Inc. and Joe Norwood (13)

10.21		Amendment to Management Retention Agreement between the Registrant and James McGinley (13)

31.1		Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer*

31.2		Rule 13a-14(a)/15d-14(a) Certification of Executive Officer*

31.3		Rule 13a-14(a)/15d-14(a) Certification of Executive Officer*

32.1		Section 1350 Certification of Chief Financial Officer*


Exhibit
Number		Description of Document
32.2		Section 1350 Certification of Executive Officer*

32.3		Section 1350 Certification of Executive Officer*

99		Cautionary Statements*

(1)		Incorporated by reference to the Registrant’s Registration Statement on Form S-1 effective June 26, 2000.

(2)		Incorporated by reference to the Registrant’s Form 8-K dated March 22, 2001.

(3)		Incorporated by reference to the Registrant’s Annual Report on Form 10-K for the year ended April 30, 2001.

(4)		Incorporated by reference to the Registrant’s Form 8-K dated February 4, 2002.

(5)		Incorporated by reference to the Registrant’s Registration Statement on Form S-8 dated January 31, 2002.

(6)		Incorporated by reference to the Registrant’s Form 8-K dated March 28, 2002.

(7)		Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended October 31, 2002.

(8)		Incorporated by reference to the Registrant’s Annual Report on Form 10-K for the fiscal year ended April 30, 2003.

(9)		Incorporated by reference to the Registrant’s Form 8-A/A filed August 7, 2003.

(10)		Incorporated by reference to the Registrant’s Form S-4/A effective September 29, 2003.

(11)		Incorporated by reference to the Registrant’s Form 8-K dated November 6, 2003.

(12)		Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended October 31, 2003.

(13)		Incorporated by reference to the Registrant’s Form 10-K/A filed August 30, 2004.

* Filed or furnished herewith.


Date: December 14, 2004	Stratos International, Inc.

	By:	/s/ David A. Slack

		David A. Slack
		Executive Vice President – Finance and
		Chief Financial Officer

	By:	/s/ Joe D. Norwood

		Joe D. Norwood
		Executive Vice President

	By:	/s/ Richard C.E. Durrant

		Richard C.E. Durrant
		Executive Vice President

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	Page
PART I FINANCIAL INFORMATION
Item 1. Financial Statements		1
Condensed Consolidated Balance Sheets as of April 30, 2004 and October 31, 2004 (unaudited)		1
Condensed Consolidated Statements of Operations (unaudited) for the three and six months ended October 31, 2003 and 2004		2
Condensed Consolidated Statements of Cash Flows (unaudited) for the six months ended October 31, 2003 and 2004		3
Notes to Condensed Consolidated Financial Statements (unaudited) October 31, 2004		4
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		12
Item 3. Quantitative and Qualitative Disclosures About Market Risk		24
Item 4. Controls and Procedures		24
PART II. OTHER INFORMATION
Item 1. Legal Proceedings		25
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		27
Item 4. Submission of Matters to Vote of Security Holders		28
Item 6. Exhibits		28
SIGNATURES		30
INDEX TO EXHIBITS		31
Certification
Certification
Certification
Certification
Certification
Certification
Cautionary Statements