DIGITAL LIGHTWAVE INC - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
____________________

FORM 10-K
(MARK ONE)

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001
OR
[ ] 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: 0-21669

DIGITAL LIGHTWAVE, INC.
(Exact name of Registrant as specified in its charter)

DELAWARE 95-4313013

(State or Other Jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
15550 LIGHTWAVE DRIVE CLEARWATER, FLORIDA 33760
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code (727) 442-6677

Securities registered pursuant to Section 12(b) of the Act:
NONE

Securities registered pursuant to Section 12(g) of the Act:

COMMON STOCK, $0.0001 PAR VALUE PER SHARE

Indicate by check mark whether 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 periods that Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Report or any
amendment to this Report. [ ]

The aggregate market value of Registrant's voting stock, held by non-
affiliates, computed by reference to the average of the closing bid and asked
prices of the Common Stock as reported by Nasdaq on March 4, 2002: $69,530,456.

The number of shares of Registrant's Common Stock issued and outstanding as
of March 4, 2002: 31,344,710.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's definitive Proxy Statement to be filed with the
Securities and Exchange Commission for the registrant's 2002 Annual Meeting of
Stockholders to be held on May 20, 2002, are incorporated by reference into
Part III of this Form 10-K.

PART I

The following discussion includes certain forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995. These
statements are based on current expectations, forecasts and assumptions that
involve risks and uncertainties that could cause actual outcomes and results to
differ materially. These risks and uncertainties include fluctuations in
operating results, changes in the United States and worldwide economy and
fluctuations in capital expenditures within the telecommunications industry,
our dependence on a limited number of products and uncertainties of the market
for our current and planned products, technological change, our dependence on
growth of the Internet, competition, our dependence on a limited number of
major customers, our dependence on contract manufacturers and suppliers, our
products may not continue to meet changing regulatory and industry standards,
our ability to achieve sustained operating profitability, our dependence on key
personnel, the significant influence of our principal stockholder, our
dependence on proprietary technology, the volatility of our market price, the
sale of a significant number of our shares pursuant to future sales contracts
could depress the price of our stock, the effect that anti-takeover provisions
have on the price of our common stock and past and future litigation risks.
For a further list and description of such risks and uncertainties, see the
reports filed by Digital Lightwave with the Securities and Exchange Commission,
including the Company's reports on Form 10-K and 10-Q. Digital Lightwave
undertakes no obligation to update or revise any forward-looking statements,
whether as a result of new information, future events or otherwise.

ITEM 1. BUSINESS

GENERAL

Digital Lightwave{reg-trade-mark}, Inc. provides the global fiber-optic
communications industry with products and technology used to develop, install,
maintain, monitor, and manage fiber optic-based networks. Telecommunications
service providers and equipment manufacturers deploy our products to provide
quality assurance and ensure optimum performance of advanced optical
communications networks and network equipment. We sell our products worldwide
to leading and emerging telecommunications service providers,
telecommunications equipment manufacturers, equipment leasing companies and
international distributors.

Fiber optics deliver increased network bandwidth for the transmission of
voice, video, audio and data traffic over public and private networks,
including the Internet. Our products provide the capabilities to cost-
effectively deploy and manage fiber-optic networks to address increasing demand
for bandwidth. While the technology of optical networking is highly advanced,
our products are used to verify that telecommunications products and systems
function and perform properly. Specific customer applications of our
diagnostic equipment include the qualification of products during
manufacturing, the verification of service during network installation and the
monitoring and maintenance of deployed networks.

Our products currently include Network Information Computers{reg-trade-mark}
(NICs{reg-trade-mark}), which are portable instruments for the installation and
maintenance testing of advanced, high-speed networks and transmission
equipment. The NIC product family provides diagnostic capabilities for testing
the performance of both optical and legacy electrical networks with an array of
communications standards and transmission rates. Introduced in 1996, the NIC
offers significant benefits over conventional test devices, with its compact
design, ease of use and flexible software-based architecture. We have
continued to enhance the NIC's functionality and performance with the release
of subsequent models. In 2000, we introduced a NIC platform that analyzes
international telecommunications standards, thereby extending our addressable
market from principally North America to other major regions of the world. In
2001, we launched the NIC Plus{trademark}, a significant enhancement to the NIC
product line. The NIC Plus provides a single platform on which to perform a
multitude of tests for networks implemented under both North American and
international communications standards, operating at transmission rates ranging
from the lowest-speed electrical rates (DS0/64K) through the highest-speed
optical rates (OC-192/STM-64), as well as emerging packet-based networks, such
as Gigabit Ethernet and Packet over SONET. The NIC Plus also offers a new
level of flexibility, enabling users to configure the product to meet their
specific needs through add-ons and modules and thereby preserve the value of
their prior investments.

In 1998, we introduced our Network Access Agent{trademark} (NAA{trademark})
product family. NAAs are unattended, software-controlled, performance
monitoring and diagnostic systems permanently installed within optical-based
networks. NAAs embed the capabilities of our portable Network Information
Computers within a customer's network infrastructure, allowing centralized,
remote network management. In 1999, we introduced the NAA IV{trademark}, a
monitoring and diagnostic system for global optical and electrical networks,
including Dense Wavelength Division Multiplexing (DWDM) technology. The
modular architecture of our NIC has enabled the transfer of technology to our
NAA product family, resulting in a broad range of embedded diagnostic products
for optical, electrical and emerging packet-based networks. The NIC
architecture allows our customers to use the same test solution in both
portable and network-installed implementations, which yields increased
flexibility and a greater return on their investment in test equipment.

Both NICs and NAAs can be configured with a multi-port, high-speed, optical
module, enabling concurrent measurement and monitoring of multiple optical
channels. This capability offers our customers the ability to thoroughly
exercise and test their equipment under fully operational load conditions.

We also provide, as an extension of our product line, optical monitoring and
diagnostic circuit packs and subsystems that are custom-designed to meet
specific customer requirements. These solutions enable customers to utilize
our flexible architecture for the testing of unique or product-specific
requirements, which can result in significant customer cost savings compared to
off-the-shelf solutions.

Digital Lightwave was incorporated in California on October 12, 1990, under
the name Digital Lightwave, Inc., and reincorporated in Delaware on March 18,
1996. Unless the context indicates otherwise, the "Company", "we", "our", and
"Digital Lightwave", as used in this Report, refer to Digital Lightwave, Inc.,
a Delaware corporation, and its predecessor entity. Our principal executive
offices are located at 15550 Lightwave Drive, Clearwater, Florida, 33760, and
the telephone number is (727) 442-6677.

INDUSTRY

The telecommunications industry has undergone significant fundamental changes
over the past decade. The volume of traffic carried over telecommunications
networks has increased significantly as the result of the rapid growth of data
traffic and the steady growth of voice traffic. Non-voice traffic has increased
substantially due to a variety of factors, including electronic mail (email);
the Internet; electronic commerce; fax, audio and video transmission; and a
proliferation of bandwidth-intensive applications, as well as personal hand-
held email and Internet appliances. Bandwidth is defined as the volume of
information that can be transmitted through a medium, such as glass fibers,
without distortion.

The telecommunications industry has addressed the demand for increased,
reliable network capacity by installing new fiber-optic transmission lines,
accelerating transmission rates and employing new technologies such as Dense
Wavelength Division Multiplexing (DWDM), a process that expands the carrying
capacity of existing fiber by permitting the transmission of multiple lightwave
signals over a single optical fiber. Faster transmission speeds, new
technologies and a broadening range of traffic types have magnified the
complexity of telecommunications networks, while continuing demands for greater
bandwidth have stressed the capacity of these networks. In addition, various
"protocols" are required for encoding and transmitting information across these
networks. Examples of these protocols include the T-Carrier protocol,
Plesiochronous Digital Hierarchy (PDH), Synchronous Optical Network Technology
(SONET), Synchronous Digital Hierarchy (SDH) and Asynchronous Transfer Mode
(ATM). New fiber-optic networks must be compatible with existing legacy
networks and protocols, as well as with wireless networks using cellular
technologies. The T-Carrier protocol, used primarily in North America, utilizes
insulated copper wire cables that carry electrically transmitted digital
signals, while PDH is the equivalent protocol for the majority of the rest of
the world. The SONET protocol is used primarily in North America and Japan for
variable optical bandwidth products which enable the transmission of voice,
video and data at very high speeds, while SDH is the equivalent protocol for
most of the remaining worldwide market. ATM is an information transfer
standard that is one of a general class of technologies commonly used for the
relay of traffic over global optical networks.

Due to its characteristics, non-voice traffic is more efficiently transmitted
in "packages". This has led to the creation and implementation of "packet
protocols", which are used in evolving networks, and to a transition in network
equipment from "circuit-switched" to "packet-switched" technology. There are
several existing and emerging packet-based protocols used in packet-switched
networks, including Gigabit Ethernet, Multi-Protocol Label Switching (MPLS),
Packet over SONET (POS), and others.

The growing demand for telecommunications capabilities, in conjunction with
the worldwide deregulation of the telecommunications industry, has led to a
proliferation of service providers entering the industry. Market conditions,
in addition to increasing volumes of data and voice traffic, have intensified
the need to provide uninterrupted service, while creating new competitive
pressures for service providers to improve operational efficiencies.

Telecommunications network diagnostic equipment is required for quality
assurance during network installation and to monitor and maintain the integrity
of existing networks. Portable test equipment is used to qualify and verify
the telecommunications infrastructure, including transmission lines, signal
generators, switches, and other equipment during the installation of new
networks. Simultaneous and independent real-time analysis is required to
monitor network performance and reduce the possibility of network interruptions
or system failures, in order to improve overall operational efficiency once the
network has been deployed.

THE DIGITAL LIGHTWAVE SOLUTION

We provide telecommunications service providers and equipment manufacturers
with capabilities to cost-effectively deploy and manage fiber-optic networks to
address the increasing demand for bandwidth. Our products are used to qualify
telecommunications equipment during the manufacturing process, verify service
during optical network installation and provide ongoing quality assurance after
new equipment has been deployed.

We believe that our Network Information Computers (NICs) and Network Access
Agents (NAAs) offer a broad range of features and capabilities that provide
distinct competitive advantages over traditional network test equipment. We
designed our NICs to offer network technicians a more compact, lightweight,
easy-to-use product with significantly greater functionality.

The NIC (i) is an integrated test instrument that is capable of analyzing
multiple protocols concurrently and independently; (ii) utilizes an intuitive
Microsoft Windows-based graphical user interface (GUI) with a touch sensor
display to create an easy-to-use diagnostic tool; and (iii) is a software-based
solution which can be easily upgraded and customized.

In 1998, we introduced our first NAA, which utilized the technology of the
NIC. NAAs are software-controlled performance monitoring and diagnostic
equipment which is permanently embedded at multiple access points within
optical networks, providing real-time analysis and network management from a
centralized location. Using these real-time analysis capabilities, a network
operator is able to monitor signal degradation, diagnose and isolate network
failures, and maintain a constant view of the network. This ensures
fulfillment of service-level agreements with the operator's customers and
enables the operator to respond immediately to certain situations in order to
prevent potential network interruptions or failures.

Our products are based on modular and scalable hardware and software
platforms and a flexible architecture that allow customers to easily upgrade
existing systems to accommodate new technologies and thereby preserve the value
of their original investment. We are utilizing the core technology of our NICs
and NAAs to continue developing portable and embedded products that address the
evolving needs of the optical networking industry.

PRODUCTS

Our current portfolio of products is organized into two product lines:
Network Information Computers (NICs) and Network Access Agents (NAAs).

Network Information Computers. Our portable NICs enable users to verify,
qualify and monitor the performance of telecommunications networks and
transmission equipment. We designed the NIC to replace existing hardware-based
network test instruments by incorporating their functions into a software-based
signal processing system, adding new functions and improving performance while
maintaining competitive pricing. Telecommunications service providers and
equipment manufacturers are able to plan for and cost-effectively implement
fiber-optic network expansion and verify and manage information concerning the
transmission of voice, data, audio, and video traffic with the NIC.
Telecommunications equipment manufacturers also use the NIC to design, engineer
and manufacture their products, install their products in the networks of their
customers and provide ongoing customer support.

NICs generate, transmit, receive, multiplex, process electrical (legacy
network) and optical signals and provide network analysis. The NIC's easy-to-
use graphical user interface is a touch sensor over a large color display and
provides simple and intuitive windowed graphics and menus. NICs may be
accessed and operated remotely by modem or through direct connection to an
Ethernet local area network (LAN). A LAN is a group of computers and other
devices dispersed over a relatively limited area and connected by a
communications link that enables any device to interact with any other in the
network. Ethernet is a protocol commonly used in LANs.

The following core technologies are used in NICs and provide a basis for
certain of our products in development: (i) a software operating environment
that runs on a Microsoft Windows platform; (ii) programs that operate our
firmware and hardware; (iii) graphical user interface programs, written in
object-oriented code, running in a windowed environment; (iv) network protocol
translators that logically process discrete network information from signals at
specific bandwidths and protocols; and (v) Network Protocol ProcessorsTM that
process information encoded in a specific protocol over a range of rates and
bandwidths.

We have developed a non-blocking switch matrix and application software that
allow our customers to "frame up" on a given signal, multiplex or demultiplex
the signal into different transmission speeds and then map the signal into
different protocols without interfering with signal transmission. A non-
blocking switch matrix is an internal switch in a system that has the ability
to switch multiple transmissions to different circuits simultaneously without
causing internal congestion in the switch itself. Demultiplexing is the
process of separating two or more signals that were previously multiplexed.
These functions allow customers to derive information concerning the
performance of the network under various existing or potential conditions.

Current models and certain features of the NIC include:

* NIC{reg-trade-mark} ASA 312{reg-trade-mark}, which analyzes North
American optical networks (SONET rates: OC-1 through OC-48) and legacy
electrical networks (T-carrier rates: DS0, DS1, DS3), operating at
transmission rates ranging from 64Kbps to 2.5 Gbps and includes ATM
analysis.

* NIC 2.5G{trademark}, which simultaneously and independently analyzes
global optical networks (SONET/SDH rates: OC-1/STM-0 through OC-48/STM-
16) and global electrical networks (T-carrier/PDH rates: DS0, DS1, DS3,
E1, E3, E4), operating at transmission rates ranging from 64 Kbps to 2.5
Gbps and includes ATM analysis.

* NIC 10G{trademark}, which verifies and qualifies the performance of
global high-speed optical networks (SONET/SDH rates: OC-48/STM-16 and
OC-192/STM-64), operating at transmission rates ranging from 2.5 Gbps to
10 Gbps and includes Packet over SONET/SDH (POS) analysis.

* NIC Plus{trademark}, a scalable testing platform for global optical
networks (SONET/SDH rates: OC-1/STM-0 through OC-192/STM-64) and global
electrical networks (T-carrier/PDH rates: DS0, DS1, DS3, E1, E3, E4),
operating at transmission rates ranging from 64 Kbps to 10 Gbps an
includes POS and ATM analysis.

We plan to continue to enhance the NIC's functionality and performance to
meet evolving customer requirements for network technologies.

Sales of our Network Information Computer generated approximately 88%, 95%
and 99% of net sales for the years ended December 31, 2001, 2000 and 1999,
respectively.

Network Access Agent. NAAs are unattended, software-controlled performance
monitoring and diagnostic equipment embedded within optical networks for
analysis, installation and management of a telecommunications network from a
remote or centralized location. NAAs are both remotely and locally accessible
over standard telecommunications links and are designed to provide network
operators with real-time information concerning performance of the network
segments in which a NAA has been installed. Installation of NAAs at multiple
access points throughout fiber-optic networks provides the capability for end-
to-end network monitoring, maintenance and management. NAAs provide
performance and quality data to the network operator through a standard
operations interface. NAAs incorporate technology that we developed for the
NIC, which includes advanced hardware and software technology that accesses
bits in optical and electrical telecommunications transmissions; a non-blocking
switch matrix that maps signals into different transmission speeds and
protocols; and object-oriented software that controls selectable features that
are accessible through the Microsoft Windows operating system environment or
other user environments.

The modular architecture of our products enables the transfer of technologies
across platforms. Due to the flexible design of our products, customers can
configure NAAs with the same capabilities as the NIC. Also, NAAs enable
customers to perform remote, multi-channel Dense Wavelength Division
Multiplexing (DWDM) diagnostics.

We plan to continue to enhance the NAA's functionality and performance to
meet evolving customer requirements for network technologies.

Sales of our NAA generated revenues of approximately 12%, 5% and 1% of annual
net sales for the years ended December 31, 2001, 2000 and 1999, respectively.

Customer-Specific Network Products. We also provide optical monitoring and
diagnostic circuit packs and subsystems that are custom-designed to meet
specific customer requirements in both portable and network installed
implementations.

CUSTOMERS

Through December 31, 2001, we sold over 4,600 units of the Network
Information Computer and over 130 Network Access Agents to over 380 customers.
Our products are purchased and used by domestic and international customers in
the following industry segments:

- - Incumbent Local Exchange Carriers,

- - Inter-Exchange Carriers,

- - Competitive Local Exchange Carriers,

- - Internet Service Providers,

- - Communications Equipment Manufacturers,

- - Carriers' Carriers,

- - Utility Companies,

- - Equipment Rental and Leasing Companies,

- - Wireless Service Providers and

- - Enterprise Network Operators.

We also sell our products to other segments of the telecommunications
industry including independent telephone companies and private network
operators.

We involve key customers in the evaluation of products in development and
continually solicit suggestions from customers regarding additional desirable
features of products that we have introduced or plan to develop. We have
generally been able to satisfy requests for additional feature sets by
providing software upgrades for loading into our products in the field.

For the year ended December 31, 2001, our largest customer, Level 3
Communications, accounted for approximately 12% of total sales. For the years
ended December 31, 2000 and 1999, our largest customer, Telogy, accounted for
approximately 15% and 21% of total sales, respectively. For the year ended
December 31, 1999, one additional customer, Technology Rental Services,
accounted for 18% of total sales. No other customer accounted for sales of 10%
or more during those years.

SALES, MARKETING AND CUSTOMER SUPPORT

Sales. We primarily sell our products in the domestic market through a
direct sales force to telecommunications service providers and network
equipment manufacturers. We primarily sell our products in the international
markets through international distributor channels.

Marketing. We focus our marketing efforts of the Network Information Computer
on the divisions of telecommunications service providers that are responsible
for planning and installing extensions of the network and on the divisions of
telecommunications equipment manufacturers that are responsible for quality
assurance. We have directed our marketing efforts of the Network Access Agent
on the strategic planning divisions of telecommunications service providers and
private network operators in order to define customer requirements. We seek to
build awareness of our products through a variety of marketing channels and
methodologies, including industry trade shows, conferences and direct mailings
to targeted customers and trade advertising.

Customer Support. We offer technical support to our customers 24 hours a
day, seven days a week. Our customer support organization is comprised of
highly skilled employees with extensive experience across a broad range of
fiber optics networks. All service and repairs are performed at either our
Clearwater, Florida facility or by a contract manufacturer. We offer between a
one-year and a three-year limited warranty on our products.

PRODUCTION

During 2001, our production operations consisted primarily of material
planning and procurement, final assembly, software loading, testing and quality
assurance. Our operational strategy relied on outsourcing of manufacturing to
reduce fixed costs and to provide flexibility in meeting market demand. We
subcontracted the manufacture of computer system boards, plastic molds and
metal chassis and certain subassemblies and components for the Network
Information Computer and the Network Access Agent. We performed final assembly
and programmed the products with our software. We implemented strict quality
control procedures throughout each stage of the manufacturing process and
tested the boards and subassemblies at various stages in the process, including
final test and qualification of the product.

In December 2001, we signed a manufacturing service agreement with Jabil
Circuit, Inc. ("Jabil"), a leading provider of technology manufacturing
services with a customer base of industry-leading companies. Under the terms of
the agreement, Jabil will serve as Digital Lightwave's primary contract
manufacturer for the Company's circuit board and product assembly and will also
provide engineering design services. Jabil purchased approximately $4.9
million of raw materials inventory from us in December 2001. Jabil will
continue to purchase our existing raw materials inventory until all parts are
depleted to safety stock levels.

In January 2002, we implemented our outsourcing strategy with Jabil. Jabil
currently provides product assembly, direct order fulfillment, design for
manufacturability and product cost improvement services for all of our Network
Information Computer and Network Access Agents products. We intend to continue
to perform final testing and qualification of the finished products at our
Clearwater, Florida facility. We are ISO 9001 certified, which is an
international standard for quality management and assurance.

We currently utilize several key components used in the manufacture of our
products from a sole-source or limited sources. We utilize certain laser and
laser amplifier components, power supplies, touch-screen sensors, single-board
computers and SONET overhead terminators used in the Network Information
Computer and the Network Access Agent from a single or a limited number of
suppliers. We purchase a filter, a controller board and an interface board from
a single or limited number of suppliers for the Network Access Agent. We are
currently attempting to qualify certain additional suppliers for certain of the
sole-sourced components. The loss of any of these key components or termination
of our relationship with Jabil could seriously disrupt our operations.

We forecast product sales quarterly and order materials and components based
on these forecasts. Lead times for materials and components that we order vary
significantly and depend on factors such as the specific supplier, purchase
terms and demand for a component at a given time. We may have excess or
inadequate inventory of certain materials and components if actual orders vary
significantly from forecasts.

ENGINEERING AND DEVELOPMENT

We have organized our engineering and development efforts into product or
project teams. We organize our teams around the development of a particular
product and each team is responsible for all aspects of the development of that
product and any enhanced features or upgrades. Our engineering teams are
located at our corporate headquarters in Clearwater, Florida.

During fiscal years 2001, 2000, and 1999, we spent approximately $15.0
million, $14.1 million and $10.2 million on engineering and development
activities, respectively.

INTELLECTUAL PROPERTY

Our success and our ability to compete depends upon our proprietary
technology that we protect through a combination of patent, copyright, trade
secret and trademark law. As of March 4, 2002, we have five issued patents
relating to the Network Information Computer and Network Access Agent in the
United States. We have filed continuation applications for each of these
issued patents. Currently we have four patents pending relating to our
technology. Our growth strategy includes a plan to expand our presence in
international markets and the laws of some foreign countries may not protect
our proprietary rights to the same extent as do the laws of the United States.

We generally enter into non-disclosure agreements and proprietary information
and invention agreements with our employees and suppliers and limit access to
and distribution of our proprietary information. It may be possible for third
parties to copy or otherwise obtain and use our technology without
authorization despite these precautions.

We may either license our proprietary rights to third parties or license
certain technologies from third parties for use in our products. The
telecommunications industry is characterized by the existence of a large number
of patents and frequent litigation based on allegations of patent infringement.
We have no reason to believe that our technology infringes on the proprietary
rights of others and we have not received any notice of claimed infringements.
Nonetheless, third parties may assert infringement claims against us in the
future that may or may not be successful. If we must defend ourselves or our
customers against such claims, we could incur substantial costs regardless of
the merits of the claims. Parties making such claims may be able to obtain
injunctive or other equitable relief that could effectively block our ability
to sell our products and could obtain an award of substantial damages. Any such
claim could seriously damage our business. In the event of a successful claim
of infringement against us, we may be required to obtain one or more licenses
from third parties including our customers.

BACKLOG

We have not entered into long-term agreements or blanket purchase orders for
the sale of our products. We generally obtain purchase orders for immediate
shipment and other cancelable purchase commitments. We do not expect to carry
substantial backlog from quarter to quarter in the future. Our sales during a
particular quarter are highly dependent upon orders placed by customers during
the quarter. Sales may fluctuate significantly from quarter-to-quarter and
year-to-year due to the timing and amount of orders from customers. Because
most of our operating expenses are relatively fixed and cannot be easily
reduced in response to decreased revenues, quarterly fluctuations in sales have
a significant effect on net income.

We believe that backlog is not a meaningful indicator of future financial
results.

SEASONALITY

Our sales are generally seasonal with the largest portion of quarterly sales
tied to telecommunications industry purchasing patterns and tend to decrease
during the first calendar quarter of the year.

COMPETITION

The market for our products is competitive and is subject to rapid
technological change, frequent product introductions with improved performance,
competitive pricing and changing industry standards. We believe that the
principal factors on which we compete include:

- Product performance,

- Product quality,

- Product reliability,

- Value,

- Customer service and support and

- Length of operating history, industry experience and name recognition.

We believe we compete favorable on all of these factors other than on the
last factor because or our limited operating history. We believe that there
are five principal competitors that currently offer products that compete with
the Network Information Computer, including Acterna, Agilent, Anritsu, NetTest
and Tektronix. Although there are several companies that offer network
monitoring and test instruments, including Acterna, Agilent, Gnubi and Spirent,
the NAA product line is the only one to offer a comprehensive solution across
WDM and DWDM networks. We are aware of certain companies that are also
developing equipment to monitor lightwave transmissions but we believe at this
point they do not offer a complete DWDM solution. Many of our competitors and
certain prospective competitors have significantly longer operating histories,
larger installed bases, greater name recognition and significantly greater
technical, financial, manufacturing and marketing resources. A number of these
competitors have long established relationships with our customers and
potential customers.

REGULATORY MATTERS

Our products must meet industry standards and regulations which are evolving
as new technologies are deployed. In the United States, our products must
comply with various regulations promulgated by the Federal Communications
Commission and Underwriters Laboratories as well as industry standards
established by the American Standards Institute and other organizations.
Internationally, our products must comply with standards established by the
European Union and communication authorities in other countries as well as with
recommendations of the Consultative Committee on International Telegraph and
Telephony. In addition, some of our planned products may be required to be
certified by Bell Communications Research in order to be commercially viable.
The failure of the our products to comply, or delays in compliance, with the
various existing and evolving standards and regulations could negatively impact
our ability to sell products.

INTERNATIONAL

We sell our products in domestic and international markets. Our domestic
sales represented approximately 80%, 91% and more than 99% of our annual net
sales for the years ending 2001, 2000 and 1999 respectively. Our international
sales represented approximately 20%, 9% and less than 1% of our annual net
sales for the years ending 2001, 2000 and 1999 respectively.

EMPLOYEES

As of March 4, 2002, we employed a full-time staff of 108 employees. In
October 2001, the Company reduced its workforce by 38 employees and consultants
and instituted temporary executive salary reductions of up to 20%. In January
2002, the Company implemented a second reduction of force of 46 employees and
contractors. All employees included in the reductions in force were given
severance based upon years of service with the Company. None of the Company's
employees are represented by labor unions.

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FACTORS THAT MAY AFFECT OPERATING RESULTS

The following factors, in addition to the other information contained in this
report, should be considered carefully in evaluating us and our prospects. This
report (including without limitation the following factors that may affect
operating results) contains forward-looking statements (within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934) regarding us and our business, financial condition,
results of operations and prospects. Words such as "expects," "anticipates,"
"intends," "plans," "believes," "seeks," "estimates" and similar expressions or
variations of such words are intended to identify forward-looking statements,
but are not the exclusive means of identifying forward-looking statements in
this report. Additionally, statements concerning future matters such as the
development of new products, enhancements or technologies, possible changes in
legislation and other statements regarding matters that are not historical are
forward-looking statements.

Forward-looking statements in this report reflect the good faith judgment of
our management and the statements are based on facts and factors we currently
know. Forward-looking statements are subject to risks and uncertainties and
actual results and outcomes may differ materially from the results and outcomes
discussed in the forward-looking statements. Factors that could cause or
contribute to such differences in results and outcomes include, but are not
limited to, those discussed below and in "Management's Discussion and Analysis
of Financial Condition and Results of Operations" as well as those discussed
elsewhere in this report. Readers are urged not to place undue reliance on
these forward-looking statements which speak only as of the date of the this
report. We undertake no obligation to revise or update any forward-looking
statements in order to reflect any event or circumstance that may arise after
the date of the report.

WE EXPERIENCE FLUCTUATIONS IN OUR OPERATING RESULTS

Our quarterly operating results have fluctuated in the past and our future
quarterly operating results are likely to vary significantly due to a variety
of factors which are outside our control. Factors that could affect our
quarterly operating results include:

- - Announced capital expenditure cutbacks by customers within the
telecommunications industry,

- - Limited number of major customers,

- - The product mix, volume, timing and number of orders we receive from our
customers,

- - The long sales cycle for obtaining new orders,

- - The timing of introduction and market acceptance of new products,

- - Our success in developing, introducing and shipping product enhancements and
new products,

- - Pricing changes by our competitors,

- - Our ability to enter into long term agreements or blanket purchase orders
with customers,

- - Our ability to obtain sufficient supplies of sole or limited source
components for our products,

- - Our ability to attain and maintain production volumes and quality levels for
our current and future products,

- - Changes in costs of materials, labor and overhead and

- - Additional customer bankruptcies.

Our operating results for any particular quarter may not be indicative of
future operating results, in part because our sales often reflect orders
shipped in the same quarter in which they are received and this makes our sales
vulnerable to short-term fluctuations. The factors have historically been and
are expected to be difficult to forecast. Any unfavorable changes in these or
other factors could have a material adverse effect on our business, financial
condition and results of operations.

Our revenues and operating results generally depend on the volume and timing
of the orders we receive from customers and our ability to fulfill the orders
received. The timing of orders may be cancelled, modified or rescheduled after
receipt. Most of our operating expenses are relatively fixed and cannot be
reduced in response to decreases in net sales. The timing of orders and any
subsequent cancellation, modification or rescheduling of orders have affected
and will continue to affect our results of operation from quarter to quarter.
The deferral of any large order from one quarter to another could have a
material adverse effect on our business, financial condition and results of
operations.

We must obtain orders during each quarter for shipment in that quarter to
achieve our revenue and profit objectives.

CHANGES IN UNITED STATES AND WORLDWIDE ECONOMIES AND FLUCTUATIONS IN CAPITAL
EXPENDITURES WITHIN THE TELECOMMUNICATIONS INDUSTRY

Our products are purchased and used by telecommunications customers. Sales
are impacted by the following conditions in this marketplace:

- - The weak economic conditions in the United States and global markets have
resulted in decreased capital expenditures by telecommunication equipment
manufacturers and equipment rental and leasing companies,

- - The telecommunications sector in the United States and global markets have
experienced significant bankruptcies and decreased capital expenditures.
This includes the competitive local exchange carriers, Internet service
providers and enterprise network operator segments and

- - The incumbent local exchange carriers are becoming increasingly active,
but historically have been slow to implement bandwidth expansion
strategies. We are now focusing on sales to this segment of the industry.

These continued weak economic conditions, additional bankruptcies and
decreased capital expenditures may contribute to quarterly or annual
fluctuations in our operating results and could have a material adverse effect
on our business, financial condition and results of operations.

WE ARE DEPENDENT ON A LIMITED NUMBER OF PRODUCTS AND ARE UNCERTAIN OF THE
MARKET FOR OUR CURRENT PRODUCTS AND PLANNED PRODUCTS

The majority of our sales are from our initial product, the Network
Information Computer and we expect that sales of Network Information Computers
will continue to account for a substantial portion of our sales for the
foreseeable future. During 1998, we started shipping a commercial version of
our Network Access Agent based on the same core technology as the Network
Information Computer. During 2001, Network Access Agents accounted for
approximately 12% of our revenues. We cannot predict the future level of
acceptance by our customers of the Network Access Agent and we may not be able
to generate significant revenues from this product. We are uncertain about the
size and scope of the market for our current and future products. Our future
performance will depend on increased sales of the Network Information Computer,
market acceptance of the Network Access Agent, our ability to enter into
additional original equipment manufacturer agreements and the successful
development, introduction and market acceptance of other new and enhanced
products. Market acceptance of our products and our credibility with our
customers might be diminished if we are delayed in introducing or producing new
products or fail to detect software or hardware errors in new products (which
frequently occur when new products are first introduced). This could have a
material adverse effect on our business, financial condition and results of
operations.

OUR INDUSTRY IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE

To remain competitive, we must respond to the rapid technological change in
our industry by developing, manufacturing and selling new products and
technology and improving our existing products and technology. Our market is
characterized by:

- Rapid technological change,

- Changes in customer requirements and preferences,

- Frequent new product introductions and

- The emergence of new industry standards and practices.

These factors could cause our sales to decrease or render our current
products obsolete. Our success will depend upon our ability to:

- Create improvements on and enhancements to our existing products,

- Develop, manufacture and sell new products to address the increasingly
sophisticated and varied needs of our current and prospective customers,

- Respond to technological advances and emerging industry standards and
practices on a cost effective and timely basis and

- Increase market acceptance of our products.

Failure to meet these objectives or to adapt to changing market conditions or
customer requirements could have a material adverse effect on our business,
financial condition and results of operations.

OUR BUSINESS DEPENDS ON THE CONTINUED GROWTH OF THE INTERNET

A significant portion of our revenues comes from telecommunications carriers,
telecommunications equipment manufacturers and other customers that rely upon
the growth of the Internet. Our future results of operations substantially
depend on the continued acceptance and use of the Internet as a medium for
commerce and communication. Rapid growth in the use of and interest in the
Internet and online services is a recent phenomenon. Our business could be
harmed if this rapid growth does not continue or if the rate of technological
innovation, deployment or use of the Internet slows or declines. The growth
and development of the market for Internet-based services may prompt the
introduction of new laws and regulations. Laws may impose additional burdens on
those companies that conduct business online and could decrease the expansion
of the use of the Internet. A decline in the growth of the Internet could
decrease demand for our products and services or increase our cost of doing
business and could have material adverse effects on our business, financial
condition and results of operations.

OUR INDUSTRY IS EXTREMELY COMPETITIVE AND SUCH COMPETITION MAY NEGATIVELY
AFFECT OUR BUSINESS

The market for our products is intensely competitive and is subject to rapid
technological change, frequent product introductions with improved performance,
competitive pricing and shifting industry standards. We believe that the
principal factors on which we compete include:

- Product performance,

- Product quality,

- Product reliability,

- Value,

- Customer service and support and

- Length of operating history, industry experience and name recognition.

We believe that there are five principal competitors that currently offer
products that compete with the Network Information Computer, including Acterna,
Agilent, Anritsu, NetTest and Tektronix. Although there are several companies
that offer network monitoring and test instruments, including Acterna, Agilent,
Gnubi and Spirent, the NAA product line is the only one to offer a
comprehensive solution across WDM and DWDM networks. We are aware of certain
companies that are also developing equipment to monitor lightwave transmissions
but at this point they have yet to offer a complete DWDM solution. Many of our
competitors and certain prospective competitors have significantly longer
operating histories, larger installed bases, greater name recognition and
significantly greater technical, financial, manufacturing and marketing
resources. In addition, a number of these competitors have long established
relationships with our customers and potential customers. We expect that
competition will increase in the future and that new competitors will enter the
market for most, if not all, of the products we will offer. Increased
competition could reduce our profit margins and cause us to lose or prevent us
from gaining market share. Any of these events could have a material adverse
effect on our business, financial condition and results of operation.

WE ARE DEPENDENT ON A LIMITED NUMBER OF MAJOR CUSTOMERS AND A DECREASE IN
ORDERS FROM ANY MAJOR CUSTOMER COULD DECREASE OUR REVENUES

For the year ended December 31, 2001, our largest customer, Level 3
Communications, accounted for approximately 12% of total sales. For the years
ended December 31, 2000 and 1999, our largest customer, Telogy, accounted for
approximately 15% and 21% of total sales, respectively. For the year ended
December 31, 1999, one additional customer, Technology Rental Services,
accounted for 18% of total sales. No other customer accounted for sales of 10%
or more during those years. There can be no assurance regarding the amount or
timing of purchases by any customer in any future period and business
fluctuations affecting our customers have affected and will continue to affect
our business.

Our success is dependent upon our ability to broaden our customer base and to
obtain orders from additional original equipment manufacturers to increase our
level of sales. None of our customers has a written agreement with us that
obligates them to purchase additional products. If one or more of our major
customers decide not to purchase additional products or cancels orders
previously placed, our net sales could decrease which could have a material
adverse effect on our business, financial condition and results of operations.

WE ARE DEPENDENT ON CONTRACT MANUFACTURERS AND SOLE AND LIMITED SOURCE
SUPPLIERS WHICH COULD ADVERSELY AFFECT OUR OPERATIONS

In January 2002, we implemented a new outsourcing strategy with a tier-one
contract manufacturer to provide product assembly, direct order fulfillment,
design for manufacturability and product cost improvement services for all our
Network Information Computer and Network Access Agents products. Failure to
smoothly and successfully implement this strategy could interrupt our
operations and adversely impact our ability to manufacture our products. In
the event our relationship with our contract manufacturer abruptly terminated
for any reason, we could have difficulty obtaining and implementing a new
contract manufacturer which would disrupt our ability to manufacture our
products, book sales and fulfill customer orders.

We currently utilize several key components used in the manufacture of our
products from a sole-source or limited sources. We utilize certain laser and
laser amplifier components, power supplies, touch-screen sensors, single-board
computers and SONET overhead terminators used in the Network Information
Computer and the Network Access Agent from a single or a limited number of
suppliers. We purchase a filter, a controller board and an interface board from
a single or limited number of suppliers for the Network Access Agent. We are
currently attempting to qualify certain additional suppliers for certain of the
sole-sourced components. The loss of any of these key components could
seriously disrupt our operations.

We forecast product sales quarterly and order materials and components based
on these forecasts. Lead times for materials and components that we order vary
significantly and depend on factors such as the specific supplier, purchase
terms and demand for a component at a given time. We may have excess or
inadequate inventory of certain materials and components if actual orders vary
significantly from forecasts.

In the past, there have been industry-wide shortages in some of the optical
components used in our Network Information Computers and Network Access Agents.
If such shortages arise again, our suppliers may be forced to allocate
available quantities among their customers and we may not be able to obtain
components and material on the schedule we require, if at all. These shortages
could lead to delays in shipping our products to our customers. Delayed
shipping to our customers could significantly harm our business. If prices of
these components increase significantly, our margins on our products will
decrease.

OUR PRODUCTS MAY NOT CONTINUE TO MEET CHANGING REGULATORY AND INDUSTRY
STANDARDS

Our products must meet industry standards and regulations which are evolving
as new technologies are deployed. In the United States, our products must
comply with various regulations promulgated by the Federal Communications
Commission, and Underwriters Laboratories as well as industry standards
established by the American Standards Institute and other organizations.
Internationally, our products must comply with standards established by the
European Union and communication authorities in other countries as well as with
recommendations of the Consultative Committee on International Telegraph and
Telephony. Some of our planned products may be required to be certified by
Bell Communications Research in order to be commercially viable. The failure of
the our products to comply, or delays in compliance, with the various existing
and evolving and regulations could prevent us from selling our products in
certain markets which could have a material adverse effect on our business,
financial condition and results of operations.

WE MAY NOT BE ABLE TO ACHIEVE SUSTAINED OPERATING PROFITABILITY

We shipped our first product, the Network Information Computer, in February
1996, and have shipped only limited quantities of our second product, the
Network Access Agent. We have incurred substantial costs, including costs to:

- Develop and enhance our technology and products,

- Develop our engineering, production and quality assurance operations,

- Recruit and train sales, marketing and customer service groups and

- Build administrative and operational support organizations.

Our accumulated net losses totaled approximately $6.4 million as of December
31, 2001. We anticipate that our losses will continue through 2002 as we create
and introduce new products and technologies and develop additional distribution
channels. We expect that any related increases in revenues will lag behind
these cost increases for the foreseeable future. If we cannot sustain operating
profitability or positive cash flow from operations, we may not be able to meet
our cash and working capital requirements. This would have a material adverse
effect on our business, financial condition and results of operations.

WE ARE DEPENDENT ON KEY PERSONNEL

Our success depends to a significant degree upon the continued contributions
of key management and other personnel, some of whom could be difficult to
replace. We do not maintain key man life insurance covering our officers. Our
success will depend on the performance of our officers, our ability to retain
and motivate our officers, our ability to integrate new officers into our
operations and the ability of all personnel to work together effectively as a
team. The Company has had significant turnover of its executive officers in
the past and could continue to have problems retaining and recruiting executive
officers in the future. In October 2001, the Company's former Chief Financial
Officer and Secretary, Steven Grant, resigned and in January 2002, the
Company's former Chairman of the Board, President and Chief Executive Officer,
Gerry Chastelet, resigned. Our failure to retain and recruit officers and
other key personnel could have a material adverse effect on our business,
financial condition and results of operations.

OUR PRINCIPAL STOCKHOLDER HAS SUBSTANTIAL INFLUENCE OVER OUR COMPANY

As of March 4, 2002, Dr. Bryan J. Zwan, the Company's chairman of the board,
president and chief executive officer, beneficially owned approximately 60% of
the outstanding shares of our common stock (including approximately 7.4 million
shares, or 24%, which are subject to forward sales agreements). Dr. Zwan has
the ability to cause a change of control of the board of directors of Digital
Lightwave by electing candidates of his choice to the board at a stockholder
meeting, approve or disapprove any matter requiring stockholder approval and
has significant influence over our affairs, including the power to cause, delay
or prevent a change in control or sale of the Company.

WE ARE DEPENDENT ON PROPRIETARY TECHNOLOGY

Our success and our ability to compete depend upon our proprietary technology
that we protect through a combination of patent, copyright, trade secret and
trademark law. As of March 4, 2002, we have five issued patents relating to the
Network Information Computer and Network Access Agent in the United States. We
have filed continuation applications for each of these issued patents.
Currently we have four patents pending relating to our technology. We cannot
assure you that the patents for which we have applied or intend to apply will
be issued or that the steps that we take to protect our technology will be
adequate to prevent misappropriation. Our competitors may independently develop
technologies that are substantially equivalent or superior to our technology.
Our growth strategy includes a plan to expand our presence in international
markets and the laws of some foreign countries may not protect our proprietary
rights to the same extent as do the laws of the United States.

We generally enter into non-disclosure agreements and proprietary information
and invention agreements with our employees and suppliers and limit access to
and distribution of our proprietary information. It may be possible for third
parties to copy or otherwise obtain and use our technology without
authorization despite these precautions.

We may either license our proprietary rights to third parties or license
certain technologies from third parties for use in our products. The
telecommunications industry is characterized by the existence of a large number
of patents and frequent litigation based on allegations of patent infringement.
We believe that our technology does not infringe on the proprietary rights of
others and we have not received any notice of claimed infringements. However,
third parties may assert infringement claims against us in the future that may
or may not be successful. We could incur substantial costs regardless of the
merits of the claims if we must defend ourselves or our customers against such
claims. Parties making such claims may be able to obtain injunctive or other
equitable relief that could effectively block our ability to sell our products
and could obtain an award of substantial damages. We may be required to obtain
one or more licenses from third parties, including our customers in the event
of a successful claim of infringement against us. Any such claim could have a
material adverse effect on our business, financial condition and results of
operations.

THE MARKET PRICE OF OUR COMMON STOCK MAY BE VOLATILE

The market price of our common stock has been and is likely in the future to
be highly volatile. Our common stock price may fluctuate significantly in
response to factors such as:

- - Quarterly variations in our operating results,

- - Announcements of technological innovations,

- - New product introductions by us or our competitors,

- - Competitive activities,

- - Changes in earnings estimates by analysts or our failure to meet such
earnings estimates,

- - Announcements by us regarding significant acquisitions, strategic
relationships or capital expenditure commitments,

- - Additions or departures of key personnel,

- - Issuance of convertible or equity securities for general or merger and
acquisition purposes,

- - Changes in federal, state or foreign regulations affecting the
telecommunications industry,

- - General market and economic conditions and

- - Defending significant litigation.

The stocks of technology companies have experienced extreme price and volume
fluctuations. These fluctuations often have been unrelated or disproportionate
to the operating performance of these companies. These broad market and
industry factors may have a material adverse effect on the market price of our
common stock, regardless of our actual operating performance. Factors like
this could have a material adverse effect on our business, financial condition
and results of operations.

THE SALE OF A SIGNIFICANT NUMBER OF OUR SHARES PURSUANT TO FUTURE SALES
CONTRACTS COULD DEPRESS THE PRICE OF OUR STOCK

Sales or issuances of a large number of shares of common stock in the public
market or the perception that sales may occur could cause the market price of
our common stock to decline. As of March 4, 2002, 31,344,710 shares of common
stock were outstanding. Of these shares, 19,786,967 were eligible for sale in
the public market without restriction (including 7,415,000 million held by Dr.
Zwan that are subject to forward sales agreements). The remaining 11,557,743
shares of outstanding common stock were held by Dr. Zwan, our majority
stockholder, and other company insiders. As an "affiliate" (as defined under
Rule 144, under the Securities Act ("Rule 144") of Digital Lightwave, Dr. Zwan
may only sell his shares of common stock in the public market in compliance
with the volume limitations of Rule 144.

SOME ANTI-TAKEOVER PROVISIONS MAY AFFECT THE PRICE OF OUR COMMON STOCK

Our Board of Directors has the authority to issue up to 20,000,000 shares of
preferred stock and to determine the preferences, rights and privileges of
those shares without any further vote or action by our stockholders. The rights
of the holders and the market value of our common stock may be adversely
affected by the rights of the holders of any series of preferred stock that may
be issued in the future. Some provisions of our certificate of incorporation,
our bylaws and Delaware law could have the effect of making it more difficult
for a third party to acquire a majority of our outstanding voting stock even if
doing so would be beneficial to our stockholders. These include provisions that
prohibit stockholders from taking action by written consent and restrict the
ability of stockholders to call special meetings.

THE COMPANY IS EXPOSED TO VARIOUS RISKS RELATED TO LEGAL PROCEEDINGS OR CLAIMS

The Company has been, currently is, or in the future may be involved in legal
proceedings or claims regarding employment law issues, contractual claims,
securities laws violations and other matters (See Item 3. Legal Proceedings).
These legal proceedings and claims, whether with or without merit, could be
time-consuming and expensive to prosecute or defend and could divert
management's attention and resources. There can be no assurance regarding the
outcome of current or future legal proceedings. The Company has incurred and
may continue to incur significant litigation expenses associated with legal
proceedings and claims, which have and could continue to have a material
adverse effect on our business, financial condition and results of operations.

ITEM 2. PROPERTIES

Our corporate headquarters and production and shipping facilities are located
in an approximately 92,000 square foot, three-story concrete and steel building
at 15550 Lightwave Drive, Clearwater, Florida. We currently lease the building
space from Lightwave Drive LLC, a limited partnership. The lease expires in
November 2008 and may be extended by the company for up to two (2) five-year
periods.

ITEM 3. LEGAL PROCEEDINGS

On November 23, 1999, Seth P. Joseph, a former officer and director of the
Company commenced arbitration proceedings against the Company alleging breach
of his employment agreement and stock option agreements, violation of the
Florida Whistleblower statute and breach of an indemnification agreement and
the Company bylaws. As relief, Mr. Joseph sought $500,000, attorneys' fees,
interest and stock options for 656,666 shares of the Company's Common Stock
exercisable at a price of $5.25 per share. The Company filed an answer denying
Mr. Joseph's allegations and alleging multiple affirmative defenses and
counterclaims. The Company's counterclaims against Mr. Joseph seek repayment of
loans totaling approximately $113,000 plus interest. Mr. Joseph subsequently
dismissed without prejudice all of his claims other than his claim under the
whistleblower statue. The arbitration hearing on Mr. Joseph's whistleblower
claim and the Company's counterclaims concluded on October 5, 2001. The parties
submitted proposed findings to the arbitrator on October 17, 2001. As part of
his proposed findings, Mr. Joseph sought an award of $48 million and attorneys'
fees and costs. On November 9, 2001, the Company was notified of the
arbitrator's decision that awarded Mr. Joseph the sum of approximately $3.7
million and attorneys' fees and costs. On December 20, 2001, the arbitrator
issued a corrected award and awarded Mr. Joseph the sum of $3.9 million and
attorneys' fees and costs in amounts yet to be determined. On January 23,
2002, Mr. Joseph filed a motion seeking the award of $1.1 million in attorneys'
fees, costs and interest thereon.

On December 26, 2001, the Company filed a petition to vacate or modify
the arbitration award in the Circuit Court of the Sixth Judicial Circuit,
Pinellas County, Florida, in an action entitled Digital Lightwave, Inc.
v. Seth P. Joseph, Case No. 01-9010C1-21. The Company filed an amended
petition on December 26, 2001, following the corrected arbitration award.
Subsequently, Mr. Joseph filed a cross-motion to confirm the arbitration
award. Oral argument on the Company's petition and Mr. Joseph's cross-motion
was heard by the Court on February 27, 2002. On March 7, 2002, the court
announced that it will deny the Company's petition to vacate the arbitration
award. The Company intends to appeal the decision. The Company has recorded
an accrual of $4.1 million related to this arbitration for the year ended
December 31, 2001. The Company believes its petition is meritorious and intends
to pursue the petition vigorously. There can be no assurance that the action
will not have a material adverse effect on the Company.

In January 2002, an employee terminated as part of the Company's October
2001 restructuring initiatives discussed in Note 12 of the Consolidated
Financial Statements -- Restructuring Charges, filed a lawsuit claiming the
Company wrongly discharged him and has withheld commission payments due him.
The suit does not seek a specified amount of damages, but does claim that the
2001 compensation plan presented to him in October 2001 unfairly lowered his
salary. The plaintiff seeks attorneys' fees, interest and punitive damages to
be assessed by the court. The suit was not properly filed with the court so
the Company does not have a deadline to respond. It is expected that the
plaintiff will refile the action and the Company will have thirty days to
respond to the complaint. The Company has accrued the estimated costs to
defend this action in the restructuring charges discussed in Note 12 of the
Consolidated Financial Statements -- Restructuring Charges.

The Company from time to time is involved in various other lawsuits and
actions by third parties arising in the ordinary course of business. The
Company is not aware of any additional pending litigation, claims or
assessments that could have a material adverse effect on the Company's
business, financial condition and results of operations.

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

At the annual meeting of stockholders of the Company on October 26, 2001, the
stockholders voted on two proposals. The first was a proposal to elect Gerry
Chastelet, Gerald A. Fallon, Dr. William F. Hamilton, Robert F. Hussey and Dr.
Bryan J. Zwan as directors of the Company. The following table sets forth the
votes in such election:

DIRECTOR VOTES FOR VOTES WITHHELD
-------- --------- --------------
Gerry Chastelet........................... 29,223,541 96,131
Gerald A. Fallon.......................... 29,230,028 89,644
Dr. William F. Hamilton................... 29,216,920 102,752
Robert F. Hussey.......................... 29,217,536 102,136
Dr. Bryan J. Zwan......................... 29,198,304 121,368

The second was a proposal to ratify the selection of
PricewaterhouseCoopers LLP as the Company's independent auditor for the fiscal
year ending December 31, 2001:

NUMBER OF SHARES:

Voted For............................................29,250,029
Voted Against........................................ 48,445
Abstentions.......................................... 21,198

EXECUTIVE OFFICERS OF THE REGISTRANT

The following table and notes set forth information about the Company's four
executive officers:

NAME AGE POSITION

Dr. Bryan J. Zwan (1) 54 Chairman, President and Chief Executive Officer

Mark E. Scott (2) 48 Vice President, Finance, Chief Financial
Officer and Secretary

James Green (3) 51 Chief Operating Officer

Dr. Glenn Dunlap (4) 58 Chief Strategy Officer

___________________________

(1)Dr. Zwan founded the Company in October 1990 and served as Chairman of the
Board from its inception until July 1999. In addition, Dr. Zwan served as the
Company's Chief Executive Officer from the Company's inception until December
31, 1998 and served as its President from inception until March 1996 and from
October 1996 until December 31, 1998. He was re-appointed Chairman of the
Board, Chief Executive Officer and President on January 23, 2002. Dr. Zwan
holds a Ph.D. in Space Physics from Rice University and B.S. degrees in Physics
and Chemistry from the University of Houston.

(2)Mr. Scott currently serves as Vice President, Finance, Chief Financial
Officer and Secretary and joined the Company in January 2002. Prior to joining
the Company, Mr. Scott served as Chief Financial Officer of Network Access
Solutions Corporation, a publicly-traded broadband solutions provider
headquartered in Herndon, Virginia. Prior to Network Access Solutions, Mr.
Scott was the Vice President, Finance and Chief Financial Officer of
Teltronics, Inc., a Sarasota, Florida-based international manufacturer of
telephone switching systems and software. Before that, he served as Vice
President, Finance and Controller of Protel, Inc., a global telecommunications
company. Mr. Scott has also held various senior financial management positions
at RHM Holdings, Inc.

(3)Mr. Green currently serves as Chief Operating Officer. He joined the
Company in August 1999 as a consultant. Prior to joining the Company, Mr. Green
served as the CEO of Trillium Industries from October 1995 to April 1999. Prior
to that, Mr. Green served as Vice President--Operations for the MATCO
Electronics Group from April 1993 to October 1995. Mr. Green is APICS Certified
and also holds a CPM Certification.

(4)Dr. Dunlap currently serves as Chief Strategy Officer and joined the
Company in February 2001. Dr. Dunlap has an extensive background in
telecommunications and microelectronics. Prior to joining the Company, he
served as Chairman, President and Chief Executive Officer of Wandel &
Goltermann ATE Systems, a manufacturer of telecommunications test systems, from
February 1996 to February 2001. Prior to that, Dr. Dunlap served as Vice
President of the Electronics Technologies Division at MCNC, from February 1992
to August 1995. Dr. Dunlap has an MS and Ph.D. in Engineering from Arizona
State University, and a BS in Aeronautics and Mathematics, also from Arizona
State University.
#

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Company's shares of Common Stock have traded on the Nasdaq National
Market System under the symbol "DIGL" since February 7, 1997. The prices set
forth below represent quotes between dealers and do not include commissions,
mark-ups or mark-downs, and may not necessarily represent actual transactions.

COMMON STOCK

--------------------------
HIGH LOW
--------- ---------
2000
1st Quarter $150.0000 $ 44.5000
2nd Quarter $104.8750 $ 26.1870
3rd Quarter $125.0000 $ 63.0000
4th Quarter $ 76.3750 $ 25.4370
2001
1st Quarter $ 52.8125 $ 17.1875
2nd Quarter $ 56.0300 $ 12.8125
3rd Quarter $ 33.8000 $ 9.8100
4th Quarter $ 11.8400 $ 5.4000

On March 4, 2002, the closing price of the Company's Common Stock was $5.62.
As of March 4, 2002, there were approximately 594 holders of record of the
Company's Common Stock.

DIVIDEND POLICY

The Company has not paid any dividends since its inception and does not
contemplate payment of dividends in the foreseeable future. The Company
anticipates that any earnings in the near future will be retained for the
development and expansion of its business. Certain of the Company's credit
facilities require consent from the banks prior to payments of dividends.

RECENT SALES OF UNREGISTERED SECURITIES

In 1999, the Company entered into a financing agreement with certain
investors pursuant to which the Company agreed to issue $3.0 million of 9%
Secured Bridge Notes due January 17, 2000. In connection with the financing
agreement, the Company issued warrants to purchase an aggregate of 550,000
shares of the Company's common stock at an exercise price of $2.75 per share,
which was the market price of the stock on the date prior to the issuance of
the warrants. The warrants had a term of five years from the date of issuance.
The Company agreed to register the warrants and the common stock issuable upon
exercise thereof under the Securities Act of 1933. The registration took place
on January 7, 2000 and the warrants were subsequently exercised.

The issuance of securities in this Item 5 was deemed to be exempt from
registration under the Securities Act of 1933, as amended (the "Act"), in
reliance on Section 4(2) of the Act as a transaction by an issuer not involving
any public offering. The recipients of the securities in such transaction
represented their intention to acquire the securities for investment only and
not with a view to or for sale in connection with any distribution thereof and
appropriate legends were affixed to the securities issued in such transaction.
The recipients were given adequate access to information about the Company.

During the fiscal year ended December 31, 2001, there were no sales of
unregistered securities.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

SELECTED CONSOLIDATED FINANCIAL DATA
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

The following selected consolidated financial data are derived from the
Consolidated Financial Statements of the Company. The selected consolidated
financial data should be read in conjunction with "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the Consolidated Financial Statements of the Company and Notes thereto.

FOR THE YEARS ENDED DECEMBER 31,

-----------------------------------------------------------------------------------------------

2001 2000 1999 1998 1997
------------- ------------- ------------- ------------- -------------
Consolidated Statement of
Operations:
Net sales $ 82,780 $ 100,675 $ 50,474 $ 24,191 $ 9,081
------------- ------------- ------------- ------------- -------------
Gross profit 51,170 67,438 33,043 14,972 5,957
------------- ------------- ------------- ------------- -------------
Operating expenses:
Engineering and development 14,985 14,092 10,204 14,335 5,342
Selling and marketing 22,261 15,628 12,724 11,363 5,260
General and administrative 8,063 7,085 5,240 7,223 3,812
Restructuring charges 500 (4) -- -- 1,018 (1) --
Litigation settlements and
charges 4,100 (5) -- -- 11,500 (2) --
------------- ------------- ------------- ------------- -------------
Total operating
expenses 49,909 36,805 28,168 45,439 14,414
------------- ------------- ------------- ------------- -------------
Income (loss) from operations 1,261 30,633 4,875 (30,467) (8,457)

Other income 1,545 770 78 642 1,767
------------- ------------- ------------- ------------- -------------
Net income (loss) $ 2,806 $ 31,403 $ 4,953 $ (29,825) $ (6,690)
============= ============= ============= ============= =============
Income (loss) per share $ 0.09 $ 1.06 $ 0.18 $ (1.13) $ (0.25)
============= ============= ============= ============= =============
Diluted income (loss) per
share $ 0.09 $ 0.98 $ 0.17 $ (1.13) (3) $ (0.25)(3)
============= ============= ============= ============= =============
Weighted average shares 30,927,386 29,548,905 26,808,158 26,475,749 26,084,208
Weighted average shares and
common equivalent shares 32,109,888 31,946,416 29,151,628 26,494,439 27,060,221
Consolidated Balance Sheet Data:
Cash $ 51,044 $ 30,481 $ 7,466 $ 3,848 $ 24,031
Working capital 64,755 58,977 12,913 2,267 32,495
Total assets 86,262 78,833 39,998 27,558 44,361
Total long-term liabilities 809 854 498 281 25
Stockholders' equity 74,066 67,369 22,153 12,320 39,419

- ---------------

(1)Includes non-recurring expense $1.0 million for restructuring charges as
described in Form 10-K for the fiscal year ended December 31, 2000.
(2) Includes a charge of $8.5 million made in connection with the settlement of
a class action legal proceeding and a one-time charge of $3.0 million made
in connection with the settlement of Haney litigation as described in Form
10-K for the fiscal year ended December 31, 2000.
(3)Incremental shares for common stock equivalents are not included in the loss
per share calculations due to the anti-dilutive effect.
(4)Includes non-recurring expense of $500,000 for restructuring charges as
described under "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Overview" and Note 12 of the Consolidated
Financial Statements -- Restructuring Charges.
(5)Includes a charge of $4.1 million made in connection with the Seth Joseph
arbitration as described under Note 13 of the Consolidated Financial
Statements -- Legal Proceedings.
#

ITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion includes certain forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995. These
statements are based on current expectations, forecasts and assumptions that
involve risks and uncertainties that could cause actual outcomes and results to
differ materially. These risks and uncertainties include fluctuations in
operating results, changes in the United States and worldwide economy and
fluctuations in capital expenditures within the telecommunications industry,
our dependence on a limited number of products and uncertainties of the market
for our current and planned products, technological change, our dependence on
growth of the Internet, competition, our dependence on a limited number of
major customers, our dependence on contract manufacturers and suppliers, our
products may not continue to meet changing regulatory and industry standards,
our ability to achieve sustained operating profitability, our dependence on key
personnel, the significant influence of our principal stockholder, our
dependence on proprietary technology, the volatility of our market price, the
sale of a significant number of our shares pursuant to future sales contracts
could depress the price of our stock, the effect that anti-takeover provisions
have on the price of our common stock and past and future litigation risks.
For a further list and description of such risks and uncertainties, see the
reports filed by Digital Lightwave with the Securities and Exchange Commission,
including the Company's reports on Form 10-K and 10-Q. Digital Lightwave
undertakes no obligation to update or revise any forward-looking statements,
whether as a result of new information, future events or otherwise.

OVERVIEW

Digital Lightwave, Inc. provides the global fiber-optic communications
industry with products and technology used to develop, install, maintain,
monitor and manage fiber optic-based networks. Telecommunications service
providers and equipment manufacturers deploy the Company's products to provide
quality assurance and ensure optimum performance of advanced optical
communications networks and network equipment. The Company's products are sold
worldwide to leading and emerging telecommunications service providers,
telecommunications equipment manufacturers, equipment leasing companies and
international distributors.

Fiber optics deliver increased network bandwidth for the transmission of
voice, video, audio, and data traffic over public and private networks,
including the Internet. The Company's products provide the capabilities to
cost-effectively deploy and manage fiber-optic networks to address increasing
demand for bandwidth. While the technology of optical networking is highly
advanced, the Company's products are used to verify that telecommunications
products and systems function and perform properly. Specific customer
applications of the Company's diagnostic equipment include the qualification of
products during manufacturing, the verification of service during network
installation and the monitoring and maintenance of deployed networks.

The Company's two product lines are Network Information Computers and Network
Access Agents. Network Information Computers are portable instruments for the
installation and maintenance testing of advanced, high-speed networks and
transmission equipment. The NIC product family provides diagnostic
capabilities for testing the performance of both optical and legacy electrical
networks with an array of communications standards and transmission rates.
NAAs are unattended, software-controlled, performance monitoring and diagnostic
systems permanently installed within optical-based networks. NAAs embed the
capabilities of our portable Network Information Computers within a customer's
network infrastructure, allowing centralized remote network management.

The Company's net sales are generated from sales of its products less an
estimate for customer returns. We expect that the average selling price
("ASP") of its NIC and its NAA will fluctuate based on a variety of factors,
including product configuration, potential volume discounts to customers, the
timing of new product introductions and enhancements and the introduction of
competitive products. Because the cost of goods sold tends to remain
relatively stable for any given product, fluctuations in the ASP may have a
material adverse effect on our business, financial condition and results of
operations.

The Company primarily sells its products through a direct sales force to
telecommunications service providers and network equipment manufacturers. The
Company sells to international markets through international distributor
channels with some direct sales and sales support. Sales of our products have
tended to be concentrated with a few major customers and we expect sales will
continue to be concentrated with a few major customers in the future. For the
year ended December 31, 2001, our largest customer, Level 3 Communications,
accounted for approximately 12% of total sales. For the years ended December
31, 2000 and 1999, our largest customer, Telogy, accounted for approximately
15% and 21% of total sales, respectively. For the year ended December 31, 1999,
one additional customer, Technology Rental Services, accounted for 18% of total
sales. No other customer accounted for sales of 10% or more during those
years.

The Company has not entered into long-term agreements or blanket purchase
orders for the sale of its products. It generally obtains purchase orders for
immediate shipment and other cancelable purchase commitments. The Company does
not expect to carry substantial backlog from quarter to quarter in the future.
Our sales during a particular quarter are highly dependent upon orders placed
by customers during the quarter. Most of our operating expenses are fixed and
cannot be easily reduced in response to decreased revenues. Variations in the
timing of revenues could cause significant variations in results of operations
from quarter to quarter and result in continuing quarterly losses. The deferral
of any large order from one quarter to another would negatively affect the
results of operations for the earlier quarter. The Company must obtain orders
during each quarter for shipment in that quarter to achieve revenue and profit
objectives.

Reduced customer capital expenditures and the overall economic weakness
caused the Company to incur net operating losses in the third and fourth
quarters of 2001. In October 2001 and January 2002, the Company took certain
measures to reduce its future operating costs. These measures included a
reduction in force, pay cuts for management and other expense reduction
actions. The Company can give no assurance as to whether its revenues will
return to previous levels or when it will return to profitability.

CRITICAL ACCOUNTING POLICIES

We believe that the following accounting policies are critical in that they
are important to portrayal of the Company's financial conditions and results
and they require difficult, subject and complex judgments that are often the
results of estimates that are inherently uncertain:

* Revenue recognition and

* Estimating valuation allowances and accrued liabilities, specifically
sales returns and other allowances, the reserve for uncollectible
accounts, the reserve for excess and obsolete inventory and assessment
of the probability of the outcome of our current litigation.

Revenue Recognition

We derive our revenue from product sales. We make certain judgments and
estimates used in connection with the revenue recognized in any accounting
period. It is likely that material differences would result in the amount and
timing of our revenue for any period if we made different judgments or utilized
different estimates.

We recognize revenue from the sale of our products when we believe the
following factors have been achieved:

* Persuasive evidence of a sales arrangement exists,

* The product has been delivered,

* The price is fixed and determinable and

* Collection of the resulting receivable is reasonably assured.

We use a binding purchase order as evidence that an arrangement for all sales
exist. Sales through our international distributors are evidenced by a master
agreement governing the relationship with the distributor. We either obtain an
end-user purchase order documenting that an order has been placed with the
distributor or proof of delivery to the end user as evidence that an
arrangement for sale exists.

For demonstration units sold to distributors, we use the distributor's
binding purchase order as evidence of a sales arrangement.

For domestic sales, delivery generally occurs when product is delivered to a
common carrier. Demonstration units sold to our international distributors are
considered delivered when the units are delivered to a common carrier. In the
case of shipments to an international distributor that will be resold, delivery
occurs when we receive either a copy of the end-user binding purchase order or
proof of delivery to the end-user. We provide an allowance for sales returns
based on historical experience.

We assess whether the price associated with our revenue transactions is fixed
and determinable and whether or not collection is reasonably assured at the
time of the transaction. Our assessment that the price is fixed and
determinable is based on the payment terms associated with the transaction.
Our standard payment terms for domestic customers are 30 days from the invoice
date. Distributor contracts provide standard payment terms of 60 days from the
invoice date. We have not offered extended payment terms. We assess
collection based on a number of factors, including past transaction history
with the customer and the credit-worthiness of the customer. We do not request
collateral from our customers. If we determine that collection of an accounts
receivable is not reasonably assured, we will defer the amount and recognize
revenue at the time collection becomes reasonably assured.

Our arrangements do not generally include acceptance clauses. However, if an
arrangement includes an acceptance provision, acceptance occurs upon the
earlier of receipt of a written customer acceptance or expiration of the
acceptance period.

Sales returns and other allowances, reserve for uncollectible accounts,
reserve for excess and obsolete inventory and litigation

The preparation of financial statements requires us to make estimates and
assumptions that affect the reported amount of assets and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reported period.

We estimate the amount of potential future product returns related to current
period product revenue. We consider many factors when making our estimates,
including analyzing historical returns, current economic trends, changes in
customer demand and acceptance of our products to evaluate the adequacy of the
sales returns and other allowances. Our estimate of the provision for sales
returns and other allowances as of December 31, 2001was $0.7 million.

We also estimate the uncollectability of our accounts receivables. We
consider many factors when making our estimates, including analyzing accounts
receivable and historical bad debts, customer concentrations, customer credit-
worthiness, current economic trends and changes in our customer payment terms
when evaluating the adequacy of the reserve for uncollectible accounts. Our
accounts receivable balance was as of December 31, 2001, $7.6 million, net of
our estimated reserve for uncollectible accounts of $5.9 million.

We estimate the amount of excess and obsolete inventory. We consider many
factors when making our estimates, including analyzing current and expected
sales trends, the amount of current parts on hand, the current market value of
parts on hand and the viability and technical obsolescence of our products when
evaluating the adequacy of the reserve for excess and obsolete inventory. Our
inventory balance as of December 31, 2001, was $16.6 million net of our
estimated reserve for excess and obsolete inventory of $3.8 million.

We estimate the amount of liability the Company may incur as a result of
pending litigation. Our estimate of legal liability is uncertain and is based
on the size of the outstanding claims and an assessment of the merits of the
claims. We accrued $4.1 million for liability resulting from pending
litigation as of December 31, 2001. We will assess the potential liability
related to our pending litigation and revise our estimates as additional
information becomes available.

We make significant judgments and estimates and assumptions in connection
with establishing the amount of sales returns and other allowances, the
uncollectability of our account receivables, the amount of excess and obsolete
inventory and the amount of liability related to pending litigation during any
accounting period. If we made different judgments or used different estimates
or assumptions for establishing such amounts, it is likely that our financial
results for any period would be materially different.

#

RESULTS OF OPERATIONS

The following table sets forth certain financial data expressed as a
percentage of net sales.

FISCAL YEAR

ENDED DECEMBER 31,
-----------------------------------------------------------
2001 2000 1999
---------- ---------- ----------
Net sales 100 % 100 % 100 %
Cost of goods sold 38 33 35
---------- ---------- ----------
Gross profit 62 67 65
Operating expenses:
Engineering and development expenses 18 14 20
Sales and marketing expenses 27 16 25
General and administrative expenses 10 7 10
Reorganization charges 1 -- --
Litigation charge 5 -- --
---------- ---------- ----------
Total operating expenses 61 37 55
---------- ---------- ----------
Operating income 1 30 10
Interest income 2 1 1
Interest expense -- -- (1)
Other income (expense),net -- -- --
---------- ---------- ----------
Net income 3 % 31 % 10 %
========== ========== ==========

-- Represents less than 1% of net sales.

YEAR ENDED DECEMBER 31, 2001 COMPARED WITH YEAR ENDED DECEMBER 31, 2000

Net Sales

Net sales decreased by $17.9 million, or 18%, to $82.8 million from $100.7
million in fiscal 2000. Sales to existing customers for the year represented
90% of sales, or $74.7 million as compared to 71% of sales, or $71.6 million
for fiscal 2000. During fiscal 2001, the Company shipped 977 total units
(including 47 NAA's) at an ASP of approximately $82,600 compared with 1,463
units (including 70 NAA's) at an ASP of approximately $65,900 for fiscal 2000.
The increase in ASP is related to the product mix with increased shipments of
higher speed NIC and NAA products.

International sales for the year ended December 31, 2001, as a percentage of
total sales, increased 11%, to 20% of total sales as compared to 9% of total
sales in 2000. The majority of these sales were made in the first and second
quarters of 2001 as part of the Company's international growth strategy.

Beginning in the third quarter of 2001, the telecommunications industry
experienced a dramatic economic downturn that was brought on by a significant
decrease in network build-outs and capital spending by the telecommunications
carriers and equipment manufacturers. Our customers' declining business
resulted in a major decrease in sales of our products during the second half of
2001.

Cost of Goods Sold

Cost of goods sold for the year ended December 31, 2001 decreased by $1.6
million, or 5%, to $31.6 million as compared to $33.2 million in 2000. The
decrease in cost of goods sold was due to the reduction in the volume of units
sold offset by a $5.2 million charge related to excess and obsolete inventory
in 2001.

Gross Profit

Gross profit for the year ended December 31, 2001 decreased by $16.3 million
to $51.1 million as compared to $67.4 million in 2000. Gross margin for the
year decreased to 61.8% from 67.0% in 2000. The decrease in gross profit was
primarily attributable to lower sales volume combined with a $5.2 million
charge for excess and obsolete inventory in 2001.

Engineering and Development

Engineering and development expenses principally include salaries for
engineering and development personnel, depreciation of production and
development assets, outside consulting fees and other development expenses.
Engineering and development expenses for the year ended December 31, 2001
increased by $0.9 million to $15.0 million, or 18% of net sales, from $14.1
million, or 14% of net sales, last year. The dollar increase related to
development efforts on the Company's NIC and NAA product lines, principally the
NIC Plus product.

Sales and Marketing

Sales and marketing expenses principally include salaries, commissions,
travel, tradeshows, promotional materials, warranty expenses and customer
incentive programs. Sales and marketing expenses for the year ended December
31, 2001 increased by $6.7 million to $22.3 million, or 27% of net sales, from
$15.6 million, or 16% of net sales in 2000. The dollar increase is directly
related to an increase in the provision for uncollectible accounts receivable
and an increase in marketing and international travel expenses associated with
the increase in international sales. These costs were partially offset by
decreased commissions paid on reduced net sales.

The Company increased the reserve for uncollectible accounts by approximately
$5.7 million in 2001. The majority of the reserve related to international
accounts with large past due balances. With the current uncertain worldwide
economic conditions, the Company determined that these international accounts
would be uncollectible. The Company's ability to pursue a cost-effective legal
remedy for payment if an account went bankrupt or insolvent was considered to
be remote.

General and Administrative

General and administrative expenses principally include salaries,
professional fees, facility rentals, compensation and information systems
related to general management functions. General and administrative expenses
for the year ended December 31, 2001, increased by $1.0 million to $8.1
million, or 10% of net sales, from $7.1 million, or 7% of net sales, last year.

The increase relates to increased professional fees relating to various legal
matters, indemnification expenses for current and former officers and
directors, employee recruiting, insurance and facilities expenses.

Restructuring Charges

In October 2001, the Company's board of directors approved a plan to
reduce the current workforce by 38 employees and consultants across all
departments and instituted temporary executive salary reductions of up to 20%.
The overall objective of the initiative was to lower operating costs and
improve efficiency.

All affected employees were terminated in October 2001 and given severance
based upon years of service with the Company. The Company recorded a
restructuring charge of $500,000 in 2001 related to this cost reduction
program. The costs included in the restructuring charge include severance to
employees included in the reduction in force, legal costs associated with the
cost reduction program and the remaining lease liability on the New Jersey
location. The costs are expected to be paid by November 2002. Activity
associated with the restructuring charges was as follows:

Balance at Payments/ Balance at
January 1, Additions Reductions December 31,
2001 2001

------------ ----------- ----------- -------------
(in thousands)
Severance $ -- $ 251 $ (172) $ 79
Legal and other expenses -- 109 (22) 87
Lease payments -- 140 (22) 118
------------- ------------- -------------- --------------
$ -- $ 500 $ (216) $ 284
============= ============= ============== ==============

In January 2002, the board of directors approved additional cost reduction
initiatives aimed at further reducing operating costs. These included a second
reduction in force of 46 employees and contractors and the outsourcing of
manufacturing and production for our product lines. All affected employees
were terminated in January 2002 and given severance based upon years of service
with the Company. The Company expects to take a restructuring charge of
approximately $1.3 million in the first quarter of 2002. The total costs
associated with the restructuring will be paid by January 2003. These actions,
combined with the October initiative, are expected to reduce the Company's
operating expenses by approximately $16 million on an annualized basis
beginning in the second quarter of 2002.

Litigation Charge

During 2001, the Company recorded a charge of $4.1 million related to the
Seth Joseph arbitration case and appeal. There was no corresponding charge in
2000.

Other Income (Expense)

Other income for the year ended December 31, 2001 increased by $0.7 million
to $1.5 million from $0.8 million last year. This category primarily represents
interest earned on invested cash balances.

Net Income

Net income for the year ended December 31, 2001, decreased by $28.6 million
to $2.8 million or $0.09 per diluted share, from a net income of $31.4 million
or $0.98 per diluted share in 2000 for the reasons discussed above.

YEAR ENDED DECEMBER 31, 2000 COMPARED WITH YEAR ENDED DECEMBER 31, 1999

Net Sales

Net sales increased by $50.2 million, or 99%, to $100.7 million from $50.5
million in 1999. Sales to existing customers for the year represented 71% of
sales, or $71.6 million as compared to 85% of sales, or $43.0 million for 1999.
During 2000, the Company shipped 1,463 total units (including 70 NAA's) at an
ASP of approximately $65,900 compared with 1,158 units (including 14 NAA's) at
an ASP of approximately $41,400 for 1999. The primary increase in ASP is
related to product mix with increased sales of higher speed NIC and NAA
products.

Cost of Goods Sold

Cost of goods sold for the year ended December 31, 2000 increased by $15.8
million to $33.2 million as compared to $17.4 million in 1999. The increase in
cost of goods sold was due to the increase in the volume of units sold and
product mix with increased shipments of higher speed NIC and NAA products.

Gross Profit

Gross profit for the year ended December 31, 2000 increased by $34.4 million
to $67.4 million as compared to $33.0 million in 1999. Gross margin for year
increased to 67.0% from 65.5% in 1999. The increase was primarily due to
product mix with increased shipments of higher speed NIC and NAA products.

Engineering and Development

Engineering and development expenses principally include salaries for
engineering and development personnel, depreciation of production and
development assets, outside consulting fees and other development expenses.
Engineering and development expenses for the year ended December 31, 2000
increased by $3.9 million to $14.1 million, or 14% of net sales, from $10.2
million, or 20% of net sales, last year.

The dollar increase is related to development efforts for the Company's NIC
and NAA product lines.

Sales and Marketing

Sales and marketing expenses principally include salaries, commissions,
travel, tradeshows, promotional material expenses and customer incentive
programs. Sales and marketing expenses for the year ended December 31, 2000
increased by $2.9 million to $15.6 million, or 16% of net sales, from $12.7
million, or 25% of net sales, last year.

The dollar increase is related to higher commissions, travel, marketing and
investor relations and employee benefit expenses.

General and Administrative

General and administrative expenses principally include salaries,
professional fees, facility rentals, compensation and information systems
related to general management functions. General and administrative expenses
for the year ended December 31, 2000 increased by $1.9 million to $7.1 million,
or 7% of net sales, from $5.2 million, or 11% of net sales, last year.

The increase relates to increased legal fees, rental and employee benefit
expenses. These items were partially offset by reductions in salary and
consulting expenses.

Other Income (Expense)

Other income for the year ended December 31, 2000 increased by $0.7 million
to $0.8 million from $0.1 million last year. This category primarily represents
interest earned on invested cash balances.

Net Income

Net income for the year ended December 31, 2000 increased by $26.4 million to
$31.4 million or $0.98 per diluted share, from a net income of $5.0 million or
$0.17 per diluted share in 1999.

INCOME TAXES

As of December 31, 2001, the Company had net operating loss carry forwards of
approximately $245 million for tax purposes. Our loss carryforwards will
expire between the years 2009 and 2021.

The major components of the net operating loss carry forwards are as follows:

* Tax deductions of $118 million related to the exercise of non-qualified
stock options,

* A ruling from the Internal Revenue Service regarding an additional
deduction related to securities litigation costs that resulted in a $127
million increase to the Company's net operating loss carryforward.

The Company has recorded a valuation allowance against the deferred tax
assets resulting from the net operating loss as it has determined that it is
more likely than not that the deferred tax assets will not be realized. The
benefit associated with the net operating loss will be reported as an increase
in additional paid-in capital and will not be recognized in the Company's
Consolidated Statement of Operations when the deferred tax assets are realized.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2001, the Company's cash and cash equivalents were
approximately $51.0 million, an increase of $20.5 million from December 31,
2000. As of December 31, 2001, the Company's working capital was approximately
$64.8 million as compared to $59.0 million at December 31, 2000. During 2001
and 2000, we reported net income of $2.8 million and $31.4 million,
respectively, and cash flows from operations of $20.8 million and $19.8
million, respectively. We had an accumulated deficit of $6.4 million at
December 31, 2001.

During the third and fourth quarters of 2001, we experienced a combined
operating loss of $25.6 million and expect to incur operating losses through
2002. Management has taken actions to significantly reduce cost of goods sold,
operating expenses and capital expenditures. These actions include
restructuring operations to more closely align operating costs with revenues.

Operating Activities. Net cash provided by operating activities for the year
ending December 31, 2001 was $20.8 million. This was primarily the result of a
decrease in accounts receivable of $11.7 million, increases in accrued
litigation charges of $4.1 million, non-cash expenses consisting primarily of
depreciation and amortization of $3.4 million, provision for excess and
obsolete inventory of $5.2 million and provision for uncollectible accounts of
$6.0 million. These were partially offset by a $9.4 million increase in
inventory, accompanied by a decrease in accounts payable and accrued
liabilities of $3.6 million.

Net cash provided by operating activities for the year ending December 31,
2000 was $19.8 million. This was primarily the result of net income of $31.4,
accompanied by increases in accounts payable and accrued liabilities of $2.9
million, non-cash expenses of depreciation and amortization of $2.9 million
and provision for excess and obsolete inventory of $0.7 million. This was
partially offset by increases in accounts receivable of $10.3 million and
inventory of $8.0 million.

Net cash used in operating activities for the year ending December 31, 1999
was $1.6 million. This was primarily the result of increases in accounts
receivable of $9.2 million and inventory of $1.2 million and a decrease in
accrued litigation charges of $1.1 million. This was partially offset by net
income of $5.0 million along with increases in accounts payable and accrued
liabilities of $1.4 million, non-cash expenses of depreciation and amortization
of $2.5 million and obsolete inventory of $0.4 million.

Investing Activities. Net cash used in investing activities was $3.5
million, $1.3 million and $1.9 million for the years ended December 31, 2001,
2000 and 1999, respectively. Investing activities related to purchases of
property and equipment.

Financing Activities. Net cash provided by financing activities was $3.3
million for the year ended December 31, 2001. This was primarily the result of
net proceeds from employee exercises of stock options of $3.9 million. These
were partially offset by principal payments on capital lease obligations of
$0.7 million.

Net cash provided by financing activities was $4.5 million for the year ended
December 31, 2000. This was primarily the result of net proceeds from employee
exercises of stock options of $7.8 million and payments received on leases of
$0.3 million. These were partially offset by principal payments on notes
payable of $3.0 million and principal payments on capital lease obligations of
$0.5 million.

Net cash provided by financing activities was $7.1 million for year ending
December 31, 1999. This was primarily the result of net proceeds from employee
exercises of stock options of $3.7 million, payments received on leases of $0.7
million and proceeds from issuance of notes payable of $3.0 million. These
were partially offset by principal payments on capital lease obligations of
$0.3 million.

Line of Credit. In October 2000, the Company entered into a Loan and Security
Agreement (the "Loan Agreement") with Congress Financial Corporation pursuant
to which Congress provided the Company with a $10.0 million line of credit.
Under the Loan Agreement, the Company is entitled to borrow up to $10.0 million
initially bearing interest at prime plus one-half of one percent (.50%),
subject to certain borrowing limitations based on amounts of the Company's
accounts receivable and inventories. The Loan Agreement expires in November
2002. All indebtedness outstanding under the Loan Agreement is collateralized
by substantially all of the Company's assets. Under the terms of the Loan
Agreement, the Company is required to maintain certain financial ratios and
other financial conditions. The Loan Agreement also prohibits the Company,
without prior written consent from Congress, from incurring additional
indebtedness, limits certain investments, advances or loans and restricts
substantial asset sales, capital expenditures and cash dividends. As of March
4, 2002, the Company had utilized $2.13 million of the $10.0 million available
under the credit facility to collateralize a letter of credit required by a
lease for office space. A fee for this letter of credit accommodation is
assessed at one and one quarter percent (1.25%) per annum. There were no
borrowings under this line of credit at December 31, 2001.

Other Material Commitments. The Company's contractual cash obligations as of
December 31, 2001, are summarized (in thousands) in the table below.

Payable
during Payable Payable
Contractual Cash Obligations Total 2002 2003-2005 after 2005

- ---------------------------------------- ---------- ------------ ------------ ----------
Operating leases $ 12,316 $ 1,787 $ 5,248 $ 5,281
Capital lease obligations 445 435 10 --
Non-cancelable purchase orders 5,439 5,439 -- --
---------- ------------ ------------ ----------
Total contractual cash obligations $ 18,200 $ 7,661 $ 5,258 $ 5,281
========== ============ ============ ==========

The Company continues to consider various financing alternatives, including
other equity or debt issuances (the "Financing Sources"). The Company
anticipates that its existing cash and cash equivalents and anticipated cash
flow from operations together with funds provided from the Financing Sources
will be sufficient to fund the Company's working capital and capital
expenditure requirements for at least the next twelve months. The anticipated
cash flow from operations assumes the Company achieves a level of sales that is
sufficient to offset expected operating expenses. In the event that these sales
levels are not attained, the Company may be required to use its cash reserves
to fund operations or supplement its working capital with additional funding or
financing alternatives. There can be no assurance, however, that the Company
will achieve sufficient sales levels or that adequate additional financing
will be available when needed or if available on terms acceptable to the
Company.

New Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board (FASB) issued
Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and
Other Intangible Assets. Statement No. 141 requires that all business
combinations initiated after June 30, 2001 be accounted for under the purchase
method of accounting. Use of the pooling-of-interests method is no longer
permitted. The Company did not make any acquisitions in 2001. With the adoption
of Statement No. 142 effective January 1, 2002, goodwill and other indefinite
lived intangibles will no longer be amortized to earnings, but will instead be
reviewed for impairment by applying a fair-value-based test. The Company had no
goodwill recorded at December 31, 2001.

In June 2001, the FASB issued Statement of Financial Accounting Standards No.
143, Accounting for Asset Retirement Obligations. Statement No. 143 requires
entities to record the fair value of a liability for an asset retirement
obligation in the period in which it is incurred. When the liability is
initially recorded, the entity capitalizes a cost by increasing the carrying
amount of the related long-lived asset. Over time, the liability is accreted to
its present value each period and the capitalized cost is depreciated over the
useful life of the related asset. Upon settlement of the liability, an entity
either settles the obligation for its recorded amount or incurs a gain or loss
upon settlement. Statement No. 143 is effective for fiscal years beginning
after June 15, 2002, with earlier application encouraged. The Company does not
expect the implementation of Statement No. 143 to have a material impact on its
financial statements.

In October 2001, the FASB issued Statement No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. Statement 144 supersedes FASB
Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of. Statement No. 144 develops one
accounting model (based on the model in Statement No. 121) for all long-lived
assets and requires that long-lived assets that are to be disposed of by sale
be measured at the lower of book value or fair value less cost to sell. That
requirement eliminates Accounting Principles Board Opinion No. 30's requirement
that discontinued operations be measured at net realizable value or that
entities include under "discontinued operations" in the financial statements
amounts for operating losses that have not yet occurred. Additionally,
Statement No. 144 expands the scope of discontinued operations to include all
components of an entity with operations that (i) can be distinguished from the
rest of the entity and (ii) will be eliminated from the ongoing operations of
the entity in a disposal transaction. Statement No. 144 is effective for
financial statements issued for fiscal years beginning after December 15, 2001
and generally its provisions are to be applied prospectively. The Company does
not expect the implementation of Statement No. 144 to have a material impact on
its financial statements.

TREND AND UNCERTAINTIES

Prior to 2001, we had experienced sequential growth over a five-year period.
This growth was attributable primarily to the rapid expansion and substantial
installation of fiber optic networks fueled by an unprecedented demand for
bandwidth to accommodate exponentially increasing Internet traffic. We
participated in that growth as a leading supplier of products that are used in
the installation, maintenance and management of fiber optic communication
networks.

During 2001, our industry experienced a dramatic economic downturn that was
brought on by a significant decrease in network build-outs and capital spending
by the telecommunications carriers and equipment manufacturers. Our customers'
declining business resulted in a major decrease in sales of our products. We
do not anticipate a near-term recovery of the fiber optic test equipment market
and do not expect the overall capital spending by telecommunication carriers
and equipment factors will increase during 2002.

In January 2002, we announced a program for rescaling our business in
response to the current market environment. Specific actions taken as part of
our plan include:

Reducing Cost. We have taken immediate steps during the last two quarters
of 2001 and in January of 2002 to reduce costs. These initiatives included
a reduction in workforce and expenses that we expect will reduce expenses by
approximately $16 million on an annualized basis beginning in the second
quarter of 2002.

With the successful migration of our current product lines to next-
generation platforms, we began outsourcing manufacturing activities with
Jabil Circuit, Inc. in January of 2002. We expect this to allow us to
further reduce operating expenses associated with manufacturing overhead and
lower the carrying risks of inventory during economically driven shifts in
customer demand.

Growing Market Share. We are focused on maintaining market leadership with
our product lines. We have evaluated our sales efforts to identify
opportunities where our account presence can be improved and are working to
exploit those opportunities. We expect new applications for our installed
product base to be realized with use of new modular add-ons and
enhancements. We are expanding our distribution channels to specific
global markets.

Accelerating Product Development. We are escalating our efforts to bring
products currently under development to market faster. We are concentrating
on the products and technologies that we believe are most important to our
customers. We plan to introduce enhancements to our product lines to meet
growing international needs and global high-speed data service requirements.

Expanding into Additional Telecommunications Markets. We are identifying
and pursuing specific telecommunication market segments, both domestically
and internationally, that we believe will be synergistic with our current
business and create opportunities for growth.

We believe that the initiatives outlined will allow us to meet our current
customer needs, develop new opportunities and position the Company for a market
recovery.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are not exposed to fluctuations in currency exchange rates because all of
our services are invoiced in U.S. dollars. We are exposed to the impact of
interest rate changes on our short-term cash investments, consisting of U.S.
Treasury obligations and other investments in respect of institutions with the
highest credit ratings, all of which have maturities of three months or less.
These short-term investments carry a degree of interest rate risk. We believe
that the impact of a 10% increase or decline in interest rates would not be
material to our investment income.

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO FINANCIAL STATEMENTS

PAGE

------------------
FINANCIAL STATEMENTS
Report of Independent Certified Public Accountants 30
Consolidated Balance Sheets 31
Consolidated Statements of Operations 32
Consolidated Statements of Stockholders' Equity 33
Consolidated Statements of Cash Flows 34
Notes to Consolidated Financial Statements 35-46
FINANCIAL STATEMENT SCHEDULE
Schedule II -- Valuation and qualifying accounts 50

#

REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

To the Board of Directors and Stockholders of
Digital Lightwave, Inc. and its subsidiaries

In our opinion, the consolidated financial statements listed in the
accompanying index present fairly, in all material respects, the financial
position of Digital Lightwave, Inc. and its subsidiaries (the "Company") at
December 31, 2001 and 2000, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2001 in
conformity with accounting principles generally accepted in the United States
of America. In addition, in our opinion, the financial statement schedule
listed in the accompanying index presents fairly, in all material respects, the
information set forth therein when read in conjunction with the related
consolidated financial statements. These financial statements and financial
statement schedule are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with auditing standards generally accepted in
the United States of America, which require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.

/s/ PRICEWATERHOUSECOOPERS LLP

Tampa, Florida
January 29, 2002

#

DIGITAL LIGHTWAVE, INC.

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)

DECEMBER 31, DECEMBER 31,

2001 2000
----------------- -----------------
ASSETS
Current assets:
Cash and cash equivalents $ 51,044 $ 30,481
Accounts receivable, less reserve for uncollectible accounts of $5,900 and
$250 in 2001 and 2000, respectively 7,638 25,301
Inventories, net 16,565 13,048
Prepaid expenses and other current assets 895 757
----------------- -----------------
Total current assets 76,142 69,587
Property and equipment, net 9,917 8,910
Other assets 203 336
----------------- -----------------
Total assets $ 86,262 $ 78,833
================= =================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued liabilities $ 7,287 $ 10,610
Accrued litigation charge 4,100 --
----------------- -----------------
Total current liabilities 11,387 10,610
Long-term liabilities 809 854
----------------- -----------------
Total liabilities 12,196 11,464
----------------- -----------------
Commitments and contingencies
Stockholders' equity:
Preferred stock, $.0001 par value; authorized 20,000,000
shares; no shares issued or outstanding -- --
Common stock, $.0001 par value; authorized
200,000,000 shares; issued and outstanding 31,269,723
and 30,476,211 shares in 2001 and 2000, respectively 3 3
Additional paid-in capital 80,511 76,620
Accumulated deficit (6,448) (9,254)
----------------- -----------------
Total stockholders' equity 74,066 67,369
----------------- -----------------
Total liabilities and stockholders' equity $ 86,262 $ 78,833
================= =================

The accompanying notes are an integral part of these consolidated financial
statements.

#

DIGITAL LIGHTWAVE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE AND PER-SHARE DATA)

FOR THE YEARS ENDED DECEMBER 31,

----------------------------------------------------------
2001 2000 1999
------------ ------------ ------------
Net sales $ 82,780 $ 100,675 $ 50,474
Cost of goods sold 31,610 33,237 17,431
------------ ------------ ------------
Gross profit 51,170 67,438 33,043
------------ ------------ ------------
Operating expenses:
Engineering and development 14,985 14,092 10,204
Sales and marketing 22,261 15,628 12,724
General and administrative 8,063 7,085 5,240
Restructuring charges 500 -- --
Litigation charge 4,100 -- --
------------ ------------ ------------
Total operating expenses 49,909 36,805 28,168
------------ ------------ ------------
Operating income 1,261 30,633 4,875
------------ ------------ ------------
Other income (expense):
Interest income 1,592 1,093 341
Interest expense (56) (112) (252)
Other income (expense), net 9 (211) (11)
------------ ------------ ------------
Total other income 1,545 770 78
------------ ------------ ------------
Income before income taxes 2,806 31,403 4,953
Provision for income taxes -- -- --
------------ ------------ ------------
Net income $ 2,806 $ 31,403 $ 4,953
============ ============ ============
Per share of common stock:
Net income per share $ 0.09 $ 1.06 $ 0.18
============ ============ ============
Diluted income per share $ 0.09 $ 0.98 $ 0.17
============ ============ ============
Weighted average common shares outstanding 30,927,386 29,548,905 26,808,158
============ ============ ============
Weighted average common and common equivalent shares
outstanding 32,109,888 31,946,416 29,151,628
============ ============ ============

The accompanying notes are an integral part of these consolidated financial
statements.

#

DIGITAL LIGHTWAVE, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2001, 2000, AND 1999
(IN THOUSANDS, EXCEPT SHARE DATA)

COMMON STOCK ADDITIONAL
------------------------------- PAID-IN ACCUMULATED
SHARES AMOUNT CAPITAL DEFICIT TOTAL
--------------- --------------- --------------- ----------------- ---------------
Balance, January 1, 1999 26,535,332 $ 3 $ 57,927 $ (45,610) $ 12,320
Issuance of common stock 1,120,771 -- 4,863 -- 4,863
Issuance of options to non-employee -- -- 13 -- 13
Issuance of stock warrants -- -- 4 -- 4
Net income -- -- -- 4,953 4,953
-------------- -------------- -------------- -------------- --------------
Balance, December 31, 1999 27,656,103 3 62,807 (40,657) 22,153
Issuance of common stock 2,820,108 -- 14,077 -- 14,077
Cost associated with exercise of
warrants -- -- (264) -- (264)
Net income -- -- -- 31,403 31,403
-------------- -------------- -------------- -------------- --------------
Balance, December 31, 2000 30,476,211 3 76,620 (9,254) 67,369
Issuance of common stock 793,512 -- 3,891 -- 3,891
Net income -- -- -- 2,806 2,806
-------------- -------------- -------------- -------------- --------------
Balance, December 31, 2001 31,269,723 $ 3 $ 80,511 $ (6,448) $ 74,066
============== ============== ============== ============== ==============

The accompanying notes are an integral part of these consolidated financial
statements.
#

DIGITAL LIGHTWAVE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

FOR THE YEARS ENDED DECEMBER 31,

-------------------------------------------------------
2001 2000 1999
-------------- -------------- --------------
Cash flows from operating activities:
Net income $ 2,806 $ 31,403 $ 4,953
Adjustments to reconcile net income to cash
provided (used) by operating activities:
Depreciation and amortization 3,399 2,877 2,524
Loss on disposal of property 38 168 19
Provision for uncollectible accounts 5,971 161 215
Provision for excess and obsolete inventory 5,167 700 397
Restructuring charges 500 -- --
Changes in operating assets and liabilities:
(Increase) decrease in accounts receivable 11,655 (10,315) (9,168)
Increase in inventories (9,380) (7,961) (1,246)
(Increase) decrease in prepaid expenses and other assets 89 (100) 424
Increase (decrease) in accounts payable and accrued liabilities (3,583) 2,860 1,364
Increase (decrease) in accrued litigation charges 4,100 -- (1,064)
-------------- -------------- --------------
Net cash provided (used) by operating
activities 20,762 19,793 (1,582)
-------------- -------------- --------------
Cash flows from investing activities:
Increase in notes receivable (200) -- --
Purchases of property and equipment (3,259) (1,326) (1,888)
-------------- -------------- --------------
Net cash used by investing activities (3,459) (1,326) (1,888)
-------------- -------------- --------------
Cash flows from financing activities:
Proceeds from notes payable -- -- 3,000
Principal payments on notes payable -- (3,000) --
Principal payments on capital lease obligations (668) (547) (307)
Payments received from lease receivables 37 249 708
Proceeds from sale of common stock, net of expense 3,891 7,846 3,687
-------------- -------------- --------------
Net cash provided by financing activities 3,260 4,548 7,088
-------------- -------------- --------------
Net increase in cash and cash equivalents 20,563 23,015 3,618
Cash and cash equivalents at beginning of period 30,481 7,466 3,848
-------------- -------------- --------------
Cash and cash equivalents at end of period $ 51,044 $ 30,481 $ 7,466
============== ============== ==============
Other supplemental disclosures:
Cash paid for interest $ 56 $ 181 $ 183
Non-cash investing and financing activities:
Capital lease obligations incurred $ 358 $ 461 $ 722
Accounts receivable related to capital leases $ - $ - $ 270
Issuance of common stock pursuant to litigation
settlement (Note 13) $ - $ 6,231 $ 1,194

The accompanying notes are an integral part of these consolidated financial
statements.
#

DIGITAL LIGHTWAVE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

GENERAL

Digital Lightwave, Inc. (the "Company") designs, develops and markets a
portfolio of portable and network based products for installing, maintaining
and monitoring fiber optic circuits and networks. Network operators and
telecommunications service providers use fiber optics to provide increased
network bandwidth to transmit voice and other non-voice traffic such as
Internet, data and multimedia video transmissions. The Company provides
telecommunications service providers and equipment manufacturers with product
capabilities to cost-effectively deploy and manage fiber optic networks to
address the rapidly increasing demand for bandwidth. The Company's wholly-
owned subsidiaries are Digital Lightwave Leasing Corporation ("DLLC") and
Digital Lightwave (UK) Limited ("DLL"). DLLC provided financing for the
purchase of the Company's product in the form of capital leases as well as
equipment rental to the Company's customers. On December 31, 2001, DLLC had no
outstanding leases and was dissolved. Its remaining assets were transferred to
the Company. DLL provides international sales support. All significant
intercompany transactions and balances are eliminated in consolidation.

CASH EQUIVALENTS

The Company considers all highly liquid investments with an initial maturity
of three months or less to be cash equivalents.

INVENTORIES

Inventories are stated at the lower of cost (first-in, first-out) or market.

PROPERTY AND EQUIPMENT

The Company's property and equipment, including certain assets under capital
leases, are stated at cost, less accumulated depreciation and amortization.
Depreciation and amortization are provided using the straight-line method over
estimated useful lives of 5 to 7 years or over the lesser of the term of the
lease or the estimated useful life of assets under capital lease or
improvements made to leased property. Maintenance and repairs are expensed as
incurred while renewals and improvements are capitalized. The accounts are
relieved of the cost and the related accumulated depreciation and amortization
upon the sale or retirement of property and equipment and any resulting gain or
loss is included in the results of operations.

Long-lived assets are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash flows expected
to be generated by the asset. If such assets are considered to be impaired,
the impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceeds the fair value of the assets. There were no fixed
asset impairments in 2001 and 2000.

ACCRUED WARRANTY

The Company provides the customer a warranty with each product sold and
accrues warranty expense based upon historical data. Warranty costs are charged
against the accrual when incurred. At December 31, 2001, the total accrued
warranty expense of $1,550,000 was comprised of current accrued warranty of
$750,000 and accrued long-term warranty of $800,000.

REVENUE RECOGNITION

The Company derives its revenue from product sales. The Company recognizes
revenue from the sale of products when persuasive evidence of an arrangement
exists, the product has been delivered, the price is fixed and determinable and
collection of the resulting receivable is reasonably assured.

For all sales, the Company uses a binding purchase order as evidence that a
sales arrangement exists. Sales through international distributors are
evidenced by a master agreement governing the relationship with the
distributor. The Company either obtains an end-user purchase order documenting
the order placed with the distributor or proof of delivery to the end user as
evidence that a sales arrangement exists. For demonstration units sold to
distributors, the distributor's binding purchase order is evidence of a sales
arrangement.

For domestic sales, delivery generally occurs when product is delivered to a
common carrier. Demonstration units sold to international distributors are
considered delivered when the units are delivered to a common carrier. In the
case of shipments to an international distributor that will be resold, delivery
occurs when the Company receives either a copy of the end-user binding purchase
order or proof of delivery to the end-user. An allowance is provided for sales
returns based on historical experience.

At the time of the transaction, the Company assesses whether the price
associated with its revenue transactions is fixed and determinable and whether
or not collection is reasonably assured. The Company assesses whether the price
is fixed and determinable based on the payment terms associated with the
transaction. Standard payment terms for domestic customers are 30 days from
the invoice date. Distributor contracts provide standard payment terms of 60
days from the invoice date. The Company does not offer extended payment terms.

The Company assesses collection based on a number of factors, including past
transaction history with the customer and the credit-worthiness of the
customer. Collateral is not requested from customers. If it is determined that
collection of an accounts receivable is not reasonably assured, the amount of
the accounts receivable is deferred and revenue recognized at the time
collection becomes reasonably assured.

Most sales arrangements do not generally include acceptance clauses. However,
if a sales arrangement includes an acceptance provision, acceptance occurs upon
the earlier of receipt of a written customer acceptance or expiration of the
acceptance period.

DEFERRED REVENUE

Deferred revenue represents amounts billed and collected from customers in
advance of shipment or amounts billed and collected from distributors prior to
the distributor's sale of the goods. Revenue is subsequently recognized at the
date of shipment or, in the case of distributor sales, at the time the
distributor ships the product to the end user.

RESEARCH AND DEVELOPMENT

Software and product development costs are included in engineering and
development and are expensed as incurred. Capitalization of certain software
development costs occurs during the period following the time that
technological feasibility is established until general release of the product
to customers. The capitalized cost is then amortized over the estimated product
life. To date, the period between achieving technological feasibility and the
general release to customers has been short and software development costs
qualifying for capitalization have been insignificant.

INCOME TAXES

The Company recognizes deferred tax liabilities and assets for the expected
future tax consequences of events that have been included in the consolidated
financial statements or tax returns. Deferred tax liabilities and assets are
determined based on the difference between the consolidated financial statement
and the tax basis of assets and liabilities using enacted tax rates in effect
for the year in which the differences are expected to reverse. The Company
provides for a valuation allowance for the deferred tax assets when it
concludes that it is more likely than not that the deferred tax assets will not
be realized.

#

COMPUTATION OF NET INCOME PER SHARE

Basic net income per share is based on the weighted average number of common
shares outstanding during the periods presented. The table below shows the
calculation of basic weighted average common shares outstanding and the
incremental number of shares arising from common stock equivalents under the
treasury stock method:

For The Year Ended December 31,

-----------------------------------------------------
2001 2000 1999
-------------- -------------- --------------
Basic:
Weighted average common shares outstanding 30,927,386 29,548,905 26,808,158
-------------- -------------- --------------
Total basic 30,927,386 29,548,905 26,808,158
Diluted:
Incremental shares for common stock
equivalents 1,182,502 2,397,511 2,343,470
-------------- -------------- --------------
Total dilutive 32,109,888 31,946,416 29,151,628
============== ============== ==============

CONCENTRATIONS OF CREDIT RISK

Financial instruments that potentially subject the Company to concentrations
of credit risk consist principally of cash and cash equivalents and accounts
receivable. As of December 31, 2001, 2000, and 1999, substantially all of the
Company's cash balances, were deposited with high quality financial
institutions. During the normal course of business, the Company extends credit
to customers conducting business primarily in the telecommunications industry
both within the United States and internationally.

For the year ended December 31, 2001, the Company's largest customer
accounted for approximately 12% of total sales. For the years ended December
31, 2000 and 1999, the Company's largest customer, accounted for approximately
15% and 21% of total sales, respectively. For the year ended December 31, 1999,
one additional customer accounted for 18% of total sales. No other customers
accounted for sales of 10% or more during those years.

The Company sells its products in both domestic and international markets.
Domestic sales represented approximately 80%, 91% and more than 99% of annual
net sales for the years ending 2001, 2000 and 1999 respectively. International
sales represented approximately 20%, 9% and less than 1% of annual net sales
for the years ending 2001, 2000 and 1999 respectively.

USE OF ESTIMATES

The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements. Estimates also affect the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from these estimates.

SEGMENT REPORTING

As of December 31, 2001, the Company was not organized by multiple operating
segments for the purpose of making operating decisions or assessing
performance. Accordingly, the Company operated in one operating segment and
reported only certain enterprise-wide disclosures.

NEW ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board (FASB) issued
Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and
Other Intangible Assets. Statement No. 141 requires that all business
combinations initiated after June 30, 2001 be accounted for under the purchase
method of accounting. Use of the pooling-of-interests method is no longer
permitted. The Company did not make any acquisitions in 2001. With the adoption
of Statement No. 142 effective January 1, 2002, goodwill and other indefinite
lived intangibles will no longer be amortized to earnings, but will instead be
reviewed for impairment by applying a fair-value-based test. The Company had no
goodwill recorded at December 31, 2001.

In June 2001, the FASB issued Statement of Financial Accounting Standards No.
143, Accounting for Asset Retirement Obligations. Statement No. 143 requires
entities to record the fair value of a liability for an asset retirement
obligation in the period in which it is incurred. When the liability is
initially recorded, the entity capitalizes a cost by increasing the carrying
amount of the related long-lived asset. Over time, the liability is accreted to
its present value each period and the capitalized cost is depreciated over the
useful life of the related asset. Upon settlement of the liability, an entity
either settles the obligation for its recorded amount or incurs a gain or loss
upon settlement. Statement No. 143 is effective for fiscal years beginning
after June 15, 2002, with earlier application encouraged. The Company does not
expect the implementation of Statement No. 143 to have a material impact on its
financial statements.

In October 2001, the FASB issued Statement No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. Statement 144 supersedes FASB
Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of. Statement No. 144 develops one
accounting model (based on the model in Statement No. 121) for all long-lived
assets and requires that long-lived assets that are to be disposed of by sale
be measured at the lower of book value or fair value less cost to sell. That
requirement eliminates Accounting Principles Board Opinion No. 30's requirement
that discontinued operations be measured at net realizable value or that
entities include under "discontinued operations" in the financial statements
amounts for operating losses that have not yet occurred. Additionally,
Statement No. 144 expands the scope of discontinued operations to include all
components of an entity with operations that (i) can be distinguished from the
rest of the entity and (ii) will be eliminated from the ongoing operations of
the entity in a disposal transaction. Statement No. 144 is effective for
financial statements issued for fiscal years beginning after December 15, 2001
and generally its provisions are to be applied prospectively. The Company does
not expect the implementation of Statement No. 144 to have a material impact on
its financial statements.

RECLASSIFICATIONS

Certain prior year amounts have been reclassified to conform with the 2001
presentation.

2. INVENTORIES

Inventories at December 31, 2001 and 2000 are summarized as follows:

2001 2000

------------ ------------
(IN THOUSANDS)
Raw materials $ 9,341 $ 8,598
Work-in process 6,417 4,657
Finished goods 4,640 221
Provision for excess and obsolete inventory (3,833) (428)
------------ ------------
$ 16,565 $ 13,048
============ ============

In December 2001, the Company signed a manufacturing service agreement with
Jabil Circuit, Inc. ("Jabil"), a leading provider of technology manufacturing
services with a customer base of industry-leading companies. Under the terms of
the agreement, Jabil will serve as Digital Lightwave's primary contract
manufacturer for the company's circuit board and product assembly and will also
provide engineering design services. Jabil purchased approximately $4.9
million of raw materials inventory from the Company in December 2001. Jabil
will continue to purchase existing raw materials inventory until all parts are
depleted to safety stock levels.

#

3. PROPERTY AND EQUIPMENT

Property and equipment at December 31, 2001 and 2000 are summarized as
follows:

2001 2000

------------ ------------
(IN THOUSANDS)
Test equipment $ 8,464 $ 6,666
Computer equipment and software 4,866 4,586
Tooling 1,331 553
Tradeshow fixtures and equipment 359 289
Office furniture, fixtures and equipment 3,124 2,730
Leasehold improvements 2,322 1,893
------------ ------------
20,466 16,717
Less accumulated depreciation (10,549) (7,807)
------------ ------------
$ 9,917 $ 8,910
============ =============

Depreciation and amortization expense was approximately $3.3 million, $2.8
million and $2.5 million for the years ended December 31, 2001, 2000 and 1999,
respectively.

Equipment under capital lease and related accumulated amortization, included
above at December 31, 2001 and 2000 are summarized as follows:

2001 2000

------------ ------------
(IN THOUSANDS)
Test equipment $ 1,163 $ 1,572
Computer equipment and software 29 29
------------ ------------
1,192 1,601
Less accumulated amortization (358) (490)
------------ ------------
$ 834 $ 1,111
============ ============

4. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

Accounts payable and accrued liabilities at December 31, 2001 and 2000 are
summarized as follows:

2001 2000

------------- -------------
(IN THOUSANDS)
Accounts payable $ 3,949 $ 6,482
Accrued warranty 750 472
Accrued returns and allowances 698 761
Employee related accruals 510 754
Current portion of capital lease obligations 415 427
Sales commissions 329 842
Accrued restructuring charges 284 --
Deferred revenue 19 566
Accrued expenses and other 333 306
------------- -------------
$ 7,287 $ 10,610
============= =============

5. INCOME TAXES

The provision (benefit) for income taxes for the years ending December 31,
2001, 2000 and 1999 are summarized as follows:

2001 2000 1999

---------- ---------- ----------
(IN THOUSANDS)
Current:
Federal $ 965 $10,302 $ 1,637
State 157 1,677 267
---------- ---------- ----------
Sub-total 1,122 11,979 1,904
---------- ---------- ----------
Deferred:
Federal (965) (10,302) (1,637)
State (157) (1,677) (267)
---------- ---------- ----------
Sub-total (1,122) (11,979) (1,904)
---------- ---------- ----------
Total $ - $ - $ -
========== ========== ==========

The tax effected amounts of temporary differences at December 31, 2001 and 2000
are summarized as follows:

2001 2000

------------- --------------
(IN THOUSANDS)
Current:
Deferred tax asset:
Deferred compensation $ 124 $ 317
Accrued liabilities 2,441 817
Other 4,104 798
Valuation allowance (6,669) (1,932)
------------- -------------
Total current deferred tax asset -- --
------------- -------------
Net current deferred tax asset -- --
------------- -------------
Non-current:
Deferred tax asset:
Net operating loss carry forward 92,524 43,757
Research and experimentation credit 4,140 1,576
Valuation allowance (95,995) (44,325)
------------- -------------
Total non-current deferred tax asset 669 1,008
------------- -------------
Deferred tax liability:
Fixed assets (669) (1,008)
------------- -------------
Total non-current deferred tax liability (669) (1,008)
------------- -------------
Net deferred tax asset $ - $ -
============= =============

A full valuation allowance has been recorded at December 31, 2001 and 2000
with respect to the deferred tax assets since the Company believes that it is
more likely than not that future tax benefits will not be realized as a result
of current and future income. Factors considered in determining that a full
valuation allowance was necessary include the Company's history of large
operating losses and uncertainty as to whether the Company would be able to
sustain long-term profitability.

As of December 31, 2001 the Company has established a valuation allowance of
approximately $102.6 million. The result is an increase in the valuation
allowance from December 31, 2000 of approximately $56.4 million.

As of December 31, 2001, the Company had net operating loss carry forwards of
approximately $245.9 million for tax purposes. Due to certain change of
ownership requirements of Section 382 of the Internal Revenue Code ("IRC"),
utilization of the Company's net operating losses incurred prior to July 1,
1993 is expected to be limited to approximately $7,500 per year. This
limitation in conjunction with the expiration period for these pre-July 1, 1993
net operating losses results in the Company's total net operating losses
available being limited to approximately $245.1 million. Loss carryforwards
will expire between the years 2009 and 2021.

As of December 31, 2001, the Company also had general business credit
carryforwards of approximately $4.1 million that expire between the years 2008
and 2021. These credits are also subject to the Section 382 annual limitation.
Approximately $15,000 of these credits are subject to the Section 382 annual
limitation.

Following is a reconciliation of the applicable federal income tax as
computed at the federal statutory tax rate to the actual income taxes reflected
in the consolidated statement of operations.

FOR THE YEAR ENDED DECEMBER 31,

-----------------------------------------------------
2001 2000 1999
---------- ---------- ----------
(IN THOUSANDS)
Tax provision at U.S. federal income tax
rate $ 954 $ 10,677 $ 1,684
State income tax provision net of federal 102 1,156 180
Other, net 66 146 40
Valuation allowance decrease (1,122) (11,979) (1,904)
Research and experimentation credit -- -- --
---------- ---------- ----------
Provision for income taxes $ -- $ -- $ --
========== ========== ==========

The valuation allowance change shown in the above reconciliation is different
from the actual change in the valuation allowance due to the tax benefits
related to the exercise of non-qualified stock options and securities
litigation costs which are directly reflected in stockholders' equity. For the
years ended December 31, 2001, 2000 and 1999, the income tax benefit of $9.7
million, $36.4 million and $5.1 million, respectively, would have been
allocated to additional paid in capital for the tax benefits associated with
the exercise of non-qualified stock options. For the year ended December 31,
2001 the income tax benefit associated with the securities litigation costs of
$47.7 million would have been allocated to additional paid-in capital. These
amounts have not been recognized due to the 100% valuation allowance against
deferred tax assets.

In January 2002, the Company received a ruling from the Internal Revenue
Service regarding an additional deduction related to securities litigation
costs. This ruling resulted in a $127 million increase to the Company's net
operating loss carryforward that has been referenced in the above amounts. The
tax benefit of this additional net operating loss has not been realized due to
the 100% valuation allowance against the deferred tax assets. This deduction
will be reported directly as an increase in additional paid-in capital and will
not be recorded in the Company's Consolidated Statement of Operations when the
tax benefit is realized.

6. NOTES PAYABLE, LINE OF CREDIT AND LETTER OF CREDIT

In 1998, the Company entered into an agreement with EAB Leasing Corp. ("EAB")
providing for sale of the Company's accounts receivable to EAB. Certain amounts
were financed during the term of the agreement that was terminated by the
Company in May 2000. All advances, interest and fees were repaid in full prior
to termination.

In 1999, the Company entered into a financing agreement with certain
investors pursuant to which the Company issued $3.0 million of 9% Secured
Bridge Notes due January 17, 2000. They were collateralized by all of the
Company's assets and were subordinated to the accounts receivable agreement
with EAB described above. In connection with the financing agreement, the
Company issued warrants to purchase an aggregate of 550,000 shares of the
Company's common stock at an exercise price of $2.75 per share, the market
price of the stock on the date prior to the issuance of the warrants. The
warrants had a term of five years from the date of issuance. The Company agreed
to register the warrants and the common stock issuable upon exercise thereof
under the Securities Act of 1933. In January 2000, such warrants were
registered and subsequently exercised. The Secured Bridge Notes and related
interest were repaid in full on the due date.

In October 2000, the Company entered into a Loan and Security Agreement (the
"Loan Agreement") with Congress Financial Corporation pursuant to which
Congress provided the Company with a $10.0 million line of credit. Under the
Loan Agreement, the Company is entitled to borrow up to $10.0 million initially
bearing interest at prime plus one-half of one percent (.50%), subject to
certain borrowing limitations based on amounts of the Company's accounts
receivable and inventories. The Loan Agreement expires in November 2002. All
indebtedness outstanding under the Loan Agreement is collateralized by
substantially all of the Company's assets. Under the terms of the Loan
Agreement, the Company is required to maintain certain financial ratios and
other financial conditions. The Loan Agreement also prohibits the Company,
without prior written consent from Congress, from incurring additional
indebtedness, limits certain investments, advances or loans and restricts
substantial asset sales, capital expenditures and cash dividends. As of
December 31, 2001, the Company had utilized $2.13 million of the $10.0 million
available under the credit facility to collateralize a letter of credit
required by a lease for office space. A fee for this letter of credit
accommodation is assessed at one and one quarter percent (1.25%) per annum.
There were no borrowings under this line of credit at December 31, 2001.

#

7. LEASES

The Company is obligated under various non-cancelable leases for equipment
and office space. Future minimum lease commitments under operating and capital
leases were as follows as of December 31, 2001:

CAPITAL OPERATING

LEASES LEASES
------------- ------------
(IN THOUSANDS)
2002 $ 435 $ 1,787
2003 10 1,711
2004 -- 1,749
2005 -- 1,788
2006 -- 1,827
Thereafter -- 3,454
------------- ------------
445 $ 12,316
------------- ============
Less: Amount representing interest 20
-------------
Present value of minimum lease payments 425
Less: Current portion 415
-------------
$ 10
=============

Total rental expense was approximately $2.0 million, $2.1 million and $1.4
million for the years ended December 31, 2001, 2000 and 1999, respectively.

8. COMMITMENTS

At December 31, 2001, the Company had outstanding non-cancelable purchase
order commitments to purchase certain inventory items totaling approximately
$5.4 million. The majority of the quantities under order are deliverable upon
demand by the Company or within thirty (30) days upon written notice of either
party.

9. RELATED PARTY TRANSACTIONS

During December 1998, a stockholder borrowed $100,000 from the Company. This
note accrued interest at 9% with the principal sum and accrued interest thereon
payable no later than December 31, 1999. On February 26, 2000, the stockholder
repaid the loan outstanding in full, including accrued interest of
approximately $10,000.

In 2001, an officer of the Company borrowed $200,000 from the Company. This
note accrues interest at the prime rate plus one percent (1.0%) with the
principal sum and accrued interest thereon payable on demand or, if earlier,
from the proceeds of any sale of the borrower's stock holdings or on the date
of termination of the borrower's employment with the Company. This note is
collateralized by the borrower's stock holdings in the Company and future cash
bonuses which may become payable.

10. COMMON STOCK AND STOCK OPTIONS

EMPLOYEE STOCK OPTION PLAN

The Company's 1996 Stock Option Plan (the "1996 Option Plan") became
effective on March 5, 1996. A reserve of 5,000,000 shares of the Company's
Common Stock has been established for issuance under the 1996 Option Plan. The
stockholders of the Company approved the 2001 Stock Option Plan (the "2001
Option Plan") at a special meeting held February 27, 2001. Under the 2001
Option Plan, 3,000,000 shares, plus (i) the number of shares available for
grant under the 1996 Option Plan and (ii) the number of shares subject to
options outstanding under the 1996 Option Plan to the extent that such options
expire or terminate for any reason prior to exercise in full, were reserved for
issuance (with the sum of (i) and (ii) not to exceed 2,735,872 shares). The
2001 Option Plan superseded the 1996 Option Plan with respect to future grants.

Transactions related to the 2001 and 1996 Option Plans are summarized as
follows:

WEIGHTED

AVERAGE
SHARES OPTION PRICE
------------ -------------
Outstanding at 1/1/99 2,690,146 $ 3.98
Granted 1,712,064 $ 6.63
Exercised (760,757) $ 4.48
Forfeited (286,439) $ 4.98
------------
Outstanding at 12/31/99 3,355,014 $ 5.12
Granted 710,648 $ 78.63
Exercised (1,244,548) $ 4.61
Forfeited (84,310) $ 59.14
------------
Outstanding at 12/31/00 2,736,804 $ 22.78
Granted 2,026,237 $ 26.18
Exercised (754,581) $ 4.51
Forfeited (882,259) $ 32.48
------------
Outstanding at 12/31/01 3,126,201 $ 26.66
============

The following table summarizes information about stock options outstanding to
employees and directors at December 31, 2001:

NUMBER OUTSTANDING OUTSTANDING NUMBER EXERCISABLE

OUTSTANDING WEIGHTED WEIGHTED EXERCISABLE WEIGHTED
AT AVERAGE AVERAGE AT AVERAGE
DECEMBER 31, REMAINING EXERCISE DECEMBER 31, EXERCISE
RANGE OF EXERCISE PRICE 2001 LIFE PRICE 2001 PRICE
---------------- -------------- -------------- -------------- -------------- --------------
$ 2.313-5.875 653,772 3.15 $ 3.867 315,160 $ 3.065
$ 6.580-9.220 380,992 3.92 $ 7.105 167,978 $ 7.263
$ 10.400-19.950 68,516 4.82 $ 16.520 9,388 $ 13.198
$ 21.0625-35.910 1,484,411 5.18 $ 26.299 94,406 $ 27.850
$ 40.870-139.125 538,510 4.52 $ 70.413 223,052 $ 68.926
-------------- --------------
3,126,201 809,984
============== ==============

Generally, options issued vest in one-third increments over a three-year
period, with the exception of certain option agreements that provide for
various vesting schedules throughout the same three-year vesting period or
options allowing vesting acceleration based on certain performance milestones.
If the performance milestones are not met, the options vest 5 1/2 years after
issue. Option agreements generally expire six years from date of issue if not
exercised. Unvested options are generally forfeited upon termination of
employment with the Company. Generally, vested shares must be exercised within
thirty days of termination or be forfeited. Total shares exercisable were
809,984, 378,049 and 392,066 as of December 31, 2001, 2000, and 1999,
respectively.

The Company applies APB No. 25 and related interpretations for accounting
for stock options. Accordingly, no compensation costs at the grant date are
recorded for options granted at fair market value. Had compensation cost for
the Company's stock options granted been determined based on the Black-Scholes
option pricing model at the date of grant, consistent with the method of FAS
123, the Company's net income (loss) and income (loss) per share would have
been adjusted to the pro forma amounts shown below:

2001 2000 1999

---------------- ------------- --------------
(IN THOUSANDS)
Pro forma net income (loss):
As reported $ 2,806 $ 31,403 $ 4,953
As adjusted (unaudited) $ (13,796) $ 21,540 $ (2,704)
Pro forma basic income (loss) per share:
As reported $ 0.09 $ 1.06 $ 0.18
As adjusted (unaudited) $ (0.45) $ 0.73 $ (0.10)

These pro forma amounts were determined using the Black-Scholes valuation
model with the following key assumptions: (i) a discount rate of 4.68%, 6.23%,
and 5.61% for December 31, 2001, 2000 and 1999, respectively; (ii) a volatility
factor based upon averaging the week ending price for Digital Lightwave and
comparable public companies for periods matching the terms of the options
granted; (iii) an average expected option life of 4.19, 4.00 and 4.00 years for
December 31, 2001, 2000 and 1999, respectively; (iv) there have been no options
that have expired; and (v) no payment of dividends.

EMPLOYEE STOCK PURCHASE PLAN

The Company's 1997 Employee Stock Purchase Plan provides employees with the
opportunity to purchase shares of the Company's Common Stock. An aggregate of
300,000 shares of the Company's Common Stock was reserved for issuance under
the Plan. At December 31, 2001 a total of 224,201 shares had been purchased by
employees participating in the plan at a weighted-average price per share of
$7.20.

11. DEFINED CONTRIBUTION PLAN

The Company offers a defined contribution plan that qualifies under IRC
section 401(k). All full-time employees are eligible to participate in the plan
after three months of service with the Company. Employees may contribute up to
15% of their salary to the plan, subject to certain Internal Revenue Service
limitations. The Company matches the first 6% of such voluntary contributions
at 50% of the amount contributed by the employee. The Company has not made
unmatched contributions. For the years ended December 31, 2001, 2000 and 1999,
total Company contributions to the plan were approximately $285,000, $273,000
and $206,000, respectively.

12. RESTRUCTURING CHARGES

In October 2001, the Company's board of directors approved a plan to reduce
the current workforce by 38 and consultants employees across all departments
and instituted temporary executive salary reductions of up to 20%. The
overall objective of the initiative was to lower operating costs and improve
efficiency.

All affected employees were terminated in October 2001 and given severance
based upon years of service with the Company. The Company recorded a
restructuring charge of $500,000 in 2001 related to this cost reduction
program. The costs included in the restructuring charge include severance to
employees included in the reduction in force, legal costs associated with the
cost reduction program and the remaining lease liability on the New Jersey
location. The costs are expected to be paid by November 2002. Activity
associated with the restructuring charges was as follows:

Balance at Payments/ Balance at
January 1, Additions Reductions December 31,
2001 2001

------------ ----------- ----------- -------------
(in thousands)
Severance $ -- $ 251 $ (172) $ 79
Legal and other expenses -- 109 (22) 87
Lease payments -- 140 (22) 118
------------- ------------- -------------- --------------
$ -- $ 500 $ (216) $ 284
============= ============= ============== ==============

13. LEGAL PROCEEDINGS

On December 21, 1998, the United States District Court for the Middle
District of Florida preliminarily approved a settlement of a consolidated
securities class action lawsuit against the Company. The settlement consisted
of $4.3 million in cash and the issuance of 1.8 million shares of Common Stock.
The Company recorded a one-time charge of $8.5 million during 1998 as a result
of the settlement. On April 30, 1999, the court entered a final judgment
approving the settlement of the class action and on May 20, 1999, a lead
plaintiff in one of the class actions filed a notice of appeal to the United
States Court of Appeals for the Eleventh Circuit. On March 16, 2000, all parts
of the appeal that pertain to the Company were dismissed with prejudice and the
District Court's judgment approving the settlement of the securities class
actions became final. In 1999, the Company issued 289,350 shares in partial
satisfaction of the settlement, which represented $1,194,000 of the accrued
settlement. In 2000, the Company issued the remaining 1,510,650 shares,
representing $6,231,000 of the accrued settlement. Since the issuance of the
shares did not involve a cash exchange, these issuances were disclosed as non-
cash investing and financing activities on the Consolidated Statement of Cash
Flows. As of December 31, 2001 certain current and former officers and
directors of the Company settled with the Securities and Exchange Commission
regarding its investigation of the circumstances underlying the restatement of
the Company's 1997 financial results.

On November 23, 1999, Seth P. Joseph, a former officer and director of the
Company commenced arbitration proceedings against the Company alleging breach
of his employment agreement and stock option agreements, violation of the
Florida Whistleblower statute and breach of an indemnification agreement and
the Company bylaws. As relief, Mr. Joseph sought $500,000, attorneys' fees,
interest and stock options for 656,666 shares of the Company's Common Stock
exercisable at a price of $5.25 per share. The Company filed an answer denying
Mr. Joseph's allegations and alleging multiple affirmative defenses and
counterclaims. The Company's counterclaims against Mr. Joseph seek repayment of
loans totaling approximately $113,000 plus interest. Mr. Joseph subsequently
dismissed without prejudice all of his claims other than his claim under the
whistleblower statue. The arbitration hearing on Mr. Joseph's whistleblower
claim and the Company's counterclaims concluded on October 5, 2001. The parties
submitted proposed findings to the arbitrator on October 17, 2001. As part of
his proposed findings, Mr. Joseph sought an award of $48 million and attorneys'
fees and costs. On November 9, 2001, the Company was notified of the
arbitrator's decision that awarded Mr. Joseph the sum of approximately $3.7
million and attorneys' fees and costs. On December 20, 2001, the arbitrator
issued a corrected award and awarded Mr. Joseph the sum of $3.9 million and
attorneys' fees and costs in amounts yet to be determined. On January 23,
2002, Mr. Joseph filed a motion seeking the award of $1.1 million in attorneys'
fees, costs and interest thereon.

On December 26, 2001, the Company filed a petition to vacate or modify the
arbitration award in the Circuit Court of the Sixth Judicial Circuit, Pinellas
County, Florida, in an action entitled Digital Lightwave, Inc. v. Seth P.
Joseph, Case No. 01-9010C1-21. The Company filed an amended petition on
December 26, 2001, following the corrected arbitration award. Subsequently,
Mr. Joseph filed a cross-motion to confirm the arbitration award. Oral
argument on the Company's petition and Mr. Joseph's cross-motion was heard by
the Court on February 27, 2002. On March 7, 2002, the court announced that it
will deny the Company's petition to vacate the arbitration award. The Company
intends to appeal the decision. The Company has recorded an accrual of $4.1
million related to this arbitration for the year ended December 31, 2001. The
Company believes its petition is meritorious and intends to pursue the petition
vigorously.

In January 2002, an employee terminated as part of the Company's October
2001 restructuring initiatives discussed in Note 12 filed a lawsuit claiming
the Company wrongly discharged him and has withheld commission payments due
him. The suit does not seek a specified amount of damages, but does claim that
the 2001 compensation plan presented to him in October 2001 unfairly lowered
his salary. The plaintiff seeks attorneys' fees, interest and punitive damages
to be assessed by the court. The suit was not properly filed with the court so
the Company does not have a deadline to respond. It is expected that the
plaintiff will refile the action and the Company will have thirty days to
respond to the complaint. The Company has accrued the estimated costs to
defend this action in the restructuring charges discussed in Note 12.

The Company from time to time is involved in various other lawsuits and
actions by third parties arising in the ordinary course of business. The
Company is not aware of any additional pending litigation, claims or
assessments that could have a material adverse effect on the Company's
business, financial condition and results of operations.

14. QUARTERLY OPERATING RESULTS (UNAUDITED)

The following table presents unaudited quarterly operating results for each
of the last eight quarters. This information has been prepared by the Company
on a basis consistent with the Company's consolidated financial statements and
includes all adjustments, consisting only of normal recurring accruals in
accordance with generally accepted accounting principles. Such quarterly
results are not necessarily indicative of future operating results.

Quarter Ended

------------------------------------------------------------------------------
March 31, June 30, September 30, December 31,
2001 2001 2001 2001
------------- ------------- ------------- -------------
(in thousands, except per share data)
Net sales $ 34,418 $ 34,517 $ 8,404 $ 5,441
Gross profit (loss) 23,919 24,094 3,958 (801)
Operating income (loss) 13,696 13,072 (11,140) (14,367)
Net income (loss) 12,979 9,323 (6,653) (12,843)
Basic income (loss) per share(1) 0.43 0.30 (0.21) (0.41)
Diluted income (loss) per share(1) 0.40 0.28 (0.21) (0.41)
Weighted average shares outstanding 30,530,827 30,851,260 31,114,286 31,203,724
Weighted average shares and equivalents
outstanding 32,204,030 32,731,565 31,114,286 31,203,724

Quarter Ended
------------------------------------------------------------------------------
March 31, June 30, September 30, December 31,
2001 2001 2001 2001
-------------- -------------- -------------- --------------
(in thousands, except per share data)
Net sales $ 18,558 $ 22,109 $ 26,085 $ 33,921
Gross profit 11,992 15,007 17,646 22,792
Operating income 4,192 6,098 7,878 12,465
Net income 4,273 6,175 7,989 12,965
Basic income per share(1) 0.15 0.21 0.26 0.43
Diluted income per share(1) 0.14 0.20 0.25 0.40
Weighted average shares outstanding 28,405,400 29,120,397 30,194,307 30,458,554
Weighted average shares and equivalents
outstanding 31,349,165 31,610,927 32,491,073 32,292,954

______________
(1)Earnings per share were calculated for each three-month period on a stand-
alone basis. Earnings per share for the quarters ended September 30, 2001 and
December 31, 2001 do not include the impact of common stock equivalents as
inclusion would be anti-dilutive.

The Company's sales and operating results may fluctuate from quarter-to-
quarter and from year-to-year due to the following factors: (i) announced
capital expenditure cutbacks by customers within the telecommunications
industry, (ii) limited number of major customers (iii) the product mix, volume,
timing and number of orders we receive from our customers, (iv) the long sales
cycle for obtaining new orders (v) the timing of introduction and market
acceptance of new products, (vi) our success in developing, introducing and
shipping product enhancements and new products, (vii) pricing changes by our
competitors, (viii) our ability to enter into long term agreements or blanket
purchase orders with customers, (ix) our ability to obtain sufficient supplies
of sole or limited source components for our products, (x) our ability to
attain and maintain production volumes and quality levels for our current and
future products and (xi) changes in costs of materials, labor and overhead.
Any unfavorable changes in these or other factors could have a material adverse
effect on the Company's business, financial condition and results of
operations. The Company does not anticipate that its backlog at the beginning
of each quarter will be sufficient to achieve expected revenue for that
quarter. To achieve its revenue objectives, the Company expects that it will
have to obtain orders during a quarter for shipment in that quarter. During
2001, our industry experienced a dramatic economic downturn that was brought on
by a significant decrease in network build-outs and capital spending by the
telecommunications carriers and equipment manufacturers. Our customers'
declining business resulted in a major decrease in sales of our products. We
do not anticipate a near-term recovery of the fiber optic test equipment market
and do not expect the overall capital spending by telecommunication carriers
and equipment factors will increase during 2002. As a result of all of the
foregoing, there can be no assurance that the Company will be able to sustain
profitability on a quarterly or annual basis.

15. SUBSEQUENT EVENTS

In January 2002, the board of directors approved additional cost reduction
initiatives aimed at further reducing operating costs. These included a second
reduction in force of 46 employees and contractors and the outsourcing of
manufacturing and production for our product lines. All affected employees
were terminated in January 2002 and given severance based upon years of
service with the Company. The Company expects to take a restructuring charge
of approximately $1.3 million in the first quarter of 2002. The total costs
associated with the restructuring will be paid by January 2003.

In October 2001, the chief financial officer and secretary resigned from the
Company. The board of directors elected Mark E. Scott in January 2002 to serve
as the company's chief financial officer and secretary.

In January 2002, the chairman of the board, president and chief executive
officer resigned from the Company. The board of directors elected the
Company's founder, Dr. Bryan J. Zwan, chairman of the board, president and
chief executive officer.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.
#

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this item is incorporated by reference to the
sections of the Registrant's definitive Proxy Statement for the Annual Meeting
of Stockholders to be held on May 20, 2002, entitled "Election of Directors"
and "Information Concerning Directors and Executive Officers."

ITEM 11. EXECUTIVE COMPENSATION

The information required by this item is incorporated by reference to the
section of the Registrant's definitive Proxy Statement for the Annual Meeting
of Stockholders to be held on May 20, 2002, entitled "Executive Compensation."

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this item is incorporated by reference to the
sections of the Registrant's definitive Proxy Statement for the Annual Meeting
of Stockholders to be held on May 20, 2002, entitled "Security Ownership of
Certain Beneficial Owners and Management."

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this item is incorporated by reference to the
sections of the Registrant's definitive Proxy Statement for the Annual Meeting
of Stockholders to be held on May 20, 2002, entitled "Certain Relationships and
Related Transactions."

PART IV

ITEM 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENTS, AND REPORTS ON FORM 8-K

(a)(1) Index to Consolidated Financial Statements.

See the Index included in Item 8 on page 29 of this Form 10-K.

(2)Financial Statement Schedule

See the Index included in Item 8 on page 29 of this Form 10-K.

(3) Exhibits.
INDEX TO EXHIBITS

Exhibit No. Description

- ------------ -----------------------------------------------
- -
3.01(1) -- Certificate of Incorporation of the Company
3.02(1) -- Amendment to Certificate of Incorporation of the Company
dated January 8, 1997
3.03(1) -- Amended and Restated By-laws of the Company
4.01(1) -- Specimen Certificate for the Common Stock
10.01(1)* -- Form of Indemnification Agreement between the Company and
officers and directors of the Company
10.02(1) -- Digital Lightwave, Inc. 1996 Stock Option Plan
10.03(3) -- Digital Lightwave, Inc. Employee Stock Purchase Plan
10.04(2) -- Lease Agreement, dated September 26, 1997, between the
Company and Monmouth/Atlantic Realty Associates
10.05(3) -- L.P. Lease Agreement, dated January 9, 1998, between the
Company and Orix Hogan-Burt Pinellas Venture.
10.06(3) -- First Lease Amendment, dated February 18, 1998, between the
Company and Orix Hogan-Burt Pinellas Venture.
10.07(3) -- First Lease Amendment, dated September 25, 1997, between the
Company and Monmouth/Atlantic Realty Associates L.P.
10.08(3) -- Second Lease Amendment, dated February 23, 1998, between the
Company and Monmouth/Atlantic Realty Associates L.P.
10.09(3)* -- Executive Employment Agreement, dated February 27, 1998,
between the Company and Steven H. Grant
10.10(4)* -- Letter Agreement dated as of December 31, 1998 between the
Company and Gerry Chastelet
10.11(4)* -- Letter Agreement dated April 13, 1998 and addendum thereto
dated February 9, 1999 between the Company and George J.
Matz
10.12(4) -- Form of Stock Purchase Agreement, dated March 31, 1999,
between the Company and certain Purchasers, with exhibits
thereto
10.13(6)* -- Form of Addenda to Employment Agreements of certain
employees dated October 18, 1999 and June 9, 2000
10.14(5) -- Memorandum of Understanding between Dr. Bryan J. Zwan and
the Company
10.15(7)* -- 2001 Stock Option Plan
10.16(8)* -- Promissory Note issued to the Company by James Green
10.17 (8) -- Form of Distributor Agreement
10.18(8)* -- Form of Letter Agreement entered into on February 27, 2001
with executive officers with respect to certain stock
options
10.19(8)* -- Letter Agreement between the Company and James Green dated October 13, 1999
10.20(8)* -- Addendum to Letter Agreement between the Company and James
Green dated February 18, 2000
10.21(8) -- Loan and Security Agreement by and between Congress
Financial Corporation (Florida) and the Company
10.22(9)* -- Form of Senior Executive Agreement
10.23(9)* -- Form of Executive Severance Agreement
10.24 -- Manufacturing contract agreement between the Company and Jabil Circuit Inc. dated December 30, 2001.
10.25* -- Letter Agreement dated January 23, 2002 between the Company and Gerry Chastelet
10.26* -- Settlement of Employment Terms and Employment Letters dated January 28, 2002 between the Company and George J.
Matz
21.01(4) -- Subsidiaries of the Registrant
23.01 -- Consent of PricewaterhouseCoopers LLP

______________
* Indicates management contract or compensatory plan or arrangement.
(1)Incorporated by reference to the similarly described exhibits filed in
connection with the Registrant's Registration Statement on Form S-1, File No.
333-09457, declared effective by the Securities and Exchange Commission on
February 5, 1997.
(2)Incorporated by reference to the exhibit filed in connection with the
Registrant's Quarterly Report on Form 10-Q for the quarterly period ended
September 30, 1997.
(3)Incorporated by reference to the similarly described exhibits filed in
connection with the Registrant's Annual Report on Form 10-K for the fiscal
year ended December 31, 1997.
(4) Incorporated by reference to the similarly described exhibits filed in
connection with the Registrant's Annual Report on Form 10-K for the fiscal
year ended December 31, 1998.
(5)Incorporated by reference to the similarly described exhibits filed in
connection with the Registrant's Form 10-Q for the quarter ended September
30, 1999.
(6)Incorporated by reference to the similarly described exhibits filed in
connection with the Registrant's Annual Report on Form 10-K for the fiscal
year ended December 31, 1999.
(7)Incorporated by reference to the similarly described exhibit filed in
connection with the Registrant's Proxy Statement filed on February 15, 2001
for the 2001 Special Meeting of Stockholders.
(8)Incorporated by reference to the similarly described exhibits filed in
connection with the Registrant's Annual Report on Form 10-K for the fiscal
year ended December 31, 2000.
(9)Incorporated by reference to the similarly described exhibits filed in
connection with the Registrant's Form 10-Q for the quarter ended March 31,
2001.

(b) Reports on Form 8-K.

None.
#

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.

DIGITAL LIGHTWAVE, INC.

By: /s/ BRYAN J.ZWAN
------------------------------------
Bryan J. Zwan
Chairman of the Board,
President and Chief Executive
Officer
Date: March 4, 2002

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

NAME TITLE DATE

- ------------------------------------ ------------------------------------ -----------------------
/s/ BRYAN J. ZWAN Chairman of the Board, March 4, 2002
- ------------------------------------ President and Chief Executive
Bryan J. Zwan Officer (Principal Executive
Officer)
/s/ MARK E. SCOTT Vice President, March 4, 2002
- ------------------------------------ Finance, Chief Financial
Mark E. Scott Officer and Secretary
(Principal Accounting Officer)
/s/ WILLIAM F. HAMILTON Director March 4, 2002
- ------------------------------------
William F. Hamilton
/s/ GERALD A. FALLON Director March 4, 2002
- ------------------------------------
Gerald A. Fallon
/s/ ROBERT F. HUSSEY Director March 4, 2002
- ------------------------------------
Robert F. Hussey

#

DIGITAL LIGHTWAVE, INC.

SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
DOLLARS IN THOUSANDS

COL. A COL. B COL. C COL. D COL. E

------------------------------- ------------- ------------------------------- -------------- --------------
ADDITIONS
-------------------------------
(1) (2)
BALANCE AT CHARGED TO CHARGED TO BALANCE
BEGINNING COSTS AND OTHER AT END
DESCRIPTION OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS OF PERIOD
--------------------------------- ------------- -------------- -------------- -------------- --------------
Year 2001
Reserve for uncollectible accounts $ 250 $ 5,971 $ - $ 321 (a) $ 5,900

Reserve for excess and obsolete
inventory 428 5,167 -- 1,762 (b) 3,833
Year 2000
Reserve for uncollectible accounts 215 161 -- 126 (a) 250

Reserve for excess and obsolete
inventory 322 700 -- 594 (b) 428

Year 1999
Reserve for uncollectible accounts -- 215 -- -- 215

Reserve for excess and obsolete
inventory 10 397 -- 85 (b) 322

______________

(a) Amounts written off as uncollectible, payments or recoveries.
(b) Amounts written off upon disposal of inventory.

#