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OPTELECOM, INC. FISCAL YEAR 2002 FORM 10-K ANNUAL REPORT TABLE OF CONTENTS

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-K

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

For the Fiscal Year Ended December 31, 2002

Commission File Number

OPTELECOM, INC.
(Exact name of registrant as specified in its charter)

DELAWARE
(State or other jurisdiction of incorporation or organization)

52-1010850
(IRS employer identification number)

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

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

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

Securities registered pursuant to Section 12(g) of the Act: Common Stock $0.03 Par Value.

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

        Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulations 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 Form 10-K or any amendment to this Form 10-K. ý

        At June 30, 2002, shares of the registrant's Common Stock, $0.03 Par Value, held by persons other than "affiliates" of the registrant had an aggregate market value of $6,539,346 based on the average closing bid and asked prices as reported by the National Association of Securities Dealers Automated Quotation System for such date.

        At March 19, 2003, the registrant had outstanding 2,908,955 shares of Common Stock, $.03 Par Value.

DOCUMENTS INCORPORATED BY REFERENCE

        None

OPTELECOM, INC.
FISCAL YEAR 2002 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

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PART I

Item 1. BUSINESS

GENERAL

        Optelecom, Inc. is a Delaware corporation whose business activities began in 1972. Optelecom's early business commenced with the design and delivery of specialized laser systems and fiber optic communications products for the defense arm of the Federal government. During the mid-1990's we successfully transitioned from having a significant number of military customers to a contemporary industry provider of copper and fiber optic based communications products for commercial and government customers. We have focused on providing integrated multi-media products for communicating video, audio, and other data over both copper wire and optical network systems.

        Optelecom currently manages its operations under three business segments: the Optical Products unit (OP) which develops, manufactures and sells optical fiber-based data communication equipment to both commercial and Government clients; the Electro-optics Technology unit (EO), which develops and manufactures innovative optical devices under contract, primarily to government and defense industry customers; and the Copper Products Unit (CP) which is focused on the delivery and distribution of video systems using Category5 (CAT5) copper cabling as the transmission medium. Segment information for all prior periods presented has been restated to conform to the current presentation.

        Fiber optic communications equipment is the main element of Optelecom's sales. The marketplace served by Optelecom is experiencing a period of continuous growth and change as the industry emerges from its infancy. Technology development is constantly and rapidly improving the capability to transmit at increasing data rates over even greater distances with fiber-based communication systems.

        In addition to the fiber market, we are addressing a marketplace which has developed as a result of the significant quantity of Category 5 (CAT5) cable that exists as an installed base both domestically and internationally. Paragon Audio Visual, our wholly-owned UK subsidiary, is providing our main sales effort into the CAT5 market and also supports sales of fiber products into Europe, Africa and the Middle East.

        In 2003 management intends to integrate the Copper Products Unit and Optical Products Unit. As a result, the Copper Products Unit will also support the full range of Optelecom's fiber optic product line in Europe, the Middle East and Africa.

        In the Electro-Optics Group, emphasis has been placed on fabrication of precision-wound coils of optical fiber used as the sensing elements of fiber optic gyroscopes. During the past decade, Optelecom has received U.S. Government contracts to investigate advanced manufacturing technology related to gyro coil winding. Optelecom currently pursues this tradition of business development and continues to seek out technology development opportunities with potential for production follow-on. The Electro-Optics Group also produces precision wound coils for applications ranging from optical fiber dispensers used in remote vehicle control systems to precision optical fiber coils for communications systems. Additionally, the group is currently engaged in a series of contracts with the U. S. Air Force and prime contractors to develop elements of a fiber optic data bus network for a new air vehicle.

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        The table below displays the Company's three-year revenue and operating income (loss) by segment:

(1)

Company totals include corporate expenses. See Note 13 of the Notes to the Financial Statements for segment information.

PRODUCTS AND MARKETS

OPTICAL PRODUCTS UNIT (OP)

        The Optical Products Unit addresses business opportunities in the worldwide optical communication equipment marketplace, specializing in optical fiber transmission technologies. The majority of its current and future revenues are and will be derived from several niche markets that apply the advantages of fiber optic telecommunications to their transmission requirements. Presently, the vertical markets we serve include communications systems for highway traffic monitoring, advanced air traffic control video monitor displays, security surveillance and control systems, and manufacturing process and control communications. Vertical markets that offer future potential sources of revenue include video teleconferencing, healthcare, and broadcasting. The OP Unit offers many product solutions to address our customers' needs. Its products are classified into the following categories:

Data Communications Products

        Data Communications Products include a comprehensive family of fiber optic modems that incorporate standard telecommunications protocols. The market applications for these products include specialty data and timing distribution modems for the military, aerospace and satellite earth station markets as well as commercial, industrial, traffic control and surveillance markets.

CCTV and Broadcast Video, Audio and Data Transmission Products

        This category includes fiber optic video only, audio only, video and data, audio and data, and video, audio and data products, which use our traditional Frequency Modulation (FM), Pulsed Frequency Modulation (PFM) and Pulsed Coded Modulation (PCM) transmission techniques. The series also includes a Windows based Graphical User Interface System Management Software which allows the user to view and manage the operating status of the entire fiber optic transmission network from a PC, greatly facilitating system maintenance. Markets for these products include video surveillance, intelligent highways, robotics, process control, military, distance learning and simulation markets. During 2002 we began a general shift away from these legacy FM based video transmission products in favor of our uncompressed digitally encoded video transmission products.

Uncompressed Digital Video Transmission Products

        Uncompressed digital video products provide an extremely high quality video signal and maintain this quality at distances far exceeding the capability of FM based transmission equipment. The bandwidth required to achieve this performance is considerably greater than that needed for lower

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video quality systems, however, the enormous bandwidth capacity of fiber optic transmission media provides an obvious path for utilization of digital video technology. Additionally, since the video transmission format is strictly digital, it can be easily combined with digitized voice and digital data streams. This feature facilitates switching and multiplexing of a variety of signals which is far more easily accomplished than with PFM systems.

        Current products include one, four, and eight channel digital video multiplexing and de-multiplexing units offering near broadcast quality performance, with many also combining audio and data with the digital video for transmission via one optical fiber using one optical wavelength for each transmission direction.

        The totally modular approach used in the digital system design architecture reduces the inventory and logistical support investment required to address the increasing demand for these products. Marketplace reception has been extremely positive and new applications involving a combination of our other product offerings with the capabilities of the digital video equipment are being constantly proposed.

CWDM (Coarse Wavelength Division Multiplexer) Systems

        Early in the year 2002, Optelecom introduced its CWDM systems to its markets. A CWDM allows the transmission and reception of multiple channels of light operating at different wavelengths through a single optical fiber. With this technology the user can configure systems which transport the video and data channel count transmitted by one wavelength (typically up to eight) multiplied by the wavelength channel capacity of the CWDM. Optelecom offers CWDM systems with optical wavelength channel counts of from two to seventeen, as well as single channel add/drop multiplexers By using a two channel WDM (Wavelength Division Multiplexer) along with two eight channel digital video multiplexers transmitting at different optical wavelengths, sixteen channels of video along with data and audio may be transmitted via one optical fiber in one direction. Similarly, by using a seventeen channel CWDM along with up to seventeen eight channel digital video multiplexers each transmitting at different optical wavelengths, one hundred thirty six channels of very high quality digital video, along with audio and data, may be transmitted via one optical fiber in one direction. Alternately, by using the seventeenth wavelength for return path audio and data, one hundred twenty eight video channels can be transmitted in one direction along with bi-directional audio and data.

        Combining Optelecom's wide variety of transmission products with available CWDM components permits the user to configure multiple variations of point-to-point or distributed linear optical networks for the transmission of video, audio, and data. via a single optical fiber.

High Resolution RGB Video Transmission Products

        Red Green Blue (RGB) Video Transmission Products include those used to remotely position a high-resolution display, such as a monitor or projector, from its video source. Because of the high bandwidth and fidelity required to transmit these signals, fiber optics is the only available means to transmit them further than approximately 1,000 feet. While VGA video, in the 1280 × 1024 pixel range, may be transmitted via copper using active baluns (such as offered by the Copper Products unit) up to distances approaching 1,000 feet, the bandwidth required to transmit ultra high resolution 2048 × 2048 pixel RGB video limits the maximum transmission distance possible over copper wire to less than 100 feet. Management is not aware of any other fiber optic RGB video transmission system that meets the performance characteristics of the high-resolution RGB products that we offer. Applications for this technology include air traffic control, military control rooms, remote conference rooms, financial trading desks and process control.

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Compressed Digital Video Transmission Products

        Applying our expertise in video communications, we have developed a low cost, high quality, compressed digital video MPEG II product set that leverages the advantages of new microprocessor technology recently made available to the marketplace. MPEG II has become the defacto compression standard embraced by the consumer and other electronics marketplaces. The products we have developed will replace older compression products since their low cost, high performance characteristics render the previous family obsolete.

        These products involve the digitization and compression of National Television System Committee (NTSC) and Phase Alternation by Line (PAL) video signal sources, allowing transmission using T1, E1, or Ethernet, over IP (Internet Protocol). They are being offered to the security and traffic markets as well as to other markets whose users are turning to video communications as a way to increase productivity. The explosive growth of the Internet facilitates the need for low cost, high quality compressed digital video for use over various private and public networks.

ELECTRO OPTICS PRODUCTS UNIT (EO)

        The Electro Optics Unit focuses on Interferometric Fiber Optic Gyro (IFOG) coils, which are components in rotation-sensing instruments that are beginning to replace mechanical and laser gyros in aircraft, missiles, and other vehicles. Optelecom has used its expertise derived from prior Department of Defense activities to develop winding technology for IFOG coils and to manufacture these coils. In 2002, continued improvements were incorporated to increase production capacity in anticipation of increased requirements for these coils. Optelecom currently supports Boeing in a program for Wright-Patterson AFB which is devoted to development of military aircraft photonic network systems. Optelecom is in the implementation stage of an effort to develop a demonstration of photonic vehicle control feedback components. Under a related Small Business Innovation Research (SBIR) contract, Optelecom is investigating photonics systems optimized for aerospace vehicles, which will culminate in the design of an optical subsystem prototype. Our photonic aerospace vehicle work provides an opportunity for Optelecom to apply its optical development and fabrication expertise to an important aircraft system application with potential application to commercial markets. The company also experienced an increase in service contract activity related to the Air Force photonic vehicle control system development during 2002.

COPPER PRODUCTS UNIT (CP)

        The Copper Products Unit designs, manufactures and markets electronic products and systems for multi-media applications utilizing twisted-pair copper or "structured wiring," also known as Category 5/5e/6 (CAT5, Cat 5e, Cat 6) cabling, which forms the standard wiring infrastructure for most modern office, industrial and, increasingly, residential buildings. This Unit is comprised of the Paragon AV business that was restructured during 2002 and is now supplied with products designed and manufactured by Optelecom, rather than predominantly sub-contracted products, as was the case at the time of its acquisition. These products include active balun (Balanced to Unbalanced) devices that facilitate the transmission of high-resolution video, audio and data signals without noticeable signal degradation over structured wiring systems. In addition, television distribution systems for the receipt and distribution of Broadcast, Satellite and Cable TV over CAT5 cable have also been developed and are being offered to the US, European and Asian markets. These TV systems are used to provide business television services to commercial organizations, particularly in the financial markets.

        A number of new products have been developed for the Copper Products Unit utilizing Optelecom's proven 9000-series architecture. This has enabled the added- value benefits of Optelecom's System Management Software products to be applied to the Copper Products and has decreased the time-to-market for new products. Using a single, compatible architecture for copper and optical

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products also enables hybrid systems to be easily configured under a single, consistent system management scheme. Such hybrid systems have applications where, for example, video is to be distributed both within (copper products) and between (optical products) buildings—such as university campuses, airports and other industrial complexes. Additionally, the ever-increasing demand for bandwidth places added demands on structured cabling systems and the capability to upgrade to optical systems while maintaining consistent system architecture and management interface is an important competitive feature of Optelecom products. Optelecom Optical Products and Paragon Audio Visual have significant similarities in their product technologies and applications; both operations are in the business of distributing multi-media (video/audio/data) information, albeit over different physical media. By drawing heavily on Optelecom's proven multimedia technologies, Paragon AV products are almost wholly integrated into the mainstream Optelecom product catalog which lays the foundation for the closer integration of the two business units.

SALES AND MARKETING

OPTICAL PRODUCTS UNIT

        The Optical Products Unit sells its products domestically through direct sales, select commercial integrators and resellers. In addition, several vendors incorporate Optelecom products in their product offerings. This enables Optelecom to penetrate markets we do not address directly.

        We continue to focus our resources on developing additional sales and distribution channels. Specifically, in 2002 we added six representatives and nine integrators domestically. Internationally, we added seven new integrators. We expect this number to continue to grow in 2003 as we further expand the market share of our fiber transmission products.

        During 2002, new collateral material necessary to allow the marketplace to fully evaluate our product offerings were distributed to existing and potential customers. Our primary method of making new customer contacts has been through participation in an expanded trade show schedule in both the Security and Traffic markets. These trade shows have resulted in a significant increase in quotations and order activity. In addition, our updated Web Site has enabled the convenient and rapid dissemination of information required by our distribution channel personnel and other interested parties to gather information necessary to select our equipment. In 2003, the Web site will be expanded to enable "registered users" to access Optelecom's infrastructure to place orders, check order status and validate their specific account information.

ELECTRO OPTICS PRODUCTS UNIT

        Electro-Optic Group sales are pursued independently of other corporate sales functions. The Electro-Optics Group relies on established contacts, response to RFP's and participation in technical conferences to market precision wound coils and other contract services.

COPPER PRODUCTS UNIT

        The Copper Products Unit has established partnerships with suppliers of "system component" products, where our partner has strong technical expertise but very weak routes to market or poorly developed integration skills. These products include multi-functional keyboard solutions, specialized graphic display adapters and video switching systems. Such products are judiciously used to augment our own products to deliver more complete systems solutions. Additionally, existing products developed for a specific market have been promoted into other market applications. Our product offerings now range from complex integration of video delivery to the individual user desk through video distribution technologies to multiple users.

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        This business model enables us to deliver complete system solutions, establishing a single source of cohesive multimedia solutions and integration services to the financial marketplace. This has enabled us to derive additional revenue from our existing client base, to appeal to new prospects within the financial marketplace and to address new markets. We plan to take these products to market by incorporating them in our offering and adding them to our newly developed distribution channels worldwide. This strategy helped the Copper Products unit win a $1.3 million order in 2001 for video and audio distribution in a commuter train passenger information system in Singapore; deliveries under this contract were completed in 2002.

        The copper products unit specializes in products for the transmission of video, audio and data over twisted-pair copper cabling—typically the Cat5/Cat6 "structured cabling" systems installed in virtually all modern commercial buildings. Historically, this unit has focused on the financial systems markets and has worked with its partners to provide multimedia distribution solutions for financial dealing rooms. In 2001, the copper products unit began to market its products more widely and this strategy was successfully continued in 2002, resulting in new sales in areas such as transportation, security and audio-visual systems.

        In many respects the copper products are similar and complimentary to Optelecom's main portfolio of fiber products. Both are used for the distribution of multimedia content (video/audio/data) in various vertical market applications. Typically, the copper products operate "inside" buildings over short distances whereas the fiber products operate "outside" or between buildings over considerable distances. However, even this distinction is becoming blurred by the increasing importance of IP-Ethernet as a transmission technology, which can operate equally effectively over twisted-pair and fiber media.

        In 2002, the restructuring of the copper products unit continued to focus on the key objective of returning the unit to profitable operation. This was successfully achieved and, in doing so, the parallel worldwide operations of the copper and optical units became more closely integrated and cooperative. Both units are in the business of multimedia distribution and are operating through a network of independent integrators and partners.

RESEARCH AND DEVELOPMENT

        During 2002, the Company invested in the development of several new products. These products will permit us to increase our penetration of the present vertical markets we serve by permitting our customers to increase information throughput at reduced price points. It is anticipated that the new Digital Video (DV) products, both compressed and uncompressed, will gain significant market share due to their extremely high reliability, increased bandwidth/channel capacities, and robust video compression techniques.

        A new network software management card incorporating an Ethernet capability was developed and introduced in 2002. This unit allows remote access to, and management of Optelecom equipment from a customers existing network.

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MANUFACTURING PROCESSES

QUALITY ASSURANCE

        Optelecom has established and maintains a Quality Assurance system fully compliant with the requirements of ISO-9001 (an internationally recognized quality system standard for companies that design and manufacture products). All operating segments have received certification to the standard. This certification is re-validated every six months and the company successfully passed audits in January and June of 2002. While all companies have until December 2003 to update from the 1994 version of ISO-9001 to the 2000 version, Optelecom is compliant as 2003 starts (a year ahead of the deadline). In 2002 strategic improvements were made to the manner in which the quality documents were numbered, organized, accessed to simplify usage to comply with the 2000 version of ISO-9001. The Corrective Action process and Quality Council meetings continue to be aggressively utilized to drive continuous improvements.

OPTICAL PRODUCTS

        The Optical Products Unit performs routine and specialized manufacturing, assembly, and product testing functions in our corporate headquarters. We use equipment to automatically assemble components onto printed circuit boards at high speed, thereby lowering manufacturing costs and reducing the time-to-market for new product designs. We also maintain a quality assurance function and testing area that performs optical and electrical testing and quality control. Raw materials and supplies used in our business include optical materials, plastic products, and various electronic components, most of which are available from numerous sources. Although the number of companies from which we can obtain optical emitters and detectors for use in our circuit assemblies is limited, availability is presently not a limiting factor. During 2002, manufacturing basics was an area of primary focus. This involved correcting, re-evaluating and improving many of the core manufacturing processes.

ELECTRO OPTICS PRODUCTS

        Electro-Optics Group uses custom facilities designed and fabricated by Optelecom for precision wound coil production and contract research and development. Currently, five coil winding machines are employed in satisfying contract winding production requirements.

COPPER PRODUCTS

        The Copper Products Unit now obtains the majority of its products from Optelecom's Engineering and Manufacturing operations, in contrast to previous subcontracting arrangements. It is our intention to maintain this practice. Paragon Audio Visual is registered under the ISO9000 quality standard.

COMPETITION

        The three business segments of Optelecom compete in separate and distinct markets.

OPTICAL PRODUCTS

        This Unit competes with other companies of roughly equal size that have similar resources. The majority of our competitors are privately held companies. We estimate the total market for Optelecom transmission products to be approximately $150 million in 2003. The size of the traffic and security surveillance markets, which represents the largest segment, is estimated to be approximately $60 million worldwide. The competition in these markets has established mature sales channels that allow for continued market penetration in both domestic and international markets. We anticipate that the expansion of Optelecom's sales and distribution channels worldwide will be the basis for sustained growth. The Company expects to increase its share of these expanding markets. In addition, our

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products contain two technologies that are in limited supply to these markets: the compressed and uncompressed Digital Video products.

ELECTRO OPTICS PRODUCTS

        Products offered by Electro Optics are sold to both small companies and large defense contractors who tend to dominate the market. These companies have greater marketing, manufacturing, financial, research and personnel resources than Optelecom. Furthermore, as Department of Defense contracting activity has declined, these companies have started to compete in markets that were primarily addressed by companies with resources similar to Optelecom's. Our approach to this competitive environment is to offer services and second source production capabilities which complement the capabilities and interests of our customers. Some prime contractors have begun subcontracting with us to use Optelecom's technology to fulfill their contract obligation.

COPPER PRODUCTS

        Copper Products are applicable within large and small sized companies in the area of CAT5/5e/6 distribution of video, audio and data, where only a small number of companies compete for this specialized market segment. As video applications become increasingly "bandwidth-hungry" there will be pressure to move towards higher-bandwidth media and Paragon is well-positioned to take full advantage of Optelecom's proven products in this area, compared to its "copper-only" competitors who will have a significantly higher "entry barrier" to optical technologies.

SEASONALITY

        Optelecom's products are based on communications equipment technology. As such, seasonality affects our revenues to the extent that normal contracting activities are affected by capital budget seasonality.

PATENTS

        Although Optelecom holds certain patents, our business as a whole is not materially dependent upon ownership of any one patent or group of patents. We do not license any patents from other parties.

BACKLOG

        At the end of 2002, the estimated backlog for each business segment was as follows: Optical Products Unit $734,000; Electro Optics Products Unit $1,070,000; Copper Products Unit $11,000. The Company expects to recognize a majority of the backlog as revenue in the first quarter of 2003.

EMPLOYEES

        At December 31, 2002, a total of 61 full-time employees worldwide were employed at Optelecom, including 14 in research, development and engineering, 14 in sales and marketing, 24 in manufacturing and 9 in general management, administration and finance. The number of employees by operating segment is as follows: Optical Products Unit—51; Copper Products Unit—5; Electro Optics—5. We expect a slight increase in headcount over the next 12 months, primarily in the areas of sales, marketing and manufacturing. Our future success will depend in part on our ability to attract, train, retain and motivate highly qualified employees. There can be no assurance that we will be successful in attracting and retaining such personnel. Our employees are not represented by any collective bargaining organization and we consider our employee relations to be good.

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Item 1A. RISK FACTORS

        The statements contained in this report on Form 10-K that are not purely historical are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 and Section 21E of the Securities Exchange Act of 1934, including, without limitations, statements regarding Optelecom's expectations, hopes, beliefs, anticipations, commitments, intentions and strategies regarding the future. Forward-looking statements include, but are not limited to, statements contained in "Item 1. Business," and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" regarding Optelecom's business and strategies, product markets, sales, marketing, customer support and service, research and development, manufacturing, competition, backlog, employees, financial performance, revenue and expense levels in the future and the sufficiency of our existing assets to fund future operations and capital spending needs. Actual results could differ from those projected in any forward-looking statements for the reasons, among others, detailed under "Risk Factors" in this Report on Form 10-K. The fact that some of the risk factors may be the same or similar to Optelecom's past filings means only that the risks are present in multiple periods. We believe that many of the risks detailed here are part of doing business in the industry in which we compete and will likely be present in all periods reported. The fact that certain risks are endemic to the industry does not lessen the significance of the risk. The forward-looking statements are made as of the date of this Form 10-K and we assume no obligation to update the forward-looking statements, or to update the reasons why actual results could differ from those projected in the forward-looking statements.

Fluctuations In Financial Performance

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

Dependence On Major Customers

        For the twelve months ended December 31, 2002 approximately 22% of our revenues were accounted for by sales to five commercial customers. This dependence of sales of our products to a few customers continues to diminish. In the event of a reduction, delay or cancellation of orders from one or more significant customers or if one or more significant customers selects products from one of our competitors for inclusion in future product generations, our business, financial condition and operating results could be materially and adversely affected. There can be no assurance that Optelecom's current customers will continue to place orders with us, that orders by existing customers will continue at current or historical levels or that we will be able to obtain orders from new customers. The loss of one or more of our current significant customers could materially and adversely affect Optelecom's business, financial condition and operating results.

Technological Change

        Optelecom's products are sold in markets that are subject to rapid technological change. Our future success will depend in part upon our ability to enhance our current products and to develop and introduce new products that keep pace with technological developments and emerging industry standards and that address the increasingly sophisticated needs of our customers. There can be no

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assurance that we will be successful in developing and marketing such products or producing enhancements that meet these changing demands, that Optelecom will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these products or that our new products and product enhancements will adequately meet the demands of the marketplace and achieve market acceptance. Our inability to develop and introduce new products or product enhancements in a timely manner or our failure to achieve market acceptance of a new product could have a material adverse effect on Optelecom.

Competition

        We face intense and increasing competition from a large number of competitors, some of which are larger than Optelecom and have larger product development, research and sales staffs. We believe that the products developed in 2001 and 2002 and the products currently being developed will position us to compete effectively through 2003 and well into 2004. There can be no assurance, however, that our competitors will not develop products that are as, or possibly more, effective than ours. We continuously monitor our competitors' product introductions to evaluate our ability to compete.

Paragon Operations (Copper Products)

        Paragon Audio Visual Ltd. ("Paragon") was acquired in December 1997. The integration was troubled and a great amount of time and resources have been expended to enhance Paragon's operating performance.

        Paragon's management team, which has been in place since the second quarter of 1999, made progress in 2002 in reducing their on-going operating losses, primarily through reduction in operating costs and increasing product margins, largely through the reduction of dependence on subcontract product manufacture. Continued integration with the US office is planned for 2003 with the intention that the Paragon operation will provide enhanced, local support for optical product sales throughout Europe, the Middle East and Africa (EMEA).

        Optelecom expects to expand its presence in international markets and may, in the future, derive an even more significant portion of its revenues from these markets. Our current and future international business activities are subject to a variety of potential risks, including political, regulatory and trade and economic policy risks. We will also be subject to the risk attendant to translations in foreign currencies. These factors could have a material adverse effect on Optelecom.

Future Capital Needs; Uncertainty Of Additional Funding

        Optelecom believes that our existing capital resources, including an existing $2,500,000 bank line-of-credit and future operating cash flows, will generate the funds needed for our long-term cash requirements.

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

Need To Attract And Retain Key Employees

        Optelecom is substantially dependent on the business and technical expertise of our senior management and on our ability to attract and retain key management and technical employees. The

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loss of members of senior management or of other key employees or our inability to attract and retain other employees with necessary business or technical skills in the future would have a material adverse effect on Optelecom's business.

Price Volatility In Public Market

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

Absence Of Dividends; Dilution

        Optelecom has not paid any cash dividends since our inception and we do not anticipate paying any cash dividends in the foreseeable future. Dilution will occur upon the exercise of outstanding stock options and may occur upon future equity financing that could be required to fund operations.

Item 2. PROPERTIES

        During 2002 the Company leased property at 9300 Gaither Road, Gaithersburg, Maryland, located near Washington, DC. This facility has 21,000 square feet of space. The lease expired on August 31, 2002 and the Company negotiated a lease extension through March, 2003. In November 2002, the Company entered into a lease to occupy a new facility located at 12920 Cloverleaf Center Drive, Germantown, Maryland, approximately 8 miles from the current facility. We moved all operations to this new space in March, 2003. The new facility has 30,000 square feet of space, 26,000 of which will be initially occupied by Optelecom, with 4,000 square feet available for sub-leasing. This expansion into a facility specifically designed and fitted to accommodate our current requirements and our anticipated near-term growth needs is expected to improve our ability to serve our customers.

        As part of the 2001 restructuring of Paragon, its facilities were consolidated in a smaller, but superior, facility in Thatcham, England, consisting of approximately 2,100 square feet of office space. Current monthly rent is approximately $2,000. This lease expires in June 2006, and the premises are in good repair, and are adequate for current requirements.

Item 3. LEGAL PROCEEDINGS

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

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

        Three items were submitted to a vote of security holders at the Company's Annual Meeting held May 7, 2002. (Reference is made to the Company's Proxy Statement filed March 25, 2002).

Item One: Election of Director

Item Two: Shareholder Proposal

Item Three: 2002 Stock Option Plan

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PART II

Item 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

        Optelecom's Common Stock, $0.03 par value (Common Stock) is traded in the over-the-counter market. Set forth below are the highest and lowest closing bid prices for the Common Stock as reported by the National Association of Securities Dealers Automated Quotation Service (NASDAQ) during each quarter for the two years ended December 31, 2002 and 2001, respectively. Such quotations do not necessarily reflect actual transactions:

        There were approximately 618 record holders of the Common Stock as of December 31, 2002.

        Optelecom has not declared any cash dividends to date and does not expect to do so in the foreseeable future.

Item 6. SELECTED CONSOLIDATED FINANCIAL DATA

        The selected consolidated financial data set forth below with respect to Optelecom's Consolidated Statements of Operations for the fiscal years ended December 31, 2002, 2001 and 2000 with respect to Optelecom's Consolidated Balance Sheets at December 31, 2002 and 2001 are derived from the audited Consolidated Financial Statements of Optelecom, which are included elsewhere in this Form 10-K. Consolidated Statements of Operations data for the fiscal years ended December 31, 1999 and 1998 and Consolidated Balance Sheet data at December 31, 1999 and 1998 are derived from Consolidated Financial Statements of Optelecom's not included herein. The selected consolidated financial data set forth below is qualified in its entirety by, and should be read in conjunction with, the Consolidated Financial Statements, the related Notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Form 10-K.

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

RESULTS OF OPERATIONS

2002 versus 2001

        2002 consolidated revenues of $14.9 million were $1.7 million or 13% higher than 2001. Sales increased in the Optical Products and Electro-Optics Units and were lower in the Copper Products Unit. Revenue for the Optical Products Unit increased by $1.9 million or 19%. This increase is attributed to the Company's focus of increasing sales channels both domestically and internationally. Sales to integrators and distributors increased substantially. Electro-Optics revenues increased to $1.2 million in 2002 from $1.1 million in 2001 as a result of expansion of the contract research and development services and the coil winding business. Revenue for the Copper Products Unit decreased by $0.4 million or 17%.

        Gross profit was $8.1 million in 2002 compared to $6.3 million in 2001. This increase of $1.8 million is primarily the result of a higher volume of sales of digital and high resolution products in 2002, which have higher profit margins. Additionally, there was a higher level of sales of lower margin copper products in the year ended December 31, 2001.

        Operating expenses were $6.5 million in 2002 compared to $7.0 million in 2001. This decrease of $0.5 million or 7.6% is primarily due to reductions in spending for engineering personnel, engineering consultants and lower corporate staff expense as a result of the 2002 restructuring of the Copper Products Unit. These reductions in 2002 spending were partially offset by higher selling personnel costs and the increased commissions necessary to support higher sales levels.

        The Company reported net income in 2002 of $1.6 million or $0.56 per diluted share compared to a net loss of $0.9 million or ($0.33) per share in 2001. There was a modest provision for state income tax in 2002 compared to no provision in 2001. The company is currently not paying federal income tax due to the net operating loss carryforwards from prior years.

2001 versus 2000

        2001 consolidated revenues of $13.2 million were $2.5 million or 23.4% higher than 2000. Sales increased in the Optical Products, Electro-Optics and Video Communications Units. Revenue for the Optical Products Unit increased by $1.7 million or 22%. This increase is attributed to the Company's focus of increasing sales channels both domestically and internationally. Sales to integrators, distributors and OEMs increased substantially. Electro-Optics revenues increased to $1.1 million in 2001 from $0.5 million in 2000 as a result of expansion of the contract research and development services and the coil winding business. Revenue for the Copper Products Unit increased slightly by $0.2 million or 8%.

        Gross Profit was $6.3 million in 2001 compared to $4.4 million in 2000. This increase was primarily the result of increased sales volume in 2001, higher material costs in 2000 and the write-off of inventory of $0.7 million during 2000.

        Operating expenses were $7.0 million in 2001 compared to $9.7 million in 2000. This decrease of $2.7 million or 28% is primarily due to the inclusion of $1.9 million of write-down of intangible assets in 2000. In addition, 2001's operating expenses were lower as a result of cost savings from personnel reductions and a reduction in discretionary spending in all areas of the Company.

        The Company reported a net loss in 2001 of $0.9 million or ($0.33) per diluted share compared to a net loss of $6.0 million or ($2.53) per diluted share in 2000. There was no provision for income tax in 2001 compared to a provision of $0.5 million in 2000.

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Operating Segments

        Optelecom's products and services are categorized into three operating segments: Optical Products Unit, Electro-Optics Unit and the Copper Products Unit. Prior to 2001, the Company had been reporting the revenues and expenses of the Electro-Optics Unit within the Optical Products Unit. During 2001 it was determined by management that the Electro-Optics business should be reported separately in order to manage the business more effectively. In addition, the Unit that was previously reported as the Video Communications Unit has been renamed the Copper Products Unit to better convey the primary product line of that business unit. The financial results for the three operating segments have been prepared on a basis that is consistent with the manner in which Optelecom management internally evaluates financial information for the purpose of assisting in making internal operating decisions. In this regard, certain common expenses have been allocated among segments differently than would be required for stand alone financial information prepared in accordance with generally accepted accounting principles.

OPTICAL PRODUCTS UNIT

        See Note 13 of the Notes to Consolidated Financial Statements.

        2002 Sales for Optical Products of $11.8 million were 19% or $1.9 million higher than 2001's sales of $9.9 million. This increase is attributed to the Company's focus of increasing sales channels both domestically and internationally. Sales to integrators and distributors increased substantially over the prior year.

        In 2002 the Optical Products Unit continued to experience the benefits of the expansion and re-alignment of its sales and marketing departments. The emphasis that was placed on developing new sales and distribution channels, both domestically and internationally resulted in higher sales in 2002. During 2002, six independent sales representative organizations and nine integrators were added domestically and seven integrators were added in the international marketplace.

        Gross profit during 2002 of $6.7 million, or 56% of sales, was higher than 2001's gross profit of $5.0 million or 50% of sales. The increase of $1.7 million is primarily the result of the higher volume of sales of digital and high resolution products in 2002, which have higher profit margins.

        Operating expenses were $5.7 million in 2002, a slight decrease of $0.2 million from 2001. Sales and marketing costs increased $0.5 million over 2001, primarily due to higher commissions as a result of higher sales levels. Engineering costs decreased $0.3 million, primarily due to the savings realized from lower staff costs and reductions in the costs of engineering consultants during 2002. General and administrative costs decreased $0.4 million from $3.1 million in 2001 to $2.7 million in 2002. Cost reductions are primarily attributed to the reductions in facility costs, consulting expenses and other discretionary administrative spending.

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ELECTRO-OPTICS UNIT

        See note 13 of the Notes to Consolidated Financial Statements

        Electro-Optics sales of $1.2 million were $0.2 million higher than 2001. The increase is primarily attributable to the increased unit sales of the coil winding division while the contract research and development portion of the business was practically unchanged from 2001 to 2002. Operating income for 2002 improved slightly as compared to 2001 due to higher sales and cost savings pertaining to direct materials and outside consulting.

COPPER PRODUCTS UNIT

        The Copper Products Unit is comprised of Paragon AV. Sales in 2002 of $1.9 million were 17% lower than 2001's sales of $2.3 million. The lower sales of 2002 are primarily attributable to reduced demand by financial institutions. The gross margin percentage increased to 46% in 2002 from 38% in 2001. This increase in gross margin in 2002 is due to a lower amount of third party components which have lower gross margins than internally manufactured products.

        Operating expenses in 2002 were $0.8 million compared to $1.1 million in 2001. This decrease of $0.3 million, or 31% from 2001 operating expense levels is due to reductions in staff and lower sales and marketing and administrative expenses.

OTHER INCOME (EXPENSE)

        Other income (expenses) totaled $0.5 million in 2002 compared to ($0.2 million) in 2001. Total interest expense was $0.09 million in 2002 compared to $0.19 million in 2001. Interest expense for 2002 decreased as result of paying down the principal on the line-of-credit and the long-term note and a reduction in the interest rate. In 2002 the average borrowing under the line-of-credit was $1.18 million compared to an average of $1.27 million in 2001. The interest rate averaged 6.59% in 2002 compared to 8.52% in 2001. Other income in 2002 relates to a refund of federal income taxes paid in a prior year.

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Impact of Inflation

        Inflation has not had any significant effect on the operations of the Company during 2002, and we do not expect it to have any significant effect during 2003.

FINANCIAL CONDITION

        The Company's Stockholders' equity increased from $2.1 million in 2001 to $3.7 million in 2002. The net income and consequent decrease in accumulated deficit of $1.6 million was accompanied by a small increase of $105,153 in common stock and paid-in-capital, due to the exercise of stock options and purchase of shares pursuant to the employee stock purchase plan.

        Other key components of Optelecom's financial condition include accounts receivable, inventory, fixed assets, accounts payable and debt. The Company's current ratio has increased to 1.98 at December 31, 2002 compared to 1.30 at December 31, 2001. This increase is attributed primarily to the decrease in the Company's accounts payable and bank line of credit. Accounts receivable increased this year from $2.5 million in 2001 to $3.2 million at December 31, 2002. A significant factor in this increase was relatively large shipments late in 2002. The Company has improved its collection process which has resulted in a reduction in days sales outstanding from 68 at December 31, 2001 to 59 at December 31, 2002.

        Inventory decreased from $2.8 million at December 31, 2001 to $2.5 million at December 31, 2002 primarily due to a decrease in production materials inventory. At the end of the year ended December 31, 2001, the Company increased its inventory of electronic optical components in response to the increasing demand for such components in anticipation of industry wide shortages. During the year ended December 31, 2002, as a result of the lessening of exposure to component shortages, we were able to focus on stocking material at subassembly and finished good levels. This resulted in our ability to service our customer's requirements in less time while benefiting from lower investment in overall inventories.

        The following chart shows the composition of inventory for the past three years, with Paragon inventory included in finished goods:

        In 2002, fixed asset additions were $0.12 million, compared to $0.09 million in 2001 and $0.37 million in 2000. The Company has adopted a conservative policy on capital purchases over the past two years in its effort to curtail spending and improve profitability.

        The Company's current liabilities decreased $1.2 million from $4.2 million in 2001 to $3.0 million in 2002 primarily as a result of a decrease of $1.1 million in the bank line-of-credit payable and $0.5 million in the notes payable balance. Accounts payable decreased $0.3 million from 2001 to 2002. These decreases were partially offset, however, by an increase of $0.2 million in commissions payable and $0.3 million in other current liabilities.

        Long term debt was eliminated as a result of paying off the remaining balance on the term loan associated with the Paragon acquisition in 1997 and the Economic Development Loan during the year ended December 31, 2002. In addition, the balance in deferred rent liability was eliminated due to the completion of the lease term on the Company's U.S. office space.

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LIQUIDITY AND CAPITAL RESOURCES

        Cash provided by operating activities was $1.8 million in 2002 compared to $0.3 million used in operating activities in 2001. After adding back adjustments such as depreciation and amortization and deferred rent to reconcile the net income / loss to net cash provided by / used in operating activities, the net cash provided was $2.0 million in 2002 compared to net cash usage of $0.6 million in 2001. This represents a substantial improvement over the prior year results. Working capital used in operating activities was $0.2 million in 2002. The net working capital usage was due to increases of $0.7 million in accounts receivable and a decrease of $0.3 million in accounts payable. These changes were offset by a net increase in commissions payable and other current liabilities of $0.5 million.

        Cash used in investing activities in 2002 increased slightly to $0.12 million compared to $0.09 million in 2001. The Company engaged in continued cost containment during 2002 as reflected in its modest level of capital expenditures.

        During 2002, the Company used $1.5 million in financing activities compared to $0.2 million provided by financing activities during 2001. The Company was successful in completely paying off ($0.5 million) its short and long-term notes and long-term capital leases. In addition, cash used in financing activities resulted from a reduction in net borrowings on the bank line-of-credit of $1.1 million compared to the prior years net increase in borrowings on the bank line-of-credit of $1.0 million. Additionally, proceeds from the exercise of stock options and common stock issued from the employee stock purchase plan totaled $0.1 million during 2002.

        Prior to September 30, 2002 Optelecom had a revolving credit agreement with a bank whereby it could borrow up to $1.7 million with interest at the bank's prime rate plus 1.5%. The total amount of potential borrowings at any given time were based on the sum of a percentage of certain eligible accounts receivable plus a percentage of qualifying inventory. This bank line-of-credit expired September 5, 2002. The bank provided an extension until September 30, 2002.

        Under a new banking facility, Optelecom has the ability, provided there are sufficient accounts receivable and inventory, to borrow up to $2.25 million under our existing bank line-of- credit as of December 31, 2002. This facility consists of two components: (a) a demand working capital line of credit which will enable the Company to borrow up to the lesser of $1.75 million or the borrowing base; and (b) a $500,000 transaction specific revolving demand export line of credit for short-term financing. The amount available will be the lesser of $500,000 or the borrowing base. The Company's borrowing base under the first facility equals the sum of 90% of eligible government billed accounts receivable, 80% of the eligible commercial billed accounts receivable and 20% of eligible related inventory capped at $500,000. The Company's borrowing base under the second facility equals the sum of 75% of the eligible export-related inventory and 90% of the eligible export-related accounts receivable. This facility is guaranteed 90% by the Export-Import Bank of the United States ("Ex-Im Bank") under Ex-Im Bank's Working Capital Guarantee Program. Both facilities carry interest at the rate of PRIME plus 1.25%, floating.

        Optelecom is required to comply with certain financial ratios including maintaining a minimum current ratio, a maximum debt to worth ratio, a maximum funded debt to EBITDA ratio and a minimum tangible net worth ratio. The Company was not in violation of any of these covenants at December 31, 2002.

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

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processes which will increase manufacturing efficiencies. Management fully understands the costs required to execute this strategy and will pursue these initiatives in a timely and fiscally prudent manner.

        The following are our contractual obligations associated with debt obligations and lease commitments:

(1)

Operating leases include our office space in the U.S. and the U.K. Total rental expense under these leases for fiscal year 2002 was $263,342.

(2)

Capital lease obligations relate to computer and test equipment.

NEW ACCOUNTING STANDARDS

        In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" (SFAS 144). The Statement supersedes FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of "(SFAS 121), however it retains the fundamental provisions of that statement related to the recognition and measurement of the impairment of long-lived assets to be held and used. SFAS 144 is effective for the Company beginning December 15, 2002. The Company does not expect the provisions of SFAS 144 to have a material impact on its financial position, results of operations or liquidity.

        In June 2002, the FASB issued Statement of Financial Accounting Standard Statement of Financial Accounting Standards No. 146, "Accounting for Costs Associated With Exit or Disposal Activities". SFAS 146 nullifies previous accounting guidance and requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The provisions of SFAS 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The Company does not expect the adoption of this statement to have a material impact on its financial position, results of operations or liquidity.

CRITICAL ACCOUNTING POLICIES

        Optelecom's discussion and analysis of its financial condition and results of operations are based upon Optelecom's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires Optelecom to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, Optelecom evaluates its estimates, including those related to product returns, bad debts, inventories, income taxes, financing operations, warranty obligations, and contingencies and litigation. Optelecom bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

        We consider certain accounting policies related to revenue recognition, valuation of accounts receivable, inventory and stock-based compensation to be critical to our business operations and the

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understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout Management's Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Notes to the Consolidated Financial Statements in Item 14 of this Annual Report on Form 10-K.

        Revenue Recognition—Revenue from commercial sales is recognized when product is shipped and accepted. Revenues from fixed-price contracts, such as contracts from the government, are recognized on the percentage-of-completion method, which relies on estimates of total expected contract revenue and costs. Optelecom follows this method since reasonably dependable estimates of the revenue and costs applicable to various stages of a contract can be made. Recognized revenues and profit are subject to revisions as the contract progresses to completion. Revenues from time-and-materials contracts are recorded at the contract rates times the labor hours plus other direct costs as incurred.

        Allowance for Doubtful Accounts—Optelecom maintains allowances for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. If the financial condition of Optelecom's customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

        Inventories—Production materials are valued at the lower of cost or market applied on a standard cost basis. Work-in-process represents direct labor, materials, and overhead incurred on products not delivered to date. Finished goods inventories are valued at the lower of cost or market, cost being determined using standards that approximate actual costs on a specific identification basis. Optelecom writes down its inventory for estimated obsolescence or unmarketable inventory based upon assumptions about future demand and market conditions as well as historical inventory turnover. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

        Stock-based Compensation—We account for stock-based compensation in accordance with Accounting Principles Board Opinion (ABP) NO. 25 "Accounting for Stock Issued to Employees" using the intrinsic value method. Accordingly, we do not recognize any stock compensation expense related to the granting of stock options with an exercise price equal to the fair value of our stock. We do not recognize stock compensation expense relating to the granting of stock options when the exercise price is deemed to be less than the fair market value of our stock and, also, when we issue restricted stock to employees. In our financial statements, we have made pro forma disclosures required by SFAS No. 148 "Accounting for Stock Based Compensation"using the fair value method.

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS

        Market risk is the potential change in an instrument's value caused by, for example, fluctuations in interest and currency exchange rates. The Company has not purchased any futures contracts nor purchased or held any derivative financial instruments for trading purposes during the twelve months ended December 31, 2002 and 2001. The primary market risk exposure is the risk that interest rates on our outstanding borrowings may increase. Optelecom also faces market risk exposure as a result of foreign currency translation adjustments of the Company's foreign subsidiary, Paragon. The Company believes this risk is immaterial.

        Optelecom currently has a bank line-of-credit with aggregate maximum borrowings totaling approximately $0.6 million. An increase in the prime rate (a benchmark pursuant to which interest rates applicable to borrowings under the credit facilities may be set) equal to another 100 basis points to the current prime rate, for example, would have increased our consolidated interest by approximately $12,000 for the twelve months ended December 31, 2002. Optelecom has not entered into any hedging arrangements with respect to the interest obligations under these lines of credit.

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CERTAIN RISKS OF FOREIGN OPERATIONS

        In December 1997, Optelecom purchased Paragon which operates primarily in countries outside the United States and is subject to certain risks such as currency exchange rates. There can be no assurances that these factors will not have an adverse impact on our future international sales or operating results. We do not currently enter into foreign currency hedging transactions and therefore may be exposed to possible losses on international transactions.

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Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

OPTELECOM, INC.

Consolidated Financial Statements as of December 31, 2002 and 2001, and the
Three Years in the period ended December 31, 2002, and Independent Auditors' Reports

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OPTELECOM, INC.

TABLE OF CONTENTS

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INDEPENDENT AUDITORS' REPORT

To the Board of Directors and
Stockholders of Optelecom, Inc.
Gaithersburg, Maryland

        We have audited the accompanying consolidated balance sheet of Optelecom, Inc. and subsidiaries (the Company) as of December 31, 2002, and the related consolidated statements of operations, stockholders' equity and cash flows for the year ended December 31, 2002. Our audits also included the financial statement schedule listed in the index at Item 14 for the year ended December 31, 2002. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audit.

        We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

        In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2002, and the results of its operations and its cash flows for the year ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule for the year ended December 31, 2002, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

ERNST & YOUNG, LLP

McLean, Virginia
February 14, 2003

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INDEPENDENT AUDITORS' REPORT

To the Board of Directors and
Stockholders of Optelecom, Inc.
Gaithersburg, Maryland

        We have audited the accompanying consolidated balance sheets of Optelecom, Inc. and subsidiaries (the Company) as of December 31, 2001, and the related consolidated statements of operations, comprehensive loss, stockholders' equity and cash flows for each of the two years ended December 31, 2001. Our audits also included the financial statement schedule as of December 31, 2001 and for each of the two years ended December 31, 2001 listed in the index at Item 14. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.

        We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

        In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2001, and the results of its operations and its cash flows for each of the two years ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

DELOITTE & TOUCHE LLP

McLean, Virginia
March 8, 2002

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OPTELECOM, INC.
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31,

See notes to consolidated financial statements.

28

OPTELECOM, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31,

See notes to consolidated financial statements.

29

OPTELECOM, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31,

See notes to consolidated financial statements.

30

OPTELECOM, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000

See notes to consolidated financial statements.

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OPTELECOM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000

1.    NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

        Nature of Business—Optelecom, Inc. (the Company) is a Delaware corporation that was organized in 1972. The Company designs, manufactures and markets video communication products, specializing in transmission and distribution equipment for the delivery of real time video.

        Optelecom reorganized its operations during 2001 into three operating segments: the Optical Products Unit which develops, manufactures, and sells optical fiber based data communication equipment to both commercial and government clients; the Electro-Optics Unit which fabricates precision-wound coils of optical fiber used in fiber optic gyroscopes, and the Copper Products unit, which is focused on the delivery and distribution of video systems over Category5 (CAT5) copper cabling as the transmission medium. Segment information for all prior periods has been restated to conform to the current presentation.

        Principles of Consolidation—The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Optelecom UK Limited (Optelecom UK), and Paragon Audio Visual Limited. All significant inter-company transactions and balances have been eliminated.

        Use of Estimates—The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

        Revenue Recognition—Revenue from commercial sales is recognized when product is shipped and accepted. Revenues from fixed-price contracts, such as contracts from the government, are recognized on the percentage-of-completion method based on costs incurred in relation to total estimated costs. Revenues from time-and-materials contracts are recorded at the contract rates times the labor hours plus other direct costs as incurred.

        Inventories—Production materials are valued at the lower of cost or market applied on a weighted average cost basis. Work-in-process represents direct labor, materials, and overhead incurred on products not delivered to date. Finished goods inventories are valued at the lower of cost or market, cost being determined using standards that approximate actual costs on a specific identification basis.

        Property, Equipment, and Depreciation—Property and equipment are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which range from 5 to 10 years. Leasehold improvements are amortized over the terms of the respective leases or the service lives of the assets, whichever is shorter.

        Impairment of Long-Lived Assets—The Company periodically reviews the carrying value of long-lived assets including intangible assets, goodwill and property and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable. In 2000, the Company wrote off all unamortized intangibles and goodwill.

        Research and Development Costs—Research and development costs are expensed as incurred as a component of engineering expense in the consolidated statements of operations. The Company incurred research and development costs of $847,000, $958,000 and $1,033,000 for the years ended December 31, 2002, 2001 and 2000, respectively.

        Income Taxes—The Company accounts for income taxes using the asset and liability approach as defined by FASB No. 109. Under this method, deferred tax assets and liabilities are determined based

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on the difference between financial reporting and tax basis of assets and liabilities based on expected tax rates at the point the items are expected to reverse. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

        Stock-Based Compensation—SFAS No. 123, Accounting for Stock-Based Compensation, allows companies to account for stock-based compensation using either the provisions of SFAS No. 123 or the provisions of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, but requires pro forma disclosure in the notes to the financial statements as if the measurement provisions of SFAS No. 123 had been adopted. The Company accounts for its stock-based employee compensation in accordance with APB No. 25. Stock-based compensation related to options granted to nonemployees is accounted for using the fair value method in accordance with the SFAS No. 123 and EITF 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

        The following table illustrates the effect on net income (loss) attributable to common stockholders and net income (loss) per common share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation.

        The effect of applying SFAS No. 123 on a pro forma net loss as stated above is not necessarily representative of the effects on reported net loss for future years due to, among other things, the vesting period of the stock options and the fair value of additional options to be granted in the future years.

        The weighted-average fair value of options granted during 2002, 2001, and 2000 was $3.15, $1.67 and $4.52, respectively. The fair value of each option is estimated on the date of grant using the minimum value option-pricing model with the following assumptions used for grants issued during the years ended December 31, 2002, 2001, and 2000:

        Foreign Currency Translation—The Company translates the assets and liabilities of its foreign subsidiaries into U.S. dollars at the current exchange rate in effect at the end of the year. The gains and losses that result from this process, and gains and losses on inter-company transactions that are long-term in nature and that the Company does not intend to repatriate, are shown in the foreign currency translation adjustment balance in the stockholder's equity section of the balance sheet. The revenue and expense accounts of the foreign subsidiaries are translated into U.S. dollars at the average rates that prevailed during the period.

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        Cash and Cash Equivalents—For the purpose of presentation in the statements of cash flows, cash and cash equivalents are defined as cash and liquid investments with original maturities of three months or less.

        Restricted Certificate of Deposit—The Company has provided a performance bond in relation to a contract which is secured by a letter of credit in the amount of $129,368. This letter of credit is fully collateralized by a certificate of deposit. The certificate of deposit is redeemable by the Company upon the satisfactory completion of the contract in 2005.

        Fair Value of Financial Instruments—The fair value of the Company's trade receivables, trade payables and the revolving credit agreement approximate their carrying amount because of the short maturity of these instruments.

        Presentation—Certain amounts from prior years have been reclassified to conform to the current year presentation.

2.    ACCOUNTS AND CONTRACTS RECEIVABLE

        Accounts and contracts receivable consisted of the following at December 31:

3.    INVENTORIES

        Inventories consisted of the following at December 31:

4.    INTANGIBLE ASSETS AND GOODWILL

        In 2000, Optelecom determined that the intangible assets associated with Paragon Audio Visual, Ltd., were impaired under the requirements of Financial Accounting Standards 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." The value of the technology originally purchased from Paragon was determined to have no future value to Optelecom. In addition, Paragon was marketing the new products to a different client base. Therefore the old customer list had no future value. The Paragon Audio Visual, Ltd. company name had value in the marketplace only by being associated with Optelecom, Inc. and the new products and client base it was serving. As such, the value of the name had no future value to Optelecom. In 2000, the remaining balance of these intangibles assets of $1.7 million was written off.

        Furthermore, as a result of the impairment of the intangible assets and the value of the other assets originally acquired, the excess value assigned over the purchase price associated with goodwill was also impaired. Also in 2000, the remaining balance of goodwill of $0.2 million was written off.

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5.    PROPERTY AND EQUIPMENT

        Property and equipment at December 31 consisted of the following: