ADVANCED FIBRE COMMUNICATIONS INC, 10-Q, 1999-05-07

ADVANCED FIBRE COMMUNICATIONS INC
10-Q, 1999-05-07
TELEPHONE & TELEGRAPH APPARATUS

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<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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

FORM 10-Q

[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 1999

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

For the transition period from ____________ to____________

Commission file number: 0-28734

ADVANCED FIBRE COMMUNICATIONS, INC.
-----------------------------------

A Delaware I.R.S. Employer
Corporation Identification No.
68-0277743

One Willow Brook Court
Petaluma, California 94954

Telephone: (707) 794-7700

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

Yes [X] No [ ]

As of April 30, 1999, 76,691,102 shares of the Registrant's Common Stock, $0.01
par value, were outstanding.

<PAGE> 2

ADVANCED FIBRE COMMUNICATIONS, INC.
REPORT ON FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1999

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
PART I. FINANCIAL INFORMATION

Item 1. Financial Statements
Condensed Consolidated Balance Sheets
March 31, 1999 and December 31, 1998..............................................2
Condensed Consolidated Statements of Income
Three months ended March 31, 1999 and 1998........................................3
Condensed Consolidated Statements of Cash Flows
Three months ended March 31, 1999 and 1998........................................4
Notes to Condensed Consolidated Financial Statements..................................5
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations....8

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.......................................................................21
Item 2. Changes in Securities and Use of Proceeds...............................................22
Item 3. Defaults Upon Senior Securities.........................................................22
Item 4. Submission of Matters to a Vote of Security Holders.....................................22
Item 5. Other Information.......................................................................22
Item 6. Exhibits and Reports on Form 8-K........................................................22
</TABLE>

1
<PAGE> 3

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

ADVANCED FIBRE COMMUNICATIONS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
(Unaudited)

<TABLE>
<CAPTION>
March 31, December 31,
1999 1998
--------- ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 43,195 $ 20,669
Marketable securities 91,432 90,084
Accounts receivable, net 64,588 74,967
Inventories, net 47,194 53,060
Other current assets 7,912 8,257
--------- ---------
Total current assets 254,321 247,037

Property and equipment, net 52,619 49,315
Other assets 10,556 11,531
--------- ---------
TOTAL ASSETS $ 317,496 $ 307,883
========= =========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 13,183 $ 12,573
Accrued liabilities 27,249 25,140
--------- ---------
Total current liabilities 40,432 37,713

Long-term liabilities 2,171 1,870

Commitments and contingencies

Stockholders' equity:
Preferred stock, $0.01 par value; 5,000,000 shares authorized in
1999 and 1998; no shares issued and outstanding -- --
Common stock, $0.01 par value; 200,000,000 shares authorized
in 1999 and 1998; 76,630,975 and 75,716,153 shares
issued and outstanding in 1999 and 1998, respectively 766 757
Additional paid-in capital 213,845 210,420
Notes receivable from stockholders (583) (730)
Retained earnings 60,865 57,853
--------- ---------
Total stockholders' equity 274,893 268,300
--------- ---------

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 317,496 $ 307,883
========= =========
</TABLE>

See accompanying notes to condensed consolidated financial statements

2
<PAGE> 4

ADVANCED FIBRE COMMUNICATIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
(Unaudited)

<TABLE>
<CAPTION>
Three Months Ended
March 31,
--------------------
1999 1998
------- -------
<S> <C> <C>
Revenues $64,966 $85,744
Cost of revenues 35,482 45,575
------- -------
Gross profit 29,484 40,169
------- -------

Operating expenses:
Research and development 11,606 8,312
Selling, general and administrative 14,876 14,761
------- -------
Total operating expenses 26,482 23,073
------- -------

Operating income 3,002 17,096

Other income, net 1,494 1,145
------- -------
Income before income taxes 4,496 18,241

Provision for income taxes 1,484 6,384
------- -------

Net income $ 3,012 $11,857
======= =======

Basic net income per share $ 0.04 $ 0.16
======= =======

Shares used in basic per share computations 76,098 73,838
======= =======

Diluted net income per share $ 0.04 $ 0.15
======= =======

Shares used in diluted per share computations 79,442 79,134
======= =======
</TABLE>

See accompanying notes to condensed consolidated financial statements

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ADVANCED FIBRE COMMUNICATIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

<TABLE>
<CAPTION>
Three Months Ended
March 31,
-----------------------
1999 1998
-------- --------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 3,012 $ 11,857
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Depreciation and amortization 2,780 1,115
Tax benefit from option exercises 1,916 3,210
Deferred incomes taxes 333 (229)
Changes in operating assets and liabilities:
Accounts receivable 10,379 (12,403)
Inventories 5,866 (7,739)
Other assets 812 (4,100)
Accounts payable 610 3,835
Other liabilities 2,430 (3,290)
-------- --------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES 28,138 (7,744)
-------- --------

CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES:
Net sales (purchases) of marketable securities (1,348) 13,102
Property and equipment additions, net (5,908) (8,009)
-------- --------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES (7,256) 5,093
-------- --------

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of common stock options and warrants, net 1,644 2,297
-------- --------
NET CASH PROVIDED BY FINANCING ACTIVITIES 1,644 2,297
-------- --------

INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 22,526 (354)

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 20,669 9,053
-------- --------

CASH AND CASH EQUIVALENTS, END OF PERIOD $ 43,195 $ 8,699
======== ========
</TABLE>

See accompanying notes to condensed consolidated financial statements

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<PAGE> 6

ADVANCED FIBRE COMMUNICATIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and pursuant to the rules and regulations of the
Securities and Exchange Commission. While these financial statements reflect all
adjustments of a normal and recurring nature which are, in the opinion of
management, necessary to present fairly the results of the interim period, they
do not include all information and footnotes required by generally accepted
accounting principles for complete financial statements. These financial
statements and notes should be read in conjunction with the financial statements
and notes thereto, for the year ended December 31, 1998, contained in the
Company's Annual Report on Form 10-K.

The unaudited condensed consolidated financial statements include Advanced Fibre
Communications, Inc., and its subsidiaries ("AFC" or the "Company"). Significant
intercompany transactions and accounts have been eliminated. Certain prior
period amounts have been reclassified to conform to the current period
presentation.

AFC operates on 13-week fiscal quarters ending on the last Saturday of each
fiscal period. For presentation purposes only, the fiscal periods are shown as
ending on the last day of the month of the respective fiscal period. The results
of operations for the three-month period ended March 31, 1999 are not
necessarily indicative of the operating results for the full year.

NOTE 2 INVENTORIES

Inventories are valued at the lower of first-in, first-out cost or market and
consisted of the following (in thousands):

<TABLE>
<CAPTION>
March 31, December 31,
1999 1998
--------- ------------
<S> <C> <C>
Raw materials $12,387 $16,135
Work-in-progress 903 566
Finished goods 33,904 36,359
------- -------

Inventories, net $47,194 $53,060
======= =======
</TABLE>

NOTE 3 COMMITMENTS AND CONTINGENCIES

ALCATEL USA/DSC. In 1997, AFC filed a lawsuit against DSC Communications
Corporation ("DSC") related to AFC's hiring of a former DSC employee. In 1998,
DSC was acquired and is now a part of Alcatel USA, Inc. For purposes of this
footnote, reference is made only to DSC. The Company's complaint responded to
DSC's litigation threats, and sought a declaratory judgment that its hiring of
the former DSC employee was lawful. Following various motions and
cross-complaints filed during 1998 and early 1999, DSC agreed to dismiss the
entire action with prejudice, and in early February 1999, the Company and DSC
filed a joint Request For Dismissal of the entire action with the Court.

During 1998, DSC filed a separate claim in the United States District Court,
Eastern District of Texas, against the Company for patent infringement, alleging
that AFC's 3GDLC product infringes a DSC patent. Certain discovery occurred
during 1998, and the parties filed various motions, including cross-motions for
summary judgment on the Company's defense that a prior Settlement Agreement
between the Company and DSC barred DSC's patent claims. The Company filed a
counterclaim against DSC in the patent action alleging federal antitrust
violations, unfair competition, breach of a prior settlement agreement and other
related claims. By a Report And Recommendation filed October 2, 1998, the United
States Magistrate Judge recommended that the District Court grant summary
judgment in the Company's favor on the patent claim

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<PAGE> 7

based on the Settlement Agreement. DSC filed an Objection to this ruling with
the District Court on October 16, 1998, and the matter remains pending.

Based on reviews of the patent claim, the Company believes that AFC's 3GDLC
product does not infringe the DSC patent, and that the Company has meritorious
defenses to such claim. The Company intends to vigorously defend the litigation
against DSC, and to prosecute its claims against DSC. However, the ultimate
outcome of these lawsuits cannot be predicted. In addition, patent litigation is
highly complex and can extend for a protracted period of time, which can divert
the attention of management and technical personnel, and require the Company to
incur substantial costs and expenses. If the patent claim were to be resolved
against AFC, this could have a material adverse effect on the Company's
business, results of operations and financial condition.

RELTEC CORPORATION. In 1997, AFC filed a lawsuit against RELTEC Corporation,
alleging trade secret misappropriation, tortious interference with a contract,
and related claims. The case involves RELTEC's acquisition of AFC's technology
through the Company's Taiwan-based licensee, Vidar-SMS Co., Ltd. Discovery
occurred during the quarter, and trial is scheduled to start in mid to late
1999.

STOCKHOLDER LITIGATION. The Company and various of its current and former
officers and directors are parties to a consolidated lawsuit which purports to
be a class action filed on behalf of certain of AFC's stockholders (excluding
the defendants and parties related to them). The lawsuit alleges that the
defendants violated certain federal securities laws. The plaintiffs filed a
consolidated Amended Complaint on or about January 27, 1999. A hearing on
defendants' motion to dismiss the complaint is scheduled for mid 1999. Limited
discovery has occurred, and only limited discovery is expected to occur pending
ruling on the motion to dismiss.

All of these actions are in the early stages of proceedings and the Company is
currently investigating the allegations. Based on its current information, the
Company believes the suit to be without merit and intends to defend itself and
its officers and directors vigorously. Although it is reasonably possible AFC
may incur a loss upon the conclusion of this claim, an estimate of any loss or
range of loss cannot be made.

No provision for any liability that may result upon adjudication has been made
in the Company's consolidated financial statements. In the opinion of
management, resolution of this matter is not expected to have a material adverse
effect on the financial position of AFC. However, depending on the amount and
timing, an unfavorable resolution of this matter could materially affect the
Company's future results of operations or cash flows in a particular period. In
connection with these legal proceedings, the Company expects to incur
substantial legal and other expenses. Stockholder suits of this kind are highly
complex and can extend for a protracted period of time, which can substantially
increase the cost of such litigation and divert the attention of the Company's
management.

NOTE 4 COMPREHENSIVE INCOME

AFC has adopted the provisions of Statement of Financial Accounting Standards
("SFAS") No. 130, Reporting Comprehensive Income. SFAS No. 130 requires
classification of items of other comprehensive income by nature in a financial
statement and disclosure of the accumulated balance of other comprehensive
income separately from retained earnings and additional paid-in capital in the
equity section of the balance sheets. Reporting comprehensive income provides a
measure of all changes in equity that result from recognized transactions and
other economic events of the period other than transactions with owners in their
capacity as owners. Additional disclosures required by this statement have not
been included in the condensed consolidated financial statements because there
are no material differences between AFC's net income and comprehensive income
for all periods presented.

NOTE 5 SEGMENT REPORTING

During the fourth quarter of 1998, the Company adopted the provisions of SFAS
No. 131, Disclosures About Segments of an Enterprise and Related Information.
SFAS No. 131 establishes annual and interim reporting standards for operating
segments of a company. On an interim basis, this Statement requires disclosure
of selected segment-related financial information. AFC derives substantially all
of its revenues from sales of one product, the Universal Modular Carrier
1000(TM) (the "UMC 1000"), and is not organized by multiple operating segments
for the purpose of making operating

6
<PAGE> 8

decisions or assessing performance. Accordingly, the Company operates in one
operating segment and reports only certain enterprise-wide disclosures.

For the three months ended March 31, 1999, revenues from sales to external
customers were $64,865,000, compared with $82,033,000 in the same period of
1998. AFC operates in one operating segment; thus, there is no difference
between reportable income and the Company's consolidated income. Long-lived
assets located in the U.S. increased to $61,844,000 as of March 31, 1999 from
$59,368,000 as of December 31, 1998. Long-lived assets located in foreign
countries decreased to $1,293,000 as of March 31, 1999 from $1,393,000 as of
December 31, 1998.

NOTE 6 NET INCOME PER SHARE

Basic earnings per share were calculated by dividing net income by the weighted
average number of common shares outstanding during the period. Diluted earnings
per share were calculated by dividing net income by the sum of the weighted
average number of common shares outstanding plus all additional common shares
that would have been outstanding if potentially dilutive common shares had been
issued. The following table sets forth the computations of shares and net income
used in the calculation of basic and diluted net income per share for the
quarterly periods ended March 31, 1999, and 1998 (in thousands, except per share
data):

<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
----------------------
1999 1998
------- -------
<S> <C> <C>
Net income $ 3,012 $11,857
======= =======

Shares used in basic per share calculations - actual
weighted average common shares outstanding for the period 76,098 73,838

Weighted average number of shares upon conversion of
redeemable convertible preferred stock -- --
Weighted average number of shares upon exercise of
dilutive options and warrants 3,344 5,296
------- -------
Shares used in diluted per share calculations 79,442 79,134
======= =======

Basic net income per share $ 0.04 $ 0.16
======= =======
Diluted net income per share $ 0.04 $ 0.15
======= =======
</TABLE>

7
<PAGE> 9

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Except for the historical financial information contained herein, the following
discussion and analysis may contain "forward-looking statements" within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended. Such statements include
declarations regarding the intent, belief or current expectations of the Company
and its management. Prospective investors are cautioned that any such
forward-looking statements are not guarantees of future performance and involve
a number of risks and uncertainties; actual results could differ materially from
those indicated by such forward-looking statements.

Among the important factors that could cause actual results to differ materially
from those indicated by such forward-looking statements, as set forth below
under "Certain Factors That Might Affect Future Operating Results," are:

- - Potential Fluctuations in Future Operating Results and Seasonality

- - Customer Concentration

- - Risks Associated with International Markets

- - Delays in Product Development and Product Feature Releases

- - Competition

- - Risk of Failure to Manage Expanding Operations

- - Concentrated Product Line, New Product Features and Rapid Technological
Change

- - Risks Associated with Pending Litigation

- - Limited Protection of Proprietary Technology; Risk of Third-Party Claims of
Infringement

- - Dependence on the Telecommunications Industry and Small to Mid-Line Size
Market

- - Dependence on Sole Source and Limited Number of Third-Party Manufacturers
and Support Organizations

- - Dependence on Key Personnel

- - Year 2000 Readiness

- - Compliance with Regulations and Industry Standards

- - Other risks identified from time to time in the Company's Reports and
Registration Statements filed with the Securities and Exchange Commission

The following discussion should be read in conjunction with the Financial
Statements and Notes thereto, on pages 2 through 7 of this Form 10-Q.

OVERVIEW

AFC designs, develops, manufactures, markets and supports the Universal Modular
Carrier 1000(TM) ("UMC 1000"), a cost-effective multi-service digital loop
carrier system developed to serve small to mid-line size markets. The UMC 1000
is designed to enable telecommunications companies and other service providers
to connect subscribers to the central office switch for voice and data
communications over copper, fiber and analog radio networks. The Third
Generation Digital Loop Carrier(TM) ("3GDLC") is an enhanced version of the UMC
1000 designed to accommodate the bandwidth and connectivity requirements of
current and future local loop applications.

RESULTS OF OPERATIONS

REVENUES. For the three months ended March 31, 1999, revenues decreased $20.7
million, or 24.2%, to $65.0 million compared with $85.7 million for the same
period of 1998. The decrease in revenues in the first quarter of 1999 from the
comparable period in 1998 was primarily due to lower international sales.
International revenues totaled $8.7 million in the first quarter of 1999,
compared with $30.2 million for the comparable period in 1998, and represented
13.4% and 35.3% of total revenues, respectively. Revenues from sales to
customers in South Africa and France, which accounted for an aggregate of 24.0%
of total revenues in the first quarter of 1998, declined in the first quarter of
1999 to an aggregate of 4.1% of total revenues. The Company also experienced
lower royalty income levels in the period ended March 31, 1999 as compared with
the comparable period of 1998.

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<PAGE> 10

Domestic revenues in the first quarter of 1999 were $56.3 million as compared
with $55.5 million in the first quarter of 1998, an increase of 1.4%. In the
period ended March 31, 1999, sales to WinStar Communications, Inc. increased
over the prior year's comparable period, but were offset by the decrease in
sales to GTE Communication Systems, a customer accounting for 10.5% of total
revenues in the first quarter of 1998. Another factor affecting domestic
revenues was the industry-wide shift to GR-303 and TR-08 digital interfaces in
the access market, a trend the Company expects to continue. Although the number
of lines purchased increased, the transition to digital interfaces reduces the
number of line cards the customer requires in the central office. During the
quarter ended March 31, 1999, the Company experienced a shift in domestic
customer-buying patterns resulting in increased shipments of the 3GDLC
incorporating the GR-303 interface. AFC believes this technology transition
currently results in an approximate 20% to 30% decrease in price per line. The
Company expects the V5 digital interface designed for international markets will
result in a similar reduction in price per line.

For the quarter ended March 31, 1999, Sprint North Supply accounted for 13.5% of
total revenues, WinStar Communications, Inc. ("WinStar") accounted for 11.7%,
and ALLTEL Supply, Inc. accounted for 10.2%. For the quarter ended March 31,
1998, Integrators of System Technology (Pty) LTD in South Africa accounted for
13.2% of total revenues, France Telecom accounted for 10.7%, and GTE accounted
for 10.5%. No other customer accounted for 10% or more of total revenues in
either period. Although the Company's largest customers have varied from period
to period, the Company anticipates that its results of operations in any given
period will continue to depend to a significant extent upon sales to a small
number of customers. AFC currently expects that sales to WinStar in the second
quarter of 1999 will decrease from the first quarter's level. There can be no
assurance that the Company's principal customers will continue to purchase
product from the Company at current levels, if at all. The loss of one or more
major customers could have a material adverse effect on the Company's business,
financial condition and results of operations.

GROSS PROFIT. For the three months ended March 31, 1999, gross profit decreased
to $29.5 million from $40.2 million for the comparable period of 1998, and
represented gross margins of 45.4% and 46.8%, respectively.

The decline in gross margins in the first quarter from 1998 to 1999 was
primarily due to lower royalty income levels and higher manufacturing costs. In
the future, gross profit may fluctuate due to a wide variety of factors,
including: the mix between domestic and international sales, the customer mix,
the product component mix, the timing and size of orders which are received and
can be shipped in a quarter, the availability of adequate supplies of key
components and assemblies, the Company's ability to introduce new products and
technologies on a timely basis, the timing of new product feature introductions
or announcements by the Company or its competitors, price competition, unit
volume, royalty revenues, and changes in warranty coverage.

RESEARCH AND DEVELOPMENT. For the three months ended March 31, 1999, research
and development expenses increased 39.8% to $11.6 million compared with $8.3
million for the same period in 1998. Research and development expenses
represented 17.9% and 9.7% of total revenues in the first quarters of 1999 and
1998, respectively.

The increase in research and development expenses from 1998 to 1999 for the
first quarter was primarily due to increased salaries and benefits and facility
costs related to the addition of personnel in engineering, and costs associated
with material and test equipment used to develop and test new product features.
As of March 31, 1999, the number of employees in research and development was
300 compared with 185 as of March 31, 1998, an increase of 62.2%. The Company
plans to continue to support the development of new product features and design
changes for product cost reductions. However, in the short term, the Company
expects that growth in research and development expenses and headcount will not
continue at rates experienced in the early half of 1998. All research and
development costs to date have been expensed as incurred.

SELLING, GENERAL AND ADMINISTRATIVE. For the three months ended March 31, 1999,
selling, general and administrative expenses increased 0.7% to $14.9 million
compared with $14.8 million for the same period in 1998. Selling, general

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<PAGE> 11

and administrative expenses represented 22.9% and 17.2% of revenues for the
first quarter of 1999 and 1998, respectively.

The net increase in selling, general and administrative expenses in the first
quarter of 1999 as compared with 1998 reflects several factors, including an
increase in litigation costs and compensation and benefits, offset in part by a
reduction in various other expenses. Selling, general and administrative
headcount increased 8.7% to 338 as of March 31, 1999 from 311 as of March 31,
1998.

INCOME TAXES. For the three months ended March 31, 1999 and 1998, the Company
recorded income taxes at an effective rate that approximated the combined
federal and state statutory rates. The effective tax rate declined from 35.0% in
the first three months of 1998 to 33.0% in the comparable period of 1999. This
reduction was primarily due to an increase in expected tax credits derived from
research and development, a lower combined effective state income tax expense,
benefits from tax exempt interest income, and the Company's Foreign Sales
Corporation.

LIQUIDITY AND CAPITAL RESOURCES

As of March 31, 1999, the Company's cash and cash equivalents were $43.2
million, compared with $20.7 million as of December 31, 1998. Marketable
securities totaled $91.4 million as of March 31, 1999, compared with $90.1
million as of December 31, 1998.

Operating activities for the three months ended March 31, 1999 generated net
cash of $28.1 million. This was primarily the result of net income, and
decreases in accounts receivable and inventory. Net cash of $7.3 million was
used in investing activities in the first quarter of 1999, primarily as a result
of purchasing fixed assets to support research and development and manufacturing
activities.

AFC has a $50.0 million unsecured bank line through two banks with an interest
rate of prime, or LIBOR, plus 0.75%. The line of credit expires in July 1999.
Under the bank line, the banks may issue letters of credit up to $10.0 million
on behalf of the Company. The bank line requires the Company to comply with
certain debt and financial covenants. As of March 31, 1999, $594,000 in letters
of credit and no borrowings were outstanding under the bank line, and the
Company was in compliance with the covenants contained under the bank line.

The Company also has lease lines totaling $5.1 million that were used for
equipment and furniture purchases.

The Company also maintains bank facilities with two banks under which the
Company may open foreign exchange contracts up to $40.0 million. There are no
borrowing provisions associated with these facilities and there are no financial
covenants associated with the facilities. At March 31, 1999, there were no
foreign exchange contracts outstanding.

The Company's facility obligations and commitments are based in part on
anticipated growth projections, and in the near-term, are relatively fixed.
Based on existing commitments for additional office space, the Company will have
excess office space in the near future. The Company is currently in negotiations
with its landlord to restructure the existing commitments. The Company's results
of operations could be adversely affected if it is unable to, in a timely
manner, restructure its existing commitments or sublease the excess facility
space at rents comparable to the Company's obligations.

The Company believes that its existing cash and short-term investments,
available credit facilities and cash flows from operating and financing
activities will be adequate to support the Company's financial resource needs,
including working capital requirements, capital expenditures and operating lease
obligations for the next twelve months.

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<PAGE> 12

FOREIGN CURRENCY AND INTEREST RATE RISK

The Company is exposed to market risk as a result of foreign exchange rate
fluctuations. The Company sells the UMC 1000 in the Asia Pacific region, an area
in which some of the countries have experienced adverse economic conditions and
the devaluation of certain currencies. The UMC 1000 is sold in this region,
primarily in China, under U.S. dollar denominated contracts. The UMC 1000 is
also marketed in Central and Latin American countries, including Brazil.
Deterioration in the Brazilian economy has resulted in the significant
devaluation of the Brazilian real, and the impact of this downturn on other
countries in the region has yet to be determined. Sales of the UMC 1000 in this
region are made under U.S. dollar denominated contracts. One of AFC's customer
contracts is payable in French francs and the receivable is hedged using forward
currency exchange contracts. The remainder of international sales are
denominated in U.S. dollars. The introduction in 1999 of the "Euro" currency may
cause increased competition among European companies which in turn may cause the
value of the Euro to materially fluctuate relative to the U.S. dollar. Adoption
of the Euro is not expected to have a material impact on AFC's business, results
of operations or financial condition. The Company has sales and representative
offices in China, Hong Kong, Singapore, India, Poland and the U.K. Operating
expenses for these offices have historically been short-term in nature and are
immaterial to the Company on a consolidated basis.

Changes in domestic interest rates create risk for AFC and may cause adverse
fluctuations of its marketable securities portfolio and cash flows. Changes in
short-term U.S. interest rates affect the market value of those marketable
securities. Because of the short-term nature of its investment portfolio, the
Company believes its exposure to these market fluctuations is not significant.
The Company may be affected by changes in the short-term U.S. Prime Rate and the
resulting interest rate on amounts borrowed under its line of credit.

SEASONALITY

AFC's customers normally install a portion of the UMC 1000 in outdoor locations.
Shipments of the UMC 1000 are subject to the effects of seasonality, with fewer
installation projects scheduled for the winter months. The majority of the
Company's sales are to companies in North America, and accordingly, the Company
believes the effect of seasonality will cause its revenues in the quarter ended
March 31 to be lower than revenues in the preceding quarter ended December 31.
In particular, revenues in the quarter ended March 31, 1999 were lower than
revenues in the quarter ended December 31, 1998.

YEAR 2000 READINESS

AFC has formed a Year 2000 Committee to understand and address the year 2000
("Y2K") issue as it affects the Company's infrastructure, operations, and the
UMC 1000 product. Representatives from each functional area of the Company are
responsible for identifying and assessing organizational readiness, preparing
remediation steps, testing, and applying new standards and contingency plans.
AFC has identified and assessed a majority of the potential Y2K-affected
hardware, software, facility equipment, and vendors. For the most part, AFC's
systems and software have been found to be Y2K compliant, or have been upgraded
to compliance through manufacturers' upgrades.

The Company is currently in the process of surveying and testing its vendors'
Y2K readiness and developing its own contingency plans in case of vendors'
failures. Contingency plans for vendor Y2K failures include pre-qualifying
alternative vendor suppliers, maintaining multiple vendor sources for critical
components and assemblies, and maintaining adequate supplies of key components
on hand. However, there can be no assurance that AFC will be able to obtain
sufficient materials from alternative sources. Current or alternative
manufacturers may not be able to meet the Company's supply requirements and such
supplies may not continue to be made available at favorable prices, or at all.

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A survey is currently underway of AFC's leased properties and facilities,
including vendors providing power, local and long distance telecommunications,
water, heating and cooling, and various services to determine the status of
embedded technology equipment that could affect AFC's operations. Temporary
disruption of AFC's manufacturing, customer service, sales and marketing,
research and development, information systems, and administrative functions may
occur as a result of vendors' Y2K non-compliance affecting the delivery of
power, telecommunications, water, and heating and cooling services. The Company
plans to test and validate its internal operations, complete the vendor surveys,
and finalize and implement contingency plans by mid-1999.

The UMC 1000 was originally designed and developed to be Y2K compliant. AFC
utilizes operating systems and software applications that were designed and
developed to properly reflect the year 2000 and subsequent years' data. Although
the Company believes that its products and operating systems are Y2K compliant,
the Company's manufacturing suppliers may utilize equipment or software that is
not compliant. Vendors' failures to adequately address their own Y2K compliance
issues could lead to disruption of services provided by vendors, delays in
delivery of components used to assemble the UMC 1000, and may affect the timing
of AFC's shipment of finished product, any of which could have a material
adverse effect on the Company's business, financial condition and results of
operations.

AFC believes it is taking the steps necessary to understand and resolve the Y2K
issues; however, failure of the Company to adequately address all known and
unknown Y2K compliance issues could have a material adverse affect on AFC's
business, financial condition and results of operations. The remaining Y2K
readiness activities are not expected to result in significant incremental
operating expenses; the Company estimates the cost to complete its Y2K readiness
and contingency plans are not expected to exceed $200,000. Expenditures to date
in relation to Y2K readiness have been immaterial.

CERTAIN FACTORS THAT MIGHT AFFECT FUTURE OPERATING RESULTS

In addition to the other information in this Quarterly Report on Form 10-Q, the
following are important factors that should be considered in evaluating the
Company and its business.

POTENTIAL FLUCTUATIONS IN FUTURE OPERATING RESULTS AND SEASONALITY. AFC's
operating results have been, and will continue to be, affected by a wide variety
of factors, some of which are outside of its control, that could have a material
adverse effect on revenues and results of operations during any particular
period. These factors include:

- - Domestic and International sales mix

- - Customer mix

- - Product component mix

- - Timing and size of orders which are received and can be shipped in a
quarter

- - Availability of adequate supplies of key components and assemblies

- - Ability to introduce new product features and technologies on a timely
basis

- - Timing of new product feature introductions or announcements by the Company
or its competitors

- - Price competition

- - Unit volume

- - Royalty revenue levels

- - Excess or obsolete inventory

- - Adequacy of manufacturing capacity

- - Customers' ability to pay when due

- - Expanded warranty coverage

The UMC 1000 is sold primarily to telecommunications companies installing the
UMC 1000 as part of their access networks. Additions to those networks represent
complex engineering projects, requiring lengthy periods from project

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<PAGE> 14

conceptualization to completion. The UMC 1000 typically represents only a
portion of a given project and, therefore, the timing of product shipment and
revenue recognition is often difficult to forecast. The Company's customers
normally install a portion of the UMC 1000 in outdoor locations. Shipments of
the system can be subject to the effects of seasonality, with fewer installation
projects scheduled for the winter months. The majority of the Company's sales
are to telecommunications companies in the North American region, and
accordingly, the Company believes this seasonality will typically cause revenues
in the quarter ended March 31 to be lower than revenues in the preceding quarter
ended December 31. In developing countries, delays and reductions in the planned
project deployment can be caused by additional factors, including currency
fluctuations, reductions in capital availability due to declines in the local
economy, priority changes in the governments' budgets, political environment and
delays in receiving government approval for deployment of the UMC 1000 system in
the local loop.

AFC's expenditures for research and development, marketing and sales, and
general and administrative functions are based in part on future growth
projections and in the near term are relatively fixed. The Company may be unable
to adjust spending in a timely manner in response to any unanticipated failure
to meet these growth projections. Accordingly, any significant decline in demand
for the UMC 1000 relative to planned levels could have a material adverse effect
on the Company's business, financial condition and results of operations in that
quarter or subsequent quarters.

All of the above factors are difficult to forecast, and these or other factors
could have a material adverse effect on the Company's business, financial
condition and results of operations. As a result, AFC believes that period to
period comparisons are not necessarily meaningful and should not be relied upon
as indications of future performance. There can be no assurance that the Company
will sustain or increase its profitability in the future.

Fluctuations in AFC's operating results may cause volatility in the price of its
Common Stock. It is possible that in any given quarter, revenues or operating
results will be below the expectations of public market analysts and investors.
In such event, the market price of AFC's Common Stock would likely be materially
adversely affected. AFC attempts, through timely press releases and
announcements, to disclose significant factors impacting, or expected to impact,
the business, financial condition and results of operations. However, due to
factors outside the Company's control, there may be little or no meaningful
relationship between the resulting market price of AFC's Common Stock and the
results of operations. Factors outside of the Company's control, such as market
analysts' published expectations and short traders' activities can cause a
material fluctuation in the stock price. Recent periods of volatility in the
market price of AFC's Common Stock resulted in stockholder litigation against
the Company and various officers and directors. Such litigation could result in
substantial costs and a diversion of management's attention and resources, which
could have a material adverse effect on the operating results and financial
condition of the Company. See Part II, - "Legal Proceedings" as it pertains to
this matter on page 21 of this Quarterly Report on Form 10-Q.

CUSTOMER CONCENTRATION. For the quarter ended March 31, 1999, Sprint North
Supply accounted for 13.5% of total revenues, WinStar Communications, Inc.
accounted for 11.7%, and ALLTEL Supply, Inc. accounted for 10.2%. For the
quarter ended March 31, 1998, Integrators of System Technology (Pty) LTD in
South Africa accounted for 13.2% of total revenues, France Telecom accounted for
10.7%, and GTE accounted for 10.5%. No other single customer accounted for 10%
or more of total revenues in either period. The Company's five largest customers
accounted for 43.3% of revenues in the first quarter of 1999 and 49.7% of
revenues in the first quarter of 1998. Although AFC's largest customers have
varied from period to period, the Company anticipates that its results of
operations in any given period will continue to depend to a significant extent
upon sales to a small number of customers. None of AFC's customers have entered
into agreements requiring them to purchase a minimum amount of product from the
Company. There can be no assurance that principal customers will continue to
purchase product at current levels, if at all. In the event that a significant
existing customer merged with another telecommunications company, there can be
no assurance that such customer will continue to purchase AFC's product. The
loss of one or more major customers could have a material adverse effect on the
Company's business, financial condition and results of operations.

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<PAGE> 15

RISKS ASSOCIATED WITH INTERNATIONAL MARKETS. Operating in international markets
subjects AFC to certain risks, including:

- - Political and economic conditions

- - Tariffs or other barriers

- - Staffing and managing international operations

- - Exchange rate fluctuations

- - Exchange and repatriation controls on foreign earnings

- - Changes in regulatory requirements

- - Negative tax consequences

- - Longer sales and payment cycles

- - Collection of accounts receivable

International sales constituted 13.4% of total revenues in the first quarter of
1999 and 35.3% in the first quarter of 1998. AFC's sales to customers in South
Africa and France decreased significantly in the first quarter of 1999 as
compared to the comparable period in 1998. The Company is continuing to
experience certain difficulties in international markets. The economies in some
of the Asia Pacific and Central and Latin America countries have deteriorated
resulting in the devaluation of currencies in certain of these countries. The
Company expects that adverse economic conditions in foreign countries or foreign
currency exchange rates will have a material adverse effect on AFC's business,
financial condition or results of operations. Management is currently in the
process of re-evaluating the Company's international strategies. As part of this
process, the Company has hired a new Chief Executive Officer with international
experience and a new vice president of international operations. There can be no
assurance that the Company will successfully expand its international
operations. Failure to meet revenue projections in the international market
could adversely affect the Company's business, financial condition and results
of operations.

AFC is entering new international markets, which demand significant management
attention and financial commitment. Successful expansion of international
operations and sales in certain markets may depend on AFC's ability to establish
and maintain productive strategic relationships. The Company relies on a number
of third party distributors and sales representatives to market and sell the UMC
1000 outside of North America. There can be no assurance that such distributors
or sales representatives will provide the support and effort necessary to
service international markets effectively. There can be no assurance that the
Company will be able to identify suitable parties for joint ventures or
strategic relationships or, even if such parties are identified, that successful
joint ventures or strategic relationships will result. There can be no assurance
that AFC will be able to increase international sales of the UMC 1000 through
strategic relationships or joint ventures. The failure to do so could
significantly limit the ability to expand international operations and could
adversely affect AFC's business, financial condition and results of operations.

International telecommunications companies are in many cases owned or strictly
regulated by local authorities. Access to such markets is often difficult to
obtain due to trade barriers and established relationships between a government
owned or controlled telecommunications company and its traditional indigenous
equipment suppliers. Many of these companies require extended payment terms and
financing options which increase the risk of nonpayment and may have a material
adverse effect on the Company's cash flows and results of operations. Customers
in certain international markets require AFC to post bid and performance bonds.
Failure to meet delivery schedules could also result in the loss of collateral
posted for the bonds or financial penalties, which could adversely affect the
Company's business, financial condition and results of operations.

International sales are currently primarily U.S. dollar denominated. As a
result, an increase in the value of the U.S. dollar relative to foreign
currencies could make AFC's product less competitive in international markets.
Refer to Part I - "Foreign Currency and Interest Rate Risk" as it pertains to

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<PAGE> 16

this matter on page 11 of this Quarterly Report on Form 10-Q.

Compliance with various country-specific regulations and standards must be
attained to compete in international markets. Any inability to obtain local
regulatory approval could delay or prevent entrance into international markets,
which could materially impact the Company's business, financial condition and
results of operations.

DELAYS IN PRODUCT DEVELOPMENT & PRODUCT FEATURE RELEASES. AFC has experienced
delays in completing development and introduction of new product variations and
feature enhancements, and there can be no assurance that such delays will not
continue or recur in the future. The Company could incur contract penalties
should it fail to meet production and delivery time schedules on certain orders.
There can be no assurance that the Company will be successful in developing new
product features and releasing products to the market before its competitors do
so, which could have a material adverse effect on the Company's business,
financial condition and results of operations. The UMC 1000 contains a
significant amount of complex hardware and software that may contain undetected
or unresolved errors that may become apparent as product features are
introduced, or as new versions are released. Technical difficulties have been
discovered in certain system installations. It is possible that, despite
significant testing, hardware or software errors will be found in the UMC 1000
after commencement of shipments, resulting in delays in, or cancellation of,
customer orders, payment of contract penalties to customers, or the loss of
market acceptance. Any of these factors could have a material adverse effect on
the Company's business, financial condition and results of operations.

COMPETITION. Many of AFC's competitors have more extensive financial, marketing
and technical resources than the Company and enjoy superior name recognition in
the market. Primary competitors include: ADC Telecommunications, Inc., Alcatel
Alsthom Compagnie, Ericsson Inc., Fujitsu America, Inc., Hitron Technology,
Inc., Huawei Technologies Co. Ltd., Lucent Technologies, Inc., NEC America,
Inc., Nokia Telecommunications, Northern Telecom Ltd., Opnet Technologies Co.
Ltd., RELTEC Corporation, Shenzhen Zhongxing Telecom Corporation, Ltd., UT
Starcom, Inc., and Vidar-SMS Co. Ltd.

As a result of the Settlement Agreement and related agreements entered into with
the Industrial Technology Research Institute, certain of its Member Companies
have been granted certain rights to manufacture and sell the European
Telecommunications Standards Institute version of the UMC 1000 outside of North
America. Such entities currently compete with AFC in international markets,
primarily in China. Upon termination of certain restrictions set forth in such
agreements, in January 2005, such Member Companies will have a worldwide,
non-exclusive, royalty-free, irrevocable license to use certain UMC 1000
technology and, consequently, such Member Companies will be able to compete with
the Company worldwide at such time. The Company has successfully settled its
litigation against Acer Netxus, Inc. ("Acer"). Among other things, the
Settlement Agreement and a related Federal Court judgment permanently enjoin
Acer from developing, manufacturing, or selling any product that uses or derives
from the UMC 1000 technology.

The Company believes rapid technological change, continuing regulatory change
and industry consolidation will continue to cause rapid evolution in the
competitive environment of the telecommunications equipment market, the full
scope and nature of which is difficult to predict. Moreover, the Company
believes that technological and regulatory change will continue to attract new
entrants to the market in which the Company competes. There can be no assurance
that AFC will be able to compete successfully in the future.

RISK OF FAILURE TO MANAGE EXPANDING OPERATIONS. AFC has experienced a period of
rapid growth over the last several years, which has imposed significant burdens
on AFC's management, operational, financial and other resources. AFC needs to
continue to recruit, train, assimilate, motivate and retain qualified managers
and employees to effectively manage its operations. The Company's results of
operations could be adversely affected if revenues do not increase sufficiently
to compensate for any increase in operating expenses and facility obligations
resulting from anticipated expansion. Any business disruption or other system
transition difficulties could have a material adverse effect on the Company's
business, financial condition and results of operations. The failure of the
Company to effectively manage its domestic and international operations or any
current or future growth could have a material adverse effect on the Company's
business, financial condition and results of operations.

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<PAGE> 17

There can be no assurance that the Company will not have excess manufacturing
capacity or that further utilization of its manufacturing and distribution
facility will continue without interruption. Any such interruption could have a
material adverse effect on the Company's business, manufacturing and
distribution functions.

The Company's facility obligations and commitments are based in part on
anticipated growth projections, and in the near term are relatively fixed. Based
on existing commitments for additional office space, AFC will have excess office
space in the future. The Company is currently in negotiations with its landlord
to restructure the existing commitments. AFC's results of operations could be
adversely affected if it is unable, in a timely manner, to restructure its
existing commitments or sublease the excess facility space at rents comparable
to the Company's obligations.

CONCENTRATED PRODUCT LINE, NEW PRODUCTS AND RAPID TECHNOLOGICAL CHANGE.
Substantially all of AFC's revenues are derived from the UMC 1000 and the
Company expects this concentration will continue in the foreseeable future. Any
decrease in the overall level of sales of, or the prices for, the UMC 1000 could
have a material adverse effect on the Company's business, financial condition
and results of operations. Factors potentially affecting sales include price
competition, introductions or announcements by competitors, a decline in the
demand for the UMC 1000, or product obsolescence, among others.

The telecommunications equipment market is characterized by rapidly changing
technology, evolving industry standards, changes in end-user requirements, and
frequent new product introductions and enhancements. The introduction of
products embodying new technologies or the emergence of new industry standards
can render existing products obsolete or unmarketable. AFC's success will depend
upon its ability to enhance the UMC 1000 technology and to develop and
introduce, on a timely basis, new products or new product feature enhancements.
New product feature enhancements must keep pace with technological developments
and emerging industry standards, and address changing customer requirements in a
cost-effective manner. There can be no assurance that AFC will be successful in
identifying, developing, manufacturing, and marketing new products or product
enhancements that respond to technological change or evolving industry
standards. There can be no assurance that the Company will overcome difficulties
that could delay or prevent the successful development, introduction and
marketing of these products and enhancements, or that its new products or
enhancements will adequately meet the requirements of the marketplace and
achieve market acceptance. Substantial costs may be incurred to modify the UMC
1000 and build AFC's infrastructure to accommodate these changes. From time to
time, the Company may announce new products or product enhancements, services or
technologies that have the potential to replace or shorten the life cycle of the
UMC 1000 and that may cause customers to defer purchasing the UMC 1000.

The introduction of new industry digital switch interfaces, such as GR-303,
TR-08, and V5 reduce the amount of equipment required to support each access
line or port. The Company estimates that this fundamental technology transition
in the access market has the current effect of reducing the price per line by
approximately 20% to 30%. There can be no assurance that technological advances
in the telecommunications industry will not reduce sales of the UMC 1000,
diminish market acceptance of the system or render the system obsolete and,
thereby, materially adversely affect the Company's business, financial condition
and results of operations.

RISKS ASSOCIATED WITH PENDING LITIGATION. AFC is a party to certain legal
proceedings as described in Part II - "Legal Proceedings" beginning on page 21
of this Quarterly Report on Form 10-Q. The Company is unable to predict the
ultimate outcome of these proceedings or determine the total expense or possible
loss, if any, that may ultimately be incurred in the resolution of these
proceedings. Regardless of the ultimate outcome, these proceedings could result
in significant diversion of management's time and significant legal costs which
could have a material adverse affect on the Company's financial results.

LIMITED PROTECTION OF PROPRIETARY TECHNOLOGY; RISK OF THIRD PARTY CLAIMS OF
INFRINGEMENT. AFC attempts to protect its technology through a combination of
copyrights, trade secret laws, contractual obligations, and patents. AFC does
not presently hold any patents for the UMC 1000 product, but two patent
applications are pending. These intellectual

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property protection measures may not be sufficient to prevent misappropriation
of AFC's technology nor will they prevent competitors from independently
developing technologies that are substantially equivalent or superior to AFC's
technology. The laws of many foreign countries do not protect AFC's intellectual
property rights to the same extent as the laws of the U.S. Failure to protect
proprietary information could have a material adverse effect on AFC's business,
financial condition and results of operations. The Company is currently involved
in a dispute with RELTEC Corporation regarding, among other things, alleged
trade secret misappropriation. See Part II - "Legal Proceedings" as it pertains
to this matter on page 21 of this Quarterly Report on Form 10-Q.

In 1996, AFC settled litigation with DSC Communications, Inc. ("DSC") under
which DSC had claimed proprietary rights to the UMC 1000 technology. In 1998,
DSC filed a lawsuit against the Company alleging, among other things, that the
Company's 3GDLC product infringes a DSC patent. See Part II - "Legal
Proceedings" beginning on page 21 of this Quarterly Report on Form 10-Q.

In 1998, AFC settled litigation with the Industrial Technology Research
Institute and its sub-licensee Member Companies, and others, involving breach of
a prior agreement, trade secret misappropriation, unfair competition and related
claims. This settlement involved AFC granting a limited license to certain of
the Company's proprietary technology. In September 1998, AFC settled litigation
with Acer Netxus, Inc. enjoining them from developing, manufacturing, and
selling any device utilizing or deriving from AFC's UMC 1000 technology.

In the future, the Company may be subject to additional litigation to defend
against claimed infringements of the rights of others or to determine the scope
and validity of the proprietary rights of others. Future litigation also may be
necessary to enforce and protect trade secrets and other intellectual property
rights owned by AFC. Any such litigation could be costly and cause diversion of
management's attention, either of which could have a material adverse effect on
the Company's business, financial condition and results of operations. Adverse
determinations in such litigation could result in the loss of the Company's
proprietary rights, subject the Company to significant liabilities, require the
Company to seek licenses from third parties, or prevent the Company from
manufacturing or selling its products, any one of which could have a material
adverse effect on the Company's business, financial condition and results of
operations. Furthermore, there can be no assurance that any necessary licenses
will be available on reasonable terms.

DEPENDENCE ON THE TELECOMMUNICATIONS INDUSTRY AND SMALL TO MID-LINE SIZE MARKET.
AFC's customers are concentrated in the public carrier telecommunications
industry and, in the U.S. market include Competitive Local Exchange Carriers,
National Local Exchange Carriers, Independent Local Exchange Carriers, and the
Regional Bell Operating Companies. Accordingly, AFC's future success depends
upon the capital spending patterns of such customers and the continued demand by
such customers for the UMC 1000. The target markets for the systems are the U.S.
and international small to mid-line size markets. Historically, these markets
have had little access to the advanced services that can be made available
through the UMC 1000 and there can be no assurance that potential customers will
consider the near term value of these advanced services to be sufficient to
influence their purchase decisions. The system may not be met with widespread
acceptance among the telecommunications companies and other potential customers
in small to mid-line size markets. Existing customers and potential customers
may adopt alternative architectures or technologies that are incompatible with
the UMC 1000 technology which could have a material adverse effect on the
Company's business, financial condition and results of operations. There can be
no assurance that telecommunications companies, foreign governments or other
customers will pursue infrastructure upgrades that will necessitate the
implementation of advanced products such as the UMC 1000. Infrastructure
improvements may be delayed or prevented by a variety of factors, including
cost, regulatory obstacles, the lack of consumer demand for advanced
telecommunications services and alternative approaches to service delivery.

DEPENDENCE ON SOLE SOURCE AND LIMITED NUMBER OF THIRD PARTY MANUFACTURERS AND
SUPPORT ORGANIZATIONS. Certain components used in the Company's products,
including the Company's proprietary application specific integrated circuits
("ASICs"), codec components, certain surface mount technology components and
other components, are only available from a single source or limited number of
suppliers. A limited number of independent contractors manufacture the
subassemblies to AFC's specifications for use in the Company's products. Some of
the sole source suppliers are companies who, from time to time, allocate parts
to telecommunications equipment manufacturers due to

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market demand for components and equipment. Many of the Company's competitors
are much larger and may be able to obtain priority allocations from these shared
suppliers, thereby limiting or making unreliable the sources of supply for these
components. There can be no assurance that shortages of components will not
occur in the future or will not result in the Company having to pay a higher
price for components. If sufficient quantities of these or any other components
cannot be obtained, delays or reductions in manufacturing or product shipments
could occur which could have a material adverse effect on AFC's business,
financial condition and results of operations. In particular, the Company relies
upon:

- - Flextronics International Ltd. and Solectron International USA, Inc. to
manufacture printed circuit board assemblies ("PCBAs")

- - Siemens Microelectronics, Inc. for PCBAs components

- - Paragon Electronic Systems, Inc., and Tyco Printed Circuit Group Inc. to
manufacture backplanes and channel bank assemblies

- - Celestica, Inc. for channel bank assemblies and protector panel
subassemblies

- - General Cable Corporation for protector panel subassemblies

- - CMOR Manufacturing and Wilco Wire Technology, Inc. for cable and wire
harnesses and various turnkey assemblies

- - American Microsystems, Inc. for ASICs

- - Hendry Telephone Products for fuse panels and racks

- - Powersafe Standby Batteries Inc. for battery systems

- - LeeMah Electronics Inc. for fully integrated cabinets

- - Pairgain Technologies Inc. for custom enclosures and boards

- - Sonoma Metal Products, Inc., Cowden Metal San Jose, Inc., Mayville Metal
Products, and EMAR Inc. to manufacture the external housing cabinets

- - Advanced Digital Graphics, Inc. for system documentation

The Company's business, financial condition and results of operations could be
adversely affected if one or more of its subcontractors were to experience
financial, operational, production, or quality assurance difficulties that
resulted in a reduction or interruption in supply to the Company or otherwise
failed to meet the Company's manufacturing requirements. The Company may not be
able to establish sufficient manufacturing supply from alternative sources.
Current or alternative manufacturers may not be able to meet the Company's
future requirements and such manufacturing services may not continue to be made
available to the Company at favorable prices, or at all.

Various third party support organizations provide post sales support to AFC's
domestic sales customers. There can be no assurance that these organizations
will be able to provide the level of customer support demanded by existing or
potential customers.

DEPENDENCE ON KEY PERSONNEL. AFC's success depends to a significant extent upon
key technical and management employees. The loss of the services of any of these
key employees could have a material adverse effect on AFC's business, financial
condition and results of operations. In general, the Company does not have
employment agreements with, or key person life insurance for, its employees.
Competition for highly qualified employees is intense and the process of
locating key technical and management personnel with the required combination of
skills and attributes is often lengthy. There can be no assurance that AFC will
be successful in retaining its existing key personnel or in attracting and
retaining the additional employees it may require.

In April 1999, AFC announced the appointment of John A. Schofield as President
and Chief Executive Officer. There can be no assurance as to the effect this
management transition may have on AFC's business, financial condition and
results of operations.

YEAR 2000 READINESS. AFC has formed a Year 2000 Committee to understand and
address the year 2000 ("Y2K") issue as it affects the Company's infrastructure,
operations, and the UMC 1000 product. Representatives from each functional area
of the Company are responsible for identifying and assessing organizational
readiness, preparing

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remediation steps, testing, and applying new standards and contingency plans.
AFC has identified and assessed a majority of the potential Y2K-affected
hardware, software, facility equipment, and vendors. For the most part, AFC's
systems and software have been found to be Y2K compliant, or have been upgraded
to compliance through manufacturers' upgrades.

COMPLIANCE WITH REGULATIONS AND INDUSTRY STANDARDS. The UMC 1000 is required to
comply with a large number of voice and data regulations and standards, which
vary between domestic and international markets, and may vary within specific
international markets. Standards for new services continue to evolve, and the
Company will need to modify the UMC 1000 or develop new versions to meet these
standards. Failure of the system to comply with, or delays in meeting compliance
of evolving standards both in domestic and international markets, could have a
material adverse effect on the Company's business, financial condition and
results of operations. Standards setting and compliance verification in the U.S.
are determined by the Federal Communications Commission, Underwriters
Laboratories, QMI, Telcordia Technologies, Inc. ("Telcordia") formerly known as
"Bellcore", other independent third party testing organizations, and by
independent telecommunications companies. In international markets, the
Company's products must comply with recommendations issued by the Consultative
Committee on International Telegraph and Telephony, Industry Canada, and
individual regional carriers' network operating system requirements and
specifications. In addition, AFC's products must comply with standards issued by
the European Telecommunications Standards Institute and implemented and enforced
by the Telecommunications Regulatory Authority of each European nation.

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The Company needs to continue to ensure that the UMC 1000 is easily integrated
with various network management systems. Telcordia testing on the UMC 1000 is
often required to ensure interoperability with various standards of operations,
administration, maintenance and provisioning systems. Telcordia testing requires
significant investments in time and money to achieve compliance. Some UMC 1000
features must pass Telcordia testing prior to field release. Failure to maintain
such compliance or to obtain it on new features released in the future could
have a material adverse effect on the Company's business, financial condition
and results of operations.

AFC was first certified ANSI/ISO/ASQC Q9001-1994 ("ISO") compliant in 1997. The
ISO standard defines a quality system aimed at achieving quality in design,
development, production, installation and servicing. In November 1998, Quality
Management Institute certified the Company's annual ISO standard. There can be
no assurance that AFC will maintain such certification. The failure to maintain
such certification may preclude selling the UMC 1000 in certain markets and
could materially adversely affect the Company's ability to compete with other
suppliers of telecommunications equipment.

Failure to maintain interoperability with other companies or adopt or maintain
industry standards in the UMC 1000 could have a material adverse effect on the
Company's ability to compete with other telecommunications equipment suppliers,
and could materially adversely affect its business, financial condition and
results of operations.

In 1996, the U.S. Congress passed regulations that affect telecommunications
services, including changes to pricing, access by competitive suppliers and many
other broad changes to the data and telecommunications networks and services.
These changes will have a major impact on the pricing of existing services, and
may affect the deployment of future services. These changes could cause greater
consolidation in the telecommunications industry, which in turn could disrupt
existing customer relationships and have a material adverse effect on the
Company's business, financial condition and results of operations. There can be
no assurance that any regulatory changes will not have a material adverse effect
on the demand for the UMC 1000. Uncertainty regarding future policies combined
with emerging new competition may also affect the demand for telecommunications
products such as the UMC 1000 system.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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could materially affect the Company's future results of operations or cash flows
in a particular period. In connection with these legal proceedings, the Company
expects to incur substantial legal and other expenses. Stockholder suits of this
kind are highly complex and can extend for a protracted period of time, which
can substantially increase the cost of such litigation and divert the attention
of the Company's management.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS:

(a). CHANGES IN SECURITIES: None

(b). USE OF PROCEEDS:

The Company completed its initial public offering in October 1996, in which it
issued and sold 10,350,000 shares of Common Stock for aggregate proceeds to the
Company of $120.3 million. Of the aggregate proceeds received in the offering,
$2.2 million were used to defray costs and expenses related to the offering,
resulting in net proceeds of approximately $118.1 million. Of the net proceeds,
$14.8 million was used to reduce debt. The remainder is invested in cash
equivalents and marketable securities.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES: None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS: None

ITEM 5. OTHER INFORMATION: None

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K:

(a). EXHIBITS:

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DOCUMENT DESCRIPTION
------- --------------------
<S> <C>
3.3.1 Fifth Amended and Restated Certificate of Incorporation of the
Registrant. (3)

3.3.2 Certificate of Designation of Series A Junior Participating
Preferred Stock. (5)

3.5 Amended and Restated Bylaws of the Registrant. (2)

4.1 Specimen Certificate of Common Stock. (1)

4.2 Series E Preferred Stock Purchase Agreement, dated September 29,
1995 between the Registrant and certain purchasers of the
Registrant's Series E Preferred Stock. (1)

4.3 Certificate of Incorporation of the Registrant (included in
Exhibit 3.3.1).

4.4 Rights Agreement dated as of May 13, 1998, between the Registrant
and BankBoston, N.A. (5)

4.5 Amendment to Rights Agreement dated as of October 19, 1998
between the Registrant and BankBoston, N.A. (7)

10.3 Form of Warrant Issued in Connection with the Sale of the
Registrant's Series C Preferred Stock on March 16, 1994. (1)

10.4 Form of Performance Warrant Issued in Connection with the Sale of
the Registrant's Series C Preferred Stock on March 16, 1994 and
May 4, 1994. (1)

10.4.1 Form of Amendment to Warrants and Performance Warrants. (1)

10.5 Warrant Issued in Connection with the Sale of the Registrant's
Series E Preferred Stock on
</TABLE>

22
<PAGE> 24

<TABLE>
<S> <C>
September 29, 1995. (1)

10.6 Restricted Stock Issuance Agreement, dated May 19, 1995 between
the Registrant, Donald Green and Maureen Green. (1)

10.7 Compensation Agreement, dated May 19, 1995 between the Registrant
and Donald Green. (1)

10.8 Promissory Note Secured by Pledge Agreement, dated May 31, 1995
by Donald Green in favor of the Registrant. (1)

10.9 Stock Pledge Agreement, dated June 16, 1995 between the
Registrant and Donald Green. (1)

10.10 Compensation Agreement, dated March 23, 1999 between the
Registrant and John A. Schofield.

10.11 Hangzhou Aftek Communication Registrant Ltd. Contract, dated June
18, 1994 between Advanced Fibre Technology Communication (Hong
Kong) Limited and Hangzhou Communication Equipment Factory of the
MPT., HuaTong Branch. (1) +

10.12 1445 & 1455 McDowell Boulevard North Net Lease, dated February 1,
1993 between the Registrant and G & W/ Redwood Associates Joint
Venture, for the premises located at 1445 McDowell Boulevard
North. (1)

10.14 Redwood Business Park Net Lease, dated July 10, 1995 between the
Registrant and G & W/Redwood Associates Joint Venture, for the
premises located at 1440 McDowell Boulevard North. (1)

10.15 Redwood Business Park Net Lease, dated June 3, 1996 between the
Registrant and G & W/Redwood Associates Joint Venture, for the
premises located at Buildings 1 & 9 of Willow Brook Court. (1)

10.17 Form of Indemnification Agreement for Executive Officers and
Directors of the Registrant. (1)

10.18 The Registrant's 1993 Stock Option/Stock Issuance Plan, as
amended (the "1993 Plan"). (1)

10.19 Form of Stock Option Agreement pertaining to the 1993 Plan. (1)

10.20 Form of Notice of Grant of Stock Option pertaining to the 1993
Plan. (1)

10.21 Form of Stock Purchase Agreement pertaining to the 1993 Plan. (1)

10.22 The Registrant's 1996 Stock Incentive Plan (the "1996 Plan"). (1)

10.23 Form of Stock Option Agreement pertaining to the 1996 Plan. (1)

10.23.1 Form of Automatic Stock Option Agreement pertaining to the 1996
Plan. (1)

10.24 Form of Notice of Grant of Stock Option pertaining to the 1996
Plan. (1)

10.24.1 Form of Notice of Grant of Non-Employee Director Automatic Stock
Option pertaining to the 1996 Plan. (1)

10.25 Form of Stock Issuance Agreement pertaining to the 1996 Plan. (1)

10.26 The Registrant's Employee Stock Purchase Plan. (1)

10.27 Stock Issuance Agreement, dated June 30, 1997 between the
Registrant and Peter A. Darbee. (2)

10.28 Note secured by Stock Pledge Agreement, dated June 30, 1997 by
Peter A. Darbee in favor of the Registrant. (2)

10.29 Stock Pledge Agreement, dated June 30, 1997 between the
Registrant and Peter A. Darbee. (2)

10.30 Consulting Agreement, dated May 19, 1997 between the Registrant
and Peter A. Darbee. (2)

10.31 Cypress Center Net Lease, dated October 9, 1997 between the
Registrant and RNM Lakeville L.P., for the premises located at
2210 South McDowell Boulevard. (4)

10.32 Redwood Business Park Net Lease, dated August 4, 1997 between the
Registrant and G & W/ Copley Redwood Business Park, L.P., for the
premises located at 1435 McDowell Boulevard North. (8)

10.33 Redwood Business Park Net Lease, dated October 23, 1997 between
the Registrant and G & W/ Copley Redwood Business Park, L.P., for
the premises located at 1465 McDowell Boulevard North. (8)

10.34 Revolving Credit Agreement, dated July 30, 1998 between the
Registrant and Banque Nationale De Paris and Bank of America
National Trust and Savings Association. (6)

10.35 Redwood Business Park Net Lease, dated July 10, 1998 between the
Registrant and G & W/Copley Redwood Business Park, L.P., for the
premises located at 1347 Redwood Way. (8)

21.1 Subsidiaries of the Registrant. (1)
</TABLE>

23
<PAGE> 25

<TABLE>
<S> <C>
27.1 Financial data schedule.
</TABLE>

1) Incorporated by reference from the Registrant's Registration Statement on
Form S-1 (no.333-8921) filed with the Securities and Exchange Commission on
July 26, 1996, as amended, and declared effective September 30, 1996.

2) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the quarter ended June 30, 1997, filed with the Securities and
Exchange Commission on August 8, 1997.

3) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the quarter ended September 30, 1997, filed with the Securities and
Exchange Commission on November 7, 1997.

4) Incorporated by reference from the Registrant's Annual Report on Form 10-K
for the year ended December 31, 1997, filed with the Securities and Exchange
Commission on March 23, 1998.

5) Incorporated by reference from the Registrant's Current Report on Form 8-K
filed with the Securities and Exchange Commission on May 19, 1998.

6) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the quarter ended June 30, 1998, filed with the Securities and
Exchange Commission on August 10, 1998.

7) Incorporated by reference from the Registrant's Current Report on Form 8-K
filed with the Securities and Exchange Commission on October 29, 1998.

8) Incorporated by reference from the Registrant's Annual Report on Form 10-K
for the year ended December 31, 1998, filed with the Securities and Exchange
Commission on March 24, 1999.

+ Portions of this Exhibit have been granted Confidential Treatment.

(b). REPORTS ON FORM 8-K: None

24
<PAGE> 26

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant had duly caused this Report to be signed on its behalf by the
undersigned thereunto duly authorized.

ADVANCED FIBRE COMMUNICATIONS, INC.
(Registrant)

Dated: May 7, 1999 By: /s/ Peter A. Darbee
-----------------------------------
Name: Peter A. Darbee
Title: Vice President, Chief Financial
Officer, Treasurer and Secretary
(Duly Authorized Signatory and
Principal Financial Officer)

<PAGE> 1
[ADVANCED FIBRE COMMUNICATIONS LOGO]

EXHIBIT 10.10

March 23, 1999

John Anthony Schofield
5011 2nd Avenue South
Minneapolis, MN 55419

Dear John:

I am pleased to offer you employment as President and Chief Executive Officer
for Advanced Fibre Communications, Inc. You will report directly to AFC's Board
of Directors, and receive a base salary of $14,423.08 biweekly or $375,000.00
annualized. This position is exempt. As an exempt employee, you are not entitled
to overtime pay. Your start date will be on or before April 12, 1999.

AFC offers a qualified employee stock option program. You will be granted an
option on 775,000 shares of common stock at an exercise price equal to the
closing market price on your date of hire. The terms and conditions of this
program are set forth in the AFC 1996 Stock Incentive Plan and related
documents.

You will be guaranteed a bonus equal to 12% of your annual salary for each of
the first two quarters of your employment. Thereafter, as the President and
Chief Executive Officer, you will be a participant in the AFC Management
Incentive Plan, a copy of which is attached hereto.

We will provide relocation assistance pursuant to our relocation policy up to
$150,000 in actual relocation expenses contingent upon your signing a Relocation
Agreement. A summary of the policy and copies of the necessary documents are
attached.

In addition, AFC will agree to provide you a loan in the amount of $500,000 with
interest accrued at a compounded annual rate of 4.67%. The loan shall be repaid
in three equal annual installments on the anniversary date of your date of hire.
The Board of Directors will have the option to forgive a portion or all of the
principal and interest on this loan at the annual anniversary dates of your
hire. A promissory note will be forwarded to you within a few days reflecting
the terms and conditions of this loan.

If you accept this offer, your employment with AFC shall be at will. Your
employment is not for any specific period of time and can be terminated by
yourself or AFC at anytime with or without "cause". The at will nature of your
employment, as set forth above, cannot be changed except in an express writing
signed by the Board of Directors.

<PAGE> 2

Although you are an at will employee, AFC agrees to extend severance pay in the
following circumstances. In the event your employment is terminated by AFC other
than for "cause' within the first twelve (12) months of employment, AFC agrees
to: (1) pay you the equivalent of twelve (12) months' of your average monthly
base salary for the preceding twelve months (payable in 12 equal monthly
payments) and (2) accelerate the vesting on your then-outstanding stock options
on a month for month basis equal to the number of months you have been employed
by AFC. For example, if you have been employed by AFC for seven months, you will
receive seven months accelerated vesting. "Cause" for termination shall include,
but shall not be limited to: (1) your conviction of, plea of nolo contendere to,
or commission of any felony or any crime involving moral turpitude, deceit or
conduct against the interests of AFC; and (2) any fraud, misrepresentation or
gross misconduct by you against AFC.

AFC recognizes its legal obligation to provide a safe and healthful work
environment for our employees and is committed to maintaining a drug-free
workplace. This offer of employment is contingent on you successfully passing a
drug test administered by a local certified laboratory. You must take your test
within 24 hours of acceptance of this offer of employment. If you have not
completed your testing within 24 hours of acceptance, this offer may be
rescinded. Human Resources will provide you with the information necessary to
obtain your test.

You will be eligible for two weeks vacation and up to 10 days paid sick leave
per year, which will be pro-rated in accordance with your date of hire.
Following each full year of service you will receive one extra day of paid
vacation, up to a total of twenty days.

AFC offers a comprehensive employee benefits package which includes medical,
dental, life, vision care and disability insurance, together with other flexible
options under a cafeteria plan. Eligibility for these benefits will commence on
your date of hire. In addition, a 401(k) plan has been established and you will
have the opportunity to participate in this plan on your date of hire. The terms
and conditions of participation in these plans are set forth in the plan
documents.

In order to comply with provisions of the Immigration Reform and Control Act,
you will be required to provide verification of work authorization. This offer
is contingent upon such verification.

This offer is being extended to you solely based on your skill, experience,
education and our view of your potential for success here. This offer is not
being made in order to acquire confidential or proprietary information or trade
secrets from any previous employer which you may have come to possess.
Consequently, we must instruct you to abide by any contractual or legal
obligations which you have to maintain the confidentiality of information which
you are obligated to protect. By accepting employment with AFC, you agree not to
use or disclose proprietary information or trade secrets from any previous
employer in the course of performing your duties for AFC under any
circumstances. You must not keep any items or materials related to your

<PAGE> 3

former employer or use such materials during your employment with AFC. If you
have any questions regarding what constitutes such information, I encourage you
to contact your former employer(s).

If this offer is acceptable to you, please sign the original of this letter and
return it to AFC in the enclosed envelope. The copy enclosed is for your
records. You may also fax your acceptance to our secure fax in the Legal
Department at (707) 794-7878. Time is of the essence and the above offer will
expire on March 31, 1999.

This offer supercedes all previous offers, negotiations or communications, oral
or written, with AFC regarding the subject hereof.

Congratulations, John, on being selected to join our team. At AFC, we strive to
hire only the best and brightest individuals who will make a difference. We look
forward to your contribution to the continued success of AFC.

Sincerely,

/s/ Donald Green

Don Green
Chairman of the Board

I agree to and accept the terms and conditions of employment outlined above. My
acceptance is based solely on the terms and conditions stated in this offer
notwithstanding any oral representations that may have been made to me.

Accepted: /s/ John A. Schofield Dated: 3/23/99
------------------------------- ----------------------

Start Date: April 12, 1999
------------------------------
(MONDAYS ONLY)

<ARTICLE> 5
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> MAR-31-1999
<CASH> 43,195
<SECURITIES> 91,432
<RECEIVABLES> 70,006
<ALLOWANCES> (5,418)
<INVENTORY> 47,194
<CURRENT-ASSETS> 254,321
<PP&E> 66,735
<DEPRECIATION> (14,116)
<TOTAL-ASSETS> 317,496
<CURRENT-LIABILITIES> 40,432
<BONDS> 0
0
0
<COMMON> 766
<OTHER-SE> 274,127
<TOTAL-LIABILITY-AND-EQUITY> 317,496
<SALES> 64,865
<TOTAL-REVENUES> 64,966
<CGS> 33,491
<TOTAL-COSTS> 35,482
<OTHER-EXPENSES> 26,286
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (1,298)
<INCOME-PRETAX> 4,496
<INCOME-TAX> 1,484
<INCOME-CONTINUING> 3,012
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 3,012
<EPS-PRIMARY> 0.04
<EPS-DILUTED> 0.04

</TABLE>