UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended          March 31, 2009                            September 30, 2008
 
OR
 
o¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                                              ______________ to                                              _____________
 
Commission file number      0-11668                                        0-11668
 
PHOTONIC PRODUCTS GROUP, INC.
(Exact name of registrant as specified in its charter)

New Jersey
22-2003247
(State or other jurisdiction of incorporation(I.R.S. Employer
or organization)Identification Number)
 
181 Legrand Avenue, Northvale, NJ  07647
(Address of principal executive offices)
(Zip Code)
 
(201) 767-1910
(Registrant’s telephone number, including area code)

(Former
 (Former name, former address and formal fiscal year, if changed since last report)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ýx No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data file required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ¨ No ¨ The Registrant is not yet subject to this requirement.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definition of “large accelerated filer, accelerated filer and smaller reporting company” in Rule 12b-2 of the exchange Act.  (Check one):

Large accelerated filer  ¨o
Accelerated filer  ¨o
Non-accelerated filer  ¨o
Smaller reporting company xý
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange act).
Yes    ¨No    Noxþ
 
Common shares of stock outstanding as of November 14, 2008:May 10, 2009:
 
11,222,97811,297,866 shares


Photonic Products Group, Inc. and Subsidiaries
 
INDEX

Part I.    FINANCIAL INFORMATION
 
   
Item 1.Financial Statements:
  
 
Consolidated Balance Sheetsbalance sheets as of September 30, 2008March 31, 2009 (unaudited)  and December 31, 20072008 (audited)
21
  
Consolidated Statementsstatements of Operationsoperations for the Threethree  months ended March 31, 2009 and Nine Months Ended September 30, 2008 and 2007 (unaudited)
2
 
Consolidated statements of cash flows for the three months ended March 31, 2009 and 2008 (unaudited)3
  
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2008 and 2007 (unaudited)
4
 Notes to Consolidated Financial Statementsconsolidated financial statements (unaudited)54
   
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
1012
   
Item 3.Quantitative and Qualitative Disclosures about Market Risk1917
   
Item 4.Controls and Procedures1917
   
Part II.  OTHER INFORMATION
 19
   
Item 1.Legal Proceedings1918
   
Item 1A.Risk Factors1918
   
Item 2.Unregistered Sales of Equity Securities and Use of Proceeds1918
   
Item 3.Defaults Uponupon Senior Securities1918
   
Item 4.Submission of Matters to a Vote of Security Holders2018
   
Item 5.Other Information2018
   
Item 6.Exhibits2018
   
Signatures
2119
 
1

PHOTONIC PRODUCTS GROUP, INC AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
 
  
September 30,
 
December 31,
 
  
2008
 
2007
 
  
(Unaudited)
 
(Audited) 
 
Assets
     
Current assets:
     
Cash and cash equivalents $3,866,282 $4,395,945 
Accounts receivable (net of allowance for doubtful accounts of $15,000 in 2008 and 2007)  1,949,242  2,181,859 
Inventories  3,226,748  2,931,080 
Deferred income taxes  306,000  — 
Other current assets  208,751  164,065 
Total current assets
  9,557,023  9,672,949 
Plant and equipment:
      
Plant and equipment, at cost  14,386,620  13,690,229 
Less: Accumulated depreciation and amortization  (10,904,169) (10,189,853)
Total plant and equipment  3,482,451  3,500,376 
Precious Metals
  112,851  112,851 
Goodwill
  1,869,646  1,869,646 
Intangible Assets
  771,221  830,144 
Other Assets
  53,760  91,981 
Total Assets
 $15,846,952 $16,077,947 
        
Liabilities and Shareholders’ Equity
       
Current Liabilities:
     
Current portion of notes payable - other $12,751 $14,814 
Accounts payable and accrued liabilities  2,020,611  2,741,966 
Customer advances  882,224  870,550 
Current obligations under capital leases  —  47,088 
Convertible note payable due within one year  2,500,000  1,700,000 
Total current liabilities
  5,415,586  5,374,418 
      
 
Secured and Convertible Notes Payable
  —  2,500,000 
Other Long Term Notes
  481,638  490,730 
Total liabilities
  5,897,224  8,365,148 
        
Commitments and Contingencies
  —  — 
        
Shareholders’ Equity:
     
10% convertible preferred stock, Series A no par value; no shares issued and outstanding  —  — 
10% convertible preferred stock, Series B no par value; no shares issued and outstanding  —  — 
Common stock: $.01 par value; 60,000,000 authorized; 11,227,578 shares issued at September 30, 2008 and 10,104,719 issued at December 31, 2007  112,275  101,046 
Capital in excess of par value  16,592,134  15,320,771 
Accumulated deficit  (6,739,731) (7,694,068)
   9,964,678  7,727,749 
Less - Common stock in treasury, at cost (4,600 shares respectively)  (14,950) (14,950)
Total Shareholders’ Equity
  9,949,728  7,712,799 
Total Liabilities and Shareholders’ Equity
 $15,846,952 $16,077,947 
  March 31,  December 31, 
  2009  2008 
  (Unaudited)  (Audited) 
Assets      
Current assets:      
Cash and cash equivalents $2,941,545  $2,672,087 
Certificates of deposit  807,738   800,000 
Accounts receivable (net of allowance for doubtful accounts of  $15,000 in 2009 and 2008)  1,796,072   2,810,602 
Inventories, net  2,639,186   2,732,336 
Other current assets  259,153   188,084 
Total current assets  8,443,694   9,203,109 
Plant and equipment:        
Plant and equipment,  at cost  14,482,251   14,445,027 
Less: Accumulated depreciation and amortization  (11,372,620)  (11,139,771)
Total plant and equipment  3,109,631   3,305,526 
Precious Metals  157,443   112,851 
Deferred Income Taxes  644,000   408,000 
Goodwill  1,869,646   1,869,646 
Intangible Assets, net  731,939   751,580 
Other Assets  47,852   81,707 
         
Total Assets $15,004,205  $15,732,149 
         
Liabilities and Shareholders’ Equity        
Current Liabilities:        
Current portion of notes payable –other $135,165  $136,892 
Accounts payable and accrued liabilities  1,674,821   2,160,665 
Customer advances  331,309   456,754 
Total current liabilities  2,141,295   2,754,311 
         
Related Party Convertible Notes Payable  2,500,000   2,500,000 
Other Long Term Notes  351,467   353,663 
Total liabilities  4,992,762   5,607,974 
         
Commitments and Contingencies  —   — 
         
Shareholders’ Equity:        
Common stock: $.01 par value; 60,000,000 authorized shares; 11,302,466 shares issued at March 31, 2009 and 11,230,678 issued at December 31, 2008  113,023   112,306 
Capital in excess of par value  16,823,426   16,622,466 
Accumulated deficit  (6,910,056)  (6,595,647)
   10,026,393   10,139,125 
Less - Common stock in treasury, at cost (4,600 shares respectively)  (14,950)  (14,950)
Total Shareholders’ Equity  10,011,443   10,124,175 
         
Total Liabilities and Shareholders’ Equity $15,004,205  $15,732,149 
 
See Notes to Consolidated Financial Statements (Unaudited)



PHOTONIC PRODUCTS GROUP, INC AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
  
Three Months Ended September 30, 
 
Nine Months Ended September 30,
 
  
2008
 
2007
 
2008
 
2007
 
Total Revenue
 $3,802,935 $3,837,660 $11,974,595 $11,057,330 
             
Cost and Expenses:
           
Cost of goods sold  2,737,511  2,021,835  8,188,376  6,466,767 
Selling, general and administrative expenses  949,125  908,438  2,913,853  2,666,919 
   3,686,636  2,930,273  11,102,229  9,133,686 
Income from operations
  116,299  907,387  872,366  1,923,644 
Other income (expense):
            
Interest expense - net  (33,179) (69,974) (143,142) (214,883)
Gain on sale of fixed asset  —  —  9,113  — 
   (33,179) (69,974) (134,029) (214,883)
Net income before income tax provision and preferred stock dividends
  83,120  837,413  738,337  1,708,761 
              
Benefit from (provision for) income taxes
  86,000  (40,000) 216,000  (80,000)
              
Net Income
  169,120  797,413  954,337  1,628,761 
              
Preferred stock dividends
  —  —  —  (233,240)
Net income applicable to common shareholders
 $169,120 $797,413 $954,337 $1,395,521 
Net income per common share— basic
 $.02 
$
.09
 $.09 $0.17 
Net income per common share— diluted
 $.01  .06 $.07 $0.12 
Weighted average shares outstanding—basic
  11,209,576  9,120,587  10,824,457  8,413,845 
Weighted average shares outstanding—diluted
  15,461,922  14,550,134  15,691,982  13,300,511 

See Notes to Consolidated Financial Statements (unaudited)

PHOTONIC PRODUCTS GROUP, INC AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

  
Nine Months Ended September 30,
 
  
2008
 
2007
 
      
Cash flows from operating activities:
     
Net income $954,337 $1,628,761 
      
Adjustments to reconcile net income to cash provided by operating activities:
     
Depreciation and amortization  802,088  848,526 
401(K) common stock contribution  160,181  166,693 
Gain on sale of fixed asset  (9,113) — 
Deferred income taxes  (306,000) — 
Stock based compensation  56,569  30,125 
Changes in assets and liabilities:
       
Accounts receivable  232,617  (42,706)
Inventories  (295,668) (660,528)
Other current assets  (44,686) 55,979 
Other assets  38,221  25,568 
Accounts payable and accrued liabilities  (721,355) (50,567)
Customer advances  11,674  (369,419)
      
Total adjustments  (75,472) 3,671 
Net cash provided by operating activities
  878,865  1,632,432 
       
Capital expenditures  (726,127) (156,505)
Proceeds from sale of fixed assets  10,000  — 
Net cash used in investing activities
  (716,127) (156,505)
       
Cash flows from financing activities:
     
Proceeds from issuance of common stock  258,255  415,248 
Exercise of warrants  807,587  — 
Principal payment of convertible note payable  (1,700,000) (1,000,000)
Principal payments of other notes payable  (11,155) (74,357)
Principal payments of capital lease obligations  (47,088) (172,541)
Net cash used in financing activities
  (692,401) (831,650)
        
Net (decrease) increase in cash and cash equivalents
  (529,663) 644,277 
        
Cash and cash equivalents at beginning of period
  4,395,945  3,078,052 
      
Cash and cash equivalents at end of period
 $3,866,282 $3,722,329 
  Three Months Ended March 31, 
  2009  2008 
       
Total Revenue $2,815,097  $4,164,248 
         
Cost and Expenses:        
Cost of goods sold  2,433,410   2,662,655 
Selling, general and administrative expenses  907,079   986,813 
   3,340,489   3,649,468 
         
Operating (loss) income  (525,392)  514,780 
         
Other income (expense):        
Interest expense—net  (32,388)  (75,580) 
Gain on sale of precious metals  7,371   — 
   (25,017)  (75,580) 
         
Net (loss) income before income taxes  (550,409)  439,200 
         
Benefit from income taxes  236,000   52,000 
         
Net (loss) income $(314,409) $491,200 
         
Net (loss) income per common share — basic $(0.03) $0.05 
         
Net (loss) income per common share —  diluted $(0.03) $0.03 
         
Weighted average common shares outstanding— basic  11,260,199   10,535,075 
         
Weighted average common shares outstanding— diluted  11,260,199   15,862,817 
 
See Notes to Consolidated Financial Statements (Unaudited)


PHOTONIC PRODUCTS GROUP, INC AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

  Three Months Ended March 31, 
  2009  2008 
       
Cash flows from operating activities:      
Net (loss) income $(314,409) $491,200 
         
Adjustments to reconcile net (loss) income to cash provided by (used in) operating activities:        
Depreciation and amortization  252,490   270,188 
401(K) common stock contribution  179,068   160,181 
Gain on sale of precious metals  (7,371)  — 
Deferred income taxes  (236,000)  (102,000)
Stock based compensation  23,595   18,573 
Changes in operating assets and liabilities:        
       Accounts receivable  1,014,530   (184,226)
        Inventories, net  93,150   (363,989)
        Other current assets  (71,069)  (32,326)
        Other assets  33,855   36,721 
        Accounts payable and accrued liabilities  (485,844)  (217,335)
        Customer advances  (125,445)  (300,011)
Total adjustments  670,959   (714,224)
Net cash provided by (used in) operating activities  356,550   (223,024)
         
Cash flows from investing activities:         
Capital expenditures  (37,224)  (186,363)
Purchase of precious metals  (53,538)  — 
Purchase of certificate of deposit, net  (7,738)  — 
Proceeds from sale of precious metals  16,317   — 
Net cash (used in) investing activities  (82,183)  (186,363)
         
Cash flows from financing activities:        
Redemption of restricted stock units  (986)  — 
Proceeds from issuance of common stock  —   139,580 
Exercise of warrants  —   591,587 
Principal payment of convertible note payable  —   (1,700,000)
Principal payments of other notes payable  (3,923)  (3,699)
Principal payments of capital lease obligations  —   (22,006)
Net cash used in financing activities  (4,909)  (994,538)
         
Net increase (decrease) in cash and cash equivalents  269,458   (1,403,925)
         
Cash and cash equivalents at beginning of period  2,672,087   4,395,945 
         
Cash and cash equivalents at end of period $2,941,545  $2,992,020 
         
Supplemental Disclosure of Cash Flow Information:        
Interest paid $3,596  $482,860 
Income taxes paid $50,000  $10,000 
See Notes to Consolidated Financial Statements (Unaudited)

3


PHOTONIC PRODUCTS GROUP, INC AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited(Unaudited)
 
NOTE 1 --SUMMARY OF ACCOUNTING POLICIES
 
Basis of Presentation
 
The accompanying unaudited interim consolidated financial statements of Photonic Products Group, Inc. and Subsidiaries (the "Company") reflect all adjustments, which are of a normal recurring nature, and disclosures which, in the opinion of management, are necessary for a fair statement of results for the interim periods.  It is suggested that these consolidated financial statements be read in conjunction with the audited consolidated financial statements as of December 31, 20072008 and 20062007 and for the years then ended and notes thereto included in the Company’s report on Form 10-K filed with the Securities and Exchange Commission.
 
Cash and cash equivalents
The Company considers cash-on-hand and highly liquid investments with original maturity dates of three months or less at the date of purchase to be cash and cash equivalents.  Investments with original maturity dates exceeding three months are separately disclosed on the consolidated balance sheets and as cash flows from investing activities on the consolidated statements of cash flows.
Inventories
 
Inventories are stated at the lower of cost (first-in-first-out basis) or market basis (net realizable value). Work in processmarket.  Cost of manufactured goods includes material, labor and overhead.  The Company records a reserve for slow moving inventory as a charge against earnings for the period is stated at actual cost, not in excess ofall products identified as surplus, slow-moving or discontinued.  Excess work-in-process costs are charged against earnings whenever estimated realizable value. Costs include labor, material and overhead.costs-of-completion exceed unbilled revenues.
 
Inventories are comprised of the following:following and are shown net of inventory reserves:

  
March 31,
2009
  
December 31,
2008
 
  (in thousands) 
Raw materials $1,027  $1,169 
Work in process, including manufactured parts and components  1,117   1,117 
Finished goods  495   446 
  $2,639  $2,732 
 
  
September 30,
2008
 December 31,
2007		 
Raw Materials $1,137,000 $1,216,000 
Work in process, including manufactured parts and components  1,544,000  1,082,000 
Finished Goods  546,000  633,000 
  $3,227,000 $2,931,000 
The December 31, 2007 inventory balances have been reclassified to conform to the basis of presentation adopted in the current quarter.
Income Taxes
The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. Deferred tax assets and liabilities are determined based on the difference between the financial statement carrying amounts and the tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse.
Net Income per Share
The basic net income per share is computed using the weighted average number of common shares outstanding for the applicable period. The diluted income per share is computed using the weighted average number of common shares plus potential common equivalent shares outstanding, including the additional dilution related to the conversion of stock options, unvested restricted stock grants, warrants, convertible preferred shares, and potential common shares issuable upon conversion of outstanding convertible notes, except if the effect on the per share amounts is anti-dilutive.
5
The following is the reconciliation of the basic and diluted earnings per share computations required by Statement of Financial Standards (“SFAS”) No. 128 (“Earnings per Share’):
  
Three Months Ended
Sept 30, 2008
 
Three Months Ended
Sept 30, 2007
 
  
Income
(Numerator)
 
Shares
(Denominator)
 
Per Share
Amount
 
Income
(Numerator)
 
Shares
(Denominator)
 
Per Share
Amount
 
Basic Earnings Per Share:
             
Net Income Applicable to Common Shareholders $169,120  11,209,576 $.02 $797,413  9,120,587 $0.09 
Effect of dilutive securities             
Convertible Debt  37,500  2,500,000    44,301  2,929,348   
Convertible Preferred Stock              832,800    
Warrants  —  1,311,477    —  1,204,208   
Options and stock grants  —  440,869    —  463,191   
Diluted Earnings Per Share:
             
Net Income Applicable to Common Shareholders $206,620  15,461,922 $.01 $841,741  14,550,134 $0.06 
  
Nine Months Ended
Sept 30, 2008
 
Nine Months Ended
Sept 30, 2007
 
  
Income
(Numerator)
 
Shares
(Denominator)
 
Per Share
Amount
 
Income
(Numerator)
 
Shares
(Denominator)
 
Per Share
Amount
 
Basic Earnings Per Share:
             
Net Income Applicable to Common Shareholders $954,337  10,824,457 $.09 $1,395,521  8,413,845 $0.17 
Effect of dilutive securities              
Convertible debt  112,500  2,500,000     150,288  3,305,861   
Warrants  —  1,766,546    —  1,182,573   
Options and stock grants  —  600,979     —  398,232    
Diluted Earnings Per Share:
               
Net Income Applicable to Common Shareholders $1,066,837  15,691,982 $.07 $1,545,809  13,300,511 $0.12 
Share-Based Compensation
The Company accounts for share-based compensation in accordance with the recognition and measurement provisions of Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), Share-Based Payment ("SFAS 123(R)"), which replaces SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes Accounting Principles Board Opinion ("APB") No. 25, Accounting for Stock Issued to Employees, and related interpretations.
Under the fair value recognition provision of SFAS 123(R), share-based compensation cost is estimated at the grant date based on the fair value of the award. The Company estimates the fair value of stock options granted using the Black-Scholes option pricing model. The fair value of restricted stock units granted is based on the closing market price of the Company’s common stock on the date of the grant. The fair value of these awards, adjusted for estimated forfeitures is amortized over the requisite service period of the award, which is generally the vesting period.
6

New Accounting Pronouncements
In December 2007, the FASB released SFAS No. 141(R), “Business Combinations (revised 2007)” (“SFAS 141(R)”), which changes many well-established business combination accounting practices and significantly affects how acquisition transactions are reflected in the financial statements. Additionally, SFAS 141(R) will affect how companies negotiate and structure transactions, model financial projections of acquisitions and communicate to stakeholders. SFAS 141(R) must be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. SFAS 141(R) will have an impact on the Company’s consolidated financial statements related to any future acquisitions.
In December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”). SFAS 160 establishes new accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. The Company does not believe that SFAS 160 will have a material impact on its consolidated financial statements.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133” (“SFAS 161”). SFAS 161 changes the disclosure requirements for derivative instruments and hedging activities. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under FASB Statement No. 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. SFAS 161 encourages, but does not require, comparative disclosures for earlier periods at initial adoption. The Company does not believe that SFAS 161 will have a material impact on its consolidated financial statements.
In April 2008, the FASB issued FASB Staff Position No. FAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 applies to all recognized intangible assets and its guidance is restricted to estimating the useful life of recognized intangible assets. FSP FAS 142-3 is effective for the first fiscal period beginning after December 15, 2008 and must be applied prospectively to intangible assets acquired after the effective date. The Company will be required to adopt FSP FAS 142-3 to intangible assets acquired beginning with the first quarter of fiscal 2010.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles,” (“SFAS 162”). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with GAAP. SFAS 162 is effective 60 days following the SEC’s approval of Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.” The Company does not believe that SFAS 162 will have a material impact on its consolidated financial statements.
In October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP FAS 157-3”). FSP FAS 157-3 clarifies the application of SFAS No. 157 in a market that is not active. FSP FAS 157-3 is effective upon issuance, including prior periods for which financial statements have not been issued. Revisions resulting from a change in the valuation technique or its application should be accounted for as a change in accounting estimate following the guidance in FASB Statement No. 154, “Accounting Changes and Error Corrections.” FSP FAS 157-3 is effective for the financial statements included in the Company’s quarterly report for the period ended September 30, 2008, and application of FSP FAS 157-3 had no impact on the Company’s condensed consolidated financial statements.
NOTE 2- EQUITY COMPENSATION PROGRAM
The Company’s 2000 Equity Compensation Program provides for grants of options, stock appreciation rights and performance shares to employees, officers, directors, and others who render services to the Company. The program consists of four plans including: (i) the Incentive Equity Compensation Program which provide for grants of “incentive stock options”, (ii) the Supplemental Program which provide for grants of stock options to non-employees, (iii) the SAR Program which allows the granting of stock appreciation rights and, (iv) the Performance Share Program under which eligible participants may receive stock awards, including restricted stock and restricted stock units. The plans are administered by the Compensation Committee of the Board of Directors. Under these plans, an aggregate of up to 6,000,000 shares of common stock may be granted. The 2000 Equity Compensation plan expires in August 2010.
Stock Option Expense
The Company's results for the three months ended September 30, 2008 and 2007 include share-based compensation expense for stock option grants, as required by SFAS 123(R), totaling $8,733 and $11,915, respectively. Such amounts have been included in the Consolidated Statements of Operations within cost of goods sold in the amount of $2,076 ($1,179 for 2007), and selling, general and administrative expenses in the amount of $6,657 ($10,736 for 2007).
For the nine months ended September 30, 2008 and 2007 share-based compensation was $26,200 and $30,125, respectively. At total of $6,229 was included in the Consolidated Statements of Operations within cost of goods sold ($6,063 for 2007), and $19,971 in selling, general and administrative expenses ($24,062 for 2007).
As of September 30, 2008 and 2007, there was $26,088 and $69,120 of unrecognized compensation costs, net of estimated forfeitures, related to non-vested stock options, which are expected to be recognized over a weighted average period of approximately 1.3 years and 2.5 years, respectively.
The fair value of options used to determine the stock option expense to be recognized is estimated using the Black-Scholes option pricing model, as of the date of the grant. The Company follows guidance under SFAS 123(R) when reviewing and updating assumptions. Expected volatility is based upon the historical volatility of our stock and other contributing factors. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of the grant. The expected term is based upon the contractual term of the option.
The following range of weighted-average assumptions were used for to determine the fair value of stock option grants during the nine months ended September 30, 2008 and 2007, respectively:
  
Nine Months Ended
Sept 30,
 
  
2008
 
2007
 
Expected Dividend yield  0.00% 0.00%
Expected Volatility  166% 156%
Risk-free interest rate  3.7% 4.5%
Expected life  10 years  10 years 
Stock Option Activity
There were no stock options granted in the nine months ended September 30, 2008. For the nine month period ended September 30, 2007, there were 29,039 options granted with a weighted average estimated fair value of stock options granted of $1.47 and a weighted average exercise price of $1.50, which was equal to the closing market price on the date of the grant.
The following table represents our stock options granted, exercised, and forfeited during the first nine months of 2008.


The following table represents non-vested stock options granted, vested, and forfeited for the nine months ended September 30, 2008.

The total fair value of options vested during the nine months ended September 30, 2008 and 2007 was $35,000 and $70,900, respectively.
Restricted Stock Unit Awards
During the nine months ended September 30, 2008, the Company granted 23,500 restricted stock units under the 2000 Performance Share Program with a fair market value of $133,300 based on the closing market price of the Company’s stock on the grant date. The grants will vest over a three year period contingent on continued employment or service over the vesting period. The Company's results for the three months ended September 30, 2008 include stock-based compensation expense of $10,690 for these restricted stock unit grants, as required by SFAS 123(R). Such amounts have been included in the Consolidated Statements of Operations within cost of goods sold in the amount of $2,185 and in selling, general and administrative expenses in the amount of $8,505.
For the nine months ended September 30, 2008, stock-based compensation expense was $30,370 for restricted stock unit grants. Such amounts have been included in the Consolidated Statements of Operations within cost of goods sold in the amount of $4,855 and in selling, general and administrative expenses in the amount of $25,515.
There were no grants of restricted stock units under this plan in the nine months ended September 30, 2007 and the Company did not recognize any related stock compensation expense during that period.
A summary of the Company’s non-vested restricted stock units at September 30, 2008 is presented below:


Disclosure: Forward Looking Statements
This Quarterly Report contains forward-looking statements as that term is defined in the federal securities laws. The Company wishes to insure that any forward-looking statements are accompanied by meaningful cautionary statements in order to comply with the terms of the safe harbor provided by the Private Securities Litigation Reform Act of 1995. The events described in the forward-looking statements contained in this Quarterly Report may not occur. Generally these statements relate to business plans or strategies, projected or anticipated benefits or other consequences of our plans or strategies, projected or anticipated benefits of acquisitions to be made by us, projections involving anticipated revenues, earnings, or other aspects of our operating results. The words “may”, “will”, “expect”, “believe”, “anticipate”, “project”, “plan”, “target”, “intend”, “estimate”, and “continue”, and their opposites and similar expressions are intended to identify forward-looking statements. We caution you that these statements are not guarantees of future performance or events and are subject to a number of uncertainties, risks, and other influences, many of which are beyond our control, that may influence the accuracy of the statements and the projections upon which the statements are based. Actual results may vary from these forward-looking statements for many reasons, including the following factors:
·adverse changes in economic or industry conditions in general or in the markets served by the Company and its customers
·actions by competitors
·inability to add new customers and/or maintain customer relationships
·inability to recruit or retain key employees.
The foregoing is not intended to be an exhaustive list of all factors that could cause actual results to differ materially from those expressed in forward-looking statements made by the Company. Investors are encouraged to review the risk factors set forth in the Company's most recent Form 10-K as filed with the Securities and Exchange Commission on March 28, 2008. Any one or more of these uncertainties, risks, and other influences could materially affect our results of operations and whether forward-looking statements made by us ultimately prove to be accurate. Our actual results, performance and achievements could differ materially from those expressed or implied in these forward-looking statements. Except as required by law, we undertake no obligation to publicly update or revise any forward looking statements, whether from new information, future events, or otherwise.
Readers are further cautioned that the Company’s financial results can vary from quarter to quarter, and the financial results for any period may not necessarily be indicative of future results.
The following discussion and analysis should be read in conjunction with the Company's consolidated financial statements and the notes thereto presented elsewhere herein. The discussion of results should not be construed to imply any conclusion that such results will necessarily continue in the future.
Critical Accounting Policies
Our significant accounting policies are described in Note 1 of the Consolidated Financial Statements. In preparing our financial statements, we made estimates and judgments that affect the results of our operations and the value of assets and liabilities we report. Our actual results may differ from these estimates under different assumptions or conditions.
For additional information regarding our critical accounting policies and estimates, see the section entitled “Managements’ Discussion and Analysis of Financial Condition and Results of Operations” in our annual report filed with the Securities and Exchange Commission on Form 10-K for the year ended December 31, 2007.
Results of Operations
Photonic Products Group, Inc.’s business units’ products continue to fall into two product categories: optical components (including standard and custom optical components and assemblies, crystals, and crystal components), and laser accessories (including wavelength conversion instruments that employ nonlinear or electro-optical crystals to perform the function of wavelength conversion, or optical switching, and optical Q-switches). Currently, its optical components product lines and services are brought to market via three PPGI business units: INRAD, Laser Optics, and MRC Optics (“MRC”). Laser accessories are brought to market by INRAD.
Revenues
Total sales for the three months ended September 30, 2008 were $3,803,000 and essentially flat as compared with total sales of $3,838,000 for the same three months in 2007. Total sales of $11,975,000 for the nine months ended September 30, 2008 were 8.3% higher as compared with $11,057,000 for the same period last year.
Shipments of custom optical components increased by approximately 2.0% in the third quarter, and by 14.9% for the first nine months, in comparison with the same periods last year.
The small increase in the third quarter was attributable to increased shipments of optical components from the MRC Optics business unit and Inrad, offset by a decrease in shipments of optical components from Laser Optics. Comparative period sales for specialty missile warning sensor crystal components increased during the period at Inrad, reflecting increased demand from one major defense industry contractor, which was partially offset by decreased sales of similar components to another customer when compared to the third quarter of last year. Sales at the MRC Optics business unit increased significantly on shipments from a strong order backlog, and as MRC made progress in resolving production problems that delay shipments in the first half of 2008. Optical component shipments from Laser Optics were down due to a push-out of deliveries requested by a major OEM customer in the semiconductor industry. These deliveries have been renegotiated to be scheduled for December of 2008 and mid 2009.
The increase in revenues from optical components for the nine months ended September 30, 2008 resulted from increased shipments at all three business units when compared to the same period in 2007.
Shipments of Inrad laser accessories were down approximately 33% in the third quarter, and 47% for the first nine months of the year, from the comparable periods last year. These reductions reflect reduced demand and sales for its Q-switches, harmonic generation systems, and related components.
Company sales were mainly to customers within the aerospace, defense, and process control and metrology industry sectors. For the third quarter of 2008, major customer sales (defined as 10% of period revenues) are summarized as follows: Sales to one defense industry customer represented 24.3% of total revenues in this quarter. By comparison, in 2007, sales to two major defense industry customers represented 12.1% and 18.4% of total revenues in the third quarter, respectively.
For the nine months ended September 30, 2008, sales to one defense industry customer represented 21.0% of the total revenues for the period, and sales to the one process industry controls and metrology customer represented 14.3% of total revenues. For the nine months ended September 30, 2007 sales to two defense industry customers represented 13.9% and 18.9% of total revenues.
Product bookings for the three months ended September 30, 2008 were $2,569,000 as compared with $5,199,000 for the same period last year. For the first nine months, product bookings were $11,213,000, compared with $13,525,000 in the first nine months of last year, down 17.1%.
It is important to note that product bookings are not equally distributed during any year. Major OEM customers typically place orders for their annual requirements once or twice per year, and at irregular intervals. In this year’s third quarter, order intake for OEM customers was below average as compared to recent years. One MRC Optics defense industry OEM customer reported that a major new production order had slipped from the third quarter and is now anticipating that the order will be received in December 2008 or January 2009. One Laser Optics process control and metrology industry OEM customer who serves semiconductor manufacturers world-wide has pushed-out release of its next production order without indication of an expected release date. Due to all these factors, total bookings for 2008 are expected to continue to trend below 2007 levels.
Product backlog on September 30, 2008 was approximately $8,865,000. This was down 5.8% from a backlog of $9,413,000 at the same point in 2007 as a result of lower bookings and higher sales volumes in the most recent quarter. By comparison, the September 30, 2008 product backlog was down 8.3% from $9,672,000 at December 31, 2007.
Cost of Goods Sold
For the three-months ended September 30, 2008, the cost of goods sold as a percentage of product revenues was 72.0% compared to 53.0% for the same period last year. In dollar terms, third quarter cost of goods sold was $2,738,000 compared with $2,022,000 in 2007, up 35.4%, on a sales drop of 0.9%. The increase in the cost of goods sold both as a percentage and in dollar terms, for the period, reflected a combination of higher material costs, higher labor costs, and higher non-labor manufacturing costs relative to sales revenues and in comparison to a highly profitable product mix in the third quarter of 2007.
Additionally, overhead absorption on work in process inventory was down significantly reflecting lower production levels during the third quarter of 2008 compared to the third quarter of 2007. The Company also increased company-wide inventory reserves by $109,000 and recorded inventory write-offs on certain MRC inventories of approximately $35,000, in the third quarter of 2008. All of the above factors contributed significantly to higher comparative cost of sales for these two periods.
In particular, material costs increased as a percentage of revenues for both the three month and nine month periods ended September 30, 2008, when compared, respectively, to the same periods in 2007. For the three months ended September 30, 2008 as compared to the same period in 2007, material costs relative to sales rose by approximately 39%. For the nine month comparison for 2008 to 2007, material costs relative to sales increased by approximately 23%. These increases are due principally to a change in product mix, including several new OEM products which contain a larger percentage of higher cost material in the manufacturing content than in the prior year. Management expects this trend to continue over the balance of 2008 and into 2009 as part of a shift to a business and product mix characterized by higher material content and a higher cost of goods sold percentage.
Production problems at our Florida facility have resulted in both higher labor and non-labor manufacturing costs and lower gross profit margins during the first nine months of the year. In the third quarter, MRC began to show some progress in resolution of previously reported production and shipment problems. This progress had a positive impact in the third quarter on the MRC top line. Shipments were up by 51% when compared to the second quarter of 2008, while cost of sales increased by only 16.3%. However, in comparison to the third quarter of 2007, although shipments were up 58%, cost of sales increased 91%, showing the cumulative impact of higher costs and production inefficiencies at MRC over the past few quarters. Work in process and finished goods inventory created in these earlier quarters and bearing higher than normal production costs had a negative impact on MRC gross profit margins as these products shipped in the current quarter. Management believes that these margins will gradually improve in the quarters ahead. Management continues to work on and implement improvements to productivity and efficiency in order to positively impact future production costs.
Gross profit in the third quarter was $1,065,000 or 28.0%, reflecting the various factors discussed above. This compares with a gross profit of $1,815,000 or 47.3% in the third quarter of 2007. For the nine months ended September 30, 2008, gross profit was $3,786,000 or 31.6%, down from $4,591,000 or 41.5% for the same period last year.
Selling, General and Administrative Expenses
Selling, general and administrative expenses (“SG&A” expenses) in the third quarter of 2008 were $949,000 or 25.0% of sales compared to $908,000 or 23.7% of sales for the three months ended September 30, 2007.
SG&A expenses for the first nine months of 2008 were $2,914,000, or 24.3% of sales, compared with $2,667,000, or 24.1% of sales in the first nine months of 2007. The increase over the nine month comparable periods of approximately $247,000 or 9.3% resulted mainly from higher recruitment, wage and relocation costs related to new personnel, to higher travel and trade show expenses related to both increased sales and business development activity during 2008, and more frequent travel between our centers of operation by corporate personnel.
Income from Operations
The Company realized income from operations of $116,000, or 3.1% of sales in the three months ended September 30, 2008. This compares to income from operations of $907,000 or 23.6% of sales for the comparable third quarter of 2007.
For the nine months ended September 30, 2008, income from operations was $872,000 or 7.3% of sales, down from $1,924,000 or 17.4% of sales for the first nine months of 2007.
The reduction in income from operations for both the third quarter and the nine months of 2008, in relation to the comparable periods in 2007, reflected production issues and associated costs which resulted in operating losses at MRC Optics, decreased operating profit at the Company’s INRAD and Laser Optics business units in the same periods mainly due to lower margins, and higher SG&A costs as discussed above.
Other Income and Expense
For the three months ended September 30, 2008, net interest expense was $33,000, a decrease from net interest expense of $70,000 in the third quarter last year.
Net interest expense was $143,000 for the first nine months of 2008, down from $215,000 in the first nine months of 2007.
The reduction resulted from lower interest expense on reduced balances of fixed interest debt which was offset by lower interest income due to decreased interest rates during the period and lower cash balances in interest bearing deposits. Interest expense for the nine months was approximately $193,000 compared to $335,000 for 2007. Interest income for the nine month period in 2008 was approximately $50,000 while interest income in 2007 was approximately $120,000 for the nine month period.
In the second quarter of 2008, the Company sold surplus manufacturing equipment with an original capital cost of $30,000 and accumulated depreciation of $29,000 for proceeds of $10,000 and recognized a gain on the sale of $9,000.
Benefit from Income Taxes
The Company recorded a current provision for the third quarter of $16,000 for estimated state tax and federal Alternative Minimum Tax liabilities. In the third quarter of 2007, the current tax provision was $40,000. The current tax provision recorded for the first nine months of this year of $90,000 compares to a provision for the first nine months of 2007 of $80,000.
 
In accordance with the provisions of Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”), the Company recognizes deferred tax liabilities and assets for the expected future tax consequences of events that have been recognized in the Company’s financial statements or tax returns.  Deferred tax liabilities and assets are determined based on the difference between the financial statements carrying amounts and the tax basis of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse.
 
At DecemberThe Company recorded a current provision of $53,000 for estimated state and federal alternative minimum tax, in accordance with SFAS No. 109, for the three months ended March 31, 2007,2009.  In addition, the Company had a netcompany reduced its deferred tax asset of approximately $2,041,000, the primary component of which was a net operating loss carryforward. Through December 31, 2007, the Company had established a valuation allowance to fully offset this deferred tax asset in the event the tax asset will not be realized in the future. In accordance with SFAS 109, the Company has determined that based on a recent history of consistent earnings and future income projections, a full valuation allowance is no longer required. Accordingly, during the nine months ended September 30, 2008, the Company reduced the valuation allowance to $1,735,000 and recognized a deferred tax benefit available from the Company’s net operating loss carry forward position of $306,000.$289,000.  This resulted in the Company recording a net benefit from income taxes of $216,000$236,000 after offsetting the tax benefit against the deferred tax liability.

4
For the three months ended March 31, 2008, the Company recorded a current tax provision of $50,000 for estimated state and federal alternative minimum tax liabilities.  In addition, the company recognized a deferred tax benefit of $102,000.  This resulted in a net benefit of $52,000 after offsetting the tax benefit against the current tax provision.
 
Effective January 1, 2007, the Company adopted the Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, and interpretation of SFAS No. 109” (“FIN 48”).  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements and requires that a tax position must be more likely than not to be sustained before being recognized in the financial statements.  The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution.  Under FIN 48, the Company must also assess whether uncertain tax positions, as filed, could result in the recognition of a liability for possible interest and penalties which the Company would include as a component of income tax expense.  For the three months ended March 31, 2009 and 2008, the Company did not recognize any tax liabilities related to uncertain tax positions.
Net (Loss) Income per Common Share
The basic net (loss) income per common share is computed using the weighted average number of common shares outstanding for the applicable period.  The diluted income per share is computed using the weighted average number of common shares plus potential common equivalent shares outstanding, including the additional dilution related to the conversion of stock options, unvested restricted stock grants, warrants, convertible preferred shares, and potential common shares issuable upon conversion of outstanding convertible notes, except if the effect on the per share amounts is anti-dilutive.  For the three month periods ended March 31, 2009, the potential dilutive effect of all common equivalent shares outstanding have been excluded from the diluted computation because their effect is anti-dilutive.
The following is the reconciliation of the basic and diluted earnings per share computations required by Statement of Financial Standards (“SFAS”) No. 128 (“Earnings per Share’):

14
  
Three Months Ended
March 31, 2009
  
Three Months Ended
March 31, 2008
 
  
Income(Loss)
(Numerator)
  
Shares
(Denominator)
  
Per Share
Amount
  
Income(Loss)
(Numerator)
  
Shares
(Denominator)
  
Per Share
Amount
 
Basic Earnings Per Share:
                  
Net (Loss) Income Applicable  to Common Shareholders $(314,409)  11,260,199  $(0.03) ) $491,200   10,535,075  $0.05 
Effect of dilutive securities:                        
    Convertible Debt  —   —       37,500   2,500,000     
    Warrants  —   —       —   2,089,502     
    Options and stock grants  —   —       —   738,240     
Diluted Earnings Per Share:                        
Net (Loss) Income Applicable to Common Shareholders $(314,409)  11,260,199  $(0.03) $528,700   15,862,817  $0.03 
 
Net IncomeStock-Based Compensation
 
The Company hadaccounts for stock-based compensation in accordance with the recognition and measurement provisions of Statement of Financial Accounting Standards ("SFAS") No. 123(R), Share-Based Payment.

5
Under the fair value recognition provision of SFAS 123(R), stock-based compensation cost is estimated at the grant date based on the fair value of the award.  The Company estimates the fair value of stock options granted using the Black-Scholes option pricing model.  The fair value of restricted stock units granted is based on the closing market price of the Company’s common stock on the date of the grant.  The fair value of these awards, adjusted for estimated forfeitures, is amortized over the requisite service period of the award, which is generally the vesting period.
Recently Adopted Accounting Pronouncements and Updates
In December 2007, the FASB issued FASB Statement No. 141 (Revised 2007), “Business Combinations” (“SFAS 141(R)”).  SFAS 141(R) will significantly change the accounting for business combinations.  Under SFAS 141(R), an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions.  SFAS 141(R) will change the accounting treatment for certain specific items, including:
·Non-controlling interests (formerly known as “minority interests”) will be recorded at fair value at the acquisition date;
·Acquired contingent liabilities will be recorded at fair value at the acquisition date and subsequently measured at either the higher of such amount or the amount determined under existing guidance for non-acquired contingencies;
·In-process research and development will be recorded at fair value as an indefinite-lived intangible asset at the acquisition date;
·Restructuring costs associated with a business combination will generally be expensed subsequent to the acquisition date; and
·Changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense.
SFAS 141(R) also includes a substantial number of new disclosure requirements.  Company adopted SFAS 141(R) on January 1, 2009 and will apply it prospectively to business combinations for which the acquisition date is on or after this date.  The adoption of SFAS 141(R) will have an impact on the Company’s accounting for future business combinations, but the effect is dependent upon the type and structure of any acquisitions that it may make in the future.
The FASB issued FASB Statement No. 160, “Non-controlling Interests in Consolidated Financial Statements - An Amendment of ARB No. 51” in December 2007 (“SFAS 160”).  SFAS 160 establishes new accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary.  Specifically, this statement requires the recognition of a non-controlling interest (minority interest) as equity in the consolidated financial statements.  The amount of net income attributable to the non-controlling interest will be included in consolidated net income on the face of $169,000the income statement.  Statement 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest.  In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated.  Such gain or loss will be measured using the fair value of the non-controlling equity investment on the deconsolidation date.  Statement 160 also includes expanded disclosure requirements regarding the interests of the parent and its non-controlling interest.  Statement 160 is effective for the thirdCompany as of January 1, 2009.  The Company adopted the disclosure provisions of SFAS No. 160 but the information regarding non-controlling interests in a subsidiary is immaterial to the 2009 consolidated financial statements.

6
In February 2008, the FASB issued FSP No. 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13, and FSP No. 157-2, Effective Date of FASB Statement No. 157.  FSP No. 157-1 amends SFAS No. 157 to exclude SFAS No. 13, Accounting for Leases, and its related interpretive accounting pronouncements that address leasing transactions.  FSP No. 157-2 delays the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of the first quarter of 2009 for the Company.  The Company adopted SFAS No. 157 for nonfinancial assets and nonfinancial liabilities but it is not expected to have a material impact on the Company’s 2009 consolidated financial statements.  However, the determination of fair value for purposes of accounting for business combinations and for conducting  periodic assessments of goodwill and other long-lived assets for impairment will be made using the definition of fair value prescribed by SFAS No. 157.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities-An Amendment of SFAS No. 133.  The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance and cash flows.  It is effective for periods beginning after November 15, 2008, with early application encouraged.  The Company adopted SFAS No. 161 on January 1, 2009 but does not expect it to have a material impact on its 2009 consolidated financial statements.
In April 2008, the FASB issued FSP No. 142-3, Determination of the Useful Life of Intangible Assets.  FSP No. 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognizable intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets.  The intent of FSP No. 142-3 is to improve the consistency between the useful life of a recognizable intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141(R), and other U.S.  generally accepted accounting principles.  The Company adopted FSP No. 142-3 on January 1, 2009 but does not expect it to have a material impact on its 2009 consolidated financial statements.
In June 2008, the FASB issued FSP Emerging Issues Task Force (“EITF”) 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities” (“FSP EITF 03-6-1”).  FSP EITF 03-6-1 provides that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method.  FSP EITF 03-6-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years.  Upon adoption, companies are required to retrospectively adjust earnings per share data (including any amounts related to interim periods, summaries of earnings and selected financial data) to conform to provisions of FSP EITF 03-6-1.  The Company determined the adoption of FSP EITF 03-6-1 will not have a material impact on its 2009 consolidated financial statements.
In June 2008, the FASB ratified EITF Issue 07-5, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock” (“EITF 07-5”).  Paragraph 11(a) of Statement of Financial Accounting Standard No 133, Accounting for Derivatives and Hedging Activities (“SFAS 133”) specifies that a contract that would otherwise meet the definition of a derivative, but is both (a) indexed our own stock and (b) classified in stockholders’ equity in the statement of financial position would not be considered a derivative financial instrument.  EITF 07-5 provides a new two-step model to be applied in determining whether a financial instrument or an embedded feature is indexed to an issuer’s own stock, including evaluating the instrument’s contingent exercise and settlement provisions, and thus able to qualify for the SFAS 133 paragraph 11(a) scope exception.  It also clarifies the impact of foreign-currency-denominated strike prices and market-based employee stock option valuation instruments on the evaluation.  The Company adopted EITF issue 07-5 in the first quarter of 2009.  The adoption of EITF 07-5 did not have a material impact on the Company’s 2009 consolidated financial statements.

7
In April 2009, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That are Not Orderly” (“FSP FAS 157-4”).  FSP FAS 157-4 provides additional guidance for determining the fair value of assets and liabilities when the volume and level of activity for the asset or liability have significantly decreased.  FSP FAS 157-4 also provides guidance on identifying circumstances that indicate an observed transaction used to determine fair value is not orderly and, therefore, is not indicative of fair value.  FSP FAS 157-4 is effective for interim and annual periods ending after June 15, 2009.  The Company does not anticipate the adoption of this FSP will have a material impact on its results of operations, cash flows or financial condition. 
In April 2009, the FASB issued FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (“FSP FAS 115-2 and FAS 124-2”).  FSP FAS 115-2 and FAS 124-2 changes the method for determining whether an other-than-temporary impairment exists for debt securities by requiring a company to assess whether it is probable that it will not be able to recover the cost basis of a security utilizing several factors, including the length of time and the extent to which fair value has been less than the cost basis, adverse conditions related to a particular security and volatility of a particular security.  FSP FAS 115-2 and FAS 124-2 also requires that an other-than-temporary impairment charge for debt securities be recorded in earnings if it is more-likely-than-not that the entity will sell or be required to sell a security before anticipated recovery of the cost basis.  In addition, if any portion of a decline in fair value below the cost basis of a security is related to credit losses, such amount should be recorded in earnings.  Lastly, FSP FAS 115-2 and FAS 124-2 expands and increases the frequency of existing disclosures about other-than-temporary impairments for debt and equity securities to all interim and annual periods.  FSP FAS 115-2 and FAS 124-2 are effective for interim and annual periods ending after June 15, 2009.  The Company is currently evaluating the impact that the adoption of FSP FAS 115-2 and FAS 124-2 will have on its results of operations, cash flows or financial condition.
In April 2009, the FASB issued FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (“FSP FAS 107-1 and APB 28-1”).  FSP FAS 107-1 and APB 28-1 increases the frequency of certain fair value disclosures from annual to quarterly.  Such disclosures include the fair value of all financial instruments within the scope of Statement of Financial Accounting Standards (“SFAS”) No. 107, “Disclosures about Fair Value of Financial Instruments,” as well as the methods and significant assumptions used to estimate fair value.  FSP FAS 107-1 and APB 28-1 is effective for interim periods ending after June 15, 2009. The Company does not anticipate the adoption of these statements to materially affect the current disclosures.

8
NOTE 2- EQUITY COMPENSATION PROGRAM AND STOCK BASED COMPENSATION
a)2000 Equity Compensation Program
The Company’s 2000 Equity Compensation Program provides for grants of options, stock appreciation rights and performance shares to employees, officers, directors, and others who render services to the Company.  The program consists of four plans including:  (i) the Incentive Equity Compensation Program which provide for grants of “Incentive Stock Options”, (ii) the Supplemental Program which provide for grants of stock options to non-employees, (iii) the SAR Program which allows the granting of stock appreciation rights and, (iv) the Performance Share Program under which eligible participants may receive stock awards, including restricted stock and restricted stock units.  The plans are administered by the Compensation Committee of the Board of Directors.  Under these plans, an aggregate of up to 6,000,000 shares of common stock may be granted.  The 2000 Equity Compensation plan expires in August 2010.
b)Stock Option Expense
The Company's results for the three months ended March 31, 2009 and 2008 include share-based compensation expense for stock option grants, as required by SFAS 123(R), totaling $12,487 and $8,733, respectively.  Such amounts have been included in the accompanying Consolidated Statements of Operations within cost of goods sold in the amount of $1,440 ($2,076 for 2008), and selling, general and administrative expenses in the amount of $11,047 ($6,657 for 2008).
As of March 31, 2009 and 2008, there were $117,695 and $26,088 of unrecognized compensation costs, net of estimated forfeitures, related to non-vested stock options, which are expected to be recognized over a weighted average period of approximately 2.8 years and 1.3 years, respectively.
The fair value of option grants used to determine the stock option expense is estimated using the Black-Scholes option pricing model, as of the date of the grant.  The Company follows guidance under SFAS 123(R) when reviewing and updating its assumptions.  Expected volatility is based upon the historical volatility of the Company’s stock and other contributing factors.  The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant.
The following range of weighted-average assumptions were used to determine the fair value of stock option grants during the three months ended March 31, 2009 and 2008, respectively:

  Three Months Ended 
  March 31, 
  2009  2008 
Expected Dividend yield  0.00%  —%
Expected Volatility  180%  —%
Risk-free interest rate  2.5%  —%
Expected term 8 -10 years   — 
The Company did not grant any stock options during the three months ended March 31, 2008.
c.Stock Option Activity
For the three month period ended March 31, 2009, there were 72,584 options granted with a weighted average estimated fair value of $1.72 and a weighted average exercise price of $1.75, which was equal to the closing market price on the date of the grant.  Of these grants, 7,742 stock options had a term of 3 years and vested as of the grant date.

9
The following table represents our stock options granted, exercised, and forfeited during the three month period ended March 31, 2009.

Stock Options 
Number of
Options
  
Weighted Average
Exercise
Price per Option
  
Weighted
Average
Remaining
Contractual
Term (years)
  
Aggregate
Intrinsic Value
 
Outstanding at January 1, 2009  1,030,139  $1.50   3.9  $ 161,000 
Granted  72,584   1.75         
Exercised  —   —         
Expired  (25,000)  1.00         
Outstanding at March 31, 2009  1,077,723  $1.53   3.5  $ 349,987 
                 
Exercisable at March 31, 2009  1,003,212  $1.51   3.0  $ 340,118 
The following table represents non-vested stock options granted, vested, and forfeited for the three months ended March 31, 2009.

Non-vested Options Options  
Weighted-Average Grant-Date
Fair Value
 
Non-vested  - January 1, 2009  33,220  $1.48 
Granted  72,584  $1.72 
Vested  31,293  $1.50 
Expired  —   — 
Non-vested – March 31, 2009  74,511  $1.70 
The total fair value of options vested during the three months ended March 31, 2009 and 2008 was $46,900 and $35,000, respectively.
d.Restricted Stock Unit Awards
The Company's results for the three months ended March 31, 2009 include stock-based compensation expense of $11,108 for restricted stock unit grants under the Company’s 2000 Performance Share Program.  Such amounts have been included in the accompanying Consolidated Statements of Operations within cost of goods sold in the amount of $1,333 and in selling, general and administrative expenses in the amount of $9,775.  There were no grants of restricted stock units under this plan during the three months ended March 31, 2009.
For the three months ended March 31, 2008, the Company’s results include stock-based compensation expense of $9,840 for restricted stock unit grants under the Company’s 2000 Performance Share Program.  Such amounts have been included in the accompanying Consolidated Statements of Operations within cost of goods sold in the amount of $1,340 and in selling, general and administrative expenses in the amount of $8,500.  In the corresponding period, the Company granted 17,500 restricted stock unit awards with a fair value of $70,000 based on the closing market price of the Company’s common stock, on the grant date.

10
Restricted stock unit awards vest over a three year period contingent on continued employment or service over the vesting period.
A summary of the Company’s non-vested restricted stock units at March 31, 2009 is presented below:

  
Restricted Stock
Units
  
Weighted-Average Grant-
Date Fair Value
 
Non-vested - January 1, 2009  31,500  $3.72 
Granted  —   — 
Vested  5,838  $4.00 
Forfeited  —   — 
Non-vested – March  31, 2009  25,662  $3.66 
NOTE 3- WORK-FORCE REDUCTION
During the three month period ended March 31, 2009, the Company reduced its combined work-force by 24 employees or approximately 23%, to reduce costs and align PPGI’s workforce with current business requirements while ensuring the Company would continue to meet its customers’ needs.  The reductions affected both the Company’s Northvale, NJ and the Sarasota, FL operations.
The following table summarizes the Company’s severance expense, including cash payments during the first quarter of 2009 and accrued severance expense included in accounts payable and accrued liabilities on the consolidated balance sheet as of March 31, 2009 (in thousands).

Severance expense recorded in the first quarter of 2009 $140 
Cash payments made in the first quarter of 2009  (86)
Accrued severance expense as of March 31, 2009 $54 
Severance expense, net of related payroll savings, did not significantly affect the Company’s operating results for the first quarter.
11
ITEM 2.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Caution Regarding Forward Looking Statements
This Quarterly Report contains forward-looking statements as that term is defined in the federal securities laws.  The Company wishes to insure that any forward-looking statements are accompanied by meaningful cautionary statements in order to comply with the terms of the safe harbor provided by the Private Securities Litigation Reform Act of 1995.  The events described in the forward-looking statements contained in this Annual Report may not occur.  Generally, these statements relate to business plans or strategies, projected or anticipated benefits or other consequences of the Company’s plans or strategies, projected or anticipated benefits of acquisitions made by the Company, projections involving anticipated revenues, earnings, or other aspects of the Company’s operating results.  The words “may”, “will”, “expect”, “believe”, “anticipate”, “project”, “plan”, “intend”, “estimate”, and “continue”, and their opposites and similar expressions are intended to identify forward-looking statements.  The Company cautions you that these statements are not guarantees of future performance or events and are subject to a number of uncertainties, risks, and other influences, many of which are beyond the Company’s control, that may influence the accuracy of the statements and the projections upon which the statements are based.  Factors which may affect the Company’s results include, but are not limited to, the risks and uncertainties discussed in Items 7 and 7A of the Company’s most recent Annual Report on Form 10-K as filed with the Securities and Exchange Commission on March 31, 2009.  Any one or more of these uncertainties, risks, and other influences could materially affect the Company’s results of operations and whether forward-looking statements made by the Company ultimately prove to be accurate.  Readers are further cautioned that the Company’s financial results can vary from quarter to quarter, and the financial results for any period may not necessarily be indicative of future results.  The foregoing is not intended to be an exhaustive list of all factors that could cause actual results to differ materially from those expressed in forward-looking statements made by the Company.  The Company’s actual results, performance and achievements could differ materially from those expressed or implied in these forward-looking statements.  The Company undertakes no obligation to publicly update or revise any forward looking statements, whether from new information, future events, or otherwise.
Critical Accounting Policies
Our significant accounting policies are described in Note 1 of the accompanying consolidated financial statements and further discussed in our annual financial statements included in our annual report on Form 10-K.  In preparing our consolidated financial statements, we made estimates and judgments that affect the results of our operations and the value of assets and liabilities we report.  Our actual results may differ from these estimates under different assumptions or conditions.
For additional information regarding our critical accounting policies and estimates, see the section entitled “Managements’ Discussion and Analysis of Financial Condition and Results of Operations” in our annual report filed with the Securities and Exchange Commission on Form 10-K for the year ended December 31, 2008.
Results of Operations
Photonic Products Group, Inc.’s business falls into two product categories: Optical Components (including standard and custom optical components and assemblies, crystals, and crystal components), and Laser Accessories (including wavelength conversion instruments that employ nonlinear or electro-optical crystals to perform the function of wavelength conversion, or optical switching, and optical Q-switches).  Its optical components product lines and services are brought to market through three business units: INRAD, Laser Optics, and MRC Optics (“MRC”).  Laser accessories are manufactured and sold by INRAD.

12
Revenues
Consolidated sales for the three months ended March 31, 2009 were $2,815,000 compared with consolidated sales of $4,164,000 in the first quarter of 2008, down from $797,000 for32.4%.
Sales of custom optical components fell approximately 31.6% in the thirdfirst quarter of 2007. 2009, attributable to decreased sales at both Laser Optics and Inrad.  At MRC, Sales of custom optical components increased by approximately 14%.
Sales of laser accessories decreased by approximately 51% in this first quarter as compared to the first quarter of last year, reflecting reduced demand for laser systems and related components.
Overall, first quarter sales to major customers who represent more than 10% of period sales fell significantly.  One large OEM customer in 2008, in the process control and metrology sector, who represented 18% of first quarter 2008 sales, pushed out scheduled delivers and had no shipments in the first quarter of 2009.
Sales to the top three customers in the three month period ended March 31, 2009 represented 42% of the sales volume, down from 46% in the comparable 2008 period.  This represents an overall drop of approximately 37% in sales revenue.
Product backlog at March 31, 2009 was $4.9 million compared to the record level backlog of $12.4 million at March 31, 2008.  The current period backlog levels reflect lower new order activity throughout the fourth quarter of 2008 and the first quarter of 2009.  This was primarily attributable to the current economic slowdown and its impact on our customers’ who experienced a decline in business activity and reduced demand for our products.
By comparison, March 31, 2008 backlog for optical components was especially strong for Laser Optics due to the timing of the release of two major OEM customers.  Our backlog levels typically vary based on the timing of such large OEM customers who place orders for their annual requirements at irregular intervals during the year.
Cost of Goods Sold
For the nine monthsthree-months ended September 30, 2008, net incomeMarch 31, 2009, cost of goods sold was $954,000, as$2,433,000 or 86.4% of sales compared with net incometo $2,663,000 or 64.0% of $1,629,000 insales, for the same period last year.
 
Net Income ApplicableOverall, material costs, labor costs and manufacturing expenses were lower than the previous year but relative to Common Shareholders and Earnings per Common Sharereduced sales revenues in the 2009 period, each cost component increased, as a percentage of sales.
 
Net income applicableMaterial costs decreased by $65,000, in the first quarter of 2009.  However, material costs as a percentage of sales increased by approximately 13%, reflecting a higher percentage of systems and components in the total sales mix, as compared to common shareholdersthe first quarter of last year.
In addition, total manufacturing labor decreased by approximately 4.8% in dollar terms from the comparable period last year, but as a percentage of sales, increased by approximately 40% on lower sales volumes in the period.  The impact of management’s work-force reduction plan in the first quarter of 2009 was affected by both the timing of the layoffs and termination expense which totaled $65,000, and, net of related payroll savings in the same period, did not materially affect this quarter’s operating results.  We expect the full savings from personnel reductions, in the manufacturing area, to take effect starting in the second quarter of this year.

13
Manufacturing overheads, excluding labor, decreased by 2.0% from the comparable period in 2008, but reflect a large percentage of fixed or semi-fixed costs which are relatively unaffected by changes in sales volumes.  As a result manufacturing expenses, as a percentage of sales were up 31.0% in the period on a sales decrease of 32.4%.
Gross margin in the first quarter was $382,000 or 13.6%, compared with a gross margin of $1,502,000 or 36.0% in the comparable period of 2008, reflecting the factors discussed above.
Selling, General and Administrative Expenses
Selling, general and administrative expenses (“SG&A” expenses) in the first quarter of 2009 were $907,000 or 32.2% of sales compared to $987,000 or 23.7% of sales for the three months ended September 30,March 31, 2008.  This represents a decrease of approximately $80,000 or 8.1%.  Legal fees and consulting fees were down $16,000 and $15,000, respectively from the first quarter of 2008.  In addition, the Company incurred recruiting fees of $16,000 related to the hiring of new personnel in MRC, in the first quarter of 2008 was $169,000 or earnings per shareand did not have any recruiting fees in the first quarter of $0.02, basic2009.
Overall, SG&A wages and $0.01 diluted.salaries expense were comparable to last years’ level and included expense savings from personnel reductions, net of termination payments of $74,000 in connection with the Company’s employee reduction plan, as well as, corporate staff changes during the quarter.  The impact of SG&A personnel reductions will take full effect in subsequent period.  In addition, the Company plans to closely monitor and manage discretionary SG&A expenses, to identify opportunities for future cost reductions.
Operating (Loss) Income
The Company had an operating loss of $(525,000) in the three months ended March 31, 2009, primarily reflecting the decrease in sales and the impact of the Company’s relatively fixed overhead and SG&A expenses, as discussed above.  This compares with a netto operating income applicable to common shareholdersof $515,000 or 12.4% of sales for the same period in 2007first quarter of $797,000 or earnings per share of $0.09, basic2008.
Other Income and $0.06 diluted.Expense
 
For the ninethree months ended September 30,March 31, 2009, net interest expense was $32,000, a decrease from net interest expense of $76,000 in the first quarter of last year.
Lower interest expense resulted from reduced balances of fixed interest debt which primarily reflected the Company’s payment of a $1.7 million Secured Promissory Note in the first quarter of 2008.  In addition, interest payments were lower on reduced balances of other notes and capital leases.
Interest expense for the first quarter of 2008, netincluded the amortization of warrant costs in the amount of $37,000.
Interest income applicablewas $11,000 this year to common shareholders was $954,000 or $0.09 per share, basic, and $0.07 per share, diluted. Fordate, compared to $25,000 in the ninethree months ended September 30, 2007, net income applicable to common shareholders was $1,396,000, or $0.17 per share, basic, and $0.12 per share diluted.
During the last six months of 2007, the Company recalled the entire issue of its Series A and Series B convertible preferred stock, which the holders elected to convert into shares of the Company’s common stock. AsMarch 31, 2008 as a result there were no stock dividends recorded by the Company during the nine months ended September 30, 2008.of reduced balances in, and lower interest rates and on short term certificates of deposit.
 
In contrast, net income applicable to common shareholdersthe first quarter of 2009, the Company sold surplus precious metal tools and recorded a gain of $7,371 on the sale.
Income Taxes
In accordance with the provisions of Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”), the Company recognizes deferred tax liabilities and assets for the expected future tax consequences of events that have been recognized in the nine months ended September 30, 2007 reflected the distribution of a common stock dividend to the holders of the Series ACompany’s financial statements or tax returns.  Deferred tax liabilities and B convertible preferred stock outstanding at that time. The number of common shares issued in settlement of the dividend wasassets are determined based on the coupon rate ofdifference between the preferred shares, the total shares outstanding,financial statements carrying amounts and the conversion pricetax basis of each seriesassets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse.

14
The Company recorded a current provision of preferred shares.$53,000 for estimated state and federal alternative minimum tax, in accordance with SFAS No. 109, for the three months ended March 31, 2009.  In addition, the company reduced its deferred tax asset valuation allowance and recognized a deferred tax benefit of $289,000.  This resulted in a net benefit of $236,000 after offsetting the tax benefit against the deferred tax liability.
For the three months ended March 31, 2008, the Company recorded a current tax provision of $50,000 for estimated state and federal alternative minimum tax liabilities.  In addition, the company recognized a deferred tax benefit of $102,000.  This resulted in a net benefit of $52,000 after offsetting the tax benefit against the current tax provision.
Effective January 1, 2007, the Company adopted the Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, and interpretation of SFAS No. 109” (“FIN 48”).  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements and requires that a tax position must be more likely than not to be sustained before being recognized in the financial statements.  The dividend value was calculated by reference totax benefits recognized in the market price of the common sharesfinancial statements from such a position are measured based on the dividend distribution date. Thelargest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution.  Under FIN 48, the Company issued 133,280 common sharesmust also assess whether uncertain tax positions, as filed, could result in 2007, representing dividendsthe recognition of a liability for possible interest and penalties which the Company would include as a component of income tax expense.  For the three months ended March 31, 2009 and 2008, the Company did not recognize any tax liabilities related to preferred shareholders of $233,240.uncertain tax positions.
 
Net Income
The Company had a net loss of $(314,000) for the three months ended March 31, 2009 as compared to net income of $491,000 for the three months ended March 31, 2008, mainly as a result of lower sales and reduced profit margins in the current period, as discussed above.
Liquidity and Capital Resources
In the first quarter of 2009, management implemented an employee reduction plan to align the Company’s workforce with business activity while maintaining customer service levels.  In connection with this, the Company recorded a termination payment expense of $140,000 of which, approximately $54,000, will be paid in the second and third quarter of 2009.  In addition, a total of $61,000 was paid for accrued vacation benefits to affected employees. Annualized savings from the reductions are expected to be approximately $1.1 million.
 
Net cash flow from operating activities was $879,000 for the nine months ended September 30, 2008, compared with cash flow provided by operating activities was $357,000 for the three months ended March 31, 2009, compared with net cash flow used in operating activities of $1,632,000$(223,000) in the ninethree months ended September 30, 2007, reflecting mainly the impact of lower net income over the comparable periods and offset by a reduction in net working capital requirements this year.March 31, 2008
 
In the first nine monthsquarter of 2008, the level of2009, a reduction in accounts receivable decreasedbalances provided $1,014,000 of cash flow primarily as a result of the sales volume decline in the first quarter.  Accounts receivable balances fell from $2,811,000 at December 31, 2008 to $1,796,000 at the end of the current quarter compared to an increase in accounts receivable the amount of $184,000 in the first quarter of 2008.
Inventory levels fell by $233,000$93,000 to $1,949,000$1,796,000 at March 31, 2009 compared to an increase of $43,000$364,000 in the three month period ended March 31, 2008.  The decrease in inventory from the comparable period last year to $2,439,000 at the September 30, 2007 date. Although sales were comparable in the quarters ended September 30, 2008 and 2007, respectively, in the third quarter of 2007 they were more heavily weighted to the later part of the quarter as compared to a more evenly distributed sales pattern in the third quarter of 2008.
Inventory levels increased by $296,000 to $3,227,000 at September 30, 2008 compared to an increase of $661,000 in the nine month period ended September 30, 2007, to $2,997,000. This year the higher inventory balance is primarily attributable to the impactrelative decline in booking levels and shipping activity in the first three months of 2009.  In addition, production problems that havein the first quarter of 2008 slowed and delayed shipments at MRC.  MRC and led to an increase in inventory levels in that period.

15
 
Accounts payable and accrued liabilities decreased by $721,000$486,000 to $2,021,000 over$1,675,000 during the first nine monthsquarter of 2008. This compares with2009, compared to a reduction of $51,000 over$217,000 during the nine month period ending September 30, 2007.first quarter of 2008.  The reduction in accounts payablethe total balance this year primarily reflects a decrease in part,purchasing activity during the quarter in response to decreased sales activity which affected trade payables.  Trade payables were $339,000, down by $237,000 or 41% from December 31, 2008.  In addition, accrued liabilities were affected by accrued vacation balances which fell by $88,000 or 22.6% reflecting payouts to terminated employees in the first quarter of 2009.  The Company also paid out $81,000 in accrued bonuses in the first quarter of 2009 related to 2008 fiscal year performance, as well as, accrued 401K expense of $179,000.  Offsetting these reductions, the Company recorded an accrual for termination expenses of $54,000 which had been expensed but not paid out during the period.
In the first quarter of 2008, trade payables increased by $365,000 but were offset by payment of $477,000 in accrued interest related to the early retirement of $1,700,000 in senior secured debt in the first quarter of 2008, offset by the accrual of interest on the remaining balance of unsecured promissory notes and other debt.March, 2008.  In addition the Company paid out $177,000 in accrued bonus in the first quarter of 2008 related to the 2007 fiscal year performance. This exceeded accrued bonus paid in the same period last year related to 2006 performance. The decrease is also attributable to a decreaseperformance and $160,000 in accrued income tax balances reflecting the Company’s payment of state tax installments during the nine months of 2008.
15
401k expenses.
 
Customer advances net of liquidations increaseddecreased by $12,000$125,000 to $331,000 in the first nine monthsquarter of 2008 to $882,0002009 compared to a decrease of $300,000 in the nine months ended September 30, 2007 of $369,000comparable period last year to $871,000.$571,000.
 
Cash flows used in investing activities were $82,000 in the first quarter of 2009.  Capital expenditures for the ninethree months ended September 30, 2008March 31, 2009 were $726,000 and included$37,000 down from $ 186,000, in the three months ended March 31, 2008.  Management has instituted a program of ongoing review of planned capital expenditures primarily for increased capacity and production capability in our both our Sarasota, Florida and Northvale, NJ locations. Mostdeferral, where practical, to minimize the impact on the Company’s cash flows over the balance of the major expendituresyear.  In addition, the Company purchased platinum in the form of a crucible used in the production of high-temperature crystals.  The purchase price of $54,000 was offset by the proceeds of surplus platinum that was sold by the Company for these projects have been incurred. Offsetting$16,000 in the impact of capital expendituressame period.  The Company recorded a gain on cash flows was the receipt of $10,000 as proceeds from the sale of surplus manufacturing equipment$7,000.
Net cash used in financing activities during the secondfirst quarter of 2008. This compares to capital expenditures2009 totaled $5,000 and consisted primarily of $157,000 in the first nine monthsprincipal payments of 2007 primarily for replacement of capital equipment at the end of its useful life.
$4,000 on Other Long Term Notes.  In the first quarter of 2008, net cash used in financing activities was $995,000 reflecting the Company continued its plan to accelerate debt repayment with the focus on strengthening the balance sheet, improving its financial flexibility, and reducing overall financing costs and paid, prior to maturity,payment of a secured promissory note for $1,700,000, plus accrued interest of $477,000, to Clarex Limited, a major shareholder.  The noteThis was set to mature on December 31, 2008. Withoffset by proceeds received from the retirementexercise of this Senior Secured note,warrants and stock options.  During the Company has eliminated allfirst three months of 2008, proceeds from the exercise of stock options were $140,000, with 77,500 stock options exercised at a weighted average price of approximately $1.80 per share and converted into an equivalent number of shares of the liens against its assets, with the exceptionCompany’s common stock.  In addition, a total of specific liens related497,890 warrants issued pursuant to the remaining capital leases.
The Company had originally issued the $1,700,000 promissory note secured by all assetsa private placement of the Company,Company’s common stock, in June2004, were exercised.  This included the exercise of 2003, and used the proceeds to pay off existing debt. The Company’s Board375,250 warrants with a total exercise price of Directors approved the issuance of 200,000 warrants to the holder, as a fee$507,000, in exchange for the issuance of the Note. In 2004, the Company approved the issuance of 200,000 additional warrants to Clarex Limited as consideration for extending the maturity375,250 shares of the note anCompany’s common stock.  An additional 36 months. The122,640 warrants were exercisable at $0.425 per share and $1.08 per share, respectively, and with expiration datesexercised using a cashless feature available for warrants originally issued to the placement agent, in exchange for 79,565 shares of March 31, 2008 and May 18, 2008, respectively.the Company’s common stock.
 
On March 28, 2008, Clarex Limited exercised 200,000 warrants with an expiration date of March 31, 2008 for a total exercise price of $85,000 and the Company issued 200,000 shares of common stock on the same date. On May 16, 2008, the second set of warrants with an expiration date of May 18, 2008 were exercised for a total exercise price of $216,000 and the Company issued 200,000 shares of common stock to Clarex Limited as of that date.
In 2004, the Company entered into an agreement with an investment banking firm to raise equity via a private placement of the Company’s common stock. In July 2004 the Company issued 1,581,000 Units consisting of 1,581,000 shares and warrants, exercisable through July 2009, to acquire an additional 1,185,750 shares at $1.35 per share. In addition, 276,675 warrants were issued to the placement agent for the private placement. The issued shares and shares underlying warrants were subsequently registered under an S-1 Registration filing. In the first nine months of 2008, a total of 518,635 warrants were exercised including 375,250 warrants with a total exercise price of approximately $507,000 which were surrendered in exchange for the issuance of 375,250 shares of the Company’s common stock. An additional 143,385 placement agent warrants were exercised using a cashless feature available for these warrants, in exchange for 89,702 shares of the Company’s common stock.
16
 
In total, including the exercise of 400,000697,890 warrants by Clarex Limited, there were 918,635 warrants exercised in the first nine monthsquarter of 2008 with a total exercise pricefor proceeds of $808,000$592,000 and in exchange for the issuance of 864,952654,815 shares of PPGI common stock. There remain a total of 943,790 outstanding warrants exercisable through August 2009. No warrants were exercised in the nine months ended September 30, 2007.

16
 
During the first nine months of 2008, proceeds from the exercise of stock options were $258,000 with 182,000 stock options exercised atThe Company had a weighted average exercise price of approximately $1.42 per sharenet increase in cash and converted into an equivalent number of shares of the Company’s common stock. By comparison,cash equivalents in the first nine monthsquarter of 2007, 611,100 stock options2009 of $269,000.  In the corresponding period, last year the Company had a net decrease of cash and cash equivalents of $1,404,000.
Cash and cash equivalents at March 31, 2009 were exercised$2,942,000 compared to $2,672,000 at a weighted average exercise price of $0.68 and total proceeds of $415,000.December 31, 2008.  The Company issued 611,100also had $808,000 in common stock as partcertificates of deposit at March 31, 2009, relatively unchanged from $800,000 at the 2007 stock option exercises.end of 2008.  The certificates of deposit have original maturity terms between three and five months and are readily convertible to cash without significant penalty.
 
AIn March 2009, the maturity dates of two notes were extended to April 1, 2011.  One note was a $1,000,000 Subordinated Convertible Promissory Note for $1,000,000, bearing an interest rate of 6% per annum and issued to Clarex Limited (“Clarex”), a major shareholder and debt holder.  The other note was originallya $1,500,000 Subordinated Convertible Promissory Note due in January 2006. Interest accrues yearly and along with principal may be converted into Common Stock, (and/or securitiesto an affiliate of Clarex.  The notes bear interest at 6%.  The Notes are convertible into common shares). The note is convertible into 1,000,0002,500,000 Units consisting of 1,000,0002,500,000 shares of Common Stockcommon stock and Warrants. The warrants have an expiration date of August 2009 and allow the holder to acquire 750,0001,875,000 shares of Common Stockcommon stock at a price of $1.35 per share.  The maturityexpiration date of the note was initiallywarrants has been extended to December 31, 2008 and, again, in January 2008, to April 1, 2009.
A second Subordinated Convertible Promissory Note for $1,500,000 originally due in January 2006, was in 2007 extended to December 31, 2008 and bears an interest rate of 6%. Interest accrues yearly and along with principal may be converted into Common Stock, and/or securities convertible into Common Stock. The note is convertible into 1,500,000 Units consisting of 1,500,000 shares of Common Stock and Warrants to acquire 1,125,000 shares of Common stock2014, at a price of $1.35 per share up to August 2009. The Holder of the Note is a major shareholder of the Company. The proceeds from the Note were used in the Company’s acquisition program. The maturity date of the note was extended in January 2008 to April 1, 2009.
The total amount of $2,500,000 in Subordinated Convertible Promissory Notes due on April 1, 2009 is classified in current liabilities on the balance sheet at September 30, 2008. The Company’s Board of Directors and the note holder are reviewing whether to extend the maturity of all or a portion of these notes.
Cash and cash equivalents at September 30, 2008 were approximately $3,866,000 compared to $4,396,000 at December 31, 2007 and $3,722,000 at September 30, 2007. The reduced cash balance over the nine month period ended September 30, 2008 reflects the accelerated payment of the $1,700,000 Secured Note in the first quarter of 2008, net of cash obtained from operating and financing activities throughout the intervening periods.same terms.
 
The Company’s management expects that future cash flow from operations and existing cash reserves will provide adequate liquidity for the Company’s operations over the balance of 2008.2009.
 
New Accounting Pronouncements
In December 2007, the FASB released SFAS No. 141(R), “Business Combinations (revised 2007)” (“SFAS 141(R)”), which changes many well-established business combination accounting practices and significantly affects how acquisition transactions are reflected in the financial statements. Additionally, SFAS 141(R) will affect how companies negotiate and structure transactions, model financial projections of acquisitions and communicate to stakeholders. SFAS 141(R) must be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. SFAS 141(R) will have an impact on the Company’s consolidated financial statements related to any future acquisitions.
17
In December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”). SFAS 160 establishes new accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. The Company does not believe that SFAS 160 will have a material impact on its consolidated financial statements.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133” (“SFAS 161”). SFAS 161 changes the disclosure requirements for derivative instruments and hedging activities. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under FASB Statement No. 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. SFAS 161 encourages, but does not require, comparative disclosures for earlier periods at initial adoption. The Company does not believe that SFAS 161 will have a material impact on its consolidated financial statements.
In April 2008, the FASB issued FASB Staff Position No. FAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 applies to all recognized intangible assets and its guidance is restricted to estimating the useful life of recognized intangible assets. FSP FAS 142-3 is effective for the first fiscal period beginning after December 15, 2008 and must be applied prospectively to intangible assets acquired after the effective date. The Company will be required to adopt FSP FAS 142-3 to intangible assets acquired beginning with the first quarter of fiscal 2010.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles,” (“SFAS 162”). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with GAAP. SFAS 162 is effective 60 days following the SEC’s approval of Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.” The Company does not believe that SFAS 162 will have a material impact on its consolidated financial statements.
In October 2008, the FASB issued FSP FAS 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP FAS 157-3”). FSP FAS 157-3 clarifies the application of SFAS No. 157 in a market that is not active. FSP FAS 157-3 is effective upon issuance, including prior periods for which financial statements have not been issued. Revisions resulting from a change in the valuation technique or its application should be accounted for as a change in accounting estimate following the guidance in FASB Statement No. 154, “Accounting Changes and Error Corrections.” FSP FAS 157-3 is effective for the financial statements included in the Company’s quarterly report for the period ended September 30, 2008, and application of FSP FAS 157-3 had no impact on the Company’s condensed consolidated financial statements.
18
ITEM 3 Q3.         UANTITATIVEQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
The Company believes that it has limited exposure to changes in interest rates from investments in certain money market accounts.  The Company does not utilize derivative instruments or other market risk sensitive instruments to manage exposure to interest rate changes. Interest on notes and leases are at fixed rates over the term of the debt.
 
ITEM 4.          CONTROLS AND PROCEDURES
 
a.    Disclosure Controls and Procedures
 
During the three months ended September 30, 2008,March 31, 2009, our management, including the principal executive officer and principal financial officer evaluated our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934) related to the recording, processing, summarization and reporting of information in the reports that we file with the SEC.  These disclosure controls and procedures have been designed to ensure that material information relating to us, including our subsidiaries, is made known to our management, including these officers and that this information is recorded, processed, summarized, evaluated and reported, as applicable, within the time periods specified in the SEC’s rules and forms.  Due to inherent limitations of control systems, not all misstatements may be detected.  Our controls and procedures can only provide reasonable, not absolute, assurance that the above objectives have been met.
 
Based upon their evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of September 30, 2008March 31, 2009 to reasonably ensure that information required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms.
 
b.    Changes in Internal Controls Over Financial Reporting
 
There were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

17
 
PART II.OTHER INFORMATION
 
ITEM 1.          LEGAL PROCEEDINGS
 
None.
 
ITEM 1A.           RISK FACTORS
 
There were no material changes in the risk factors previously disclosed in the Company’s Report on Form 10-K for the year ended December 31, 20072008 which was filed with the Securities and Exchange Commission on March 28, 2008.31, 2009.
 
ITEM 2.          UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
None.
 
ITEM 3.          DEFAULTS UNDER SENIOR SECURITIES
 
None.
 
19
ITEM 4.          SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On April 20, 2009, the Company provided Notice of the Annual Meeting of Shareholders to be held on Wednesday, May 13, 2009 for the purposes of electing four directors to hold office for a term of one year and to transact such other business as may properly com before the meeting or any adjournment thereof.
Only shareholders of record at the close of business on April 3, 2009, the record date fixed by the Board of Directors, will be entitled to notice of, and to vote at, the Annual Meeting.
ITEM 5.          OTHER INFORMATION
 
None.
 
ITEM 5.6.          EXHIBITSOTHER INFORMATION
 
None.
ITEM 6.EXHIBITS
11.An exhibit showing the computation of per-share earnings is omitted because the computation can be clearly determined from the material contained in this Quarterly Report on Form 10-Q.
31.1Certificate of the Registrant’s Chief Executive Officer, Daniel Lehrfeld,Joseph J. Rutherford, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2Certificate of the Registrant’s Chief Financial Officer, William J. Foote, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1Certificate of the Registrant’s Chief Executive Officer, Daniel Lehrfeld,Joseph J. Rutherford, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2Certificate of the Registrant’s Chief Financial Officer, William J. Foote, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

2018
 
SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Photonic Products Group, Inc.
  
By:
Photonic Products Group, Inc.



/s/  Joseph J. Rutherford
 By:  /s/ Daniel LehrfeldJoseph J. Rutherford
 
Daniel Lehrfeld
President and Chief Executive Officer
  
By:/s/  William J. Foote
 
William J. Foote
 
Chief Financial Officer and Secretary
 
Date:    November 14, 2008May 12, 2009

2119