-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, RbeqirF8FcBFtS/r1t2j6aGKm1TVUJFpK40i/KLOS9x7vXPsfDdQPPWxa4HJriiJ jWL2WPZrJzI1uCW0R7YgWg== 0000950128-01-000513.txt : 20010326 0000950128-01-000513.hdr.sgml : 20010326 ACCESSION NUMBER: 0000950128-01-000513 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20001231 FILED AS OF DATE: 20010323 FILER: COMPANY DATA: COMPANY CONFORMED NAME: TOLLGRADE COMMUNICATIONS INC \PA\ CENTRAL INDEX KEY: 0001002531 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-TELEPHONE INTERCONNECT SYSTEMS [7385] IRS NUMBER: 251537134 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-27312 FILM NUMBER: 1577099 BUSINESS ADDRESS: STREET 1: 493 NIXON RD CITY: CHESWICK STATE: PA ZIP: 15024 BUSINESS PHONE: 4122742156 10-K405 1 j8729201e10-k405.txt TOLLGRADE COMMUNICATIONS, INC. 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2000 COMMISSION FILE NUMBER 0-27312 TOLLGRADE COMMUNICATIONS, INC. (Exact name of registrant as specified in its charter) PENNSYLVANIA 25-1537134 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 493 NIXON ROAD, CHESWICK, PENNSYLVANIA 15024 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: 412-820-1400 SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, PAR VALUE $.20 PER SHARE (Title of Class) Indicate by a 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 Registration was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X ----- The Registrant estimates that as of March 7, 2001, the aggregate market value of shares of the Registrant's Common Stock held by non-affiliates (excluding for purposes of this calculation only, 179,033 shares of Common Stock held of record or beneficially by the executive officers and directors of the Registrant as a group) of the Registrant was $324,406,770. As of March 7, 2001, the Registrant had outstanding 13,352,912 shares of its Common Stock. DOCUMENTS INCORPORATED BY REFERENCE Parts of Form 10-K into which Document Document is incorporated Portions of the Annual Report to Shareholders for the year ended December 31, 2000 II and IV Portions of the Proxy Statement to be distributed in connection with the 2001 Annual Meeting of Shareholders III 2 PART I CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. The statements contained in this Annual Report on Form 10-K, specifically those contained in Item 1 Business and Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operation, and statements incorporated by reference into this Form 10-K from the 2000 Annual Report to Shareholders, along with statements in other reports filed with the Securities and Exchange Commission, external documents and oral presentations, which are not historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements represent Tollgrade Communications, Inc.'s (the "Company") present expectations or beliefs concerning future events. The Company cautions that such statements must be qualified by important factors that could cause actual earnings and other results to differ materially from those achieved in the past or those expected by the Company. These statements as to management's beliefs, strategies, plans, expectations or opinions in connection with Company performance, are based on a number of assumptions concerning future conditions that may ultimately prove to be inaccurate. Such statements must be qualified by important factors that could cause actual earnings and other results to differ materially from those achieved in the past or those expected by the Company. These include: customers' ability to meet established purchase forecasts and their own growth projections; the ability of certain customers to maintain financial strength and access to capital; the ability for sales and marketing partners to meet their own performance objectives and provide vendor financing to certain local exchange carriers; customer's seasonal buying patterns and the risk of order cancellations; risk of shortage of key components and possibility of limited source of supply; manufacturing delays and availability of manufacturing capacity; intense competition in the market for the Company's products; rapid technological change along with the need to continually develop new products and gain customer acceptance and approval; the Company's dependence on a relatively narrow range of products; competition; the Company's dependence on key employees; difficulties in managing the Company's growth; the Company's dependence upon a small number of large customers and certain suppliers; the Company's dependence upon proprietary rights; risks of third party claims of infringement; possibility of product defects; and government regulation. The Company does not undertake any obligation to publicly update any forward-looking statements. ITEM 1. BUSINESS. The Company was incorporated in Pennsylvania in 1986 and began operations in 1988. Its principal offices are located at 493 Nixon Road, Cheswick, Pennsylvania 15024 and its telephone number is (412) 820-1400. The Company designs, engineers, markets and supports test system, test access and status monitoring products for the telecommunications and cable television industries. The Company's telecommunications proprietary test access products enable telephone companies to use their existing line test systems to remotely diagnose problems in "Plain Old Telephone Service" ("POTS") lines containing both copper and fiber optics. POTS lines comprise the vast majority of lines in service today throughout the world. In addition to traditional voice service, POTS includes lines for popular devices such as computer modems and fax machines. POTS excludes the more complex lines, such as data communications service lines, commonly referred to as "special services." In general, POTS line test systems, which are located at telephone companies' central offices, focus on helping local exchange carriers conduct the full range of fault diagnosis in the "local loop", which 2 3 is the portion of the telephone network which connects end users to a telephone company's central office. In addition, these line test systems have the ability to remotely qualify, deploy and maintain next generation services that include Digital Subscriber Line ("DSL") service and Integrated Services Digital Network ("ISDN") service. These test systems reduce the time needed to identify and resolve problems and eliminate or reduce the cost of dispatching a technician to the problem site. Most POTS line test systems were designed for use over copper wireline only, so that the introduction of fiber-optic technology into the local loop renders it inaccessible to these test systems. The Company's metallic channel unit ("MCU"(R)) products solve this problem by extending test-system access through the fiber-optic portion into the copper portion of the local loop. In addition, the Company's DigiTest(R) system is designed to provide complete hardware testing for POTS and local loop prequalification and in-service testing for DSL service. The Company's LIGHTHOUSE(R) cable status monitoring system provides a broad testing solution for the Broadband Hybrid Fiber Coax distribution system found in the cable television industry. This status monitoring system gathers status information and reports on strategic components within the cable network. Products. The Company's MCU products plug into the digital loop carrier ("DLC") systems that are large systems manufactured by equipment vendors such as Lucent (formerly part of AT&T), that are used by telephone companies to link the copper and fiber-optic portions of the local loop. DLC systems are located at the telephone company central offices and at remote sites within a local user area, and effectively multiplex the services of the copper lines into a single fiber-optic line. In many instances, several DLC systems are located at a single remote site to serve several thousand different end-user homes and offices. Generally, for every DLC remote site, at least two MCU line-testing products are deployed. To ensure compatibility of the MCU with these DLC systems, the Company pays royalties pursuant to license agreements for the use of proprietary design integrated circuits ("PDICs"). The PDICs are the design and property of the DLC system manufacturer from which they are purchased. The Company maintains license agreements with and pays royalties to Lucent Technologies, Fujitsu Network Transmission Systems, Inc., NEC America, Inc. and Reliance Comm/Tec Corporation. In general, the current terms for expiration of these agreements range at various times between August 2001 and an indefinite duration, with renewal provisions (unless earlier terminated) for periods of between one and five years. In addition, certain of these agreements can be terminated prior to renewal. The Company incurred $1,904,000, $2,012,000 and $2,507,000 respectively in 1998, 1999 and 2000 as royalties under the license agreements, which royalties are calculated either based on a percentage of the list price of the MCU products or a fixed amount per unit that incorporates the technology licensed under each such agreement. Certain of the license agreements require the Company to maintain the confidentiality of the licensor's proprietary information and/or the terms and conditions of the agreement itself. In addition, the Company maintains license agreements that do not contain royalty provisions with Advanced Fibre Communications, Alcatel USA Sourcing, L.P. (formerly DSC Technologies Corporation), Northern Telecom Inc., UTSTARCOM, Inc., Next Level Communications and SAGEM SA (a French corporation). The expiration dates of these agreements range at various times between May 2001 and November 2004, with renewal provisions (unless earlier terminated) for periods of one or more years. Future license agreements entered into by the Company may contain terms comparable to, or materially different than, the terms of existing agreements as competitive and other conditions warrant. The loss of PDICs license agreements or the inability of the Company to maintain an adequate supply of PDICs could have a material adverse effect on the Company's business. Other MCU technology is also used with home and business alarm systems. As with home service line testing, home alarm systems must be monitored from the alarm company's headquarters along a hybrid copper and fiber-optic line. The Company's alarm-related MCU products are used to facilitate the transport of analog alarm signals from subscriber homes to alarm company monitoring stations across the hybrid telephone network. These units plug into equipment at both central office and remote locations. MCU products and related hardware accounted for more than 90%, 74% and 70% of the Company's sales in 1998, 1999 and 2000, respectively. 3 4 The Company's next-generation DigiTest centralized network test platform provides a system solution for providing service assurance needs POTS and ISDN service. In addition, the DigiTest system provides a full range of features that enable local exchange carriers to prequalify and maintain their networks for DSL service. The DigiTest product line is designed to work in conjunction with the major Operation Support System ("OSS") equipment manufacturers. The DigiTest system serves as an integral component of those OSS systems that allow for request and retrieval of precise measurement results that form the basis for state-of-the-art fault diagnosis for both traditional narrowband and wideband applications. DigiTest's compact digital measurement unit ("DMU") which resides in the central office, acts as the test head in the test system, with the ability to determine subscriber line characteristics with network diagnostic functions including load coil detection, loop length measurement and longitudinal balance for Single-Ended Loop Qualification ("SELQ"). DigiTest's digital wideband unit ("DWU") next-generation testing platform enables single-ended loop qualification by identifying and locating bridged taps and measuring crosstalk and wideband noise, all important factors in the prequalification and in-service maintenance of local loops for DSL service. The DigiTest system also includes the Digital Measurement Node ("DMN"), which consists of a metal-chassis, backplane and an alarm/fuse card which is used to house the DMU and DWU. To ensure interoperability with these OSS systems, the Company pays royalties pursuant to license agreements for the use of certain network interface information to Lucent Technologies and Nortel Networks Corporation. In general, the current terms for expiration of these agreements range at various times between July 2002 and September 2003, with renewal provisions (unless earlier terminated) for a period of one year. The Company incurred $0, $116,000 and $404,000 respectively in 1998, 1999 and 2000 as royalties under the license agreements, which royalties are calculated based on a percentage of the sale price of the DMU and certain DWU units that incorporate the technology licensed under such agreements. The license agreements require the Company to maintain the confidentiality of the licensor's proprietary information and/or the terms and conditions of the agreement itself. The Company markets and sells its DigiTest products directly as well as through certain OEM arrangements with Lucent Technologies and Nortel Networks Corporation. The Company's cable products consist of a complete cable status monitoring system that provides a comprehensive testing solution for the Broadband Hybrid Fiber Coax distribution system. The status monitoring system consists of a host for user interface, control and configuration; a headend controller for managing network communications; and transponders that are strategically located within the cable network to gather status reports from power supplies, line amplifiers and fiber-optic nodes. The Company has entered into a license agreement with C-COR.net Corp. (formerly C-COR Electronics, Inc.; a cable television systems developer) in which the Company provides its status monitoring transponder technology that is incorporated into C-COR's cable network management system. The Company, under certain other business arrangements, also markets and sells its cable products directly as well as through various OEM customers such as ANTEC and Motorola (formerly General Instrument). Product and Technology Development. The Company's product development personnel are organized into teams, each of which is effectively dedicated to a specific product line(s) or technology. Each product team also implements the Company's ongoing value engineering programs that are designed to replace the Company's products with successive generations having additional features and/or lower costs. The Company continuously monitors developing technologies in order to introduce products as defined standards and markets emerge. In addition, the Company continues to investigate the development of new applications for its MCU technology and other technologies to service the telecommunications industry. During 1998, 1999 and 2000, research and development expenses were approximately $6,880,000, $8,757,000 and $12,456,000, respectively. Proprietary Rights. The names "Tollgrade(R)", "MCU(R)", "LIGHTHOUSE(R)", "DigiTest (R)", "Telaccord(R)" and "MICRO-BANK(R)", and the Company's corporate logo are registered trademarks of the 4 5 Company. "Team Tollgrade(SM)" is a service mark of the Company. The Company has obtained three United States patents on the MCU products with expiration dates ranging from 2010 to 2014 and a United States patent on a cable product that expires in 2016. In addition, the Company has one U.S. provisional, six United States, three Canada and one international patent cooperation treaty ("PCT") patent applications pending. The Company will seek additional patents from time to time related to its research and development activities. The Company protects its trademarks, patents, inventions, trade secrets, and other proprietary rights by contract, trademark, copyright and patent registration, and internal security. Customers. The Company's primary telecommunication customers are the four regional Bell operating companies ("RBOCs"), which are Verizon Communications, BellSouth Corporation, SBC Communications Inc., and Qwest Inc., as well as major independent telephone companies. Sales in 2000 to Verizon Communications, BellSouth Corporation, SBC Communications, Inc., and Qwest Communications Corp. accounted for approximately 11%, 14%, 29% and 10%, respectively of total revenues. In addition, sales to Sprint USA accounted for approximately 12% of the Company's sales in 2000. The Company's primary cable products are sold on a direct basis as well as to certain cable Original Equipment Manufacturer ("OEM") customers such as C-COR.net Corp., ANTEC Corporation and Motorola, Inc. (formerly General Instrument). Sales of the Company's cable products in 2000 were approximately 9% of total revenues. The Company's relationships with its customers are material to the Company's business, and the loss of any such relationship could have a material adverse effect on the Company's business. Manufacturing. The Company's manufacturing operations consist primarily of quality control, functional testing, final assembly, burn-in and shipping. The Company is ISO 9001 registered from the British Standards Institution, Inc. ISO 9000 is a harmonized set of standards that define quality assurance management. Written by the International Organization for Standardization (ISO), it is recognized throughout the United States, Canada, the European Union and Japan. To be registered, the Company develops and maintains internal documentation and processes to support the production of quality products to ensure customer satisfaction. The Company utilizes two key independent subcontractors to perform a majority of the circuit board assembly and in-circuit testing work on its products. The Company also utilizes other subassembly contractors on a more limited basis. The loss of the subcontractors could cause delays in the Company's ability to meet production obligations and could have a material adverse effect on the Company's results of operations. In addition, shortages of raw material to, or production capacity constraints at, the Company's subcontractors could negatively affect the Company's ability to meet its production obligations and result in increased prices for affected parts. Any such reduction may result in delays in shipments of the Company's products or increases in the price of components, either of which could have a material adverse impact on the Company. The Company currently procures all of its components from outside suppliers. Generally, the Company uses industry standard components for its products. Application specific integrated circuits (ASICs) are a key component to the manufacturing process and are custom made to the Company's specifications. Although the Company has generally been able to obtain ASICs on a timely basis, a delay in the delivery of these components could have a material adverse impact on the Company. Backlog. The Company's backlog at December 31, 2000 was approximately $8.2 million, as compared to approximately $12.1 million at December 31, 1999. The Company's backlog consists of firm customer purchase orders for the Company's various products. The backlog at December 31, 2000 includes a one-time order from Qwest of approximately $1.3 million related to the Company's Broadcast Program Channel Unit, which will be used for the Salt Lake City Winter Olympic Games. Periodic fluctuations in customer orders and backlog result from a variety of factors, including but not limited to the timing of significant orders and shipments. While these fluctuations could impact short-term results, they are not necessarily indicative of long-term trends in sales of the Company's products. 5 6 Competitive Conditions. The market for telecommunications and cable television equipment is highly competitive. The deciding competitive factors in the Company's market include price, product features, performance, reliability, service and support, breadth of product line, technical documentation and prompt delivery. The Company believes that it competes favorably on all of these factors, and certain of its products have proprietary or patented features. The Company also attempts to enter into development agreements for its MCU products with the manufacturers of DLC and other complex systems, which serves to ensure compatibility for its products. Competition would increase if new companies enter the Company's product markets or existing competitors expand their product lines. For instance, the telecommunications reform legislation has lifted the restrictions that previously prevented the RBOCs from manufacturing telecommunications equipment. Pursuant to this legislative reform, the RBOCs, which are the Company's largest customers, may become competitors of the Company in the markets served by the Company. For the Company's line-testing MCU devices, the primary competitive technologies are the remote monitoring units made by Teradyne, Inc. and the Harris Communications Product Division of Harris Communications, Inc. In addition, the Anritsu Wiltron Test and Measurement Group, a division of Anritsu Corporation, offers the Wiltron LoopMATE, a modular remote test head, which competes with the Company's POTS testing capabilities. The Company believes the MCU is simpler and less costly to install and permits the full complement of centralized testing to be performed as quickly and accurately as with copper by-pass wiring. The alarm-related MCU product's primary competitor is the Turbo 2000 unit made by ANTEC Corporation. The primary competitors for the Company's DigiTest product line include Harris Corporation, Hekimian Laboratories and Turnstone Systems, Inc. For the Company's cable products, the primary competitors for status monitoring are Acterna Corporation and AM Communications, Inc. Employees. At December 31, 2000, the Company had 411 full-time employees, all in the United States. None of the Company's employees are represented by a collective bargaining agreement. Government Regulation. The telecommunications industry is subject to regulation in the United States and other countries. Federal and state regulatory agencies, including the FCC and various state public utility commissions and public service commissions, regulate most of the Company's domestic customers. While such regulation does not typically affect the Company directly, the effects of such regulations on the Company's customers may, in turn, adversely impact the Company's business and operating results. Governmental authorities also have promulgated regulations which, among other things, set installation and equipment standards for private telecommunications systems and require that all newly installed hardware be registered and meet certain government standards. ITEM 2. PROPERTIES. The Company's headquarters and principal administrative, engineering, manufacturing, warehouse and maintenance facilities are located in Cheswick, Pennsylvania. The Company occupies 100% of the approximate 111,600 square foot facility. The Company occupies its current facilities under a lease that expires in December 2002 with an option to renew the term of the lease for one additional period of three years. The Company has recently completed a facility occupancy and planning study to determine the various alternatives available for facility expansion that may be necessary to accommodate potential future growth. The Company is currently evaluating these alternatives that include the solicitation and potential procurement of certain land parcels that surround the current leased facility for the possible expansion of parking and/or new building structures that the Company believes will provide adequate space to support future operations and sales growth, if necessary. 6 7 ITEM 3. LEGAL PROCEEDINGS. There are currently no outstanding or pending material legal proceedings with respect to the Company or its business. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. During the fourth quarter of 2000, there were no matters submitted to a vote of security holders through solicitation of proxies or otherwise. 7 8 EXECUTIVE OFFICERS OF THE COMPANY Information relating to the executive officers of the Company as of January 31, 2001 is set forth below: Christian L. Allison Chairman of the Board since April 1998; Chief Executive Officer since September 1995; also Treasurer from May 1992 until April 1997; also Secretary from May 1992 until April 1996; also President from October 1993 until January 2001; Age 39. Sara M. Antol General Counsel since December 2000; Secretary since April 1996; Chief Counsel from April 1996 until December 2000; prior thereto, employed by the law firm of Babst, Calland, Clements and Zomnir, P.C.; Age 39. Richard A. Bair, Jr. Executive Vice President, Engineering/Testing since August 2000; Vice President Engineering, DigiTest from June 2000 until August 2000; Engineering Manager from April 1999 until August 2000; Senior Design Engineer from March 1996 until April 1999; Design Engineer from March 1995 until March 1996; Age 38. Robert L. Cornelia Executive Vice President, Operations since May 1996; prior thereto, Vice President, Manufacturing; Age 38. Bradley N. Dinger Controller since September 1996; prior thereto, Assistant Controller of AMSCO International, Inc. (manufacturer of health care equipment); Age 38. Rocco L. Flaminio Vice Chairman and Chief Technology Officer; Executive Vice President; Age 76. Mark C. Frey Senior Vice President, Access Products; Age 47. Samuel C. Knoch Chief Financial Officer since August 1996; Treasurer since April 1997; Controller of AMSCO International, Inc. (manufacturer of health care equipment) from October 1994 until August 1996; Age 44. Joseph G. O'Brien Senior Vice President, Human Resources since October 1997; Director of Employee Development from April 1997 until October 1997; Coordinator, Elderberry Junction, Goodwill Industries (a charitable organization) from May 1995 until April 1997; Age 41. Timothy D. O'Brien Director of Corporate Communications since August 1997; Vice President of Ketchum Public Relations (a public relations firm) from November 1995 until August 1997; prior thereto, Account Supervisor at Ketchum; Age 40. Mark B. Peterson President since January 2001; Executive Vice President, Sales and Marketing from November 1999 until January 2001; Executive Vice 8 9 President, Sales from October 1997 until November 1999; prior thereto, Testing Application Group product manager (MLT and Switched Access Remote Test Systems (SARTS) product lines) of Lucent Technologies (a manufacturer of communication systems, software and products and formerly AT&T Bell Laboratories) from October 1995 until October 1997; Age 40. Matthew J. Rosgone Senior Vice President, Purchasing/Manufacturing since July 1998; Vice President, Purchasing from July 1996 until July 1998; Director of Purchasing from July 1995 until July 1996; prior thereto, Buyer; Age 32. Roger A. Smith Executive Vice President, Technology since June 2000; Senior Vice President, Test Systems from July 1998 until June 2000; Engineering Manager from June 1997 until July 1998; Senior Software Engineer from June 1996 until June 1997; prior thereto, Senior Software Development Engineer of Caldon Inc. (a manufacturer of ultrasonic flow meters for nuclear power industry); Age 40. 9 10 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS. Information relating to the market for the Company's Common Stock and other matters related to the holders thereof is set forth under the caption "Common Stock Market Price" on page 27 of the Company's 2000 Annual Report to Shareholders and is incorporated herein by reference. ITEM 6. SELECTED FINANCIAL DATA. A summary of selected financial data for the Company, including each of the last five fiscal years in the period ended December 31, 2000, is set forth under the caption "Selected Consolidated Financial Data" on page 6 of the Company's 2000 Annual Report to Shareholders and is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. A discussion of the Company's financial condition and results of operations is set forth under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 7 through 13 of the Company's 2000 Annual Report to Shareholders and is incorporated herein by reference. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Company's consolidated financial statements, together with the report thereon of PricewaterhouseCoopers LLP, are set forth on pages 15 through 26 of the Company's 2000 Annual Report to Shareholders and are incorporated herein by reference. Such financial statements and supplementary data are listed in Part IV Item 14(a) (1), Exhibits, Financial Statement Schedules, and Reports on Form 8-K. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. 10 11 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. In addition to the information reported in Part I of this Form 10-K, under the caption "Executive Officers of the Company," the information required by this item appears beneath the caption "Election of Directors" in the Company's definitive Proxy Statement for its 2001 Annual Meeting of Shareholders and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION. Information relating to executive compensation is set forth beneath the caption "Executive Compensation" in the Company's definitive Proxy Statement for its 2001 Annual Meeting of Shareholders and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information relating to the security ownership of beneficial owners of 5% or more of the Common Stock and of the executive officers and directors of the Company is set forth under the caption "Stock Ownership of Management and Certain Beneficial Owners" in the Company's definitive Proxy Statement for its 2001 Annual Meeting of Shareholders and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information relating to certain relationships and related transactions is set forth beneath the caption "Certain Relationships and Related Transactions" in the Company's definitive Proxy Statement for its 2001 Annual Meeting of Shareholders and is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)(1) The following financial statements and supplementary data are incorporated in Item 8 of Part II of this Form 10-K by reference to pages 14 through 27 of the Company's 2000 Annual Report to Shareholders, which are incorporated herein by reference: Statement of Management's Responsibility for Financial Reporting, dated January 19, 2001 Report of Independent Accountants, dated January 19, 2001 Consolidated Balance Sheets at December 31, 1999 and 2000 Consolidated Statements of Operations for each of the three years in the period ended December 31, 2000 Consolidated Statements of Changes in Shareholders' Equity for each of the three years ended December 31, 2000 Consolidated Statements of Cash Flows for each of the three years ended December 31, 2000 Notes to Consolidated Financial Statements Statements of Operations Data by Quarter (a)(2) The following financial statement schedule is included herewith on page 16 and made a part hereof: Schedule II (Valuation and Qualifying Accounts) 11 12 (a)(3) The following exhibits are included herewith and made a part hereof: Exhibit Number Description - ------- ----------- 3.1 Amended and Restated Articles of Incorporation of the Company, as amended through May 6, 1998 (conformed copy), filed as Exhibit 3.1 to the Annual Report of Tollgrade Communications, Inc. on Form 10-K for the year ended December 31, 1998 (the "1998 Form 10-K"). 3.1a Statement with Respect to Shares dated July 23, 1996 (conformed copy), filed as Exhibit 3.1a to the 1998 Form 10-K. 3.2 Amended and Restated Bylaws of the Company, filed as Exhibit 3.2 to the Report on Form 10-Q of the Company filed on August 10, 1999 and incorporated herein by reference thereto. 4.1 Rights Agreement, dated as of July 23, 1996 between the Company and Chase Mellon Shareholder Services, L.L.C., filed as Exhibit 1 to the Company's Registration Statement on Form 8-A and incorporated herein by reference thereto. 10.1 Common Stock Purchase Agreement dated November 7, 1994, between the Company and the investors listed on Schedule A thereto (attachments and exhibits omitted), filed as Exhibit 10.1 to the Company's Registration Statement on Form S-1 (the "S-1") and incorporated herein by reference thereto. 10.2* 1995 Long-Term Incentive Compensation Plan, amended and restated as of January 5, 2001, filed as Exhibit B to the Company's 2001 Proxy Statement and incorporated herein by reference thereto. 10.3 License Agreement, dated August 24, 1993 between Fujitsu Network Transmission Systems, Inc. and the Company, filed as Exhibit 10.4 to the S-1 and incorporated herein by reference thereto. 10.4 License Agreement, dated September 26, 1994 between NEC America, Inc. and the Company, filed as Exhibit 10.5 to the S-1 and incorporated herein by reference thereto. 10.5 Interface License Agreement, dated March 22, 1995 between Northern Telecom Inc. and the Company, filed as Exhibit 10.7 to the S-1 and incorporated herein by reference thereto. 10.6 Technical Information Agreement, dated February 1, 1993 between American Telephone and Telegraph Company and the Company, filed as Exhibit 10.8 to the S-1 and incorporated herein by reference thereto. 10.7 Technology License Agreement, dated November 16, 1994 between DSC Technologies Corporation and the Company, filed as Exhibit 10.12 to the S-1 and incorporated herein by reference thereto. 12 13 10.8 License Agreement, dated August 24, 1993 between Reliance Comm/Tec Corporation and the Company, filed as Exhibit 10.13 to the S-1 and incorporated herein by reference thereto. 10.9* Employment Agreement, dated as of December 13, 1995, between the Company and Christian L. Allison, filed as Exhibit 10.11 to the Annual Report of the Company on Form 10-K for the year ended December 31, 1995 (the "1995 Form 10-K"). 10.10* Stock Option Agreement entered into December 14, 1995 between the Company and R. Craig Allison, together with a schedule listing substantially identical agreements with Gordon P. Anderson, Jeffrey Blake, John H. Guelcher, Richard H. Heibel, Joseph T. Messina and Douglas T. Halliday, filed as Exhibit 10.14 to the 1995 Form 10-K. 10.11* Form of Stock Option Agreement dated December 14, 1995 and December 29, 1995 for Non-Statutory Stock Options granted under the 1995 Long-Term Incentive Compensation Plan, filed as Exhibit 10.15 to the Annual Report of the Company on Form 10-K for the year ended December 31, 1996 (the "1996 Form 10-K"). 10.12* Form of Stock Option Agreement for Non-Statutory Stock Options granted under the 1995 Long-Term Incentive Compensation Plan, filed as Exhibit 10.2 to the Report on Form 10-Q of the Company filed on November 12, 1996. 10.13* Form of Non-employee Stock Option Agreement entered into December 13, 1996 and December 30, 1997 between the Company and Lawrence Arduini, filed as Exhibit 10.19 to the 1996 Form 10-K. 10.14* Amendment to Employment Agreement, dated as of December 13, 1996, between the Company and Christian L. Allison, filed as Exhibit 10.20 to the 1996 Form 10-K. 10.15* Amendment to Employment Agreement, dated as of December 13, 1997, between the Company and Christian L. Allison, filed as Exhibit 10.21 to the Annual Report of the Company on Form 10-K for the year ended December 31, 1997 (the "1997 Form 10-K"). 10.16 Amendment, dated February 21, 1997, to Technical Information Agreement relating to Metallic Channel Units Types A and B, dated February 1,1993, between American Telephone and Telegraph Company (AT&T) (licensor) and the Company (licensee) incorporated by reference to Exhibit 10.3 to the Report on Form 10-Q of the Company filed on November 10, 1997. 10.17* Form of Non-employee Director Stock Option Agreement with respect to the Company's 1995 Long-Term Incentive Compensation Plan, filed as Exhibit 10.25 to the 1997 Form 10-K. 10.18* Amendment to Employment Agreement, dated as of December 30, 1998, between the Company and Christian L. Allison, filed as Exhibit 10.28 to the 1998 Form 10-K. 10.19* Amendment to Employment Agreement, dated as of January 18, 2000, between the Company and Christian L. Allison, filed as Exhibit 10.25 to the 1999 Form 10-K. 13 14 10.20* Change in Control Agreement, entered into February 9, 2000 between the Company and Sara M. Antol, together with a schedule listing substantially identical agreements with Robert Cornelia, Ruth Dilts, Bradley Dinger, Rocco Flamino, Mark Frey, Samuel Knoch, James Price, and Matthew Rosgone, filed as Exhibit 10.26 to the 1999 Form 10-K. 10.21* Change in Control Agreement, entered into December 20, 1999 between the Company and Scott Robbins, filed as Exhibit 10.27 to the 1999 Form 10-K. 10.22* Change in Control Agreement, entered into August 10, 2000 between the Company and Stephen M. Garda, filed as Exhibit 10.30 to the Report on Form 10-Q of the Company filed on November 13, 2000. 10.23* Amendment to Employment Agreement, dated as of January 3, 2001, between the Company and Christian L. Allison, filed herewith. 10.24* Change in Control Agreement, entered into January 19, 2001 between the Company and Joseph G. O'Brien, together with a schedule listing substantially identical agreements with Lawrence J. Fey, William J. Gumbert, Gary L. Gump, Michael D. McSparrin, Timothy D. O'Brien, Mark B. Peterson, Roger A. Smith and Jeffrey J. Tatusko, filed herewith. 10.25* 1998 Employee Incentive Compensation Plan, amended and restated as of December 14, 2000, filed herewith. 13.1 Company's 2000 Annual Report to Shareholders, filed herewith. 21.1 List of subsidiaries of the Company, filed as Exhibit 21.1 to the S-1 and incorporated herein by reference thereto. 23.1 Consent of PricewaterhouseCoopers LLP, filed herewith. 27 Financial Data Schedule. * Management contract or compensatory plan, contract or arrangement required to be filed by item 601(b)(10)(iii) of Regulation S-K. The Company agrees to furnish to the Commission upon request copies of all instruments not listed above which define the rights of holders of long-term debt of the Company. Copies of the exhibits filed as part of this Form 10-K are available at a cost of $.20 per page to any shareholder of record upon written request to the Secretary, Tollgrade Communications, Inc., 493 Nixon Road, Cheswick, Pennsylvania 15024. (b) Reports on Form 8-K filed during the quarter ended December 31, 2000. None. 14 15 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized as of March 23, 2001. TOLLGRADE COMMUNICATIONS, INC. By /s/Christian L. Allison ------------------------------------- Christian L. Allison Chairman and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated as of March 23, 2001. SIGNATURE TITLE /s/Christian L. Allison Director, Chairman and - --------------------------------------- Chief Executive Officer, Christian L. Allison (Principal Executive Officer) /s/James J. Barnes Director - --------------------------------------- James J. Barnes /s/Daniel P. Barry Director - --------------------------------------- Daniel P. Barry /s/David S. Egan Director - --------------------------------------- David S. Egan /s/Rocco L. Flaminio Director, Vice Chairman - --------------------------------------- and Chief Technology Officer Rocco L. Flaminio /s/ Richard H. Heibel, M.D. Director - --------------------------------------- Richard H. Heibel, M.D. /s/Robert W. Kampmeinert Director - --------------------------------------- Robert W. Kampmeinert /s/Samuel C. Knoch Chief Financial Officer - --------------------------------------- and Treasurer Samuel C. Knoch (Principal Financial Officer) /s/Bradley N. Dinger Controller - --------------------------------------- (Principal Accounting Officer) Bradley N. Dinger 15 16 Report of Independent Accountants on Financial Statement Schedule To the Board of Directors Tollgrade Communications, Inc.: Our audits of the consolidated financial statements referred to in our report dated January 19, 2001 appearing in the 2000 Annual Report to Shareholders of Tollgrade Communications, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the financial statement schedule listed in Item 14(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ PRICEWATERHOUSECOOPERS LLP Pittsburgh, Pennsylvania January 19, 2001 16 17 SCHEDULE II TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1998, 1999 and 2000 (In thousands)
Col. A Col. B Col. C Col. D Col. E - ------ --------- ------ ------ ------ Additions Balance at ------------------------------ Beginning Charged to Charged to Balance at of Year Expense Other Accounts Deductions End of Year --------- ---------- ------------- --------- ----------- Inventory reserve: Year ended December 31, 1998 $ 179 $ 88 $ -- $ -- $ 267 Year ended December 31, 1999 267 393 -- -- 660 Year ended December 31, 2000 660 743 -- (318) 1,085 Allowance for doubtful accounts: Year ended December 31, 1998 $ 50 $ 50 $ -- $ -- $ 100 Year ended December 31, 1999 100 100 -- (19) 181 Year ended December 31, 2000 181 22 -- (3) 200 Warranty reserve: Year ended December 31, 1998 $ 300 $ 135 $ -- $ -- $ 435 Year ended December 31, 1999 435 165 -- -- 600 Year ended December 31, 2000 600 588 -- (143) 1,045
17 18 EXHIBIT INDEX (Pursuant to Item 601 of Regulation S-K) Exhibit Number Description - ------- ----------- 3.1 Amended and Restated Articles of Incorporation of the Company, as amended through May 6, 1998 (conformed copy), filed as Exhibit 3.1 to the Annual Report of Tollgrade Communications, Inc. on Form 10-K for the year ended December 31, 1998 (the "1998 Form 10-K"). * 3.1a Statement with Respect to Shares dated July 23, 1996 (conformed copy), filed as Exhibit 3.1a to the 1998 Form 10-K. * 3.2 Amended and Restated Bylaws of the Company, filed as Exhibit 3.2 to the Report on Form 10-Q of the Company filed on August 10, 1999 and incorporated herein by reference thereto. * 4.1 Rights Agreement dated as of July 23, 1996 between the Company and Chase Mellon Shareholder Services, L.L.C., filed as Exhibit 1 to the Company's Registration Statement on Form 8-A and incorporated herein by reference thereto. * 10.1 Common Stock Purchase Agreement dated November 7, 1994, between the Company and the investors listed on Schedule A thereto (attachments and exhibits omitted), filed as Exhibit 10.1 to the Company's Registration Statement on Form S-1 (the "S-1") and incorporated herein by reference thereto. * 10.2 1995 Long-Term Incentive Compensation Plan, amended and restated as of January 5, 2001, filed as Exhibit B to the Company's 2001 Proxy Statement and incorporated herein by reference thereto. * 10.3 License Agreement, dated August 24, 1993 between Fujitsu Network Transmission Systems, Inc. and the Company, filed as Exhibit 10.4 to the S-1 and incorporated herein by reference thereto. * 10.4 License Agreement, dated September 26, 1994 between NEC America, Inc. and the Company, filed as Exhibit 10.5 to the S-1 and incorporated herein by reference thereto. * 18 19 10.5 Interface License Agreement, dated March 22, 1995 between Northern Telecom Inc. and the Company, filed as Exhibit 10.7 to the S-1 and incorporated herein by reference thereto. * 10.6 Technical Information Agreement, dated February 1, 1993 between American Telephone and Telegraph Company and the Company, filed as Exhibit 10.8 to the S-1 and incorporated herein by reference thereto. * 10.7 Technology License Agreement, dated November 16, 1994 between DSC Technologies Corporation and the Company, filed as Exhibit 10.12 to the S-1 and incorporated herein by reference thereto. * 10.8 License Agreement, dated August 24, 1993 between Reliance Comm/Tec Corporation and the Company, filed as Exhibit 10.13 to the S-1 and incorporated herein by reference thereto. * 10.9 Employment Agreement, dated as of December 13, 1995, between the Company and Christian L. Allison, filed as Exhibit 10.11 to the Annual Report of the Company on Form 10-K for the year ended December 31, 1995 (the "1995 Form 10-K"). * 10.10 Stock Option Agreement entered into December 14, 1995 between the Company and R. Craig Allison, together with a schedule listing substantially identical agreements with Gordon P. Anderson, Jeffrey Blake, John H. Guelcher, Richard H. Heibel, Joseph T. Messina and Douglas T. Halliday, filed as Exhibit 10.14 to the 1995 Form 10-K. * 10.11 Form of Stock Option Agreement dated December 14, 1995 and December 29, 1995 for Non-Statutory Stock Options granted under the 1995 Long-Term Incentive Compensation Plan, filed as Exhibit 10.15 to the Annual Report of the Company on Form 10-K for the year ended December 31, 1996 (the "1996 Form 10-K"). * 10.12 Form of Stock Option Agreement for Non-Statutory Stock Options granted under the 1995 Long Term Incentive Compensation Plan, filed as Exhibit 10.2 to the Report On Form 10-Q of the Company filed on November 12, 1996. * 10.13 Form of Non-employee Stock Option Agreement entered into December 13, 1996 and December 30, 1997 between the Company and Lawrence Arduini, filed as Exhibit 10.19 to the 1996 Form 10-K. * 19 20 10.14 Amendment to Employment Agreement, dated as of December 13, 1996, between the Company and Christian L. Allison, filed as Exhibit 10.20 of the 1996 Form 10-K. * 10.15 Amendment to Employment Agreement, dated as of December 13, 1997, between the Company and Christian L. Allison, filed as Exhibit 10.21 to the Annual Report of the Company on Form 10-K for the year ended December 31, 1997 (the "1997 Form 10-K"). * 10.16 Amendment, dated February 21, 1997, to Technical Information Agreement relating to Metallic Channel Units Types A and B, dated February 1, 1993, between American Telephone and Telegraph Company (AT&T) (licensor) and the Company (licensee) incorporated by reference to Exhibit 10.3 to the Report on Form 10-Q of the Company filed on November 10, 1997. * 10.17 Form of Non-employee Director Stock Option Agreement with respect to the Company's 1995 Long-Term Incentive Compensation Plan, filed as Exhibit 10.25 to the 1997 Form 10-K. * 10.18 Amendment to Employment Agreement, dated as of December 30, 1998, between the Company and Christian L. Allison, filed as Exhibit 10.28 to the 1998 Form 10-K. * 10.19 Amendment to Employment Agreement, dated as of January 18, 2000, between the Company and Christian L. Allison, filed as Exhibit 10.25 to the 1999 Form 10-K. * 10.20 Change in Control Agreement, entered into February 9, 2000 between the Company and Sara M. Antol, together with a schedule listing substantially identical agreements with Robert Cornelia, Ruth Dilts, Bradley Dinger, Rocco Flamino, Mark Frey, Samuel Knoch, James Price and Matthew Rosgone, filed as Exhibit 10.26 to the 1999 Form 10-K. * 10.21 Change in Control Agreement, entered into December 20, 1999 between the Company and Scott Robbins, filed as Exhibit 10.27 to the 1999 Form 10-K. * 10.22 Change in Control Agreement, entered into August 10, 2000 between the Company and Stephen M. Garda, filed as Exhibit 10.30 to the Report on Form 10-Q of the Company filed on November 13, 2000. * 10.23 Amendment to Employment Agreement, dated as of January 3, 2001, between the Company and Christian L. Allison, filed herewith. 10.24 Change in Control Agreement, entered into January 19, 2001 between the Company and Joseph G. O'Brien, together with a schedule listing substantially identical agreements with Lawrence J. Fey, William J. Gumbert, Gary L. Gump, Michael D. McSparrin, Timothy D. O'Brien, Mark B. Peterson, Roger A. Smith and Jeffrey J. Tatusko, filed herewith. * 20 21 10.25 1998 Employee Incentive Compensation Plan, amended and restated as of December 14, 2000, filed herewith. 13.1 Company's 2000 Annual Report to Shareholders, filed herewith. 21.1 List of subsidiaries of the Company, filed as Exhibit 21.1 to the S-1 and incorporated herein by reference thereto. * 23.1 Consent of PricewaterhouseCoopers LLP, filed herewith. 27 Financial Data Schedule - ---------------- * Incorporated by reference. 21 EX-10.23 2 j8729201ex10-23.txt AMEND. EMP. AGGRREMENT CHRISTIAN L. ALLISON 1 EXHIBIT 10.23 AMENDMENT THIS AMENDMENT, dated as of January 3, 2001 and effective as of December 13, 2000 (the "Amendment") is entered into between TOLLGRADE COMMUNICATIONS, INC. ("Tollgrade") and CHRISTIAN L. ALLISON (the "Executive"). AMENDMENT TO AGREEMENT WHEREAS, Tollgrade and the Executive entered into an Agreement dated as of the 13th day of December, 1995, as amended by those certain amendments dated January 14, 1997, January 8, 1998, December 30, 1998 and January 18, 2000, governing the employment of Executive and certain benefits to be received by Executive in the event his employment is terminated (collectively, the "Agreement"); and WHEREAS, Tollgrade and the Executive desire to amend the Agreement upon the terms and conditions stated in this Amendment. NOW, THEREFORE, in consideration of the promises and the faithful performance of the mutual covenants herein contained, and intending to be legally bound hereby, Tollgrade and the Executive agree as follows: 1. Capitalized terms used herein and not otherwise defined shall have the meaning assigned to them in the Agreement. 2. The Agreement shall be amended such that the Executive's base salary, as specified in Section 2(b) of the Agreement, shall be increased to $315,000 per annum, plus the cost of the Executive's annual long term disability premium. 3. Except as modified by this Amendment, the provisions of the Agreement shall remain in full force and effect. IN WITNESS WHEREOF, the parties have executed this Amendment as of the date first written above. TOLLGRADE COMMUNICATIONS, INC. By: /s/ Sara Antol /s/ Christian L. Allison ------------------------------- --------------------------- Title: Secretary & General Counsel ------------------------------- EX-10.24 3 j8729201ex10-24.txt CHANGE IN CONTROL AGREEMENT 1 EXHIBIT 10.24 AGREEMENT This Agreement, made as of the 19th day of January, 2001 by and between TOLLGRADE COMMUNICATIONS, INC., a Pennsylvania corporation (the "Corporation") and JOSEPH G. O'BRIEN, an individual residing in the Commonwealth of Pennsylvania and an employee of the Corporation (the "Executive"). WITNESSETH: WHEREAS, the Board of Directors of the Corporation has determined that it is in the best interests of the Corporation to enter into this Agreement with the Executive to provide for compensation of the Executive upon termination of employment under certain circumstances relating to a change in control of the Corporation; and WHEREAS, the Executive desires to obtain such benefits in the event the Executive's employment is terminated under the circumstances provided herein. NOW, THEREFORE, in consideration of the covenants and premises contained herein, and intending to be legally bound hereby, the parties hereto agree as follows: 1. DEFINITION OF TERMS. The following terms when used in this Agreement shall have the meaning hereafter set forth: "ANNUAL SALARY ADJUSTMENT PERCENTAGE" shall mean the mean average percentage increase in base salary for all elected officers of the Corporation during the two full calendar years immediately preceding the time to which such percentage is being applied; provided however, that if after a Change-in-Control, as hereinafter defined, there should be a significant change in the number of elected officers of the Corporation or in the manner in which they are compensated, then the foregoing definition shall be changed by substituting for the phrase "elected officers of the Corporation" the phrase "persons then performing the functions formerly performed by the elected officers of the Corporation." "CAUSE FOR TERMINATION" shall mean: (a) the deliberate and intentional failure by the Executive to devote substantially his entire business time and best efforts to the performance of his duties (other than any such failure resulting from the Executive's incapacity due to physical or mental illness or disability) after a demand for substantial performance is delivered to the Executive by the Board of Directors which specifically identifies the manner in which the Board of Directors believes that the Executive has not substantially performed his duties, or (b) wilfully engaging by the Executive in conduct which constitutes a fraud against the Corporation or a material breach of this Agreement, or (c) the Executive's conviction of any crime which constitutes a felony. 1 2 For purposes of this definition, no act, or failure to act, on the Executive's part shall be considered "deliberate and intentional" or "willfully" unless done, or omitted to be done, by the Executive not in good faith and without reasonable belief that his action or omission was in the best interests of the Corporation. "CHANGE-IN-CONTROL" shall mean the determination (which may be made effective as of a particular date specified by the Board of Directors of the Corporation) by the Board of Directors of the Corporation, made by a majority vote that a change in control has occurred, or is about to occur. Such a change shall not include, however, a restructuring, reorganization, merger, or other change in capitalization in which the Persons who own an interest in the Corporation on the date hereof (the "Current Owners")(or any individual or entity which receives from a Current Owner an interest in the Corporation through will or the laws of descent and distribution) maintain more than a sixty-five percent (65%) interest in the resultant entity. Regardless of the Board's vote or whether or not the Board votes, a Change-in-Control will be deemed to have occurred as of the first day any one (1) or more of the following subparagraphs shall have been satisfied: (a) Any Person (other than the Person in control of the Corporation as of the date of this Agreement, or other than a trustee or other fiduciary holding securities under an employee benefit plan of the Corporation, or a corporation owned directly or indirectly by the stockholders of the Corporation in substantially the same proportions as their ownership of stock of the Corporation), becomes the beneficial owner, directly or indirectly, of securities of the Corporation representing more than thirty five percent (35%) of the combined voting power of the Corporation's then outstanding securities; or (b) The stockholders of the Corporation approve: (i) A plan of complete liquidation of the Corporation; (ii) An agreement for the sale or disposition of all or substantially all of the Corporation's assets; or (iii) A merger, consolidation, or reorganization of the Corporation with or involving any other corporation, other than a merger, consolidation, or reorganization that would result in the voting securities of the Corporation outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least sixty-five percent (65%) of the combined voting power of the voting securities of the Corporation (or such surviving entity) outstanding immediately after such merger, consolidation, or reorganization. However, in no event shall a Change in Control be deemed to have occurred, with respect to the Executive, if the Executive is part of a purchasing group which consummates the Change-in-Control transaction. The Executive shall be deemed "part of the purchasing group" for purposes of the preceding sentence if the Executive is an equity participant or has agreed to become an equity participant in the purchasing company or group (except for (i) passive ownership of less than five percent (5%) of the voting securities of the purchasing company; or (ii) ownership of equity participation in the purchasing company or group which is otherwise deemed not to be significant, as determined prior to the Change-in-Control by a majority of the non-employee continuing Directors of the Board of Directors of the Corporation). 2 3 "DATE OF TERMINATION" shall mean: (a) if the Executive's employment is terminated for Disability, the date that a Notice of Termination is given to the Executive; (b) if the Executive terminates due to his death or Retirement, the date of death or Retirement, respectively; (c) if the Executive decides to terminate employment upon Good Reason for Termination, the date following such decision specified by the Corporation after it has been notified of the Executive's decision to terminate employment; or (d) if the Executive's employment is terminated for any other reason, the date on which such termination becomes effective pursuant to a Notice of Termination. "DISABILITY" shall mean such incapacity due to physical or mental illness or injury as causes the Executive to be unable to perform his duties with the Corporation during 180 consecutive days. "GOOD REASON FOR TERMINATION" shall mean the occurrence of: (a) without the Executive's express written consent, the assignment to the Executive of any duties materially and substantially inconsistent with his positions, duties, responsibilities and status with the Corporation immediately prior to a Change-in-Control, or a material change in his reporting responsibilities, titles or offices as in effect immediately prior to a Change-in-Control, or any removal of the Executive from or any failure to re-elect the Executive to any of such positions, except in connection with the termination of the Executive's employment due to Cause for Termination, Disability or Retirement (as hereinafter defined) or as a result of the Executive's death; (b) (i) a reduction by the Corporation prior to a Change-in-Control in the Executive's base salary unless such reduction is the result of the Board of Directors of the Corporation determining that the Executive has not adequately discharged his duties; (ii) a reduction by the Corporation after a Change-in-Control in the Executive's base salary as in effect immediately prior to any Change-in-Control or a failure by the Corporation after a Change-in-Control to increase the Executive's base salary by the Annual Salary Adjustment Percentage; (c) a failure by the Corporation to continue to provide incentive compensation comparable to that provided by the Corporation immediately prior to any Change-in-Control; (d) a failure by the Corporation after a Change-in-Control to continue in effect any benefit or compensation plan, stock option plan, pension plan, life insurance plan, health and accident plan or disability plan in which the Executive is participating immediately prior thereto (provided, however, that there shall not be deemed to be any such failure if the Corporation substitutes for the discontinued plan, a plan providing the Executive with substantially similar benefits) or the taking of any action by the Corporation which would adversely affect the Executive's participation in or materially reduce the Executive's benefits under any of such plans or deprive the Executive of any material fringe benefit enjoyed by the Executive immediately prior to a Change-in-Control 3 4 (provided, however, that any act or failure to act by the Corporation that is on a plan-wide basis, i.e., it similarly affects all employees of the Corporation or all employees eligible to participate in any such plan, as the case may be, shall not constitute Good Reason for Termination); (e) the failure of the Corporation to obtain the assumption of this Agreement by any successor as contemplated in SECTION 10(c) hereof; (f) any purported termination of the employment of the Executive by the Corporation which is not (i) due to the Executive's Disability, Retirement (as hereinafter defined) or Cause for Termination, or (ii) effected as a Notice of Termination, as defined herein; or (g) the Corporation's requiring the Executive to be based anywhere other than the Corporation's executive offices at which the Executive has his principal office immediately prior to a Change-in-Control or executive offices located within 50 miles of the location of the Corporation's executive offices immediately prior to a Change-in-Control, except for required travel on the Corporation's business to an extent substantially consistent with the Executive's present business travel obligations. "NOTICE OF TERMINATION" shall mean a written statement which sets forth the specific reason for termination and, if such is claimed to be a Cause for Termination or Good Reason for Termination, in reasonable detail the facts and circumstances which indicate that such is Cause for Termination or Good Reason for Termination. "OPTIONS" shall mean any stock options issued pursuant to any present or future stock option plan of the Corporation. "PERSON" shall have the meaning ascribed to such term in Section 3(a)(9) of the Securities Exchange Act of 1934, as in effect on the date hereof and used in Sections 13(d) and 14(d) thereof, including a "group" as defined in Section 13(d) thereof. "RETIREMENT" shall mean the termination of the Executive's employment after age 65 or in accordance with any mandatory retirement arrangement with respect to an earlier age agreed to by the Executive. "STOCK APPRECIATION RIGHT" shall mean any stock appreciation rights issued pursuant to any stock option plan of the Corporation or any future stock appreciation rights plan. 2. TERMS OF EMPLOYMENT. The Executive acknowledges that this Agreement does not constitute an employment contract and that the Executive's employment relationship with the Corporation is at-will and not for any particular period. Rather, this Agreement is only intended to set forth certain liquidated damages to be paid in the event of termination of the Executive upon the terms and conditions specified herein. 3. TERM OF AGREEMENT. The initial term of this Agreement shall be for a period of four (4) years. Upon expiration of the initial term, the Company shall, in its sole discretion, determine whether this Agreement shall be renewed upon such terms it deems advisable. 4. PAYMENTS FOLLOWING TERMINATION OF EMPLOYMENT UPON A CHANGE-IN-CONTROL. (a) If the Executive's employment with the Corporation shall be terminated: 4 5 (i) due to the Executive's death, (ii) by the Executive other than the Executive's having terminated for Good Reason for Termination following a Change-in-Control, or (iii) by the Corporation due to Cause for Termination or for Disability or Retirement, then the Corporation shall have no obligations to the Executive other than to pay the Executive any unpaid portion of base salary due until the Date of Termination and any other sums due in accordance with the then various policies, practices and benefit plans of the Corporation. (b) If the Executive's employment with the Corporation shall have terminated during the period commencing six months prior to the date of a Change-in-Control and ending on the third anniversary of a Change-in-Control other than in the circumstances described in subsection (a) above, then the Corporation shall pay on or before the fifth day following the Date of Termination (or if the Date of Termination preceded the date of the Change-in-Control, on or before the fifth day following the date of the Change-in-Control), to the Executive the following sums: (i) in cash any unpaid portion of the Executive's full base salary for the period from the last period for which the Executive was paid to the Date of Termination, or the date of the Change-in-Control, as the case may be; and (ii) an amount in cash as liquidated damages for lost future renumeration equal to the product obtained by multiplying (A) the lesser of (1) two, or (2) a number equal to the number of calendar months remaining from the Date of Termination to the date on which the Executive is 65 years of age (or, if earlier, the age agreed to by the Executive pursuant to any prior arrangement) divided by twelve, or (3) a number equal to the greater of (i) one (1.0) or (ii) thirty six (36) less the number of completed months commencing after the date of the Change-in-Control during which the Executive was employed by the Corporation and did not have Good Reason for Termination times (iii) one-twelfth (1/12) times (B) the sum of (1) the greater of (i) the Executive's annual base salary for the year in effect 5 6 on the Date of Termination (provided that in the case of Termination for Good Reason by the Executive the date immediately preceding the date of the earliest event which gave rise to the Termination for Good Reason by the Executive shall be used instead of the Date of Termination) or (ii) the Executive's annual base salary for the year in effect on the date of the Change-in-Control; plus (2) the greater of (i) the average annual cash award received by the Executive as incentive compensation or bonus for one calendar year immediately preceding the Date of Termination (provided that in the case of Termination for Good Reason by the Executive the date immediately preceding the date of the event which gave rise to the Termination for Good Reason by the Executive shall be used instead of the Date of Termination) or (ii) the average annual cash award received by the Executive as incentive compensation or bonus for one calendar year immediately preceding the date of the Change-in-Control. 5. OUTPLACEMENT SERVICES. If the Executive's employment with the Corporation should terminate under circumstances as to entitle the Executive to receive payment hereunder, the Corporation shall reimburse the Executive for any reasonable fees or other costs incurred by the Executive during the two (2) years following the Date of Termination in retaining executive placement agencies, up to a maximum dollar amount not to exceed fifteen percent (15%) of the Executive's base salary at the time of such termination. Such reimbursement shall be made within five (5) days following the Executive's presentment of bills or other evidence of the costs incurred with executive placement agencies. 6. TAX IMPLICATIONS. If any payment due to the Executive pursuant to this Agreement result in a tax being imposed on the Executive pursuant to Section 4999 of the Internal Revenue Code of 1954, as amended, or any successor provision ("Section 4999"), then the Corporation shall, at the Executive's option, either (i) reduce the total payments payable to the Executive to the maximum amount payable without incurring the Section 4999 tax, or (ii) pay to the Executive the total amount payable, with the understanding that Section 4999 tax will be due on that total amount. 7. BENEFITS. If the Executive's employment with the Corporation should terminate under circumstances as to entitle the Executive to receive payment hereunder, the Executive shall also be deemed, for purposes of medical insurance, pension and other benefits of the Corporation, to have 6 7 remained in the continuous employment of the Corporation for the two (2) year period following the Date of Termination and shall be entitled to all of the medical insurance, pension or other benefits provided by the Corporation as if the Executive had so remained in the employment of the Corporation. If, for any reason, whether by law or provisions of the Corporation's employee medical insurance, pension or other benefit plans, or otherwise any benefits which the Executive would be entitled to under this SECTION 6 cannot be paid pursuant to such employee benefit plans, then the Corporation contractually agrees to pay the Executive the difference between the benefits which the Executive would have received in accordance with this Section if the relevant employee medical insurance, pension or other benefit plan could have paid such benefit and the amount of benefits, if any, actually paid by such employee medical insurance, pension or other benefit plan. The Corporation shall not be required to fund its obligation to pay the foregoing difference. 8. OTHER EMPLOYMENT. In the event of termination under the circumstances contemplated in SECTION 4(b) hereunder, the Executive shall have no duty to seek any other employment after termination of his employment with the Corporation and the Corporation hereby waives and agrees not to raise or use any defense based upon the position that the Executive had a duty to mitigate or reduce the amounts due him hereunder by seeking other employment whether suitable or unsuitable and should the Executive obtain other employment, then the only effect of such on the obligations of the Corporation shall be that the Corporation shall be entitled to credit against any payments that would otherwise be made pursuant to SECTION 7 hereof, any comparable payments to which the executive is entitled under the employee benefit plans maintained by the Executive's other employer or employers in connection with services to such employer or employers after termination of this employment with the Corporation. 9. STOCK APPRECIATION RIGHTS AND OPTIONS. If the Executive's employment should terminate under circumstances as to entitle the Executive to receive payment hereunder, then with respect to any standing Stock Appreciation Rights and/or Options which did not immediately become exercisable upon the occurrence of a Change-in-Control, such Stock Appreciation Right or Option shall be automatically vested and remain outstanding in accordance with its terms and be exercisable thereafter until the stated expiration date of such Stock Appreciation Right or Option. 10. MISCELLANEOUS. (a) This Agreement shall be construed under the laws of the Commonwealth of Pennsylvania. (b) This Agreement constitutes the entire understanding of the parties hereto with respect to the subject matter hereof and may only be amended or modified by written agreement signed by the parties hereto. This Agreement specifically supercedes the agreement entered into between the Corporation and the Executive dated as of August 5, 1996 with respect to the subject matter hereof, and by the execution of this Agreement, the previous agreement is hereby terminated and of no further force and effect. (c) The Corporation will require any successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business and/or assets of the Corporation, by agreement in form and substance satisfactory to the Executive, to expressly assume and agree to perform this Agreement in the same manner required of the Corporation and to perform it as if no such succession had taken place. As used in this Agreement, "Corporation" shall mean the Corporation as hereinbefore defined and any successor to its business and/or assets as aforesaid which executes and delivers the agreement provided for in this subsection (c) or which otherwise becomes 7 8 bound by all of the terms and provisions of this Agreement by operation of law. (d) This Agreement shall inure to the benefit of and be enforceable by the Executive and the Corporation and their respective legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. If the Executive should die while any amounts would still be payable to him hereunder if he had continued to live, all such amounts, unless otherwise provided herein, shall be paid in accordance with the terms of this Agreement to his devisee, legatee or other designee or, if there be no such designee, to his estate. (e) Any notice or other communication provided for in this Agreement shall be in writing and, unless otherwise expressly stated herein, shall be deemed to have been duly given if mailed by United States registered mail, return receipt requested, postage prepaid, addressed in the case of the Executive to his office at the Corporation with a copy to his residence and in the case of the Corporation to its principal executive offices, attention to the Chief Executive Officer. (f) No provision of this Agreement may be modified, waived or discharged unless such waiver, modification or discharge is agreed to in writing signed by the Executive and approved by resolution of the Board of Directors of the Corporation. No waiver by either party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. No agreements or representations, oral or otherwise, express or implied, with respect to the subject matter hereof have been made by either party which are not set forth expressly in this Agreement. (g) The invalidity or unenforceability of any provisions of this Agreement shall not affect the validity or unenforceability of any other provision of this Agreement, which shall remain in full force and effect. If any provision hereof shall be deemed invalid or unenforceable, either in whole or in part, this Agreement shall be deemed amended to delete or modify, as necessary, the offending provision and to alter the bounds thereof in order to render it valid and enforceable. (h) This Agreement may be executed in one or more counterparts, each of which shall be deemed to be an original but all of which taken together will constitute one and the same instrument. (i) If litigation should be brought to enforce, interpret or challenge any provision contained herein, the prevailing party shall be entitled to its reasonable attorney's fees and disbursements and other costs incurred in such litigation and, if a money judgment be rendered in favor of the Executive, to interest on any such money judgment obtained calculated at the prime rate of interest in effect from time to time at Mellon Bank, N.A., from the date that the payment should have been made or damages incurred under this Agreement. IN WITNESS WHEREOF, this Agreement has been executed on the date first above written. TOLLGRADE COMMUNICATIONS, INC. By: /s/ Sara M. Antol --------------------------------- Secretary & General Counsel /s/ Joseph G. O'Brien --------------------------------- 8 9 Schedule 10.24 Change in Control Agreements dated January 19, 2001 were entered into between the Company and Lawrence J. Fey, William J. Gumbert, Gary L. Gump, Timothy D. O'Brien, Michael D. McSparrin, Mark B. Peterson, Roger A. Smith and Jeffrey J. Tatusko 9 EX-10.25 4 j8729201ex10-25.txt 1998 EMPLOYMENT INCENTIVE COMPENSATION PLAN 1 EXHIBIT 10.25 TOLLGRADE COMMUNICATIONS, INC. 1998 EMPLOYEE INCENTIVE COMPENSATION PLAN (AS AMENDED THROUGH DECEMBER 14, 2000) ARTICLE 1. ESTABLISHMENT, OBJECTIVES AND DURATION. 1.1 ESTABLISHMENT OF THE PLAN. Tollgrade Communications, Inc., a Pennsylvania corporation (hereinafter referred to as the "Company"), hereby establishes an incentive compensation plan for all employees excluding officers and directors of the Company, to be known as the "Tollgrade Communications, Inc. 1998 Employee Incentive Compensation Plan" (hereinafter referred to as the "Plan"), as set forth in this document. The Plan permits the grant of Nonqualified Stock Options, Stock Appreciation Rights, Restricted Stock, Performance Shares and Performance Units. The Plan shall be effective as of January 29, 1998 (the "Effective Date") and shall remain in effect as provided in SECTION 1.3 hereof. 1.2 OBJECTIVES OF THE PLAN. The objectives of the Plan are to optimize the profitability and growth of the Company through incentives which are consistent with the Company's goals and which link the personal interests of Employees to those of the Company's stockholders; to provide Employees with an incentive for excellence in individual performance; and to promote teamwork among Employees. The Plan is further intended to provide flexibility to the Company in its ability to motivate, attract, and retain the services of Employees who make significant contributions to the Company's success and allow Employees to share in the success of the Company. 1.3 DURATION OF THE PLAN. The Plan was adopted by the Board of Directors on January 29, 1998, and shall commence on the Effective Date, as described in SECTION 1.1 hereof, and shall remain in effect, subject to the right of the Board of Directors to amend or terminate the Plan at any time pursuant to ARTICLE 14 hereof, until all Shares subject to it shall have been purchased or acquired according to the Plan's provisions. However, in no event shall an Award be granted under the Plan on or after January 29, 2008. ARTICLE 2. DEFINITIONS Whenever used in the Plan, the following terms shall have the meanings set forth below, and when the meaning is intended, the initial letter of the word shall be capitalized: 2.1 "AWARD" means, individually or collectively, a grant under this Plan of Nonqualified Stock Options, Stock Appreciation Rights, Restricted Stock, Performance Shares or Performance Units. 2.2 "AWARD AGREEMENT" means an agreement entered into by the Company and each Employee setting forth the terms and provisions applicable to Awards granted under this Plan. 2.3 "BENEFICIAL OWNER" OR "BENEFICIAL OWNERSHIP" shall have the meaning ascribed to such term in Rule 13d-3 of the General Rules and Regulations under the Exchange Act. 2.4 "BOARD" OR "BOARD OF DIRECTORS" means the Board of Directors of the Company. 2.5 "CHANGE IN CONTROL" of the Company shall be deemed to have occurred (as of a particular day, as specified by the Board) if the Board, by a majority vote, agrees that a Change in Control has occurred, or is about to occur. Such a change shall not include, however, a restructuring, reorganization, merger or other change in capitalization in which the Persons who own an interest in the Company on the Effective Date (the "Current Owners") (or any individual or entity which received from a Current Owner an interest in the Company through will or the laws of descent and distribution) maintain more than a fifty percent (50%) interest in the resultant entity. 1 2 Regardless of the Board's vote, a Change in Control will be deemed to have occurred as of the first day any one (1) or more of the following paragraphs shall have been satisfied: (a) Any Person (other than the Person in control of the Company as of the Effective Date of the Plan, or other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company, or a corporation owned directly or indirectly by the stockholders of the Company in substantially the same proportions as their ownership of stock in the Company), becomes the Beneficial Owner, directly or indirectly, of securities of the Company representing more than fifty percent (50%) of the combined voting power of the Company's then outstanding securities; or (b) The stockholders of the Company approve: (i) A plan of complete liquidation of the Company; or (ii) An agreement for the sale or disposition of all or substantially all of the Company's assets (other than one in which the stockholders of the Company, as determined immediately prior to such transaction, hold, directly or indirectly, as determined immediately following such transaction, a majority of the voting power of each surviving, resulting or acquiring corporation which, immediately following such transaction, holds more than 10% of the consolidated assets of the Company immediately prior to the transaction); or (iii) A merger, consolidation, or reorganization of the Company with or involving any other corporation, other than a merger, consolidation, or reorganization that would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least fifty percent (50%) of the combined voting power of the voting securities of the Company (or such surviving entity) outstanding immediately after such merger, consolidation or reorganization. However, in no event shall a Change in Control be deemed to have occurred, with respect to a Employee, if that Employee is part of a purchasing group which consummates the Change in Control transaction. The Employee shall be deemed "part of a purchasing group" for purposes of the preceding sentence if the Employee is an equity participant or has agreed to become an equity participant in the purchasing company or group (except for (i) passive ownership of less than five percent (5%) of the voting equity securities of the purchasing company; or (ii) ownership of equity participation in the purchasing company or group which is otherwise deemed not to be significant, as determined prior to the Change in Control by a majority of the nonemployee continuing Directors). 2.6 "CODE" means the Internal Revenue Code of 1986, as amended from time to time. 2.7 "COMMITTEE" means the Compensation Committee of the Board, as specified in ARTICLE 3 herein, or such other Committee appointed by the Board to administer the Plan with respect to grants of Awards. 2.8 "COMPANY" means Tollgrade Communications, Inc., a Pennsylvania corporation, any successor thereto as provided in ARTICLE 17 herein. 2.9 "DIRECTOR" means any individual who is a member of the Board of Directors of the Company. 2.10 "EFFECTIVE DATE" shall have the meaning ascribed to such term in SECTION 1.1 hereof. 2.11 "EMPLOYEE" means any full-time active employee of the Company who is not an Officer, as defined in SECTION 2.17 hereof. Directors shall not be considered employees under the Plan. 2.12 "EXCHANGE ACT" means the Securities Exchange Act of 1934, as amended from time to time, or any successor act thereto. 2 3 2.13 "FAIR MARKET VALUE" shall be the mean between the following prices, as applicable, for the date as of which fair market value is to be determined as quoted in The Wall Street Journal (or in such other reliable publication as the Committee, in its discretion, may determine to rely upon): (i) if the Common Stock is listed on the New York Stock Exchange, the highest and lowest sales prices per share of the Common Stock as quoted in the NYSE Composite Transactions listing for such date, (ii) if the Common Stock is not listed on such exchange, the highest and lowest sales prices per share of Common Stock for such date on (or on any composite index including) the principal united States securities exchange registered under the 1934 Act on which the Common Stock is listed or (iii) if the Common Stock is not listed on such exchange, the highest and lowest sales prices per share of the Common Stock for such date on the National Association of Securities Dealers Automated Quotations System or any successor system then in use ("NASDAQ"). If there are no such sale price quotations for the date as of which fair market value is to be determined but there are such sale price quotations within a reasonable period both before and after such date, then fair market value shall be determined by taking a weighted average of the means between the highest and lowest sales prices per share of the Common Stock as so quoted on the nearest date before and the nearest date after the date as of which fair market value is to be determined. The average should be weighted inversely by the respective number of trading days between the selling dates and the date as of which fair market value is to be determined. If there are no such sale prices quotations on or within a reasonable period both before and after the date as of which fair market value is to be determined, then fair market value of the Common Stock shall be the mean between the bona fide bid and asked prices per share of Common Stock as so quoted for such date on NASDAQ, or if none, the weighted average of the means between such bona fide bid and asked prices on the nearest trading date before and the nearest trading date after the date as of which fair market value is to be determined, if both such dates are within a reasonable period. The average is to be determined in the manner described above in this SECTION 2.13. If the fair market value of the Common Stock cannot be determined on any basis previously set forth in this SECTION 2.13 for the date as of which fair market value is to be determined, the Committee shall in good faith determine the fair market value of the Common Stock on such date. Fair market value shall be determined without regard to any restriction other than a restriction which, by its terms, will never lapse. 2.14 "FREESTANDING SAR" means an SAR that is granted independently of any Options, as described in ARTICLE 7 herein. 2.15 "INSIDER" shall mean an individual who, immediately prior to the grant of any Award, owns stock possessing more than ten percent (10%) of the total combined voting power of all classes of stock for the Company. For purposes of this SECTION 2.15, an individual (i) shall be considered as owning not only Shares of Stock owned individually but also all Shares of stock that are at the time owned, directly or indirectly, by or for the spouse, ancestors, lineal descendants and bothers and sisters (whether by whole or half blood) of such individual and (ii) shall be considered as owning proportionately any Shares owned, directly or indirectly, by or for any corporation, partnership, estate or trust in which such individual is a stockholder, partner or beneficiary. 2.16 "NONQUALIFIED STOCK OPTION" OR "NQSO" means an option to purchase Shares granted under ARTICLE 6 herein and which is not intended to meet the requirements of Code Section 422. 2.17 "OFFICER" means any person serving as an officer on behalf of the Company, as defined in the Company's bylaws and by requirements of Pennsylvania corporate law, and by the requirements of the rules of the National Association of Securities Dealers, Inc. 2.18 "OPTION" means a Nonqualified Stock Option, as described in ARTICLE 6 herein. 2.19 "OPTION PRICE" means the price at which a Share may be purchased by a Employee pursuant to an Option. 2.20 "PERFORMANCE-BASED EXCEPTION" means the performance-based exception from the tax deductibility limitations of Code Section 162(m). 3 4 2.21 "PERFORMANCE SHARE" means an Award granted to an Employee, as described in ARTICLE 9 herein. 2.22 "PERFORMANCE UNIT" means an award granted to an Employee, as described in ARTICLE 9 herein. 2.23 "PERIOD OF RESTRICTION" means the period during which the transfer of Shares of Restricted Stock is limited in some way (based upon the passage of time, the achievement of performance goals, or upon the occurrence of other events as determined by the Committee, at its discretion), and the Shares are subject to a substantial risk of forfeiture, as provided in ARTICLE 8 herein. 2.24 "PERSON" shall have the meaning ascribed to such term in Section 3(a)(9) of the Exchange Act and used in Sections 13(d) and 14(d) thereof, including a "group" as defined in Section 13(d) thereof. 2.25 "RESTRICTED STOCK" means an award granted to an Employee pursuant to ARTICLE 8 herein. 2.26 "RETIREMENT" shall mean any voluntary termination of employment by an Employee following the attainment of age 65. 2.27 "SHARES" means the shares of Common Stock of the Company. 2.28 "STOCK APPRECIATION RIGHT" OR "SAR" means an Award, granted alone or in connection with a related Option, designated as an SAR, pursuant to the terms of ARTICLE 7 herein. 2.29 "TANDEM SAR" means an SAR that is granted in connection with a related Option pursuant to ARTICLE 7 herein, the exercise of which shall require forfeiture of the right to purchase a Share under the related Option (and when a Share is purchased under the Option, the Tandem SAR shall similarly be canceled). ARTICLE 3. ADMINISTRATION 3.1 THE COMMITTEE. Except as set forth in SECTION 3.5 below, the Plan shall be administered by the Compensation Committee of the Board, or by any other Committee appointed by the Board consisting of not less than two (2) Directors who (i) are "non-employee" directors and otherwise meet the "disinterested administration" rules of Rule 16b-3 under the Exchange Act and (ii) are "outside directors" under Section 162(m)(4)(C) of the Code, or any successor provision. The members of the Committee shall be appointed from time to time by, and shall serve at the discretion of, the Board of Directors. 3.2 AUTHORITY OF THE COMMITTEE. Except as set forth in SECTION 3.4 below, except as limited by law or by the Articles of Incorporation or Bylaws of the Company, and subject to the provisions herein, the Committee shall have full power to grant Options (with or without SARs) and to award Restricted Stock, Performance Shares and Performance Units as described herein and to determine the Employees to whom any such award shall be made and the number of Shares to be covered thereby; determine the sizes and types of Awards; determine terms and conditions of Awards in a manner consistent with the Plan; construe and interpret the Plan and any agreement or instrument entered into under the Plan as they apply to Employees; and (subject to the provisions of ARTICLE 14 herein) amend the terms and conditions of any outstanding Award to the extent such terms and conditions are within the discretion of the Committee as provided in the Plan. Further, the Committee shall make all other determinations which may be necessary or advisable for the administration of the Plan, as the Plan applies to Employees. As permitted by law the Committee may delegate its authority as identified herein. 3.3 DECISIONS BINDING. All determinations and decisions made by the Committee pursuant to the provisions of the Plan and all related orders and resolutions of the Board shall be final, conclusive and binding on all persons, including the Company, its stockholders, Employees, and their estates and beneficiaries. 3.4 NON-COMPETITION. If a grantee of an Option, Restricted Stock, Performance Units or Performance Shares (i) engages in the operation or management of a business (whether as owner, partner, officer, director, employee or otherwise and whether during or after employment) which is in competition with the 4 5 Company, (ii) induces or attempts to induce any customer, supplier, licensee or other individual, corporation or other business organization having a business relationship with the Company to cease doing business with the Company or any in any way interferes with the relationship between any such customer, supplier, licensee or other person and the Company or (iii) solicits any employee of the Company to leave the employment thereof or in any way interferes with the relationship of such employee with the Company, the Committee, in its discretion, may immediately terminate all outstanding Options held by the grantee, declare forfeited all Restricted Stock held by the grantee as to which the restrictions have not yet lapsed and/or immediately cancel any award of Performance Units or Performance Shares. Whether a grantee has engaged in any of the activities referred to in the preceding sentence which would cause the outstanding Options to be terminated, and/or the Restricted Stock to be forfeited and/or any award of Performance Units or Performance Shares to be canceled shall be determined, in its discretion, by the Committee, and any such determination by the Committee shall be final and binding. ARTICLE 4. SHARES SUBJECT TO THE PLAN 4.1 NUMBER OF SHARES AVAILABLE FOR GRANTS. Subject to adjustment as provided in SECTION 4.3 herein, the number of Shares hereby reserved for issuance to Employees under the Plan shall be 940,000; provided that, of that total, the maximum number of Shares of Restricted Stock granted pursuant to ARTICLE 8 herein, shall be 50,000. 4.2 LAPSED AWARDS. If any Award granted under this Plan is canceled, terminates, expires or lapses for any reason (with the exception of termination of a Tandem SAR upon exercise of the related Option, or the termination of a related Option upon exercise of the corresponding Tandem SAR), any Shares subject to such Award shall again be available for the grant of an Award under the Plan. 4.3 ADJUSTMENTS IN AUTHORIZED SHARES. In the event of any change in corporate capitalization, such as a stock split, or a corporate transaction, such as any merger, consolidation, separation, including a spin-off, or other distribution of stock or property of the Company, any reorganization (whether or nor such reorganization comes within the definition of such term in Code Section 368) or any partial or complete liquidation of the Company, such adjustment shall be made in the number and class of Shares which may be delivered under SECTION 4.1 and in the number and class of and/or price of Shares subject to outstanding Awards granted under the Plan, and in the number and class of and/or price of Shares subject to outstanding Awards granted under the Plan, as may be determined to be appropriate and equitable by the Committee, in its sole discretion, to prevent dilution or enlargement of rights; provided, however, that the number of Shares subject to any Award shall always be a whole number. ARTICLE 5. ELIGIBILITY AND PARTICIPATION 5.1 ELIGIBILITY. Persons eligible to participate in this Plan shall include all Employees of the Company, excluding Officers and Directors. 5.2 ACTUAL PARTICIPATION. Subject to the provisions of the Plan, the Committee may, from time to time, select from all eligible Employees those to whom Awards shall be granted and shall determine the nature and amount of each Award. ARTICLE 6. STOCK OPTIONS 6.1 GRANT OF OPTIONS. Subject to the terms and provisions of the Plan, the Committee may grant Nonqualified Stock Options in such number, and upon such terms, and at any time and from time to time as shall be determined by the Committee. 6.2 AWARD AGREEMENT. Each Option shall be evidenced by an Award Agreement that shall specify the Option Price, the duration of the Option, the number of Shares to which the Option pertains, and such other provisions as the Committee shall determine. 5 6 6.3 OPTION PRICE. The Option Price at which each Option may be exercised shall be no less than one hundred percent (100%) of the fair market value per share of the Common Stock covered by the Option on the date of grant. For purposes of this SECTION 6.3, the fair market value of the Common Stock shall be as determined in SECTION 2.14. 6.4 DURATION OF OPTIONS. Each Option granted to an Employee shall expire at such time as the Committee shall determine at the time of grant; provided, however, that no Option shall be exercisable after the expiration of ten years from the date of grant. 6.5 EXERCISE OF OPTIONS. Options granted under this Article 6 shall be exercisable at such times and be subject to such restrictions and conditions as the Committee shall in each instance approve, which need not be the same for each grant or for each Employee. 6.6 PAYMENT. Options granted under this Article 6 shall be exercised by the delivery of a written notice of exercise to the Company, setting forth the number of Shares with respect to which the Option is to be exercised, accompanied by full payment for the Shares. The Option Price upon exercise of the Option shall be payable to the Company in full either: (a) in cash in United States Dollars (including check, bank draft or money order), or (b) by tendering previously acquired Shares having an aggregate Fair Market Value at the time of exercise equal to the total Option Price, or (c) by a combination of (a) and (b). The Company will also cooperate with any person exercising an Option who participates in a cashless exercise program of a broker or other agent under which all or part of the Shares received upon exercise of the Option are sold through the broker or other agent or under which the broker or other agent makes a loan to such person. Notwithstanding the foregoing, unless the Committee, in its discretion, shall otherwise determine at the time of grant the exercise of the Option shall not be deemed to occur and no Shares of Common Stock will be issued by the Company upon exercise of the Option until the Company has received payment of the Option Price in full. 6.7 RESTRICTIONS ON SHARE TRANSFERABILITY. The Committee may impose restrictions on any Shares acquired pursuant to the exercise of an Option granted under this ARTICLE 6 as it may deem advisable, including, without limitation, restrictions under applicable Federal securities laws, under the requirements of any stock exchange or market upon which such Shares are then listed and/or traded, and under any blue sky or other state securities laws applicable to such Shares. 6.8 TERMINATION OF EMPLOYMENT. Unless the Committee, in its discretion, shall otherwise determine: (i) If the employment of an Employee who is not disabled within the meaning of Section 422(c)(6) of the Code (a "Disabled Grantee") is voluntarily terminated with the consent of the Company or an Employee retires under any retirement plan of the Company, any Option held by such Employee shall be exercisable by the Employee (but only to the extent exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of termination, whichever is the shorter period; (ii) If the employment of an Employee who is a Disabled Grantee is voluntarily terminated with the consent of the Company, any outstanding Option held by such Employee shall be exercisable by the Employee in full (whether or not so exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of termination of employment, whichever is the shorter period; (iii) Following the death of an Employee during employment, any outstanding Option held by the Employee at the time of death shall be exercisable in full (whether or not so exercisable by the Employee immediately prior to the death of the Employee) by the person entitled to do so under the Will of the Employee, or, if the Employee shall fail to make testamentary disposition of the stock option or shall die 6 7 intestate, by the legal representative of the Employee at any time prior to the expiration date of such stock option or within one year after the date of death of the Employee, whichever is the shorter period; (iv) Following the death of an Employee after termination of employment during the period when an Option is exercisable, the Option shall be exercisable by such person entitled to do so under the Will of the Employee by such legal representative (but only to the extent exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of death, whichever is the shorter period; (v) Unless the exercise period of a stock option following termination of employment has been extended as provided in SECTION 13.1, if the employment of an Employee terminates for any reason other than voluntary termination with the consent of the Company, retirement under any retirement plan of the Company or death, all outstanding Options held by the Employee at the time of such termination of employment shall automatically terminate. Whether termination of employment is a voluntary termination with the consent of the Company shall be determined, in its discretion, by the Committee and any such determination by the Committee shall be final and binding. 6.9 NONTRANSFERABILITY OF OPTIONS. No Option granted under the Plan may be sold, transferred, pledged, assigned, or otherwise alienated or hypothecated, other than by Will or if the Employee dies intestate by the laws of descent and distribution of the state of domicile of the Employee at the time of death. Further, all Options granted to an Employee under the Plan shall be exercisable during his or her lifetime only by the Employee. ARTICLE 7. STOCK APPRECIATION RIGHTS 7.1 GRANT OF SARS. Subject to the terms and conditions of the Plan, SARs may be granted to Employees at any time and from time to time as shall be determined by the Committee. The Committee may grant Freestanding SARs, Tandem SARs, or any combination of these forms of SARs. The Committee shall have complete discretion in determining the number of SARs granted to each Employee (subject to ARTICLE 4 herein) and, consistent with the provisions of the Plan, in determining the terms and conditions pertaining to such SARs. The grant price of a Freestanding SAR shall equal the Fair Market Value of a Share on the date of grant of the SAR. The grant price of Tandem SARs shall equal the Option Price of the related Option, as provided in SECTION 6.3. 7.2 EXERCISE OF TANDEM SARS. Tandem SARs may be exercised for all or part of the Shares subject to the related Option upon the surrender of the right to exercise the equivalent portion of the related Option. A Tandem SAR may be exercised only with respect to the Shares for which its related Option is then exercisable. 7.3 EXERCISE OF FREESTANDING SARS. Freestanding SARs may be exercised upon whatever terms the Committee, in its sole discretion, imposes upon them. 7.4 SAR AGREEMENT. Each SAR grant shall be evidenced by an Award Agreement that shall specify the grant price, the term of the SAR, and such other provisions as the Committee shall determine. 7.5 TERM OF SARS. The term of an SAR granted under the Plan shall be determined by the Committee, in its sole discretion; provided however, that such term shall not exceed ten (10) years. 7.6 PAYMENT OF SAR AMOUNT. Upon exercise of an SAR, an Employee shall be entitled to receive payment from the Company in an amount determined by multiplying: (a) the difference between the Fair Market Value of a Share on the date of exercise over the grant price; by 7 8 (b) the number of Shares with respect to which the SAR is granted. At the discretion of the Committee, the payment upon SAR exercise may be in cash, in Shares of equivalent value, or in some combination thereof. 7.7 RULE 16B-3 REQUIREMENTS. Notwithstanding any other provision of the Plan, the Committee may impose such conditions on the exercise of an SAR as may be required to satisfy the requirements of Section 16 of the Exchange Act (or any successor rule). 7.8 TERMINATION OF EMPLOYMENT. Each SAR Award Agreement shall set forth the extent to which the Employee shall have the right to exercise the SAR following termination of the Employee's employment with the Company and/or its Subsidiaries. Such provisions shall be determined in the sole discretion of the Committee, shall be included in the Award Agreement entered into with Employees, need not be uniform among all SARs issued pursuant to the Plan, and may reflect distinctions based on the reasons for termination of such employment. 7.9 NONTRANSFERABILITY OF SARS. No SAR granted under the Plan may be sold, transferred, pledged, assigned, or otherwise alienated or hypothecated, other than by will or, if the grantee dies intestate, by the laws of descent and distribution of the state of domicile of the grantee at the time of death. Further, all SARs granted to an Employee under the Plan shall be exercisable during his or her lifetime only by such Employee. ARTICLE 8. RESTRICTED STOCK 8.1 GRANT OF RESTRICTED STOCK. Subject to the terms and provisions of the Plan, the Committee, at any time and from time to time, may grant Shares of Restricted Stock to Employees in such amounts as the Committee shall determine. 8.2 RESTRICTED STOCK AGREEMENT. Each Restricted Stock grant shall be evidenced by a Restricted Stock Award Agreement that shall specify the Period(s) of Restriction, the number of Shares of Restricted Stock granted, and such other provisions as the Committee shall determine. 8.3 TRANSFERABILITY. Except as provided in this ARTICLE 8, the Shares of Restricted Stock granted herein may not be sold, transferred, pledged, assigned or otherwise alienated or hypothecated until the end of the applicable Period of Restriction established by the Committee and specified in the Restricted Stock Award Agreement, or upon earlier satisfaction of any other conditions, as specified by the Committee in its sole discretion and set forth in the Restricted Stock Award Agreement. All rights with respect to the Restricted Stock granted to an Employee under the Plan shall be available during his or her lifetime only to such Employee. 8.4 OTHER RESTRICTIONS. Subject to ARTICLE 10 herein, the Committee shall impose such other conditions and/or restrictions on any Shares of Restricted Stock granted pursuant to the Plan as it may deem advisable including, without limitation, a requirement that Employees pay a stipulated purchase price for each Share of Restricted Stock, restrictions based upon the achievement of specific performance goals (Company-wide, divisional, and/or individual), time-based restrictions on vesting following the attainment of the performance goals, and/or restrictions under applicable Federal or state securities laws. The Company shall retain the certificates representing Shares of Restricted Stock in the Company's possession until such time as all conditions and/or restrictions applicable to such Shares have been satisfied. Except as otherwise provided in this ARTICLE 8, Shares of Restricted Stock covered by each Restricted Stock grant made under the Plan shall become freely transferable by the Employee after the last day of the applicable Period of Restriction. 8.5 VOTING RIGHTS. During the Period of Restriction, Employees holding Shares of Restricted Stock granted hereunder may exercise full voting rights with respect to those Shares. 8 9 8.6 DIVIDENDS AND OTHER DISTRIBUTIONS. During the Period of Restriction, Employees holding Shares of Restricted Stock granted hereunder may be credited with regular cash dividends paid with respect to the underlying Shares while they are so held. The Committee may apply any restrictions to the dividends that the Committee deems appropriate. In the event that any dividend constitutes a "derivative security" or an "equity security" pursuant to Rule 16(a) under the Exchange Act, such dividend shall be subject to a vesting period equal to the remaining vesting period of the Shares of Restricted Stock with respect to which the dividend is paid. 8.7 TERMINATION OF EMPLOYMENT. Each Restricted Stock Award Agreement shall set forth the extent to which the Employee shall have the right to receive unvested Restricted Shares following termination of the Employee's employment with the Company. Such provisions shall be determined in the sole discretion of the Committee, shall be included in the Award Agreement entered into with each Employee, need not be uniform among all Shares of Restricted Stock issued pursuant to the Plan, and may reflect distinctions based upon the reasons for termination of such employment. ARTICLE 9. PERFORMANCE UNITS AND PERFORMANCE SHARES 9.1 GRANT OF PERFORMANCE UNITS/SHARES. Subject to the terms of the Plan, Performance Units and/or Performance Shares may be granted to Employees in such amounts and upon such terms, and at any time and from time to time, as shall be determined by the Committee. 9.2 VALUE OF PERFORMANCE UNITS/SHARES. Each Performance Unit shall have an initial value that is established by the Committee at the time of grant. Each Performance Share shall have an initial value equal to the Fair Market Value of a Share on the date of grant. The Committee shall set performance goals in its discretion which, depending upon the extent to which they are met, will determine the number and/or value of Performance Units/Shares that will be paid out to the Employee. For purposes of this ARTICLE 9, the time period during which the performance goals must be met shall be called a "Performance Period." 9.3 EARNING OF PERFORMANCE UNITS/SHARES. Subject to the terms of this Plan, after the applicable Performance Period has ended, the holder of Performance Units/Shares shall be entitled to receive payout on the number and value of Performance Units/Shares earned by the Employee over the Performance Period, to be determined as a function of the extent to which the corresponding performance goals have been achieved. 9.4 FORM AND TIMING OF PERFORMANCE UNITS/SHARES. Payment of earned Performance Units/Shares shall be made in a single lump sum within seventy-five (75) calendar days following the close of the applicable Performance Period. Subject to the terms of this Plan, the Committee, in its sole discretion, may pay earned Performance Units/Shares in the form of cash or Shares (or a combination thereof) which have an aggregate Fair Market Value equal to the value of the earned Performance Units/Shares at the close of the applicable Performance Period. Such Shares may be granted subject to any restrictions deemed appropriate by the Committee. At the discretion of the Committee, Employees may be entitled to receive any dividends declared with respect to Shares which have been earned in connection with grants of Performance Units and/or Performance Shares which have been earned, but not yet distributed to Employees (such dividends shall be subject to the same accrual, forfeiture, and payout restrictions as apply to dividends earned with respect to Shares of Restricted Stock, as set forth in SECTION 8.6 herein). In addition, Employees may, at the discretion of the Committee, be entitled to exercise their voting rights with respect to such Shares. 9.5 TERMINATION OF EMPLOYMENT DUE TO DEATH, DISABILITY OR RETIREMENT. Unless otherwise determined by the Committee and set forth in the Employee's Award Agreement, in the event the employment of an Employee is terminated by reason of death, disability or Retirement during a Performance Period, the Employee shall receive a payout of the Performance Units/Shares which is prorated, as specified by the 9 10 Committee in its discretion. Payment of earned Performance Units/Shares shall be made at a time specified by the Committee in its sole discretion and set forth in the Employee's Award Agreement. 9.6 TERMINATION OF EMPLOYMENT FOR OTHER REASONS. In the event that an Employee's employment terminates for any reason other than those reasons set forth in SECTION 9.5 herein, all Performance Units/Shares shall be forfeited by the Employee to the Company unless determined otherwise by the Committee, as set forth in the Employee's Award Agreement. 9.7 NONTRANSFERABILITY. Performance Units/Shares may not be sold, transferred, pledged, assigned or otherwise alienated or hypothecated, other than by will or if the grantee dies intestate by the laws of descent and distribution of the state of domicile of the grantee at the time of death. Further, an Employee's rights under the Plan shall be exercisable during the Employee's lifetime only by the Employee or the Employee's legal representative. ARTICLE 10. BENEFICIARY DESIGNATION Each Employee under the Plan may, from time to time, name any beneficiary or beneficiaries (who may be named contingently or successively) to whom any benefit under the Plan is to be paid in case of his or her death before he or she receives any or all of such benefit. Each such designation shall revoke all prior designations by the same Employee, shall be in a form prescribed by the Company, and will be effective only when filed by the Employee in writing with the Company during the Employee's lifetime. In the absence of any such designation, benefits remaining unpaid at the Employee's death shall be paid to the Employee's estate. ARTICLE 11. DEFERRALS The Committee may permit or require an Employee to defer such Employee's receipt of the payment of cash or the delivery of Shares that would otherwise be due to such Employee by virtue of the exercise of an Option or SAR, the lapse or waiver of restrictions with respect to Restricted Stock, or the satisfaction of any requirements or goals with respect to Performance Units/Shares. If any such deferral election is required or permitted, the Committee shall, in its sole discretion, establish rules and procedures for such payment deferrals. ARTICLE 12. RIGHTS OF EMPLOYEES 12.1 EMPLOYMENT. Nothing in the Plan shall interfere with or limit in any way the right of the Company to terminate any Employee's employment at any time, nor confer upon any Employee any right to continue in the employ of the Company. 12.2 PARTICIPATION. No Employee shall be entitled to have the right to be selected to receive an Award under this Plan, or having been so selected, to be selected to receive a future Award. ARTICLE 13. CHANGE IN CONTROL 13.1 TREATMENT OF OUTSTANDING AWARDS. Upon the occurrence of a Change in Control, unless otherwise specifically prohibited under applicable laws, or by the rules and regulations of any governing governmental agencies or national securities exchanges: (a) Any and all Options and SARs granted hereunder shall become immediately exercisable, and shall remain exercisable throughout their entire term; (b) Any restriction periods and restrictions imposed on Restricted Shares shall lapse; (c) The target payout opportunities attainable under all outstanding Awards of Restricted Stock, Performance Units and Performance Shares shall be deemed to have been fully earned for the entire Performance Period(s) as of the effective date of the Change in Control. The vesting of all Awards 10 11 denominated in Shares shall be accelerated as of the effective date of the Change in Control, and there shall be paid out in cash to Employees within thirty (30) days following the effective date of the Change in Control an amount equal to one hundred percent (100%) of all targeted cash payout opportunities associated with outstanding cash-based Awards; and (d) Subject to ARTICLE 14 herein, the Committee shall have the authority to make any modifications to the Awards as determined by the Committee to be appropriate before the effective date of the Change in Control. 13.2 ACCELERATION OF AWARD VESTING. Notwithstanding any provision of this Plan or any Award Agreement provision to the contrary, the Committee, in its sole and exclusive discretion, shall have the power at any time to accelerate the vesting of any Award granted under the Plan to any Employee, including without limitation acceleration to such a date that would result in said Awards becoming immediately vested. 13.3 TERMINATION, AMENDMENT AND MODIFICATIONS OF CHANGE IN CONTROL PROVISIONS. Notwithstanding any other provision of this Plan or any Award Agreement provision, the provisions of this ARTICLE 13 may not be terminated, amended or modified on or after the date of a Change in Control to affect adversely any Award theretofore granted under the plan without the prior written consent of the Employee with respect to said Employee's outstanding Awards; provided, however, the Board of Directors, upon recommendation of the committee, may terminate, amend, or modify this ARTICLE 13 at any time and from time to time prior to the date of a Change in Control. ARTICLE 14. AMENDMENT, MODIFICATION AND TERMINATION 14.1 AMENDMENT, MODIFICATION AND TERMINATION. The Board may at any time and from time to time, alter, amend, suspend, or terminate the Plan in whole or in part. 14.2 ADJUSTMENT OF AWARDS UPON THE OCCURRENCE OF CERTAIN UNUSUAL OR NONRECURRING EVENTS. The Committee may make adjustments in the terms and conditions of, and the criteria included in, Awards in recognition of unusual or nonrecurring events (including, without limitation, the events described in SECTION 4.3 hereof) affecting the Company or the financial statements of the Company or of changes in applicable laws, regulations, or accounting principles, whenever the Committee determined that such adjustments are appropriate in order to prevent dilution or enlargement of the benefits or potential benefits intended to be made available under the Plan; provided that no such adjustment shall be authorized to the extent that such authority would be inconsistent with the Plan's meeting the requirements of Section 162(m) of the Code, as from time to time amended. 14.3 AWARDS PREVIOUSLY GRANTED. No termination, amendment, or modification of the Plan shall adversely affect in any material way any Award previously granted under the Plan, without the written consent of the Employee holding such Award. 14.4 COMPLIANCE WITH CODE 162(m). At all times when Code Section 162(m) is applicable, all Awards granted under this Plan shall comply with the requirements of Code Section 162(m); provided, however, that in the event the Committee determines that such compliance is not desired with respect to any Award or Awards available for grant under the Plan, then compliance with Code Section 162(m) will not be required. In addition, in the event that any changes are made to Code Section 162(m) to permit greater flexibility with respect to any Award or Awards available under the Plan, the Committee may, subject to this ARTICLE 14, make any adjustments it deems appropriate. ARTICLE 15. WITHHOLDING 15.1 TAX WITHHOLDING. The Company shall have the power and the right to deduct or withhold, or require any Employee to remit to the Company, an amount sufficient to satisfy Federal, state and local taxes, domestic or foreign, required by law or regulation to be withheld with respect to any taxable event arising as a result of this Plan. 11 12 15.2 SHARE WITHHOLDING. With respect to withholding required upon the exercise of Options or SARs, upon the lapse of restrictions on Restricted Stock, or upon any other taxable event arising as a result of Awards granted hereunder, Employees may elect, subject to the approval of the Committee, to satisfy the withholding requirement, in whole or in part, by having the Company withhold Shares having a Fair Market Value on the date the tax is to be determined equal to the minimum statutory total tax which could be imposed on the action. All such elections shall be irrevocable, made in writing, signed by the Employee, and shall be subject to any restrictions or limitations that the Committee, in its sole discretion, may determine. ARTICLE 16. INDEMNIFICATION Each person who is or shall have been a member of the Committee, or of the Board, shall be indemnified and held harmless by the Company against and from any loss, cost, liability or expense that may be imposed upon or reasonably incurred by him or her in connection with or resulting from any claim, action, suit or proceeding to which he or she may be a party or in which he or she may be involved by reason of any action taken or failure to act under the Plan and against and from any and all amounts paid by him or her in settlement thereof, with the Company's approval, or paid by him or her in satisfaction of any judgment in any such action, suit or proceeding against him or her, provided he or she shall give the Company an opportunity at its own expense, to handle and defend the same before he or she undertakes to handle and defend it on his or her own behalf. The foregoing right of indemnification shall not be exclusive of any other right of indemnification to which such persons may be entitled under the Company's Articles of Incorporation or Bylaws, as a matter of law, or otherwise, or any power that the Company may have to indemnify them or hold them harmless. ARTICLE 17. SUCCESSOR All obligations of the Company under the Plan with respect to Awards granted hereunder shall be binding upon any successor to the Company, whether the existence of such successor is the result of a direct or indirect purchase, merger, consolidation, or otherwise, of all or substantially all of the business and/or assets of the Company. ARTICLE 18. LEGAL CONSTRUCTION 18.1 GENDER AND NUMBER. Except where otherwise indicated by the context, any masculine term used herein shall also include the feminine; the plural shall include the singular and the singular shall include the plural. 18.2 SEVERABILITY. In the event any provision of the Plan shall be held illegal or invalid for any reason, the illegality or invalidity shall not affect the remaining parts of the Plan, and the Plan shall be construed and enforced as if the illegal or invalid provision had not been included. 18.3 REQUIREMENTS OF LAW. The granting of Awards and the issuance of Shares under the Plan shall be subject to all applicable laws, rules, and regulations, and to such approvals by governmental agencies or national securities exchanges as may be required. 18.4 SECURITIES LAW COMPLIANCE. With respect to (i) any person who is required to file reports pursuant to the rules promulgated under Section 16 of the Exchange Act and (ii) insiders, transactions under this Plan are intended to comply with all applicable conditions of Rule 16b-3 or its successors under the Exchange Act. To the extent any provision of the Plan or action by the Committee fails to so comply, it will be deemed null and void to the extent permitted by law and deemed advisable by the Committee. 18.5 GOVERNING LAW. To the extent not preempted by Federal law, the Plan and all agreements hereunder, shall be construed in accordance with and governed by the laws of the Commonwealth of Pennsylvania. 12 EX-13.1 5 j8729201ex13-1.txt 2000 ANNUAL REPORT 1 Exhibit 13.1 Know how good your network can be. [GRAPHIC] Tollgrade Communications, Inc. 2000 Annual Report to Shareholders 2 Tollgrade was into network service assurance before it was popular. Since the company's founding in 1988, testing has been Tollgrade's primary focus, developing strategic partnerships with the leading names in tele- communications equipment and marketing its own products and services to the leading local exchange carriers and CATV companies in the industry. Through it all, Tollgrade has evolved from a simple equipment vendor, to a systems developer and total solutions provider. In the year 2000, testing became a hot issue in the telecommunications sector as new entrants, new carriers and the investment community discovered the critical role cost-effective, automated testing can play in rolling out new services and improving competitive positioning. Opportunity was at hand in 2000, and Tollgrade was properly positioned to come out on top. And, in the process, we rediscovered our roots. Tollgrade is not simply about testing or status monitoring. We're not just about service, and we're really no longer limited simply to providing network assurance solutions for our customers. We're about all of the above and nothing less. If you are a local exchange carrier right now, you will find comfort in knowing that with Tollgrade on your side -- our people and our products -- you can truly KNOW HOW GOOD YOUR NETWORK CAN BE. Anything less and it wouldn't be Tollgrade. [GRAPHIC] TABLE OF CONTENTS 1 2000 Financial Highlights 2 Letter to Shareholders 4 2000 Operations Highlights 6 Selected Consolidated Financial Data 7 Management's Discussion and Analysis of Results of Operations and Financial Condition 14 Statement of Management's Responsibility for Financial Reporting 15 Report of Independent Accountants 16 Consolidated Financial Statements 20 Notes to Consolidated Financial Statements 28 Shareholder Information IBC Board of Directors and Executive Officers 3 2000 Financial Highlights (In thousands, except per share data and number of employees) December 31, 1999 DECEMBER 31, 2000 OPERATIONS Total Revenues $ 61,111 $ 114,426 - ----------------------------------------------------------------------------- Net Income $ 10,623 $ 27,495 - ----------------------------------------------------------------------------- Earnings Per Share-- Diluted $ .89 $ 2.06 - ----------------------------------------------------------------------------- Weighted Average Shares of Common Stock and Equivalents 11,958,976 13,359,270 - ----------------------------------------------------------------------------- Number of Employees 282 411 - ----------------------------------------------------------------------------- FINANCIAL POSITION Total Assets $ 66,202 $ 131,275 - ----------------------------------------------------------------------------- Working Capital $ 49,958 $ 111,135 - ----------------------------------------------------------------------------- Shareholders' Equity $ 57,504 $ 122,760 - ----------------------------------------------------------------------------- REVENUES (DOLLARS IN THOUSANDS) 1996 1997 1998 1999 2000 ---- ---- ---- ---- ---- $37,490 $45,421* $46,277* $61,111 $114,426 * Includes license fees of $250 and $150, respectively NET INCOME (DOLLARS IN THOUSANDS) 1996 1997 1998 1999 2000 ---- ---- ---- ---- ---- $5,597 $6,883 $6,967 $10,623 $27,495 DILUTED EARNINGS PER SHARE 1996 1997 1998 1999 2000 ---- ---- ---- ---- ---- $0.47 $0.58 $0.58 $0.89 $2.06 4 LETTER TO SHAREHOLDERS Tollgrade saw unprecedented growth in revenue and market capitalization in 2000, yet 2001 will be as challenging as any period in our company's history. [Photo] Chris Allison Chairman and Chief Executive Officer Dear Shareholder, Charles Dickens begins his novel A Tale of Two Cities with the words, "It was the best of times. It was the worst of times." Those thoughts could apply to today's telecommunications industry and public stock markets just as easily as they described the days preceding the French Revolution. Tollgrade saw unprecedented growth in revenue and market capitalization in 2000, yet 2001 will be as challenging as any period in our company's history. As we face what amounts to a "perfect storm" of economic uncertainty and a shifting telecommunications industry, we are comforted by the fact that we have a sturdy ship with her bow pointed toward stable portions of the telecommunications equipment sector. During the first half of 2000, capital expenditures were robust in all sectors of the telecommunications industry. Competitive Local Exchange Carriers (CLECs) continued to make huge investments in their networks only to see their business models begin to fail. Regional Bell Operating Companies (RBOCs) and Multiple System Operators (MSOs) conducted huge infrastructure build-outs to compete in the broadband arena, yet rollout of Digital Subscriber Line (DSL) and cable modem services didn't meet the ambitious expectations the public had set. Tollgrade, like other telecommunications equipment providers, benefited from this land rush. Our 2000 revenues were $114.4 million. That's 87.2% higher than our 1999 revenues of $61.1 million. 2000 net income was 158.8% over 1999 and earnings per common share increased by 131.5% to $2.06 versus $.89 in 1999. Despite our great year, we've seen significant changes in the telecommunications industry during the latter part of 2000. CLECs either went out of business or dramatically slowed their deployments. MSO hybrid-fiber-coax build-outs in the CATV industry took longer to complete than previously anticipated. RBOCs began re-examining all of their network deployments. Fortunately for Tollgrade, our business emphasis was, and continues to be, aimed at larger carriers. As a result, our fundamental underpinnings can help us face these tough business conditions. We have a solid franchise among RBOC customers for solving Plain Old Telephone Service (POTS) testability problems through our MCU(R) product line, our POTS testability consulting business and DigiTest(R). Verizon began deploying DigiTest during the fourth quarter of 2000 to replace aging POTS test systems so it could roll out DSL faster. SBC Telecom has made DigiTest a fundamental part of its POTS and DSL deployment. Our MCU business will continue to be the flagship of the fleet. Tollgrade is THE name for POTS testing among the RBOCs. During 2000, we increased sales of our MCU product line by approximately $32.8 million, or 68.9%. Also, DigiTest is a great new product for both POTS testing and DSL service delivery. We're proving its merit with widespread deployment of DigiTest at Sprint and initial DigiTest deployment at SBC Telecom and other CLECs through our partners Lucent and Nortel. DigiTest is world-class. Sales of DigiTest increased by approximately $14.4 million, or 218.4% in 2000. 2 5 LETTER TO SHAREHOLDERS LIGHTHOUSE is proving to be a player in status monitoring among MSOs such as RCN and AT&T, and with node vendors such as ANTEC and Motorola. In 2000, the sales of our LIGHTHOUSE Cable Status Monitoring System increased by approximately $5.5 million, or 126.9%. Finally, we are a strong company in delivering innovation and world-class customer service while running a tight ship. We posted some great numbers in 2000, which give us a strong foundation for the tough times we all will see in 2001. So what's our plan going forward? First, we want to continue our leadership in POTS testability. Our goal is that no Digital Loop Carrier (DLC) system will be installed without MCU technology. We also want to focus our Professional Services group like a laser beam on the RBOCs to make sure that their DLC systems are testable -- which will drive MCU sales. Second, we are focusing our DigiTest efforts on Lucent MLT-1 replacement. This means that, as RBOCs replace older MLT-1 Lucent test hardware, we are there with our DigiTest system. Our goal this year is to deploy DigiTest for POTS test head replacement in RBOCs, as well as for DSL deployment among RBOCs and blue-chip carriers. While we need the financial instability of many CLECs to heal, and consolidation to progress in 2001, we will still pursue stable companies in this market sector. Third, we want our valued POTS customers to know about the great things that DigiTest can do for them in DSL testing, particularly leveraging their MCU investments with low-cost, high-value DigiTest technology. Fourth, we will focus our DigiTest POTS and DSL technology marketing efforts on blue-chip, non-RBOC carriers and emerging carriers with solid footing. Fifth, we want to grow our relationships with Lucent and Nortel and use those relationships to enter new markets. Sixth, we want to keep our large MSO customers happy with our LIGHTHOUSE technology and grow that business, as one-way systems are converted into two-way transmission, particularly in the area of power supply monitoring. Seventh, we want to grow our Professional Services business through the expansion of existing relationships and the creation of new services. Eighth, we want to continue the development of innovation in our R&D efforts by the expansion of existing technology and the identification of new technology. Let me close with the following thoughts: Five years ago, Tollgrade entered the public market with a little more than $22 million in sales. We ended 2000 with a little more than $114 million in sales. In between that time, we've seen varying levels of investment in public communications networks, changes in infrastructure, deregulation, labor strikes and the emergence of the Internet. Tollgrade is like a strong ship that has weathered storms in the past with a bright outlook and her wheel pointed toward a spot on the horizon. That has not and will not change. /s/ Chris Allison Chris Allison Chairman and Chief Executive Officer Company Milestones in 2000 In addition to Tollgrade's operational performance, four key events transpired in 2000 that helped to characterize a great year. March 20 Two-for-one stock split took effect, increasing the number of Tollgrade's outstanding shares to over 13 million. April 4 Tollgrade introduced its Digital Wideband Unit (DWU) for DSL testing. The DWU enables local exchange carriers to conduct the full range of loop qualification and in-service tests for DSL service. October 16 Forbes Magazine ranked Tollgrade 31st on its list of "The 200 Best Small Companies in America." This was the third time in four years Tollgrade was included on the list. December 15 Tollgrade celebrated its fifth anniversary on The Nasdaq Stock Market(SM) by pressing the button to open the day's trading. 3 6 2000 OPERATIONS HIGHLIGHTS In 2000, Tollgrade achieved growth across each of its three major product lines and its Professional Services business unit. [PHOTO] Tollgrade's MCU Technology continued to serve as the cornerstone of the company's growth. MCU technology enables local exchange carriers to obtain critical test access in digital loop carrier environments and for the deployment of digital subscriber line (DSL) service. [PHOTO] Tollgrade's DigiTest System, which tests Plain Old Telephone Service (POTS) and is used for DSL loop qualification and in-service testing, contributed to Tollgrade's success in a big way in 2000. The system is designed to serve as a hardware platform for the industry's leading test operations support systems and serves as the current hardware standard for next-generation testing of POTS lines in North America. Its state-of-the-art DSL loop qualification and testing capabilities have given DigiTest its distinct advantage. [PHOTO] Tollgrade's LIGHTHOUSE Cable Status Monitoring System, which addresses the broadband status monitoring needs of the CATV industry, continued to grow in 2000. The system, which consists of a headend controller, host software and transponders for power supplies, amplifiers and nodes, has become one of the status monitoring solutions of choice in the broadband world. Tollgrade Professional Services entered its second full year of operation in 2000 and exceeded all of its growth expectations. The Tollgrade Professional Services team grew from 18 professionals at the start of the year, to 26 seasoned experts, serving both the telecom and CATV industries by year's end. REVENUES BY PRODUCT (PERCENTAGE OF 2000 REVENUE) [GRAPHIC]
MCU TECHNOLOGY DIGITEST SYSTEM LIGHTHOUSE PROFESSIONAL FOR TEST EXTENSION FOR POTS AND DSL TESTING CABLE STATUS MONITORING SERVICES OTHER - ------------------ ------------------------ ----------------------- -------- ----- 70.2% 18.4% 8.6% 2.2% 0.6%
4 7 2000 OPERATIONS HIGHLIGHTS MCU TECHNOLOGY FOR TEST EXTENSION Key Customers -- BellSouth, Verizon, Qwest, Nortel, Advanced Fibre Communications, SBC Communications (includes Southwestern Bell, Pacific Bell, Ameritech and Southern New England Telephone), SBC Telecom - the CLEC subsidiary of SBC, Sprint North Supply - the procurement division of Sprint USA, Allegiance Telecom and Choice One Communications Highlights -- BellSouth increased its purchasing rates of MCU technology as part of a long-term remediation program to improve its testability rates system-wide. SBC Communications incorporated a comprehensive purchasing program of MCU technology as part of its Project Pronto initiative to roll out DSL service. [GRAPHIC] Customer demand drove increased sales of Tollgrade's Telaccord product, which provides test access in a DSL environment. DIGITEST SYSTEM FOR POTS AND DSL TESTING Key Customers -- Nortel Networks, Sprint North Supply, Lucent Technologies, Choice One, Echelon Communications, SBC Telecom, Verizon and TriVergent. Highlights -- Tollgrade expanded its customer list to include large independent carriers and Regional Bell Operating Companies, along with emerging CLECs through the rollout of its DigiTest system. The company introduced its Digital Wideband Unit (DWU) for DSL loop qualification and in-service testing and demonstrated the unit's ability to combine a range of measurements to arrive at accurate DSL rate prediction. In addition, Tollgrade saw its first sales of DigiTest for the POTS test-head replacement market. As a result, Tollgrade's DigiTest is well positioned to serve as the hardware [GRAPHIC] test platform going forward for the replacement of obsolete test hardware in the North American network. LIGHTHOUSE CABLE STATUS MONITORING Key Customers -- AT&T Broadband, RCN Corporation, ANTEC, C-COR.net and Motorola. Highlights -- Tollgrade's LIGHTHOUSE Cable Status Monitoring system continued to penetrate the CATV marketplace at a time when cable modem shipments enjoyed a rapid increase throughout the country, expanding the availability of broadband services over the HFC network. RCN selected Tollgrade to build out [GRAPHIC] its status monitoring system to proactively monitor the company's power supplies and nodes. PROFESSIONAL SERVICES Key Customers -- SBC Communications, Verizon, BellSouth, Qwest, Sprint Communications, AT&T Broadband and RCN Corporation. Highlights -- Tollgrade's Professional Services business doubled its revenues year-over-year. In the process, our professionals spent nearly 38,000 hours in the field, conducting training, troubleshooting and spearheading testability improvement initiatives that improved our customers' testability to an average of 90 percent. In addition, Tollgrade Professional Services [GRAPHIC] helped the company build even stronger relationships with our customers to aid in the sale of new products. 5 8 SELECTED CONSOLIDATED FINANCIAL DATA The selected consolidated financial data of the Company as of December 31, 1996, 1997, 1998, 1999, 2000 and for the years then ended is derived from audited consolidated financial statements of the Company.
(In thousands, except per share data) Years Ended December 31, 1996 1997 1998 1999 2000 - ------------------------------------------------------------------------------------------------------------------- STATEMENTS OF OPERATIONS DATA: Revenues(1) $ 37,490 $ 45,421 $ 46,277 $ 61,111 $114,426 Cost of product sales 18,322 20,104 19,620 25,014 42,638 ................................................................................................................... Gross profit 19,168 25,317 26,657 36,097 71,788 Operating expenses: Selling and marketing 4,767 5,446 5,704 7,006 12,289 General and administrative 2,552 3,768 4,128 4,723 6,216 Research and development 3,921 5,945 6,880 8,757 12,456 ................................................................................................................... Total operating expenses 11,240 15,159 16,712 20,486 30,961 - ------------------------------------------------------------------------------------------------------------------- Income from operations 7,928 10,158 9,945 15,611 40,827 Other income, net 845 899 1,062 949 2,525 ................................................................................................................... Income before income taxes 8,773 11,057 11,007 16,560 43,352 Provision for income taxes 3,176 4,174 4,040 5,937 15,857 - ------------------------------------------------------------------------------------------------------------------- Net income $ 5,597 $ 6,883 $ 6,967 $ 10,623 $ 27,495 - ------------------------------------------------------------------------------------------------------------------- Earnings per share: (2) Basic $ .51 $ .61 $ .60 $ .92 $ 2.18 Diluted .47 .58 .58 .89 2.06 - ------------------------------------------------------------------------------------------------------------------- Weighted average shares of common stock and equivalents: Basic 11,002 11,372 11,683 11,574 12,636 Diluted 11,879 11,923 11,933 11,959 13,359 - -------------------------------------------------------------------------------------------------------------------
As of December 31, 1996 1997 1998 1999 2000 - ------------------------------------------------------------------------------------------------------------------- BALANCE SHEET DATA: Working capital $ 27,232 $ 34,570 $ 40,539 $ 49,958 $111,135 Total assets 34,626 43,713 49,865 66,202 131,275 Shareholders' equity 30,006 38,101 45,696 57,504 122,760 - -------------------------------------------------------------------------------------------------------------------
1996 1997 1998 1999 2000 - ------------------------------------------------------------------------------------------------------------------- OTHER DATA: (3) Number of employees at year end 184 205 230 282 411 Average revenue per employee $ 204 $ 222 $ 201 $ 217 $ 278 - -------------------------------------------------------------------------------------------------------------------
(1) Includes license fees of $250 and $150 for 1997 and 1998, respectively. (2) 1998 includes $.02 per share related to the after-tax effect of net key man life insurance proceeds associated with the death of the Company's former Chairman R. Craig Allison. (3) Data not derived from Company's audited financial statements. 6 9 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following discussion should be read in conjunction with the "Selected Consolidated Financial Statements" and notes thereto appearing elsewhere in this Annual Report to Shareholders. CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. The statements contained in this Annual Report to Shareholders, specifically those contained in the following Management's Discussion and Analysis of Results of Operations and Financial Condition which are not historical are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements represent Tollgrade Communications, Inc.'s (the "Company") present expectations or beliefs concerning future events. The Company cautions that such statements must be qualified by important factors that could cause actual earnings and other results to differ materially from those achieved in the past or those expected by the Company. These statements as to management's beliefs, strategies, plans, expectations or opinions in connection with Company performance, are based on a number of assumptions concerning future conditions that may ultimately prove to be inaccurate. Such statements must be qualified by important factors that could cause actual earnings and other results to differ materially from those achieved in the past or those expected by the Company. These include: o Customers' ability to meet established purchase forecasts and their own growth projections; o The ability of certain customers to maintain financial strength and access to capital; o The ability for sales and marketing partners to meet their own performance objectives and provide vendor financing to certain local exchange carriers; o Customers' seasonal buying patterns and the risk of order cancellations; o Risk of shortage of key components and possibility of limited source of supply; o Manufacturing delays and availability of manufacturing capacity; o Intense competition in the market for the Company's products; o Rapid technological change along with the need to continually develop new products and gain customer acceptance and approval; o The Company's dependence on a relatively narrow range of products; o Competition; o The Company's dependence on key employees; o Difficulties in managing the Company's growth; o The Company's dependence upon a small number of large customers and certain suppliers; o The Company's dependence upon proprietary rights; o Risks of third party claims of infringement; and o Possibility of product defects; and o Government regulation. The Company does not undertake any obligation to publicly update any forward-looking statements. OVERVIEW The Company was organized in 1986 and began operations in 1988. The Company designs, engineers, markets and supports test system, test access and status monitoring products for the telecommunications and cable television industries. The Company's telecommunications proprietary test access products enable telephone companies to use their existing line test systems to remotely diagnose problems in Plain Old Telephone Service ("POTS") lines containing both copper and fiber-optics. The Company's MCU(R) product line, which includes POTS line testing as well as alarm-related products, represented approximately 70% of the Company's revenue for the year ended December 31, 2000 and will continue to account for a majority of the Company's revenues for the foreseeable future. The Company's DigiTest(R) centralized network test system platform focuses on helping local exchange carriers conduct the full range of fault diagnosis, along with the ability to qualify, deploy and maintain next generation services that include Digital Subscriber Line ("DSL") service and Integrated Services Digital Network ("ISDN") service. The Company's DigiTest system is designed to provide complete hardware testing for POTS and local loop prequalification for DSL services. The system currently consists of three integrated pieces of hardware, the Digital Measurement Node ("DMN"), the Digital Measurement Unit ("DMU"), and the Digital 7 10 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Wideband Unit ("DWU"). When used in an integrated fashion, the DigiTest system permits local exchange carriers to perform a complete array of central office testing including POTS, DSL line prequalification, bridge tap detection, data rate prediction, and in-service wideband testing. Sales of the DigiTest product line accounted for approximately 18% of the Company's revenue for the year ended December 31, 2000. The Company's LIGHTHOUSE(R)cable products consist of a complete cable status monitoring system that provides a broad testing solution for the Broadband Hybrid Fiber Coax distribution system. The status monitoring system includes a host for user interface, control and configuration; a headend controller for managing network communications; and transponders that are strategically located within the cable network to gather status reports from power supplies, line amplifiers and fiber-optic nodes. Sales of the LIGHTHOUSE product line accounted for approximately 9% of the Company's revenue for the year ended December 31, 2000. Through 2000, the Company continued to build upon and extend its Professional Services offering to customers. The cornerstone of the Company's Professional Services business is the Testability Improvement Initiatives. These services may offer the customer the opportunity to make dramatic improvements in testability levels, while training their own staffs in targeted geographic regions over a defined period of time. By making improvements in the customers' digital loop carrier ("DLC") testability levels, the customers' internal repair technicians can make use of automated systems to diagnose and repair subscriber loop problems, thereby automatically eliminating the need for the involvement of several highly trained people to test and diagnose line problems. The Professional Services business levels continued to increase in 2000, but are not yet considered material to the Company's revenue for the year ended December 31, 2000. The Company's telecommunications product and services sales are primarily to the four Regional Bell Operating Companies ("RBOCs"), as well as major independent telephone companies and to certain DLC equipment manufacturers. For the year ended December 31, 2000, approximately 64% of the Company's total revenue was generated from sales to these four RBOCs, the two largest of which comprised approximately 43% of total revenues. The Company markets and sells its products directly, as well as through various Original Equipment Manufacturer ("OEM") arrangements. The Company's operating results have fluctuated and may continue to fluctuate as a result of various factors, including the timing of orders from and shipments to the RBOCs. This timing is particularly sensitive to various business factors within each of the RBOCs including the RBOCs relationships with their various organized labor groups. In addition, the markets for the Com- pany's new products, specifically DigiTest and LIGHTHOUSE, are highly competitive. Due to the rapidly evolving market in which these products compete, additional competitors with significant market presence and financial resources could further intensify the competition for these products. The Company believes that recent changes within the telecommunication marketplace, including industry consolidation, as well as the Company's ability to successfully penetrate certain new markets, have resulted in some discounting and more favorable terms granted to certain customers of the Company. In addition, the Company experienced certain customer demands to consolidate product purchases that have translated into large bulk orders. Although the Company will continue to strive to meet the demands of its customers, which include delivery of quality products at an acceptable price and on acceptable terms, there are no assurances that the Company will be successful in negotiating acceptable terms and conditions in its purchase orders or its customer purchase agreements. Additionally, continuing consolidation efforts among the RBOCs, and their ability to consolidate their inventory and product procurement systems could cause fluctuations or delays in the Company's order patterns. Also, recent efforts in the cable status monitoring industry to standardize transponders among status monitoring systems could cause pricing pressure as well as affect deployment within certain customers of the Company's cable products. These standards, if adopted by the standards setting body, are expected to become final in the year 2001 and may affect the Company's revenues from such products in subsequent periods. The Company cannot predict such future events or business conditions and the Company's results could be adversely affected by these industry trends in the primary markets its serves. Although international sales to date have not been significant, the Company believes that certain international markets may offer opportunities. However, the international telephony markets differ from those found domestically due to the different types and configurations of equipment used by those international communica- 8 11 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION tion companies to provide services. In addition, certain competitive elements also are found internationally which do not exist in the Company's domestic markets. These factors, when combined, have made entrance into these international markets very difficult. From time to time, the Company has utilized the professional services of various marketing consultants to assist in defining the Company's international market opportunities. With the assistance of these consultants and through direct marketing efforts by the Company, it has been determined that its present MCU technology offers limited opportunities in certain international markets for competitive and other technological reasons. However, the Company continues to evaluate opportunities for its other products in international markets. There can be no assurance that any continued efforts by the Company will be successful or that the Company will achieve significant international sales. The Company believes that continued growth will depend, in part, on its ability to design and engineer new products and, therefore, spends a significant amount on research and development. Research and development expenses as a percent of revenues were approximately 11% for the year ended December 31, 2000. The Company believes that the near-term economic climate could be one of challenge and uncertainty. In addition, the Company believes that future growth may be affected as a result of an overall near-term economic slowdown whereby customers may become more conservative in their ordering patterns and quantities, or that certain emerging carriers become financially unstable. Due to this uncertainty, the Company will evaluate its investments in marketing and research and development expenses and monitor, control or decrease expense levels, as appropriate. YEAR ENDED DECEMBER 31, 2000 COMPARED TO YEAR ENDED DECEMBER 31, 1999 REVENUES Revenues for the year ended December 31, 2000 were $114.4 million, and were $53.3 million or 87.2% higher than the revenues of $61.1 million for the year ended December 31, 1999. The increase in revenues is primarily associated with an increase in the unit volume sales of core MCU products, increased sales associated with the Company's next generation DigiTest system, increased sales of the Company's LIGHTHOUSE Cable Status Monitoring System, as well as increased billings related to the Company's Professional Services business. During 2000, the Company increased the sales of its MCU product line by approximately $32.8 million, or 68.9%. This increase in sales of the MCU product line resulted primarily from increased sales to SBC Communications, Inc. (including Ameritech, Pacific Bell, and SNET) associated with Project Pronto, that company's broadband initiative. In addition, MCU sales increased to Verizon (formerly Bell Atlantic) during 2000 primarily as a result certain ongoing remediation programs launched by the Company to improve Verizon's MLT testability and flow-through capabilities. Also contributing to the increase in MCU sales during 2000 were increased sales of core MCU products to BellSouth primarily associated with a program to upgrade select DLC systems within certain regions from remote terminal test devices to MCU technology. The MCU product line accounted for approximately 70.2% of the current year revenues. During 2000, the sales of the Company's DigiTest product line increased by approximately $14.4 million, or 218.4%. This increase in DigiTest sales was primarily the result of increased direct shipments during 2000 to Sprint USA and SBC Telecom, Inc., which is the Competitive Local Exchange Carrier ("CLEC") subsidiary of SBC. In addition, sales of DigiTest to Nortel Networks and Lucent for deployment into the CLEC markets, as well as sales to Verizon for the replacement of certain Lucent Loop Testing System ("LTS") test head trunks for qualification of copper lines for Digital Subscriber Line ("DSL") service, contributed to the overall increase in DigiTest sales during the current year. Overall, DigiTest sales accounted for approximately 18.4% of the current year revenues. During 2000, the sales of the Company's LIGHTHOUSE Cable Status Monitoring System increased by approximately $5.5 million, or 126.9%. This increase was primarily a result of increased product sales to RCN Corporation, offset slightly by a decrease in sales during the current year to AT&T Broadband as a result of their decision to delay purchases of cable related equipment. Overall, sales of the LIGHTHOUSE Cable Status Monitoring System accounted for approximately 8.6% of the current year revenues. Periodic fluctuations in customer orders and backlog result from a variety of factors, including but not limited to the timing of significant orders and shipments. While these fluctuations could impact short-term results, they are not necessarily indicative of long-term trends in sales of the Company's products. Management believes that there is a continuing possibility that customer requirements for certain important MCU products which are utilized in legacy DLC systems may be satisfied at some point. In order to 9 12 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION reduce associated risks, the Company is focusing on the development of new product lines to attempt to meet the other requirements of customers. GROSS PROFIT Gross profit for 2000 was $71.8 million compared to $36.1 million for 1999, representing an increase of $35.7 million, or 98.9%. Gross profit as a percentage of revenues increased to 62.7% for 2000 compared to 59.1% for 1999. The overall increase in gross profit resulted primarily from the increased sales levels, while improvements in gross margin as a percentage of sales were a result of a favorable sales mix in relation to higher-margined products, as well as increased sales volumes and associated manufacturing efficiencies. Maintaining the Company's current gross margin levels is contingent on its ability to negotiate price increases and gain further cost reductions. Furthermore, continuing gross margin levels will depend on the actual mix of products sold which will include the effect of the Company's cable products that carry lower gross margins than earned historically on the Company's telecommunication products. In addition, if the sales mix of the Company's DigiTest product line increases with partner companies, such as Nortel Networks or Lucent, the overall margins would decline slightly as a result of a greater mix of lower-margin OEM sales versus direct sales. SELLING AND MARKETING EXPENSE Selling and marketing expense consist primarily of personnel costs as well as commissions and travel expenses of direct sales and marketing personnel, and costs associated with various promotions and related marketing programs. Selling and marketing expense for 2000 was $12.3 million, or 10.7% of revenues, compared to $7.0 million, or 11.5% of revenues for 1999. This increase of $5.3 million, or 75.4%, is primarily due to an increase in the number of sales and marketing personnel to support new product introductions and enhance customer support, as well as an increase in commissions associated with the increased sales level and increased expenditures on advertising, promotion and related marketing activities. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expenses consist primarily of personnel costs for finance, administrative and general management personnel as well as accounting and legal expenses. General and administrative expense for 2000 was $6.2 million, or 5.4% of revenues, compared to $4.7 million, or 7.7% of revenues for 1999. This increase of $1.5 million, or 31.6%, is primarily attributable to an increase in employee recruiting-related expenditures, increased legal expenses as well as an increase in certain professional service and consulting fees. RESEARCH AND DEVELOPMENT EXPENSE Research and development expenses consist primarily of personnel costs and costs associated with the development of new products and technologies, including DigiTest and LIGHTHOUSE, and enhancing features of existing products. Research and development expense for 2000 was $12.5 million, or 10.9%, of revenues, compared to $8.8 million, or 14.3%, of revenues for 1999. This increase of $3.7 million, or 42.3%, was principally due to the addition of personnel to support new product development activities and the project costs associated with product development. The Company expenses all research and development costs as they are incurred. OTHER INCOME AND EXPENSE Other income, which consists primarily of interest income, was $2.5 million for 2000 compared to $1.0 million for 1999. The increase of $1.5 million, or 166.2%, is primarily attributable to an increase in funds available for investment between periods. PROVISIONS FOR INCOME TAXES The Company's effective tax rate for 2000 was 36.6% of income before income taxes, compared to the 35.9% rate in 1999. The increase in the effective income tax rate was primarily due to higher relative levels of state income taxes associated with expanding business activities. NET INCOME AND EARNINGS PER SHARE For the year ended December 31, 2000, net income was $27.5 million compared to $10.6 million for the year ended December 31, 1999, representing an increase of $16.9 million, or 158.8%. Diluted earnings per common share of $2.06 for 2000 increased by 131.5%, or $1.17, from the $.89 earned in 1999. Diluted weighted average shares of common stock and equivalents outstanding were 13,359,270 in 2000 compared to 11,958,976 in 1999. This increase in the diluted weighted average shares of common stock and equivalents outstanding is primarily the result of the effect of an increase in the average share price of common stock between periods. As a percentage of revenues, net income for 2000 increased to 24.0% from 17.4% in 1999. YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998 REVENUES Revenues for the year ended December 31, 1999 were $61.1 million, and were $14.8 million, or 32.1%, higher than the revenues of $46.3 million for the year ended 10 13 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION December 31, 1998. The increases in revenues were primarily associated with the sale of new products, as well as increased sales of core MCU products. During 1999, the Company generated revenues of approximately $9.4 million associated with new product introductions including the Company's DigiTest product line, while same product and services sales between periods increased $5.4 million, or 11.8%. Contributing to the increase in same product and services sales in 1999 was continued strong purchasing by Qwest (formerly US West) associated with that company's continued effort to improve testability in selected states, offset by the lower sales to certain Verizon (formerly Bell Atlantic) regions. The Company believes the decreased sales within the Verizon region during 1999 was the result of higher than expected inventories as a result of slower than expected deployment of MCU products within certain regions. Verizon's testability improvement initiatives migrated to more complex embedded DLC architectures that require the provisioning of additional equipment and increased installation time. The Company implemented certain strategies, including providing professional services which provide comprehensive technical training and other testability improvement initiatives services which were designed to return product usage to historical levels. The effectiveness of these programs resulted in some increased deployment of the Company's MCU technology, which in turn began to reduce existing inventory levels within Verizon. There were no assurances as to the ultimate effectiveness of these programs in returning product deployment to historical levels. GROSS PROFIT Gross profit for 1999 was $36.1 million compared to $26.7 million for 1998, representing an increase of $9.4 million, or 35.4%. Gross profit as a percentage of revenues increased to 59.1% for 1999 compared to 57.6% for 1998. The overall increase in gross profit resulted primarily from the increased sales levels, while improvements in gross margin as a percentage of sales were a result of a favorable sales mix in relation to higher-margined products, as well as increased sales volumes and associated manufacturing efficiencies. SELLING AND MARKETING EXPENSE Selling and marketing expense consist primarily of personnel costs as well as commissions and travel expenses of direct sales and marketing personnel, and costs associated with marketing programs. Selling and marketing expense for 1999 was $7.0 million, or 11.5% of revenues, compared to $5.7 million, or 12.3% of revenues for 1998. This increase of $1.3 million, or 22.8%, was primarily related to increased costs associated with certain performance-based compensation programs, as well as an increase in spending on general advertising, promotion and related marketing activities. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expenses consist primarily of personnel costs for finance, administrative and general management personnel as well as accounting and legal expenses. General and administrative expense for 1999 was $4.7 million, or 7.7%, of revenues, compared to $4.1 million, or 8.9%, of revenues for 1998. This increase of $0.6 million, or 14.4%, was primarily attributable to an increase in professional service consulting fees, as well as an increase in expense for the Company's management incentive compensation program associated with the Company's financial performance for the year ended December 31, 1999. RESEARCH AND DEVELOPMENT EXPENSE Research and development expenses consist primarily of personnel costs and costs associated with the development of new products and technologies, including DigiTest and LIGHTHOUSE, and enhancing features of existing products. Research and development expense for 1999 was $8.8 million, or 14.3%, of revenues, compared to $6.9 million, or 14.9%, of revenues for 1998. This increase of $1.9 million, or 27.3%, was principally due to costs associated with new product development and the addition of personnel to support these new product development activities. In addition, research and development expenses reflect an increase in expense associated with the Company's management incentive compensation program as mentioned above. The Company expenses all research and development costs as they are incurred. OTHER INCOME AND EXPENSE Other income, which consists primarily of interest income, was $1.0 million for 1999 compared to $1.1 million for 1998. The decrease of $0.1 million, or 10.6%, was primarily the result of the prior year period including approximately $0.2 million of net key man life insurance proceeds associated with the death of the Company's former Chairman R. Craig Allison. PROVISIONS FOR INCOME TAXES The Company's effective tax rate for 1999 was 35.9% of income before income taxes, compared to the 36.7% rate in 1998. The decrease in the effective income tax rate reflects the effect of certain permanent differences comprising a larger percentage of pre-tax book income. 11 14 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION NET INCOME AND EARNINGS PER SHARE For the year ended December 31, 1999, net income was $10.6 million compared to $7.0 million for the year ended December 31, 1998, representing an increase of $3.7 million, or 52.5%. Diluted earnings per common share of $.89 for 1999 increased by 53.4%, or $.31, from the $.58 earned in 1998. Fiscal year 1998 includes approximately $0.2 million, or $.02 per share, related to the after-tax effect of net key man life insurance as previously discussed above. Excluding the effect of net key man life insurance proceeds, net income increased $3.9 million, or 55.7%, while diluted earnings per share for 1999 increased 58.9%, or $0.33 per share. Diluted weighted average shares of common stock and equivalents outstanding were 11,958,976 in 1999 compared to 11,933,102 in 1998. As a percentage of revenues, net income for 1999 increased to 17.4% from 15.1% in 1998. LIQUIDITY AND CAPITAL RESOURCES The Company had working capital of $111.1 million as of December 31, 2000 compared to the working capital of $50.0 million as of December 31, 1999. The increase of $61.2 million, or 122.5%, can be attributed to operating cash flow (income from operations before depreciation and amortization) and proceeds from the exercise of stock options exceeding requirements for purchases of property and equipment. Significant components of the Company's change in working capital include an increase in cash and cash equivalents which include the effect of additional operating cash flow, as well as cash received as a result of stock option exercises, an increase in raw materials and work-in-process inventories to support the new product introductions of the Company's DigiTest and LIGHTHOUSE cable status monitoring system as well as an increase in MCU-related inventory to support certain project-related customer programs, and an increase in accounts receivable-trade as a result of the increased sales levels during the latter part of 2000. In addition, the Company's current deferred and refundable tax assets as of December 31, 2000 includes a current tax benefit of approximately $9.0 million resulting from the exercise of certain nonstatutory stock options under the Company's various stock option programs during 2000. The Company is entitled to a tax deduction in the current tax year equal to the difference between the fair market value of the shares received by the option holders upon exercise and the exercise price of the nonstatutory stock options. The Company anticipates that these tax deductions will be utilized either through a refund of prior year taxes paid or through the elimination of income taxes payable in 2001. As of December 31, 2000, the Company had $61.6 million of cash and cash equivalents, short-term and long-term investments, which are unrestricted and available for corporate purposes including acquisitions, and other general working capital requirements. The Company made capital expenditures of $4.1 million in 2000, primarily related to production test equipment and fixtures, computer hardware to support new hires and to upgrade and expand the IT infrastructure, as well as various leasehold expansion and improvements made to the Company's facilities. Capital expenditures were $2.3 million and $1.7 million for 1999 and 1998, respectively, and were primarily related to upgrades to the IT infrastructure, office equipment, test fixtures and development systems, tooling and leasehold improvements. The Company has recently completed a facility occupancy and planning study to determine the various alternatives available for facility expansion that may be necessary to accommodate potential future growth. The Company is currently evaluating these alternatives that include the solicitation and potential procurement of certain land parcels that surround the current lease facility for the possible expansion of parking and or new building structures. This purchase of properties is approximately $1.8 million and will most likely occur during the first half of 2001. Planned capital expenditures for 2001 are anticipated to total approximately $6.0 million. These planned capital projects include test fixtures and development systems, computer and office equipment and leasehold improvements to the Company's facilities. On April 22, 1997, the Company's Board of Directors authorized a program to purchase up to 400,000 shares of its common stock over the next two years. The program intended that the shares would be utilized to provide stock under certain employee benefit programs. As of April 22, 1999, the expiration of this initial program, the Company had purchased 382,400 shares of common stock under this program. The Company used existing cash and short-term investments to finance these purchases. On May 6, 1999, the Company's Board of Directors authorized a new program to purchase up to 400,000 shares of its common stock over a two-year period. As of December 31, 2000, the Company had not initiated any purchases of common stock under this program. The number of shares that the Company intends to purchase and the time of such purchases will be determined by the Company, at its discretion. 12 15 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The Company plans to use existing cash and short-term investments to finance the purchases. The impact of inflation on both the Company's financial position and the results of operations have been minimal and are not expected to adversely affect 2001 results. The Company's financial position enables it to meet cash requirements for operations and capital expansion programs. On July 23, 1996, the Board of Directors of the Company declared a dividend of one preferred stock purchase right for each outstanding share of the Company's common stock. The rights will be exercisable only if a person or group acquires or announces a tender or exchange offer for 20% or more of the Company's common stock. In such an event, each right will entitle shareholders to buy one-hundredth of a share of a new series of preferred stock at an exercise price of $115.00. Each one-hundredth of a share of the new preferred stock has terms designed to make it the economic and voting equivalent of one share of common stock. If a person or group acquires 20% or more of the Company's outstanding common stock, each right not owned by the person or group will entitle its holder to purchase, at the right's exercise price, a number of shares of the Company's common stock (or, at the option of the Company, the new preferred stock) having a market value of twice the exercise price. Further, at any time after a person or group acquires 20% or more (but less than 50%) of the outstanding common stock, the Board of Directors may, at its option, exchange part or all of the rights (other than rights held by the acquiring person or group) for shares of the Company's common or preferred stock on a one-for-one basis. If after a person or group acquires 20% or more of the outstanding common stock, each right will entitle its holder to purchase, at the right's exercise price, a number of the acquiring company's common shares having a market value at that time of twice the exercise price. The Board of Directors is entitled to redeem the rights for one cent per right at any time before a 20% position has been acquired. The Board of Directors is also authorized to reduce the 20% thresholds referred to above to not less than 10%. The rights were not distributed in response to any specific effort to acquire control of the Company, nor is the Company presently aware of any such effort. The distribution of the rights will not affect the Company's reported earnings and is not taxable to shareholders or to the Company. Shareholders will not receive any documents evidencing their rights unless and until the rights become exercisable. Until that time, the rights will not trade separately from the common stock. The rights will expire on August 15, 2006. BACKLOG As of December 31, 2000, the Company's backlog was $8.2 million compared to the backlog at December 31, 1999 of $12.1 million. The Company's backlog consists of firm customer purchase orders for the Company's various products. Backlog at December 31, 2000 also includes approximately $1.3 million related to the one-time order from Qwest for the Company's Broadcast Program Channel Unit destined for use at the Salt Lake City Winter Olympic Games. The Company believes that customers are returning to a more typical seasonal-based ordering pattern where the first quarter of the year is typically lower than the preceding quarter. The shippable backlog entering the first quarter of 2001 is lower than 2000 levels. Periodic fluctuations in customer orders and backlog result from a variety of factors, including but not limited to the timing of significant orders and shipments. While these fluctuations could impact short-term results, management believes these fluctuations are not necessarily indicative of long-term trends in sales of the Company's products. ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes standards for reporting information about various derivative financial instruments and accounting for their change in fair value. The Company does not hold or issue derivative instruments for hedging purposes and therefore the adoption of this standard in 2000 did not have a material effect on the consolidated financial position or results of operations of the Company. In December 1999, the Staff of the Securities and Exchange Commission issued Staff Accounting Bulletin 101, "Revenue Recognition in Financial Statements" ("SAB 101"), which provides guidance related to revenue recognition. The Company has adopted this standard in 2000 and the impact did not have a material effect on its business, results of operations and financial condition. 13 16 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES STATEMENT OF MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL REPORTING The accompanying consolidated financial statements of Tollgrade Communications, Inc. and Subsidiaries have been prepared by management, who are responsible for their integrity and objectivity. The statements have been prepared in conformity with generally accepted accounting principles and include amounts based on management's best estimates and judgements. Financial information elsewhere in this Annual Report is consistent with that in the financial statements. Management has established and maintains a system of internal control designed to provide reasonable assurance that assets are safeguarded and that the financial records reflect the authorized transactions of the Company. The system of internal control includes widely communicated statements of policies and business practices that are designed to require all employees to maintain high ethical standards in the conduct of Company affairs. The internal controls are augmented by organizational arrangements that provide for appropriate delegation of authority and division of responsibility. The financial statements have been audited by PricewaterhouseCoopers LLP, Independent Accountants. As part of their audit of the Company's 2000 financial statements, PricewaterhouseCoopers LLP considered the Company's system of internal control to the extent they deemed necessary to determine the nature, timing and extent of their audit tests. The Report of Independent Accountants follows. The Board of Directors pursues its responsibility for the Company's financial reporting through its Audit Committee, which is composed entirely of outside directors. The Audit Committee has met periodically with the Independent Public Accountants and management. The Independent Public Accountants had direct access to the Audit Committee, with and without the presence of management representatives, to discuss the results of their audit work and their comments on the adequacy of internal accounting controls and the quality of financial reporting. /s/ Christian L. Allison Christian L. Allison Chairman and Chief Executive Officer /s/ Samuel C. Knoch Samuel C. Knoch Chief Financial Officer and Treasurer January 19, 2001 14 17 REPORT OF INDEPENDENT ACCOUNTANTS January 19, 2001 To the Board of Directors and Shareholders of Tollgrade Communications, Inc. and Subsidiaries: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, changes in shareholders' equity and cash flows present fairly, in all material respects, the financial position of Tollgrade Communications, Inc. and its subsidiaries at December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICEWATERHOUSECOOPERS LLP /s/ PricewaterhouseCoopers LLP Pittsburgh, Pennsylvania January 19, 2001 15 18 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
ASSETS December 31, 1999 DECEMBER 31, 2000 - ------------------------------------------------------------------------------------------------------------------- Current assets: Cash and cash equivalents $ 15,555,810 $ 30,423,783 Short-term investments 13,516,676 28,405,655 Accounts receivable: Trade 10,865,244 18,775,643 Other 335,155 813,809 Inventories 17,335,747 30,499,482 Prepaid expenses and deposits 461,934 787,098 Refundable taxes due -- 8,950,672 Deferred tax assets 575,251 983,246 Total current assets 58,645,817 119,639,388 Long-term investments 2,850,000 2,750,000 Property and equipment, net 4,337,115 6,503,923 Deferred tax assets 367,626 2,380,828 Patents 1,396 417 ................................................................................................................... Total assets $ 66,201,954 $ 131,274,556 - ------------------------------------------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY - ------------------------------------------------------------------------------------------------------------------- Current liabilities: Accounts payable $ 911,769 $ 1,874,328 Accrued expenses 1,222,866 1,937,589 Accrued salaries and wages 2,209,473 2,813,433 Royalties payable 793,689 1,142,478 Income taxes payable 2,443,609 636,938 Deferred income 1,106,483 100,000 ................................................................................................................... Total current liabilities 8,687,889 8,504,766 Deferred tax liabilities 9,950 9,950 ................................................................................................................... Total liabilities 8,697,839 8,514,716 Commitments Shareholders' equity: Preferred stock, $1.00 par value; authorized shares, 10,000,000; issued shares, -0- in 1999 and 2000, respectively -- -- Common stock, $.20 par value; authorized shares, 50,000,000; issued shares, 12,102,280 in 1999 and 13,329,264 in 2000 2,420,456 2,665,853 Additional paid-in capital 28,828,568 66,343,728 Treasury stock, at cost, 386,800 shares in 1999 and 2000, respectively (3,164,975) (3,164,975) Retained earnings 29,420,066 56,915,234 ................................................................................................................... Total shareholders' equity 57,504,115 122,759,840 ................................................................................................................... Total liabilities and shareholders' equity $ 66,201,954 $ 131,274,556 - -------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 16 19 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 1998 1999 2000 - ------------------------------------------------------------------------------------------------------------------- Revenues $ 46,277,409 $ 61,111,103 $ 114,426,097 Cost of product sales 19,620,226 25,014,418 42,637,979 ................................................................................................................... Gross profit 26,657,183 36,096,685 71,788,118 Operating expenses: Selling and marketing 5,704,323 7,006,118 12,288,646 General and administrative 4,127,580 4,722,970 6,216,427 Research and development 6,880,015 8,756,551 12,456,337 ................................................................................................................... Total operating expenses 16,711,918 20,485,639 30,961,410 Income from operations 9,945,265 15,611,046 40,826,708 Other income (expense): Interest expense (107,694) (1,549) -- Interest and other income 1,169,531 950,380 2,525,460 ................................................................................................................... Total other income (expense) 1,061,837 948,831 2,525,460 Income before income taxes 11,007,102 16,559,877 43,352,168 Provision for income taxes 4,039,800 5,937,000 15,857,000 ................................................................................................................... Net income $ 6,967,302 $ 10,622,877 $ 27,495,168 - -------------------------------------------------------------------------------------------------------------------
EARNINGS PER SHARE INFORMATION: - ------------------------------------------------------------------------------------------------------------------- Weighted average shares of common stock and equivalents: Basic 11,682,694 11,573,580 12,636,284 Diluted 11,933,102 11,958,976 13,359,270 ................................................................................................................... Net income per common share: Basic $ .60 $ .92 $ 2.18 Diluted $ .58 $ .89 $ 2.06 - -------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 17 20 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
Additional Preferred Stock Common Stock Paid-in Treasury Unearned Retained Shares Amount Shares Amount Capital Stock Compensation Earnings Total - ------------------------------------------------------------------------------------------------------------------------------------ Balance at December 31, 1997 -- $-- 11,454,700 $2,290,939 $24,086,846 $ (70,355) $(35,934) $11,829,887 $ 38,101,383 Exercise of common stock options -- -- 387,628 77,527 1,076,112 -- -- -- 1,153,639 Tax benefit from exercise of stock options -- -- -- -- 1,163,441 -- -- -- 1,163,441 Restricted stock - compensation charged to expense, net -- -- -- -- -- -- 28,934 -- 28,934 Shares forfeited -- -- (1,400) (280) (6,720) -- 7,000 -- -- Purchase of treasury stock -- -- -- -- -- (1,718,932) -- -- (1,718,932) Net income -- -- -- -- -- -- -- 6,967,302 6,967,302 ................................................................................................................................... Balance at December 31, 1998 -- -- 11,840,928 2,368,186 26,319,679 (1,789,287) -- 18,797,189 45,695,767 Exercise of common stock options -- -- 261,352 52,270 2,123,652 -- -- -- 2,175,922 Tax benefit from exercise of stock options -- -- -- -- 385,237 -- -- -- 385,237 Purchase of treasury stock -- -- -- -- -- (1,375,688) -- -- (1,375,688) Net income -- -- -- -- -- -- -- 10,622,877 10,622,877 ................................................................................................................................... Balance at December 31, 1999 -- -- 12,102,280 2,420,456 28,828,568 (3,164,975) -- $29,420,066 57,504,115 EXERCISE OF COMMON STOCK OPTIONS -- -- 1,226,984 245,397 11,580,460 -- -- -- 11,825,857 TAX BENEFIT FROM EXERCISE OF STOCK OPTIONS -- -- -- -- 25,934,700 -- -- -- 25,934,700 NET INCOME -- -- -- -- -- -- -- 27,495,168 27,495,168 ................................................................................................................................... BALANCE AT DECEMBER 31, 2000 -- $ -- 13,329 $2,665,853 $66,343,728 $(3,164,975) $ -- $56,915,234 $122,759,840 - ------------------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 18 21 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 1998 1999 2000 - ------------------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income $ 6,967,302 $ 10,622,877 $ 27,495,168 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,387,598 1,252,743 1,910,245 Deferred income taxes (545,420) (253,512) (481,541) Provision for losses on inventory 88,000 393,000 743,129 Provision for allowance for doubtful accounts 50,000 100,000 22,189 Compensation expense for restricted stock 28,934 -- -- Changes in assets and liabilities: Increase in accounts receivable-trade (53,377) (3,077,184) (7,932,588) (Increase) decrease in accounts receivable-other 216,410 (34,475) (478,654) Increase in inventories (1,188,657) (4,526,976) (13,906,864) (Increase) decrease in prepaid expenses and deposits 56,839 (109,521) (325,164) Increase (decrease) in accounts payable (272,106) 224,690 962,559 Increase (decrease) in accrued expenses, salaries and wages, royalties payable and deferred income (816,995) 2,649,211 660,989 Increase (decrease) in income taxes payable (157,754) 1,655,130 (1,806,671) ................................................................................................................... Net cash provided by operating activities 5,760,774 8,895,983 6,862,797 ................................................................................................................... Cash flows from investing activities: Purchase of investments (17,380,104) (15,183,124) (38,637,741) Redemption/maturity of investments 17,844,566 14,618,612 23,848,762 Capital expenditures (1,695,975) (2,272,485) (4,076,074) Purchase of treasury stock (1,718,932) (1,375,688) -- ................................................................................................................... Net cash used in investing activities (2,950,445) (4,212,685) (18,865,053) ................................................................................................................... Cash flows from financing activities: Proceeds from the exercise of stock options including related tax benefits 2,317,080 2,561,159 26,870,229 ................................................................................................................... Net cash provided by financing activities 2,317,080 2,561,159 26,870,229 ................................................................................................................... Net increase in cash and cash equivalents 5,127,409 7,244,457 14,867,973 Cash and cash equivalents at beginning of year 3,183,944 8,311,353 15,555,810 ................................................................................................................... Cash and cash equivalents at end of year $ 8,311,353 $ 15,555,810 $ 30,423,783 - ------------------------------------------------------------------------------------------------------------------- Supplemental disclosure of cash flow information: Cash paid during the year for interest $ 107,694 $ 1,549 -- Cash paid during the year for income taxes $ 3,596,079 $ 4,078,830 $ 3,145,422 - ------------------------------------------------------------------------------------------------------------------- Supplemental disclosure of non-cash financing activity: Tax benefit from the exercise of stock options $ -- $ -- $ 10,890,328 - -------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 19 22 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND BASIS OF PRESENTATION Tollgrade Communications, Inc. (the Company) designs, engineers, markets and supports test system, test access and status monitoring products for the telecommunications and cable television industries. The Company's telecommunications proprietary test access products enable telephone companies to use their existing line test systems to remotely diagnose problems in Plain Old Telephone Service (POTS) lines containing both copper and fiber optics. The Company's test system products, specifically DigiTest, focus on helping local exchange carriers conduct the full range of fault diagnosis along with the ability to prequalify, deploy and maintain next-generation services including Digital Subscriber Line service. The Company's cable products consist of a complete cable status monitoring system that provides a comprehensive testing solution for the Broadband Hybrid Fiber Coax distribution system. The status monitoring system consists of a host for user interface, control and configuration; a headend controller for managing network communications; and transponders that are strategically located within the cable network to gather status reports from power supplies, line amplifiers and fiber-optic nodes. The Company was organized in 1986 and began operations in 1988. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the reporting period. Actual results could differ from those estimates. PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated. CASH AND CASH EQUIVALENTS The Company considers highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Substantially all of the Company's cash and cash equivalents are maintained at one financial institution. No collateral or security is provided on these deposits, other than $100,000 of deposits per financial institution insured by the Federal Deposit Insurance Corporation. INVESTMENTS Short-term investments at December 31, 1999 and 2000 consist of a treasury note and/or individual municipal bonds stated at cost, which approximates market value. These securities have a maturity of one year or less at date of purchase and/or contain a callable provision in which the bonds can be called within one year from date of purchase. Long-term investments are individual municipal bonds with a maturity of more than one year but less than eighteen months. The primary investment purposes are to provide a reserve for future business purposes, including possible acquisitions and capital expenditures. Realized gains and losses are computed using the specific identification method. The Company classifies its investment in all debt securities as "held to maturity" in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." INVENTORIES Inventories are stated at the lower of cost or market, with cost determined on the first-in, first-out method. The Company provides appropriate reserves for any inventory deemed slow moving or obsolete. PROPERTY AND EQUIPMENT Property and equipment is stated at cost. Property and equipment is depreciated on a straight-line method over their estimated useful lives ranging from 3 to 7 years. Leasehold improvements are amortized over the related lease period or the estimated useful life, whichever is shorter. The cost of renewals and betterments that extend the lives or productive capacities of properties is capitalized. Expenditures for normal repairs and maintenance are charged to operations as incurred. The cost of property and equipment retired or otherwise disposed of and the related accumulated depreciation or amortization are removed from the accounts, and any resulting gain or loss is reflected in current operations. PATENTS The costs of patents are being amortized on a straight-line method over a period of five years. 20 23 PRODUCT WARRANTY The Company records estimated warranty costs on the accrual basis of accounting. These reserves are based on applying historical returns and cost experience to the current level of product shipments. REVENUE RECOGNITION Revenue from product sales is recognized at the time of shipment. Revenue from Professional Services is recognized upon services being rendered. Revenue for license and royalty fees is recognized when earned. In December 1999, the Staff of the Securities and Exchange Commission issued Staff Accounting Bulletin 101, "Revenue Recognition in Financial Statements" ("SAB 101"), which provides guidance related to revenue recognition. The Company has adopted this standard in 2000 and the impact did not have a material effect on its business, results of operations and financial condition. RESEARCH AND DEVELOPMENT COSTS Research and development costs are charged to operations in the year incurred. INCOME TAXES The Company follows the provisions of SFAS No. 109, "Accounting for Income Taxes" (SFAS 109). Under SFAS 109, deferred tax liabilities and assets are determined based on the "temporary differences" between the financial statement 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. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. SEGMENT INFORMATION The Company follows the provisions of SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information, Financial Reporting for Segments of a Business." This statement establishes standards for reporting information about operating segments, products and services, geographic areas and major customers in annual and interim financial statements. The Company manages and operates its business as one segment. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes standards for reporting information about various derivative financial instruments and accounting for their change in fair value. The Company does not hold or issue derivative instruments for hedging purposes and therefore the adoption of this standard in 2000 did not have a material effect on the consolidated financial position or results of operations of the Company. PER SHARE INFORMATION Net income per share has been computed in accordance with the provisions of SFAS No. 128, "Earnings Per Share" for all periods presented. On February 10, 2000, the Company's Board of Directors authorized a two-for-one stock split of the Company's common stock, payable in the form of a 100 percent stock dividend. On March 20, 2000, shareholders of record received one additional share of common stock for each share of common stock held of record on February 28, 2000. All share and per share information reflects the two-for-one split of the Company's common stock. SFASNo. 128 requires companies with complex capital structures to report earnings per share on a basic and diluted basis, as defined. Basic earnings per share are calculated on the actual number of weighted average common shares outstanding for the period, while diluted earnings per share must include the effect of any dilutive securities. All prior periods have been restated in accordance with SFAS No. 128. A reconciliation of earnings per share is as follows:
Years Ended December 31, 1998 1999 2000 - ------------------------------------------------------------------------------------------------------------- Net Income $ 6,967,302 $10,622,877 $27,495,168 - ------------------------------------------------------------------------------------------------------------- Weighted average common shares outstanding 11,682,694 11,573,580 12,636,284 ............................................................................................................. Effect of dilutive securities - stock options 250,408 385,396 722,986 ............................................................................................................. 11,933,102 11,958,976 13,359,270 - ------------------------------------------------------------------------------------------------------------- Earnings per share: Basic $ .60 $ .92 $ 2.18 - ------------------------------------------------------------------------------------------------------------- Diluted $ .58 $ .89 $ 2.06 - -------------------------------------------------------------------------------------------------------------
21 24 2. INVENTORIES Inventories consisted of the following: December 31, 1999 DECEMBER 31, 2000 - ------------------------------------------------------------------------------ Raw materials $ 8,173,299 $13,800,196 Work in process 7,410,203 12,981,052 Finished goods 1,752,245 3,718,234 .............................................................................. $17,335,747 $30,499,482 - ------------------------------------------------------------------------------ 3. PROPERTY AND EQUIPMENT Property and equipment consisted of the following:
December 31, 1999 DECEMBER 31, 2000 - ------------------------------------------------------------------------------------------- Test equipment and tooling $4,217,189 $ 5,900,085 Office equipment and fixtures 3,269,761 4,735,551 Leasehold improvements 1,590,704 2,059,764 ........................................................................................... 9,077,654 12,695,400 Less accumulated depreciation and amortization 4,740,539 6,191,477 ........................................................................................... $4,337,115 $ 6,503,923 - -------------------------------------------------------------------------------------------
4. SHAREHOLDERS' EQUITY COMMON STOCK The Company has 50,000,000 authorized shares which have a par value of $.20 per share. As of December 31, 1999 and 2000, there were 12,102,280 and 13,329,264 issued shares, respectively. STOCK REPURCHASE PROGRAM On April 22, 1997, the Company's Board of Directors authorized a program to purchase up to 400,000 shares of its common stock over a two-year period. The program intended that the shares would be utilized to provide stock under certain employee benefit programs. As of April 22, 1999, the expiration of this initial program, the Company had purchased 382,400 shares of common stock under this program. The Company has used existing cash and short-term investments to finance these purchases. On May 6, 1999, the Company's Board of Directors authorized a new program to purchase up to 400,000 shares of its common stock over a two-year period. As of December 31, 2000, the Company had not initiated any purchases of common stock under this new program. The number of shares that the Company intends to purchase and the time of such purchases will be determined by the Company at its discretion. The Company plans to use existing cash and short-term investments to finance any such purchases. STOCK COMPENSATION PLANS Under the Company's stock compensation plans, directors, officers and other employees may be granted options to purchase shares of the Company's common stock. The option price on all outstanding options is equal to the fair market value of the stock at the date of the grant, as defined. The options generally vest ratably over a two-year period, with one-third vested upon grant. The Company's option programs cover all employees and are used to attract and retain qualified personnel in all positions. On December 14, 2000, the Board of Directors of the Company approved a proposal to increase the number of shares available under the 1998 Employee Incentive Compensation Plan (the "1998 Plan") by 200,000 shares, from 740,000 to 940,000 shares. The aggregate number of shares of the Company's Common Stock which may be issued under the 1995 Long-Term Incentive Compensation Plan (the "1995 Plan") and the 1998 Plan is 2,210,000 and 940,000 shares respectively, subject to proportionate adjustment in the event of stock splits and similar events. The maximum number of shares which may be awarded under the 1995 Plan to any one Named Executive Officer during any calendar year of the life of the plan is 200,000 shares. All full-time active employees of the Company, excluding officers and directors, are eligible to participate in the 1998 Plan. The shares authorized but not granted under these plans at December 31, 1999 and 2000 were as follows:
Shares Authorized But Not Granted December 31, 1999 DECEMBER 31, 2000 - ------------------------------------------------------------------------------------------------------------------- 1995 Long-Term Incentive Compensation Plan 510,016 193,373 1998 Employee Incentive Compensation Plan 67,988 188,626 ................................................................................................................... Total 578,004 381,999 - -------------------------------------------------------------------------------------------------------------------
22 25 Certain employees and directors of the Company were granted stock options under the 1995 Plan and the 1998 Plan and various other agreements. The Company has adopted the disclosure-only provisions of SFAS No. 123 "Accounting for Stock-Based Compensation," but applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for its plans. If the Company had elected to recognize compensation cost for these stock options based on the fair value at the grant dates for awards granted under those plans in 1998, 1999 and 2000 consistent with the method prescribed by SFAS No. 123, net income and earnings per share would have been changed to the pro forma amounts indicated below:
Years Ended December 31, 1998 1999 2000 - --------------------------------------------------------------------------------------------------------------- Net income As reported $6,967,302 $10,622,877 $27,495,168 Pro forma $5,159,610 $ 8,889,233 $23,019,191 ............................................................................................................... Diluted earnings per share As reported $ .58 $ .89 $ 2.06 Pro forma $ .43 $ .74 $ 1.72 - ---------------------------------------------------------------------------------------------------------------
The fair value of the stock options used to compute pro forma net income and earnings per share disclosures is the estimated present value at grant date using the Black-Scholes option-pricing model with the following weighted average assumptions for 1998, 1999 and 2000: expected volatility of 50.8% in 1998, 51.9% in 1999 and 77.0% in 2000; a risk-free interest rate of 4.82% in 1998, 4.97% in 1999, and 5.83% in 2000; and an expected holding period of 4 years. The weighted average fair value of stock options, calculated using the Black-Scholes option-pricing model, granted during 1998, 1999 and 2000, is $3.84, $4.76 and $58.36, respectively. Transactions involving stock options under the Company's various stock option plans and otherwise are summarized below:
Weighted Average Number of Shares Range of Option Price Exercise Price - -------------------------------------------------------------------------------------------------------------- Outstanding, December 31, 1997 1,506,534 $ .47850 - $ 12.87500 $ 7.92 Granted 1,084,000 7.28125 - 13.56250 8.59 Exercised (387,428) .48000 - 11.75000 2.98 Cancelled (80,667) 6.00000 - 13.56250 10.33 - -------------------------------------------------------------------------------------------------------------- Outstanding, December 31, 1998 2,122,439 6.00000 - 13.56250 9.08 Granted 432,000 7.50000 - 17.25000 10.41 Exercised (256,220) 6.00000 - 12.87500 8.30 Cancelled (103,196) 6.00000 - 13.56250 10.18 - -------------------------------------------------------------------------------------------------------------- Outstanding, December 31, 1999 2,195,023 6.00000 - 17.25000 9.38 Granted 416,625 51.62500 - 159.18750 95.84 Exercised (1,223,793) 6.00000 - 51.62500 9.59 Cancelled (24,615) 6.00000 - 159.18750 28.96 - -------------------------------------------------------------------------------------------------------------- OUTSTANDING, DECEMBER 31, 2000 1,363,240 $ 6.00000 - $159.18750 $35.25 - --------------------------------------------------------------------------------------------------------------
Weighted Average Options exercisable at: Number of Shares Exercise Price - ------------------------------------------------------------------------------- December 31, 1998 1,423,316 $ 9.20 December 31, 1999 1,660,425 9.49 DECEMBER 31, 2000 997,680 21.92 - ------------------------------------------------------------------------------- 23 26 The following table summarizes the status of the stock options, outstanding and exercisable, at December 31, 2000:
Stock Options Outstanding Stock Options Exercisable - ------------------------------------------------------------------------------------------------------------------- Weighted Average Weighted Weighted Range of Exercise Remaining Average Average Prices Shares Contractual Life Exercise Price Shares Exercise Price - ------------------------------------------------------------------------------------------------------------------- $ 6.00000 - $ 7.28125 265,433 6.68 $ 6.74 265,433 $ 6.74 ................................................................................................................... $ 7.50000 - $ 7.68750 227,944 7.66 7.56 216,611 7.55 ................................................................................................................... $ 8.75000 - $ 10.31250 269,476 7.54 9.70 179,509 9.92 ................................................................................................................... $ 11.03125 - $ 55.89850 350,211 8.35 32.84 251,779 25.38 ................................................................................................................... $ 71.87500 - $117.34400 213,834 9.64 115.26 71,855 115.27 ................................................................................................................... $159.18750 - $159.18750 36,342 9.53 159.19 12,493 159.19 ................................................................................................................... TOTAL 1,363,240 7.98 $ 35.25 997,680 $ 21.92 - -------------------------------------------------------------------------------------------------------------------
SERIES A JUNIOR PARTICIPATING PREFERRED STOCK PURCHASE RIGHTS In order to protect shareholder value in the event of an unsolicited offer to acquire the Company, on July 23, 1996, the Board of Directors of the Company declared a dividend of one preferred stock purchase right for each outstanding share of the Company's common stock. The dividend was payable on August 15, 1996 to shareholders of record as of that date. The aforementioned rights are exercisable only if a person or group acquires or announces an offer to acquire 20% or more of the Company's common stock. In such an event, each right will entitle shareholders to buy one-hundredth of a share of a new series of preferred stock at an exercise price of $115.00. Each one-hundredth of a share of the new preferred stock has terms designed to make it the economic and voting equivalent of one share of common stock. If a person or group acquires 20% or more of the Company's outstanding common stock, each right not owned by the person or group will entitle its holder to purchase at the right's exercise price a number of shares of the Company's common stock (or, at the option of the Company, the new preferred stock) having a market value of twice the exercise price. Further, at any time after a person or group acquires 20% or more (but less than 50%) of the outstanding common stock, the Board of Directors may at its option, exchange part or all of the rights (other than rights held by the acquiring person or group) for shares of the Company's common or preferred stock on a one-for-one basis. Each right further provides that if the Company is acquired in a merger or other business transaction, each right will entitle its holder to purchase, at the right's exercise price, a number of the acquiring company's common shares having a market value at that time of twice the exercise price. The Board of Directors is entitled to redeem the rights for one cent per right at any time before a 20% position has been acquired. The Board of Directors is also authorized to reduce the 20% thresholds referred to above to not less than 10%. 5. LICENSE AND ROYALTY FEES The Company has entered into several technology license agreements with certain major Digital Loop Carrier (DLC) vendors and major Operation Support System (OSS) equipment manufacturers under which the Company has been granted access to the licensor's patent technology and the right to manufacture and sell the patent technology in the Company's product line. The Company is obligated to pay royalty fees, as defined, through the terms of these license agreements. Royalty fees of $1,903,701, $2,011,930 and $2,910,803 were incurred in 1998, 1999 and 2000, respectively, and are included in cost of product sales in the accompanying consolidated statements of operations. 24 27 6. INCOME TAXES The provision for income taxes consisted of the following: Years Ended December 31, 1998 1999 2000 - ------------------------------------------------------------------------------- Current: Federal $4,030,841 $5,478,412 $14,212,441 State 554,379 712,100 2,126,100 ............................................................................... 4,585,220 6,190,512 16,338,541 - ------------------------------------------------------------------------------- Deferred: Federal (475,494) (221,011) (434,521) State (69,926) (32,501) (47,020) ............................................................................... (545,420) (253,512) (481,541) ............................................................................... $4,039,800 $5,937,000 $15,857,000 - ------------------------------------------------------------------------------- Reconciliations of the federal statutory rate to the effective tax rates are as follows: Years Ended December 31, 1998 1999 2000 - ------------------------------------------------------------------------------ Federal statutory tax rate 34% 34% 35% Research and development tax credit (1) -- -- State income taxes 3 3 5 Foreign sales corporation tax benefit -- (1) -- Other 1 -- (3) .............................................................................. Effective tax rate 37% 36% 37% - ------------------------------------------------------------------------------ The components of and changes in the deferred tax assets and liabilities recorded in the accompanying balance sheets at December 31, 1999 and 2000 were as follows:
Deferred Deferred December 31, Expense December 31, Expense DECEMBER 31, 1998 (Credit) 1999 (Credit) Other 2000 - ------------------------------------------------------------------------------------------------------------------------------------ DEFERRED TAX ASSETS: Excess of tax basis over book basis for: Property and equipment $149,797 $ 27,989 $ 121,808 $ (63,082) $ -- $ 184,890 Inventory 204,778 (42,404) 247,182 (74,621) -- 321,803 Reserves recorded for: Warranty 169,650 (64,350) 234,000 (173,550) -- 407,550 Inventory 104,130 (153,270) 257,400 (165,750) -- 423,150 Allowance for doubtful accounts 39,000 (31,670) 70,670 (7,330) -- 78,000 Net operating loss carryforward -- -- -- -- 1,939,656 1,939,656 Other 22,010 10,193 11,817 2,792 -- 9,025 .................................................... .......... .......... Total deferred tax assets 689,365 942,877 3,364,074 - ---------------------------------------------------- ---------- ---------- DEFERRED TAX LIABILITIES: Excess of book basis over tax basis for: Other (9,950) -- (9,950) -- (9,950) .................................................... .......... .......... Total deferred tax liabilities (9,950) (9,950) (9,950) - ---------------------------------------------------- ---------- ---------- - ------------------------------------------------------------------------------------------------------------------------------------ Net deferred taxes $679,415 $(253,512) $ 932,927 $(481,541) $1,939,656 $3,354,124 Reconciliation to the balance sheet: Current portion of deferred tax assets 354,891 575,251 983,246 Long-term portion of deferred tax liabilities (9,950) (9,950) (9,950) .................................................................................................................................... Long-term deferred taxes $334,474 $ 367,626 $2,380,828 - ------------------------------------------------------------------------------------------------------------------------------------
25 28 7. LEASE COMMITMENTS The Company leases office space and equipment under agreements which are accounted for as operating leases. The office lease expires December 31, 2002 and may be extended up to an additional 3 years. The equipment lease expires in August 2005. The Company is also involved in various month-to-month leases for research and development equipment. In addition, the office lease includes provisions for possible adjustments in annual future rental commitments relating to excess taxes and excess maintenance costs that may occur. The Company made additional rental payments of $4,827, $0 and $9,198 in 1998, 1999 and 2000, respectively. Minimum annual future rental commitments under noncancelable leases as of December 31 are: 2001 ...................................................... $ 701,230 2002 ...................................................... 741,550 2003 ...................................................... 76,270 2004 ...................................................... 76,270 2005 ...................................................... 54,024 The rent expense for all lease commitments was $425,714, $599,615 and $731,320 in 1998, 1999 and 2000, respectively. 8. MAJOR CUSTOMERS, REVENUE CONCENTRATION AND DEPENDENCE ON CERTAIN SUPPLIERS The Company designs, engineers, markets and supports test system, test access and status monitoring products for the telecommunications and cable television industries. Sales are concentrated primarily with the four Regional Bell Operating Companies (RBOCs) as well as major independent telephone companies and to certain digital loop carrier equipment manufacturers. Sales are primarily from the Company's metallic channel unit (MCU) product line. The MCU product line accounted for more than 70% of the Company's net product sales for 2000. The Company expects that revenues from MCU products will continue to account for a majority of the Company's revenues for the foreseeable future. The DigiTest product line accounted for approximately 18% of the Company's net product sales for 2000. Sales to the RBOCs accounted for approximately 82%, 61% and 64% of the Company's net product sales for fiscal years 1998, 1999 and 2000, respectively. During fiscal year 1998, sales to three RBOCs individually exceeded 10% of consolidated revenues and on a combined basis, comprised 76% of the Company's net product sales. During fiscal years 1999 and 2000, sales to four RBOCs individually exceeded 10% of consolidated revenues and on a combined basis, comprised 61% and 64%, respectively, of the Company's net product sales. In addition, sales to an Original Equipment Manufacturer accounted for approximately 3%, 11% and 4% of the Company's net product sales for fiscal years 1998, 1999 and 2000, respectively. Due to the Company's present dependency on the RBOCs, the loss of one or more of the RBOCs as a customer, or the reduction of orders for the Company's products by the RBOCs, could materially and adversely affect the Company. The Company utilizes two key independent subcontractors to perform a majority of the circuit board assembly and in-circuit testing work on its products. The Company also utilizes other subassembly contractors on a more limited basis. The loss of the subcontractors could cause delays in the Company's ability to meet production obligations and could have material adverse effect on the Company's results of operations. In addition, shortages of raw material to, or production capacity constraints at, the Company's subcontractors could negatively affect the Company's ability to meet its production obligations and result in increased prices for affected parts. Any such reduction may result in delays in shipments of the Company's products or increases in the price of components, either of which could have a material adverse impact on the Company. 9. EMPLOYEE BENEFIT PLANS The Company has a 401(k) benefit plan. Eligible employees, as defined in the plan, may contribute up to 20% of eligible compensation or not to exceed the regulatory imposed limit, as defined. The Company does not make any matching contributions to the plan. 10. DEFERRED AND REFUNDABLE TAX ASSETS The Company's current refundable tax assets as of December 31, 2000 include a tax benefit of $8,950,672 resulting from the exercising of certain nonstatutory stock options by various directors, officers and other employees under the Company's various stock option programs during 2000. The Company is entitled to a tax deduction in the current tax year ended December 31, 2000 equal to the difference between the fair market value of the shares received by the option holders upon exercise and the exercise price of the nonsatutory stock options. It is anticipated that these deductions will be utilized either through a refund of prior year taxes paid or through the elimination of income taxes payable in 2001. 26 29 STATEMENTS OF OPERATIONS DATA BY QUARTER The following table presents unaudited quarterly operating results for each of the Company's last eight fiscal quarters. This information has been prepared by the Company on a basis consistent with the Company's audited financial statements and includes all adjustments (consisting only of normal recurring adjustments) that the Company considers necessary for a fair presentation of the data. Such quarterly results are not necessarily indicative of the future results of operations.
(In thousands, except per share data) Quarter Ended (Unaudited) March 31, June 30, Sept. 30, Dec. 31, MARCH 31, JUNE 30, SEPT. 30, DEC. 31, 1999 1999 1999 1999 2000 2000 2000 2000 - ------------------------------------------------------------------------------------------------------------------- Revenues $ 11,120 $ 14,270 $ 13,403 $ 22,318 $ 22,418 $ 29,667 $ 29,788 $ 32,554 Cost of product sales 4,752 5,903 6,040 8,320 8,372 11,414 10,841 12,012 ................................................................................................................... Gross profit 6,368 8,367 7,363 13,998 14,046 18,253 18,947 20,542 Operating expenses: Selling and marketing 1,398 1,767 1,561 2,280 2,384 3,028 3,440 3,438 General and administrative 1,048 965 980 1,729 1,378 1,495 1,591 1,752 Research and development 1,876 2,158 2,126 2,597 2,590 3,098 3,178 3,589 ................................................................................................................... Total operating expenses 4,322 4,890 4,667 6,606 6,352 7,621 8,209 8,779 ................................................................................................................... Income from operations 2,046 3,477 2,696 7,392 7,694 10,632 10,738 11,763 Other income, net 271 236 334 107 470 546 662 848 ................................................................................................................... Income before income taxes 2,317 3,713 3,030 7,499 8,164 11,178 11,400 12,611 Provision for income taxes 831 1,340 1,092 2,674 2,939 4,024 4,104 4,790 ................................................................................................................... Net income $ 1,486 $ 2,373 $ 1,938 $ 4,825 $ 5,225 $ 7,154 $ 7,296 $ 7,821 - ------------------------------------------------------------------------------------------------------------------- Net income per common share Basic $ .13 $ .21 $ .17 $ .41 $ .43 $ .57 $ .57 $ .60 Diluted $ .13 $ .20 $ .16 $ .39 $ .39 $ .54 $ .54 $ .58 Weighted average shares of common stock and equivalents:) Basic 11,576 11,538 11,548 11,631 12,219 12,563 12,821 12,940 Diluted 11,759 11,612 12,017 12,397 13,546 13,318 13,460 13,434 - -------------------------------------------------------------------------------------------------------------------
================================================================================ COMMON STOCK MARKET PRICES The Company's Common Stock has been included for quotation on the Nasdaq National Market System under the Nasdaq symbol "TLGD" since the Company's initial public offering in December 1995. The following table sets forth, for the periods indicated, the high and low sales prices for the Common Stock on such market: High Low - -------------------------------------------------------------------------------- 1999: First Quarter $ 9-13/16 $ 7-1/2 Second Quarter 8-7/16 7-1/16 Third Quarter 13-7/16 7-1/2 Fourth Quarter 19-11/16 10-1/2 2000: First Quarter $ 84 $16-1/16 Second Quarter 147-3/16 31-1/2 Third Quarter 168-7/8 78-5/8 Fourth Quarter 148 25-3/4 - -------------------------------------------------------------------------------- At January 31, 2001, the Company had 175 holders of record of its Common Stock and 13,340,246 shares outstanding. The Company has never paid any dividends on its Common Stock and does not expect to pay cash dividends in the foreseeable future. 27 30 SHAREHOLDER INFORMATION SHAREHOLDERS ANNUAL MEETING The Annual Meeting of Shareholders of Tollgrade Communications, Inc., will be held at The Syria Mosque, 1877 Shriners Way, Cheswick, PA 15024, on Thursday, May 3, 2001, at 3:00 p.m. Notice of the meeting and proxy materials were included with this Annual Report. TRANSFER AGENT AND SHAREHOLDER INQUIRIES The Company's transfer agent is Mellon Investor Services, L.L.C. Inquiries concerning transfer requirements, lost certificates and change of address should be directed to: Mellon Investor Services, L.L.C. P.O. Box 3315 South Hackensack, NJ 07606 or: 85 Challenger Road Ridgefield Park, NJ 07660 1-800-756-3353 TDD for Hearing Impaired: 1-800-231-5469 Foreign Shareholders: 201-329-8660 TDD Foreign Shareholders: 201-329-8354 www.mellon-investor.com. All other inquiries should be directed to: Tollgrade Communications, Inc. Investor Relations Department 493 Nixon Road Cheswick, PA 15024 1-800-878-3399 www.tollgrade.com. Form 10-K A copy of the Tollgrade Communications, Inc. Form 10-K for 2000, which will be filed with the Securities and Exchange Commission during the first quarter of 2001, is available without attachments at no charge upon written request. Inquiries should be directed to the Investor Relations Department, Tollgrade Communications, Inc., 493 Nixon Road, Cheswick, PA 15024. INDEPENDENT AUDITORS PricewaterhouseCoopers LLP, Pittsburgh, Pennsylvania. COUNSEL Reed Smith LLP, Pittsburgh, Pennsylvania. STOCK MARKET LISTING Tollgrade Communications, Inc. is listed on The Nasdaq Stock Market.(SM) Symbol: TLGD. (R)TOLLGRADE, MCU, DigiTest and LIGHTHOUSE are registered trademarks of Tollgrade Communications, Inc. TM TELACCORD is a trademark of Tollgrade Communications, Inc. All other trademarks are the property of their respective owners. (C)2001 Tollgrade Communications, Inc. All rights reserved. 28 31 Board of Directors [PHOTO] CHRIS ALLISON Chairman and Chief Executive Officer [PHOTO] JAMES J. BARNES Attorney at Law, Buchanan Ingersoll P.C. [PHOTO] DANIEL P. BARRY Private Investor, Director of Respironics, Inc. [PHOTO] DAVID S. EGAN President, ClubCom, Inc. [PHOTO] ROCCO L. FLAMINIO Vice Chairman and Chief Technology Officer [PHOTO] RICHARD H. HEIBEL, M.D. Board Certified Cardiologist (retired) [PHOTO] ROBERT W. KAMPMEINERT Chairman, President and Chief Executive Officer, Parker/Hunter Incorporated EXECUTIVE OFFICERS [PHOTO] CHRIS ALLISON Chairman and Chief Executive Officer [PHOTO] SARA M. ANTOL General Counsel and Secretary [PHOTO] RICHARD A. BAIR, JR. Executive Vice President, Engineering [PHOTO] ROBERT L. CORNELIA Executive Vice President, Operations [PHOTO] BRADLEY N. DINGER Controller [PHOTO] ROCCO L. FLAMINIO Vice Chairman and Chief Technology Officer [PHOTO] MARK C. FREY Senior Vice President, Test Access Division [PHOTO] SAMUEL C. KNOCH Chief Financial Officer and Treasurer [PHOTO] JOSEPH G. O'BRIEN Senior Vice President, Human Resources [PHOTO] TIMOTHY D. O'BRIEN Director of Corporate Communications [PHOTO] MARK B. PETERSON President [PHOTO] MATTHEW J. ROSGONE Senior Vice President, Purchasing, Manufacturing and Documentation [PHOTO] ROGER A. SMITH Executive Vice President, Technology 32 [TOLLGRADE LOGO] CORPORATE HEADQUARTERS 493 Nixon Road, Cheswick, PA 15024 1-800-878-3399 www.tollgrade.com EX-23.1 6 j8729201ex23-1.txt CONSENT OF PRICEWATERHOUSECOOPERS LLP 1 Exhibit 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (Registration No. 333-4290, Registration No. 333-52907, Registration No. 333-83007 and Registration No. 333-55470) of Tollgrade Communications, Inc. and Subsidiaries of our report dated January 19, 2001, relating to the financial statements, which appears in the Annual Report to Shareholders, which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report dated January 19, 2001 relating to the financial statement schedule, which appears in this Form 10-K. /s/ PRICEWATERHOUSECOOPERS LLP Pittsburgh, Pennsylvania March 23, 2001 EX-27 7 j8729201ex27.txt FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FORM 10-K FOR THE YEAR ENDED 12/31/2000 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 0001002531 TOLLGRADE COMMUNICATIONS, INC. YEAR DEC-31-2000 JAN-01-2000 DEC-31-2000 30,423,783 28,405,655 18,975,643 200,000 30,499,482 119,639,388 12,695,400 6,191,477 131,274,556 8,504,766 0 0 0 2,665,853 120,093,987 131,274,556 114,426,097 114,426,097 42,637,979 42,673,979 0 0 0 43,352,168 15,857,000 0 0 0 0 27,495,168 2.18 2.06
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