-----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, Hervzy3elFeDCoZzHe1zWsB83nQIjICFWS11iq3LIY/qKuigGengPtmXQs+XDe4A VJ0pphJZU2jBHPI/Zv/1iQ== 0000950128-02-000403.txt : 20020514 0000950128-02-000403.hdr.sgml : 20020514 ACCESSION NUMBER: 0000950128-02-000403 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20020330 FILED AS OF DATE: 20020514 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-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-27312 FILM NUMBER: 02645026 BUSINESS ADDRESS: STREET 1: 493 NIXON RD CITY: CHESWICK STATE: PA ZIP: 15024 BUSINESS PHONE: 4122742156 10-Q 1 j9449801e10-q.txt TOLLGRADE COMMUNICATIONS, INC. -------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC ------------------------------- FORM 10-Q (Mark One) [X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended March 30, 2002 [ ] Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from ___________ to ____________ Commission file number 0-27312 TOLLGRADE COMMUNICATIONS, INC. (Exact Name of Registrant as Specified in its Charter) PENNSYLVANIA 25-1537134 (State or Other Jurisdiction (I.R.S. Employer of Incorporation or Organization) Identification Number) 493 NIXON RD. CHESWICK, PA 15024 (Address of Principal Executive Offices, including zip code) 412-820-1400 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- As of April 30, 2002, there were 13,547,736 shares of the Registrant's Common Stock, $0.20 par value per share, and no shares of the Registrant's Preferred Stock, $1.00 par value per share, outstanding. - ------------------------------------------------------------------------------- This report consists of a total of 24 pages. The exhibit index is on page 23. TOLLGRADE COMMUNICATIONS, INC. QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED MARCH 30, 2002 TABLE OF CONTENTS PART I. FINANCIAL INFORMATION PAGE NO. ITEM 1 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS: CONDENSED CONSOLIDATED BALANCE SHEETS AS OF MARCH 30, 2002 AND DECEMBER 31, 2001 ................................... 3 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE-MONTH PERIODS ENDED MARCH 30, 2002 AND MARCH 31, 2001... 4 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE-MONTH PERIODS ENDED MARCH 30, 2002 AND MARCH 31, 2001 .. 5 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.......... 6 REVIEW REPORT OF INDEPENDENT ACCOUNTANTS...................... 12 ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION....................................... 12 PART II. OTHER INFORMATION ITEM 1 LEGAL PROCEEDINGS............................................. 21 ITEM 2 CHANGES IN SECURITIES......................................... 21 ITEM 3 DEFAULTS UPON SENIOR SECURITIES............................... 21 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........... 21 ITEM 5 OTHER INFORMATION............................................. 21 ITEM 6 EXHIBITS AND REPORTS FILED ON FORM 8-K........................ 21 SIGNATURE.............................................................. 22 EXHIBIT INDEX.......................................................... 23 2 PART I. FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
DECEMBER 31, MARCH 30, 2002 2001 - ------------------------------------------------------------------------------------------------------------------- ASSETS CURRENT ASSETS: Cash and cash equivalents $ 34,225,969 $ 32,105,845 Short-term investments 4,682,176 6,489,323 Accounts receivable: Trade 13,483,035 9,296,551 Other 605,354 320,501 Inventories 21,351,551 22,183,616 Prepaid expenses and deposits 974,263 916,723 Refundable income taxes 496,736 1,396,736 Deferred tax assets 1,339,016 1,116,756 - ------------------------------------------------------------------------------------------------------------------- TOTAL CURRENT ASSETS 77,158,100 73,826,051 Long-term investments -- 150,000 Property and equipment, net 8,423,017 8,012,546 Deferred tax assets 2,410,694 2,812,987 Intangibles 38,500,000 38,500,000 Goodwill 16,161,763 16,161,763 Capitalized software costs, net 6,572,350 6,935,000 Other assets 262,146 231,614 =================================================================================================================== TOTAL ASSETS $ 149,488,070 $ 146,629,961 =================================================================================================================== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $649,048 $ 805,398 Accrued warranty 2,318,000 2,068,000 Accrued expenses 1,131,406 691,697 Accrued salaries and wages 834,320 329,126 Accrued royalties payable 378,723 397,451 Income taxes payable 1,622,931 1,433,554 Deferred income 1,530,000 472,674 - ------------------------------------------------------------------------------------------------------------------- TOTAL CURRENT LIABILITIES 8,464,428 6,197,900 Deferred tax liabilities 577,004 293,477 - ------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES 9,041,432 6,491,377 Commitments and contingent liabilities -- -- Shareholders' equity: Common stock, $.20 par value; authorized shares, 50,000,000; issued shares, 13,547,336 and 13,513,119, respectively 2,709,467 2,702,624 Additional paid-in capital 70,424,459 70,010,254 Treasury stock, at cost, 461,800 and 386,800 shares, respectively (4,790,783) (3,164,975) Retained earnings 72,103,495 70,590,681 - ------------------------------------------------------------------------------------------------------------------- TOTAL SHAREHOLDERS' EQUITY 140,446,638 140,138,584 =================================================================================================================== TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 149,488,070 $ 146,629,961 ===================================================================================================================
The accompanying notes are an integral part of the condensed consolidated financial statements. 3 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
FOR THE THREE MONTHS ENDED MARCH 30, 2002 MARCH 31, 2001 =================================================================================================== REVENUES: Products $14,929,379 $27,463,753 Services 2,592,895 526,249 - --------------------------------------------------------------------------------------------------- $17,522,274 $27,990,002 COST OF PRODUCT SALES: Products $ 6,062,344 $11,851,107 Services 954,874 423,176 Amortization 365,040 -- - --------------------------------------------------------------------------------------------------- $ 7,382,258 $12,274,283 - --------------------------------------------------------------------------------------------------- GROSS PROFIT 10,140,016 15,715,719 - --------------------------------------------------------------------------------------------------- OPERATING EXPENSES: Selling and marketing 2,417,309 2,449,824 General and administrative 1,526,251 1,530,152 Research and development 3,994,641 3,359,541 - --------------------------------------------------------------------------------------------------- Total operating expenses 7,938,201 7,339,517 - --------------------------------------------------------------------------------------------------- INCOME FROM OPERATIONS 2,201,815 8,376,202 Interest and other income, net 237,999 906,977 - --------------------------------------------------------------------------------------------------- INCOME BEFORE INCOME TAXES 2,439,814 9,283,179 Provision for income taxes 927,000 3,528,010 =================================================================================================== NET INCOME $ 1,512,814 $ 5,755,169 =================================================================================================== EARNINGS PER SHARE INFORMATION: Weighted average shares of common stock and equivalents: Basic 13,099,210 12,957,833 Diluted 13,421,307 13,377,185 - --------------------------------------------------------------------------------------------------- Net income per common and common equivalent shares: Basic $ .12 $ .44 Diluted $ .11 $ .43 ===================================================================================================
The accompanying notes are an integral part of the condensed consolidated financial statements. 4 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Three Months Ended March 30, 2002 March 31, 2001 - --------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 1,512,814 $ 5,755,169 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 933,921 581,485 Tax benefit from exercise of stock options 176,579 -- Refund of income taxes paid 900,000 8,150,170 Deferred income taxes 463,560 (224,129) Provision for losses on inventory 563,000 23,218 Provision for allowance for doubtful accounts -- 175,000 Changes in assets and liabilities: Increase in accounts receivable-trade (4,186,484) (1,407,256) (Increase) decrease in accounts receivable-other (152,353) 44,268 Decrease in inventories 269,065 240,018 (Increase) decrease in prepaid expenses and deposits (57,540) 238,279 Decrease in accounts payable (156,350) (1,501,390) Increase in accrued warranty 250,000 176,000 Increase in accrued expenses and deferred income 1,364,535 46,613 Increase (decrease) in accrued salaries and wages 505,194 (2,156,672) Decrease in royalties payable (18,728) (260,014) Increase in income taxes payable 189,377 3,624,502 - --------------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 2,556,590 13,505,261 - --------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Redemption/maturity of investments 2,317,930 7,002,881 Purchase of investments (360,783) (5,906,520) Capital expenditures (979,352) (1,071,479) Purchase of treasury stock (1,625,808) -- Investments in other assets (32,922) -- - --------------------------------------------------------------------------------------------------------------------- Net cash (used in) provided by investing activities (680,935) 24,882 - --------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from exercise of stock options 244,469 332,731 - --------------------------------------------------------------------------------------------------------------------- Net cash provided by financing activities 244,469 332,731 - --------------------------------------------------------------------------------------------------------------------- Net increase in cash and cash equivalents 2,120,124 13,862,874 Cash and cash equivalents at beginning of period 32,105,845 30,423,783 - --------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $34,225,969 $44,286,657 =====================================================================================================================
The accompanying notes are an integral part of the condensed consolidated financial statements. 5 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements included herein have been prepared by Tollgrade Communications, Inc. (the "Company") in accordance with accounting principles generally accepted in the United States of America for the interim financial information and Article 10 of Regulation S-X. The condensed consolidated financial statements as of and for the three-month period ended March 30, 2002 should be read in conjunction with the Company's consolidated financial statements (and notes thereto) included in the Company's Annual Report on Form 10-K for the year ended December 31, 2001. Accordingly, the accompanying condensed consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements, although the Company believes that the disclosures are adequate to make the information presented not misleading. In the opinion of the Company's management, all adjustments considered necessary for a fair presentation of the accompanying condensed consolidated financial statements have been included, and all adjustments are of a normal and recurring nature. Operating results for the three-month period ended March 30, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. 2. ACQUISITION AND INTANGIBLE ASSETS On September 30, 2001, the Company acquired certain assets and assumed certain liabilities of the LoopCareTM Product line from Lucent Technologies, Inc. ("Lucent") for approximately $62,029,000 in cash which includes approximately $2,200,000 of acquisition-related costs. The acquisition has been recorded under the purchase method of accounting and, accordingly, the results of operations of the LoopCare product line since October 1, 2001 have been included in the consolidated financial statements. The Company has utilized the transitional guidance of Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets" which were issued in July 2001. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 and that goodwill, as well as any intangible assets believed to have an indefinite useful life, shall not be amortized for financial reporting purposes. In connection with the acquisition, $45,800,000 of intangible assets were identified, of which $7,300,000 were related to capitalized software and determined to have a definite life, while the remaining $38,500,000 of the identified intangible assets as well as goodwill are not being amortized as they have been determined to have an indefinite useful life. As of January 1, 2002, the Company fully adopted the provisions of SFAS No. 142. SFAS 142 requires that goodwill be analyzed for impairment under a two-step process. The first step of the goodwill impairment test is to identify potential impairment by comparing the fair value of the reporting unit with its carrying amount, including the goodwill. The second step, used to measure 6 the potential impairment loss of the goodwill, is to compare the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. SFAS 142 requires that management complete the first step of the goodwill impairment test by June 30, 2002. Step two of the goodwill impairment test is required to be completed by December 31, 2002. In addition, intangible assets that are not subject to amortization must be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test for non-amortizable intangible assets should consist of a comparison of the fair value of an intangible asset with its carrying amount. The Company intends to meet the compliance requirements of SFAS 142. The following condensed proforma results of operations reflect the proforma combination of the Company and the acquired LoopCare business as if the combination occurred on January 1, 2001; compared with the actual results of operations for the first quarter of 2002 which included the LoopCare operations:
(In thousands, Except per Share Data) Three Months Ended Historical Proforma March 30, 2002 March 31, 2001 -------------- -------------- Revenues $17,522 $31,338 - ------------------------------------------------------------------------------ Income from operations 2,202 9,438 - ------------------------------------------------------------------------------ Net income 1,513 6,239 - ------------------------------------------------------------------------------ Net income per share - ------------------------------------------------------------------------------ Diluted $ 0.11 $ 0.47 - ------------------------------------------------------------------------------
The proforma results of operations for the quarter ended March 31, 2001 reflected above include one-fourth of the annual audited results of the LoopCare product line business for 2001. Proforma adjustments made include an estimated allocation of selling, general and administrative expenses to the LoopCare operations based upon budgeted costs for 2002 and proforma amortization of the developed product software over five years. Proforma adjustments were also made to take into account the cost of money in connection with the acquisition costs. This was projected by reducing interest income at historical earning rates for working capital deemed to have been available to apply to the acquisition costs and projecting interest expense on borrowed funds for residual acquisition costs at the historical prime rates of interest plus 1.5%. Adjustments were also made to reflect the tax consequences of the foregoing proforma adjustments. The following information is provided regarding the Company's intangible assets: As of March 30, 2002 -------------------- Gross Carrying Accumulated Amount Amortization -------------- ------------ Amortized intangible assets: Developed product software $ 7,302,390 $ 730,040 =========== =========== Unamortized intangible assets: LoopCare trade name $ 1,300,000 Base software 5,200,000 Post warranty maintenance service agreements 32,000,000 ----------- $38,500,000 =========== 7 As of December 31, 2001 ----------------------- Gross Carrying Accumulated Amount Amortization -------------- ------------ Amortized intangible assets: Developed product software $ 7,300,000 $ 365,000 =========== ========== Unamortized intangible assets: LoopCare trade name $ 1,300,000 Base software 5,200,000 Post warranty maintenance service agreements 32,000,000 ----------- $38,500,000 Aggregate amortization expense: For year ended December 31, 2001 $ 365,000 =========== Estimated amortization expense: For year ended December 31, 2002 $ 1,460,398 For year ended December 31, 2003 $ 1,460,478 For year ended December 31, 2004 $ 1,460,478 For year ended December 31, 2005 $ 1,460,478 For year ended December 31, 2006 $ 1,095,478 3. INVENTORIES At March 30, 2002 and December 31, 2001, inventories consisted of the following:
(Unaudited) March 30, December 31, 2002 2001 ----------- ------------ Raw materials . . . . . . . . . . . . . . . . . $11,308,503 $11,697,886 Work in progress. . . . . . . . . . . . . . . . 6,430,034 6,443,549 Finished goods. . . . . . . . . . . . . . . . . 5,043,864 5,153,181 ----------- ----------- $22,782,401 $23,294,616 Reserves for slow moving and obsolete inventory (1,430,850) (1,111,000) ----------- ----------- $21,351,551 $22,183,616 =========== ===========
8 4. SHORT-TERM AND LONG-TERM INVESTMENTS Short-term investments at March 30, 2002 and December 31, 2001 consisted of individual municipal bonds stated at cost, which approximated 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 comprised of individual municipal bonds with a maturity of more than one year but less than eighteen months and are stated at cost, which approximated market value. The primary investment purpose is to provide a reserve for future business purposes, including 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" as the Company has the positive intent and ability to hold the securities to maturity which is in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The estimated fair values of the Company's financial instruments are as follows:
(Unaudited) March 30, December 31, 2002 2001 --------------------------- -------------------------- Carrying Fair Carrying Fair Amount Value Amount Value Financial assets: Cash and cash equivalents . . . . . . . . $34,225,969 $34,225,969 $32,105,845 $32,105,845 Short-term and long-term investments. . . 4,682,176 4,645,076 6,639,323 6,658,247 ----------- ----------- ----------- ----------- $38,908,145 $38,871,045 $38,745,168 $38,764,092 =========== =========== =========== ============
9 5. INCOME PER COMMON SHARE Net income per share is calculated by dividing net income by the weighted average number of common shares plus incremental common stock equivalent shares (shares issuable upon exercise of stock options). Incremental common stock equivalent shares are calculated for each measurement period based on the treasury stock method, which uses the monthly average market price per share. The calculation of net income per common and common equivalent shares follows (unaudited):
-------------------------------------------------------------------------------- Three Months Three Months Ended Ended March 30, 2002 March 31, 2001 -------------------------------------------------------------------------------- Net income $ 1,512,814 $ 5,755,169 -------------------------------------------------------------------------------- Common and common equivalent shares: Weighted average number of common shares outstanding during the period............................. 13,099,210 12,957,833 Common shares issuable upon exercise of outstanding stock options: Diluted.................................... 322,097 419,352 Common and common equivalent shares outstanding during the period: -------------------------------------------------------------------------------- Diluted.................................... 13,421,307 13,377,185 -------------------------------------------------------------------------------- Earnings per share data Net income per common and common Equivalent shares: Basic...................................... $ .12 $ .44 Diluted.................................... $ .11 $ .43
10 6. DEFERRED AND REFUNDABLE TAX ASSETS The Company's current refundable tax assets as of December 31, 2001 included a tax benefit of $1,396,736 resulting from the exercising of certain nonqualified stock options by various directors, officers and other employees under the Company's stock option programs during 2001. The Company is entitled to a tax deduction 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 nonqualified stock options. The Company received $8,417,270 in 2001 in federal and state refunds in taxes paid in prior years. During the first quarter of 2002, the Company received $900,000 in federal income tax refunds associated with prior year taxes paid. It is anticipated that the remaining current deferred and refundable tax assets will be substantially utilized in 2002 either through refunds of prior year taxes paid or the elimination of income taxes due. 7. STOCK REPURCHASE PROGRAM On April 19, 2001, the Company announced its Board of Directors authorized the continuation of a share repurchase program that was originally initiated on April 22, 1997. Prior to the extension, the Company had repurchased 382,400 shares of common stock. The Company was authorized to repurchase a total of one million shares of its common stock. Through December 31, 2001, no additional shares were repurchased under this extended program. On January 24, 2002, the Board of Directors authorized the continuation of the share repurchase program under which the Company may repurchase a total of one million shares of its common stock before December 31, 2002. During the quarter ended March 30, 2002, the Company purchased an additional 75,000 shares of the Company's common stock under this program. 11 REVIEW REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Tollgrade Communications, Inc. and subsidiaries: We have reviewed the accompanying condensed consolidated balance sheet of Tollgrade Communications, Inc. and its subsidiaries as of March 30, 2002 and the related condensed consolidated statement of operations for each of the three-month periods ended March 30, 2002 and March 31, 2001 and the condensed consolidated statement of cash flows for the three-month periods ended March 30, 2002 and March 31, 2001. These financial statements are the responsibility of the Company's management. We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. We previously audited in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet as of December 31, 2001, and the related consolidated statements of operations, shareholders' equity and of cash flows for the year then ended (not presented herein), and in our report dated January 21, 2002 we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2001, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived. /s/ PricewaterhouseCoopers LLP Pittsburgh, Pennsylvania April 10, 2002 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto appearing elsewhere in this report. CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. The statements 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 General economic conditions and the economic conditions of the telecommunications industry; 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 of sales and marketing partners to meet their own performance objectives (and, in certain cases, continue to 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 manufacturing components and possibility of limited source of supply; o Manufacturing delays and availability of manufacturing capacity; o Intense competition in all markets for the Company's products; o Uncertain pace and scope of 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 and a small number of large customers; o The Company's dependence on key employees and upon proprietary rights; o Difficulties in managing the Company's growth; o The Company's dependence upon certain suppliers; o Risks of third party claims of infringement; o Risk of product defects; and o Changes in government regulation affecting the business of the Company and its customers. The Company does not undertake any obligation to publicly update any forward-looking statements. 13 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. Effective September 30, 2001, the Company purchased certain assets of the LoopCareTM product business from Lucent Technologies, Inc. ("Lucent"). These assets consisted of LoopCare software base code and developed enhancements, as well as the rights to existing maintenance contracts for the LoopCare software. Effective September 30, 2001, revenues from the sales of either software base code or developed enhancements are either reported separately or as part of the Company's revenues attributable to test system products to which they synergistically relate, while the revenues from existing and any new maintenance contracts are reflected as part of the Company's Professional Services revenues. The Company has determined that its business has one reportable segment in the test assurance industry. All product sales are considered components of the business of testing infrastructure and networks for the telecommunications and cable television industries. While the Company does internally develop sales results associated with the various product categories, this information is not considered sufficient for segment reporting purposes nor does the chief operating decision maker make critical decisions or allocate assets based solely on this information. Its products and services have similar economic characteristics, the same or similar production processes and are sold to similar types or classes of customers in, or entering into, the telecommunications business through similar distribution means. The LoopCare software product line business was acquired by the Company to broaden its DigiTest(R) test platform into a system level offering. 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 54% of the Company's revenue for the first quarter ended March 30, 2002. The Company's MCU product line will continue to account for a majority of the Company's revenues for the foreseeable future. The Company's DigiTest centralized network test system platform, which includes certain LoopCare software base code and developed enhancements, 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 the complete solution for testing POTS and performing local loop prequalification for DSL services. The system currently consists of the comprehensive LoopCare diagnostic software, as well as three integrated pieces of hardware, the Digital Measurement Node ("DMN"), the Digital Measurement Unit ("DMU"), and the Digital 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, bridged tap detection, data rate prediction, and in-service wideband testing. Sales of the DigiTest product line, accounted for approximately 12% of the Company's revenue for the first quarter of 2002. Of these DigiTest sales, approximately 5% included sales of related LoopCare software. 14 The first quarter of 2002 included sales of the Company's Digital Access Unit ("DAU"). The DAU provides automated test access of locally non-switched, two wire circuits and it helps facilitate the line sharing or the spectral unbundling process for both incumbent (ILEC) and competitive local exchange carriers (CLECs). Sales of this product line represented less than 1% of total revenue for the current quarter. The Company's LoopCare software products consist primarily of engineered enhancements to the LoopCare base code software, which result in increased connectivity and versatility of LoopCare within the customers' existing quality assurance systems. Sales of stand-alone LoopCare software accounted for approximately 15% of total first quarter 2002 revenue. 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 4% of the Company's revenue for the first quarter of 2002. Through the first quarter of 2002, the Company continued to build upon and extend its Services offering to customers. The cornerstone of the Company's Professional Services offering is the Testability Improvement Initiatives. These services may offer the customer the opportunity to make improvements in testability levels, while training their own staffs in targeted geographic regions over a defined period of time. In this way, 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 do so. The service offering was expanded upon the acquisition of software maintenance contracts related to the LoopCare software product line. Including these software maintenance revenues, services revenue accounted for approximately 15% of the Company's revenue for the first quarter ended March 30, 2002. The Company's telecommunication product sales and services are primarily to the four Regional Bell Operating Companies ("RBOCs") as well as major independent telephone companies and to certain digital loop carrier ("DLC") equipment manufacturers. For the first quarter ended March 30, 2002, approximately 74% of the Company's total revenue was generated from sales to these four RBOCs. During the first quarter of 2002, sales to three RBOCs (SBC, BellSouth and Verizon) individually exceeded 10% of consolidated revenues and on a combined basis, comprised approximately 71% (36.3%, 20.0% and 14.3%, respectively) of the Company's net product sales. Due to the Company's present dependency on these key customers, the loss of one or more of them as a customer or the reduction of orders for the Company's products by them could materially and adversely affect the Company. The Company's operating results have fluctuated and may continue to fluctuate as a result of various factors, including the timing of orders from, shipments to, and acceptance of software by the RBOCs and significant independent telephone companies. This timing is particularly sensitive 15 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 Company's products, specifically, LoopCare, 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, certain customers have consolidated 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 industry to consolidate as well as 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 were adopted by the standards setting body in the year 2001 and may adversely affect the Company's revenues from such products in the year 2002 and in subsequent periods. In addition, markets for the Company's LIGHTHOUSE products have been, and may continue to be, difficult for the foreseeable future. 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. The Company believes the addition of the LoopCare software product line may provide further opportunities to penetrate this market. The Company recorded its initial LoopCare Software sale in the international market in the first quarter of 2002. However, the international telephony markets differ from those found domestically due to the different types and configurations of equipment used by those international communication 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. The Company continues to evaluate opportunities for its other products including its LoopCare Software products in international markets. However, there can be no assurance that any continued efforts by the Company will be successful or that the Company will achieve significant international sales. 16 The Company believes that future growth will be affected as a result of an overall continued economic slowdown whereby customers may become even more conservative in their ordering patterns and quantities, and certain emerging carriers will continue to be hampered by financial instability. Due to this uncertainty, the Company will continue to evaluate its investments in production, marketing and research and development expenses and monitor, control or decrease expense levels, as appropriate. 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 percentage of revenues were 22.8% for the first quarter of 2002 compared to 12.0% for the first quarter of 2001. RESULTS OF OPERATIONS - FIRST QUARTER REVENUES Revenues for the first quarter of 2002 of $17,522,274 were $10,467,728, or 37.4%, lower than the revenues of $27,990,002 reported for the first quarter of 2001. The decrease in revenues for the first quarter of 2002 resulted from slower deployments of the MCU product-line caused by the continuing budget restrictions of the RBOCs. This decrease in sales of the MCU product line resulted from decreased sales to all RBOCs, which is primarily associated with slow-downs in capital spending programs to upgrade DLC systems within certain regions with MCU technology. In addition, for similar reasons, Tollgrade OEM resellers shipped fewer Digital Loop Carrier systems to their end customers, which reduced MCU product sales to these customers. The first quarter of 2001 included shipments of $1,300,000 of Program Channel Units used to broadcast the Winter Olympic Games from Salt Lake City, Utah; the first quarter of 2002 did not contain any shipments of these special application products. Sales of Tollgrade's DigiTest system products, which includes LoopCare software, declined substantially between quarterly periods. Increases in sales of DigiTest hardware and related LoopCare software to Sprint Canada and KPN Belgium were more than offset by a substantial decline in sales of DigiTest hardware to Nortel for international applications, and to Sprint USA as a result of the discontinuation of their ION project. In addition, sales of the Company's DAU product line declined between periods from the discontinuation of Sprint's ION project. The Company's first quarter 2002 Service revenues include $2,008,000 software maintenance related to LoopCare. Professional Services revenue amounted to $585,000 for the quarter, which related to installation oversight and project management services. These services were provided to the Ameritech region of SBC, with lesser amounts billed to Verizon and Bell South. Periodic fluctuations in customer orders and backlog result from a variety of factors, including but not limited to, the timing of significant orders from, shipments to, and acceptance of software by the RBOCs, and are not necessarily indicative of long-term trends in sales of the Company's products. 17 GROSS PROFIT Gross profit for the first quarter of 2002 was $10,140,016 compared to $15,715,719 for the first quarter of 2001, representing a decrease of $5,575,703, or 35.5%. Gross profit as a percentage of revenues increased to 57.9% in the first quarter of 2002, compared to 56.1% in the same quarter last year. The overall increase in gross profit as a percentage of sales resulted primarily from higher margins associated with the sales of LoopCare software products, offset by increased cost per unit sold due to substantially lower hardware production, the product mix of hardware sales during the quarter relative to last year and certain charges amounting to $563,000 for slow moving inventory and inventory obsolescence and warranty items amounting to $250,000 during the first quarter of 2002. The Company's gross margin is and will continue to be highly sensitive to the mix of products shipped. SELLING AND MARKETING EXPENSE Selling and marketing expense for the first quarter of 2002 was $2,417,309 compared to $2,449,824 for the first quarter of 2001. This decrease of $32,515, or 1.3%, is primarily due to decreases in commissions and various promotions and related marketing programs offset by increases caused by the addition of LoopCare personnel. As a percentage of revenues, selling and marketing expenses increased to 13.8% in the first quarter of 2002 from 8.8% in the first quarter of 2001. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expense for the first quarter of 2002 was $1,526,251, a decrease of $3,901, or 0.3%, from the $1,530,152 recorded in the first quarter of 2001. Certain general reserves in the amount of $165,000 provided for by the Company in 2001 were not required in 2002, however these decreases were offset by an increase in salaries and wages in 2002 resulting from the addition of administrative personnel and increased incentive compensation reserve requirements. As a percentage of revenues, general and administrative expenses increased to 8.7% in the first quarter of 2002 from 5.5% in the first quarter of 2001. RESEARCH AND DEVELOPMENT EXPENSE Research and development expense in the first quarter of 2002 was $3,994,641, an increase of $635,100, or 18.9%, over the $3,359,541 recorded in the first quarter of 2001. The increase is primarily associated with the addition of approximately 29 engineering personnel added as a result of the LoopCare acquisition along with other associated expenses. As a percentage of revenues, research and development expense increased to 22.8% in the first quarter of 2002 from 12.0% in the first quarter of 2001. INTEREST AND OTHER INCOME Interest and other income consists of interest income in both quarterly periods. For the first quarter of 2002, interest and other income was $237,999 compared to $906,977 for the first quarter of 2001, representing a decrease of $668,978, or 73.8%. This decrease is primarily a result of the decrease in funds available for investments, as a direct result of the LoopCare acquisition for $62,029,000 in cash at the beginning of the fourth quarter of 2001. PROVISION FOR INCOME TAXES The provision for income taxes for the first quarter of 2002 was $927,000, a decrease of $2,601,010 or 73.7%, from the $3,528,010 for the first quarter of 2001. The effective income tax rate for the 18 first quarter of 2002 was approximately 38.0% of pretax income, which is consistent with the prior year. NET INCOME AND EARNINGS PER SHARE As a result of the above factors, net income for the first quarter of 2002 was $1,512,814, a decrease of $4,242,355, or 73.7%, from the $5,755,169 recorded in the first quarter of 2001. Basic and diluted earnings per common share of $.12 and $.11, respectively, for the first quarter of 2002 decreased by $.32 and $.32, or 72.7% and 74.4%, from the $.44 and $.43, respectively, earned in the first quarter of 2001. Basic and diluted weighted average common and common equivalent shares outstanding were 13,099,210 and 13,421,307, respectively, in the first quarter of 2002 compared to 12,957,833 and 13,377,185, respectively, in the first quarter of 2001. As a percentage of revenues, net income for the first quarter of 2002 decreased to 8.6% compared to the 20.6% for the first quarter of 2001. CRITICAL ACCOUNTING POLICIES The Company's financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. Certain of these accounting principles are more important than others in gaining an understanding of the basis upon which the Company's financial statements have been prepared. A comprehensive review of these policies is contained in the Company's 2001 Annual Report on Form 10-K filed on March 22, 2002. There have been no significant changes in these policies or the application thereof during the first quarter of 2002. LIQUIDITY AND CAPITAL RESOURCES At March 31, 2002, the Company had working capital of $68,693,672, which represented an increase of $1,065,521, or 1.6%, from the $67,628,151 of working capital as of December 31, 2001. The increase in working capital is a result of operating cash flows and proceeds from the exercise of stock options exceeding requirements for purchase of property and equipment and approximately $1,625,000 of treasury stock. The Board of Directors has authorized the continuation of a share repurchase program it started in 1997. Under the current extension, the Company may repurchase a total of one million shares of its common stock before December 31, 2002. Since the initial repurchase program was instituted in April of 1997, and as of March 30, 2002, the Company has repurchased 461,800 shares of common stock. The repurchased shares are authorized to be utilized under certain employee benefit programs. The number of shares the Company intends to purchase and the timing of such purchases will be determined by the Company at its discretion. The Company will use existing cash and short-term investments to finance the purchases. Effective December 20, 2001, the Company executed a five-year $25.0 million Unsecured Revolving Credit Facility (the "Facility") with a bank. In accordance with the terms of the Facility, the proceeds must be used for general corporate purposes, working capital needs, and in connection with certain acquisitions, as defined. The Facility contains certain standard covenants with which the Company must comply, including a minimum fixed charge ratio, a minimum defined level of 19 tangible net worth and a restriction on the amount of capital expenditures that can be made on an annual basis, among others. Commitment fees are payable quarterly at 0.25% of the unused commitment. As of March 30, 2002, there were no outstanding borrowings under the Facility and the Company is in compliance with all debt covenants. No borrowings for working capital are currently anticipated, as the Company believes internally generated funds will be sufficient to sustain working capital requirements for the foreseeable future. The Company's days sales outstanding (DSO's) in accounts receivable trade, based on the past twelve months rolling revenue, was 71 and 43 days as of March 30, 2002 and December 31, 2001, respectively. The increase is a direct result of the timing of a substantial amount of revenue recognition including LoopCare software product sales in the latter part of the first quarter of 2002. The Company's inventory turnover ratio was 1.2 turns and 1.3 turns for March 30, 2002 and December 31, 2001, respectively. Management believes that operating cash flow and cash reserves are adequate to finance currently planned capital expenditures and to meet the overall liquidity needs of the Company. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's current investment policy limits its investments in financial instruments to cash and cash equivalents, individual municipal bonds, and corporate and government bonds. The use of financial derivatives and preferred and common stocks is strictly prohibited. The Company believes it minimizes its risk through proper diversification along with the requirements that the securities must be of investment grade with an average rating of "A" or better by Standard & Poor's. The Company holds its investment securities to maturity and believes that earnings and cash flows are not materially affected by changes in interest rates, due to the nature and short-term investment horizon for which these securities are invested. BACKLOG The Company's backlog consists of firm customer purchase orders. As of March 31, 2002, the Company had an adjusted backlog of $8,119,432 compared to $4,936,448 at December 31, 2001 and $5,605,349 at March 31, 2001. The March 30, 2002 backlog includes approximately $6,434,356 related to software maintenance contracts. This maintenance and support will be provided and billed for on a straight-line basis throughout 2002. Including these scheduled maintenance billings, approximately 47% of the current backlog is scheduled to be recognized as revenue in the second quarter of 2002. 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. 20 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None. ITEM 2. CHANGES IN SECURITIES None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: The following exhibits are being filed with this report: Exhibit Number Description ------- ----------- 15 Letter re unaudited interim financial information 21 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TOLLGRADE COMMUNICATIONS, INC. (REGISTRANT) Dated: May 14, 2002 /S/ CHRISTIAN L. ALLISON ------------------------------------- CHRISTIAN L. ALLISON CHAIRMAN, PRESIDENT AND CHIEF EXECUTIVE OFFICER Dated: May 14, 2002 /S/ SAMUEL C. KNOCH ------------------------------------- SAMUEL C. KNOCH CHIEF FINANCIAL OFFICER AND TREASURER Dated: May 14, 2002 /S/ CHARLES J. SHEARER ------------------------------------- CHARLES J. SHEARER CONTROLLER 22 EXHIBIT INDEX (Pursuant to Item 601 of Regulation S-K) Exhibit Number Description ------- ----------- 15 Letter re unaudited interim financial information 23 EX-15 3 j9449801ex15.txt LETTER EXHIBIT 15 May 13, 2002 Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 RE: Tollgrade Communications, Inc. and subsidiaries 1). Form S-8 (Registration No. 333-4290 and Registration No. 333-83007) 1995 Long-Term Incentive Compensation Plan and Individual Stock Options Granted to Certain Directors and Employees Prior to the Adoption of the Plan 2). Form S-8 (Registration No. 333-52907 and Registration No. 333-55470) 1998 Employee Incentive Compensation Plan Commissioners: We are aware that our report dated April 10, 2002 on our review of interim financial information of Tollgrade Communications, Inc. and subsidiaries as of and for the three month period ended March 30, 2002 and included in the Company's quarterly report on Form 10-Q for the quarter then ended is incorporated by reference in the registration statements referred to above. Very truly yours, /s/ PricewaterhouseCoopers LLP -----END PRIVACY-ENHANCED MESSAGE-----