-----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, ScXZfZHMHEml31zX2NQaZqEg+D6Ax7XQ5eE19zQycAyV2Yf+7/K0NG0/8uFen6Ki WL65u4zU9cQ5QRUpNq4APA== 0000950128-03-001211.txt : 20031112 0000950128-03-001211.hdr.sgml : 20031111 20031112113533 ACCESSION NUMBER: 0000950128-03-001211 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20030927 FILED AS OF DATE: 20031112 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: 03991859 BUSINESS ADDRESS: STREET 1: 493 NIXON RD CITY: CHESWICK STATE: PA ZIP: 15024 BUSINESS PHONE: 4122742156 10-Q 1 j0390901e10vq.txt TOLLGRADE COMMUNICATIONS, INC. ------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 ------------------------------- FORM 10-Q (Mark One) [ X ] Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 27, 2003 [ ] 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 _______ Indicate by check mark whether the Registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act). Yes ___X___ No _______ As of October 31, 2003, there were 13,574,820 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 38 pages. The exhibit index is on page 34. 1 TOLLGRADE COMMUNICATIONS, INC. QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 27, 2003 TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION PAGE NO. -------- ITEM 1 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED): CONDENSED CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 27, 2003 AND DECEMBER 31, 2002 .........................................................................3 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE-MONTH AND NINE- MONTH PERIODS ENDED SEPTEMBER 27, 2003 AND SEPTEMBER 28, 2002..............................4 CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER'S EQUITY FOR THE NINE-MONTH PERIOD ENDED SEPTEMBER 27, 2003.................................................5 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE-MONTH PERIOD ENDED SEPTEMBER 27, 2003 AND SEPTEMBER 28, 2002............................................6 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.......................................7 REPORT OF INDEPENDENT ACCOUNTANTS.........................................................15 ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION.......................................................................16 ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK................................31 ITEM 4 CONTROLS AND PROCEDURES...................................................................31 PART II. OTHER INFORMATION ITEM 6 EXHIBITS AND REPORTS FILED ON FORM 8-K....................................................32 SIGNATURES..............................................................................................33 EXHIBIT INDEX...........................................................................................34
2 PART I. FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
SEPTEMBER 27, 2003 DECEMBER 31, 2002* - ---------------------------------------------------------------------------------------------------------- ASSETS CURRENT ASSETS: Cash and cash equivalents $ 31,896,516 $ 33,799,284 Short-term investments 13,682,004 19,328,883 Accounts receivable: Trade 10,094,445 7,946,276 Other 54,6909 152,290 Inventories 12,294,05 14,092,596 Prepaid expenses and other current assets 895,228 1,529,968 Refundable income taxes 424,720 637,156 Deferred tax assets 1,743,936 1,404,122 - ---------------------------------------------------------------------------------------------------------- TOTAL CURRENT ASSETS 71,085,598 78,890,575 Property and equipment, net 8,527,541 7,438,870 Deferred tax assets 3,055,476 2,769,573 Intangibles 44,500,000 38,500,000 Goodwill 19,835,083 16,161,763 Capitalized software costs, net 8,168,754 5,539,002 Other assets 336,696 242,115 ========================================================================================================== TOTAL ASSETS $ 155,509,148 $ 149,541,898 ========================================================================================================== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 1,125,606 $ 499,642 Accrued warranty 2,565,608 1,980,520 Accrued expenses 1,310,998 748,576 Accrued salaries and wages 1,002,533 543,339 Accrued royalties payable 272,533 322,380 Income taxes payable 1,352,451 1,141,293 Deferred income 810,693 465,887 - ---------------------------------------------------------------------------------------------------------- TOTAL CURRENT LIABILITIES 8,440,422 5,701,637 Deferred tax liabilities 2,623,866 1,484,247 - ---------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES 11,064,288 7,185,884 Commitments and contingent liabilities -- -- Shareholders' equity: Common stock, $.20 par value; authorized shares, 50,000,000; issued shares, 13,552,736 in 2002 and 13,574,820 in 2003 2,714,964 2,710,547 Additional paid-in capital 70,740,333 70,489,025 Treasury stock, at cost, 461,800 shares (4,790,783) (4,790,783) Retained earnings 75,780,346 73,947,225 - ---------------------------------------------------------------------------------------------------------- TOTAL SHAREHOLDERS' EQUITY 144,444,860 142,356,014 ========================================================================================================== TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 155,509,148 $ 149,541,898 ==========================================================================================================
* Amounts derived from audited financial statements 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)
================================================================================================================================ THREE MONTHS ENDED NINE MONTHS ENDED ------------------------------- ------------------------------- SEPTEMBER 27, SEPTEMBER 28, SEPTEMBER 27, SEPTEMBER 28, 2003 2002 2003 2002 ================================================================================================================================ REVENUES: Products $12,529,421 $11,260,585 $38,015,322 $38,207,243 Services 3,086,812 2,691,611 9,277,881 7,851,137 - -------------------------------------------------------------------------------------------------------------------------------- TOTAL REVENUES: 15,616,233 13,952,196 47,293,203 46,058,380 - -------------------------------------------------------------------------------------------------------------------------------- COST OF PRODUCT SALES: Products 5,528,304 5,645,694 17,055,017 16,577,424 Services 1,010,193 867,969 2,776,240 2,722,795 Amortization of intangibles 490,437 366,298 1,890,928 1,096,767 7,028,934 6,879,961 21,722,185 20,396,986 - -------------------------------------------------------------------------------------------------------------------------------- GROSS PROFIT 8,587,299 7,072,235 25,571,018 25,661,394 - -------------------------------------------------------------------------------------------------------------------------------- OPERATING EXPENSES: Selling and marketing 2,319,913 2,162,734 6,711,353 6,804,876 General and administrative 1,664,797 1,216,570 5,230,062 4,011,415 Research and development 3,754,154 3,370,548 10,981,935 10,761,258 - -------------------------------------------------------------------------------------------------------------------------------- TOTAL OPERATING EXPENSES 7,738,864 6,749,852 22,923,350 21,577,549 - -------------------------------------------------------------------------------------------------------------------------------- INCOME FROM OPERATIONS 848,435 322,383 2,647,668 4,083,845 Interest and other income, net 76,486 150,767 308,979 588,766 - -------------------------------------------------------------------------------------------------------------------------------- INCOME BEFORE INCOME TAXES 924,921 473,150 2,956,647 4,672,611 Provision for income taxes 351,470 179,798 1,123,526 1,775,592 ================================================================================================================================ NET INCOME $ 573,451 $ 293,352 $ 1,833,121 $ 2,897,019 ================================================================================================================================ EARNINGS PER SHARE INFORMATION: Weighted average shares of common stock and equivalents: Basic 13,112,966 13,090,936 13,102,121 13,096,496 Diluted 13,345,743 13,216,502 13,300,250 13,340,724 Net income per common and common equivalent shares: Basic $ .04 $ .02 $ .14 $ .22 Diluted $ .04 $ .02 $ .14 $ .22 ================================================================================================================================
The accompanying notes are an integral part of the condensed consolidated financial statements. 4 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 27, 2003 (Unaudited)
ADDITIONAL PREFERRED COMMON STOCK PAID-IN TREASURY RETAINED SHARES AMOUNT SHARES AMOUNT CAPITAL STOCK EARNINGS TOTAL - ---------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2002 -- $ -- 13,552,736 $2,710,547 $70,489,025 $(4,790,783) $73,947,225 $142,356,014 Exercise of common Stock options -- -- 22,084 4,417 196,108 -- -- 200,525 Tax benefit from exercise of stock options -- -- -- -- 55,200 -- -- 55,200 Net Income -- -- -- -- -- -- 1,833,121 1,833,121 - ---------------------------------------------------------------------------------------------------------------------------- Balance at September 27, 2003 -- $ -- 13,574,820 $2,714,964 $70,740,333 $(4,790,783) $75,780,346 $144,444,860 - ----------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the condensed consolidated financial statements. 5 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Nine Months Ended - ----------------------------------------------------------------------------------------------------------------------- Sept. 27, 2003 Sept. 28, 2002 -------------- -------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $1,833,121 $2,897,019 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 3,638,461 2,820,998 Tax benefit from exercise of stock options 55,200 113,769 Refund and utilization of income taxes paid 212,436 522,761 Deferred income taxes 629,732 569,004 Provision for losses on inventory 301,966 2,064,518 Disposition of slow moving and obsolete inventory (295,799) (756,518) Provision for allowance for doubtful accounts 517,307 100,000 Changes in assets and liabilities: Increase in accounts receivable-trade (2,665,476) (1,697,142) Decrease (Increase) in accounts receivable-other 97,600 (106,317) Decrease in inventory 2,952,488 4,705,849 Decrease in prepaid expenses and other assets 600,504 167,370 Increase (decrease) in accounts payable 625,964 (633,459) Increase in accrued warranty 288,088 204,265 Increase in accrued expenses and deferred income 117,140 363,539 Increase in accrued salaries and wages 459,194 396,456 Decrease in accrued royalties payable (49,847) (290,277) Increase (decrease) in income taxes payable 211,158 (77,618) - ----------------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 9,529,237 11,364,217 - ----------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of Cheetah (14,899,010) --- Redemption/maturity of investments 6,636,046 7,284,312 Purchase of investments (989,167) (14,590,032) Capital expenditures (2,380,399) (1,729,818) Investments in other assets -- (30,532) - ----------------------------------------------------------------------------------------------------------------------- Net cash used in investing activities (11,632,530) (9,066,070) - ----------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Purchase of treasury stock -- (1,625,808) Proceeds from exercise of stock options 200,525 278,175 - ----------------------------------------------------------------------------------------------------------------------- Net cash provided by (used for) financing activities 200,525 (1,347,633) - ----------------------------------------------------------------------------------------------------------------------- Net (decrease) increase in cash and cash equivalents (1,902,768) 950,514 Cash and cash equivalents at beginning of period 33,799,284 32,105,845 - ----------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $31,896,516 $33,056,359 =======================================================================================================================
The accompanying notes are an integral part of the condensed financial statements 6 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 interim financial information and Article 10 of Regulation S-X. The condensed consolidated financial statements as of and for the three-month and nine-month periods ended September 27, 2003 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, 2002. 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 Company 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 and nine-month periods ended September 27, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003. 2. ACCOUNTING FOR STOCK-BASED COMPENSATION The Company has two stock-based employee compensation plans. The Company accounts for these plans under the recognition and measurement provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees." Under these provisions, stock- based employee compensation cost is not reflected in net income for any year, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant. If the Company had elected to recognize compensation cost for these stock options based on the fair value method set forth in SFAS No. 123, "Accounting for Stock-Based Compensation," net income and earnings per share would have reflected the pro forma amounts indicated below:
Three Months ended Nine Months ended ------------------------------- -------------------------------- Sept. 27, 2003 Sept. 28, 2002 Sept. 27, 2003 Sept. 28, 2002 -------------- -------------- -------------- -------------- Net income, as reported $ 573,451 $ 293,352 $ 1,833,121 $ 2,897,019 Deduct: Total stock-based compensation expense based on the fair value method for all awards, net of related tax effects 395,518 1,117,816 1,402,198 3,985,477 --------- ----------- ----------- ------------ Pro forma net income $ 177,933 $ (824,464) $ 430,923 $ (1,088,458) ========= =========== =========== ============ Earnings (loss) per share: Basic - as reported $ 0.04 $ 0.02 $ 0.14 $ 0.22 Basic - pro forma $ 0.01 $ (0.06) $ 0.03 $ (0.08) Diluted - as reported $ 0.04 $ 0.02 $ 0.14 $ 0.22 Diluted - pro forma $ 0.01 $ (0.06) $ 0.03 $ (0.08)
7 3. ACQUISITION AND INTANGIBLE ASSETS On February 13, 2003, the Company acquired certain assets and assumed certain liabilities of the Cheetah(TM) Status and Performance Monitoring Product Line ("Cheetah") from Acterna, LLC ("Acterna") for approximately $14,300,000 in cash. The Company also capitalized acquisition-related costs of approximately $599,000 for a total estimated cost of approximately $14,899,000. In addition, as part of the acquisition, contingent purchase consideration of up to $2,400,000 in the form of an earn-out may be payable based on certain 2003 performance targets for the acquired product line. If made, such earn-out payment would be accounted for as an addition to goodwill. The acquired assets consist principally of existing sales order backlog, product inventory, intellectual property, software and related computer equipment, while the assumed liabilities principally relate to deferred software maintenance, warranty and other obligations. The $14,300,000 due at closing and related acquisition expenses were paid from available cash and short-term investments. The acquisition was recorded under the purchase method of accounting and accordingly, the results of operations of the acquired product line from February 14, 2003 forward are included in the consolidated financial statements of the Company. The Company has made an allocation of the purchase price to the fair value of assets acquired and liabilities assumed. The allocation is subject to change based upon continuing review and determinations. Further, the purchase price may change due to the earn-out and other provisions in the purchase agreement, which would require further adjustment to the allocation of purchase price. Such adjustments may be material. The following summarizes the current estimated fair values as of the date of acquisition: Inventories $ 1,160,000 Property and Equipment, net 537,000 Deferred Tax Assets 116,000 Intangible Assets: Customer Base $ 5,000,000 Cheetah Trademark 1,000,000 Base Software 2,900,000 Proprietary Technology 1,000,000 Sales Order Backlog 600,000 10,500,000 ------------- Goodwill 3,673,000 -------------------------------------------------------------------------------- Total Assets Acquired $ 15,986,000 -------------------------------------------------------------------------------- Deferred Income (625,000) Other Liabilities (462,000) -------------------------------------------------------------------------------- Total Liabilities Assumed $ (1,087,000) -------------------------------------------------------------------------------- NET ASSETS ACQUIRED $ 14,899,000 --------------------------------------------------------------------------------
An independent valuation consultant assisted management in its initial determination of fair value assigned to certain intangible assets other than goodwill. Discounted future cash flow models were utilized where appropriate. The Cheetah product line has maintained a significant market share in cable status and performance monitoring equipment for more than 25 years and has a large installed customer base, including many of the largest multiple system cable operators. The Company expects that, on average, approximately 85% of future revenues attributable to Cheetah products will be derived from this customer base and, based on prior experience, does not anticipate turnover or loss of these customers. Therefore, the Company has concluded that the customer 8 base and Cheetah trademark intangible assets have an indefinitely long life. Consequently, in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets", the values assigned to customer base and the Cheetah trademark, as well as to related goodwill, are not being amortized for financial reporting purposes. The Company intends that the base software will be used in future releases of CheetahNet (TM) (formerly NetMentor(TM)) and other software products with little change into the foreseeable future. Similarly, the proprietary technology embedded in transponder hardware is designed to have a relatively long useful life. Therefore, the Company has determined that the base software and proprietary software have a remaining useful life of ten years and are being amortized for financial reporting purposes over that period. The Company obtained a backlog of customer purchase orders totaling approximately $2,383,000 in connection with the Cheetah acquisition. Using a discounted cash flow analysis, the Company determined an acquired value of $600,000 for this backlog. This asset is being amortized as the related orders are being realized as sales revenue. Amortization of approximately $540,000 was recognized in cost of sales from the date of the acquisition through September 27, 2003 and it is expected that the balance of $60,000, which is included in prepaid expenses and other current assets, will be amortized in the fourth quarter of 2003. For tax purposes, the Company is amortizing all intangible assets over 15 years. SFAS No. 142 provides that entities evaluate the remaining useful lives of intangible assets determined to have indefinite useful lives periodically to determine whether events and circumstances continue to support an indefinite useful life and that such assets be tested at least annually for impairment of value. The Company's policy is to test all intangible assets for impairment in value as of December 31 of each year or more frequently if events or changes in circumstances indicate that assets might be impaired. The following condensed proforma results of operations reflect the proforma combination of the Company and the acquired Cheetah product line as if the combination occurred on January 1, 2002.
(In Thousands, Except Per Share Data) -------------------------------------------------------------- Three Months Ended Nine Months Ended ----------------------------- ----------------------------- Sept. 27, 2003 Sept 28, 2002 Sept. 27, 2003 Sept 28, 2002 Historical Proforma Proforma Proforma -------------- ------------- -------------- ------------- Revenues $ 15,616 $ 19,348 $48,656 $ 62,246 - ---------------------------------------------------------------------------------------------------------------- Income from operations 848 1,972 3,318 8,086 - ---------------------------------------------------------------------------------------------------------------- Net income 573 1,274 2,250 5,252 - ---------------------------------------------------------------------------------------------------------------- Diluted earnings per share $ 0.04 $ 0.10 $ 0.17 $ 0.39 - ----------------------------------------------------------------------------------------------------------------
The proforma results of operations for the nine months ended September 27, 2003 include revenues of Acterna for the Cheetah product line through February 13, 2003, the date of acquisition. Revenues for 2002, cost of sales and operating expenses for proforma determinations were based on historical information provided by Acterna with proforma adjustments made to adjust gross margins to 50% of revenues and to adjust operating expenses based upon the Company's financial plan for Cheetah for 2003. These adjustments were made to reflect significant changes to operations made by the Company since the acquisition. This proforma financial information is presented for comparative purposes only and is not necessarily indicative of the operating results that actually 9 would have incurred had the Cheetah product line acquisition been consummated on January 1, 2002. In addition, these results are not intended to be a projection of future results. The following information is provided regarding the Company's intangible assets:
As of September 27, 2003 As of December 31, 2002 ----------------------------- ----------------------------- Gross Gross Carrying Accumulated Carrying Accumulated Amount Amortization Amount Amortization -------- ------------ -------- ------------ Amortized intangible assets: Current: Sales Order Backlog $ 600,000 $ 539,655 $ -- $ -- Long Term: Developed product software 7,452,714 2,940,210 7,368,100 1,829,098 Base Software - Cheetah 2,900,000 181,250 -- -- Proprietary Technology 1,000,000 62,500 -- -- ----------------------------- ----------------------------- 11,952,714 3,723,615 $ 7,368,100 $ 1,829,098 ============================= ============================= Non-amortized intangible assets: LoopCare trade name $ 1,300,000 $ -- $ 1,300,000 $ -- Base software - LoopCare 5,200,000 -- 5,200,000 -- Post warranty maintenance -- -- service agreements 32,000,000 -- 32,000,000 -- Customer Base - Cheetah 5,000,000 -- -- -- Cheetah Trademark 1,000,000 -- -- -- ----------------------------- ----------------------------- $44,500,000 $ -- $38,500,000 $ -- ============================= =============================
Estimated amortization expense for the years ended: December 31, 2003 $ 2,424,699 December 31, 2004 1,880,543 December 31, 2005 1,880,543 December 31, 2006 1,515,543 December 31, 2007 416,446 10 4. INVENTORIES At September 27, 2003 and December 31, 2002, inventories consisted of the following:
September 27, December 31, 2003 2002 ------------- ------------ Raw materials ............................................. $ 8,353,314 $ 9,726,789 Work in process ........................................... 4,515,342 4,518,164 Finished goods ............................................ 1,774,403 2,190,476 ------------ ------------ $ 14,643,059 $ 16,435,429 Allowance for slow moving and obsolete inventory ..................................... (2,349,000) (2,342,833) ------------ ------------ $ 12,294,059 $ 14,092,596 ============ ============
5. SHORT-TERM INVESTMENTS Short-term investments at September 27, 2003 and December 31, 2002 consisted of individual municipal bonds stated at cost, which approximated market value. These securities have maturities 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. 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. The estimated fair values of the Company's financial instruments are as follows:
September 27, December 31, 2003 2002 ------------------------- ------------------------- Carrying Fair Carrying Fair Amount Value Amount Value -------- ----- --------- ----- Financial assets: Cash and cash equivalents ..................... $31,896,516 $31,896,516 $33,799,284 $33,799,284 Short-term investments ........................ 13,682,004 13,681,855 19,328,883 19,257,039 ----------- ----------- ----------- ----------- $45,578,520 $45,578,371 $53,128,167 $53,056,323 =========== =========== =========== ===========
6. 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. 11 The calculation of net income per common and common equivalent shares follows:
Three Months Three Months Nine Months Nine Months Ended Ended Ended Ended September 27, 2003 September 28, 2002 September 27, 2003 September 28, 2002 - -------------------------------------------------------------------------------------------------------------------------------- Net income $ 573,451 $ 293,352 $ 1,833,121 $ 2,897,019 - -------------------------------------------------------------------------------------------------------------------------------- Common and common equivalent shares: Weighted average number of common shares Outstanding during the period 13,112,966 13,090,936 13,102,121 13,096,496 Common shares issuable upon exercise of outstanding stock options: Diluted 232,777 125,566 198,129 244,228 Common and common equivalent shares Outstanding during the period: Diluted 13,345,743 13,216,502 13,300,250 13,340,724 ================================================================================================================================ Earnings per share data Net income per common and common Equivalent shares: Basic $ .04 $ .02 $ .14 $ .22 Diluted $ .04 $ .02 $ .14 $ .22
7. ACCOUNTING PRONOUNCEMENTS On August 15, 2001, the Financial Accounting Standards Board (FASB) issued Statement of Accounting Standard (SFAS) No. 143, "Accounting for Asset Retirement Obligations.". The Company adopted this statement on January 1, 2003 and such adoption did not have a material effect on the Company's financial statements. In June 2002, the FASB issued SFAS No. 146, "Accounting For Costs Associated With Exit Or Disposal." SFAS No. 146 nullifies Emerging Issues Task Forces (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)." The new Statement requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. This statement did not have a material effect on the Company's financial position or results of operations. 12 In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires that upon issuance of a guarantee, a guarantor must recognize a liability for the fair value of an obligation assumed under a guarantee. FIN 45 also requires additional disclosures by a guarantor in its interim and annual financial statements about the obligations associated with guarantees issued. The recognition provisions of FIN 45 are effective for any guarantees issued or modified after December 31, 2002. The provisions of FIN 45 did not have a material impact on the Company's results of operations or financial position. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." This Statement amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition to SFAS No. 123's fair value method of accounting for stock-based employee compensation. This Statement also amends the disclosure provisions of SFAS No. 123 and APB No. 28, Interim Financial Reporting, to require disclosure in the summary of significant accounting policies footnote in the financial statements of the effects of an entity's accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. The Company has elected to continue to follow the disclosure-only provisions of SFAS No. 123 and adopted the disclosure provisions of SFAS No. 148. On January 17, 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities - an interpretation of ARB No. 51" ("FIN 46"). FIN 46 clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements", to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Certain provisions of FIN 46 were effective for the Company after January 31, 2003 and did not have a material impact on the Company's results of operations or financial condition. On October 8, 2003, the FASB issued FASB Staff Position No. 46-e, which allows public entities, who meet certain criteria, to defer the effective date for applying the provisions of FIN 46 to interests held by the public entity in certain variable interest entities or potential variable interest entities created before February 1, 2003 until the end of the first interim or annual period ending after December 15, 2003. In April 2003, the FASB issued Statement No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging." This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement was effective for the Company after April 30, 2003 and did not have a material impact on the Company's results of operations or financial condition. In May 2003, the FASB issued Statement No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). This statement was effective for the Company after May 31, 2003 and did not have a material impact on the Company's results of operations or financial condition. The Company early adopted Emerging Issues Task Force (EITF) Issue 00-21, "Accounting for Revenue Arrangements with Multiple Deliverables," which applies to all deliverables within contractually binding arrangements that include multiple revenue-generating activities. This issue was finalized in May of 2003 and did not have a material impact on the Company's results of operations or financial condition. 13 8. PRODUCT WARRANTY The Company records estimated warranty costs on the accrual basis of accounting. Warranty accruals are determined by applying historical returns to the current level of product shipments and the cost experience associated therewith. In the case of software, accruals are based on the expected cost of providing services within the agreed-upon warranty period. Activity in the warranty accrual is as follows:
Three Months Ended Nine Months Ended -------------------------------- ------------------------------- Sept. 27, 2003 Sept. 29, 2002 Sept. 27, 2003 Sept. 28, 2002 - -------------------------------------------------------------------------------------------------------------------------------- Balance at the beginning of the period $ 3,123,000 $ 2,275,000 $ 1,981,000 $ 2,068,000 Accruals for warranties issued during the period 234,000 183,000 900,000 411,000 Accruals related to pre-existing warranties (264,000) (51,000) (56,000) 215,000 Cheetah opening accrual (321,000) -- 297,000 -- Settlements during the period (206,000) (135,000) (556,000) (422,000) - --------------------------------------------------------------------------------------------------------------------------------- Balance at the end of the period $ 2,566,000 $ 2,272,000 $ 2,566,000 $ 2,272,000 =================================================================================================================================
The Company had recorded $618,000 on the Cheetah opening balance sheet to provide an estimated accrual for pre-acquisition warranty costs for the Cheetah products. This accrual was decreased to $297,000 through an adjustment to goodwill in the current quarter to finalize the opening balance sheet accrual. This estimate utilizes actual warranty experience. 14 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 September 27, 2003, and the related condensed consolidated statements of operations for each of the three-month and nine-month periods ended September 27, 2003 and September 28, 2002 and the condensed consolidated statement of cash flows for the nine-month periods September 27, 2003 and September 28, 2002 and the statement of changes in shareholders' equity for the nine-month period ended September 27, 2003. 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, 2002, 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 22, 2003 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, 2002, 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 October 15, 2003 15 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 this Quarterly Report on Form 10-Q, including, but not limited to those contained in Item 2- Management's Discussion and Analysis of Results of Operations and Financial Condition, along with statements in other reports filed with the Securities and Exchange Commission (the "SEC"), external documents and oral presentations, which are not historical facts are considered "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 statements, which may be expressed in a variety of ways, including the use of forward-looking terminology such as "will," "believes," "intends," "expects," "plans," "could" or "may," or the negatives thereof, other variations thereon or comparable terminology, relate to, among other things, projected cash flows which are used in the valuation of intangible assets, the anticipated results of negotiations for purchase orders and other customer purchase agreements, the ability to utilize deferred and refundable tax assets, opportunities which the Services group offers to customers, the potential loss of certain customers, the timing of orders from customers, the effect of consolidations in the markets to which Tollgrade Communications, Inc. (the "Company") sells, the effects of the economic slowdown in the telecommunications and cable industries, the possibility of future provisions for slow moving and obsolete inventory, and the effect on earnings and cash flows of changes in interest rates. The Company does not undertake any obligation to publicly update any forward-looking statements. These forward-looking statements and other forward-looking statements contained in other public disclosures of the Company which make reference to the cautionary factors contained in this Form 10-Q are based on assumptions that involve risks and uncertainties and are subject to change based on the considerations described below. These risks, uncertainties and other factors may cause actual results, performance or achievements to differ materially from anticipated future results, performance or achievements expressed or implied by such forward looking statements. The Company wishes to caution each reader of this Form 10-Q to consider the following factors and certain other factors discussed herein and in other past reports including, but not limited to, prior year Annual Reports and Form 10-K and Form 10-Q reports filed with the SEC. The factors discussed herein may not be exhaustive. Therefore, the factors discussed herein should be read together with other reports and documents that are filed by the Company with the SEC from time to time, which may supplement, modify, supersede or update the factors listed in this document. General economic conditions and the economic conditions of the telecommunications and cable industries, including the effect of subscriber line loss and competition for the Company's Regional Bell Operating Company ("RBOC") customers from wireless, cable providers and other carriers entering the local telephone service market can and have affected the capital budgets of the Company's customers. If such conditions result in a further reduction of such budgets, the Company's revenues could be adversely affected. If the Company's customers find themselves unable to meet their established purchase forecasts and their own growth projections, such customers may curtail their purchases of the Company's products, which would adversely affect the Company's revenues. 16 If the Company would be unable to establish or maintain customer or sales distribution or original equipment manufacturer ("OEM") relationships relating to the Cheetah cable status and performance monitoring product line, it could affect the rate of incoming orders, which would adversely affect the Company's sales and revenues. If the financial strength of certain of the Company's major customers should deteriorate or such customers should encounter difficulties in accessing capital, the ability of such customers to purchase and pay for the Company's products could be impaired, with a corresponding adverse effect on the Company's revenues. If third parties with whom the Company has entered into sales and marketing partnerships should fail to meet their own performance objectives, customer demand for the Company's products could be adversely affected, which would have an adverse effect on the Company's revenues. Seasonal fluctuations in customer demand for the Company's products can create corresponding fluctuations in period-to-period revenues, and any increases in the rate of order cancellations by customers could adversely affect future revenues. The carrying value of certain intangible assets, including goodwill, acquired by the Company from Lucent Technologies, Inc. ("Lucent") and Acterna, LLC could be impaired if changing market conditions indicate that lower than anticipated cash flows will be produced by such intangible assets. If the Company were to encounter a shortage of key manufacturing components from limited sources of supply, or to experience manufacturing delays caused by reduced manufacturing capacity or integration issues related to the acquisition of the Cheetah product line, the loss of key assembly subcontractors or other factors, the Company's ability to produce and ship its manufactured products could be adversely affected, with an adverse effect upon revenues. Disputes between the Company's customers and their organized labor groups could cause those customers to reduce or curtail their purchase of the Company's products until the resolution of such disputes, which would adversely affect revenues. The introduction of improved products or services or reduced prices by the Company's competitors could reduce the demand for the Company's products and services and adversely affect revenues. The Company's sales of its core Metallic Channel Unit ("MCU(R)") technology largely depends on the rate of customer deployment of new, and retrofitting of existing, Digital Loop Carrier ("DLC") systems in the United States. Any further significant decline in the rate of DLC deployment, or saturation of existing domestic markets or portions thereof, could have an adverse affect on the Company's future results. If the Company proves unable to respond effectively to technological change in its industry, such as an evolution of the telephone network from circuit to packet-based or the cable industry testing protocols from proprietary to standardized, by developing new products and services and obtaining customer approval and acceptance of its products and services, demand for the Company's products and services could be adversely affected, which would adversely affect revenues. The Company is dependent on a relatively narrow range of products and a small number of large customers. As a result, the failure of one or a small number of the Company's products to gain or maintain acceptance in the marketplace, or the decision by one or a few of the Company's customers to curtail their purchases of the Company's products, could have an adverse effect on revenues. 17 If one or more of a small number of key employees of the Company were to cease to be associated with the Company, the Company's future results could be adversely affected. If the Company is unable to successfully assert and defend its proprietary rights in the technology utilized in its products, or if third parties were able to successfully assert that the Company's use of technology infringed upon the proprietary rights of others, the future results of the Company could be adversely affected. If one or more of the Company's products were to prove to be defective, the Company's relationships with its customers could be jeopardized and the Company could be subject to potential liability, which would adversely affect the Company's future results. If for any reason demand for the Company's products should decrease, including the successful development of a secondary market for the Company's products by a third party, the Company could continue to find itself with excess inventory and obsolete parts on hand, which could adversely affect future results. Changes in government regulation, such as modification or repeal of The Telecommunications Act of 1996, increasing the costs of doing business by the Company or its customers, or preventing the Company or its customers from engaging in business activities they may wish to conduct, could adversely affect the Company's future results. The Company has recently completed certain acquisitions and expects to pursue additional acquisitions and new business opportunities in the future as part of its business strategy. If the Company fails to integrate successfully the operations and products of acquired businesses, or if such acquisitions subject the Company to unexpected liabilities and claims, the Company's future results could be adversely affected. The Company's future sales in international markets are subject to numerous risks and uncertainties, including local economic and labor conditions, political instability including terrorism and other acts of war or hostility, unexpected changes in the regulatory environment, trade protection measures, tax laws, the ability of the Company to market current or newly developed products suitable for international markets, the ability of the Company to obtain and maintain successful distribution and resale channels, and foreign currency exchange rates. Reductions in the demand for or the sales of the Company's products in international markets could adversely affect future results. OVERVIEW The Company was organized in 1986, began operations in 1988 and completed its initial public offering in 1995. The Company designs, engineers, markets and supports test system, test access and status and performance monitoring products for the telecommunications and cable television industries. In 2001, the Company purchased certain assets of the LoopCare(TM) product line from Lucent. The acquired assets consisted principally of LoopCare software base code and developed enhancements, as well as the rights to existing maintenance contracts for the LoopCare software, while the assumed liabilities principally relate to deferred software maintenance and warranty obligations under contract. Revenues from the sales of LoopCare software base code or developed enhancements are either reported separately or as part of the Company's revenues attributable to test system products in which the software is an essential functional component, while the revenues from maintenance contracts are reflected as part of the Company's Services revenues. On February 13, 2003, the Company purchased certain assets and assumed certain liabilities related to the Cheetah(TM) Status and Performance Monitoring Product Line from Acterna, LLC. The acquired assets consisted principally of existing sales order backlog, product inventory, intellectual property, software and 18 related computer equipment, while the assumed liabilities principally related to deferred software maintenance, warranty and other obligations. The product line consists of a full complement of system software and hardware designed to allow cable television providers to test, monitor and maintain their operating systems. The Cheetah offerings also include installation and maintenance services. 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. Although the Company does internally develop sales results associated with the various product categories, this information is not considered sufficient for segment reporting purposes and the chief operating decision maker does not make critical decisions or allocate assets based solely on this information. The Company's 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 and cable businesses through similar distribution means. The LoopCare software product line was acquired by the Company to broaden its DigiTest(R) test platform into a system level offering, to contribute to the Company's revenue base, and as a competitive defense to protect the Company's MCU and DigiTest products' market share. The Cheetah products were acquired to establish the Company as the market leader within the global cable broadband marketplace. The combination of the newly acquired Cheetah operation and CheetahLight(TM) (formerly LIGHTHOUSE(TM)) provide a complete line of solutions for customers network monitoring needs. The Company's proprietary telecommunications 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 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 diagnoses, 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 also sells LoopCare base code software primarily to competitive local exchange carriers ("CLECs") to be used with test heads other than the Company's DigiTest products. 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 integrated pieces of hardware, including the Digital Measurement Node ("DMN"), the Digital Measurement Unit ("DMU"), the Digital Wideband Unit ("DWU") and the Digital Wideband Node ("DWN"). The Company recently released the next generation of its DigiTest products, the DigiTest EDGE(TM) test head, developed as a global platform for broadband test applications. This new test head has been undergoing field trials at RBOC and other customer sites. During the third quarter, the Company had a modest, first sale of the DigiTest EDGE product to an incumbent local exchange carrier ("ILEC"), which made a $79,000 contribution to revenues. 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. 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. The Company's cable hardware and software products, which are being integrated, offer a complete cable status and performance monitoring system that provides a comprehensive testing solution for the broadband Hybrid Fiber Coax distribution system. The offerings include the CheetahLight and CheetahNet(TM) (formerly NetMentor(TM)) software systems and maintenance, head-end controllers, return path switch hardware, 19 transponders and other equipment which gather status and performance reports from power supplies, line amplifiers and fiber optic nodes. The cornerstones of the Company's Services offerings are 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 eliminating the need for the involvement of several highly trained employees. The Services business was considerably expanded upon the acquisition of software maintenance contracts related to the LoopCare and CheetahNet software product lines. The Company's primary customers for its telecommunication products and services are the four RBOCs as well as major independent telephone companies and certain digital loop carrier ("DLC") equipment manufacturers. For the third quarter ended September 27, 2003, approximately 55.1% of the Company's total revenue was generated from sales to these four RBOC customers. During the third quarter of 2003, sales to three RBOC customers (SBC, Bell South and Verizon) individually exceeded 10% of consolidated revenues and on a combined basis, comprising approximately 50.7% (21.8%, 14.5% and 14.4%, respectively) of the Company's net sales for the period. Due in part to diversification in the Company's product lines which resulted from the acquisition of the LoopCare and Cheetah product lines, the percentage of revenue generated from the Company's RBOC customers has declined from levels previously seen. Due to the Company's present dependency on these key customers, the potential loss of one or more of them as a customer or their reduction of orders for the Company's products 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 RBOC customers and significant independent telephone companies. This timing is particularly sensitive to various business factors within each of the RBOC customers, including the availability of funds in their capital and expense budgets, their relationships with various organized labor groups and a tendency for the RBOC customers to place large orders for shipment of hardware and software near the end of a quarter. In addition, the markets for the Company's products, specifically LoopCare, DigiTest and Cheetah, 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 and continuing changes within the telecommunications equipment marketplace, including industry consolidation, as well as the Company's ability to successfully penetrate certain new markets, have required it to grant more favorable terms to some of its customers. In addition, certain customers have consolidated product purchases, translating into large bulk orders for the Company's products. These customers, partly in response to discounting programs, tend to place these large bulk orders toward the end of a quarter for shipment of large quantities of hardware and software in the last month of the quarter. Although the Company will continue to strive to meet the demands of its customers, which include the delivery of quality products at an acceptable price and on acceptable terms, there can be no assurance that the Company will be successful in negotiating acceptable terms and conditions in customer purchase orders or customer purchase agreements. Additionally, efforts among the RBOC customers to consolidate their inventory and product procurement systems could cause fluctuations or delays in the Company's order patterns. Consolidation in the cable industry, as well as the adoption of industry standards to allow transponders to function among various status monitoring systems, could and have caused pricing pressure as competitors have begun lowering product pricing, which may adversely affect revenues from sales of the Company's cable products. Moreover, further evolution of cable industry standards could eliminate the need for some of the 20 Company's customers to purchase certain status monitoring equipment otherwise required for proprietary implementations, which could adversely affect revenues. Further, a recent court decision may lead the Company's cable customers to share their high-speed internet, or broadband, networks with competing internet service providers. Markets for the Company's cable products have been and may continue to be highly competitive and 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. International sales were approximately 2.6% of total revenues in the third quarter ended September 27, 2003. The Company believes that certain international markets may offer opportunities, however, the 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 are found internationally which do not exist in the Company's domestic markets. These factors, when combined, have made entrance into international markets 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. It has been determined that present MCU technology offers limited opportunities in certain international markets for competitive and technological reasons. The Company continues to actively pursue opportunities for its other products, including its LoopCare software and DigiTest hardware products in international markets. In order to fully pursue those opportunities, it will be necessary for the Company to either undertake research and development efforts to overcome technological barriers that exist in interfacing those products with existing international telecommunications services equipment or acquire such technology. The Cheetah cable products have a presence and acceptance in Europe and China and the Company intends to capitalize and expand upon that presence. Given these risks, there can be no assurance that continued efforts by the Company will be successful or that the Company will achieve significant international sales with any of its product lines. In addition, Lucent, while continuing to market its DSL services, has reduced its research and development efforts in this area, which could have an adverse effect on the Company's deployment of LoopCare internationally through the Lucent OEM channel. The Company's LoopCare OEM resale agreement with Lucent, which was scheduled to expire on September 30, 2003, has been extended through December 31, 2003 as renewal discussions continue. Although the Company expects to renew this agreement, there can be no guarantee that such agreement will be completed which could eliminate sales through this channel. Further, the international markets introduce the risk of loss from currency fluctuations. While the Company endeavors to price its products in U. S. dollars, this is not always possible and may be less so in the future. Many international customers are also small and undercapitalized which presents possible exposure to credit losses to a greater degree than has historically been seen from domestic customers. The Company believes that its future growth will continue to be affected by the economic slowdown in the telecommunications industry as established RBOC and large ILEC customers strive to further reduce their capital and operating expense budgets, which will directly impact RBOC and ILEC ordering patterns and quantities. The Company believes that its RBOC and ILEC customers have restricted their capital expenditure budgets in response to market conditions, such as the loss of local telephone subscriber lines to cable and wireless competitors, the after-effects of overspending in 1999 and 2000, indecision regarding long-term network architectures and the impact of Federal Communications Commission ("FCC") rule changes. In addition, sales of the Company's core MCU technology to these RBOC and ILEC customers largely depends on the rate of customer deployment of new and retrofitting Digital Loop Carrier ("DLC") systems. The rate of DLC deployment has declined from levels previously seen in the market. Further decline in DLC deployment or 21 saturation of existing domestic markets or portions thereof, could cause demand for the MCU products to decline going forward. Emerging technologies, such as the development of packet-based internet voice communication and the evolution in the cable industry toward industry-standardized technology, may also reduce the demand for the Company's current products. In addition, certain emerging carriers continue to be hampered by financial instability caused in large part by a lack of access to capital. Due to the effect of these adverse conditions, the Company will continue to evaluate its investments in production, marketing and research and development expenses and will monitor, control or decrease expense levels, as appropriate. The Company also believes that future growth will depend, in part, on its ability to design and engineer new products and, therefore, the Company incurs significant research and development costs. Research and development expenses as a percentage of revenues were approximately 24% in both the third quarter of 2003 and the third quarter of 2002. APPLICATION OF 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 critical 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 2002 Annual Report on Form 10-K filed on March 26, 2003 and in its Quarterly Reports on Form 10-Q for the periods ending March 29, 2003 and June 28, 2003 filed on May 13, 2003 and August 12, 2003, respectively. There were no significant changes in these policies or the application thereof during the third quarter of 2003. RESULTS OF OPERATIONS THE FOLLOWING DISCUSSION OF THE RESULTS OF OPERATIONS AND FINANCIAL CONDITION OF THE COMPANY SHOULD BE READ IN CONJUNCTION WITH THE RESPONSE TO PART I, ITEM 1 OF THIS REPORT THIRD QUARTER OF 2003 COMPARED TO THIRD QUARTER OF 2002 REVENUES The Company's Revenues for the third quarter of 2003 were $15,616,000, an increase of $1,664,000 or 11.9% over the revenues of $13,952,000 reported for the third quarter of 2002. The third quarter 2003 results include revenues for the Cheetah product line acquired on February 13, 2003. MCU product line revenues were $6,559,000 in the third quarter of 2003, an increase of $2,008,000 from revenues for the year earlier quarter of $4,551,000. While RBOC customers are continuing to restrain capital spending in traditional POTS line areas such as Digital Loop Carrier deployment, strength in the current quarter came primarily from increased sales to an RBOC under a remote measurement unit replacement program and to an original equipment manufacturer under targeted marketing programs. MCU sales comprised 42.0% of total third quarter 2003 revenues compared to 32.6% for the third quarter of 2002. MCU sales are expected to continue to account for a substantial portion of the Company's revenues for the foreseeable future. 22 Sales of the Company's DigiTest system products, which include LoopCare software, decreased 42.0% between quarterly periods. In the third quarter of 2002, DigiTest revenues benefited from a major centralized test head replacement program at an RBOC customer while no similar project was in progress in the third quarter of 2003. The 2003 quarter included sales to both RBOC and CLEC accounts for Loop Test System (LTS) modernization as well as initial DigiTest system sales to new CLEC customers. DigiTest product sales for the third quarter of 2003 were $2,433,000, a decrease of $1,760,000 from the year earlier quarter, and represented 15.6% of total revenue for the current quarter compared to 30.0% for the third quarter of 2002. The Company had no sales of LoopCare software products separate and unrelated to DigiTest system products during the third quarter of 2003, compared to revenues of $686,000 in the third quarter of 2002. LoopCare software enhancement revenue tends to be uneven from period to period due to the timing of feature availability, extended business case approval and customer budget constraints. The Company believes that the lack of LoopCare software sales in the present quarter is not necessarily reflective of a trend, but is attributable to the uneven nature of the software sales process. LoopCare software product sales comprised 4.9% of total revenues during the third quarter of 2002. Services revenues, which include installation oversight and project management services provided to RBOC and other customers and fees for LoopCare and Cheetah software maintenance, were approximately $3,086,000 in the third quarter of 2003, or 19.8% of total quarterly revenues compared to 19.4% for the prior year quarter. Services revenues increased $379,000 over the results of the third quarter of 2002 with revenue from CheetahNet software maintenance fees contributing $339,000 to this increase. LoopCare software maintenance also increased over the prior year period, substantially offset by a decrease of 29% in the Company's traditional testability improvement services. Overall sales of cable hardware and software products were $3,538,000 in the third quarter of 2003, an increase of $2,764,000 or 357.1% from the prior year's quarter. The new Cheetah line contributed $3,391,000 to the current quarter revenues. CheetahLight (formerly LIGHTHOUSE) product sales were $147,000 in the third quarter of 2003, a decrease of 81.0% from the $774,000 reported for the year earlier period. The decrease is largely attributable to uneven ordering patterns created by changes in procurement procedures related to the merger of Comcast and AT&T. Combined sales of cable status monitoring system products amounted to 22.6% of total third quarter 2003 revenue compared to 5.5% for the prior year quarter. The Company's acquisition of the Cheetah product line has given the Company a greater market share in this industry, and created additional product diversification, causing cable product revenues to encompass a greater share of total Company revenues. During the third quarter of 2002, the Company recognized sales of $977,000 or 7.0% of revenues from a major central office test system upgrade package delivery which included hardware resale and services and an additional 0.6% of sales came from other products. 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 RBOC customers, and are not necessarily indicative of long-term trends in sales of the Company's products. GROSS PROFIT Gross profit for the third quarters of 2003 and 2002 were $8,587,000 and $7,072,000, respectively, representing an increase of $1,515,000 or 21.4% from the results of the prior year's quarter and resulting primarily from additional sales volume related to the Cheetah products. Gross profit as a percentage of revenues increased to 55.0% in the third quarter of 2003 compared to 50.7% in the same quarter last year. The increase in gross profit as a percentage of sales resulted from a mix of factors. Valuation provisions in the third quarter of 2002 for 23 inventory were $625,000 higher than in the corresponding current year quarter. In addition, the third quarter of 2002 included $977,000 of revenues from a relatively low margin resale of third party hardware. Margin improvement in the third quarter of 2003 also resulted from $162,000 of reduced warranty costs. These factors more than offset the lack of higher margin LoopCare software revenue and the effect of the new Cheetah product sales that produce comparatively lower margins due to competitive CATV markets. The Company's gross margin is and will continue to be highly sensitive to the mix of products shipped, the level of operations and the level of reserves required for slow moving and obsolete inventory. SELLING AND MARKETING EXPENSE Selling and marketing expense for the third quarter of 2003 was $2,320,000 compared to $2,163,000 for the third quarter of 2002. The increase of $157,000 or 7.3% is due primarily to the inclusion of Cheetah expenses of $351,000 and higher test and evaluation expenses of $92,000, partially offset by lower salaries and wages of $170,000, and lower sales commissions of $117,000 in other parts of the business. As a percentage of revenues, selling and marketing expenses decreased from 15.5% in the third quarter of 2002 to 14.9% in the third quarter of 2003. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expense for the third quarter of 2003 was $1,665,000, an increase of $448,000 or 36.8% from the $1,217,000 recorded in the third quarter of 2002. The increase is attributable primarily to the addition of $272,000 of expenses related to the recently acquired Cheetah product line, including a related provision for bad debts of $187,000, as well as higher general business insurance and professional service costs. As a percentage of revenues, general and administrative expenses increased to 10.7% in the third quarter of 2003 from 8.7% in the third quarter of 2002. RESEARCH AND DEVELOPMENT EXPENSE Research and development expense in the third quarter of 2003 was $3,754,000, an increase of $383,000 or 11.4% from the $3,371,000 recorded in the third quarter of 2002. The increase resulted from the addition of Cheetah research and development expenses of $823,000, partially offset by estimated savings of $480,000 resulting from a general reduction in work force at the end of the third quarter of 2002. As a percentage of revenues, research and development expense decreased to 24.0% in the third quarter of 2003 from 24.2% in the year earlier quarter. INTEREST AND OTHER INCOME Interest and other income, composed primarily of interest income in both quarterly periods, was $76,000 in the third quarter of 2003 compared to $151,000 for the third quarter of 2002, representing a decrease of $75,000 or 49.7%. This decrease was the result of both the lower market yields on short-term interest bearing investments compared with the prior year quarter and fewer funds available for investment due to the acquisition of the Cheetah product line in February 2003. PROVISION FOR INCOME TAXES The provision for income taxes for the third quarter of 2003 was $351,000, an increase of $171,000 or 95.0% from the $180,000 recorded for the third quarter of 2002. The effective income tax rate for both periods was estimated at approximately 38% of pretax income. 24 NET INCOME AND EARNINGS PER SHARE As a result of the above factors, net income for the third quarter of 2003 was $573,000, an increase of $280,000 or 95.6% over the $293,000 recorded in the third quarter of 2002. Basic and diluted earnings per common share of $0.04 for the third quarter of 2003 were double the $0.02 earned in the third quarter of 2002. Basic and diluted weighted average common and common equivalent shares outstanding were 13,112,966 and 13,345,743, respectively, in the third quarter of 2003 compared to 13,090,936 and 13,216,502, respectively, in the third quarter of 2002. As a percentage of revenues, net income for the third quarter of 2003 increased to 3.7% from 2.1% for the third quarter of 2002. RESULTS OF OPERATIONS YEAR-TO-DATE NINE MONTHS ENDED SEPTEMBER 27, 2003 COMPARED TO NINE MONTHS ENDED SEPTEMBER 28, 2002 REVENUES For the first nine months of 2003, revenues were $47,293,000 compared to $46,058,000 for the same period of 2002, representing an increase of $1,235,000 or 2.7%. The third quarter 2003 results include revenues for the Cheetah product line that the Company acquired on February 13, 2003. Sales of the Company's MCU products were $17,407,000 in the current period, a decrease of $4,203,000 or 19.4% from sales of $21,610,000 in the same period of 2002. MCU product line revenues decreased in the first nine months of 2003 compared with the prior year period due to the continuing budget restrictions of the RBOCs and the effects from subscriber POTS line losses and reduced legacy DLC deployment and utilization. This reduced demand in the period was partially offset by increased MCU shipments to original equipment manufacturers of next generation DLC systems which are being utilized to facilitate DSL broadband rollout in the domestic RBOC market. MCU sales comprised 36.8% of total revenue for the first nine months of 2003 compared to 46.9% for the year earlier period. Sales of the Company's DigiTest system products, which include LoopCare system software, were $5,584,000, a decrease of $1,273,000 or 18.6% between nine-month periods due primarily to two factors, a reduction of DigiTest hardware sales to an RBOC customer that had completed a major test head replacement program in the 2002 period and due to a reduction in sales to Sprint Canada. Sales of DigiTest products represented 11.8% of total revenue for the first nine months of 2003 compared to 14.9% for the first nine months of 2002. Sales of LoopCare software products separate and unrelated to DigiTest system products were $2,699,000 in the first nine months of 2003, a reduction of $3,412,000 or 55.8% between the nine-month periods. Sales in 2003 were made primarily to two RBOC customers. In the first nine months of 2002, 66.9% of the Company's LoopCare revenues resulted from significant software enhancement sales to a third RBOC customer. LoopCare software enhancement revenue tends to be uneven from period to period due to the timing of feature availability, extended business case approval and customer budget constraints. LoopCare product software sales comprised 5.7% of total revenues during the first nine months of 2003 compared to 13.3% in the year earlier period. The Company's Services revenues for the first nine months of 2003 were $9,323,000, an increase of $1,471,000 or 18.7% over the similar period in 2002. The increase is due primarily to the inclusion of $823,000 from software maintenance related to the new Cheetah product line and increased LoopCare software maintenance of $613,000. Service revenues are derived primarily from RBOC customers and include installation oversight 25 and project management services. These revenues represented 19.7% of total revenue for the first nine months of 2003 compared to 17.0% in the year earlier period. Overall sales of CATV hardware and software products were $12,280,000, an increase of $9,846,000 or 404.5% from results of the first nine months of 2002. The new Cheetah line contributed $9,397,000 to this increase. CheetahLight (formerly LIGHTHOUSE) product sales were $2,883,000, an increase of 18.4% from the $2,434,000 reported for the year earlier period, primarily attributable to shipments to a new domestic customer in 2003. Combined sales of cable status monitoring system products amounted to 26.0% of total revenue for the first nine months of 2003 compared to 5.3% for the same period of 2002. During the first nine months of 2002, the Company recognized sales of $1,034,000 or 2.3% of revenues from a major central office test system upgrade package delivery which included hardware resale and services and an additional 0.3% of sales came from other products. GROSS PROFIT Gross profit for the first nine months of 2003 was $25,571,000 compared to $25,661,000 for the first nine months of 2002, representing a decrease of $90,000 or 0.4%. Gross profit as a percentage of revenues decreased to 54.1% in the first nine months of 2003, compared to 55.7% in the same period last year. The slight decline was caused mostly by lower sales of higher margin MCU and DigiTest hardware and LoopCare software, with such sales being substantially replaced by the addition of lower margin Cheetah and higher CheetahLight cable product sales. Other factors that negatively affected margins in the 2003 nine-month period were greater amortization expense of $798,000 associated with the Cheetah acquisition and higher provisions for warranty expense of $218,000. Partially offsetting these negative factors is reduced expense for slow moving and obsolete inventory of $1,815,000 in the first nine months of 2003 compared to the first nine months of 2002. The amortization expense related to the Cheetah acquisition included $540,000 of amortization of purchased sales order backlog, of which only $60,000 remains to be amortized at September 27, 2003. SELLING AND MARKETING EXPENSE Selling and marketing expense for the first nine months of 2003 was $6,711,000 compared to $6,805,000 for the first nine months of 2002. This decrease of $94,000 or 1.4% was attained despite the inclusion of $862,000 of expenses related to the acquired Cheetah product line. Cost reductions in other areas of the business resulted primarily from decreased salaries and wages of $621,000, reduced travel expenses of $251,000 and reduced commissions of $251,000 commissions, offset by higher test and evaluation expenses of $180,000. As a percentage of revenues, selling and marketing expenses decreased to 14.2% in the first nine months of 2003 from 14.8% in the same period of 2002. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expense for the first nine months of 2003 was $5,230,000, an increase of $1,219,000 or 30.4% from the $4,011,000 recorded in the first nine months of 2002. The increase is attributable primarily to the addition of $776,000 in expenses from the Cheetah product line, which includes a $530,000 provision for bad debts. Expenses also increased due to higher business insurance, incentive compensation and professional services costs. As a percentage of revenues, general and administrative expenses increased to 11.1% in the first nine months of 2003 from 8.7% in the same period of 2002. 26 RESEARCH AND DEVELOPMENT EXPENSE Research and development expense for the first nine months of 2003 was $10,982,000, an increase of $221,000 or 2.1%, from the $10,761,000 recorded in the first nine months of 2002. The overall increase includes $1,870,000 of additional expenses related to the acquired Cheetah product line, largely offset by an estimated decrease of $1,440,000 of expenses associated with a general reduction in work force at the end of the third quarter of 2002. As a percentage of revenues, research and development expense decreased to 23.2% in the first nine months of 2003 from 23.4% in the similar period of 2002. INTEREST AND OTHER INCOME Interest and other income is comprised primarily of interest income in both nine month periods. For the first nine months of 2003, interest and other income was $309,000 compared to $589,000 for the first nine months of 2002, a decrease of $280,000 or 47.5%. This decrease is the result of both lower market yields on short-term interest bearing investments compared with the prior year period and fewer funds available for investment due to the acquisition for cash of Cheetah in February 2003. PROVISION FOR INCOME TAXES The provision for income taxes for the first nine months of 2003 was $1,124,000, a decrease of $652,000 or 36.7% from the $1,776,000 recorded for the first nine months of 2002. The effective income tax rate for both periods was estimated at approximately 38% of pretax income. NET INCOME AND EARNINGS PER SHARE As a result of the above factors, net income for the first nine months of 2003 was $1,833,000, a decrease of $1,064,000 or 36.7% from the $2,897,000 recorded in the first nine months of 2002. Basic and diluted earnings per common share of $0.14 for the first nine months of 2003 decreased by $0.08 or 36.4% from the $0.22 earned in the first nine months of 2002. Basic and diluted weighted average common and common equivalent shares outstanding were 13,102,121 and 13,300,250, respectively, in the first nine months of 2003 compared to 13,096,496 and 13,340,724, respectively, in the first nine months of 2002. As a percentage of revenues, net income for the first nine months of 2003 decreased to 3.9% from 6.3% for the first nine months of 2002. CHEETAH ACQUISITION On February 13, 2003, the Company acquired certain assets and assumed certain liabilities of the Cheetah(TM) Status and Performance Monitoring Product Line from Acterna, LLC for approximately $14,300,000 in cash. The Company also capitalized acquisition related costs of approximately $599,000 for a total cost of approximately $14,899,000. In addition, as part of the agreement, contingent purchase consideration of up to $2,400,000 in the form of an earn-out may be payable based on certain 2003 performance targets for the acquired product line. The acquired assets consisted principally of existing sales order backlog, product inventory, intellectual property, software and related computer equipment, while the assumed liabilities principally related to deferred software maintenance, warranty and other obligations. The $14,300,000 due at closing and related acquisition expenses were paid from available cash and short-term investments. The Company believes that the acquired product line complements its current cable operations and positions the Company as a leading supplier of testing equipment and software for the cable industry. The acquisition was recorded under the purchase method of accounting and accordingly, the results of operations of the acquired product line from February 14, 2003 forward are included in the consolidated financial statements of the Company. The purchase price allocation will be finalized when all relevant amounts have been determined. An adjustment was made in the current quarter to reduce the estimated acquired warranty liability by $320,500 27 to $297,000 based upon experience to date. Adjustments will be made to the various assets acquired and liabilities assumed based on final valuations, and such adjustments may be material. LIQUIDITY AND CAPITAL RESOURCES The Company had working capital of $62,645,000 as of September 27, 2003, a decrease of $10,544,000 or 14.4%, from the $73,189,000 of working capital as of December 31, 2002. The decrease in working capital is primarily the result of the purchase of the Cheetah product line and related acquisition expenses for $14,899,000 in cash on February 13, 2003, partially offset by working capital generated from operations in excess of purchases of property and equipment. As of September 27, 2003, the Company had $45,579,000 of cash, cash equivalents and short-term investments that are unrestricted and available for corporate purposes, including acquisitions and other general working capital requirements. The Company has in place a five-year $25.0 million Unsecured Revolving Credit Facility (the "Facility") with a bank. Under the terms of the Facility, the proceeds must be used for general corporate purposes, working capital needs, and in connection with certain acquisitions. The Facility contains certain standard covenants with which the Company must comply, including a minimum fixed charge ratio, a minimum defined level of tangible net worth and a restriction on the amount of capital expenditures that can be made on an annual basis, among others. A maximum leverage ratio restricts total borrowings of the Company to approximately $17,550,000 during the fourth quarter of 2003. Commitment fees are payable quarterly at a rate of 0.25% of the unused commitment. The Facility was amended in February 2003 in connection with the acquisition of the Cheetah product line to adjust the determination of base net worth. As of September 27, 2003 and currently, there are no outstanding borrowings under the Facility, and the Company is in compliance with all debt covenants. Borrowings for working capital are not currently anticipated, as the Company believes its cash reserves and internally generated funds will be sufficient to sustain working capital requirements for the foreseeable future. The Company expects to incur capital expenditures totaling approximately $3,000,000 in 2003 including post-acquisition capital expenditures of $1,857,000 related to the acquired Cheetah product line. The Company's asset purchases include test fixtures and development systems, computer and office equipment as well as purchases of MIS/IT infrastructure and leasehold improvements for Cheetah. The Board of Directors has authorized the continuation of a share repurchase program initiated in 1997. Under the current extension, the Company may repurchase a total of one million shares of its common stock before December 31, 2003. The Company has repurchased 461,800 shares of common stock since the repurchase program was instituted. The repurchased shares are authorized for use under certain employee benefit programs. The Company at its discretion will determine the number of shares and the timing of such purchases, which will be made using existing cash and short-term investments. No such shares have been acquired in 2003. COMMITMENTS The Company leases office space and equipment under agreements that are accounted for as operating leases. The office lease for the Cheswick facility expires December 31, 2003 and is extended to December 31, 2005. The equipment leases expire in August 2005 for the Cheswick facility and January 2007 for the Bridgewater facility. On February 18, 2003, the Company entered into a lease for office space to house the Cheetah product line in Sarasota, Florida under a lease expiring on April 26, 2008. The Company is also involved in various month-to-month leases for research and development equipment. Minimum annual future rental commitments under non-cancelable leases as of September 27, 2003 are: 28 2003 (Three Months) $ 397,000 2004 1,594,000 2005 1,592,000 2006 860,000 2007 432,000 2008 (Nine Months) 102,000 KEY RATIOS The Company's days sales outstanding (DSO) in accounts receivable trade, based on the past twelve months rolling revenue, were 68 and 53 days as of September 27, 2003 and December 31, 2002, respectively. This increase is due primarily to the fact that a much higher percentage of total quarterly revenue was recorded in September of the third quarter of 2003 compared to December in the fourth quarter of 2002. The Company's inventory turnover ratio was 1.9 turns as of September 27, 2003 and 1.4 as of December 31, 2002. Management believes that operating cash flow and cash reserves are adequate to both finance currently planned capital expenditures and meet the overall liquidity needs of the Company. OFF-BALANCE SHEET ARRANGEMENTS The Company does not engage in transactions or arrangements with unconsolidated or other special purpose entities. BACKLOG The Company's backlog consists of firm customer purchase orders and signed software maintenance agreements. As of September 27, 2003, the Company had a backlog of $8,786,000, including approximately $6,545,000 related to software maintenance contracts, compared to $8,122,000 as of June 28, 2003 and $7,179,000 at December 31, 2002. The Company entered into extended term LoopCare software maintenance agreements in 2003 with two RBOC customers; one of which is for a term of three years expiring on December 31, 2005 and the second of which is for a term of one year and nine months expiring on December 31, 2004. The Company has adopted a policy to include a maximum of twelve months revenue from multi-year agreements in reported backlog. Software maintenance revenue is deemed earned and recognized as income on a straight-line basis over the terms of the underlying agreements. The Company expects that approximately 47% of current backlog will be recognized as revenue in the fourth quarter of 2003. 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. ACCOUNTING PRONOUNCEMENTS On August 15, 2001, the Financial Accounting Standards Board (FASB) issued Statement of Accounting Standard (SFAS) No. 143, "Accounting for Asset Retirement Obligations.". The Company adopted this statement on January 1, 2003 and such adoption did not have a material effect on the Company's financial statements. 29 In June 2002, the FASB issued SFAS No. 146, "Accounting For Costs Associated With Exit Or Disposal." SFAS No. 146 nullifies Emerging Issues Task Forces (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)." The new Statement requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. This statement did not have a material effect on the Company's financial position or results of operations. In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires that upon issuance of a guarantee, a guarantor must recognize a liability for the fair value of an obligation assumed under a guarantee. FIN 45 also requires additional disclosures by a guarantor in its interim and annual financial statements about the obligations associated with guarantees issued. The recognition provisions of FIN 45 are effective for any guarantees issued or modified after December 31, 2002. The provisions of FIN 45 did not have a material impact on the Company's results of operations or financial position. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." This Statement amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition to SFAS No. 123's fair value method of accounting for stock-based employee compensation. This Statement also amends the disclosure provisions of SFAS No. 123 and APB No. 28, Interim Financial Reporting, to require disclosure in the summary of significant accounting policies footnote in the financial statements of the effects of an entity's accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. The Company has elected to continue to follow the disclosure-only provisions of SFAS No. 123 and adopted the disclosure provisions of SFAS No. 148. On January 17, 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities - an interpretation of ARB No. 51" ("FIN 46"). FIN 46 clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements", to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Certain provisions of FIN 46 were effective for the Company after January 31, 2003 and did not have a material impact on the Company's results of operations or financial condition. On October 8, 2003, the FASB issued FASB Staff Position No. 46-e, which allows public entities, who meet certain criteria, to defer the effective date for applying the provisions of FIN 46 to interests held by the public entity in certain variable interest entities or potential variable interest entities created before February 1, 2003 until the end of the first interim or annual period ending after December 15, 2003. In April 2003, the FASB issued Statement No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging." This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement was effective for the Company after April 30, 2003 and did not have a material impact on the Company's results of operations or financial condition. In May 2003, the FASB issued Statement No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some 30 circumstances). This statement was effective for the Company after May 31, 2003 and did not have a material impact on the Company's results of operations or financial condition. The Company early adopted Emerging Issues Task Force (EITF) Issue 00-21, "Accounting for Revenue Arrangements with Multiple Deliverables," which applies to all deliverables within contractually binding arrangements that include multiple revenue-generating activities. This issue was finalized in May of 2003 and did not have a material impact on the Company's results of operations or financial condition. ITEM 3. 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 will not be materially affected by changes in interest rates, due to the nature and short-term investment horizon for which these securities are invested. ITEM 4. CONTROLS AND PROCEDURES The Chief Executive Officer and the Chief Financial Officer of the Company (its principal executive officer and principal financial officer, respectively) have concluded, based on their evaluation as of the end of the period covered by this report, that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports filed or submitted by it under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and include controls and procedures designed to ensure that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company's management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. There were no changes in the Company's internal control over financial reporting or in other factors during the period covered by this report that have materially affected or are likely to materially affect these controls. 31 PART II. OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS FILED 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 31.1 Rule 13a - 14(a) Certification of Chief Executive Officer, filed herewith 31.2 Rule 13a - 14(a) Certification of Chief Financial Officer, filed herewith 32 Rule 13a -14(b) Certifications of Chief Executive Officer and Chief Financial Officer, filed herewith (b) Reports on Form 8-K: 1. A Report on Form 8-K was filed on July 21, 2003 under Regulation FD, which contained as an exhibit the Company's Earnings Release for the second quarter 2003. 2. A report on Form 8-K was filed on August 4, 2003 under Regulation FD, which contained as an exhibit a shareholder presentation. 3. A report on Form 8-K was filed on August 28, 2003 under Regulation FD, which contained as an exhibit a shareholder presentation. 32 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TOLLGRADE COMMUNICATIONS, INC. (REGISTRANT) Dated: November 11, 2003 /S/ CHRISTIAN L. ALLISON ------------------------------------- CHRISTIAN L. ALLISON CHAIRMAN AND CHIEF EXECUTIVE OFFICER Dated: November 11, 2003 /S/ SAMUEL C. KNOCH ------------------------------------- SAMUEL C. KNOCH CHIEF FINANCIAL OFFICER AND TREASURER Dated: November 11, 2003 /S/ CHARLES J. SHEARER ------------------------------------- CHARLES J. SHEARER CONTROLLER 33 EXHIBIT INDEX (Pursuant to Item 601 of Regulation S-K) Exhibit Number Description ------- ----------- 15 Letter re unaudited interim financial information 31.1 Rule 13a - 14(a) Certification of Chief Executive Officer, filed herewith 31.2 Rule 13a - 14(a) Certification of Chief Financial Officer, filed herewith 32 Rule 13a - 14(b) Certifications of Chief Executive Officer and Chief Financial Officer, filed herewith 34 EX-15 3 j0390901exv15.txt EXHIBIT 15 EXHIBIT 15 November 11, 2003 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 October 15, 2003 on our review of interim financial information of Tollgrade Communications, Inc. and subsidiaries as of and for the three month period ended September 27, 2003 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 35 EX-31.1 4 j0390901exv31w1.txt EXHIBIT 31.1 Exhibit 31.1 Rule 13a - 14(a) CERTIFICATION OF CHIEF EXECUTIVE OFFICER I, Christian L. Allison, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Tollgrade Communications, Inc. 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 11, 2003 /s/ Christian L. Allison - ------------------------------- Name: Christian L. Allison Title: Chief Executive Officer 36 EX-31.2 5 j0390901exv31w2.txt EXHIBIT 31.2 Exhibit 31.2 Rule 13a - 14(a) CERTIFICATION OF CHIEF FINANCIAL OFFICER I, Samuel C. Knoch, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Tollgrade Communications, Inc. 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 11, 2003 /s/ Samuel C. Knoch - ------------------------------ Name: Samuel C. Knoch Title: Chief Financial Officer 37 EX-32 6 j0390901exv32.txt EXHIBIT 32 Exhibit 32 Rule 13a - 14(b) CERTIFICATIONS OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER Pursuant to 18 U.S.C. Section 1350, the undersigned officers of Tollgrade Communications, Inc. (the "Corporation"), hereby certify that the Corporation's Quarterly Report on Form 10-Q for the quarter ended September 27, 2003 (the "Report") fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Corporation. Dated: November 11, 2003 /s/ Christian L. Allison - --------------------------------- Name: Christian L. Allison Title: Chief Executive Officer /s/ Samuel C. Knoch - --------------------------------- Name: Samuel C. Knoch Title: Chief Financial Officer 38 -----END PRIVACY-ENHANCED MESSAGE-----