Tollgrade Communications, Inc. 10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)


þ		Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 24, 2005


o		Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from to

Commission file number 000-27312

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 No.)
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 þ No o

Indicate by check mark whether the Registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act).

Yes þ No o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No þ

As of September 30, 2005, there were 13,169,740 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.

PART I. FINANCIAL INFORMATION

Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

In Thousands (except per share amounts)(Unaudited)


	September			December
	24, 2005			31, 2004 *
ASSETS
Current assets:
Cash and cash equivalents	$	35,787		$	32,622
Short-term investments		21,526			18,537
Accounts receivable:
Trade, net of allowance for doubtful accounts of $464 in 2005 and $754 in 2004		13,299			10,691
Other		1,460			106
Inventory		10,279			12,941
Prepaid expenses and other current assets		957			2,543
Refundable income taxes		752			964
Deferred tax assets		1,198			1,143

Total current assets		85,258			79,547

Property and equipment, net		6,799			7,860
Deferred tax assets		205			176
Intangibles, net		45,001			45,108
Goodwill		18,682			19,340
Capitalized software costs, net		4,585			6,453
Receivable from officer		154			156
Other assets		153			194

Total assets	$	160,837		$	158,834

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	941		$	1,087
Accrued warranty		2,067			2,081
Accrued expenses		1,972			1,772
Accrued salaries and wages		444			718
Accrued royalties payable		225			414
Income taxes payable		179			168
Deferred income		2,108			2,462

Total current liabilities		7,936			8,702

Deferred tax liabilities		3,298			2,623

Total liabilities		11,234			11,325

Commitments and contingent liabilities		—			—
Shareholders’ equity:
Preferred stock, $1.00 par value; authorized shares 10,000,000; issued shares, -0- in 2005 and 2004		—			—
Common stock, $.20 par value; authorized shares, 50,000,000; issued shares, 13,631,540 in 2005 and13,622,940 in 2004		2,726			2,725
Additional paid-in capital		71,207			71,135
Treasury stock, at cost, 461,800 shares in 2005 and 2004		(4,791	)		(4,791	)
Retained earnings		80,461			78,440

Total shareholders’ equity		149,603			147,509

Total liabilities and shareholders’ equity	$	160,837		$	158,834


*		Amounts derived from audited financial statements

The accompanying notes are an integral part of the condensed consolidated financial statements.

TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)


	For the					For the
	Three Months Ended					Nine Months Ended
	September		September			September		September
	24, 2005		25, 2004			24, 2005		25, 2004
Revenues:
Products	$	13,573	$	10,358		$	38,411	$	37,080
Services		3,229		3,280			9,757		9,631

Total revenues:		16,802		13,638			48,168		46,711

Cost of product sales:
Products		5,987		4,556			18,211		16,836
Services		911		945			2,642		2,803
Amortization of intangibles		543		510			1,624		1,493
Impairment of acquired software		424		—			424		—

		7,865		6,011			22,901		21,132


Gross Profit:		8,937		7,627			25,267		25,579


Selling and marketing		1,918		2,198			6,594		7,053

General and administrative		1,911		1,849			5,640		5,445

Research and development		3,465		3,853			10,554		12,160

Severance		—		269			775		269


Total operating expenses		7,294		8,169			23,563		24,927


Income (loss) from operations		1,643		(542	)		1,704		652

Interest and other income, net		313		109			828		267


Income (loss) before income taxes		1,956		(433	)		2,532		919

Provision (benefit) for income taxes		372		(159	)		511		248


Net income (loss)	$	1,584	$	(274	)	$	2,021	$	671
Earnings (loss) per share information:
Weighted average shares of common stock and equivalents:
Basic		13,162		13,148			13,162		13,134
Diluted		13,221		13,148			13,202		13,263

Net income (loss) per common and common equivalent shares:
Basic	$	0.12	$	(0.02	)	$	0.15	$	0.05

Diluted	$	0.12	$	(0.02	)	$	0.15	$	0.05

The accompanying notes are an integral part of the condensed consolidated financial statements.

TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

For the Nine Months Ended September 24, 2005

In Thousands
(Unaudited)


									Additional
	Preferred Stock				Common Stock				Paid-In		Treasury			Retained
	Shares		Amount		Shares		Amount		Earnings		Stock			Earnings		Total
Balance at December 31, 2004		—	$	—		13,623	$	2,725	$	71,135	$	(4,791	)	$	78,440	$	147,509

Exercise of common stock options		—		—		9		1		64		—			—		65

Tax benefit from exercise of stock options		—		—		—		—		8		—			—		8

Net income		—		—		—		—		—		—			2,021		2,021

Balance at September 24, 2005		—	$	—		13,632	$	2,726	$	71,207	$	(4,791	)	$	80,461	$	149,603

The accompanying notes are an integral part of the condensed consolidated financial statements.

TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

In Thousands (Unaudited)


	Nine Months Ended
	September			September
	24, 2005			25, 2004
Cash flows from operating activities:
Net income	$	2,021		$	671
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,515			3,440
Tax benefit from exercise of stock options		8			65
Deferred income taxes		591			97
Provision for losses on inventory		237			37
Impairment of acquired software		424			—
Provision for allowance for doubtful accounts		80			(51	)
Changes in assets and liabilities:
(Increase) decrease in accounts receivable-trade		(2,688	)		17
(Increase) decrease in accounts receivable-other		(875	)		3
Decrease (increase) in inventory		2,425			(63	)
Decrease in prepaid expenses and other assets		1,629			74
Decrease (increase) in refundable taxes		212			(41	)
Decrease in accounts payable		(146	)		(372	)
Decrease in accrued warranty		(14	)		(122	)
Increase in accrued expenses and deferred income		25			519
Decrease in accrued royalties payable		(189	)		(192	)
Decrease in accrued salaries and wages		(274	)		(332	)
Increase in income taxes payable		11			51

Net cash provided by operating activities		6,992			3,801

Cash flows from investing activities:
Purchase of short-term investments		(15,479	)		(9,291	)
Redemption/maturity of short-term investments		12,490			7,481
Capital expenditures, including capitalized software		(903	)		(2,040	)
Investments in other assets		—			(715	)

Net cash used in investing activities		(3,892	)		(4,565	)

Cash flows from financing activities:
Proceeds from exercise of stock options		65			270

Net cash provided by financing activities		65			270

Net increase (decrease) in cash and cash equivalents		3,165			(494	)
Cash and cash equivalents at beginning of period		32,622			31,060

Cash and cash equivalents at end of period	$	35,787		$	30,566

The accompanying notes are an integral part of the condensed consolidated financial statements.

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 24, 2005 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, 2004. 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 statement 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 24, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.

With respect to the unaudited financial information of the Company for each of the three-month and nine-month periods ended September 24, 2005 and September 25, 2004, included in this Form 10-Q, PricewaterhouseCoopers LLP reported that they have applied limited procedures in accordance with professional standards for a review of such information. However, their separate report dated October 19, 2005 appearing herein, states that they did not audit and they do not express an opinion on that unaudited financial information. Accordingly, the degree of reliance on their report on such information should be restricted in light of the limited nature of the review procedures applied. PricewaterhouseCoopers LLP is not subject to the liability provisions of Section 11 of the Securities Act of 1933 (Act) for their report on the unaudited financial information because that report is not a “report” within the meaning of Sections 7 and 11 of the Act.

2. ACCOUNTING FOR STOCK-BASED COMPENSATION

The Company has two stock-based employee compensation plans. The Company accounts for stock-based awards to employees and directors using the intrinsic value method of accounting in accordance with Accounting Principles Board (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 Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” net income (loss) and earnings (loss) per share would have reflected the pro forma amounts indicated below:


	Three Months Ended					Nine Months Ended
	(In Thousands)					(In Thousands)
	September		September			September		September
	24, 2005		25, 2004			24, 2005		25, 2004
Net income (loss), as reported	$	1,584	$	(274	)	$	2,021	$	671

Deduct: Total stock-based compensation expense based on the fair value method for all awards, net of related tax effects		73		50			81		243


Pro forma net income (loss)	$	1,511	$	(324	)	$	1,940	$	428


	Three Months Ended					Nine Months Ended
	(In Thousands)					(In Thousands)
	September		September			September		September
	24, 2005		25, 2004			24, 2005		25, 2004
Earnings (loss) per share:
Basic – as reported	$	0.12	$	(0.02	)	$	0.15	$	0.05
Basic – pro forma	$	0.11	$	(0.02	)	$	0.15	$	0.03

Diluted – as reported	$	0.12	$	(0.02	)	$	0.15	$	0.05
Diluted – pro forma	$	0.11	$	(0.02	)	$	0.15	$	0.03

3. ACQUISITION

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 $14.3 million in cash. In addition, acquisition-related costs of approximately $0.6 million were capitalized for a total cost of approximately $14.9 million. The transaction provided for an earn-out to be paid in the first half of 2004 of up to $2.4 million based on certain 2003 performance targets. On September 21, 2005, Tollgrade settled the earn-out payment and calculation of the final purchase price with Acterna. Among other matters, this settlement resulted in Tollgrade receiving a subsequent cash payment from Acterna on September 26, 2005 in the amount of $0.5 million. As a result of this settlement, Tollgrade adjusted the goodwill associated with this transaction by $0.7 million. This adjustment reflects the cash subsequently received and settlement of certain obligations Tollgrade had with Acterna.

4. INTANGIBLE ASSETS

The following information is provided regarding the Company’s intangible assets and goodwill:


	As of September 24, 2005						As of December 31, 2004
	(In Thousands)						(In Thousands)
	Gross						Gross
	Carrying				Accumulated		Carrying		Accumulated
	Amount		Impairment		Amortization		Amount		Amortization
Amortized intangible assets:

Cheetah sales order backlog, included in inventory	$	543	$	—	$	543	$	543	$	543
Exclusivity agreement		715		—		214		715		107

Total Amortized Intangibles	$	1,258	$	—	$	757	$	1,258	$	650


Non-amortized intangible assets:
LoopCare trade name	$	1,300	$	—	$	—	$	1,300	$	—
Base software — LoopCare		5,200		—		—		5,200		—
Post warranty maintenance service agreements		32,000		—		—		32,000		—
Customer Base — Cheetah		5,000		—		—		5,000		—
Cheetah Trademark		1,000		—		—		1,000		—

Total Non-Amortized Intangibles	$	44,500	$	—	$	—	$	44,500	$	—

Total Intangibles	$	45,758	$	—	$	757	$	45,758	$	650


Capitalized software:
Developed product software	$	7,664	$	—	$	5,961	$	7,591	$	4,817
Base software — Cheetah		2,900		—		773		2,900		556
Proprietary technology		1,000		—		267		1,000		192
Acquired software		538		424		92		538		11

Total capitalized software (long term)	$	12,102	$	424	$	7,093	$	12,029	$	5,576


Goodwill	$	18,682	$	—	$	—	$	19,340	$	—

During the third quarter of 2005, we recorded an impairment charge of $0.4 million related to software acquired in 2004 that no longer is considered a part of the Company’s product strategy going forward.

Estimated amortization expense for the years ended (in thousands):


2005 (Remaining 3 months)	$	522
2006	$	1,717
2007	$	602
2008	$	582
2009	$	455
Thereafter	$	1,208

5. INVENTORY

At September 24, 2005 and December 31, 2004, inventory consisted of the following (in thousands):


	September			December
	24, 2005			31, 2004
Raw materials	$	5,848		$	7,631
Work in process		4,069			4,442
Finished goods		2,019			2,288

		11,936			14,361
Reserve for slow moving and obsolete inventory		(1,657	)		(1,420	)

	$	10,279		$	12,941

6. SHORT-TERM INVESTMENTS

Short-term investments at September 24, 2005 and December 31, 2004 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 intent and ability to hold the securities to maturity.

The estimated fair values of the Company’s financial instruments are as follows (in thousands):


	September 24, 2005				December 31, 2004
	Carrying				Carrying
	Amount		Fair Value		Amount		Fair Value
Financial assets:
Cash and cash equivalents	$	35,787	$	35,787	$	32,622	$	32,622
Short-term investments		21,526		21,527		18,537		18,538

	$	57,313	$	57,314	$	51,159	$	51,160

7. RETIREMENT EXPENSE

On January 17, 2005, the Company entered into an Agreement with Christian L. Allison, the Company’s former Chief Executive Officer and former member of the Board of the Company (the “Agreement”). Under the terms of the Agreement, Mr. Allison resigned effective as of January 18, 2005 (the “Retirement Date”), as director and executive officer of the Company and any and all other positions he held with the Company or its subsidiaries or other affiliates.

Mr. Allison received the following separation payments: (a) an amount equal to the sum of (i) Mr. Allison’s base salary through the Retirement Date to the extent not then paid and (ii) any vacation pay and other cash entitlements accrued by Mr. Allison as of the Retirement Date to the extent not then paid; (b) two times his contractual base salary of $0.3 million for a total of $0.6 million; and (c) a lump sum payment of $75,000. The Company agreed to pay all premiums on behalf of Mr. Allison to continue medical insurance for his immediate family through the second anniversary of the Retirement Date. Additionally, the Company has agreed to continue to indemnify, to the fullest extent permitted by applicable law, and to provide directors’ and officers’ liability insurance, if available in the director’s and officer’s liability insurance market, through the sixth anniversary of the Retirement Date, for Mr. Allison’s actions taken or omissions occurring at or prior to the Retirement Date. The Company also agreed to pay up to $50,000 of the reasonable fees and expenses of Mr. Allison’s legal counsel incurred in connection with the negotiation and execution of the Agreement. The

Company recorded a total charge in the first quarter of 2005 related to Mr. Allison’s retirement of approximately $0.8 million.

Mr. Allison also will be entitled to receive any vested benefits payable to him under the terms of any employee benefit plan or program of the Company in accordance with the terms of such plan or program. Under the terms of the Agreement and the Company’s 1995 Long-Term Incentive Compensation Plan (as amended through January 24, 2002), all options to acquire shares of the Company’s common stock held by Mr. Allison were fully vested prior to the Retirement Date and will remain exercisable by Mr. Allison for at least one year following the Retirement Date.

8. COST ALIGNMENT

On July 8, 2004 and July 21, 2004, the Company announced a cost alignment program which eliminated, in two phases, approximately 50 positions. The majority of the reductions impacted the research and development, manufacturing, and related overhead areas of the Company. The cost alignment initiative resulted in a pre-tax severance expense of $0.3 million. All costs associated with the program were incurred and paid during the quarter ended September 25, 2004. Therefore, no remaining obligations exist at the end of the third quarter of 2005.

9. PER SHARE INFORMATION

Net income (loss) per share has been computed in accordance with the provisions of SFAS No. 128, “Earnings Per Share” for all periods presented. SFAS No. 128 requires companies with complex capital structures to report earnings per share on a basic and diluted basis. Basic earnings per share is computed using the weighted average number of shares outstanding during the period, while diluted earnings per share is calculated to reflect the potential dilution that occurs related to issuance of capital stock option grants. The three months ended September 25, 2004 do not include the effect of dilutive securities due to the net loss which would make those securities anti-dilutive to the earnings per share calculation. The difference between basic and diluted earnings per share relates solely to the effect of capital stock options.

A reconciliation of earnings (loss) per share is as follows (in thousands):


	Three Months Ended					Nine Months Ended
	September		September			September		September
	24, 2005		25, 2004			24, 2005		25, 2004

Net income (loss)	$	1,584	$	(274	)	$	2,021	$	671


Common and common equivalent shares:
Weighted average common shares outstanding		13,162		13,148			13,162		13,134

Effect of dilutive securities — stock options		59		—			40		129

		13,221		13,148			13,202		13,263


Earnings (loss) per share:

Basic	$	0.12	$	(0.02	)	$	0.15	$	0.05

Diluted	$	0.12	$	(0.02	)	$	0.15	$	0.05

Unexercised stock options to purchase our capital stock of 1.2 million and 1.3 million shares for the three months ended September 24, 2005 and September 25, 2004, respectively, and 1.3 million shares and 1.1 million shares for the nine months ended September 24, 2005 and September 25, 2004, respectively, are not included in

the computation of diluted earnings per share because the option exercise price for these shares was greater than the average market price.

10. RECEIVABLE FROM OFFICER

The Company extended a loan for $0.2 million under a promissory note to an officer of the Company in July 2001. The note provides for interest at 5% per annum with repayment under various conditions but no later than May 20, 2008. The loan is secured by 40,200 shares of common stock of Acterna, LLC as collateral, which currently have no value.

11. PRODUCT WARRANTY

The Company records estimated warranty costs on the accrual basis of accounting. These reserves are based on applying historical returns to the current level of product shipments and the cost experience associated therewith. The nine-months ended September 24, 2005 includes a reduction of certain warranty reserves of approximately $0.2 million. In the case of software, the reserves are based on the expected cost of providing services within the agreed-upon warranty period.

Activity in the warranty accrual is as follows (in thousands):


	Nine Months Ended			Year Ended
	September 24, 2005			December 31, 2004
Balance at the beginning of the period	$	2,081		$	2,150

Accruals for warranties issued during the period		1,042			1,435

Settlements during the period		(1,056	)		(1,504	)


Balance at the end of the period	$	2,067		$	2,081

12. CONTINGENCIES AND COMMITMENTS

The Company is, from time to time, party to various legal claims and disputes, either asserted or unasserted, which arise in the ordinary course of business. While the final resolution of these matters cannot be predicted with certainty, the Company does not believe that the outcome of any of these claims will have a material adverse effect on the Company’s consolidated financial position, or annual results of operations or cash flow.

13. MAJOR CUSTOMERS

The Company’s primary customers for its telecommunications products and services are the four Regional Bell Operating Companies (RBOCs), certain major independent telephone companies and several digital loop carrier (“DLC”) equipment manufacturers. Of these major customer groups, the RBOCs are the most significant; for the third quarter ended September 24, 2005, sales to the RBOCs accounted for approximately 35.0% of the Company’s total revenue, compared to approximately 56.4% of total revenue for the third quarter of 2004. Sales to one of the four RBOC customers individually exceeded 10% of the Company’s total revenue and comprised 20.3% of the Company’s total revenue for the third quarter of 2005. Additionally, during the quarter ended September 24, 2005, we had sales to one telecommunications Original Equipment Manufacturer (“OEM”) that

exceeded 10% of the third quarter sales. Total sales to the two customers that individually exceeded 10% of the third quarter sales were $7.2 million, or 42.9% of third quarter, 2005 revenues.

14. INTERNATIONAL SALES

International sales represented approximately $5.7 million or 34.0% of the Company’s total revenue for the quarter ended September 24, 2005, compared to $1.1 million, or 8.4%, in the September 25, 2004 quarter. Our international sales are primarily in three geographic areas: the Americas (excluding the United States); Europe, the Middle East and Africa (EMEA); and Asia. Sales for the Americas were approximately $1.0 million, sales for EMEA were $4.5 million and sales in Asia were $0.2 million.

15. GOODWILL

Statement of Financial Accounting Standards No. 142 (“SFAS 142”) requires goodwill and intangible assets with indefinite lives to be measured for potential impairment at least annually. In connection therewith, and upon the adoption of SFAS 142 in 2001, the Company selected December 31 as our annual measurement date.

We have determined that we only have one reporting unit and test goodwill for potential impairment by comparing the estimated fair value of the Company’s equity using the average stock price over a 12 month period with our book carrying value. Our last required measurement date was December 31, 2004, at which time our analysis of the fair value of equity reflected no potential impairment of goodwill as our estimate of the fair value of our equity exceeded the book carrying value.

Interim measurements for potential impairment are required by SFAS 142 if certain events or changes in business conditions would indicate a permanent decline in the fair value of the Company’s equity. Since December 31, 2004, although the estimated fair value of our equity, using our share prices, has fluctuated significantly, there have been no events which have occurred that the Company believes would warrant an interim review for potential impairment of goodwill. Unless such an event would occur between now and our year-end, we intend to test goodwill for potential impairment at December 31, 2005, utilizing estimates of fair value of our equity. Upon that review, if the Company does not have supporting evidence to indicate that the fair value of our equity exceeds its book carrying value, we could be required to take an impairment charge against goodwill.

On September 21, 2005, Tollgrade settled the earn-out payment and calculation of the final purchase price with Acterna. Among other matters, this settlement resulted in Tollgrade receiving a cash payment from Acterna on September 26, 2005 in the amount of $0.5 million. As a result of this settlement, Tollgrade adjusted the goodwill associated with this transaction by $0.7 million. This adjustment reflects the cash received and settlement of certain obligations Tollgrade had with Acterna.

16. INCOME TAXES

The Company follows the provisions of SFAS No. 109, “Accounting for Income Taxes.” Under SFAS No. 109, deferred tax liabilities and assets are determined based on the “temporary differences” between the financial statement carrying amounts and the tax basis of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. We continue to generate deferred tax assets that we believe will be used in the future. This utilization is dependant on the Company’s ability to generate sufficient taxable income in future periods. Should future operating levels decline to a point not sufficient to support such utilization, these assets may not be realizable and, thus, could be subject to a valuation allowance. The Company’s effective tax rate for the three- and nine-month periods was affected by the proportional impact of certain permanent items on the calculation, including those created by tax-exempt interest and international sales.

17. ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123(R), “Shared-Based Payment”. Statement 123(R) requires the measurement of all employee stock-based compensation awards using a fair value method as of the date of the grant and recording such expense in the consolidated financial statements. In addition, the adoption of Statement 123(R) will require additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from share-based payment arrangements. In April of 2005, the SEC approved a rule that delayed the effective date of FASB Statement No. 123(R). Statement 123(R) is now effective for public companies for annual periods that begin after June 15, 2005. Currently, the charge that would result in applying Statement 123(R) would not be material to the Company. See Note 2 to the financial statements.

In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151 (“SFAS 151”), “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” This statement amends the guidance in ARB No. 43 Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that “...under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal to require treatment as a current period charges...” This statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this statement will be effective for inventory costs during the fiscal years beginning after June 15, 2005. We do not believe that the adoption of this statement will have a material impact on its financial condition or results of operations.

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders
of Tollgrade Communications, Inc.:

We have reviewed the accompanying condensed consolidated balance sheet of Tollgrade Communications, Inc. as of September 24, 2005 and the related condensed consolidated statements of income for each of the three-month and nine-month periods ended September 24, 2005 and September 25, 2004 and changes in shareholders’ equity for the nine-month period ended September 24, 2005 and the condensed consolidated statements of cash flows for the nine month periods ended September 24, 2005 and September 25, 2004. These interim financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), 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 have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2004, and the related consolidated statement of operations, of changes in shareholders’ equity, and of cash flows for the year then ended, management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004 and the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004 (not presented herein); and in our report dated March 2, 2005, we expressed unqualified opinions thereon. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2004 is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.

PricewaterhouseCoopers LLP
Pittsburgh, Pennsylvania
October 19, 2005

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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, (a) the significant portion of our revenues generated from MCU® sales and the expected consequences of the maturation of this market; (b) the opportunities developing in the cable broadband market and the Company’s plans for the development of new cable products, circumstances surrounding our LoopCare™ sales; (c) possible future charges to income as a result of goodwill impairment or asset impairment or other matters; (d) the potential revenue opportunities under our contract for deployment of products in Saudi Arabia and South Africa; (e) the results of the Company’s efforts to obtain certain product certifications and the effect of such results on future sales; (f) the maturation of our legacy cable products and the lower expected margins for our cable products resulting from increased sales of our DOCSIS® certified transponders; (g) certain cost alignment initiatives; (h) projected cash flows which are used in the valuation of intangible assets; (i) the anticipated results of negotiations for our remaining RBOC maintenance agreement and the accounting treatment of fees arising thereunder; (j) changes in our backlog and the amount of backlog that may be recognized as revenue in future periods; (k) the Company’s anticipated short-term borrowings and expected 2005 capital expenditures; (l) the ability to utilize deferred and refundable tax assets; (m) opportunities which the Services group offers to customers; (n) the potential loss of certain customers; (o) the timing of orders from customers; (p) the effect of consolidations in the markets to which we sell; (q) the effects of the economic slowdown in the telecommunications and cable industries; (r) the possibility of future provisions for slow moving and obsolete inventory; and (s) 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. 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 factors described below 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.

OVERVIEW

About the Company

Tollgrade Communications, Inc. (the “Company”) was organized in 1986, began operations in 1988 and completed its initial public offering in 1995.

The Company is a leading provider of hardware and software network assurance testing solutions for the telecommunications and cable broadband industries. We design, engineer, market and support test and management systems which enable telephone and cable operators to efficiently manage their networks in an age of increased competition, continually evolving technology and ongoing pressure to control or reduce costs.

We provide equipment that enables telephone companies to remotely qualify, verify provisioning and isolate troubles for “Plain Old Telephone Service” (“POTS”) lines and broadband local access networks. When these networks are not functioning properly, our products help to isolate the problem to the customer’s premises, local copper and fiber network, central office and/or core data network segments. In doing so, our solutions add value to our customers by improving mean-time-to-repair and technician dispatch efficiency. In addition, our products help telephone companies assess whether existing POTS lines are suitable for Digital Subscriber Line (DSL) service for the delivery of Internet and other broadband services, such as IP Voice and Video.

For broadband cable networks, the outside plant segment of the network is a hybrid of fiber and coaxial facilities which is highly dependent upon standby power for network reliability. If commercial power fails, such standby power supplies must sustain the network, or services such as video, data and voice become inoperable. We provide products to cable companies that monitor the status of those standby power supplies and associated fiber nodes, thereby enabling cable operators to proactively isolate network troubles among customer premises, coaxial, fiber and Hub office network segments. As cable operators expand their current broadband service offerings to include IP Voice, our solutions can be upgraded to enable the remote isolation of DOCSIS®, Internet and IP Voice troubles among those same network segments. Similarly, our solutions also add value to our cable customers by improving mean-time-to-repair and technician dispatch efficiency.

About its customers

The Company’s primary customers for its telecommunications products and services are the four Regional Bell Operating Companies (RBOCs), certain major independent telephone companies and several digital loop carrier (“DLC”) equipment manufacturers. Of these major customer groups, the RBOCs are the most significant; for the third quarter ended September 24, 2005, sales to the RBOCs accounted for approximately 35.0% of the Company’s total revenue, compared to approximately 56.4% of total revenue for the third quarter of 2004. Sales to one of the four RBOC customers accounted for approximately 20.3% of the Company’s revenue and individually exceeded 10% of the Company’s total revenue for the third quarter of 2005. In addition to this RBOC customer, we had sales to one telecommunications Original Equipment Manufacturer (“OEM”) that exceeded 10% of third quarter sales. Total sales to the two customers that individually exceeded 10% of third quarter sales were $7.2 million or 42.9% The Company is and will continue to be highly dependent on the four RBOCs for a significant portion of its total revenue. Such dependency has generally declined in recent years due to changes in the

Company’s product sales mix away from our legacy MCU products over to our DigiTest® and cable hardware and software products. Contributing to this shift during 2005 were expanded sales of the Company’s LoopCare and DigiTest®/DigiTest EDGE® test system to international customers in addition to non-RBOC independent local exchange carriers (“LECs”).

The Company’s cable products are sold to a customer base which ranges from small cable operators to certain of the largest cable equipment manufacturers and cable operators in the world. No sales to any one cable customer exceeded 10% of the third quarter 2005 revenue.

PRODUCTS

TELECOMMUNICATION TEST SYSTEMS

Our proprietary telecommunications test and measurement products enable the 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 as well as qualify and troubleshoot problems on broadband DSL lines. POTS lines provide traditional voice service as well as connections for popular communication devices such as computer modems and fax machines. POTS excludes non-switched and private lines, such as data communications service lines, commonly referred to as “special services.” POTS lines still comprise the vast majority of lines in service today throughout the world. The Company also sells LoopCare and DigiTest to carriers that do not yet have POTS and DSL test systems, as well as those seeking to replace older generation test systems. The objective is for the carrier to eliminate false dispatches while providing high quality troubleshooting of problems for its subscribers.

DigiTest and LoopCare

Our DigiTest system electrically measures the characteristics of a copper telephone circuit and reports those measurements to our LoopCare Operation Support System (OSS). The LoopCare OSS, in turn, analyzes that measurement data and creates an easy-to-understand fault description. At the same time, the LoopCare system can generate a dispatch to a work center so that a repairman can fix the problem. LoopCare and DigiTest also can determine whether the customer line is suitable for DSL services. DigiTest can also serve as a replacement for aging Loop Test Systems (LTS) equipment ubiquitously deployed in current POTS networks. In addition, upgrades to DigiTest hardware can provide troubleshooting for DSL service problems.

LoopCare is the major incumbent OSS utilized by the RBOCs for over twenty-five years to test the integrity and quality of their POTS network infrastructure. The LoopCare OSS, which we offer both as part of the DigiTest system and as a stand-alone software product that can interface with certain other test heads on the market, currently manages testing operations for more than 75% of the copper pairs in the United States, and is the qualification, installation and maintenance tool used to troubleshoot more than 150 million POTS, ISDN and DSL subscribers worldwide.

The DigiTest system includes direct Ethernet connectivity to Digital Measurement Node (DMN) test heads and our next generation broadband test platform, DigiTest EDGE®. Through Ethernet connections, the LoopCare OSS can communicate directly with remotely deployed DigiTest hardware, allowing it to manage up to four DMNs and eight simultaneous test sessions through a single Internet Protocol (IP) address. DigiTest EDGE provides a global platform for broadband test applications, by combining a narrowband and wideband metallic testing platform with DSL, Asynchronous Transfer Mode (ATM), IP and Hypertext Transfer Protocol (HTTP) performance tests. In 2004, we announced a new LoopCare feature and new DigiTest hardware that uses innovative insertion loss measures to provide a customer

with highly accurate predictions of potential DSL Connection Speed. These test capabilities, when managed by our LoopCare OSS, enable service providers to accurately isolate a DSL problem between the customer’s premises, the local exchange carrier’s local loop and Digital Subscriber Line Access Multiplexer (DSLAM) serving network, and the Internet service provider’s data network.

In addition to the LoopCare OSS software sold as part of the DigiTest system, we also sell new LoopCare features to existing customers and the base LoopCare OSS as a stand-alone product to LECs for use with test heads other than our DigiTest hardware. LoopCare feature products include:

	•		the Common Object Request Broker Architecture (CORBA)-based Application Programming Interface;

	•		Benchmark Data Base;

	•		DSL Testing;

	•		the Advanced Testhead Feature Package;

	•		Batch Testing;

	•		Fax Unalert;

	•		Loop Length Reporting;

	•		Enabling Flow Through by Re-Classification of VER 55-58 Codes;

	•		LoopCare TCP/IP Communications Network; and

	•		Testing Voice Services in a Broadband Passive Optical Network (bPON).

MCU

Our core MCU products plug into DLC systems, the large network transmission systems used by telephone companies to link the copper and fiber-optic portions of the local loop. MCU products allow our customers to extend their line testing capabilities to all of their POTS lines served by a DLC system regardless of whether the system is fed by a copper or fiber optic link. DLC systems, which are located at telephone companies’ central offices and at remote sites within local user areas, effectively multiplex the services of a single fiber-optic line into multiple copper lines. In many instances, several DLC systems are located at a single remote site to create multiple local loops that serve several thousand different end-user homes and businesses. Generally, for every DLC remote site, customers will deploy at least two MCU line-testing products.

CABLE TESTING PRODUCTS

The Company’s Cheetah™ performance and status monitoring products provide a broad network assurance solution for the Broadband Hybrid Fiber Coax (HFC) distribution system found in the cable television industry. Our Cheetah products gather status information and report on critical components within the cable network. The Company’s monitoring systems include complete hardware and software solutions that enable efficient HFC plant status monitoring. By providing a constant, proactive view of the health and status of outside plant transmission systems, the products can reduce operating costs and increase subscriber satisfaction.

Our direct sales cable offerings currently consist of our CheetahLight™ (formerly LIGHTHOUSE®) and CheetahNet™ (formerly NetMentor™) software systems and maintenance, head-end controllers, return path switch hardware, transponders and other equipment which gather status and performance reports from power supplies, line amplifiers and fiber optic nodes. In addition, we manufacture and sell, primarily on an OEM basis, transponders which meet the DOCSIS® standards, allowing customers the flexibility to utilize those transponders in either our proprietary monitoring systems or those offered by other vendors. In the second quarter of 2005, the Company also introduced Cheetah XD™, the Company’s new

broadband assurance software, which provides cross domain fault and performance tools for DOCSIS-based network management.

Cable television service providers continue to evolve their offerings from traditional one-way video delivery to bi-directional services, including the communications “triple play” of voice, video and data service. The Company is currently engaged in research and development efforts for network assurance products that address quality problems related to these advanced services. During 2004, we introduced our DOCSIS certified transponders which can provide internet protocol (IP) band monitoring. The Company intends to leverage its experience in delivering network assurance technologies to telecom providers by developing more advanced performance management solutions for once-traditional cable suppliers. The Company is actively engaged in research and development of Voice Over Internet Protocol (VoIP) solutions, as well as data network integrity technologies. As part of this strategy, we have entered into certain third party license agreements to augment our next generation technology, including VoIP technology.

SERVICES

Our Services offerings include software maintenance as well as our professional services, which are designed to assist our customers in ensuring the proper operation of all of the components of their voice test systems. The scope of our Services business was considerably expanded upon the acquisition of software maintenance relationships related to the LoopCare and CheetahNet software product lines. Offsetting this expansion, however, is a trend toward a decrease in the demand for our professional services caused by a decline in our RBOC customers’ capital investment in their traditional voice services, which tends to drive the professional services. Furthermore, the timing of the extension renewal of certain of the more significant software maintenance agreements can have a major impact on the Company’s services revenue on any particular fiscal quarter or year.

BACKLOG

Our backlog consists of firm customer purchase orders and signed software maintenance agreements. As of September 24, 2005, the Company had backlog of approximately $12.3 million compared to $14.7 million as of December 31, 2004 and $8.1 million as of September 25, 2004. The backlog at September 24, 2005 and December 31, 2004 includes approximately $5.1 million and $5.5 million, respectively, related to software maintenance contracts, which are earned and recognized as income on a straight-line basis during the remaining term of the underlying agreements. The Company’s policy is to include a maximum of twelve months revenue from multi-year maintenance agreements in reported backlog. As of September 24, 2005, the Company had executed LoopCare software maintenance agreements with two of the four RBOCs that extend those agreements beyond 2005. One of these agreements expires in December 2006, the other agreement was still being negotiated during the second quarter of 2005 and has since been extended for a three-year term expiring in December, 2007. The decrease in backlog from December 31, 2004 is primarily related to the completion of significant milestones of certain large projects as well as the two RBOC software maintenance agreements that expire at December 31, 2005. Negotiations with these two RBOCs to extend the terms of their agreements are proceeding.

Management expects that approximately 56% of the current backlog will be recognized as revenue in the fourth quarter of 2005. 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. Although these fluctuations could affect short-term results, they are not necessarily indicative of long-term trends in sales of our products.

REPORTING SEGMENT

We have determined that our business has one reporting unit and one operating segment, 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 we internally develop historical sales information associated with the various product categories, this information is not considered to be sufficient for segment reporting purposes as only sales data is accumulated and provided to the Chief Operating Decision Maker. Our products and services have similar economic characteristics and the same or similar production processes, and are sold through similar distribution channels and means to similar types and classes of customers already in, or entering into, the telecommunications and cable businesses.

INTERNATIONAL SALES

International sales represented approximately $5.7 million, or 34.0%, of the Company’s total revenue for the quarter ended September 24, 2005, compared to $1.1 million, or 8.4%, in the quarter ended September 25, 2004. Our international sales are primarily in three geographic areas: the Americas (excluding the United States); Europe, the Middle East and Africa (EMEA); and Asia. Sales for the Americas were approximately $1.0 million, sales for EMEA were $4.5 million and sales in Asia were $0.2 million. Although our international sales have increased year over year, and our marketing activity in international markets has expanded, our historical success in marketing and selling our telecommunications products in international markets has not equaled our success in domestic markets, due in part to incompatibility of certain of our telecommunications products with networks deployed abroad. We continue to evaluate opportunities in the international market that will enhance our international presence and growth. Through our original equipment manufacturer (OEM) relationship with Lucent, our LoopCare products have been sold internationally in conjunction with purchases of Lucent hardware. Of particular note is our recent success with Lucent Technologies International (LTI) in bidding and obtaining an agreement with the Saudi Telecom Company (STC) in Saudi Arabia to sell the Company’s broadband offerings in addition to LoopCare software customization and an operating platform update effort. In a similar vein, we bid on, and obtained, an agreement with our reseller, Telesciences, to sell our broadband offerings to Telkom South Africa. However, these are both complex and uncertain projects and require the support of a number of parties which can affect progress throughout the term of the projects, and there can be no assurance that either project will provide a significant revenue contribution in any particular fiscal quarter.

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 2004 Annual Report on Form 10-K filed on March 3, 2005. Management believes the Company’s critical accounting policies are those related to Staff Accounting Bulletin (SAB 104), “Revenue Recognition”; AICPA’s Statement of Position (SOP) 97-2 “ Software Revenue Recognition,” and Emerging Issues Task Force (EITF) Issue 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables”; Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations”; SFAS No. 142, “Goodwill and Other Intangible Assets”; SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”; and SFAS No. 109, “Accounting for Income Taxes.” Additionally, we believe inventory valuations, allowances for doubtful accounts and warranty reserves are also critical accounting policies. Management believes these policies to be critical because they are both important to the portrayal of the Company’s financial condition and results and they require management to make judgments and estimates based on

matters that are inherently uncertain. There were no significant changes in these policies or the application thereof during the nine-month period ended September 24, 2005.

GOODWILL

Interim measurements for potential impairment are required by SFAS 142 if certain events or changes in business conditions would indicate a permanent decline in the fair value of the Company’s equity. Since December 31, 2004, although the estimated fair value of our equity, using our share prices, has fluctuated significantly, there have been no events which have occurred that the Company believes would warrant an interim review for potential impairment of goodwill. Unless such an event would occur between now and our year-end, we intend to test goodwill for potential impairment at December 31, 2005, utilizing estimates of fair value of our equity. Upon that review, if the Company does not have supporting evidence to indicate that the fair value of our equity value exceeds its book carrying value, we could be required to take an impairment charge against goodwill.

INCOME TAXES

RESULTS OF OPERATIONS

THE FOLLOWING DISCUSSION OF THE RESULTS OF OPERATIONS AND FINANCIAL CONDITION OF THE COMPANY SHOULD BE READ IN CONJUNCTION WITH PART I, ITEM 1 OF THIS REPORT

THIRD QUARTER OF 2005 COMPARED TO THIRD QUARTER OF 2004

Revenues

The Company’s revenues for the third quarter of 2005 were $16.8 million, an increase of $3.2 million or 23.2%, compared to revenues of $13.6 million reported for the third quarter of 2004.

Sales of the Company’s DigiTest system products, which include LoopCare software, were $5.2 million in the third quarter of 2005, an increase of $2.3 million, compared to the third quarter of 2004 of $2.9 million. DigiTest revenue was favorably affected by deployment of products into Saudi Arabia and South Africa, but was offset, in part, by a decrease in sales to RBOC and CLEC customers as a result of the timing of purchases and budget availability. DigiTest system sales accounted for 31.0% and 21.3% of total revenues for the third quarter of 2005 and 2004, respectively.

Overall sales of cable hardware and software products increased $0.8 million or 33.3% from $2.4 million during the third quarter of 2004 to $3.2 million in the third quarter of 2005. Cable hardware and software product sales amounted to 19.0% and 17.6% of total third quarter 2005 and 2004 revenue, respectively. During the third quarter of 2005, we experienced strong sales of our Cheetah software solutions and legacy transponders. As many customers demand products that meet the DOCSIS standards, we expect to experience a decline in sales of our legacy cable equipment, and an increase in sales of our DOCSIS certified products. Although sales levels of our legacy products are expected to decline, we anticipate that there will be periods of higher than expected demand, similar to what was experienced in the third quarter of 2005. We expect our DOCSIS certified transponders, which have been primarily sold on an OEM basis, will generate lower margins than we have historically achieved with our legacy cable equipment. We are continuing the process of taking a number of cost saving initiatives, which include attempting to affect design and manufacturing efficiencies, reducing the cost of raw materials and redesigning the software that is used in the DOCSIS product. Additionally, we continue to design differentiating technologies that we believe will increase the value and revenue opportunities for our related software and enhanced VoIP service assurance products.

Sales of MCUs during the third quarter of 2005 were $4.9 million, an increase of $0.2 million compared to $4.7 million during the third quarter of 2004. The increase is attributable to increased bulk purchases likely due to hurricane and storm related restoration projects by certain RBOCs. MCU sales as a percentage of revenue declined from 34.6% for the third quarter of 2004 to 29.2% for the third quarter of 2005.

We expect MCU sales for the foreseeable future to continue to account for a meaningful portion of the Company’s revenue. However, as a result of the continuing maturation of this product line, the RBOCs’ trend of limiting capital spending in their traditional POTS networks and the evolution of the transmission network toward end-to-end fiber, the Company believes revenues from this product line will continue to decline over time. Although sales levels are expected to decline, we anticipate that there might be periods of higher than expected demand, similar to what was experienced in the third quarter of 2005.

Sales of LoopCare software products separate and unrelated to DigiTest system products were $0.2 million in the third quarter of 2005 compared with $0.3 million recorded in the third quarter of 2004. The LoopCare software product line, which involves software license fees that individually are significant in amount, typically has long and unpredictable sales, purchase approval and acceptance cycles. When making a purchase decision for LoopCare software, our customers generally must complete a full technical evaluation of the software and develop a favorable business case within their organization for each feature sale. As a result, revenue from this product line can fluctuate significantly on a quarter by quarter basis. LoopCare software product sales comprised 1.2% of total revenues during the third quarter of 2005 compared to 2.2% in the third quarter of 2004.

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 comparable at $3.3 million in the third quarter of 2005. Service revenues amounted to 19.6% and 24.3% of total third quarter 2005 and 2004 revenue, respectively.

Gross Profit

Gross profit for the third quarter of 2005 increased $1.3 million or 17.2%, to $8.9 million. The increase in gross profit is attributed primarily to product mix which included more DigiTest products and an increase in sales of Cheetah™ software and legacy Cheetah products. During the third quarter of 2005, we recorded an impairment charge of $0.4 million related to certain software purchased in 2004 that no longer is a part of the Company’s product strategy going forward. As a percentage of sales, gross profit for the third quarter of 2005 was 53.2% versus 55.9% for the third quarter of 2004.

Selling and Marketing Expense

Selling and marketing expense, which consists primarily of payroll related costs, consulting expense and travel costs, decreased $0.3 million to $1.9 million for the third quarter of 2005 from $2.2 million in 2004. The decrease is attributed to lower selling and test and evaluation costs. As a percentage of revenues, selling and marketing expenses decreased from 16.1% in the third quarter of 2004 to 11.4% in the third quarter of 2005.

General and Administrative Expense

General and administrative expense for the third quarter of 2005, which consists primarily of payroll related costs, insurance expense and professional services, remained relatively stable at $1.9 million compared to $1.8 million recorded in the third quarter of 2004. As a percentage of revenues, general and administrative expenses decreased from 13.6% in the third quarter of 2004 to 11.4% in the third quarter of 2005.

Research and Development Expense

Research and development expense, which consists primarily of payroll related costs and depreciation expense, decreased by $0.4 million or 10.1% to $3.5 million in the third quarter of 2005 from $3.9 million in the third quarter of 2004. The decrease in research and development expense is associated with lower salaries and wages, employee benefits and prototype expenses. As a percentage of revenues, research and

development expense decreased to 20.6% in the third quarter of 2005 from 28.3% in the prior year quarter.

Interest and Other Income

Interest and other income for the third quarter of 2005 was $0.3 million, an increase of $0.2 million from the $0.1 million recorded in the third quarter of 2004. The increase is due to a larger portion of our portfolio being allocated to short-term investments with higher yields.

Provision (Benefit) for Income Taxes

Income taxes for the third quarter of 2005 was an expense of $0.4 million. The provision for income taxes in the third quarter of 2004 was a benefit of ($0.2) million. The effective income tax rate for the third quarter of 2005 was a charge of 19.0% compared to a benefit of 36.7% in the third quarter of 2004. The effective rate, for both periods, was affected by the proportional impact of certain permanent items on the calculation, including those created by tax exempt interest and international sales. While we have made our best estimate of our effective rate for 2005, based on the Company’s operating results and permanent differences, we believe it is possible that our effective income tax rate could vary during the remainder of 2005.

Net Income (Loss) and Earnings (Loss) Per Share

As a result of the above factors, the net income for the third quarter of 2005 was $1.6 million compared to net loss in the third quarter of 2004 of ($0.3) million. For the third quarter of 2005, our basic and diluted earnings per common share were $0.12 compared to net loss of ($0.02) per common share recorded in the prior year quarter. Basic and diluted weighted average common and common equivalent shares outstanding were 13,162,000 and 13,221,000 in the third quarter of 2005, respectively, compared to 13,148,000 for both basic and diluted in the third quarter of 2004. The three months ended September 25, 2004 do not include the effect of dilutive securities due to the net loss for that quarter which would have made those securities anti-dilutive to the earnings per share calculation.

NINE MONTHS ENDED SEPTEMBER 24, 2005 COMPARED TO NINE MONTH ENDED SEPTEMBER 25, 2004

Revenues

The Company’s revenues for the nine months ended September 24, 2005 were $48.2 million, an increase of $1.5 million, or 3.1%, compared to revenues of $46.7 million reported for the nine months ended September 25, 2004.

Sales of the Company’s DigiTest system products, which include LoopCare software, were $13.2 million in the nine months ended September 24, 2005, an increase of $8.4 million, compared to the nine months ended September 25, 2004 of $4.8 million. DigiTest revenue was favorably affected by deployments of products into Saudi Arabia and South Africa, but was offset, in part, by a decrease in sales of these products to RBOC and CLEC customers as a result of the timing of purchases and budget availability. DigiTest system sales accounted for 27.4% and 10.3% of total revenues for the first nine months of 2005 and 2004, respectively.

Overall sales of cable hardware and software products were $12.8 million in the nine months ended September 24, 2005, a decrease of $1.0 million, or 7.2%, from $13.8 million during the nine months

ended September 25, 2004. Cable hardware and software product sales amounted to 26.6% and 29.6% of the first nine months of 2005 and 2004 revenue, respectively. During the nine months ended September 24, 2005, we experienced strong sales of our DOCSIS certified transponders, offset by a reduction in legacy transponders and associated headend equipment and a decline in sales of our legacy CheetahLight cable equipment. As many customers demand products that meet the DOCSIS standards, they are reducing their purchases of legacy cable equipment, while increasing their purchases of the DOCSIS certified products. We continue to design differentiating technologies that we believe will increase the value and revenue opportunities for our related software and enhanced VoIP service assurance products.

Sales of MCUs during the nine months ended September 24, 2005 were $10.4 million, a decrease of $5.4 million, or 34.2%, compared to the nine months ended September 25, 2004. As a result, MCU sales represented 21.6% of total nine months ended September 24, 2005 revenues compared to 33.8% for the nine months ended September 25, 2004. MCU sales in the nine months ended September 25, 2004 were particularly strong due to carryover 2003 capital budgeting of one of the RBOCs and strong OEM sales.

Sales of LoopCare software products separate and unrelated to DigiTest system products were $1.7 million in the nine months ended September 24, 2005 compared with $2.6 million recorded in the nine months ended September 25, 2004. The LoopCare software product line, which involves software license fees that individually are significant in amount, typically has long and unpredictable sales, purchase approval and acceptance cycles. When making a purchase decision for LoopCare software, our customers generally must complete a full technical evaluation of the software and develop a favorable business case within their organization. As a result, revenue from this product line can fluctuate significantly on a quarter by quarter basis. LoopCare software product sales comprised 3.5% of total revenues during the nine months ended September 24, 2005 compared to 5.6% in the nine months ended September 25, 2004.

Services revenues, which include installation oversight and project management services provided to RBOC and other customers and fees for LoopCare and Cheetah software maintenance, increased $0.4 million, or 4.1%, to $10.1 million in the nine months ended September 24, 2005. Service revenues amounted to 21.0% and 20.8% for the first nine months of 2005 and 2004 revenue, respectively. The increase is primarily attributed to services provided in conjunction with our cable products and our deployment within Saudi Arabia.

Gross Profit

Gross profit for the nine months ended September 24, 2005 decreased $0.3 million, or 1.2%, to $25.3 million. The decrease in gross profit is primarily a result of product mix which favored lower margin DOCSIS products and a $0.4 million impairment charge recorded in the third quarter of 2005, offset by strong sales of our DigiTest products. As a percentage of sales, gross profit for the first nine months of 2005 was 52.5% versus 54.8% for the nine months ended September 25, 2004. Gross margin, as a percentage of sales, was favorably impacted by increased sales of our DigiTest products, however, this was offset by a decline in our MCU business and by an increase in sales of our lower-margined DOCSIS-based cable product.

Selling and Marketing Expense

Selling and marketing expense, which consists primarily of payroll related costs, consulting expense and travel costs, decreased $0.5 million, or 6.5%, to $6.6 million for the nine months ended September 24, 2005 from $7.1 million in the nine months ended September 25, 2004. The decrease is associated with a decrease in salaries and wages, travel and test and evaluation costs. As a percentage of revenues, selling and marketing expenses decreased from 15.1% in the first nine months of 2004 to 13.7% in the first nine months of 2005.

General and Administrative Expense

General and administrative expense, which consists primarily of payroll related costs, insurance expense and professional services, for the nine months ended September 24, 2005 was $5.6 million, an increase of $0.2 million, or 3.6%, from the $5.4 million recorded in the nine months ended September 25, 2004. The increase is primarily attributed to an increase in salaries and wages, casual labor and bad debt costs, offset by a decrease in professional services. As a percentage of revenues, general and administrative expenses remained flat at 11.7% in the first nine months of 2004 and the first nine months of 2005.

Research and Development Expense

Research and development expense, which consists primarily of payroll related costs and depreciation expense, decreased by $1.6 million or 13.2% to $10.6 million in the nine months ended September 24, 2005 from $12.2 million in the nine months ended September 25, 2004. The decrease in research and development expense is associated with lower salaries and wages, employee benefits, consulting costs and prototype expenses. During 2004, the Company announced a cost alignment program in which we eliminated approximately 50 positions, primarily impacting research and development. The reduction in salaries and wages in the nine months ended September 24, 2005 is attributable to this program. As a percentage of revenues, research and development expense decreased to 21.9% in the nine months ended September 24, 2005 from 26.0% in the prior year’s first nine months.

Retirement Expense

On January 17, 2005, the Company entered into an Agreement with Christian L. Allison, the Company’s Former Chief Executive Officer and former member of the Board of the Company (the “Agreement”). Under the terms of the Agreement, Mr. Allison resigned effective as of January 18, 2005 (the “Retirement Date”), as director and executive officer of the Company and any and all other positions he held with the Company or its subsidiaries or other affiliates.

connection with the negotiation and execution of the Agreement. The Company recorded a total charge in the first quarter of 2005 related to Mr. Allison’s retirement of approximately $0.8 million.

Interest and Other Income

Interest and other income, comprised primarily of interest income in both nine month periods, for the nine months ended September 24, 2005 was $0.8 million, an increase of $0.6 million, from the amount recorded in the nine months ended September 25, 2004. The increase is due to a larger portion of our portfolio being allocated to short-term investments with higher yields.

Provision for Income Taxes

Income taxes for the nine months ended September 24, 2005 and September 25, 2004 included a provision of $0.5 million and $0.2 million, respectively. The effective income tax rate for the nine months ended September 24, 2005 was 20.2% compared to 27.0% in the nine months ended September 25, 2004. The effective tax rate, for both periods, was affected by the proportional impact of certain permanent items on the calculation, including those created by tax-exempt interest and international sales. While we have made our best estimate of our effective rate for 2005, based on the Company’s operating results and permanent differences, we believe it is possible that our effective income tax rate could vary during the remainder of 2005.

Net Income and Earnings Per Share

As a result of the above factors, the net income for the nine months ended September 24, 2005 was $2.0 million compared to net income in the nine months ended September 25, 2004 of $0.7 million. For the nine months ended September 24, 2005, our basic and diluted earnings per common share was $0.15 per common share compared to net earnings of $0.05 per common share recorded in the prior year’s first nine months. Basic and diluted weighted average common and common equivalent shares outstanding were 13,162,000 and 13,202,000 in the nine months ended September 24, 2005 compared to 13,134,000 and 13,263,000, respectively, in the nine months ended September 25, 2004.

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 (“Cheetah”) from Acterna, LLC (“Acterna”) for approximately $14.3 million in cash. In addition, acquisition-related costs of approximately $0.6 million were capitalized for a total cost of approximately $14.9 million. The transaction provided for an earn-out to be paid in the first half of 2004 of up to $2.4 million based on certain 2003 performance targets. On September 21, 2005, Tollgrade settled the earn-out payment and calculation of the final purchase price with Acterna. This settlement resulted in Tollgrade receiving a cash payment from Acterna on September 26, 2005 in the amount of $0.5 million. As a result of this settlement, Tollgrade adjusted the goodwill associated with this transaction by $0.7 million. This adjustment reflects the cash received and settlement of certain obligations Tollgrade had with Acterna.

LIQUIDITY AND CAPITAL RESOURCES

Net cash provided by operating activities for the nine months ended September 24, 2005, was $7.0 million compared to $3.8 million for the same period in the prior year. The increase is attributed to a significant increase in earnings and lower investments in working capital items, particularly inventories and prepaids as a result of timing, offset by an increase in trade accounts receivable due to timing as well as increased sales levels in the third quarter of 2005 compared to the third quarter of 2004. The Company had working capital of $77.3 million at September 24, 2005, an increase of $6.5 million, from $70.8 million of working capital as of December 31, 2004. Cash used in investing activities decreased from $4.6 million for the nine months ended September 25, 2004 to $3.9 million for the nine months ended September 24, 2005. The change is attributed to a reduction in capital spending and purchases of software. As of September 24, 2005, the Company had $57.3 million 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 may be used for general corporate purposes, working capital needs, and in connection with certain acquisitions. The Facility contains certain covenants with which we 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. A maximum leverage ratio restricts our total borrowings to approximately $19.8 million during the first nine months of 2005. Commitment fees are payable quarterly at an annual rate of 0.25% of the unused commitment. The Facility was amended in February 2003 in connection with our acquisition of the Cheetah product line to adjust the determination of base net worth. As of September 24, 2005 and currently, there are no outstanding borrowings under the Facility, and we are in compliance with all debt covenants. We do not anticipate any short-term borrowings for working capital as we believe our 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 $2.0 million in 2005 including projects for test fixtures related to the manufacturing process and purchases of computer and office equipment.

The Company has in place a stock repurchase program, which is more fully described in Part II, Item 2(e) of this Report. At management’s discretion, the Company may repurchase shares under this program, however, the number of shares and the timing of such purchases has not presently been determined. Any such purchases would be made using existing cash and short-term investments. No shares were repurchased under this program in the nine months ended September 24, 2005.

The impact of inflation on both the Company’s financial position and the results of operations has been minimal and is not expected to adversely affect our 2005 results. Our financial position enables us to meet our cash requirements for operations and capital expansion programs.

RELATED PARTY TRANSACTION

Gregory Quiggle was hired by the Company as Executive Vice President of Marketing on August 13, 2001. In connection with the recruitment of Mr. Quiggle, the Company made a loan to Mr. Quiggle in the amount of $0.2 million pursuant to a Promissory Note (the “Note”) with interest accruing at 5% per annum. The remaining outstanding balance is due and payable on or before the earlier of (i) May 2, 2008, (ii) the date of termination of Mr. Quiggle’s employment with the Company, or (iii) the date that Mr. Quiggle sells or otherwise transfers ownership of all or a portion of 40,200 shares of common stock of Acterna LLC, which shares are being held by the Company as collateral for payment of the Note. Presently, the shares of stock being held as collateral have no value. The Note has not been modified since its issuance.

KEY RATIOS

The Company’s days sales outstanding (DSO) in trade accounts receivable, based on the past twelve months rolling revenue, was 78 and 67 days as of September 24, 2005 and December 31, 2004, respectively. The increase in DSO’s is directly related to the timing of billings and cash collections related to products and services that were sold during the quarter. The Company’s inventory turnover ratio was 2.8 and 2.3 turns at September 24, 2005 and December 31, 2004, respectively.

ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard No. 123(R), “Shared-Based Payment”. Statement 123(R) requires the measurement of all employee stock-based compensation awards using a fair value method as of the date of the grant and recording such expense in the consolidated financial statements. In addition, the adoption of Statement 123(R) will require additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from share-based payment arrangements. In April of 2005, the SEC approved a rule that delayed the effective date of FASB Statement No. 123. Statement 123(R) is now effective for public companies for annual periods that begin after June 15, 2005. Currently, the charge that would result in applying Statement 123(R) would not be material to the Company. See Note 2 to the financial statements.

RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATING RESULTS AND FINANCIAL CONDITION

We wish 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 Form 10-K and Form 10-Q reports and annual reports filed with the SEC. Our business and results of operations could be seriously impaired by any of the following risks. The factors discussed herein may not be exhaustive. Therefore, the factors contained herein should be read together with other reports and documents that we file with the SEC from time to time, which may supplement, modify, supersede or update the factors listed in this document.

We depend upon a few major customers for a majority of our revenues, and the loss of any of these customers, or the substantial reduction in the products that they purchase from us, would significantly reduce our revenues and net income.

We depend upon a few major customers for a significant portion of our revenues. We expect to derive a significant portion of our revenues from a limited number of telecommunications customers in the future, and we expect that revenues from this sector may continue to decline. The loss of any of these customers would significantly reduce our revenues and net income. Furthermore, decreases in the capital budgets of these customers could lead to their reduced demand for our products, which could in turn have a material adverse affect on our business and results of operation. The capital budgets of our RBOC customers, as well as many of our other customers, are dictated by a number of factors, most of which are beyond our control, including:

	•		the conditions of the telecommunications market and the economy in general;

	•		subscriber line loss and related reduced demand for telecommunications services;

	•		changes or shifts in the technology utilized in the networks;

	•		labor disputes between our customers and their collective bargaining units;

	•		the failure to meet established purchase forecasts and growth projections;

	•		competition among the RBOCs, competitive exchange carriers and wireless telecommunications and cable providers; and

	•		reorganizations, including management changes, at one or more of our customers or potential customers.

If the financial strength of one or more of our major customers should deteriorate, or if they have difficulty acquiring investment capital due to any of these or other factors, a substantial decrease in our revenues would likely result.

Our operating results may vary from quarter to quarter, causing our stock price to fluctuate.

Our operating results have in the past been subject to quarter to quarter fluctuations, and we expect that these fluctuations will continue, and may increase in magnitude, in future periods. Demand for our products is driven by many factors, including the availability of funding in customers’ capital budgets. There is a trend for some of our customers to place large orders near the end of a quarter or fiscal year, in part to spend remaining available capital budget funds. Seasonal fluctuations in customer demand for our products driven by budgetary and other reasons can create corresponding fluctuations in period-to-period revenues, and we therefore cannot assure you that our results in one period are necessarily indicative of our revenues in any future period. In addition, the number and timing of large individual sales has been difficult for us to predict, and large individual sales have, in some cases, occurred in quarters subsequent to those we anticipated, or have not occurred at all. The loss or deferral of one or more significant sales in a quarter could harm our operating results. It is possible that in some quarters our operating results will be below the expectations of public market analysts or investors. In such events, or in the event adverse conditions prevail, the market price of our common stock may decline significantly.

The sales cycle for our software products is long, and the delay or failure to complete one or more large license transactions in a quarter could cause our operating results to fall below our expectations.

The sales cycle is highly customer specific and can vary from a few weeks to many months. The software requirements of customers is highly dependent on many factors, including but not limited to their projections of business growth, capital budgets and anticipated cost savings from implementation of our software. Our delay or failure to complete one or more large license transactions in a quarter could harm our operating results. Our software involves significant capital commitments by customers. Potential customers generally commit significant resources to an evaluation of available enterprise software and require us to expend substantial time, effort and money educating them about the value of our solutions. Licensing of our software products often requires an extensive sales effort throughout a customer’s organization because decisions to license such software generally involve the evaluation of the software by a significant number of customer personnel in various functional and geographic areas, each often having specific and conflicting requirements. A variety of factors, including actions by competitors and other factors over which we have little or no control, may cause potential customers to favor a particular supplier or to delay or forego a purchase.

Many of the Company’s products must comply with significant governmental and industry-based regulations, certifications, standards and protocols, some of which evolve as new technologies are deployed. Compliance with such regulations, certifications, standards and protocols may prove costly and time-consuming for the Company, and the Company cannot provide assurance that its products will continue to meet these standards in the future. In addition, regulatory compliance may present barriers to entry in particular markets or reduce the profitability of the Company’s product offerings. Such regulations, certifications, standards and protocols may also adversely affect the industries in which we compete, limit the number of potential customers for the Company’s products and services or otherwise have a material adverse effect on its business, financial condition and results of operations. Failure to comply, or delays in compliance, with such regulations, standards and protocols or delays in receipt of such certifications could delay the introduction of new products or cause the Company’s existing products to become obsolete.

We depend on sales of our MCU products for a meaningful portion of our revenues, but this product is mature and its sales will continue to decline.

A large portion of our sales have historically been attributable to our MCU products. We expect that our MCU products may continue to account for a meaningful percentage of our revenues for the foreseeable future. However, these sales are declining. MCU sales largely depend upon the rate of deployment of new, and the retrofitting of existing, Digital Loop Carrier (DLC) systems in the United States. Installation and replacement of DLC systems are, in turn, driven by a number of factors, including the availability of capital resources and the demand for new or better Plain Old Telephone Service (POTS). Our customers have begun to implement next generation network improvements such as Fiber-to-the-Premises (FTTP), which do not require the use of our MCU products as the present hybrid POTS network. If our major customers fail to continue to build out their DSL networks and other projects requiring DLC deployments, or if we otherwise satisfy the domestic telecommunications market’s demand for MCUs, our MCU sales will continue to decline and our future results would be materially and adversely affected.

Although we are unable to predict future prices for our MCU products, we expect that prices for these products will continue to be subject to significant downward pressure in certain markets for the reasons

described above. Accordingly, our ability to maintain or increase revenues will be dependent on our ability to expand our customer base, increase unit sales volumes of these products and to successfully, develop, introduce and sell new products such as our cable and software products. We cannot assure you that we will be able to expand our customer base, increase unit sales volumes of existing products or develop, introduce and/or sell new products.

Our Services business is subject to a trend of reduced capital spending by our major customers.

Our Services business, which includes software maintenance as well as professional services, is sensitive to the decline in our RBOC customers’ capital investment in their traditional voice services, which tends to drive the professional services. Furthermore, the timing of the extension or renewal of certain of the more significant software maintenance agreements can have a major impact on the Company’s Services revenues for any particular fiscal quarter or year. We are also experiencing intense pricing pressure from many of our larger software maintenance customers, as they continue to attempt to reduce their own internal costs. Accordingly, our ability to maintain historical levels or increase levels of Services revenues cannot be assured, and in fact, such levels may continue to decrease.

We recently emphasized our network assurance and testing software solutions and cable status monitoring products.

We acquired the LoopCare software and Cheetah product lines in 2001 and 2003, respectively. A substantial portion of our research and development expenses currently relates to these products. We have adjusted our business model to focus heavily on our cable performance and status monitoring products. In addition, sales of our legacy cable products are declining as the market for these products evolves. We are actively engaged in research to improve and expand our cable products, including research and development of VoIP solutions. Our cable products have lower margins than our MCU, LoopCare and DigiTest system products. If sales of our cable testing products do not increase or are not accepted in the marketplace, or if our research and development activities do not produce marketable products that are both competitive and accepted by our customers, our overall revenues and profitability will be adversely affected.

In addition, although software products generally generate higher margin returns for us than our hardware products, the initial development costs of software applications, coupled with the inherent problems with pricing software, can make it difficult to assess the potential profitability of new software products. Unless we acquire proprietary software, we must internally develop any new software products. Software development is a relatively expensive and lengthy process. In addition, because it is customary in our industry to sell perpetual enterprise licenses that cover an entire customer’s operations, it can be difficult to assess at the time of sale the exact price that we should charge for a particular license.

The sale of our products is dependent upon our ability to satisfy the proprietary requirements of our customers and to respond to rapid technological change, including evolving industry-wide standards.

We depend upon a relatively narrow range of products for the majority of our revenue. Our success in marketing our products is dependent upon their continued acceptance by our customers. In some cases, our customers require that our products meet their own proprietary requirements. If we are unable to satisfy such requirements, or forecast and adapt to changes in such requirements, our business could be materially harmed.

Rapid technological change, including evolving industry standards, could also render our products obsolete. The adoption of industry-wide standards, such as the HMS and DOCSIS cable standards, may result in the elimination of or reductions in the demand for many of our proprietary products, such as our Cheetah head-end hardware products and other Cheetah products. Furthermore, standards for new services and technologies continue to evolve, requiring us to continually modify our products or to develop new versions to meet these new standards. Certain of these certifications are limited in scope, which may require that the product be recertified if any modifications to hardware or firmware are made. If we are unable to forecast the demand for, and to develop new products or to adapt our existing products to meet, these evolving standards and other technological innovations, or if our products and services do not gain the acceptance of our customers, there could be a negative effect on our revenues for sales of such products.

Our customers are subject to an evolving governmental regulatory environment that could significantly reduce the demand for our products or increase our costs of doing business.

Our customers have historically been subject to a number of governmental regulations, many of which have been repealed or amended as a result of the passage of The Telecommunications Act of 1996. Deregulatory efforts have affected and likely will continue to affect our customers in several ways, including the introduction of competitive forces into the local telephone markets and the imposition (or removal) of controls on the pricing of services. These and other regulatory changes may limit the scope of our customers’ deployments of future services and budgets for capital expenditures, which could significantly reduce the demand for our products.

Moreover, as the Federal Communications Commission (FCC) adopts new and amends existing regulations, and as the courts analyze the FCC’s authority to do so, our customers cannot accurately predict the rules by which they will be able to compete in their respective markets. Changes in the telecommunications regulatory environment could, among other results, increase our costs of doing business, require our customers to share assets with competitors or prevent the Company or our customers from engaging in business activities they may wish to conduct, which could adversely affect our future results.

Our limited ability to protect our proprietary information and technology may adversely affect our ability to compete.

Many of our products consist entirely or partly of proprietary technology owned by us. Although we seek to protect our technology through a combination of copyrights, trade secret laws, contractual obligations and patents, these protections many not be sufficient to prevent the wrongful appropriation of our intellectual property, nor will they prevent our competitors from independently developing technologies that are substantially equivalent or superior to our proprietary technology. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the United States. In order to defend our proprietary rights in the technology utilized in our products from third party infringement, we may be required to institute legal proceedings. If we are unable to successfully assert and defend our proprietary rights in the technology utilized in our products, our future results could be adversely affected.

Our products could infringe the intellectual property rights of others, and resulting claims against us could be costly and require us to enter into disadvantageous license or royalty arrangements.

Although we attempt to avoid infringing known proprietary rights of third parties in our product development efforts, we may become subject to legal proceedings and claims for alleged infringement from time to time in the ordinary course of business. Any claims relating to the infringement of third-party proprietary rights, even if not meritorious, could result in costly litigation, divert management’s attention and resources, require us to reengineer or cease sales of our products or require us to enter into royalty or license agreements which are not advantageous to us. In addition, parties making claims may be able to obtain an injunction, which could prevent us from selling our products in the United States or abroad.

Some of our products require technology that we must license from the manufacturers of systems with which our products must be compatible. The success of our proprietary MCU products, in particular, rely upon our ability to acquire and maintain licensing arrangements with the various manufacturers of DLC systems for the Proprietary Design Integrated Circuits (PDICs) unique to each. Although most of our PDIC licensing agreements have perpetual renewal terms, all of them can be terminated by either party. If we are unable to obtain the PDICs necessary for our MCU products to be compatible with a particular DLC system, we may be unable to satisfy the needs of our customers. Furthermore, future PDIC license agreements may contain terms comparable to, or materially different than, the terms of existing agreements, as dictated by competitive or other conditions. The loss of these PDIC license agreements, or our inability to maintain an adequate supply of PDICs on acceptable terms, could have a material adverse effect on our business.

Our reliance on third parties to manufacture certain aspects of our products involves risks, including, delays in product shipments and reduced control over product quality.

We depend upon a limited number of third party subcontractors to manufacture certain aspects of our products. Furthermore, the components of our hardware products are procured from a limited number of outside suppliers. Our reliance upon such third party contractors involve several additional risks, including reduced control over manufacturing costs, delivery times, reliability and quality components. Although our products generally use industry standard products, some parts, such as ASICs, are custom-made to our specifications. If we were to encounter a shortage of key manufacturing components from limited sources of supply, or experience manufacturing delays caused by reduced manufacturing capacity or integration issues related to our acquisition of the Cheetah product line, the loss of key assembly subcontractors or other factors, we could experience lost revenues, increased costs, delays in, cancellations or rescheduling of orders or shipments, any of which would materially harm our business.

If we are unable to satisfy our customers’ specific product quality, certification or network requirements, our business could be disrupted and our financial condition could be harmed.

Our customers demand that our products meet stringent quality, performance and reliability standards. We have, from time to time, experienced problems in satisfying such standards. For example, in 2004, we were unable to ship certain of our transponder products to a customer due to delays in both the CableLabs DOCSIS certification of these products and the manufacturing of the product until final engineering enhancements were completed. Though we received CableLabs certification in the third quarter of 2004, and resolved these technological issues for that customer, defects or failures have in the past, and may in the future occur relating to our product quality, performance and reliability. From time to time, our customers also require us to implement specific changes to our products to allow these products to operate

within their specific network configurations. If we are unable to remedy these failures or defects or if we cannot affect such required product modifications, we could experience lost revenues, increased costs, including inventory write-offs, warranty expense and costs associated with customer support, delays in or cancellations or rescheduling of orders or shipments and product returns or discounts, any of which would harm our business.

We have completed, and may pursue additional acquisitions, which will complicate our management tasks and could result in substantial expenditures.

We have completed, and we may pursue additional acquisitions of companies, product lines and technologies as part of our efforts to enhance our existing products, to introduce new products and to fulfill changing customer requirements. Acquisitions involve numerous risks, including the disruption of our business, exposure to assumed or unknown liabilities of the acquired target, and the failure to integrate successfully the operations and products of acquired businesses. Goodwill arising from acquisitions may result in significant charges against our operating results in one or more future periods. Furthermore, we may never achieve the anticipated results or benefits of an acquisition, such as increased market share or the successful development and sales of a new product. The effects of any of these risks could materially harm our business and reduce our future results of operations.

The failure of acquired assets to meet expectations, or a decline on our fair value determined by market prices of our stock, could indicate impairment of our intangible assets and result in impairment charges.

The carrying value of certain of our intangible assets, consisting primarily of goodwill related to our LoopCare software and Cheetah product line acquisitions from Lucent Technologies, Inc. and Acterna, LLC, respectively, could be impaired by changing market conditions. Statement of Financial Accounting Standards No. 142 (“SFAS 142”) requires goodwill and intangible assets with indefinite lives to be measured for potential impairment at least annually and the Company selected December 31 as our annual measurement date. We have determined that we only have one reporting unit and test goodwill for potential impairment by comparing the estimated fair value of the Company’s equity using the average stock price over a 12 month period with our book carrying value. Our last required measurement date was December 31, 2004, at which time our analysis of the fair value of equity reflected no potential impairment of goodwill given an estimated fair value of $158.2 million, compared to our book carrying value of $147.5 million.

Interim measurements for potential impairment are required by SFAS 142 if certain events or changes in business conditions would indicate a possible permanent decline in the fair value of the Company’s equity. Since December 31, 2004, although the estimated fair value of our equity, based on our share prices, has fluctuated significantly, there have been no events which have occurred that the Company believes would warrant an interim review for potential impairment of goodwill. Unless such an event would occur between now and our year-end, we intend to test goodwill for potential impairment at December 31, 2005, utilizing estimates of fair value of our equity including any applicable change-in-control share premiums permitted in accordance with SFAS 142. Upon that review, if the Company does not have supporting evidence to indicate that our equity value exceeds its book carrying value, or if we do not realize the expected revenues from an intangible asset, we could be required to take an impairment charge in our financial statements during the period in which any impairment is determined.

Our future sales in international markets are subject to numerous risks and uncertainties.

Our 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, our ability to market current or develop new products suitable for international markets, difficulties with deployments and acceptances of products, obtaining and maintaining successful distribution and resale channels and foreign currency exchange rates. For example, our current contracts in Saudi Arabia and South Africa are subject to a number of specific risks and uncertainties, such as potential political instability, difficulty in deployment of products, risks from customized product requirements, difficulty of obtaining proper acceptances and delays caused by third party elements of the project. These specific risks, or an overall reduction in the demand for or the sales of our products in international markets, could adversely affect future results.

If our accounting controls and procedures are circumvented or otherwise fail to achieve their intended purposes, our business could be seriously harmed.

We evaluate our disclosure controls and procedures as of the end of each fiscal quarter, and are annually reviewing and evaluating our internal controls over financial reporting in order to comply with SEC rules relating to internal control over financial reporting adopted pursuant to the Sarbanes-Oxley Act of 2002. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

If we ship products that contain defects, the market acceptance of our products and our reputation will be harmed and our customers could seek to recover their damages from us.

Our products are complex, and despite extensive testing, may contain defects or undetected errors or failures that may become apparent only after our products have been shipped to our customer and installed in their network or after product features or new versions are released. Any such defect, error or failure could result in failure of market acceptance of our products or damage to our reputation or relations with our customers, resulting in substantial costs for both the Company and our customers as well as the cancellation of orders, warranty costs and product returns. In addition, any defects, errors, misuse of our products or other potential problems within or out of our control that may arise from the use of our products could result in financial or other damages to our customers. Our customers could seek to have us pay for these losses. Although we maintain product liability insurance, it may not be adequate.

Our future results are dependent on our ability to establish, maintain and expand our distribution channels and our existing third-party distributors.

We market and sell certain of our products, including our DigiTest and Cheetah product lines, through domestic and international OEM relationships. Our future results are dependent on our ability to establish, maintain and expand third party relationships with OEM as well as other marketing and sales distribution channels. If, however, the third parties with whom we have entered into such OEM and other arrangements should fail to meet their own performance objectives, customer demand for our products could be adversely affected, which would have an adverse effect on our revenues.

We face intense competition, which could result in our losing market share or experiencing a decline in our gross margins.

The markets for some of our products are very competitive. Some of our competitors may have greater technological, financial, manufacturing, sales and marketing, and personnel resources than we have. As a result, these competitors may have an advantage in responding more rapidly or effectively to changes in industry standards or technologies. Competition is particularly difficult in the cable markets, due to the introduction of the DOCSIS standard, which allows customers to purchase system components from multiple vendors. Moreover, better financed competitors may be better able to withstand the pricing pressures that increased competition may bring. If our introduction of improved products or services is not timely or well received, or if our competitors reduce their prices for products that are comparable to ours, demand for our products and services could be adversely affected.

We may also compete directly with our customers. Generally, we sell our products either directly or indirectly through OEM channels and other means, to end-user telecommunications and cable television providers. It is possible that our customers, as the result of bankruptcy or other rationales for dismantling network equipment, could attempt to resell our products. The successful development of such a secondary market for our products by a third party could negatively affect demand for our products, reducing our future revenues.

We are dependent upon our ability to attract, retain and motivate our key personnel.

Our success depends on our ability to attract, retain and motivate the key management and technical personnel necessary to implement our business plan and to grow our business. Despite the adverse economic conditions of the past several years, competition for certain specific technical and management skill sets is intense. If we are unable to identify and hire the personnel that we need to succeed, or if one or more of our present key employees were to cease to be associated with the Company, our future results could be adversely affected.

Consolidations in, or a continued slowdown in, the telecommunications industry could harm our business.

We have derived a substantial amount of our revenues from sales of products and related services to the telecommunications industry. The telecommunications industry has experienced significant growth and consolidation in the past few years, although, over recent years, trends indicate that capital spending by this industry has decreased and may continue to decrease in the future as a result of a general decline in economic growth in local and international markets. In particular, RBOC and large ILEC customers have been adversely affected by subscriber line losses and the after-effects of overspending in 1999 and 2000 as well as by competition from cable and wireless carriers and other carriers entering the local telephone service market. Certain emerging carriers also continue to be hampered by financial instability caused in large part by a lack of access to capital. In the event of further significant slowdown in capital spending of the telecommunications industry, our business would be adversely affected. Furthermore, as a result of industry consolidation, there may be fewer potential customers requiring our software in the future. Larger, consolidated telecommunications companies may also use their purchasing power to create pressure on the prices and the margins we could realize. We cannot be certain that consolidations in, or a slowdown in the growth of, the telecommunication industry will not harm our business.

Our expenses are relatively fixed in the short term, and we may be unable to adjust spending to compensate for unexpected revenue shortfalls.

We base our expense levels in part on forecasts of future orders and sales, which are extremely difficult to predict. A substantial portion of our operating expenses is related to personnel, facilities and sales and marketing. The level of spending for such expenses cannot be adjusted quickly and is, therefore, relatively fixed in the short term. Accordingly, our operating results will be harmed if revenues fall below our expectations in a particular quarter.

Our restructuring and cost reduction plans may be ineffective or may limit our ability to compete.

In 2004, we undertook a reduction in work force in response to our evolving business model. We have also undertaken certain cost reduction efforts as they relate to the manufacturing of certain of our products, in an attempt to improve profit margins for those products. These actions could have long term adverse effects on our business. There are several risks inherent in our efforts to bring our cost base in line with the current environment by reducing our workforce. These include the risk that we will not be successful in achieving our planned cost reductions, and that even if we are successful in doing so, we will still not be able to reduce expenditures quickly enough to see a positive profitability effect and may have to undertake further restructuring initiatives that would entail additional charges and create additional risks. In addition, there is the risk that cost-cutting initiatives will impair our ability to effectively develop and market products and remain competitive. Also, our attempts to reduce the base costs of certain or our products may not be successful. Each of the above measures could have long-term effects on our business by reducing our pool of talent, decreasing or slowing improvements in our products, making it more difficult for us to respond to customers, limiting our ability to increase production quickly if and when the demand for our products increases and limiting our ability to hire and retain key personnel. These circumstances could cause our earnings to be lower than they otherwise might be.

We rely on software that we have licensed from third-party developers to perform key functions in our products.

We rely on software that we license from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. We could lose the right to use this software or it could be made available to us only on commercially unreasonable terms. Although we believe that, in most cases, alternative software is available from other third-party suppliers or internal developments, the loss of or inability to maintain any of these software licenses or the inability of the third parties to enhance in a timely and cost-effective manner their products in response to changing customer needs, industry standards or technological developments could result in delays or reductions in product shipments by us until equivalent software could be developed internally or identified, licensed and integrated, which would harm our business.

We are affected by a pattern of product price decline in certain markets, which can harm our business.

Because our cable products generate lower margins for us than our proprietary MCU and software offerings, an increase in the percentage of our sales of cable-related products relative to our traditional products will result in lower profitability. Furthermore, as consolidations within the cable industry and the adoption of the DOCSIS standards have caused and could continue to cause pricing pressure as our competitors’ lower product pricing, our revenues have been and may continue to be

adversely affected. Although we have developed DOCSIS compliant hardware and our relationship with our OEM partner is one that we believe will prominently position us to succeed in the marketing of DOCSIS products, these DOCSIS products will likely generate lower margins than have historically been generated by our proprietary technology. As a result, as our business shifts from our higher margin proprietary products to lower margin cable offerings and standardized products for which we have competition, we will need to sell greater volumes of our products to maintain our profitability.

Our common stock price may be extremely volatile.

Our common stock price has been and is likely to continue to be highly volatile. The market price may vary in response to many factors, some of which are outside our control, including:

	•		General market and economic conditions;

	•		Changes in the telecommunications industry;

	•		Actual or anticipated variations in operating results;

	•		Announcements of technological innovations, new products or new services by us or by our competitors or customers;

	•		Changes in financial estimates or recommendations by stock market analysts regarding us or our competitors;

	•		Announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments;

	•		Announcements by our customers regarding end market conditions and the status of existing and future infrastructure network deployments;

	•		Additions or departures of key personnel; and

	•		Future equity or debt offerings or our announcements of these offerings.

In addition, in recent years, the stock market in general, and The NASDAQ National Market and the securities of technology companies in particular, have experienced extreme price and volume fluctuations. These fluctuations have often been unrelated or disproportionate to the operating performance of individual companies. These broad market fluctuations have in the past and may in the future materially and adversely affect our stock price, regardless of our operating results. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been initiated against such company. Such litigation could result in substantial costs and a diversion of our management’s attention and resources that could harm our business.

We may be subject from time to time to legal proceedings, and any adverse determinations in these proceedings could materially harm our business.

We may from time to time be involved in various lawsuits and legal proceedings, which arise in the ordinary course of business. Litigation matters are inherently unpredictable, and we cannot predict the outcome of any such matters. If we ultimately lose or settle a case, we may be liable for monetary

damages and other costs of litigation. Even if we are entirely successful in a lawsuit, we may incur significant legal expenses and our management may expend significant time in the defense. An adverse resolution of a lawsuit or legal proceeding could negatively impact our financial position and results of operations.

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 pursuant to Rule 13a-15 of the Securities Exchange Act of 1934 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 controls over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) that occurred during our most recent fiscal quarter that have materially affected or are reasonably likely to materially affect these controls.

PART II. OTHER INFORMATION

Item 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

On January 27, 2005, our Board of Directors authorized the continuation through December 31, 2005 of a share repurchase program which expired on December 31, 2004. Under this extension, we may repurchase a total of one million shares of our common stock before December 31, 2005. Since the initial repurchase program was instituted in April 1997, and as of September 24, 2005, the Company has repurchased 461,800 shares of common stock. The repurchased shares are authorized to be utilized under certain employee benefit programs. At our discretion, we will determine the number of shares and the timing of such purchases, which will be made using existing cash and short-term investments. No shares were repurchased under this program in the three and nine months ended September 24, 2005.


	PAGE NO.
PART 1. FINANCIAL INFORMATION

Item 1 Condensed Consolidated Financial Statements (unaudited):

Condensed Consolidated Balance Sheets as of September 24, 2005 and December 31, 2004		3

Condensed Consolidated Statements of Operations for the three month and nine month periods ended September 24, 2005 and September 25, 2004		4

Condensed Consolidated Statement of Changes in Shareholders’ Equity for the nine month period ended September 24, 2005		5

Condensed Consolidated Statements of Cash Flows for the nine month periods ended September 24, 2005 and September 25, 2004		6

Notes to Condensed Consolidated Financial Statements		7

Report of Independent Registered Public Accounting Firm		15

Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations		16

Item 3 Quantitative and Qualitative Disclosures About Market Risk		41

Item 4 Controls and Procedures		41

PART II. OTHER INFORMATION

Item 2 Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities		42

Item 6 Exhibits		43

SIGNATURES		44

EXHIBIT INDEX		45
EX-10.2
EX-15
EX-31.1
EX-31.2
EX-32


Exhibit
Number		Description
10.1		Lease between Regional Industrial Development Corporation of Southwestern Pennsylvania and Tollgrade Communications, Inc. dated August 31, 2005, filed as Exhibit 10.1 to the Report on Form 8-K filed with the SEC on September 7, 2005.

10.2		Seventh Extension Agreement, dated September 29, 2005, between Tollgrade Communications, Inc. and Dictaphone Corporation, filed herewith

15		Letter re audited interim financial information

31.1		Certification of Chief Executive Officer, filed herewith

31.2		Certification of Chief Financial Officer, filed herewith

32		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18.U.S.C. Section 350, filed herewith


Dated: November 3, 2005				/s/ Mark B. Peterson

				Mark B. Peterson
				Chairman and Chief Executive Officer

Dated: November 3, 2005				/s/ Samuel C. Knoch

				Samuel C. Knoch
				Chief Financial Officer and Treasurer

Dated: November 3, 2005				/s/ Sean M. Reilly

				Sean M. Reilly
				Controller


Exhibit
Number		Description
10.1		Lease between Regional Industrial Development Corporation of Southwestern Pennsylvania and Tollgrade Communications, Inc. dated August 31, 2005, filed as Exhibit 10.1 to the Report on Form 8-K filed with the SEC on September 7, 2005.

10.2		Seventh Extension Agreement, dated September 29, 2005, between Tollgrade Communications, Inc. and Dictaphone Corporation, filed herewith

15		Letter re audited interim financial information

31.1		Certification of Chief Executive Officer, filed herewith

31.2		Certification of Chief Financial Officer, filed herewith

32		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18.U.S.C. Section 350, filed herewith


TOLLGRADE COMMUNICATIONS, INC.		DICTAPHONE CORPORATION

By:	/s/ Jennifer M. Reinke	By:	/s/ James Davis

Name:	Jennifer M. Reinke	Name:	James Davis
Title:	Assistant Secretary	Title:	Sr. V.P., Operations

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 officer 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)) and internal controls over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) 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)		Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

	c)		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

	d)		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 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

	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.


/s/ Mark B. Peterson
Name: Mark B. Peterson
Title: Chief Executive Officer


/s/ Samuel C. Knoch

Name: Samuel C. Knoch
Title: Chief Financial Officer