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 30, 2006


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 of incorporation or organization)		(I.R.S. Employer 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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act). (Check one):

Large Accelerated Filer o Accelerated Filer þ Non-accelerated filer 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 29, 2006, there were 13,708,774 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 par value) (Unaudited)


	September 30, 2006			December 31, 2005*

ASSETS
Current assets:
Cash and cash equivalents	$	51,169		$	49,421
Short-term investments		7,245			18,010
Accounts receivable:
Trade, net of allowance for doubtful accounts of $432 in 2006 and $465 in 2005		15,100			9,456
Other		1,292			1,406
Inventories		10,953			9,934
Prepaid expenses and other current assets		847			1,397
Deferred tax assets and refundable income tax		3,445			1,803
Assets held for sale		1,190			—

Total current assets		91,241			91,427

Property and equipment, net		3,549			6,390
Deferred tax assets		207			46
Intangibles and capitalized software, net		42,020			43,616
Goodwill		23,857			21,562
Receivable from officer		149			153
Other assets		119			135

Total assets	$	161,142		$	163,329

LIABILITIES AND SHAREHOLDERS’ EQUITY

Current liabilities:
Accounts payable	$	1,473		$	1,262
Accrued warranty		2,133			2,220
Accrued expenses		3,605			2,579
Accrued salaries and wages		158			660
Accrued royalties payable		160			581
Income taxes payable		441			869
Deferred income		2,836			2,450

Total current liabilities		10,806			10,621
Deferred tax liabilities		2,615			2,447

Total liabilities		13,421			13,068
Contingencies and commitments
Shareholders’ equity:
Preferred stock, $1.00 par value; Authorized shares, 10,000; issued shares, -0- in 2006 and 2005		—			—
Common stock, $.20 par value; authorized shares, 50,000; issued shares, 13,709 in 2006 and 13,664 in 2005		2,742			2,733
Additional paid-in capital		72,338			71,469
Treasury stock, at cost, 462 shares in 2006 and 2005		(4,791	)		(4,791	)
Retained earnings		77,432			80,850

Total shareholders’ equity		147,721			150,261

Total liabilities and shareholders’ equity	$	161,142		$	163,329


*		Amounts derived from audited financial statements presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

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)


	Three Months Ended					Nine Months Ended
	September 30,			September 24,		September 30,			September 24,
	2006			2005		2006			2005

Revenues:
Products	$	12,053		$	13,573	$	38,828		$	38,412
Services		2,896			3,229		9,982			9,757

Total revenues:		14,949			16,802		48,810			48,169

Cost of product sales:
Products		5,454			5,987		19,238			18,210
Services		982			911		3,601			2,643
Amortization of intangibles		962			718		2,853			2,147
Inventory restructuring writedown		4,346			—		4,346			—
Write-down of acquired software		—			424		—			424

		11,744			8,040		30,038			23,424

Gross Profit:		3,205			8,762		18,772			24,745

Selling and marketing		2,459			1,918		8,081			6,594
General and administrative		1,751			1,910		5,935			5,640
Research and development		3,233			3,465		10,484			10,554
Restructuring		1,500			—		1,500			—
Retirement Expense		—			—		—			775

Total operating expenses		8,943			7,293		26,000			23,563

(Loss) income from operations		(5,738	)		1,469		(7,228	)		1,182

Interest and other income, net		729			313		1,984			827

(Loss) income before income taxes		(5,009	)		1,782		(5,244	)		2,009
(Benefit) provision for income taxes		(1,759	)		311		(1,826	)		328

Net (loss) income	$	(3,250	)	$	1,471	$	(3,418	)	$	1,681


(Loss) earnings per share information:
Weighted average shares of common stock and equivalents:
Basic		13,247			13,162		13,236			13,162
Diluted		13,247			13,221		13,236			13,202
Net (loss) income per common and common equivalent shares:
Basic	$	(0.25	)	$	0.11	$	(0.26	)	$	0.13

Diluted	$	(0.25	)	$	0.11	$	(0.26	)	$	0.13

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 30, 2006
(In thousands) (Unaudited)


									Additional
	Preferred Stock				Common Stock				Paid-In		Treasury			Retained
	Shares		Amount		Shares		Amount		Capital		Stock			Earnings			Total


Balance at December 31, 2005		—	$	—		13,664	$	2,733	$	71,469	$	(4,791	)	$	80,850		$	150,261

Exercise of common stock options		—		—		45		9		397		—			—			406

Tax benefit from exercise of stock options		—		—		—		—		94		—			—			94

Stock-based compensation expense		—		—		—		—		378		—			—			378

Net loss		—		—		—		—		—		—			(3,418	)		(3,418	)

Balance at September 30, 2006		—		—		13,709	$	2,742	$	72,338	$	(4,791	)	$	77,432		$	147,721

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 30,			September 24,
	2006			2005

Cash flows from operating activities :
Net (loss) income	$	(3,418	)	$	1,681
Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities:
Depreciation and amortization		4,483			4,038
Compensation expense related to stock plans		378			—
Deferred income taxes		(2,280	)		408
Restructuring and asset impairment		5,338			—
Provision for losses on inventory		(44	)		237
Write-down of acquired software		—			424
Provision for allowance for doubtful accounts		(47	)		80
Changes in assets and liabilities (net of acquired business):
Accounts receivable-trade		(3,770	)		(2,688	)
Accounts receivable-other		114			(875	)
Inventory		(4,208	)		2,425
Prepaid expenses and other assets		570			1,629
Refundable taxes		645			212
Accounts payable		(425	)		(146	)
Accrued warranty		(87	)		(14	)
Accrued expenses and deferred income		1,089			63
Accrued royalties payable		(421	)		(226	)
Accrued salaries and wages		(502	)		(274	)
Income taxes payable		(428	)		10

Net cash (used in) provided by operating activities		(3,013	)		6,984

Cash flows from investing activities:
Purchase of Emerson product line		(5,501	)		—
Purchase of short-term investments		(7,589	)		(15,479	)
Redemption/maturity of short-term investments		18,354			12,490
Capital expenditures, including capitalized software		(1,003	)		(903	)

Net cash provided by (used in) investing activities		4,261			(3,892	)

Cash flows from financing activities:
Proceeds from exercise of stock options		406			65
Tax benefit from exercise of stock options		94			8

Net cash provided by financing activities		500			73

Net increase in cash and cash equivalents		1,748			3,165

Cash and cash equivalents at beginning of period	$	49,421		$	32,622

Cash and cash equivalents at end of period	$	51,169		$	35,787

The accompanying notes are an integral part of the condensed financial statements.
See Note 4 for certain non-cash investing activities related to the Emerson acquisition.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

BASIS OF PRESENTATION

We report our quarterly results for the first three interim periods of 2006 based on fiscal quarters ending on Saturdays and for the fourth interim period ending on December 31. For the three months ended September 30, 2006 and the three months ended September 24, 2005, there were 13 weeks in each period. The accompanying unaudited condensed consolidated financial statements included herein have been prepared by Tollgrade Communications, Inc. (the “Company” or “Tollgrade”) 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 and nine-month periods ended September 30, 2006 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, 2005. 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 and nine-month periods ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.

With respect to the unaudited financial information of the Company for each of the three and nine-month periods ended September 30, 2006 and September 24, 2005, included in this Form 10-Q, PricewaterhouseCoopers LLP (“PwC”) reported that they have applied limited procedures in accordance with professional standards for a review of such information. However, their report dated October 26, 2006 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. PwC is not subject to the liability provisions of Section 11 of the Securities Act of 1933 (the “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.

RECLASSIFICATIONS

Certain reclassifications have been made to prior year amounts to conform to the current year presentation.

SEGMENT INFORMATION

The Company follows the provisions of SFAS No. 131, “Disclosure about Segments of an Enterprise and Related Information, Financial Reporting for Segments of a Business.” This statement establishes standards for reporting information about operating segments, products and services, geographic areas and major customers in annual and interim financial statements. On February 24, 2006, the Company purchased certain assets and assumed certain liabilities associated with the test systems business unit of

Emerson Network Power, Energy Systems, North America, Inc. (“Emerson”). This acquisition is currently being integrated into the Company and consolidated into our current product offerings. As such, the Company will continue to manage and operate its business as one operating segment.

NEW ACCOUNTING STANDARDS

In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainties in income taxes recognized on an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. The Interpretation is effective for fiscal years beginning after December 15, 2006. We are reviewing the adoption of FIN 48 and assessing the impact on our results of operations and our financial position.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB No. 108”). SAB No. 108 addresses the process and diversity in practice of quantifying financial statement misstatements resulting in the potential build up of improper amounts on the balance sheet. We will be required to adopt the provisions of SAB No. 108 in fiscal year 2006. We currently do not believe that adoption of SAB No. 108 will have a material impact on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, (“SFAS No. 157”). SFAS No. 157 establishes a framework for measuring fair value and expands disclosures about fair value measurements. The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements. The Statement is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We do not believe that the adoption of the provisions of SFAS No. 157 will materially impact our financial position and results of operations.


2.		RESTRUCTURING

On July 27, 2006, Tollgrade announced a restructuring program which included the consolidation of the Sarasota, Florida facility, discontinuation of various products and the write-down of certain real estate. The restructuring program will result in the reduction of approximately 20 employees, of which 15 were terminated during the third quarter of 2006. All remaining employee reductions are to be completed in the fourth quarter of 2006. The total expense associated with the restructuring program recorded in the third quarter of 2006 was $5.8 million and included $0.2 million associated with employee severance and relocation, $0.9 million for lease termination costs and fixed asset write-downs, a $4.3 million charge for the discontinuation of various products that are not part of the Company’s future strategic focus, and a charge of $0.4 million for the impairment of real estate. The Company expects to record a charge of approximately $0.3 million in the fourth quarter of 2006 in connection with the final implementation of this program. The effective rate for the three month period ended September 30, 2006 was impacted by losses associated with the restructuring program, which was treated as a discrete item for income tax purposes under FASB Interpretation No. 18, “Accounting for Income Taxes in Interim Periods — an Interpretation of APB Opinion No. 28.”

The components of the charges and accrual at September 30, 2006 for this program are as follows (in thousands):


	Balance at										Balance at
	July 1, 2006		Expense		Cash payments			Asset write-downs			September 30, 2006

Facility Rationalization including employee costs	$	—	$	1,078	$	(159	)	$	(570	)	$	349
Inventory write-down		—		4,346		—			(4,346	)		—
Real Estate impairment		—		422		—			(422	)		—

Total	$	—	$	5,846	$	(159	)	$	(5,338	)	$	349

As a result of the restructuring program, the Company is in the process of selling certain real estate that will not be used by the Company. The value of the assets held for sale was based on management’s estimates of market value, supported by independent real estate broker opinions. We anticipate the sale of this real estate will be completed within a year.

EMERSON INTEGRATION PROGRAM

In conjunction with the Emerson acquisition, the Company implemented an integration plan to relocate certain former Emerson employees to our Cheswick, Pennsylvania location and to close the acquired leased facility in Ft. Worth, Texas. The plan was completed in the third quarter of 2006 and is expected to cost approximately $0.1 million. These costs have been accounted for under Emerging Issue Task Force No. 95-3 (EITF 95-3) “Recognition of Liabilities in Connection with a Purchase Business Combination.”

As a result, the relocation costs and facility closure have been recorded as part of the Emerson purchase price allocation. The following table summarizes the associated costs (in thousands):


	Balance at		Adjustment to						Balance at
	July 1, 2006		Goodwill			Cash payments			September 30, 2006

Relocation Costs	$	320		($219	)	$	(7	)	$	94
Facility Rationalization		46		—			(9	)		37

Total	$	366		($219	)	$	(16	)	$	131

Additionally, in connection with the Emerson integration program, we completed a workforce reduction that resulted in the elimination of six positions associated with the acquired product line. Employees impacted by the reduction were provided a termination benefit to ensure effective integration. All costs associated with this program have been incurred and paid as of September 30, 2006. The total charge associated with this program is under $0.1 million.


3.		ACCOUNTING FOR STOCK-BASED COMPENSATION

Under the Company’s stock compensation plans, directors, officers and other employees may be granted options to purchase shares of the Company’s common stock. The exercise price on all outstanding options is equal to the fair market value of the stock at the date of the grant, as defined in the applicable plans. The options generally vest over a two-year period with one-third vested upon

grant and expire ten years from the date of grant. The Company issues new shares upon the exercise of stock options.

In March 2006, the Company’s Board of Directors adopted the 2006 Long-Term Incentive Compensation Plan (the “2006 Plan”), which was approved by Shareholders on May 9, 2006, and provides up to 1,300,000 shares available for grant. As of September 30, 2006, there were 1,280,000 shares authorized but not granted under the 2006 Plan. The 2006 Plan was intended to replace the Company’s 1995 Long-Term Incentive Compensation Plan which, by its terms, provided that no shares could be awarded beyond October 15, 2005. The 1998 Employee Incentive Compensation Plan (the “1998 Plan”) is still an active plan and there are 990,000 shares reserved there under. As of September 30, 2006, there were 133,888 shares authorized but not granted under the 1998 Plan. All full-time active employees of the Company, excluding officers and directors, are eligible to participate in the 1998 Plan.

Stock-Based Compensation Expense

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004) “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payments awards made to employees and directors for employee stock options, based on estimated fair values. The Company previously accounted for the stock-based compensation under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under the intrinsic value method of APB 25, no stock-based compensation expense had been recognized in the Company’s Consolidated Statement of Operations, because the exercise price of the Company’s stock options granted to employees and directors equaled the fair market value of the underlying stock at the date of grant. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) related to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s 2006 fiscal year. The Company’s Condensed Consolidated Financial Statements as of and for the three and nine months ended September 30, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company’s Condensed Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Under the modified prospective method of adoption for SFAS No. 123(R), the compensation cost recognized by the Company beginning in 2006 includes (a) compensation cost for all equity incentive awards granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for all equity incentive awards granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). The Company uses the straight-line attribution method to recognize share-based compensation costs over the service period of the award. Stock-based compensation expense recognized under SFAS 123(R) for the three and nine months ended September 30, 2006 was $0.1 million and $0.4 million, respectively, which consisted of stock-based compensation expense related to employee stock options.

SFAS 123(R) requires companies to estimate the fair value of share-based payments awards on the

date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s Condensed Consolidated Statement of Operations. In accordance with SFAS No. 123(R), the Company adjusts share-based compensation on a quarterly basis for changes to the estimate of expected equity award forfeitures based on actual forfeiture experience. The effect of adjusting the forfeiture rate for all expense amortization after January 1, 2006 is recognized in the period the forfeiture estimate is changed. The effect of forfeiture adjustments in the third quarter and nine months of 2006 was insignificant.

On November 10, 2005, the FASB issued FASB Staff Position No. SFAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” The Company is evaluating the alternative transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R).

Pro forma information under SFAS 123 for periods prior to January 1, 2006

Prior to January 1, 2006, the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25. The following table illustrates the effect on net income and earnings per share for the three months and nine months ended September 24, 2005 based on the fair value method set forth in SFAS No. 123.


	Three Months Ended		Nine Months Ended
	September 24, 2005 (in thousands)		September 24, 2005 (in thousands)

Net income	$	1,471	$	1,681
Less: Total stock-based compensation determined under the fair value method for all awards, net of related tax		73		81

Pro forma net income	$	1,398	$	1,600

Income per share:
Basic	$	0.11	$	0.13

Basic — pro forma	$	0.11	$	0.12

Diluted	$	0.11	$	0.13

Diluted — pro forma	$	0.11	$	0.12

Share-based compensation recognized in 2006 as a result of the adoption of SFAS No. 123(R) as well as pro forma disclosures according to the original provisions of SFAS No. 123 for periods prior to the adoption of SFAS No. 123(R) use the Black-Scholes option pricing model for estimating fair value of options granted under the Company’s equity incentive plans. The weighted average estimated values of employee stock option grants, as well as the weighted average assumptions that were used in calculating such values during the third quarter of 2006 and 2005, and the nine months of 2006 and 2005, were based on estimates at the date of grant as follows:

Stock Options


	Three Months Ended						Nine Months Ended
	September 30, 2006			September 24, 2005(A)			September 30, 2006			September 24, 2005 (A)

Weighted average estimated values	$	4.90		$	4.14		$	4.90		$	4.14
Expected life (in years)		5.0			4.0			5.0			4.0
Risk free interest rate		4.7	%		4.0	%		4.7	%		4.0	%
Volatility		56.59	%		57.62	%		56.59	%		57.62	%


(A)		Assumptions used in the calculation of fair value according to original provisions of SFAS No. 123.

No options were granted in the first six months of 2006 and 2005, therefore, the assumptions used for the three and nine month period ended September 30, 2006 and September 24, 2005 are the same. Expected volatility is based on historical stock price over the estimated holding period. The expected life of options granted is based on the simplified calculation of expected life, described in the U.S. Securities and Exchange Commission’s Staff Accounting Bulletin 107 due to changes in the vesting terms and contractual life of current option grants compared to the Company’s historical grants. The risk free rate is based upon the treasury note applicable for that specific holding period.

Transactions involving stock options under the Company’s various plans and otherwise are summarized below:

Number of

Weighted Average

Range of Options Price

Exercise Price

Outstanding, December 31, 2005

1,780,037

7.28 — 159.19

26.87

Granted

20,000

9.19

Exercised

(44,984

)

7.56 — 12.55

9.02

(A)

Cancelled

(337,834

)

7.28 — 117.34

15.94

Outstanding, September 30, 2006

1,417,219

7.28 — 159.19

29.79


	Number of Shares

Options exercisable at:
December 31, 2005		1,605,113
September 30, 2006		1,246,296


(A)		The intrinsic value associated with exercised options which was $271,483 represents the difference between the exercise price and the value of Tollgrade stock at the time of exercise.

The following table summarizes the status of stock options, outstanding and exercisable, at September 30, 2006:


	Stock Options Outstanding								Stock Options Exercisable
			Weighted Average
Range of Exercise	Number Outstanding		Remaining		Weighted Average		Aggregate Intrinsic		Number Exercisable		Weighted Average		Aggregate Intrinsic
Prices	as of 09/30/06		Contractual Life		Exercise Price		Value		as of 09/30/06		Exercise Price		Value (A)
$7.28		51,000		2.21	$	7.28	$	85,104		51,000	$	7.28	$	85,104
7.29 — 9.49		441,252		7.08		8.54		218,185		270,329		8.47		157,896
9.50 — 12.55		128,717		4.50		11.34		—		128,717		11.34		—
12.56 — 15.84		119,000		3.70		13.81		—		119,000		13.81		—
15.85 — 21.70		159,500		5.03		19.15		—		159,500		19.15		—
21.71 — 28.70		172,000		5.03		27.93		—		172,000		27.92		—
28.71 — 55.90		191,700		4.60		44.73		—		191,700		44.74		—
55.91 — 103.59		10,000		3.96		97.25		—		10,000		97.25		—
103.60 — 117.34		128,000		3.88		117.34		—		128,000		117.34		—
$117.35 — 159.19		16,050		3.78		159.19		—		16,050		159.19		—

Total		1,417,219		5.22	$	29.79	$	303,289		1,246,296	$	32.69	$	243,000


(A)		The aggregate intrinsic value in the preceding table represents the difference between the exercise price and the value of Tollgrade stock on September 30, 2006 of $8.95. The total number of in-the-money options exercisable as of September 30, 2006 was 251,309.


			Weighted Average Exercise		Weighted Average Remaining		Aggregate Intrinsic
	No. of Shares		Price		Contractual Term		Value¹

Vested		1,246,296	$	32.69		3.8	$	243,000
Expected to Vest		170,923		8.64		8.9		60,289

Total		1,417,219	$	29.79		5.2	$	303,289


(1)		The aggregate intrinsic value in the preceding table represents the difference between the exercise price and the value of Tollgrade stock on September 30, 2006 of $8.95.

As of September 30, 2006, there was $516,158 of unrecognized compensation cost related to stock options granted under the Company’s equity incentive plans. The unrecognized compensation cost is expected to be recognized over a weighted average period of 1.1 years.

4. ACQUISITION

On February 24, 2006, Tollgrade acquired certain assets and assumed certain liabilities associated with the test systems business unit of Emerson for $5.5 million in cash. The acquisition was recorded under the purchase method of accounting in accordance with the provisions of SFAS No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets,” and accordingly, the results of operations of the acquired Emerson test systems business from February 24, 2006 forward are included in the consolidated financial statements of the Company. The Company has made a preliminary allocation of the purchase price to the fair value of assets acquired and liabilities assumed. The purchase price allocation was made on a preliminary basis and remains subject to change based on the parties agreement regarding the final closing net assets as required by the Asset Purchase Agreement. We are currently reviewing the closing net asset statement in accordance with that

The following condensed pro forma results of operations reflect the pro forma combination of the Company and the acquired Emerson test systems business as if the combination occurred as of the beginning of each of the periods presented. Revenues for the periods prior to the Company’s ownership were based on historical information provided by Emerson. The pro forma financial information is presented for comparative purposes only and is not necessarily indicative of the operating results that actually would have been incurred had the Emerson acquisition been consummated on January 1, 2005 or 2006. In addition, these results are not intended to be projections of future results.


	(In Thousands, Except Per Share Data)
	Unaudited Pro Forma			Unaudited Pro Forma
	Three Months Ended			Three Months Ended
	September 30, 2006			September 24, 2005
Revenues	$	14,949		$	18,744
(Loss) income from operations	$	(5,738	)	$	1,481
Net (loss) income	$	(3,250	)	$	1,481
Diluted (loss) earnings per share	$	(0.25	)	$	0.11


	(In Thousands, Except Per Share Data)
	Unaudited Pro Forma			Unaudited Pro Forma
	Nine Months Ended			Nine Months Ended
	September 30, 2006			September 24, 2005
Revenues	$	50,376		$	55,812
(Loss) income from operations	$	(7,218	)	$	1,625
Net (loss) income	$	(3,412	)	$	2,052
Diluted (loss) earnings per share	$	(0.26	)	$	0.16

5. INTANGIBLE ASSETS

The following information is provided regarding the Company’s intangible assets and goodwill (in thousands):


			September 30, 2006						December 31, 2005
	Useful				Accumulated						Accumulated
	Life (Years)		Gross		Amortization		Net		Gross		Amortization		Net
Amortizing Intangible Assets:
Post Warranty Service Agreements		50	$	32,000	$	640	$	31,360	$	32,000	$	160	$	31,840
Technology		5-10		17,878		11,733		6,145		16,973		9,698		7,275
Customer Relationships		5-10		2,843		672		2,171		2,650		449		2,201
Purchased Backlog		1		97		97		—		—		—		—
Tradename		3		62		18		44		—		—		—

Non-Amortizing Intangible Assets:
Tradenames				2,300		—		2,300		2,300		—		2,300


Total Intangible Assets			$	55,180	$	13,160	$	42,020	$	53,923	$	10,307	$	43,616



Goodwill			$	23,857			$	23,857	$	21,562			$	21,562

On February 24, 2006, the Company acquired certain assets and assumed certain liabilities associated with the test systems business of Emerson for $5.5 million in cash, as discussed in Note 4. The allocation of the purchase price to intangible assets and goodwill is as follows (in thousands):


Customer Relationship (useful life of 5 years)	$	193
Purchased Technology (useful life of 5 years)	$	761
Tradename (useful life of 3 years)	$	62
Backlog (useful life of 6 months)	$	97
Goodwill	$	2,295

Finite lived intangible assets are generally amortized on a straight-line basis with the exception of any customer relationship assets and software-related intangible assets. The customer relationship assets are amortized utilizing an accelerated method which reflects the pattern in which the economic benefits of the customer relationship asset are consumed or otherwise used. Software-related intangible assets are amortized based on the greater of the amount computed using the ratio that current gross revenues bear to the total of current and anticipated future gross revenues for that product, or the straight-line method over the remaining estimated economic life. All amortization of intangible assets is recorded in cost of goods sold.

The Company currently estimates its total amortization expense to be $0.6 million for the remaining three months of 2006 and $2.3 million, $2.2 million, $2.0 million, and $1.9 million for the years ended December 31, 2007, 2008, 2009, and 2010, respectively, and $30.7 million for periods thereafter.


6.		INVENTORY

Inventory consisted of the following (in thousands):


	September 30, 2006			December 31, 2005
Raw materials	$	7,520		$	6,966
Work in process		3,326			3,448
Finished goods		2,734			1,615

		13,580			12,029
Reserve for slow moving and obsolete inventory		(2,627	)		(2,095	)

	$	10,953		$	9,934

During the third quarter of 2006, the Company implemented a restructuring program which included the elimination of products that were not considered part of the Company’s ongoing strategic focus. This resulted in a pre-tax charge of $4.3 million of which approximately $3.7 million has been removed from inventory and scrapped, and $0.6 million that was not removed from inventory but reserved. The remaining $0.6 million is expected to be scrapped in the fourth quarter of 2006.


7.		SHORT-TERM INVESTMENTS

Short-term investments at September 30, 2006 and December 31, 2005, which are classified as available for sale, primarily consisted of individual municipal bonds stated at cost, which approximated market value. These securities have maturities of more than three months and less than one year from the date of purchase and/or contain a callable provision in which bonds can be called within one year from date of purchase. The primary investment purpose is to provide a return on investment of funds held for future business purposes, including acquisitions and capital expenditures. Realized gains and losses are computed using the specific identification method.


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


9.		PER SHARE INFORMATION

Net 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 and nine month periods ended September 30, 2006 did not include the effect of dilutive securities, which amounted to 21,000 and 88,000, respectively, due to the net loss reported in each of those periods which would make those securities anti-dilutive to the earnings per share calculation.
A reconciliation of earnings per share is as follows (in thousands, except per share data):


	Three Months Ended		Nine Months Ended
	September 24, 2005		September 24, 2005
Net Income	$	1,471	$	1,681

Common and common equivalent shares:
Weighted average common shares outstanding		13,162		13,162
Effect of dilutive securities- stock options		59		40

		13,221		13,202

Income per share:
Basic	$	0.11	$	0.13
Diluted	$	0.11	$	0.13


10.		RECEIVABLE FROM OFFICER

In July 2001, the Company provided a loan for $0.2 million under a promissory note to an officer of the

Company. 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 in the name of Acterna, LLC as collateral, which currently have no value. The balance of the loan at September 30, 2006 and December 31, 2005 was approximately $149,000 and $153,000, respectively. The loan has not been modified since its original issuance.


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. 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 30, 2006			December 31, 2005
Balance at the beginning of the period	$	2,220		$	2,081

Accruals for warranties issued during the period		1,050			1,502
Settlements during the period		(1,137	)		(1,363	)


Balance at the end of the period	$	2,133		$	2,220

During 2005, settlements during the period included a $0.2 million change in estimate of certain warranty reserves.


12.		CONTINGENCIES AND COMMITMENTS

The Company is, from time to time, a 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.

The Company has in place a five-year $25.0 million Unsecured Revolving Credit Facility (the “Facility”) with a bank. The Facility expires in December 2006 and has no outstanding borrowings as of September 30, 2006.


13.		MAJOR CUSTOMERS AND INTERNATIONAL SALES

28.0% of the Company’s total revenue for the third quarter of 2006. Sales to one of the four RBOCs individually exceeded 10% of the Company’s total revenue for the third quarter of 2005. The Company did not have any sales exceeding 10% of consolidating revenues during the three month period ended September 30, 2006 or September 24, 2005 to any of its customers for cable products and services.

For the nine months ended September 30, 2006 and September 24, 2005, sales to the RBOCs accounted for approximately 31.4% and 34.0%, respectively, of the Company’s total revenue. Sales to two of the four RBOC customers individually exceeded 10% of the Company’s total revenue and comprised 24.7% of the Company’s total revenue for the nine months ended September 30, 2006. Sales to one of the four RBOC customers individually exceeded 10% of the Company’s total revenue and comprised 14.8% of the Company’s total revenue for the nine months ended September 24, 2005. The Company had sales to one non-RBOC customer that exceeded 10% of the Company’s total revenue and comprised 15.1% of the Company’s total revenue for the nine months ended September 24, 2005. The Company had sales to one cable customer that exceeded 10% of the Company’s consolidated revenue and comprised 12.6% of the Company’s total revenue for both the nine month periods ended September 30, 2006 and September 24, 2005.

International sales represented approximately $5.2 million or 34.8% of the Company’s total revenue for the quarter ended September 30, 2006, compared to $5.7 million, or 34.0%, in the third quarter 2005. Our international sales were primarily in three geographic areas based upon customer location for the quarter ended September 30, 2006: the Americas (excluding the United States); Europe, the Middle East and Africa (“EMEA”); and Asia. Sales for the Americas were approximately $1.2 million, sales for EMEA were $3.8 million and sales in Asia were $0.2 million.

International sales represented approximately $11.4 million or 23.4% of the Company’s total revenue for the nine months ended September 30, 2006, compared to $12.3 million, or 25.5%, for the nine months ended September 24, 2005. Our international sales were primarily in three geographic areas based upon customer location for the nine months ended September 30, 2006: the Americas (excluding the United States); EMEA; and Asia. Sales for the Americas were approximately $3.6 million, sales for EMEA were $7.3 million and sales in Asia were $0.5 million.


14.		SERIES A JUNIOR PARTICIPATING PREFERRED STOCK PURCHASE RIGHTS

On July 23, 2006, the preferred share purchase rights under the Rights Agreement, dated July 23, 1996, between the Company and Chase Mellon Shareholder Services, LLC, as Rights Agent, expired pursuant to their terms.

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 30, 2006, and the related condensed consolidated statements of operations for each of the three-month and nine-month periods ended September 30, 2006 and September 24, 2005, the condensed consolidated statement of changes in shareholders’ equity for the nine-month period ended September 30, 2006 and the condensed consolidated statements of cash flows for the nine-month periods ended September 30, 2006 and September 24, 2005. 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, 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, 2005, and the related consolidated statements of operations, 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, 2005 and the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005; and in our report dated March 2, 2006, we expressed unqualified opinions thereon. The consolidated financial statements and management’s assessment of the effectiveness of internal control over financial reporting referred to above are not presented herein. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2005, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.

PricewaterhouseCoopers LLP
Pittsburgh, PA
October 23, 2006

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 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. 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, as a result of various factors, including those described in Part II, Item 1A under “Risk Factors.” 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 designs, engineers, markets and supports test system, test access and status monitoring hardware and software products for the telecommunications and cable television industries. The Company’s telecommunications proprietary test access products enable telephone companies to use their existing line test systems to remotely diagnose problems in Plain Old Telephone Service (“POTS”) lines containing both copper and fiber optics. The Company’s test system products, specifically the DigiTest^® test platform and now the hardware and software acquired in the Emerson acquisition, focus on helping local exchange carriers conduct the full range of fault diagnosis along with the ability to pre-qualify, deploy and maintain next-generation services, including Digital Subscriber Line service. The Company’s cable products consist of a complete cable status monitoring system that provides a comprehensive testing solution for the Broadband Hybrid Fiber Coax

distribution system. The status monitoring system consists of a host for user interface, control and configuration; a headend controller for managing network communications; and transponders that are strategically located within the cable network to gather status reports from power supplies, line amplifiers and fiber-optic nodes.

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 quarter ended September 30, 2006, sales to the RBOCs accounted for approximately 35.2% the Company’s total revenue, compared to approximately 35.0% of total revenue for the third quarter of 2005. Sales to two of the four RBOC customers individually exceeded 10% of the Company’s total revenue for the third quarter of 2006, and was approximately 28.0% of the Company’s total revenue for the three months ended September 30, 2006. For the nine months ended September 30, 2006 and September 24, 2005, sales to the RBOCs accounted for approximately 31.4% and 34.0%, respectively, of the Company’s total revenue. Sales to two of the four RBOC customers individually exceeded 10% of the Company’s total revenue and comprised 24.7% of the Company’s total revenue for the nine months ended September 30, 2006. Sales to one of the four RBOC customers individually exceeded 10% of the Company’s total revenue and comprised 14.8% of the Company’s total revenue for the nine months ended September 24, 2005. The Company continues to be highly dependent on the four RBOCs for a significant portion of its total revenue, but that proportion has decreased as the RBOC customers have diverted capital spending to rebuilding their networks with new, Ethernet-based technology. This has caused changes in the Company’s product mix from our legacy telco hardware products to our cable hardware and software products, which carry lower profit margins, as well as other next generation related telecommunications products. The Company had sales to one non-RBOC customer that exceeded 10% of the Company’s total revenue and comprised 15.1% of the Company’s total revenue for the nine months ended September 24, 2005.

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. The Company did not have any individual cable customer that comprised over 10% of the total revenue for the quarter ended September 30, 2006. During the quarter ended September 24, 2005, the Company did not have sales to any cable customer that exceeded 10% of consolidated revenue. The Company had sales to one cable customer that exceeded 10% of the Company’s consolidated revenue and comprised 12.6% of the Company’s total revenue for both the nine month periods ended September 30, 2006 and September 24, 2005.

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 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 lines in service today throughout the world. The Company also sells LoopCare™ and DigiTest^®, and N(x)Test™, N(x)DSL-3™, and LTSC™, the products acquired in the recent Emerson acquisition, 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; N(x)Test, N(x)DSL-3 and LTSC

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 widely deployed in current POTS networks. In addition, upgrades to DigiTest hardware can provide troubleshooting for DSL service problems.

LoopCare has remained 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 also has available 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, T-1 and Hypertext Transfer Protocol (HTTP) performance tests. In addition, LoopCare, working in conjunction with the DigiTest hardware and using innovative insertion loss measurements, can provide a customer with highly accurate predictions of potential DSL connect speeds. These test capabilities, when managed by our LoopCare OSS, enable service providers to accurately isolate a DSL problem between 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.

Our DigiTest family of products also includes the DigiTest HUB™, our next generation central office test platform designed to support multiple testing environments. The DigiTest HUB addresses emerging broadband testing requirements, but also retains interfaces to legacy equipment, allowing for a seamless migration from traditional to packet-based delivery of services and allowing service providers to continue automated, mass-market processes. The DigiTest HUB is a modular 12-slot chassis for medium to large Central Office applications from where a variety of services emanate. Plug-in modules can be added, as required to support POTS and DSL Layer 1-7. Test plug-in resources

can be shared to multiple network elements by the use of a module that multiplexes the test access path. This includes sharing a test resource to remote access elements as fiber is driven further out into the network in topologies such as FTTx. When coupled with our LoopCare OSS, the DigiTest HUB serves the testing needs of both legacy and evolving broadband networks to facilitate a low-cost, asset-preserving transition.

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 independent telephone companies 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;

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

•		Multi-DSL Prequalification Features; and

•		Breakthrough CPE and Fast Answering CPA Suppression.

Our recently acquired N(x)Test product is a modular, subscriber loop measurement unit, which utilizes an open architecture, standard interfaces and DSP measurement technology. The N(x)Test unit can address broadband testing, standard demand and interactive testing and OSS-controlled ALT batch processing on subscriber loops, as well as expanded testing capability related to the pre-qualification of loops for DSL services through the network element. The N(x)DSL-3 test unit provides higher layer testing capability for various DSL services a customer may deploy. N(x)DSL-3 can be coupled with N(x)Test, providing the ability to conduct a full range of POTS and DSL testing, or used as a stand-alone, DSL-only test head. Our LTSC, Line Test Systems Controller, is a software package with multi-tasking capabilities that can stand alone or become an integrated process to an existing OSS in order to provide a totally integrated line testing platform for the customer’s operations. Designed with an open architecture, the LTSC system provides client/server access to the N(x)Test/N(x)DSL-3 systems deployed within the customer’s network in order to maintain the Quality Of Service for typical POTS as well as DSL services as the customer migrates towards a next generation network.

MCU

Our 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, our products can reduce operating costs and increase subscriber satisfaction.

Our cable offerings currently consist of our proprietary CheetahLight™ (formerly LIGHTHOUSE^®) and CheetahNet™ (formerly NetMentor™) software systems and maintenance, our CheetahXD™ Broadband Assurance Software and maintenance head-end controllers, return path switch hardware, both proprietary and DOCSIS^®-based and Euro-DOCSIS™-based transponders and other equipment which gather status and performance reports from power supplies, line amplifiers and fiber optic nodes. In 2003, we entered into an agreement with Alpha, the leading supplier of power management products to the cable industry, initially to serve as the exclusive provider of DOCSIS-based status monitoring equipment for its power supply systems. This agreement contains an initial term which expires in November 2007 and automatically renews on an annual basis thereafter unless terminated. In November 2005, this agreement was modified to make the right to sell the external version of the product non-exclusive, allowing us to sell that product directly to end customers. Since the modification of this agreement, we have experienced a decline in orders of DOCSIS-based transponders from Alpha, as they have also expanded their transponder purchases from the Company’s competitors, but this decline has been partially offset by an increase in direct sales of our DOCSIS-based transponders to end customers.

SERVICES

Our Services offerings include software maintenance as well as professional services, which are designed to make sure that all of the components of our customers’ voice test systems operate properly. The Services business was considerably expanded upon the acquisition of software maintenance relationships related to the LoopCare and CheetahNet software product lines and with our internal development of the CheetahXD™ software. Our Services business has shifted away from traditional MCU-based services, which have been replaced by more project-specific business. As a result, revenues from Services have become less predictable.

BACKLOG

Our backlog consists of firm customer purchase orders and signed software maintenance agreements. As of September 30, 2006, the Company had backlog of approximately $11.6 million compared to $14.7 million as of December 31, 2005 and $12.3 million as of September 24, 2005. The decrease in the backlog from December 31, 2005 is attributed to completion of significant milestones for certain

large projects and timing of the renewal of certain maintenance agreements that expire on December 31, 2006. The backlog at September 30, 2006 and December 31, 2005 includes approximately $4.7 million and $6.2 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.

We have entered into LoopCare software maintenance agreements with all four RBOCs. Two of these agreements expire December 31, 2006, while the other two agreements expire on December 31, 2007 and December 31, 2008, respectively.

Management expects that approximately 62% of the current backlog will be recognized as revenue in the fourth quarter of 2006. 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 impact short-term results, they are not necessarily indicative of long-term trends in sales of our products.

OPERATING SEGMENT

We have determined that our business has one operating segment, test assurance. All product sales relate to the business of testing infrastructure and networks for the telecommunications and cable television industries. Our products have similar production processes, and are sold through comparable 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 $5.2 million, or 34.8% of the Company’s total revenue for the quarter ended September 30, 2006, compared to $5.7 million, or 34.0%, for the quarter ended September 24, 2005. Our international sales were primarily in three geographic areas based upon customer location for the quarter ended September 30, 2006: the Americas (excluding the United States); Europe, the Middle East and Africa (“EMEA”); and Asia. Sales for the Americas were approximately $1.2 million, sales for EMEA were $3.8 million and sales in Asia were $0.2 million.

International sales represented approximately $11.4 million, or 23.4% of the Company’s total revenue for the nine months ended September 30, 2006, compared to $12.3 million, or 25.2%, for the nine months ended September 24, 2005. Our international sales were primarily in three geographic areas based upon customer location for the nine months ended September 30, 2006: the Americas (excluding the United States); EMEA; and Asia. Sales for the Americas were approximately $3.6 million, sales for EMEA were $7.3 million and sales in Asia were $0.5 million.

Our marketing activity in international markets has expanded. We continue to evaluate opportunities in the international market that will enhance our international presence. Through our OEM relationships with Lucent and Telesciences, we have experienced some success selling our DigiTest and LoopCare products into certain international markets, and we continue to target specific opportunities with those OEM channels. Additionally, we believe the Emerson acquisition will enhance our international sales opportunities for our telecommunications products into their existing customer base, and into

greenfield opportunities for POTS and DSL testing. As part of that acquisition, the Company also assumed an agreement to provide the LTSC software and N(x)Test and associated hardware to a customer in Eastern Europe. The Company received acceptance on the pilot phase of this project and recorded revenue related to the pilot and product deployment in the third quarter of 2006. Also, the Company has sold these and other products to Ericsson on an as-ordered basis for resale to providers in the United Kingdom, and is hoping to put in place an agreement to formalize that relationship.

SERIES A JUNIOR PARTICIPATING PREFERRED STOCK PURCHASE RIGHTS

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. The application of certain of these accounting principles is more critical than others in gaining an understanding of the basis upon which our financial statements have been prepared. We deem the following accounting policies to involve critical accounting estimates.

Revenue Recognition

We market and sell test system hardware and related software to the telecommunications and cable television industries. The Company follows Staff Accounting Bulletin (SAB) 104, “Revenue Recognition,” for hardware and software sales. This bulletin requires, among other things, that revenue should be recognized only when title has transferred and risk of loss has passed to a customer with the capability to pay, and that there are no significant remaining obligations of the Company related to the sale. The majority of our hardware sales are made to RBOCs and other large customers. Delivery terms of hardware sales are predominantly FOB origin. Where title and risk of loss do not pass to the customer until the product reaches the customer’s delivery site, revenue is deferred unless the Company can objectively determine delivery occurred before the end of the applicable reporting period. Revenue is recognized for these customers upon shipment against a valid purchase order. We reduce collection risk by requiring letters of credit or other payment guarantees for significant sales to new customers, certain international customers and/or those in weak financial condition.

For perpetual software license fees and maintenance revenue, we follow the AICPA’s Statement of Position (SOP) 97-2, “Software Revenue Recognition.” This statement requires that software license fee revenue be recorded only when evidence of a sales arrangement exists, the software has been delivered, and a customer with the capacity to pay has accepted the software, leaving no significant obligations on the part of the Company to perform. We require a customer purchase order or other written agreement to document the terms of a software order and written, unqualified acceptance from the customer prior to revenue recognition. In certain limited cases, however, agreements provide for automatic customer acceptance after the passage of time from a pre-determined event and we have relied on these provisions for an indication of the timing of revenue recognition. In isolated cases for orders of custom software, or orders that require significant software customization, we employ contract accounting using the percentage-of-completion method, whereby revenue is recognized based on costs incurred to date compared to total estimated contract cost in accordance with SOP 81-1,

“Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” The revenue for orders with multiple deliverables such as hardware, software and/or installation or other services may be separated into stand-alone fair values if not already documented in the purchase order or agreement and where list prices or other objective evidence of fair value exists to support such allocation, in accordance with the provisions of Emerging Issues Task Force (EITF) Issue 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” Revenue will not be recognized for any single element until all elements considered essential to the functionality of the delivered elements under the contract are delivered and accepted.

The recognition of revenue under EITF 00-21 requires certain judgment by management. If any undelivered elements, which can include hardware, software or services, are essential to the functionality of the system as defined in the contract, revenue will not be recorded until all of the items considered essential are delivered as one unit of accounting. Our internal policy requires that we obtain a written acceptance from our customers for each specific customer situation where new products are sold. Revenue will not be recorded until written acceptance is received from the customer. Although infrequent, in some situations contingencies will be noted by the customer on the written acceptance. In these situations, management will use judgment to determine the importance of such contingencies for recognizing revenue related to the sale. The Company’s general practice is to defer revenue recognition unless these contingencies are inconsequential.

Our LoopCare and other software customers may enter into separate agreements for software maintenance upon expiration of the stated software warranty period. Maintenance agreements include software upgrades and bug fixes as they become available; however, newly developed features must be purchased separately. Post-warranty maintenance for new features is either included under the current maintenance agreement without additional charge, and is considered in the maintenance agreement fees, or is separately charged upon expiration of the warranty. Depending upon the timing of the enhancement purchase and the length of the maintenance agreement, we must evaluate whether or not a portion of a perpetual right to use fee should be treated as post-contract support to be deferred and recognized over the remaining life of the maintenance agreement.

Software maintenance revenue is recognized on a straight-line basis over the period the respective arrangements are in effect. Revenue recognition, especially for software products, involves critical judgments and decisions that can result in material effects to reported net income.

Goodwill and Intangible Assets

At September 30, 2006, we had net intangible assets of $65.9 million including Goodwill of $23.9 million primarily resulting from the acquisitions of the LoopCare product line in September 2001, the Cheetah product line in February 2003 and the test business of Emerson in February of 2006. In connection with these acquisitions, we utilized the guidance of Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets,” which were issued in July 2001. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 and that goodwill, as well as any indefinite-lived intangible assets, not be amortized for financial reporting purposes. Finite-lived intangible assets are amortized on a straight-line basis or an accelerated method, whichever better reflects the pattern in which the economic benefits of the asset are consumed or otherwise used. Software-related intangible assets are amortized based on the greater of the amount computed using the

ratio that current gross revenues bear to the total of current and anticipated future gross revenues for that product or the straight-line method over the remaining estimated economic life.

In connection with the assets acquired in the 2001 LoopCare transaction, intangible assets of $45.1 million were identified with residual goodwill of $16.6 million. These include Developed Product Software valued at $7.3 million and LoopCare Base Software valued at $4.5 million. Both have been determined to have finite useful lives of five years and ten years, respectively, and are being amortized over those periods. Also identified were intangible assets related to the LoopCare trade name of $1.3 million and Post-Warranty Service Agreements of $32.0 million. Because of the longevity of the LoopCare trade name and the stability, level of embedment, and unique dependence of the RBOCs on the post warranty maintenance services, these intangible assets were determined to have indefinite useful lives at the acquisition date. With regard to the Post-Warranty Maintenance Service Agreements, during the fourth quarter of 2005 management determined that events and circumstances which supported the indefinite life of this asset had changed. More specifically, during the fourth quarter of 2005, one of the Company’s key customers disclosed that its FTTP initiative had exceeded 5% of its subscriber base, which indicates that the intangible asset related to the Post-Warranty Service Agreements may not have an indefinite useful life. This development as well as circumstances surrounding recent post-warranty contract renewals led the Company to conclude that in accordance with SFAS No. 142 a finite useful life should be assigned and the intangible asset should be amortized beginning October 1, 2005. Management currently believes that the hybrid fiber/copper network currently deployed by the RBOCs, which is tested by the underlying LoopCare Base Software, will exist for at least an additional 50 years. Management has therefore assigned a useful life to this asset of 50 years.

In the 2003 Cheetah acquisition, intangible assets of $7.8 million were identified with residual goodwill of $4.9 million. The intangible assets consisted of the Cheetah Base Software valued at $2.9 million, the Cheetah Customer Base valued at $2.7 million, Proprietary Technology valued at $1.0 million, and Cheetah Maintenance Agreements valued at $0.2 million. The Cheetah Base Software, Proprietary Technology and Cheetah Maintenance Agreements were determined to have useful lives of ten years, while the Cheetah Customer Base whose value is based on discounted cash flows generated on hardware sales which typically continue five years beyond the sale of the corresponding Base Software, was assigned a useful life of 15 years. A Cheetah trademark asset valued at $1.0 million was identified and determined to have an indefinite useful life.

On February 24, 2006, we acquired certain assets and assumed certain liabilities associated with the test business of Emerson Network Power, Energy Systems, North America, Inc. for $5.5 million in cash. We have performed a preliminary allocation of the purchase price to the net assets acquired and have determined a preliminary estimate of useful life. The preliminary purchase price allocation remains subject to change based on the finalization of the closing net assets. The Asset Purchase Agreement requires the final purchase price to be calculated and agreed to by the Company and Emerson based on the Closing Net Assets as of the date of the acquisition; we are currently reviewing the Closing Net Asset Statement in accordance with the agreement and any adjustments in the finalization of the purchase price may be material. Based on our preliminary purchase price allocation, we have identified $0.2 million of customer relationship intangible assets and $0.8 million in technology related intangible assets both having an estimated life of five years. We also have identified $0.1 million associated with a tradename that is expected to have a useful life of 3 years.

Finally, we allocated $0.1 million of the purchase price to the sales order backlog that was acquired, which was consumed during the first quarter of 2006. Based on the preliminary purchase price allocation, goodwill is approximately $2.3 million.

Sensitivity Analysis:

Certain portions of the telecom market serviced by the Company’s products are evolving and, when appropriate, management reviews the impact of such changes on the key assumptions underlying the valuation of each of its intangible assets. Technological advances, as well as potential changes in strategic direction by any of the Company’s key telecom or cable customers, could result in an impairment or substantial reduction in one or more of the estimated lives over which the respective intangible asset(s) is/are currently being amortized. The following table lists intangible assets with a remaining life at September 30, 2006 of at least one year and that have a net book value exceeding $0.1 million:


	Years
							Twelve-month
			Remaining Life at		Carrying Value at		Rolling Projected
Asset Description	Original Life		9/30/06		9/30/06		Amortization
					(in millions)
LoopCare
Base Software		10		5.0		2.2	$	0.5
Post-Warranty
Maintenance Service
Agreements		50		49.0		31.4		0.6
Cheetah
Base Software		10		6.25		1.8		0.3
Proprietary Technology		10		6.0		0.6		0.1
Customer Base		15		11.0		2.0		0.3
Emerson
Proprietary Technology		5		4.5		0.7		0.2
Customer Relationship		5		4.5		0.2		0.1
Other		3-5		2.5		0.5		0.2

						39.4	$	2.3

In the event that the Company would reevaluate the above estimated useful lives in the future due to changed events and circumstances, annual amortization would increase based on the respective intangible asset’s carrying value and revised remaining useful life.

Reviews for Impairment:

Goodwill and certain other intangible assets, determined to have an indefinite life, are not amortized. Instead, these assets are reviewed for impairment at least annually or more frequently if events or changes in circumstance indicate that the carrying value of such assets may not be recoverable. During these reviews for impairment of indefinite lived assets, other than goodwill, we review any changes in facts and circumstances which would impact the estimated useful life of the asset. We perform our annual impairment tests on December 31st of each year. With respect to goodwill, we have

determined that we have one reporting unit. Our goodwill impairment test indicated no impairment in 2005 or in prior years. Indefinite lived intangible assets are valued using the relief from royalty method with no residual value. For indefinite lived intangible assets, our annual impairment tests indicated no impairment and the results of our review of useful lives, based on current events and circumstances, continue to support the indefinite lives.

During the second and third quarters of 2006, we continued to experience margin pressure, operating losses and volatility in our stock price. We considered the culmination of these events to be a triggering event under SFAS No. 142 as of June 30, 2006 and September 30, 2006. Therefore, we performed a review for impairment as of these dates which included consideration of several key factors impacting our share price as well as a completion of a discounted cash flow analysis. This overall analysis supported the carrying value of goodwill and no impairment was recorded as of either June 30, 2006 or September 30, 2006. The continuation of these market effects may, however, require us to record an impairment charge in any period in which impairment is determined, which could adversely affect future results.

We review our finite lived intangible assets and their related useful lives whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable, including a change in the competitive landscape; any internal decisions to pursue new or different technology strategies; a loss of a significant customer; or a significant change in the market place including changes in the prices paid for our products or changes in the size of the market for our products. An impairment results if the carrying value of the asset exceeds the sum of the future undiscounted cash flows expected to result from the use and disposition of the asset or the period of economic benefit has changed. If impairment were indicated, the amount of the impairment would be determined by comparing the carrying value of the asset group to the fair value of the asset group. Fair value is generally determined by calculating the present value of the estimated future cash flows using an appropriate discount rate. The projection of the future cash flows and the selection of a discount rate require significant management judgment. The key assumptions that management must estimate include sales volume, prices, inflation, product costs, capital expenditures and sales and marketing costs. For developed technology, we also must estimate the likelihood of both pursuing a particular strategy and the level of expected market adoption. We also considered the impact of margin pressure and operating losses on our other indefinite lived intangible assets and our definite lived intangible assets and have determined no impairment of those assets existed at the end of the third quarter of 2006.

If the estimate of an intangible asset’s remaining useful life would be changed, the remaining carrying amount of the intangible asset would be amortized prospectively over the revised remaining useful life.

This testing relative to impairments involves critical accounting estimates and estimates of revenues and cash flows. However, these expectations may not be realized and future events and market conditions might indicate material impairment of value that could result in material charges to net income. Such a future situation would not, however, in and of itself affect our cash flow or liquidity.

Inventory Valuation

We utilize a standard cost system that approximates first-in, first-out costing of the products. Standards are monitored monthly and changes are made on individual parts if warranted; otherwise standard costs are updated on all parts annually, normally in November of each year. Excess capacity is not included in the standard cost of inventory. We evaluate our inventories on a monthly basis for

slow moving, excess and obsolete stock on hand. The carrying value of such inventory that is determined not to be realizable is reduced, in whole or in part, by a charge to cost of sales and reduction of the inventory value in the financial statements. The evaluation process, which has been consistently followed, relies in large part on a review of inventory items that have not been sold, purchased or used in production within a one-year period. Management also reviews, where appropriate, inventory products that do not meet this threshold but which may be unrealizable due to discontinuance of products, evolving technologies, loss of certain customers or other known factors. As a result of this comprehensive review process, an adjustment to the reserve for slow moving and obsolete inventory is normally made monthly. Inventory identified as obsolete is also discarded from time to time when circumstances warrant.

Inventory realization is considered a critical accounting estimate since it relies in large part on management judgments as to future events and differing judgments could materially affect reported net income.

Allowance for Doubtful Accounts

The allowance is based on our assessment of the collectibility of customer accounts. We regularly review the allowance by considering factors such as historical experience, credit quality, age of the accounts receivable balances and current conditions that may affect a customer’s ability to pay.

If a major customer’s creditworthiness deteriorates, or if actual defaults are higher than our historical experience, or if other circumstances arise, our estimates of the recoverability of amounts due to us could be overstated, and an additional allowance could be required, which could have an adverse impact on our revenue.

Income Taxes

We follow the provisions of SFAS No. 109, “Accounting for Income Taxes,” in reporting the effects of income taxes in our consolidated financial statements. Deferred tax assets and liabilities 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 periodically evaluate all remaining deferred tax assets based on our current outlook and as of September 30, 2006, we believe all remaining assets will be utilized. There have been no significant changes in our state net operating losses or valuation allowances during the current quarter.

Warranty

We provide warranty coverage on our various products. Terms of coverage range from up to one year on software to two to five years for hardware products. We review products returned for repair under warranty on a quarterly basis and adjust the accrual for future warranty costs based upon cumulative returns experience. We also evaluate special warranty problems for products with high return rates to correct the underlying causes and, where deemed necessary, to provide additional warranty expense for expected higher returns of these products. Warranty costs associated with software sales are also accrued based on the projected hours to be incurred during the warranty period (normally three months). The accounting for warranty costs involves critical estimates and judgments that can have a material effect on net income.

These areas involving critical accounting estimates are periodically reviewed and discussed with the Audit Committee of our Board of Directors.

RESULTS OF OPERATIONS

THIRD QUARTER OF 2006 COMPARED TO THIRD QUARTER OF 2005

Revenues

The Company’s revenues for the third quarter of 2006 were $14.9 million, a decrease of $1.9 million, or 11.0%, compared to revenues of $16.8 million reported for the third quarter of 2005.

Sales of the Company’s DigiTest system products, which include LoopCare software, were $2.6 million in the third quarter of 2006, a decrease of $2.6 million compared to the third quarter of 2005 of $5.2 million. The decrease is primarily caused by reduced deployments of products into the Middle East as we completed this project, offset, in part by increased sales of product into Africa. DigiTest system sales accounted for 17.4% and 31.0% of total revenues for the third quarter of 2006 and 2005, respectively. As our RBOC and independent carrier customers continue to introduce new fiber-based technologies into their networks, we expect our DigiTest product sales to be more project-oriented and, as such, less predictable, at least until these customers begin to focus more heavily on the testing requirements of their new networks. However, we have implemented product strategies, such as the DigiTest HUB and EDGE products, which we continue to market to our telco customers as a way to transition their networks to these new network elements. However, there can be no assurances that these customers will implement our products in accordance with our plans.

Sales of LoopCare software products separate and unrelated to DigiTest system products were $0.7 million in the third quarter of 2006 compared with $0.2 million recorded in the third quarter of 2005. This increase represents additional software customization performed for a customer in the Middle East and for Cincinnati Bell. 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. In addition, customers who traditionally purchased LoopCare to manage their testing needs are in the midst of a technical migration, and, as described above, are currently diverting capital spending to those new network elements, which is impacting our LoopCare sales to those customers. As part of our product strategy, the Company has plans to continue to enhance LoopCare for the new network and assist our customers with their network migration in a seamless fashion. In addition, the Company’s sales and marketing plans also include expanding LoopCare sales into independent carrier and international customer networks. However, as a result of all these factors, revenue from this product line can fluctuate significantly on a quarter by quarter basis. LoopCare software product sales comprised 4.7% of total revenues during the third quarter of 2006 compared to 1.2% in the third quarter of 2005.

Overall sales of cable hardware and software products were $2.9 million compared to $3.2 million during the third quarter of 2005. The decrease is related to the inclusion in the prior year of revenue associated with certain legacy products and a large sale, in the prior year, of VoIP products to an international customer. We continue to focus our cable strategy for our DOCSIS-based transponders. The market is highly competitive and can impact sales volumes over the short and possibly long-term.

To address this competitive threat and attempt to improve DOCSIS-based equipment margins, which are generally lower than our proprietary technology, we will continue our efforts to sell directly to end customers in addition to designing differentiating technologies that we believe will increase the value and revenue opportunities for our related software and enhanced VoIP service assurance products, as these technologies are adopted by cable carriers. However, there can be no assurances that these customers will implement our VoIP-supporting products in accordance with our plans. Cable hardware and software product sales amounted to 19.5% and 19.0% of total third quarter 2006 and 2005 revenue, respectively.

Sales of MCUs during the third quarter of 2006 were $4.1 million, a decrease of 16.3% from $4.9 million reported in third quarter of 2005. The third quarter of 2005 was favorably impacted by receipt of bulk orders that were purchased related to hurricane and storm related restoration projects by certain RBOCs. As a result, MCU sales represented 27.5% of total third quarter 2006 revenues compared 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, and such sales may fluctuate somewhat unpredictably on a quarterly basis. 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.

Service revenues, which include installation oversight and project management services provided to RBOC and other customers and fees for LoopCare and Cheetah software maintenance, were $2.9 million in the third quarter of 2006, a decrease of 12.1% from $3.3 million recorded in the third quarter of 2005. The decline is primarily attributed to lower sales of software maintenance for traditional legacy cable products. Service revenues amounted to 19.5% and 19.6% of total third quarter 2006 and 2005 revenue, respectively.

Sales of the Company’s acquired Emerson Test Systems product line, which became part of the Company on February 24, 2006, were $1.7 million in the third quarter 2006 and amounted to 11.4% of revenues in the third quarter of 2006. During the third quarter of 2006, we received acceptance on the pilot phase of our product deployment into Eastern Europe. This acceptance and continued product deployment contributed significantly to the revenue associated with this product line.

Gross Profit

Gross profit declined $5.6 million from $8.8 million in the third quarter of 2005 to $3.2 million in the third quarter of 2006. The third quarter of 2006 included a charge of $4.3 million associated with product lines that have been discontinued. The remaining impact on gross margin dollars is the effect of reduced sales in the current quarter. As a percentage of sales, gross profit for the current quarter was 21.4% versus 52.1% for the year ago period. The significant decrease in gross margin is associated with the inventory write-down resulting from the restructuring program announced by the Company on July 27, 2006, which impacted gross margins by 29.1%. Gross margin as a percentage of sales was also impacted by product mix due to lower overall sales of DigiTest and MCUs in the third quarter of 2006.

Selling and Marketing Expense

Selling and marketing expense, which consists primarily of payroll-related costs, consulting expense, and travel costs, increased $0.5 million, or 28.2%, to $2.5 million for the third quarter of 2006. The increase is associated with an increase in salaries and wages due to additional headcount related to the purchase of the Emerson business, SFAS 123(R) stock compensation expense and increased commissions. The increase in sales commission expense is due to the effect of certain OEM sales in the third quarter of 2005 that, unlike direct sales, were not subject to commissions. As a percentage of revenues, selling and marketing expenses increased from 11.4% in the third quarter of 2005 to 16.4% in the third quarter of 2006.

General and Administrative Expense

General and administrative expense, which consists primarily of payroll-related costs, insurance expense and professional services, decreased $0.2 million or 8.3%, to $1.8 million during the third quarter of 2006. The decrease was associated with lower charges for doubtful accounts and a reduction in casual labor offset, in part, by SFAS 123(R) expense and professional services. As a percentage of revenues, general and administrative expenses increased from 11.4% in the third quarter of 2005 to 11.7% in the third quarter of 2006.

Research and Development Expense

Research and development expense, which consists primarily of payroll related costs and depreciation expense, decreased by $0.2 million, or 6.7%, to $3.2 million in the third quarter of 2006. The decrease in research and development expense is associated with a decrease in prototype expenses and rent expense, offset in part by additional employee costs associated with the acquisition of the Emerson product line. As a percentage of revenues, research and development expense for the third quarter of 2006 was 21.6%, up from 20.6% for the third quarter of 2005.

Restructuring

On July 27, 2006, Tollgrade announced a restructuring program which includes the consolidation of the Sarasota facility, discontinuance of various products, and write-down of certain fixed assets and real estate. The restructuring program will result in the reduction of approximately 20 employees of which 15 were terminated during the third quarter of 2006. All remaining employee reductions will be completed in the fourth quarter of 2006. The total expense recorded in the third quarter of 2006 was $5.8 million associated with the restructuring program and included $0.2 million associated with employee severance and relocation costs, $0.9 million for lease termination costs and fixed asset write-downs, a $4.3 million charge for the discontinuance of various products that are not part of the Company’s future strategic focus, and a charge of $0.4 million for impairment of real estate. The Company expects to record a charge of approximately $0.3 million in the fourth quarter of 2006 in connection with the final implementation of this program. We expect the restructuring program listed above and the Emerson integration program (discussed below) to provide annual cost savings of approximately $3.3 million.

The components of the charges and accrual at September 30, 2006 for this restructuring program are as follows:


	Balance at										Balance at
	June 30, 2006		Expense		Cash payments			Asset Write-Downs			September 30, 2006

Facility Rationalization including employee costs	$	—	$	1,078	$	(159	)	$	(570	)	$	349
Inventory write-down		—		4,346		—			(4,346	)		—
Real Estate impairment		—		422		—			(422	)		—

Total	$	—	$	5,846	$	(159	)	$	(5,338	)	$	349

Emerson Integration Program

In conjunction with the Emerson acquisition, the Company has implemented an integration plan to relocate certain former Emerson employees to our Cheswick, Pennsylvania location and the closure of the acquired facility in Ft. Worth, Texas. These costs will be accounted for under Emerging Issue Task Force No. 95-3 (EITF 95-3) “Recognition of Liabilities in Connection with a Purchase Business Combination.”

As a result, the relocation costs and facility closure have been recorded as part of the Emerson purchase price allocation. The cost consisted of relocation and facility rationalization costs, primarily rent for the Texas location that was closed. As of July 1, 2006, we had recorded an obligation of $0.4 million related to this program. During the third quarter of 2006, we reduced this obligation by $0.2 million associated with a reduction in relocation costs. This $0.2 million reduction was recorded as an adjustment under EITF 95-3. The remaining obligation is $0.1 million and is expected to be paid in the fourth quarter of 2006.

Additionally, in connection with the Emerson integration program, we completed a workforce reduction that resulted in the elimination of six positions associated with the acquired Emerson product line. Employees impacted by the reduction were provided a termination benefit to ensure an effective integration of the Emerson product line. All costs associated with this program have been incurred and paid as of September 30, 2006. The total charge associated with this program is under $0.1 million.

Interest and Other Income

Interest and other income, comprised primarily of interest income in both quarterly periods, for the third quarter of 2006 was $0.7 million, an increase of $0.4 million from the third quarter of 2005. The increase is due to higher yields on our investments and rising interest rates.

Income Taxes

Income taxes for the third quarter of 2006 included a benefit of $1.8 million due to the current quarter pretax loss. The provision for income taxes in the third quarter of 2005 was a charge of $0.3 million. The effective income tax rate for the third quarter of 2006 was a benefit of 35.1% compared to a charge of 17.5% in the third quarter of 2005. The effective rate for the three month period ended September 30, 2006 was impacted by losses associated with the restructuring program, which was treated as a discrete item for income tax purposes under FASB Interpretation No. 18, “Accounting for Income Taxes in Interim Periods — an Interpretation of APB Opinion No. 28,” and the proportional impact of certain permanent items. While we have made an estimate of our effective rate for 2006, 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 2006. We expect our 2006 full year effective tax rate to be approximately 35%. This includes the impact of the restructuring expense recorded in the third quarter of 2006.

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

For the third quarter of 2006, our basic and diluted loss per common share was $(0.25) compared to net income of $0.11 per basic common share and diluted common share recorded in the prior year quarter. Basic and diluted weighted average common and common equivalent shares outstanding were 13.2 million in the third quarters of 2006 and 2005. The three months ended September 30, 2006 do not include the effect of dilutive securities due to the current quarter net loss which would make those securities anti-dilutive to the earnings per share calculation.

NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO NINE MONTHS ENDED SEPTEMBER 24, 2005

Revenues

The Company’s revenues for the nine months ended September 30, 2006 were $48.8 million, an increase of $0.6 million, or 1.3%, compared to revenues of $48.2 million reported for the nine months ended September 24, 2005.

Sales of the Company’s DigiTest system products, which include LoopCare software, were $10.4 million in the nine months ended September 30, 2006, a decrease of $2.8 million, compared to the nine months ended September 24, 2005 of $13.2 million. The decrease in DigiTest revenue was associated with a reduction in product deployed into the Middle East. This was offset, in part, by increased sales to one of our RBOC customers and the deployment of products at an ILEC customer. DigiTest system sales accounted for 21.3% and 27.4% of total revenues for the first nine months of 2006 and 2005, respectively.

Sales of LoopCare software products separate and unrelated to DigiTest system products were $1.8 million in the nine months ended September 30, 2006 compared with $1.7 million recorded in the nine months ended September 24, 2005. 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. In addition, customers who traditionally purchased LoopCare to manage their testing needs are in the midst of a technical migration, and, as described above, are diverting capital spending to those new network elements, which is impacting our LoopCare sales to those customers. As part of our product strategy, the Company has plans to continue to enhance LoopCare for the new network and assist our customers with their network migration in a seamless fashion. In addition, the Company’s sales and marketing plans also include expanding LoopCare sales into independent carrier and international customer networks. However, as a result of all these factors, revenue from this product line can fluctuate significantly on a quarter by quarter basis. LoopCare software product sales comprised 3.7% of total revenues during the nine months ended September 30, 2006 compared to 3.5% in the nine months ended September 24, 2005.

Overall sales of cable hardware and software products increased from $12.8 million for the nine months ended September 24, 2005 to $13.3 million for the nine months ended September 30, 2006. During the nine months ended September 30, 2006, we experienced strong sales of our DOCSIS-based transponders (primarily in the first quarter of 2006), offset by an expected 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-based products. Furthermore, the standardization of this product has led to increased competition, as customers are able to purchase system components from a number of vendors. 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. Cable hardware and software product sales amounted to 27.3% and 26.6% of the first nine months of 2006 and 2005 revenue, respectively.

Sales of MCUs during the nine months ended September 30, 2006 remained consistent with the nine months ended September 24, 2005 at $10.4 million. As a result, MCU sales represented 21.3% of total revenues for the nine months ended September 30, 2006 compared to 21.6% for the nine months ended September 24, 2005.

Service revenues, which include installation oversight and project management services provided to RBOC and other customers and fees for LoopCare and Cheetah software maintenance were $10.0 million in the nine months ended September 30, 2006 compared to $10.1 million for the nine months ended September 24, 2005. Service revenues amounted to 20.5% and 21.0% for the first nine months of 2006 and 2005 revenue, respectively.

Sales of the Company’s newly acquired Emerson Test Systems product line, which became part of the Company on February 24, 2006, were $2.9 million for the nine month period ending September 30, 2006. During the third quarter of 2006, we received acceptance on the pilot phase of our product deployment into a customer in Eastern Europe. This acceptance and continued product deployment contributed significantly to the revenue associated with the acquired Emerson product line.

Gross Profit

Gross profit for the nine months ended September 30, 2006 was $18.8 million compared to $24.7 million for the nine months ended September 24, 2005. The decrease in gross profit is primarily a result of the $4.3 million inventory charge recorded in the third quarter of 2006. As a percentage of

sales, gross profit for the first nine months of 2006 was 38.5% versus 51.4% for the year ago period. Gross margin, as a percentage of sales, was impacted by the inventory charge resulting from the restructuring program announced by the Company on July 27, 2006, which impacted margins by 8.9%. Additionally, our margins were impacted by lower margins in two service projects, the dilutive effect that the Emerson product line had on the first two quarters of 2006 and product mix associated with our lower margined cable product. During the third quarter of 2006, we finalized the integration of the Emerson product line which has, along with increased sales, resulted in the Emerson product line becoming accretive to gross margins in the third quarter of 2006.

Selling and Marketing Expense

Selling and marketing expense, which consists primarily of payroll related costs, consulting expense and travel costs, increased $1.5 million, or 22.6%, to $8.1 million for the nine months ended September 30, 2006 from $6.6 million in the nine months ended September 24, 2005. The increase is associated with additional salaries and wages associated with the Emerson acquisition, SFAS 123(R) stock compensation expense, increased commissions and increased consulting and travel costs associated with international sales. As a percentage of revenues, selling and marketing expenses increased from 13.7% in the first nine months of 2005 to 16.6% in the first nine months of 2006.

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 30, 2006 was $6.0 million, an increase of $0.3 million, or 5.2%, from the nine months ended September 24, 2005. The increase is primarily attributed to an increase in SFAS 123(R) stock compensation expense and professional services, offset in part by a reduction in insurance expense. As a percentage of revenues, general and administrative expenses increased from 11.7% in the first nine months of 2005 to 12.2% in the first nine months of 2006.

Research and Development Expense

Research and development expense, which consists primarily of payroll related costs and depreciation expense, decreased slightly from $10.6 million in the nine months ended September 24, 2005 to $10.5 million in the nine months ended September 30, 2006. The decrease in research and development expense is associated with a reduction in consulting costs and prototype expense, offset by an increase in salaries and wages related to the Emerson acquisition. As a percentage of revenues, research and development expense decreased to 21.5% in the nine months ended September 30, 2006 from 21.9% 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. 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, for the nine months ended September 30, 2006 was $2.0 million, an increase of $1.2 million from the amount recorded in the nine months ended September 24, 2005. The increase is due to a larger portion of our portfolio being allocated to short-term investments with higher yields.

Income Taxes

Income taxes for the nine months ended September 30, 2006 included a benefit of $1.8 million compared to a provision of $0.3 million for the nine months ended September 24, 2005. The effective income tax rate for the nine months ended September 30, 2006 was 34.8% compared to 16.3% in the nine months ended September 24, 2005. The effective rate for the nine month period ended September 30, 2006 was impacted by losses associated with the restructuring program, which was treated as a discrete item for income tax purposes under FASB Interpretation No. 18, “Accounting for Income Taxes in Interim Periods — an Interpretation of APB Opinion No. 28.” While we have made an estimate of our effective rate for 2006, 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 2006.

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

As a result of the above factors, the net loss for the nine months ended September 30, 2006 was $(3.4) million compared to net income in the nine months ended September 24, 2005 of $1.7 million. For the nine months ended September 30, 2006, our basic and diluted loss per common share was $(0.26) compared to net earnings of $0.13 per common share recorded in the prior year’s first nine months. Basic and diluted weighted average common and common equivalent shares outstanding were 13.2 million in the nine months ended September 30, 2006 and September 24, 2005.

LIQUIDITY AND CAPITAL RESOURCES

Net cash used in operating activities for the nine months ended September 30, 2006 was $3.0 million compared to net cash provided of $7.0 million for the same period in the prior year. The decrease in net cash provided is attributed to an increase in inventory and trade receivables partly offset by a decrease in accrued expenses and non-cash restructuring expenses. The increase in inventory was a result of additional purchases made by the Company in the third quarter of 2006 for expected future business and to acquire certain inventory items that have longer lead times. The increase in trade receivables is a result of the timing of payment on certain larger accounts and certain contract-based billing requirements that have contractually delayed cash payments.

The Company had working capital of $80.4 million at September 30, 2006, a decrease of $0.4 million from $80.8 million of working capital as of December 31, 2005. As of September 30, 2006, we had approximately $58.4 million in cash, cash equivalent and short term investments, which are available

for corporate purposes, including acquisitions and other general working capital requirements, compared to $67.4 million at December 31, 2005. The decrease in cash, cash equivalents and short term investments from December 31, 2005 is primarily attributed to the $5.5 million purchase of the Emerson test product line and an increase in inventory and trade receivables.

Cash from investing activities reflects a use of $3.9 million for the nine months ended September 24, 2005, while cash of $4.3 million was provided in the nine months ended September 30, 2006. The change is attributed to redemption of short-term investments, offset by the second quarter 2006 purchase of the Emerson product line for $5.5 million in cash.

The Company has in place a five-year $25.0 million Unsecured Revolving Credit Facility (the “Facility”) with a bank. The Facility expires in December 2006. Under the terms of the Facility, the proceeds must be used for general corporate purposes, working capital needs and in connection with certain acquisitions. The Facility contains certain standard covenants with which 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 restricted our total borrowing capacity to approximately $21.0 million during the third quarter of 2006. 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 30, 2006 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 $3.0 million in 2006 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 30, 2006.

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 $210,000 pursuant to a Promissory Note (the “Note”) with interest accruing at 5% per annum. The remaining outstanding balance as of September 30, 2006 of approximately $149,000 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 in the name 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 accounts receivable trade, based on the past twelve months rolling revenue, was 85 and 78 days as of September 30, 2006 and September 24, 2005, respectively. The change was attributable to the timing of cash collection and contractual restrictions on billing. The Company’s inventory turnover ratio was 4.0 and 2.8 turns at September 30, 2006 and September 24, 2005, respectively. The increase in the inventory turnover ratio is associated with the restructuring program.

NEW ACCOUNTING STANDARDS

In June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainties in income taxes recognized on an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. The Interpretation is effective for fiscal years beginning after December 15, 2006. We are reviewing the adoption of FIN 48 and assessing the impact on our results of operations and our financial position.

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 investment in 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 generally 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, as amended, 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 the fiscal quarter ended September 30, 2006 that have materially affected or are reasonably likely to materially affect these controls.

PART II. OTHER INFORMATION

Item 1A. RISK FACTORS

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. Currently, we face this issue as certain international projects are completed, and there are no assurances that we will have continuing revenue streams from these customers or be successful in replacing that lost revenue stream. 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 wireline 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. Some of our customers tend to place large orders near the end of a quarter or fiscal year, in part to spend remaining available capital budget funds. Further, our customers’ purchases have become more project-based, which tend to be larger orders with unique acceptance requirements. 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.

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

We have substantially completed the restructuring program that we announced on July 27, 2006, which included the consolidation of facilities and staff from the Company’s cable operations in Sarasota, Florida and a completion of integration plans from the recent acquisition of Emerson Test Systems. In conjunction with the restructuring effort, we have identified certain products and assets that no longer meet our long-term objectives and strategy. While we believe that these actions will reduce costs, they may not be sufficient to achieve the required operational efficiencies that will enable us to respond more quickly to changes in the market, and we may be required to undertake further restructuring initiatives that would require us to incur additional charges. In addition, there is the risk that our recent and any future cost-cutting initiatives will impair our ability to effectively develop and market products and remain competitive. Such initiatives 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.

Our Services business is subject to a trend of compressed margins and 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 professional services. Furthermore, the timing of the extension or renewal of certain of the more significant software maintenance agreements, including our software maintenance agreements with the RBOCs, two of which are scheduled to expire on December 31, 2006, could 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.

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 acquisitions from Lucent Technologies, Inc. in 2001, JDS Uniphase (formerly, Acterna, LLC) in 2003 and Emerson in 2006, could become impaired by changing market conditions, among other factors. Statement of Financial Accounting Standards No. 142 (“SFAS 142”) requires goodwill and intangible assets with indefinite lives to be measured for impairment at least annually or more frequently if events and circumstances indicate that the carrying value of such assets may not be recoverable. We perform annual impairment tests on December 31 of each year. We have determined that we have one reporting unit and test goodwill for impairment by comparing the fair value of the Company’s equity, which we estimate based on the quoted market price of our common stock and an estimated control premium, to the Company’s book value. Our last required measurement date was December 31, 2005, at which time our test indicated no impairment. Interim impairment tests are required by SFAS 142 if certain events or changes in business conditions occur. During the third quarter of 2006, we continued to experience margin pressure, operating losses and a decline in our stock price. We considered the culmination of these events to be a triggering event under SFAS 142. Therefore, we performed a review for impairment by performing a cash flow analysis. This analysis supported the carrying value of goodwill and no impairment was recorded. The continuation of these market effects may, however, require us to record an impairment change in any period in which impairment is determined, which could adversely affect future results.

The sales cycle for our system products is long, and the delay or failure to complete one or more large 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 system 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 hardware and software systems. Our delay or failure to complete one or more large transactions in a quarter could harm our operating results. Our systems involve significant capital commitments by customers. Potential customers generally commit significant resources to an evaluation of available enterprise software and associated hardware and require us to expend substantial time, effort and money educating them about the value of our solutions. System sales often require an extensive sales effort throughout a customer’s organization because decisions to acquire software licenses and associated system hardware generally involve the evaluation of the products 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 does 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.

We have emphasized our network assurance and testing 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. Further, we recently completed the acquisition of the wireline test system unit of Emerson Network Power. 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, to respond to rapid technological change, including evolving industry-wide standards, and to develop and implement product strategies as customers migrate to new network technologies.

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 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. With respect to the DOCSIS cable standards, the market acceptance of these standards has also resulted in a trend towards an increasing commoditization of DOCSIS-based products and an increasing number of competitors due to lower proprietary barriers to entry, each of which has negatively affected sales volumes and gross margins for these products.

In addition, the evolution of our telecommunications customers’ networks to fiber-intensive IP-based technology could cause a reduction in the purchase of our existing DigiTest and LoopCare products for legacy network architectures. Our ability to provide traditional network assurance benefits for these new fiber-intensive IP-based network technologies will be dependent on our ability to modify our products to meet these new technologies and the adoption of our products, such as the DigiTest HUB and EDGE, by our customers to transition to the new technologies.

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 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 or gross margins for 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 for critical components and 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, and some critical components may be single-sourced. 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 Emerson 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. 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 impairment 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.

We recently completed our first significant acquisition involving international business and customers. In addition to the risks identified in the foregoing paragraph, the Emerson acquisition is subject to additional risks due to its international scope. Our ability to integrate this business may be particularly challenging due to the unique topology of international telecommunications networks, as well as requirements of doing business in particular countries. Further, our ability to sell certain products internationally will be reliant upon certain key manufacturing relationships and we may be unable to continue those relationships. Also, revenue forecasts for the Emerson acquisition are dependant on a few large customer projects and contracts, which bear significant deployment, acceptance and subsequent revenue recognition risks, which may all adversely affect the Company’s ability to make this acquisition accretive in 2006.

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. These risks will be evident with the customer contracts assumed as part of the Emerson acquisition, which 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 customers 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 and certain of the newly acquired Emerson products, through domestic and international OEM relationships. Our future results are dependent on our ability to establish, maintain and expand third party relationships with OEM channels 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 cease doing business with us or otherwise 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. Recent competition from certain network element providers offering chip-based testing functionality may also intensify the pricing pressure for our telco products and adversely affect future revenues from such products. We also face increasing pressure from certain of our RBOC customers on software maintenance agreements, as they continue to divert spending from legacy networks to next generation network elements.

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.

We rely on software that we have licensed from third-party developers to perform key functions in our products and we rely on certain hardware sourced through OEM channels.

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 also rely on certain hardware that is sold to us on a private-label OEM basis. We could lose the right to use this software or the software and/or hardware could be made available to us only on commercially unreasonable terms. Although we believe that, in most cases, alternative software or hardware 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 existing cable-related products will result in lower profitability. Furthermore, 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. As a result of these factors, our revenues have been and may continue to be adversely affected. Although we have developed DOCSIS-based hardware and our relationship with our OEM partner is one that we believe will prominently position us to succeed in the marketing of DOCSIS-based products, these 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 there is greater 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 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On December 15, 2005, our Board of Directors authorized the continuation through December 31, 2006 of a share repurchase program which expired on December 31, 2005. Under this extension, we can repurchase a total of one million shares of our common stock before December 31, 2006. Since the initial repurchase program was instituted in April 1997, and as of December 31, 2005, the Company has repurchased 0.5 million 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 during the nine months ended September 30, 2006.

Item 6. EXHIBITS

(a)

Exhibits:

The following exhibits are being filed with this report:


Exhibit
Number				Description
10.1				Extension Agreement, dated September 26, 2006, between the Company and Bulova Technologies EMS LLC, filed herewith

10.2				Form of Stock Option Agreement for Non-Statutory Stock Options granted under the 2006 Long-Term Incentive Compensation Plan, 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

™LoopCare is a trademark of Tollgrade Communications, Inc.
™Cheetah is a trademark of Tollgrade Communications, Inc.
™HUB is a trademark of Tollgrade Communications, Inc.
™N(x)Test is a trademark of Tollgrade Communications, Inc.
™N(x)DSL is a trademark of Tollgrade Communications, Inc.
™LTSC is a trademark of Tollgrade Communications, Inc.
^®DigiTest is a registered trademark of Tollgrade Communications, Inc.
^®EDGE is a registered trademark of Tollgrade Communications, Inc.
^®MCU is a registered trademark of Tollgrade Communications, Inc.
^®LIGHTHOUSE is a registered trademark of Tollgrade Communications, Inc.
^®DOCSIS is a registered trademark of Cable Television Laboratories, Inc.
All other trademarks are the property of their respective owners.


	PAGE NO.
PART I. FINANCIAL INFORMATION
Item 1 Condensed Consolidated Financial Statements (unaudited):
Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005		3
Condensed Consolidated Statements of Operations for the three and nine month periods ended September 30, 2006 and September 24, 2005		4
Condensed Consolidated Statement of Changes in Shareholders’ Equity for the nine month period ended September 30, 2006		5
Condensed Consolidated Statements of Cash Flows for the nine month periods ended September 30, 2006 and September 24, 2005		6
Notes to Condensed Consolidated Financial Statements		7
Report of Independent Registered Public Accounting Firm		20
Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations		21
Item 3 Quantitative and Qualitative Disclosures about Market Risk		42
Item 4 Controls and Procedures		43
PART II. OTHER INFORMATION
Item 1A Risk Factors		43
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds		54
Item 6 Exhibits		55
SIGNATURES		56
EXHIBIT INDEX		57
Exhibit 10.1
Exhibit 10.2
Exhibit 15
Exhibit 31.1
Exhibit 31.2
Exhibit 32
EX-10.1
EX-10.2
EX-15
EX-31.1
EX-31.2
EX-32


Accounts Receivable	$	1,827
Inventories		1,113
Property and Equipment		112
Intangible Assets:
Customer Relationship		193
Tradename		62
Purchased Technology		761
Sales Order Backlog		97
Goodwill		2,295

Total Assets Acquired		6,460

Deferred Income		175
Accounts Payable		636
Restructuring		148

Total Liabilities		959

Net Assets Acquired	$	5,501


	Tollgrade Communications, Inc. (Registrant)
Dated: October 27, 2006	/s/ Mark B. Peterson
	Mark B. Peterson
	Chief Executive Officer


Dated: October 27, 2006	/s/ Samuel C. Knoch
	Samuel C. Knoch
	Chief Financial Officer and Treasurer


Dated: October 27, 2006	/s/ Sean M. Reilly
	Sean M. Reilly
	Controller


TOLLGRADE COMMUNICATIONS, INC.			BULOVA TECHNOLOGIES EMS LLC


By:	/s/ Jennifer M. Reinke		By:	/s/ James Davis
	Name:	Jennifer M. Reinke		Name:	James Davis
	Title:	Assistant Secretary		Title:	President



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

	1)		Form S-8 (Registration No. 333-4290, 333-65502, 333-83007, and 333-95965) 1995 Long-Term Incentive Plan and Individual Stock Options Granted to Certain Directors and Employees Prior to the Adoption of the Plan

	2)		Form S-8 (Registration No. 333-52907, 333-55470 and 333-96969) 1998 Employee Incentive Compensation Plan

	3)		Form S-8 (Registration No. 333-136693) 2006 Long-Term Incentive Compensation Plan



/s/ Samuel C. Knoch
Name:	Samuel C. Knoch
Title:	Chief Financial Officer