##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, DC 20549
 
 FORM 10-Q
  þ
    
    Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the quarterly period ended July 1, 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.
  Pennsylvania
(State or other jurisdiction
of incorporation or organization)
    
    25-1537134
(I.R.S. Employer
Identification No.)
 493 Nixon Rd.
Cheswick, PA 15024
 412-820-1400
  þ o
  Large Accelerated Filer o
    
    Accelerated Filer þ
    
    Non-accelerated filer o
  o þ




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##### 



TOLLGRADE COMMUNICATIONS, INC.
 Quarterly Report on Form 10-Q
For the Quarter Ended July 1, 2006  Table of Contents
 PAGENO.PART I. FINANCIAL INFORMATIONItem 1 Condensed Consolidated Financial Statements (unaudited):Condensed Consolidated Balance Sheets as of July 1, 2006 and December 31, 2005
    
    
    3Condensed Consolidated Statements of Operations for the three and six month periods ended July 1, 2006 and June 25, 2005
    
    
    4Condensed Consolidated Statement of Changes in Shareholders Equity for the six month period ended July 1, 2006
    
    
    5Condensed Consolidated Statements of Cash Flows for the six month periods ended July 1, 2006 and June 25, 2005
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Report of Independent Registered Public Accounting Firm
    
    
    19Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    20Item 3 Quantitative and Qualitative Disclosures about Market Risk
    
    
    41Item 4 Controls and Procedures
    
    
    41PART II. OTHER INFORMATIONItem 1A Risk Factors
    
    
    41Item 2
Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    53Item 4 Submission of Matters to a Vote of Security Holders
    
    
    53Item 6 Exhibits
    
    
    54SIGNATURES
    
    
    55EXHIBIT INDEX
    
    
    56Exhibit 10.1Exhibit 15Exhibit 31.1Exhibit 31.2Exhibit 32EX-15EX-31.1EX-31.2EX-32
  2




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##### Table of Contents



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)
 July 1, 2006
    
    December 31, 2005*ASSETSCurrent assets:Cash and cash equivalents
    
    $
    51,376
    
    
    $
    49,421Short-term investments
    
    
    10,190
    
    
    
    18,010Accounts receivable:Trade, net of allowance for doubtful accounts of
$519 in 2006 and $465 in 2005
    
    
    10,826
    
    
    
    9,456Other
    
    
    1,912
    
    
    
    1,406Inventories
    
    
    11,602
    
    
    
    9,934Prepaid expenses and other current assets
    
    
    1,216
    
    
    
    1,397Deferred tax assets and refundable income tax
    
    
    1,623
    
    
    
    1,803Total current assets
    
    
    88,745
    
    
    
    91,427Property and equipment, net
    
    
    6,155
    
    
    
    6,390Deferred tax assets
    
    
    72
    
    
    
    46Intangibles and capitalized software, net
    
    
    42,909
    
    
    
    43,616Goodwill
    
    
    24,075
    
    
    
    21,562Receivable from officer
    
    
    151
    
    
    
    153Other assets
    
    
    124
    
    
    
    135Total assets
    
    $
    162,231
    
    
    $
    163,329LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,454
    
    
    $
    1,262Accrued warranty
    
    
    2,149
    
    
    
    2,220Accrued expenses
    
    
    2,031
    
    
    
    2,579Accrued salaries and wages
    
    
    722
    
    
    
    660Accrued royalties payable
    
    
    191
    
    
    
    581Income taxes payable
    
    
    327
    
    
    
    869Deferred income
    
    
    1,958
    
    
    
    2,450Total current liabilities
    
    
    8,832
    
    
    
    10,621Deferred tax liabilities
    
    
    2,577
    
    
    
    2,447Total liabilities
    
    
    11,409
    
    
    
    13,068Contingencies and commitmentsShareholders 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
    
    
    
    2,733Additional paid-in capital
    
    
    72,189
    
    
    
    71,469Treasury stock, at cost, 462 shares in 2006 and 2005
    
    
    (4,791
    )
    
    
    (4,791
    )Retained earnings
    
    
    80,682
    
    
    
    80,850Total shareholders equity
    
    
    150,822
    
    
    
    150,261Total liabilities and shareholders equity
    
    $
    162,231
    
    
    $
    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.  3




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TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data) (Unaudited)
 Three Months Ended
    
    
    Six Months EndedJuly 1, 2006
    
    
    June 25, 2005
    
    
    July 1, 2006
    
    
    June 25, 2005Revenues:Products
    
    $
    12,415
    
    
    $
    12,703
    
    
    $
    26,775
    
    
    $
    24,615Services
    
    
    3,838
    
    
    
    4,389
    
    
    
    7,085
    
    
    
    6,752Total revenues:
    
    
    16,253
    
    
    
    17,092
    
    
    
    33,860
    
    
    
    31,367Cost of product sales:Products
    
    
    6,316
    
    
    
    6,170
    
    
    
    13,975
    
    
    
    12,222Services
    
    
    1,404
    
    
    
    936
    
    
    
    2,429
    
    
    
    1,732Amortization of intangibles
    
    
    913
    
    
    
    716
    
    
    
    1,890
    
    
    
    1,4308,633
    
    
    
    7,822
    
    
    
    18,294
    
    
    
    15,384Gross Profit:
    
    
    7,620
    
    
    
    9,270
    
    
    
    15,566
    
    
    
    15,983Selling and marketing
    
    
    2,937
    
    
    
    2,438
    
    
    
    5,623
    
    
    
    4,676General and administrative
    
    
    1,864
    
    
    
    1,895
    
    
    
    4,183
    
    
    
    3,730Research and development
    
    
    3,590
    
    
    
    3,693
    
    
    
    7,250
    
    
    
    7,089Retirement Expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    775Total operating expenses
    
    
    8,391
    
    
    
    8,026
    
    
    
    17,056
    
    
    
    16,270(Loss) income from operations
    
    
    (771
    )
    
    
    1,244
    
    
    
    (1,490
    )
    
    
    (287
    )Interest and other income, net
    
    
    628
    
    
    
    252
    
    
    
    1,255
    
    
    
    514(Loss) income before income taxes
    
    
    (143
    )
    
    
    1,496
    
    
    
    (235
    )
    
    
    227(Benefit) provision for income taxes
    
    
    (39
    )
    
    
    441
    
    
    
    (67
    )
    
    
    17Net (loss) income
    
    $
    (104
    )
    
    $
    1,055
    
    
    $
    (168
    )
    
    $
    210(Loss) earnings per share information:Weighted average shares of common
stock and equivalents:Basic
    
    
    13,247
    
    
    
    13,161
    
    
    
    13,230
    
    
    
    13,161Diluted
    
    
    13,247
    
    
    
    13,168
    
    
    
    13,230
    
    
    
    13,190Net (loss) income per common and
common equivalent shares:Basic
    
    $
    (0.01
    )
    
    $
    0.08
    
    
    $
    (0.01
    )
    
    $
    0.02Diluted
    
    $
    (0.01
    )
    
    $
    0.08
    
    
    $
    (0.01
    )
    
    $
    0.02
  4




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TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS EQUITY
For the Six Months Ended July 1, 2006
(In thousands) (Unaudited)
 AdditionalPreferred Stock
    
    
    Common Stock
    
    
    Paid-In
    
    
    Treasury
    
    
    RetainedShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Capital
    
    
    Stock
    
    
    Earnings
    
    
    TotalBalance at
December 31, 2005
    
    
    
    
    
    $
    
    
    
    
    13,664
    
    
    $
    2,733
    
    
    $
    71,469
    
    
    $
    (4,791
    )
    
    $
    80,850
    
    
    $
    150,261Exercise of common
stock options
    
    
    
    
    
    
    
    
    
    
    45
    
    
    
    9
    
    
    
    397
    
    
    
    
    
    
    
    
    
    
    
    406Tax benefit from
exercise of stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    94
    
    
    
    
    
    
    
    
    
    
    
    94Stock-based
compensation
expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    229
    
    
    
    
    
    
    
    
    
    
    
    229Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (168
    )
    
    
    (168
    )Balance at
July 1, 2006
    
    
    
    
    
    $
    
    
    
    
    13,709
    
    
    $
    2,742
    
    
    $
    72,189
    
    
    $
    (4,791
    )
    
    $
    80,682
    
    
    $
    150,822
  5




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TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands) (Unaudited)
 Six Months EndedJuly 1, 2006
    
    June 25, 2005Cash flows from operating activities:Net (loss) income
    
    $
    (168
    )
    
    $
    210Adjustments to reconcile net (loss) income to net cash
provided by operating activities:Depreciation and amortization
    
    
    2,989
    
    
    
    2,665Compensation expense related to stock plans
    
    
    229
    
    
    
    Deferred income taxes
    
    
    (367
    )
    
    
    (53
    )Provision for losses on inventory
    
    
    (97
    )
    
    
    274Provision for allowance for doubtful accounts
    
    
    54
    
    
    
    7Changes in assets and liabilities (net of acquired business):Accounts receivable-trade
    
    
    403
    
    
    
    (2,056
    )Accounts receivable-other
    
    
    (506
    )
    
    
    (1,089
    )Inventory
    
    
    (458
    )
    
    
    184Prepaid expenses and other assets
    
    
    194
    
    
    
    1,176Refundable taxes
    
    
    651
    
    
    
    212Accounts payable
    
    
    (441
    )
    
    
    173Accrued warranty
    
    
    (71
    )
    
    
    (174
    )Accrued expenses and deferred income
    
    
    (1,581
    )
    
    
    (227
    )Accrued royalties payable
    
    
    (390
    )
    
    
    (333
    )Accrued salaries and wages
    
    
    62
    
    
    
    (472
    )Income taxes payable
    
    
    (542
    )
    
    
    169Net cash (used in) provided by operating activities
    
    
    (39
    )
    
    
    666Cash flows from investing activities:Purchase of Emerson product line
    
    
    (5,501
    )
    
    
    Purchase of short-term investments
    
    
    (6,528
    )
    
    
    (15,328
    )Redemption/maturity of short-term investments
    
    
    14,348
    
    
    
    4,445Capital expenditures, including capitalized software
    
    
    (825
    )
    
    
    (692
    )Net cash provided by (used in) investing activities
    
    
    1,494
    
    
    
    (11,575
    )Cash flows from financing activities:Proceeds from exercise of stock options
    
    
    406
    
    
    
    Tax benefit from exercise of stock options
    
    
    94
    
    
    
    Net cash provided by financing activities
    
    
    500
    
    
    
    Net increase (decrease) in cash and cash equivalents
    
    
    1,955
    
    
    
    (10,909
    )Cash and cash equivalents at beginning of period
    
    $
    49,421
    
    
    $
    32,622Cash and cash equivalents at end of period
    
    $
    51,376
    
    
    $
    21,713
  6




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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 1. BASIS OF PRESENTATION
   RECLASSIFICATIONS
  SEGMENT INFORMATION
  7




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NEW ACCOUNTING STANDARDS
    2. ACCOUNTING FOR STOCK-BASED COMPENSATION
 Stock-Based Compensation Expense
   8




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9




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Pro forma information under SFAS 123 for periods prior to January 1, 2006
  Three Months Ended
    
    Six Months EndedJune 25, 2005
    
    June 25, 2005(in thousands)
    
    (in thousands)Net income
    
    $
    1,055
    
    
    $
    210Less: Total
stock-based
compensation
determined under the
fair value method
for all awards, net
of related tax
    
    
    7
    
    
    
    9Pro forma net income
    
    $
    1,048
    
    
    $
    201Income per share:Basic
    
    $
    0.08
    
    
    $
    0.02Basic  pro forma
    
    $
    0.08
    
    
    $
    0.02Diluted
    
    $
    0.08
    
    
    $
    0.02Diluted  pro forma
    
    $
    0.08
    
    
    $
    0.02
 Stock Compensation Plans
   Shares Authorized But Not GrantedJuly 1, 2006
    
    December 31, 20051998 Employee Incentive Compensation Plan
    
    
    116,188
    
    
    
    107,0542006 Long-term Incentive Compensation Plan
    
    
    1,300,000
    
    
    
    N/A
 10




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Number of
    
    
    
    
    
    Weighted AverageShares
    
    Range of Options Price
    
    Exercise PriceOutstanding, December 31, 2005
    
    
    1,780,037
    
    
    
    $7.28  159.19
    
    
    $
    26.87Granted
    
    
    
    
    
    
    
    
    
    
    Exercised
    
    
    (44,984
    )
    
    $
    7.56  12.55
    
    
    
    9.02Cancelled
    
    
    (313,484
    )
    
    
    7.28  55.90
    
    
    
    14.17Outstanding, July 1, 2006
    
    
    1,421,569
    
    
    
    7.28  159.19
    
    
    
    30.24
 Number of SharesOptions exercisable at:December 31, 2005
    
    
    1,605,113July 1, 2006
    
    
    1,247,311
  Stock Options Outstanding
    
    
    Stock Options ExercisableWeightedNumber
    
    
    Average
    
    
    Weighted
    
    
    
    
    
    
    Number
    
    
    WeightedOutstanding
    
    
    Remaining
    
    
    Average
    
    
    Aggregate
    
    
    Exercisable
    
    
    Average
    
    
    AggregateRange of
    
    as of
    
    
    Contractual
    
    
    Exercise
    
    
    Intrinsic
    
    
    as of
    
    
    Exercise
    
    
    IntrinsicExercise Prices
    
    07/01/06
    
    
    Life
    
    
    Price
    
    
    Value
    
    
    07/01/06
    
    
    Price
    
    
    Value7.28
    
    
    51,000
    
    
    
    2.46
    
    
    $
    7.28
    
    
    $
    123,354
    
    
    
    51,000
    
    
    $
    7.28
    
    
    $
    123,3547.29  9.49
    
    
    427,752
    
    
    
    7.12
    
    
    
    8.53
    
    
    
    503,497
    
    
    
    253,494
    
    
    
    8.45
    
    
    
    317,5109.50  12.55
    
    
    131,367
    
    
    
    4.75
    
    
    
    11.34
    
    
    
    
    
    
    
    131,367
    
    
    
    11.34
    
    
    
    12.56  15.84
    
    
    124,300
    
    
    
    4.04
    
    
    
    13.89
    
    
    
    
    
    
    
    124,300
    
    
    
    13.89
    
    
    
    15.85  21.70
    
    
    159,500
    
    
    
    5.28
    
    
    
    19.15
    
    
    
    
    
    
    
    159,500
    
    
    
    19.15
    
    
    
    21.71  28.70
    
    
    175,250
    
    
    
    5.28
    
    
    
    27.93
    
    
    
    
    
    
    
    175,250
    
    
    
    27.93
    
    
    
    28.71  55.90
    
    
    193,350
    
    
    
    4.84
    
    
    
    44.83
    
    
    
    
    
    
    
    193,350
    
    
    
    44.83
    
    
    
    55.91  103.59
    
    
    10,000
    
    
    
    4.21
    
    
    
    97.25
    
    
    
    
    
    
    
    10,000
    
    
    
    97.25
    
    
    
    103.60  117.34
    
    
    133,000
    
    
    
    4.13
    
    
    
    117.34
    
    
    
    
    
    
    
    133,000
    
    
    
    117.34
    
    
    
    117.35  159.19
    
    
    16,050
    
    
    
    4.03
    
    
    
    159.19
    
    
    
    
    
    
    
    16,050
    
    
    
    159.19
    
    
    
    Total
    
    
    1,421,569
    
    
    
    5.39
    
    
    $
    30.24
    
    
    $
    626,851
    
    
    
    1,247,311
    
    
    $
    33.26
    
    
    $
    440,864
  3. ACQUISITION
  11




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Accounts Receivable
    
    
    
    
    
    $
    1,827Inventories
    
    
    
    
    
    
    1,113Property and Equipment
    
    
    
    
    
    
    131Intangible Assets:Customer Relationship
    
    
    193Tradename
    
    
    62Purchased Technology
    
    
    761Sales Order Backlog
    
    
    75Goodwill
    
    
    2,513Total Assets Acquired
    
    
    
    
    
    
    6,675Deferred Income
    
    
    
    
    
    
    175Accounts Payable
    
    
    
    
    
    
    633Restructuring
    
    
    
    
    
    
    366Total Liabilities
    
    
    
    
    
    
    1,174Net Assets Acquired
    
    
    
    
    
    $
    5,501
 12




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(In Thousands, Except Per Share Data)Unaudited Pro Forma
    
    Unaudited Pro FormaThree Months Ended
    
    Three Months EndedJuly 1, 2006
    
    June 25, 2005Revenues
    
    $
    16,253
    
    
    $
    19,421(Loss) income from operations
    
    $
    (771
    )
    
    $
    1,487Net (loss) income
    
    $
    (104
    )
    
    $
    1,226Diluted (loss) earnings per
share
    
    $
    (0.01
    )
    
    $
    0.09
 (In Thousands, Except Per Share Data)Unaudited Pro Forma
    
    Unaudited Pro FormaSix Months Ended
    
    Six Months EndedJuly 1, 2006
    
    June 25, 2005Revenues
    
    $
    35,426
    
    
    $
    37,068(Loss) income from operations
    
    $
    (1,477
    )
    
    $
    153Net (loss) income
    
    $
    (159
    )
    
    $
    617Diluted (loss) earnings per
share
    
    $
    (0.01
    )
    
    $
    0.05
 4. INTANGIBLE ASSETS
  July 1, 2006
    
    December 31, 2005UsefulLife
    
    
    
    Accumulated
    
    
    
    
    
    Accumulated(Years)
    
    Gross
    
    Amortization
    
    Net
    
    Gross
    
    Amortization
    
    NetAmortizing Intangible Assets:Post Warranty Service Agreements
    
    50
    
    $
    32,000
    
    
    $
    480
    
    
    $
    31,520
    
    
    $
    32,000
    
    
    $
    160
    
    
    $
    31,840Technology
    
    5-10
    
    
    17,826
    
    
    
    11,039
    
    
    
    6,787
    
    
    
    16,973
    
    
    
    9,698
    
    
    
    7,275Customer Relationships
    
    5-10
    
    
    2,843
    
    
    
    595
    
    
    
    2,248
    
    
    
    2,650
    
    
    
    449
    
    
    
    2,201Purchased Backlog
    
    1
    
    
    75
    
    
    
    75
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Tradename
    
    3
    
    
    62
    
    
    
    8
    
    
    
    54
    
    
    
    
    
    
    
    
    
    
    
    Non-Amortizing Intangible
Assets:Tradenames
    
    
    
    
    2,300
    
    
    
    
    
    
    
    2,300
    
    
    
    2,300
    
    
    
    
    
    
    
    2,300Total Intangible Assets
    
    
    
    $
    55,106
    
    
    $
    12,197
    
    
    $
    42,909
    
    
    $
    53,923
    
    
    $
    10,307
    
    
    $
    43,616Goodwill
    
    
    
    $
    24,075
    
    
    
    
    
    
    $
    24,075
    
    
    $
    21,562
    
    
    
    
    
    
    $
    21,562
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5. INVENTORY
  July 1, 2006
    
    
    December 31, 2005Raw materials
    
    $
    6,196
    
    
    $
    5,712Work in process
    
    
    3,552
    
    
    
    3,449Finished goods
    
    
    3,852
    
    
    
    2,86813,600
    
    
    
    12,029Reserve for slow moving and obsolete inventory
    
    
    (1,998
    )
    
    
    (2,095
    )$
    11,602
    
    
    $
    9,934
 6. SHORT-TERM INVESTMENTS
  7. RETIREMENT EXPENSE
  14




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8. EMERSON INTEGRATION PROGRAM
   Accrual at
    
    Adjustment to
    
    
    
    
    
    Accrual atApril 1, 2006
    
    Goodwill
    
    Cash Payments
    
    July 1, 2006Relocation Costs
    
    $
    
    
    
    $
    0.3
    
    
    $
    
    
    
    $
    0.3Facility Rationalization
    
    
    
    
    
    
    0.1
    
    
    
    
    
    
    
    0.1Total
    
    $
    
    
    
    $
    0.4
    
    
    $
    
    
    
    $
    0.4
  9. PER SHARE INFORMATION
  15




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Three Months Ended
    
    
    Six Months EndedJune 25, 2005
    
    
    June 25, 2005Net Income
    
    $
    1,055
    
    
    $
    210Common and common equivalent shares:Weighted average common shares outstanding
    
    
    13,161
    
    
    
    13,161Effect of dilutive securities- stock options
    
    
    7
    
    
    
    2913,168
    
    
    
    13,190Income per share:Basic
    
    $
    0.08
    
    
    $
    0.02Diluted
    
    $
    0.08
    
    
    $
    0.02
 10. RECEIVABLE FROM OFFICER
  11. PRODUCT WARRANTY
   Six Months Ended
    
    
    Year EndedJuly 1, 2006
    
    
    December 31, 2005Balance at the beginning of the period
    
    $
    2,220
    
    
    $
    2,081Accruals for warranties issued during the period
    
    
    627
    
    
    
    1,502Settlements during the period
    
    
    (698
    )
    
    
    (1,363
    )Balance at the end of the period
    
    $
    2,149
    
    
    $
    2,220
  12. CONTINGENCIES AND COMMITMENTS
  16




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13. MAJOR CUSTOMERS AND INTERNATIONAL SALES
     14. SUBSEQUENT EVENT
  17




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18




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19




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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.
 will, believes, intends, expects, plans, could or may,
  OVERVIEW
 About the Company
 ®
 20




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About its customers
 ®
  PRODUCTS
 TELECOMMUNICATION TEST SYSTEMS
 ®
 21




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DigiTest and LoopCare; N(x)Test, N(x)DSL-3 and LTSC
   ®
  22




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
    
    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.
  MCU
  23




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CABLE TESTING PRODUCTS
  ® ®
 SERVICES
  BACKLOG
  24




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OPERATING SEGMENT
  INTERNATIONAL SALES
    25




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APPLICATION OF CRITICAL ACCOUNTING POLICIES
  Revenue Recognition
   26




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Goodwill
and Intangible Assets
   27




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Sensitivity Analysis
  28




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YearsTwelve-monthRemaining
    
    
    Carrying
    
    
    RollingOriginal
    
    
    Life at
    
    
    Value at
    
    
    ProjectedAsset Description
    
    Life
    
    
    7/1/06
    
    
    7/1/06
    
    
    Amortization(in millions)LoopCareBase Software
    
    
    10
    
    
    
    5.25
    
    
    $
    2.4
    
    
    $
    0.5Post-Warranty
Maintenance Service Agreements
    
    
    50
    
    
    
    49.25
    
    
    
    31.5
    
    
    
    0.6CheetahBase Software
    
    
    10
    
    
    
    6.50
    
    
    
    1.9
    
    
    
    0.3Proprietary Technology
    
    
    10
    
    
    
    6.25
    
    
    
    0.7
    
    
    
    0.1Customer Base
    
    
    15
    
    
    
    11.25
    
    
    
    2.1
    
    
    
    0.3EmersonProprietary Technology
    
    
    5
    
    
    
    4.75
    
    
    
    0.7
    
    
    
    0.2Customer Relationship
    
    
    5
    
    
    
    4.75
    
    
    
    0.2
    
    
    
    0.1Other
    
    
    3-5
    
    
    
    2.75
    
    
    
    0.5
    
    
    
    0.2$
    40.0
    
    
    $
    2.3
  Reviews for Impairment:
   29




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Inventory Valuation
  30




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Allowance for Doubtful Accounts
   Income Taxes
  Warranty
   31




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RESULTS OF OPERATIONS
 SECOND QUARTER OF 2006 COMPARED TO SECOND QUARTER OF 2005
 Revenues
     32




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Gross Profit
  33




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Selling and Marketing Expense
  General and Administrative Expense
 .
 Research and Development Expense
  Emerson Integration Program
  34




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Accrual at
    
    Adjustment to
    
    
    
    
    
    Accrual atApril 1, 2006
    
    Goodwill
    
    Cash Payments
    
    July 1, 2006Relocation Costs
    
    $
    
    
    
    $
    0.3
    
    
    $
    
    
    
    $
    0.3Facility Rationalization
    
    
    
    
    
    
    0.1
    
    
    
    
    
    
    
    0.1Total
    
    $
    
    
    
    $
    0.4
    
    
    $
    
    
    
    $
    0.4
  Interest and Other Income
  Benefit from Income Taxes
  Net (Loss) Income and (Loss) Income Per Share
  Subsequent Event
  35




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SIX MONTHS ENDED JULY 1, 2006 COMPARED TO SIX MONTHS ENDED JUNE 25, 2005
 Revenues
    36




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Gross Profit
  Selling and Marketing Expense
  37




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General and Administrative Expense
  Research and Development Expense
  Retirement Expense
  Interest and Other Income
  Provision for Income Taxes
  38




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Net (Loss) Income and (Loss) Earnings Per Share
  LIQUIDITY AND CAPITAL RESOURCES
     39




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RELATED PARTY TRANSACTION
  KEY RATIOS
  NEW ACCOUNTING STANDARDS
   40




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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  
 Item 4. CONTROLS AND PROCEDURES
   
 PART II. OTHER INFORMATION
 
 Item 1A. RISK FACTORS
  41




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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.
  
    
    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.
  Our operating results may vary from quarter to quarter, causing our stock price to fluctuate.
  42




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Our restructuring and cost reduction plans may be ineffective or may limit our ability to compete.
  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.
  43




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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.
   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.
  44




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Our Services business is subject to a trend of compressed margins and reduced capital spending by
our major customers.
  We have emphasized our network assurance and testing solutions and cable status monitoring
products.
   45




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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.
     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.
  46




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Our limited ability to protect our proprietary information and technology may adversely affect our
ability to compete.
  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.
   47




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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.
  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.
  We have completed, and may pursue additional acquisitions, which will complicate our management
tasks and could result in substantial expenditures.
  48




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Our future sales in international markets are subject to numerous risks and uncertainties.
  If our accounting controls and procedures are circumvented or otherwise fail to achieve their
intended purposes, our business could be seriously harmed.
  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.
  49




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Our future results are dependent on our ability to establish, maintain and expand our distribution
channels and our existing third-party distributors.
  We face intense competition, which could result in our losing market share or experiencing a
decline in our gross margins.
   We are dependent upon our ability to attract, retain and motivate our key personnel.
  50




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Consolidations in, or a continued slowdown in, the telecommunications industry could 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 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.
  51




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We are affected by a pattern of product price decline in certain markets, which can harm our
business.
  Our common stock price may be extremely volatile.
  
    
    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.
  52




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We may be subject from time to time to legal proceedings, and any adverse determinations in these
proceedings could materially harm our business.
  
 Item 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
  
 Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  Nominee for Director
    
    Total Votes Cast
    
    For
    
    WithheldJames J. Barnes
    
    12,578,293
    
    11,128,503
    
    1,449,790Brian C. Mullins
    
    12,578,293
    
    10,872,364
    
    1,705,929
  53




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Item 6. EXHIBITS
   ExhibitNumber
    
    Description10.1
    
    Tollgrade Communications, Inc. 2006 Long-Term Incentive
Compensation Plan filed as Exhibit
10.1 to the Companys Current Report on Form 8-K filed with the
SEC on May 11, 2006, and incorporated herein by reference15
    
    Letter re audited interim financial information31.1
    
    Certification of Chief Executive Officer, filed herewith31.2
    
    Certification of Chief Financial Officer, filed herewith32
    
    Certification of Chief Executive Officer and Chief Financial
Officer pursuant to 18.U.S.C. Section 350, filed herewith
 ®  ®  ®  ®  ®
 54




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SIGNATURES
  Tollgrade Communications, Inc.(Registrant)Dated: July 27, 2006
    
    /s/ Mark B. PetersonMark B. PetersonChief Executive OfficerDated: July 27, 2006
    
    /s/ Samuel C.
KnochSamuel C. KnochChief Financial Officer and TreasurerDated: July 27, 2006
    
    /s/ Sean M.
ReillySean M.
ReillyController
 55




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EXHIBIT INDEX
  ExhibitNumber
    
    Description10.1
    
    Tollgrade Communications, Inc. 2006 Long-Term Incentive
Compensation Plan filed as Exhibit
10.1 to the Companys Current Report on Form 8-K filed with the
SEC on May 11, 2006, and incorporated herein by reference15
    
    Letter re audited interim financial information31.1
    
    Certification of Chief Executive Officer, filed herewith31.2
    
    Certification of Chief Financial Officer, filed herewith32
    
    Certification of Chief Executive Officer and Chief Financial
Officer pursuant to 18.U.S.C. Section 350, filed herewith
 56