##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, DC 20549
   FORM 10-Q
 (Mark One) [ X ]     Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 25, 2004 [    ]     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
    
    25-1537134(State or other jurisdiction
    
    (I.R.S. Employerof incorporation or organization)
    
    Identification No.)
 493 Nixon Rd.
Cheswick, PA 15024
(Address of principal executive offices, including zip code) 412-820-1400
(Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [ X ]
    
    No [    ]
 Indicate by check mark whether the Registrant is an accelerated filer (as
defined by Rule 12b-2 of the Exchange Act). Yes [ X ]
    
    No [    ]
 As of October 29, 2004, there were 13,161,140 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. 1




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TOLLGRADE COMMUNICATIONS, INC. Quarterly Report on Form 10-Q
For the Quarter Ended September 25, 2004 Table of Contents PAGE NO.PART I. FINANCIAL INFORMATIONItem 1
    
    Condensed Consolidated Financial Statements (unaudited):Condensed Consolidated Balance Sheets as of September 25, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the three month and nine month periods ended September 25, 2004 and September 27, 2003
    
    
    4Condensed Consolidated Statement of Changes in Shareholders' Equity for the nine month period ended September 25, 2004
    
    
    5Condensed Consolidated Statements of Cash Flows for the nine month periods ended September 25, 2004 and September 27, 2003
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Report of Independent Registered Public Accounting Firm
    
    
    15Item 2
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    16Item 3
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    40Item 4
    
    Controls and Procedures
    
    
    40PART II. OTHER INFORMATIONItem 2
    
    Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    41Item 6
    
    Exhibits and Reports Filed on Form 8-K
    
    
    41SIGNATURES
    
    
    43EXHIBIT INDEX
    
    
    44Exhibit 10.55Exhibit 10.56Exhibit 10.57Exhibit 10.58Exhibit 15Exhibit 31.1Exhibit 31.2Exhibit 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
 (Unaudited)
 September 25, 2004
    
    December 31, 2003 *ASSETSCurrent assets:Cash and cash equivalents
    
    $
    30,566,488
    
    
    $
    31,059,972Short-term investments
    
    
    19,434,469
    
    
    
    17,624,668Accounts receivable:Trade
    
    
    9,289,356
    
    
    
    9,254,718Other
    
    
    118,597
    
    
    
    122,231Inventory
    
    
    11,181,418
    
    
    
    11,154,676Prepaid expenses and other current assets
    
    
    1,394,085
    
    
    
    1,534,034Refundable income taxes
    
    
    424,479
    
    
    
    383,704Deferred tax assets
    
    
    1,990,173
    
    
    
    1,361,947Total current assets
    
    
    74,399,065
    
    
    
    72,495,950Property and equipment, net
    
    
    8,309,978
    
    
    
    8,292,412Deferred tax assets
    
    
    1,412,202
    
    
    
    1,152,846Intangibles, net
    
    
    45,143,500
    
    
    
    44,500,000Goodwill
    
    
    19,339,682
    
    
    
    19,339,682Capitalized software costs, net
    
    
    6,366,404
    
    
    
    7,712,624Receivable from officer
    
    
    157,776
    
    
    
    160,940Other assets
    
    
    242,959
    
    
    
    174,520Total assets
    
    $
    155,371,566
    
    
    $
    153,828,974LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    634,611
    
    
    $
    1,007,178Accrued warranty
    
    
    2,027,869
    
    
    
    2,149,905Accrued expenses
    
    
    734,297
    
    
    
    589,215Accrued salaries and wages
    
    
    580,064
    
    
    
    911,725Accrued royalties payable
    
    
    204,108
    
    
    
    395,710Income taxes payable
    
    
    1,068,863
    
    
    
    1,018,230Deferred income
    
    
    854,294
    
    
    
    480,235Total current liabilities
    
    
    6,104,106
    
    
    
    6,552,198Deferred tax liabilities
    
    
    2,432,409
    
    
    
    1,447,690Total liabilities
    
    
    8,536,515
    
    
    
    7,999,888Commitments and contingent liabilities
    
    
    
    
    
    
    Shareholders equity:Preferred stock, $1.00 par value;
Authorized shares, 10,000,000; issued shares, -0-
In 2003 and 2004
    
    
    
    
    
    
    Common stock, $.20 par value; authorized shares,
50,000,000; issued shares, 13,580,370 in 2003 and
13,622,940 in 2004
    
    
    2,724,588
    
    
    
    2,716,074Additional paid-in capital
    
    
    71,134,745
    
    
    
    70,808,584Treasury stock, at cost, 461,800 shares
    
    
    (4,790,783
    )
    
    
    (4,790,783
    )Retained earnings
    
    
    77,766,501
    
    
    
    77,095,211Total shareholders equity
    
    
    146,835,051
    
    
    
    145,829,086Total liabilities and shareholders equity
    
    $
    155,371,566
    
    
    $
    153,828,974
 * Amounts derived from audited financial statements The accompanying notes are an integral part of the condensed consolidated
financial statements. 3




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##### Table of Contents



TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
  For the
    
    For
theThree Months Ended
    
    Nine Months EndedSeptember 25,
    
    September 27,
    
    September 25,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Revenues:Products
    
    $
    10,357,756
    
    
    $
    12,529,421
    
    
    $
    37,079,886
    
    
    $
    38,015,322Services
    
    
    3,280,541
    
    
    
    3,086,812
    
    
    
    9,631,371
    
    
    
    9,277,881Total revenues
    
    
    13,638,297
    
    
    
    15,616,233
    
    
    
    46,711,257
    
    
    
    47,293,203Cost of product sales:Products
    
    
    4,555,684
    
    
    
    5,528,304
    
    
    
    16,836,608
    
    
    
    17,055,017Services
    
    
    945,587
    
    
    
    1,010,193
    
    
    
    2,802,891
    
    
    
    2,776,240Amortization of intangibles
    
    
    509,817
    
    
    
    490,437
    
    
    
    1,493,344
    
    
    
    1,890,9286,011,088
    
    
    
    7,028,934
    
    
    
    21,132,843
    
    
    
    21,722,185Gross Profit
    
    
    7,627,209
    
    
    
    8,587,299
    
    
    
    25,578,414
    
    
    
    25,571,018Operating Expenses:Selling and marketing
    
    
    2,198,125
    
    
    
    2,319,913
    
    
    
    7,052,855
    
    
    
    6,711,353General and administrative
    
    
    1,849,454
    
    
    
    1,664,797
    
    
    
    5,444,874
    
    
    
    5,230,062Research and development
    
    
    3,852,481
    
    
    
    3,754,154
    
    
    
    12,159,234
    
    
    
    10,981,935Severance and related expense
    
    
    268,637
    
    
    
    
    
    
    
    268,637
    
    
    
    Total operating expenses
    
    
    8,168,697
    
    
    
    7,738,864
    
    
    
    24,925,600
    
    
    
    22,923,350(Loss) income from operations
    
    
    (541,488
    )
    
    
    848,435
    
    
    
    652,814
    
    
    
    2,647,668Interest and other income, net
    
    
    108,525
    
    
    
    76,486
    
    
    
    266,902
    
    
    
    308,979(Loss) income before income taxes
    
    
    (432,963
    )
    
    
    924,921
    
    
    
    919,716
    
    
    
    2,956,647(Benefit) provision for income taxes
    
    
    (158,774
    )
    
    
    351,470
    
    
    
    248,426
    
    
    
    1,123,526Net (loss) income
    
    $
    (274,189
    )
    
    $
    573,451
    
    
    $
    671,290
    
    
    $
    1,833,121(Loss) earnings per share information:Weighted average shares of common stock and equivalents:Basic
    
    
    13,148,183
    
    
    
    13,112,966
    
    
    
    13,133,510
    
    
    
    13,102,121Diluted
    
    
    13,148,183
    
    
    
    13,345,743
    
    
    
    13,263,016
    
    
    
    13,300,250Net (loss) income per common and common equivalent shares:Basic
    
    $
    (0.02
    )
    
    $
    .04
    
    
    $
    .05
    
    
    $
    .14Diluted
    
    $
    (0.02
    )
    
    $
    .04
    
    
    $
    .05
    
    
    $
    .14
 The accompanying notes are an integral part of the condensed consolidated financial statements. 4




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TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS EQUITY
 For the Nine Months Ended September 25, 2004
  AdditionalPreferred Stock
    
    Common Stock
    
    Paid-In
    
    Treasury
    
    RetainedShares
    
    Amount
    
    Shares
    
    Amount
    
    Capital
    
    Stock
    
    Earnings
    
    TotalBalance at
December 31, 2003
    
    
    
    
    
    $
    
    
    
    
    13,580,370
    
    
    $
    2,716,074
    
    
    $
    70,808,584
    
    
    $
    (4,790,783
    )
    
    $
    77,095,211
    
    
    $
    145,829,086Exercise of common stock options
    
    
    
    
    
    
    
    
    
    
    42,570
    
    
    
    8,514
    
    
    
    261,198
    
    
    
    
    
    
    
    
    
    
    
    269,712Tax benefit from exercise of stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    64,963
    
    
    
    
    
    
    
    
    
    
    
    64,963Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    671,290
    
    
    
    671,290Balance at September 25, 2004
    
    
    
    
    
    $
    
    
    
    
    13,622,940
    
    
    
    2,724,588
    
    
    
    71,134,745
    
    
    
    (4,790,783
    )
    
    
    77,766,501
    
    
    
    146,835,051
 The accompanying notes are an integral part of the condensed consolidated financial statements. 5




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TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
  Nine Months EndedSeptember 25,
    
    September 27,2004
    
    2003Cash flows from operating activities:Net income
    
    $
    671,290
    
    
    $
    1,833,121Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization
    
    
    3,440,145
    
    
    
    3,638,461Tax benefit from exercise of stock options
    
    
    64,963
    
    
    
    55,200Income taxes (paid) refundable
    
    
    (40,775
    )
    
    
    212,436Deferred income taxes
    
    
    97,137
    
    
    
    629,732Disposition of slow moving and obsolete inventory
    
    
    297,537
    
    
    
    301,966Provision for losses on inventory
    
    
    (259,610
    )
    
    
    (295,799
    )Provision for allowance for doubtful accounts
    
    
    (51,267
    )
    
    
    517,307Changes in assets and liabilities:Decrease (Increase) in accounts receivable-trade
    
    
    16,629
    
    
    
    (2,665,476
    )Decrease in accounts receivable-other
    
    
    3,634
    
    
    
    97,600(Increase) Decrease in inventory
    
    
    (64,669
    )
    
    
    2,952,488Decrease in prepaid expenses and other assets
    
    
    74,674
    
    
    
    600,504(Decrease) Increase in accounts payable
    
    
    (372,567
    )
    
    
    625,964(Decrease) Increase in accrued warranty
    
    
    (122,036
    )
    
    
    288,088Increase in accrued expenses and deferred income
    
    
    519,141
    
    
    
    117,140Decrease in accrued royalties payable
    
    
    (191,602
    )
    
    
    (49,847
    )(Decrease) Increase in accrued salaries and wages
    
    
    (331,661
    )
    
    
    459,194Increase in income taxes payable
    
    
    50,633
    
    
    
    211,158Net cash provided by operating activities
    
    
    3,801,596
    
    
    
    9,529,237Cash flows from investing activities:Purchase of Cheetah
    
    
    
    
    
    
    (14,899,010
    )Purchase of short-term investments
    
    
    (9,291,024
    )
    
    
    (989,167
    )Redemption/maturity of short-term investments
    
    
    7,481,223
    
    
    
    6,636,046Capital expenditures, including capitalized software
    
    
    (2,039,991
    )
    
    
    (2,380,399
    )Investments in other assets
    
    
    (715,000
    )
    
    
    Net cash used in investing activities
    
    
    (4,564,792
    )
    
    
    (11,632,530
    )Cash flows from financing activities:Proceeds from exercise of stock options
    
    
    269,712
    
    
    
    200,525Net cash provided by financing activities
    
    
    269,712
    
    
    
    200,525Net decrease in cash and cash equivalents
    
    
    (493,484
    )
    
    
    (1,902,768
    )Cash and cash equivalents at beginning of period
    
    
    31,059,972
    
    
    
    33,799,284Cash and cash equivalents at end of period
    
    $
    30,566,488
    
    
    $
    31,896,516
 The accompanying notes are an integral part of the condensed financial statements 6




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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements included
herein have been prepared by Tollgrade Communications, Inc. (the Company) in
accordance with accounting principles generally accepted in the United States
of America for interim financial information and Article 10 of Regulation S-X.
The condensed consolidated financial statements as of and for the three-month
and nine-month periods ended September 25, 2004 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, 2003. Accordingly, the accompanying condensed consolidated
financial statements do not include all of the information and footnotes
required by accounting principles generally accepted in the United States of
America for complete financial statements, although the Company believes that
the disclosures are adequate to make the information presented not misleading.
In the opinion of Company management, all adjustments considered necessary for
a fair presentation of the accompanying condensed consolidated financial
statements have been included, and all adjustments are of a normal and
recurring nature. Operating results for the three-month and nine-month periods
ended September 25, 2004 are not necessarily indicative of the results that may
be expected for the year ending December 31, 2004. With respect to the unaudited financial information of the Company for each of
the three-month and nine-month periods ended September 25, 2004 and September
27, 2003, included in this Form 10-Q, PricewaterhouseCoopers LLP reported that
they have applied limited procedures in accordance with professional standards
for a review of such information. However, their separate report dated
November 1, 2004 appearing herein, states that they did not audit and they do
not express an opinion on that unaudited financial information. Accordingly,
the degree of reliance on their report on such information should be restricted
in light of the limited nature of the review procedures applied.
PricewaterhouseCoopers LLP is not subject to the liability provisions of
Section 11 of the Securities Act of 1933 (Act) for their report on the
unaudited financial information because that report is not a report within
the meaning of Sections 7 and 11 of the Act. 2. ACCOUNTING FOR STOCK-BASED COMPENSATION The Company has two stock-based employee compensation plans. The Company
accounts for these plans under the recognition and measurement provisions of
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued
to Employees. Under these provisions, stock-based employee compensation cost
is not reflected in net income for any year, as all options granted under the
plans had an exercise price equal to the market value of the underlying common
stock on the date of grant. If the Company had elected to recognize
compensation cost for these stock options based on the fair value method set
forth in Statement of Financial Accounting Standards (SFAS) No. 123,
Accounting for Stock-Based Compensation, net (loss)income and (loss)earnings
per share would have reflected the pro forma amounts indicated below: 7




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##### Table of Contents



Three Months Ended
    
    Nine Months EndedSeptember 25,
    
    September 27,
    
    September 25,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Net (loss)income, as reported
    
    $
    (274,189
    )
    
    $
    573,451
    
    
    $
    671,290
    
    
    $
    1,833,121Deduct: Total stock-based
compensation expense based
on the fair value method for
all awards, net of related
tax effects
    
    
    50,081
    
    
    
    395,518
    
    
    
    242,959
    
    
    
    1,402,198Pro forma net (loss)income
    
    $
    (324,270
    )
    
    $
    177,933
    
    
    $
    428,331
    
    
    $
    430,923Earnings (loss) per share:Basic  as reported
    
    $
    (0.02
    )
    
    $
    0.04
    
    
    $
    0.05
    
    
    $
    0.14Basic  pro forma
    
    $
    (0.02
    )
    
    $
    0.01
    
    
    $
    0.03
    
    
    $
    0.03Diluted  as reported
    
    $
    (0.02
    )
    
    $
    0.04
    
    
    $
    0.05
    
    
    $
    0.14Diluted  pro forma
    
    $
    (0.02
    )
    
    $
    0.01
    
    
    $
    0.03
    
    
    $
    0.03
 3. ACQUISITION On February 13, 2003, the Company acquired certain assets and assumed certain
liabilities of the Cheetah status and performance monitoring product line
(Cheetah) from Acterna, LLC (Acterna) for approximately $14,300,000 in
cash. In addition, acquisition-related costs of approximately $599,000 were
capitalized for a total cost of approximately $14,899,000. The transaction
provided for an earn-out to be paid in the first half of 2004 of up to
$2,400,000 based on certain 2003 performance targets. The current calculation
indicates that amounts due under this provision are immaterial. The acquired
assets consist principally of existing sales order backlog, product inventory,
intellectual property, software and related computer equipment, while the
assumed liabilities principally relate to deferred software maintenance,
warranty and other obligations. The $14,300,000 due at closing and related
acquisition expenses were paid from available cash and short-term investments.
The Company believes that the acquired product line complements its legacy
LIGHTHOUSE® cable products and positions the Company as a leading supplier of
testing equipment and software for the cable industry. The acquisition was
recorded under the purchase method of accounting 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 product line from February 14, 2003 forward are included in the
consolidated financial statements of the Company. The Company has made an allocation of the Cheetah purchase price to the fair
value of assets acquired and liabilities assumed. The purchase price remains
subject to change pending resolution between the parties of outstanding
contingencies regarding the earn-out provision and remaining purchase price
adjustments. Any changes to the purchase price arising from the resolution of
these matters are expected to be accounted for as adjustments to goodwill and
may be material. The following condensed proforma results of operations reflect the
proforma combination of the Company and the acquired Cheetah product line as if
the combination occurred on January 1, 2003. 8




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##### Table of Contents



(In Thousands, Except Per Share Data)
Nine Months Ended
September 27, 2003
Proforma Revenues
    
    $
    48,656Income from operations
    
    
    3,318Net income
    
    
    2,250Diluted earnings per share
    
    $
    0.17
 This proforma financial information is presented for comparative purposes only
and is not necessarily indicative of the operating results that actually would
have occurred had the Cheetah product line acquisition been consummated on
January 1, 2003. In addition, these results are not intended to be a
projection of future results. 9




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4. INTANGIBLE ASSETS The following information is provided regarding the Companys intangible assets
and goodwill: As of September 25, 2004
    
    As of December 31, 2003Gross
    
    
    
    
    
    GrossCarrying
    
    Accumulated
    
    Carrying
    
    AccumulatedAmount
    
    Amortization
    
    Amount
    
    AmortizationAmortized intangible assets:Cheetah sales order
backlog, included in
inventory
    
    $
    543,273
    
    
    $
    543,273
    
    
    $
    543,273
    
    
    $
    539,442Exclusivity agreement
    
    
    715,000
    
    
    
    71,500
    
    
    
    
    
    
    
    Total Amortized Intangibles
    
    $
    1,258,273
    
    
    $
    614,773
    
    
    $
    543,273
    
    
    $
    539,442Non-amortized intangible
assets:LoopCare trade name
    
    $
    1,300,000
    
    
    $
    
    
    
    $
    1,300,000
    
    
    $
    Base software  LoopCare
    
    
    5,200,000
    
    
    
    
    
    
    
    5,200,000
    
    
    
    Post warranty maintenance
service agreements
    
    
    32,000,000
    
    
    
    
    
    
    
    32,000,000
    
    
    
    Customer Base  Cheetah
    
    
    5,000,000
    
    
    
    
    
    
    
    5,000,000
    
    
    
    Cheetah Trademark
    
    
    1,000,000
    
    
    
    
    
    
    
    1,000,000
    
    
    
    Total Non-Amortized
Intangibles
    
    $
    44,500,000
    
    
    $
    
    
    
    $
    44,500,000
    
    
    $
    Total Intangibles
    
    $
    45,758,273
    
    
    $
    614,773
    
    
    $
    45,043,273
    
    
    $
    539,442Capitalized software:Developed product software
    
    $
    7,555,277
    
    
    $
    4,438,873
    
    
    $
    7,483,483
    
    
    $
    3,313,359Base software  Cheetah
    
    
    2,900,000
    
    
    
    483,333
    
    
    
    2,900,000
    
    
    
    265,833Proprietary technology
    
    
    1,000,000
    
    
    
    166,667
    
    
    
    1,000,000
    
    
    
    91,667Total capitalized software
(long term)
    
    $
    11,455,277
    
    
    $
    5,088,873
    
    
    $
    11,383,483
    
    
    $
    3,670,859Goodwill:LoopCare
    
    $
    15,949,808
    
    
    $
    
    
    
    $
    15,949,808
    
    
    $
    Cheetah
    
    
    3,389,874
    
    
    
    
    
    
    
    3,389,874
    
    
    
    Total Goodwill
    
    $
    19,339,682
    
    
    $
    
    
    
    $

    19,339,682
    
    
    $
    
 Estimated amortization expense for the years ended: December 31, 2004
    
    $
    2,004,364December 31, 2005
    
    $
    2,044,060December 31, 2006
    
    $
    1,679,060December 31, 2007
    
    $
    579,962December 31, 2008
    
    $
    559,771
 10




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We have entered into certain third party license agreements to augment our
next-generation technology. During the first quarter of 2004, the Company
entered into a License Agreement (Initial Agreement) with a third party
software vendor for certain Voice Over Internet Protocol (VoIP) technology,
pursuant to which the Company obtained a non-exclusive license to use,
further develop and incorporate into certain of its products such technology.
In conjunction with this agreement during the first quarter of 2004, we prepaid
approximately $0.3 million in services, license and royalty fees. The Initial Agreement was replaced and superseded by a second license agreement
during the second quarter of 2004, pursuant to which the Company obtained a
perpetual worldwide right and license to use, further develop and incorporate
such technology into any of its products. Additionally, the agreement provides
that during the term of the agreement, the Company is the sole and exclusive
licensee for particular applications of this technology. The agreement is for
a period of five years. In conjunction with this agreement, the Company paid
approximately $0.7 million for the exclusivity right and prepaid approximately
$0.1 million of additional royalty fees. Including the fees paid in connection
with the initial agreement, total fees paid under this agreement during 2004
were approximately $1.1 million. In addition, there is a continuing obligation
for the Company to pay additional royalties which may total $0.8 million or
less, depending upon the volume of sales of the underlying product which
incorporates the technology. Royalty expense will be recognized based on the
underlying related product sales. The exclusivity fee will be amortized on a
straight line basis over the five year contract period effective April 1, 2004. 5. INVENTORY At September 25, 2004 and December 31, 2003, inventory consisted of the
following: September 25, 2004
    
    December 31, 2003Raw materials
    
    $
    7,075,358
    
    
    $
    7,398,419Work in process
    
    
    3,967,156
    
    
    
    3,723,409Finished goods
    
    
    1,565,977
    
    
    
    1,497,84812,608,491
    
    
    
    12,619,676Reserve for slow moving and obsolete inventory
    
    
    (1,427,073
    )
    
    
    (1,465,000
    )$
    11,181,418
    
    
    $
    11,154,676
 6. SHORT-TERM INVESTMENTS Short-term investments at September 25, 2004 and December 31, 2003 consisted of
individual municipal bonds stated at cost, which approximated market value.
These securities have maturities of one year or less at date of purchase and/or
contain a callable provision in which the bonds can be called within one year
from date of purchase. The primary investment purpose is to provide a reserve
for future business purposes, including acquisitions and capital expenditures.
Realized gains and losses are computed using the specific identification
method. The Company classifies its investment in all debt securities as held to
maturity, as the Company has the intent and ability to hold the securities to
maturity. 11




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The estimated fair values of the Companys financial instruments are as
follows: September 25, 2004
    
    December 31, 2003Carrying Amount
    
    Fair Value
    
    Carrying Amount
    
    Fair ValueFinancial assets:Cash and cash equivalents
    
    $
    30,566,488
    
    
    $
    30,566,488
    
    
    $
    31,059,972
    
    
    $
    31,059,972Short-term investments
    
    
    19,434,469
    
    
    
    19,445,784
    
    
    
    17,624,668
    
    
    
    17,609,031$
    50,000,957
    
    
    $
    50,012,272
    
    
    $
    48,684,640
    
    
    $
    48,669,003
 7. SEVERANCE On July 8, 2004 and July 21, 2004, the Company announced a cost alignment
program which eliminated, in two phases, approximately 50 positions. The
majority of the reductions impacted the research and development,
manufacturing, and related overhead areas of the Company. The cost alignment
initiative resulted in a pre-tax severance expense of $0.3 million. All costs
associated with the program were incurred and paid during the quarter ended
September 25, 2004. Therefore, no remaining obligations exist at the end of
the period. 8. PER SHARE INFORMATION Net (loss) income per share has been computed in accordance with the provisions
of SFAS No. 128, Earnings Per Share for all periods presented. SFAS No. 128
requires companies with complex capital structures to report earnings per share
on a basic and diluted basis. Basic earnings per share is computed using the
weighted average number of shares outstanding during the period, while diluted
earnings per share is calculated to reflect the potential dilution that occurs
related to issuance of capital stock option grants. The three months ended
September 25, 2004 do not include the effect of dilutive securities due to the
current net loss which would make those securities anti-dilutive to the
earnings per share calculation. The difference between basic and diluted
earnings per share relates solely to the effect of capital stock options. A reconciliation of (loss) earnings per share is as follows: Three Months
    
    Three Months
    
    Nine Months
    
    Nine MonthsEnded
    
    Ended
    
    Ended
    
    EndedSeptember 25, 2004
    
    September 27, 2003
    
    September 25, 2004
    
    September 27, 2003Net (loss) income
    
    $
    (274,189
    )
    
    $
    573,451
    
    
    $
    671,290
    
    
    $
    1,833,121Common and common equivalent shares:Weighted average common shares outstanding
    
    
    13,148,183
    
    
    
    13,112,966
    
    
    
    13,133,510
    
    
    
    13,102,121Effect of dilutive securities  stock options
    
    
    
    
    
    
    232,777
    
    
    
    129,506
    
    
    
    198,12913,148,183
    
    
    
    13,345,743
    
    
    
    13,263,016
    
    
    
    13,300,250(Loss) earnings per share:Basic
    
    $
    (0.02
    )
    
    $
    .04
    
    
    $
    .05
    
    
    $
    .14Diluted
    
    $
    (0.02
    )
    
    $
    .04
    
    
    $
    .05
    
    
    $
    .14
 Unexercised stock options to purchase our capital stock of 1.3 million and
0.9 million shares for the three months ended September 25, 2004 and September
27, 2003, respectively, and 1.1 million shares for the nine months ended
September 25, 2004 and 0.9 million for the nine months ended September 27,
2003, are not 12




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included in the computation of diluted earnings per share because the option
exercise price for these shares was greater than the average market price. 9. ACCOUNTING PRONOUNCEMENTS On January 17, 2003, the FASB issued FASB Interpretation No. 46, Consolidation
of Variable Interest Entities  an interpretation of ARB No. 51 (FIN 46).
FIN 46 clarifies the application of Accounting Research Bulletin No. 51,
Consolidated Financial Statements, to certain entities in which equity
investors do not have the characteristics of a controlling financial interest
or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other
parties. Certain provisions of FIN 46 were effective for the Company after
January 31, 2003 and did not have an impact on the Companys results of
operations or financial condition. FIN 46 was revised in December 2003 and is
effective for the first financial reporting period ending after March 15, 2004.
The Company adopted the provisions of FIN 46 effective January 1, 2004, which
did not have an impact on the financial statements. The Company has no interest
in any variable interest entities. 10. 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. As reported in the Companys Report on Form 10-Q for the quarter ended June 26,
2004, the Company sold $1,253,000 of our new Internet-addressable monitoring
probes during the second quarter of 2004. Although the Companys customer, Alpha Technologies, Inc., had waived certification,
the Company was in the
process of obtaining certification by Cable Television Laboratories, Inc.
(Cablelabs) for the embedded version of this product. We previously reported that
certain modifications needed to be made to the product to achieve certification
as to compliance with industry standards. During the third quarter of 2004, we
completed those modifications and received the Cablelabs DOCSIS® certification
for the Alpha embedded version of this product. Activity in the warranty accrual is as follows: Nine Months Ended
    
    Year EndedSeptember 25, 2004
    
    December 31, 2003Balance at the beginning of the period
    
    $
    2,150,000
    
    
    $
    1,981,000Accruals for warranties issued during the period
    
    
    172,000
    
    
    
    690,000Cheetah opening accrual
    
    
    
    
    
    
    225,000Settlements during the period
    
    
    (294,000
    )
    
    
    (746,000
    )Balance at the end of the period
    
    $
    2,028,000
    
    
    $
    2,150,000
 13




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11. CONTINGENCIES AND COMMITMENTS The Company has arrangements with certain manufacturing subcontractors under
which the Company is contingently obligated to purchase up to $2.0 million of
raw material parts in the event they would not be consumed by the manufacturing
process in the normal course of business. The Company enters into these
commitments in order to secure components that can only be purchased on a
non-cancelable, non-returnable basis and to assure availability of components
that have long lead times. In addition, the Company is, from time to time, party to various legal claims
and disputes, either asserted or unasserted, which arise in the ordinary course
of business. While the final resolution of these matters cannot be predicted
with certainty, the Company does not believe that the outcome of any of these
claims will have a material adverse effect on the Companys consolidated
financial position, or annual results of operations, or cash flow. 14




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Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of
Tollgrade Communications, Inc. and subsidiaries: We have reviewed the accompanying condensed consolidated balance sheet of
Tollgrade Communications, Inc. and its subsidiaries as of September 25, 2004,
and the related condensed consolidated statements of operations for each of the
three-month and nine-month periods ended September 25, 2004 and September 27,
2003 and the condensed consolidated statement of cash flows for the nine-month
periods ended September 25, 2004 and September 27, 2003. 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 previously audited in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheet as
of December 31, 2003, and the related consolidated statements of operations,
shareholders equity and of cash flows for the year then ended (not presented
herein), and in our report dated January 21, 2004 (which included an
explanatory paragraph relating to the Companys adoption of changing its method
of accounting for goodwill) we expressed an unqualified opinion on those
consolidated financial statements. In our opinion, the information set forth
in the accompanying condensed consolidated balance sheet as of December 31,
2003, is fairly stated in all material respects in relation to the consolidated
balance sheet from which it has been derived. PricewaterhouseCoopers LLP
Pittsburgh, Pennsylvania
November 1, 2004 15




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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. The statements contained in this Quarterly Report on Form 10-Q, including, but
not limited to those contained in Item 2- Managements Discussion and Analysis
of Results of Operations and Financial Condition, along with statements in
other reports filed with the Securities and Exchange Commission (the SEC),
external documents and oral presentations, which are not historical facts are
considered forward-looking statements within the meaning of Section 27A of
the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. These statements, which may be expressed in
a variety of ways, including the use of forward-looking terminology such as
"will, believes, intends, expects, plans, could or may,or the
negatives thereof, other variations thereon or comparable terminology, relate
to, among other things, the Companys intent with regard to holding short-term
investments, the Companys plans for the development of certain cable products,
the results of the Companys efforts to obtain certain product certifications
and the effect of such results on future sales, certain cost alignment
initiatives, projected cash flows which are used in the valuation of intangible
assets, the anticipated results of negotiations for purchase orders and other
customer purchase agreements, changes in our backlog, the amount of backlog
that may be recognized as revenue in future periods, the ability to utilize
deferred and refundable tax assets, opportunities which the Services group
offers to customers, the potential loss of certain customers, the timing of
orders from customers, the effect of consolidations in the markets to which we
sell, the significant portion of our revenues generated from MCU® sales and the
expected consequences of the maturation of this market, the opportunities
developing in the cable broadband market, certain international sales
opportunities, circumstances surrounding our LoopCare sales, the impact of the
acquisition of the Cheetah product line on our position in the cable industry,
the effects of the economic slowdown in the telecommunications and cable
industries, the possibility of future provisions for slow moving and obsolete
inventory, and the effect on earnings and cash flows of changes in interest
rates. The Company does not undertake any obligation to publicly update any
forward-looking statements. These forward-looking statements and other forward-looking statements contained
in other public disclosures of the Company which make reference to the
cautionary factors contained in this Form 10-Q are based on assumptions that
involve risks and uncertainties and are subject to change. These risks,
uncertainties and other factors may cause actual results, performance or
achievements to differ materially from anticipated future results, performance
or achievements expressed or implied by such forward looking statements. The
Company wishes to caution each reader of this Form 10-Q to consider the factors
described below and certain other factors discussed herein and in other past
reports including, but not limited to, prior year Annual Reports and Form 10-K
and Form 10-Q reports filed with the SEC. The factors discussed herein may not
be exhaustive. Therefore, the factors discussed herein should be read together
with other reports and documents that are filed by the Company with the SEC
from time to time, which may supplement, modify, supersede or update the
factors listed in this document. 16




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OVERVIEW About the Company Tollgrade Communications, Inc. (the Company) was organized in 1986, began
operations in 1988 and completed its initial public offering in 1995. The Company is a leading provider of hardware and software network assurance
testing solutions for the telecommunications and cable broadband service
providers. We design, engineer, market and support test systems, test access
and status monitoring products which enable telephone and cable operators to
efficiently troubleshoot service problems on their networks in an age of
increased competition, continually evolving technology, and ongoing pressure to
control or reduce costs. We provide equipment that enables telephone companies
to repair their wire telephone lines when they are not functioning properly.
When the telephone lines are out of service, our products help to diagnose the
problem. In addition, our products can assess whether the lines are suitable
for Digital Subscriber Line (DSL) service. The Companys cable products are focused on proactive monitoring of primarily
power supplies, as well as nodes, in Hybrid Fiber Coax (HFC) systems used by
cable providers to deliver video and digital broadband services. Cable
networks are highly dependent on other equipment manufacturers power supplies,
which serve as backup power for the utility power; if such power supplies fail,
the cable operators run the risk of service interruptions to their customers.
We provide products to cable companies that monitor the status of those power
supplies. The Companys primary cable products are the Cheetah performance and status
monitoring products, which include our proprietary transponders, HMS
transponders and the newly developed Internet addressable transponders. These
products gather status information and report on critical components,
principally power supplies, within the Broadband HFC distribution system. In
February 2003, the Company acquired the Cheetah status and performance
monitoring product line to complement the Companys legacy LIGHTHOUSE®
products. Troubleshooting problems in voice circuits consists of accessing telephone
lines, measuring electrical characteristics and analyzing those measurements to
determine the cause and source of the problem. Our primary telecommunications
products therefore consist of the MCU® and Digital Access Unit (DAU) (access),
DigiTest® and DigiTest EDGE (measurement) and LoopCare (analysis). The MCU
allows customers to extend line-testing capabilities through the fiber optic
networks to the copper portions of the local loop. The DAU provides test
access for DSL transmission equipment. DigiTest, DigiTest EDGE and LoopCare
electronically measure and sectionalize the characteristics of certain portions
of a telephone circuit. 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 17




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RBOCs are the most significant; for the third quarter ended September 25, 2004,
sales to the RBOCs accounted for approximately 56.4% of the Companys total
revenue, compared to approximately 51% and 40.1%of total revenue for the first
and second quarters of 2004, respectively, and 55.3% of the Companys total
revenue for the third quarter ended September 27, 2003. Sales to three of the
four RBOC customers (BellSouth, SBC and Verizon) individually exceeded 10% of
the Companys total revenues (20.6%, 14.7% and 17.6%, respectively), and on a
combined basis, comprised 53% of the Companys total revenues for the third
quarter of 2004. The Company continues to be highly dependent on the four
RBOCs for a significant portion of its total revenue but such dependency has
generally declined in recent years due to relative increases in sales of our
cable hardware and software products. During the last year, the Company has
also expanded sales of its LoopCare and DigiTest/DigiTest EDGE test system to
non-RBOC independent local exchange carriers (LECs). The Companys cable products are sold to a customer base which ranges from
small cable operators to certain of the largest cable equipment manufacturers
and cable operators in the world. During the third quarter of 2004, no
individual sales to the Companys cable customers exceed 10% of the Companys
total revenue. PRODUCTS: TELECOMMUNICATION TEST SYSTEMS Our proprietary telecommunications test access products enable the RBOCs to use
their existing line test systems to remotely diagnose problems in Plain Old
Telephone Service (POTS) lines containing both copper and fiber optics as well
as qualify and troubleshoot problems on broadband DSL lines. The Company also
sells LoopCare and DigiTest to carriers that do not 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. POTS lines
comprise the vast majority of lines in service today throughout the world. In
addition to traditional voice service, POTS lines provide connections for
popular 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. DSL provides the ability to
transmit high speed data over traditional copper lines. DigiTest(R)
and LoopCare(R) 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 condition. 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 have the capability to tell the
telephone company whether the customer line is suitable for DSL service. In
addition, upgrades to DigiTest hardware can provide troubleshooting for DSL
service problems. The DigiTest system includes direct Ethernet connectivity to Digital
Measurement Node (DMN) test heads and our next generation broadband test
platform, DigiTest EDGE. Through Ethernet connections, the LoopCare OSS can
communicate directly with remotely deployed DigiTest hardware, allowing it to
manage up to four DMNs and eight simultaneous test sessions through a single
Internet Protocol (IP) address. DigiTest EDGE provides a global platform for
broadband test applications, by combining a narrowband and wideband metallic
testing platform with DSL, Asynchronous Transfer Mode (ATM), IP and Hypertext
Transfer Protocol (HTTP) performance tests. This combination of test 18




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capabilities, when managed by our LoopCare OSS, enables service providers to
accurately isolate a DSL problem between the customers premises, the local
exchange carriers local loop and Digital Subscriber Line Access Multiplexer
(DSLAM) serving network, and the Internet service providers data network. LoopCare, which we acquired from Lucent in 2001, has remained the major 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, currently manages more than 75% of the copper
pairs in the United States, and is the qualification, installation and
maintenance process for more than 150 million POTS, ISDN and DSL subscribers
worldwide. 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 LoopCare OSS
as a stand-alone product to LECs for use with test heads other than our
DigiTest hardware. LoopCare feature products include the Common Object Request
Broker Architecture (CORBA)-based Application Programming Interface, Benchmark
Data Base, DSL Testing, the Advanced Testhead Feature Package, Batch Testing,
Fax Unalert, Loop Length Reporting, Enabling Flow Through by Re-Classification
of VER 55-58 Codes, LoopCare TCP/IP Communications Network, and Testing Voice
Services in a Broadband Passive Optical Network (bPON). MCU Our 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, including copper and fiber-optic lines
linked by DLCs. 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 cable performance and status monitoring products provide a broad
network assurance solution for the Broadband HFC distribution system found in
the cable television industry. Our Cheetah products gather status information
and report on critical components within the cable network. On February 13,
2003, we acquired the Cheetah product line from Acterna, LLC, for $14.3 million
in cash plus transaction costs of $0.6 million. As a result of this
acquisition, our cable offerings now consist of our CheetahLight (formerly
LIGHTHOUSE®) and CheetahNet (formerly NetMentor) software systems and
maintenance, head-end controllers, return path switch hardware, transponders
and other equipment which gather status and performance reports from power
supplies, line amplifiers and fiber optic nodes. Cable television service providers continue to evolve their offerings from
traditional one-way video delivery to bi-directional services, including the
communications triple play of voice, video and data service. The Company
will seek to evaluate, develop and market network assurance products that
address quality problems related to these advanced services. During the third
quarter of 2004, we obtained certification from Cablelabs for the Companys
DOCSIS certified Alpha embedded transponders. The product provides internet
protocol (IP) band monitoring. By using our DOCSIS certified Alpha embedded
transponders and next generation software, the Company intends to leverage its
experience in 19




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delivering network assurance technologies to telecom providers by developing
more advanced performance management solutions for once-traditional cable
suppliers. The Company is actively engaged in research and development of
Voice Over Internet Protocol (VoIP) solutions, as well as data network
integrity technologies. As part of this strategy, we have entered into certain third party license
agreements to augment our next generation technology. During the first and
second quarters of 2004, the Company entered into License Agreements with a
third party software vendor to further enhance our VoIP technology. SERVICES Our Services offerings include software maintenance as well as our professional
services, which are designed to assist our customers in ensuring the proper
operation of all of the components of their voice test systems. The Services
business was considerably expanded upon the acquisition of software maintenance
relationships related to the LoopCare and CheetahNet software product lines. RECENT DEVELOPMENTS During the third quarter of 2004, the Companys management decided to implement
a cost reduction program for a variety of reasons, including:  
    
    A slowing MCU sales environment due primarily to the maturing of its
product life cycle, a decrease in the deployment of DLC systems as a
result of loss of lines to competitors, as well as a shift to new
fiber-based network architectures.
    
    A delay in the deployment of DigiTest and DigiTest EDGE to large LEC
customers as a result of such customers protracted field trial
activity, lengthy business case analysis, contract negotiations and
reduced capital expenditure budgets.
    
    A delay in customers approval of key LoopCare features as a result
of protracted field trial and business case analysis.
    
    A change in the Companys product mix to those with lower profit
margins. The cost alignment program focused primarily on the elimination of
approximately fifty positions. It also focused on tighter expense control
through travel, trade show and car lease restrictions, as well as the
elimination of any incentive compensation accruals. BACKLOG Our backlog consists of firm customer purchase orders and signed software
maintenance agreements. As of September 25, 2004, the Company had backlog of
approximately $8.1 million compared to $15.3 million as of December 31, 2003
and $8.8 million as of September 27, 2003. The decrease in the backlog from
December 31, 2003 is attributed to a lower maintenance backlog, heavy MCU
shipments in the first half of 2004, as well as a negotiated cancellation of
certain MCU orders totaling $0.7 million associated with a second quarter
incentive purchase. We have entered into LoopCare software maintenance agreements with all four
RBOCs. Three of these agreements have terms which expire on December 31, 2004
(one can be extended for another year) while the fourth RBOC maintenance
agreement will expire December 31, 2005. The backlog at September 25, 2004
included approximately $4.9 million related to software maintenance contracts,
which will be earned 20




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and recognized as income on a straight-line basis during the remaining terms of
the underlying agreements. The backlog specifically related to software
maintenance products as of December 31, 2003 and September 27, 2003 were $6.1
million and $6.5 million, respectively. We have adopted a policy to include a
maximum of twelve months revenue from multi-year agreements in reported
backlog. Software maintenance revenue is deemed to be earned and recognized as
income on a straight-line basis over the terms of the underlying agreements. Management expects that approximately 68% of the current backlog will be
recognized as revenue in the fourth quarter of 2004. 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. REPORTING SEGMENT We have determined that our business has one reporting segment, the test
assurance industry. All product sales are considered components of the business
of testing infrastructure and networks for the telecommunications and cable
television industries. Although we internally develop historical sales
information associated with the various product categories, this information is
not considered to be sufficient for segment reporting purposes. Our products
and services have similar economic characteristics and the same or similar
production processes, and are sold through similar distribution channels and
means to similar types and classes of customers already in, or entering into,
the telecommunications and cable businesses. INTERNATIONAL SALES International sales represented approximately 8.4%, or $1.1 million, of the
Companys total revenue for the quarter ended September 25, 2004, compared to
2.6%, or $0.4 million, in the September 27, 2003 quarter. International sales
represented approximately 7.7% of the Companys total revenue for the nine
months ended September 25, 2004, compared to 7.2% for the nine month period
ended September 27, 2003. Although our international sales have increased year
over year, and our marketing activity in international markets has expanded,
our overall success in marketing and selling our telecommunications products in
international markets remains limited, due in part to incompatibility of
certain of our telecommunications products in networks employed abroad. We
continue to evaluate opportunities in the international market that will
enhance our international presence and growth. As part of the effort to expand
our international sales, we periodically receive and respond to requests for
proposals from certain international telephone and cable service providers.
During the first quarter of 2004, we were notified that we were selected as a
vendor for an international project. However, the commercial terms and
conditions, which will be significant to the Company, have not been agreed
upon, nor has the final scope of work or schedule for completion been
finalized. As a result, the opportunity presented is still being negotiated
and has risk of not being consummated. APPLICATION OF CRITICAL ACCOUNTING POLICIES The Companys financial statements are prepared in conformity with accounting
principles generally accepted in the United States of America. Certain of
these accounting principles are more critical than others in gaining an
understanding of the basis upon which the Companys financial statements have
been 21




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prepared. A comprehensive review of these policies is contained in the
Companys 2003 Annual Report on Form 10-K filed on March 15, 2004. Management
believes the Companys critical accounting policies are those related to Staff
Accounting Bulletin (SAB 104), Revenue Recognition; AICPAs Statement of
Position (SOP) 97-2  Software Revenue Recognition, and Emerging Issues Task
Force (EITF) Issue 00-21, Accounting for Revenue Arrangements with Multiple
Deliverables; Statement of Financial Accounting Standards (SFAS) No. 141,
Business Combinations; SFAS No. 142, Goodwill and Other Intangible Assets;
SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets;
and SFAS No. 109, Accounting for Income Taxes. Management believes these
policies to be critical because they are both important to the portrayal of the
Companys financial condition and results and they require management to make
judgments and estimates based on matters that are inherently uncertain. There
were no significant changes in these policies or the application thereof during
2004. 22




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RESULTS OF OPERATIONS THE FOLLOWING DISCUSSION OF THE RESULTS OF OPERATIONS AND FINANCIAL
CONDITION OF THE COMPANY SHOULD BE READ IN CONJUNCTION WITH PART I, ITEM 1 OF
THIS REPORT THIRD QUARTER OF 2004 COMPARED TO THIRD QUARTER OF 2003 Revenues The Companys revenues for the third quarter of 2004 were $13.6 million, a
decrease of $2.0 million or 12.7%, compared to revenues of $15.6 million
reported for the third quarter of 2003. Sales of MCUs, which are sold primarily to the RBOCs, during the third quarter
of 2004 were $4.7 million, a decrease of $1.9 million compared to the third
quarter of 2003. As a result, MCU sales were 34.2% of total third quarter 2004
revenues compared to 42.0% for the third quarter of 2003. The decrease between
periods is primarily attributed to a decrease in the amount of DLC systems
being deployed among the RBOCs, restricted POTS capital spending by the RBOCs,
purchases by SBC in 2003 of a significant amount of its 2004 MCU requirements
and reduced OEM sales to Advanced Fiber Communications (AFC). There has also
been a delay in testability initiatives due to tight professional service
budgets, which affects MCU retrofit sales. We expect MCU sales for the foreseeable future to continue to account for a
meaningful portion of the Companys revenue. However, as a result of the
continuing maturation of this product line, the RBOCs trend of limiting
capital spending in their traditional POTS networks and the evolution of the
transmission network towards end to end fiber, the Company believes this
product line is meaningful but mature and on an overall basis we expect it to
decline over time. The significant purchases made in the fourth quarter of
2003 and first quarter of 2004 coupled with the mature nature of the MCU
products have resulted in lower year over year comparative sales in the third
quarter of 2004 and it is expected that this trend will continue in the fourth
quarter of 2004. Sales of the Companys DigiTest system products, which include LoopCare
software, were $2.9 million in the third quarter of 2004, an increase of $0.4
million or 18.2%, compared to the third quarter of 2003. DigiTest revenue was
favorably affected by purchases made by LEC customers as well as continuing
RBOC LTS modernization initiatives. DigiTest system sales accounted for 21.1%
and 15.6% of total revenues for the third quarter of 2004 and 2003,
respectively. We currently have active DigiTest and LoopCare product trials
underway in a number of our large customers. These trials are at various
stages and it is difficult to predict with any certainty the ultimate outcome
of these trials as well as product acceptances. Sales of LoopCare software products separate and unrelated to DigiTest system
products were $0.3 million in the third quarter of 2004; no sales were recorded
in the third quarter of 2003. The LoopCare software product line, which
involves software license fees that individually are significant in amount,
typically has long and unpredictable sales, purchase approval and acceptance
cycles. When making a purchase decision for LoopCare software, our customers
generally must complete a full technical evaluation of the software and a
develop a favorable business case within their organization. As a result,
revenue from this product line can fluctuate significantly on a quarter by
quarter basis. LoopCare software product sales comprised 2.4% of total
revenues during the third quarter of 2004. Like our 23




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DigiTest products, we currently have active LoopCare stand-alone software
feature product trials underway in a number of large customers. These trials
are at various stages and it is difficult to predict with any certainty the
ultimate outcome of these trials as well as product acceptances. Overall sales of cable hardware and software products decreased $1.1 million or
31.1%, to $2.4 million in the third quarter of 2004 compared to the third
quarter of 2003. During the third quarter, we received Cablelabs DOCSIS
certification for our Alpha embedded transponders certifying that these
products comply with industry standards. The Company chose not to begin
manufacturing until final engineering enhancements needed to obtain
certification were completed. In addition, forced evacuations from our Florida
facilities due to hurricanes modestly exacerbated the difficulty in producing
and delivering product to our customers in the third quarter. Included in our
backlog at the end of the third quarter of 2004 are orders of approximately
$1.7 million of the external version of our Internet addressable probes. We
expect the majority of this order to be recognized as revenue in the fourth
quarter of 2004. Cable hardware and software product sales amounted to 17.9%
and 22.7% of total third quarter 2004 and 2003 revenue, respectively. Services revenues, which include installation oversight and project management
services provided to RBOC and other customers and fees for LoopCare and Cheetah
software maintenance, increased $0.3 million to $3.4 million in the third
quarter of 2004. Service revenues amounted to 24.5% and 19.8% of total third
quarter 2004 and 2003 revenue, respectively. Periodic fluctuations in customer orders and backlog result from a variety of
factors, including but not limited to the timing of significant orders from,
shipments to, and acceptance of software by RBOC customers, and are not
necessarily indicative of long-term trends in sales of the Companys products. As referenced above in the section entitled Recent Developments, during
the third quarter of 2004, we implemented a cost alignment program which
focused primarily on the elimination of approximately fifty positions. The
majority of the reductions were in the research and development and
manufacturing overhead areas of the Company. As a result of the cost alignment
program we have recorded, in the third quarter, a restructuring charge of
approximately $0.3 million. The restructuring program resulted in a gross
pre-tax cost reduction of $0.8 million in the third quarter of 2004 and is
expected to result in $1.0 million in pre-tax cost reductions in the fourth
quarter of 2004. All actions, including cash payments, related to this cost
alignment were completed during the third quarter of 2004. Gross Profit Gross profit for the third quarter of 2004 decreased $1.0 million or 11.2% to
$7.6 million. The decrease in gross profit is attributed primarily to reduced
sales of MCUs and cable hardware and software products. As a percentage of
sales, gross profit for the quarter was 55.9% versus 55.0% for the year ago
period. Gross margin, as a percentage of sales, increased in the third quarter
compared to the previous years third quarter due to the sales mix which
included a larger portion of higher margin DigiTest and LoopCare software
sales, and less lower margin cable hardware and software sales. Selling and Marketing Expense Selling and marketing expense, which consists primarily of payroll related
costs, consulting expense and travel costs, decreased $0.1 million to $2.2
million for the third quarter of 2004 from $2.3 million in 2003. The decrease
is related to travel costs and consulting costs offset by slight increases in
salaries and wages and commissions. As a percentage of revenues, selling and
marketing expenses increased from 14.9% in 24




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the third quarter of 2003 to 16.1% in the third quarter of 2004. We expect the
cost alignment programs undertaken during the third quarter of 2004 will have a
modest impact on future selling and marketing expenses. General and Administrative Expense General and administrative expense, which consists primarily of payroll related
costs, insurance expense and professional services, for the third quarter of
2004 was $1.8 million, an increase of $0.2 million, or 11.1%, from the $1.7
million recorded in the third quarter of 2003. The increase is primarily
attributed to the increased salary costs of $0.1 million and increased
professional services of $0.3 million offset, in part by, a decrease of $0.3
million in bad debt allowances due to favorable results from collection efforts
and current lower sales levels. As a percentage of revenues, general and
administrative expenses increased from 10.7% in the third quarter of 2003 to
13.6% in the third quarter of 2004. Research and Development Expense Research and development expense, which consists primarily of payroll related
costs, depreciation expense and rent expense increased slightly to $3.9 million
in the third quarter of 2004 from $3.8 million in the third quarter of 2003.
As a percentage of revenues, research and development expense increased to
28.2% in the third quarter of 2004 from 24.0% in the prior year quarter. The
effect of our cost alignment initiatives completed during the third quarter of
2004 were largely offset by increases in consulting fees, costs associated with
our next generation cable products and costs related to the certification of
our embedded DOCSIS transponders. Interest and Other Income Interest and other income, comprised primarily of interest income in both
quarterly periods, remained flat at $0.1 million in the third quarter of 2004
and in the third quarter of 2003. Provision (Benefit) for Income Taxes Income taxes for the third quarter of 2004 included a benefit of $(0.2) million
due to the current quarter pretax loss. The provision for income taxes in the
third quarter of 2003 was a charge of $0.4 million. The effective income tax
rate for the third quarter of 2004 was a benefit of 36.7% compared to a charge
of 38% in the third quarter of 2003. The change in the effective rate is
attributed to the increase in the permanent difference in proportion to the
Companys net loss before tax. While we have made our best estimate of our
effective rate for 2004, based on the Companys operating results and permanent
differences, it is reasonably possible our effective income tax rate could vary
during the remainder of 2004. Net (Loss) Income and (Loss) Earnings Per Share As a result of the above factors, the net loss for the third quarter of 2004
was $(0.3) million compared to net income in the third quarter of 2003 of $0.6
million. For the third quarter of 2004, our basic and diluted loss per common
share was $(0.02) compared to net income of $0.04 per common share recorded in
prior year quarter. Basic and diluted weighted average common and common
equivalent shares outstanding were 13,148,183 in the third quarter of 2004
compared to 13,112,966 and 13,345,743, respectively, in the third quarter of
2003. 25




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NINE MONTHS ENDED SEPTEMBER 25, 2004 COMPARED TO NINE MONTHS ENDED SEPTEMBER
27, 2003 Revenues The Companys revenues for the nine months ended September 25, 2004 were $46.7
million, a decrease of $0.6 million, or 1.2%, compared to revenues of $47.3
million reported for the nine months ended September 27, 2003. Revenue for the
period ended September 27, 2003 included the Cheetah product line from the
February 13, 2003 acquisition date through September 27, 2003. The revenue for
the period ended September 25, 2004 includes the operations of Cheetah for the
entire period. MCU revenues for the nine months ended September 25, 2004 were $15.8 million, a
decrease of $1.6 million or 9.2% over the first nine months of 2003. The
decrease in the first nine months of 2004 compared to 2003 was due primarily a
decrease in the amount of DLC systems being deployed among the RBOCs,
restricted POTS capital spending by the RBOCs, SBC purchasing in 2003 a
significant amount of 2004 MCU requirements for their DSL footprint expansion
program, as well as reduced OEM sales, in 2004, to Advanced Fiber
Communications (AFC). Testability programs that drive MCU retrofit sales have
also been delayed due to tight services budgets. MCU revenues were also
negatively affected by reduced spending by our RBOC customers in the second and
third quarter of 2004. We expect these factors to have a negative impact on
the Companys the full year financial results for 2004. Sales of MCUs accounted for 33.9% of total revenue for the first nine months of
2004 compared to 36.8% for the same period in the prior year and we expect MCU
sales for the foreseeable future to continue to account for a meaningful
portion of the Companys revenue. However, as a result of the continuing
maturation of this product line, the RBOCs trend of limiting capital spending
in their traditional POTS networks and the evolution of the transmission
network towards end to end fiber, we believe this product line is meaningful
but mature and on an overall basis, as a percentage of our total revenue, we
expect it to continue to decline over time. Sales of the Companys DigiTest system products, which include LoopCare
software, were $5.2 million in the first nine months of 2004. While these
sales were not as robust as the prior year, the Company sold new systems to
Matanuska Telephone Association and TDS Telecom. The Company also had test
head sales attributed to customer purchases as a result of growth within their
previously-purchased systems. We are also engaged in field trials among
certain RBOC, LEC and international customers. The decrease in DigiTest
revenue is primarily attributed to extended evaluation of these products, as
well as limited capital expenditures among key customers. In the second
quarter of 2004, the Company entered into a negotiated settlement of a dispute
with a distributor which resulted in the return of equipment that the
distributor purchased in the prior year. This settlement was in the amount of
$0.4 million and resulted in net DigiTest sales of $4.8 million. Sale of
DigiTest system products for the first nine months of 2003 were $5.6 million
and there was not a similar return offsetting revenue in the prior year.
Including the impact of the negotiated settlement, DigiTest system sales
accounted for 10.3% and 11.8% of total revenues for the first nine months of
2004 and 2003, respectively. Sales of LoopCare software products separate and unrelated to DigiTest system
products declined modestly from $2.7 million for the nine months ended
September 27, 2003 to $2.6 million for the nine months ended September 25,
2004. The LoopCare software product line, which involves software license fees
that individually are significant in amount, typically has long and
unpredictable sales, purchase approval and acceptance cycles. The Company
believes that the modest decline in LoopCare software sales is not necessarily
reflective of a trend, but is attributable to the uneven nature of the software
sales 26




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process. LoopCare software product sales comprised 5.6% and 5.7% of total
revenues during the first nine months revenue of 2004 and 2003, respectively. Overall sales of cable hardware and software products increased $1.5 million or
11.9%, to $13.7 million for the first nine months of 2004 compared to the same
period in the prior fiscal year. The increase is attributable to Cheetah
results included for the entire first nine months of the current year and sales
of both our HMS and Internet-addressable monitoring probes. The orders for the
new Internet-addressable monitoring probes are reflective of a significant
commitment by cable companies to leverage their hybrid fiber coaxial
infrastructure to deliver voice, data and video services. While the Company
received an order for the external version of the Internet-addressable
transponders, it did not begin manufacturing the product until relatively late
in the third quarter of 2004. Cable hardware and software sales amounted to
29.4% and 26.0% of the first nine months revenue of 2004 and 2003,
respectively. Services revenues, which include installation oversight and project management
services provided to RBOC and other customers and fees for LoopCare and Cheetah
software maintenance, increased for the first nine months of 2004 by $0.4
million or 3.9% to $9.7 million over the same period in the prior year.
Service revenues amounted to 20.7% and 19.7% for the first nine months in 2004
and 2003 revenue, respectively. Gross Profit Gross profit for the nine months ended September 25, 2004 was $25.6 million
remaining flat compared to the first nine months of 2003. As a percentage of
sales, gross profit for the first nine months of 2004 was 54.8% versus 54.1%
for the year ago period. Gross margin increased compared to the prior year
period due to lower warranty costs of $0.5 million, lower consulting costs of
$0.2 million and reduced amortization expense of $0.4 million, offset by lower
LoopCare software and MCU sales, higher discounting and lower absorption of
manufacturing overhead costs due to lower production volumes. The decrease in
amortization expense is related to the purchased Cheetah sales backlog which
had higher amortization in 2003 compared to 2004. Although we experienced
positive growth in cable hardware and software, these products have a lower
margin than the MCU, LoopCare and DigiTest system products and we would expect
the increase in sales of these products as a percentage of overall sales to
negatively affect our gross margin in future periods. Selling and Marketing Expense For the nine months ended September 25, 2004, selling and marketing expense,
which consists primarily of payroll related costs, consulting expense and
travel costs, increased by $0.3 million or 5.1% to $7.1 million. The increase
is attributed to salaries and wages which increased by approximately $0.3
million, commissions which increased by $0.3 million and additional travel
costs which increased by approximately $0.1 million. These increases were
offset by lower incentive compensation expense of $0.1 million and decrease in
consulting fees of $0.3 million. As a percentage of revenues, selling and
marketing expenses were 15.1% in the first nine months of 2004 compared to
14.2% in the first nine months of 2003. General and Administrative Expense General and administrative expense, which consists primarily of payroll related
costs, insurance expense and professional services, increased by $0.2 million
or 4.1% to $5.4 million for the first nine months of 2004 compared to $5.2
million for the first nine months of 2003. The increase is attributed to
additional 27




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costs related to CheetahNet and CheetahLight product lines, increased salary
costs of $0.3 million and professional services of $0.4 million offset by a
decrease in bad debt expense of $0.6 million and lower incentive compensation
expense of $0.1 million. The decrease in bad debt expense is associated with a
$0.4 million charge taken in the prior year for one customer who filed for
bankruptcy. As a percentage of revenues, general and administrative expenses
increased from 11.1% for the first nine months of 2003 to 11.7% for the first
nine months of 2004. Research and Development Expense Research and development expense, which consists primarily of payroll related
costs, depreciation expense and rent expense in the nine months ended September
25, 2004 was $12.2 million, an increase of $1.2 million, or 10.7%, from the
$11.0 million recorded in the first nine months of 2003. The increase is
attributed to salary and benefit costs of $0.4 million consulting expenses
which increased $0.3 million and increased depreciation of $0.2 million.
Certain of these increases reflect additional costs year over year due to the
Cheetah acquisition. These increases were mitigated by a reduction of $0.2
million in incentive compensation. As a percentage of revenues, research and
development expense increased to 26.0% in the first nine months of 2004 from
23.2% during the same period in the prior year. Interest and Other Income Interest and other income, comprised primarily of interest income in both
periods, remained flat at $0.3 million for the nine months ended September 25,
2004 and the nine months ended September 27, 2003. Provision for Income Taxes The provision for income taxes for the nine months ended September 25, 2004 was
$0.2 million compared to the nine months ended September 27, 2003 of $1.1
million. The effective income tax rate for the first nine months of 2004 was
27.0% compared to 38.0% in the same period in the prior year. The change in
the effective rate is attributed to permanent book basis versus tax basis
differences as a result of the second and third quarter 2004 pre-tax loss.
While we have made our best estimate of our effective rate for 2004, based on
the Companys operating results and permanent differences, it is reasonably
possible our effective income tax rate could vary during the remainder of 2004. Net Income and Earnings Per Share As a result of the above factors, net income for the first nine months of 2004
was $0.7 million compared to $1.8 million in the first nine months of 2003.
For the first nine months of 2004, our basic and diluted earnings per common
share was $0.05. For the first nine months of 2003 the basic and diluted
earnings per share was $0.14. Basic and diluted weighted average common and
common equivalent shares outstanding were 13,133,510 and 13,263,016
respectively, for the nine months ended September 25, 2004 compared to
13,102,121 and 13,300,250, respectively, in the nine months ended September 27,
2003. CHEETAH ACQUISITION On February 13, 2003, we acquired certain assets and assumed certain
liabilities of the Cheetah Status and Performance Monitoring Product Line from
Acterna, LLC for approximately $14.3 million in cash. We also capitalized
acquisition related costs of approximately $0.6 million for a total cost of
approximately $14.9 million. The transaction provided for an earn-out to be
paid in the first half of 2004 of up to $2.4 million based on certain 2003
performance targets. The current calculation indicates that amounts due 28




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under this provision are immaterial. The acquired assets consisted principally
of existing sales order backlog, product inventory, intellectual property,
software and related computer equipment, while the assumed liabilities
principally related to deferred software maintenance, warranty and other
obligations. The $14.3 million due at closing and related acquisition expenses
were paid from available cash and short-term investments. We believe that the
acquired product line complements our legacy LIGHTHOUSE cable offering and
positions the Company as a leading supplier of testing equipment and software
for the cable industry. The acquisition was recorded under the purchase method
of accounting and, accordingly, the results of operations of the acquired
product line from February 14, 2003 forward are included in our consolidated
financial statements. The purchase price remains subject to change pending
resolution between the parties of outstanding contingencies regarding the
earn-out provision and post closing purchase price adjustments. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities for the nine months ended September
25, 2004, was $3.8 million compared to $9.5 million for the same period in the
prior year. The decrease is attributed to lower net income and changes in
working capital. The Company had working capital of $68.3 million at September
25, 2004, an increase of $2.4 million, or 3.6%, from $65.9 million of working
capital as of December 31, 2003. The increase in working capital is primarily
the result of operating cash flow in excess of purchases of property and
equipment and investments in other assets. Significant changes in the
composite elements of working capital during the nine months ended September
25, 2004 include a $1.3 million increase in cash and short-term investments and
a $0.6 million increase in deferred tax assets. Cash used in investing
activities declined from $11.6 million for the nine months ended September 27,
2003 to $4.6 million for the nine months ended September 25, 2004. The change
is attributed to cash paid for the Cheetah acquisition in 2003 offset by
increased purchases of short-term investments during 2004.These increases in
working capital were partially offset by a $0.4 million increase in deferred
income. As of September 25, 2004, the Company had $50.0 million of cash, cash
equivalents and short-term investments that are unrestricted and available for
corporate purposes, including acquisitions and other general working capital
requirements. The Company has in place a five-year $25.0 million Unsecured Revolving Credit
Facility (the Facility) with a bank. Under the terms of the Facility, the
proceeds 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 restricts our total borrowings to approximately $15.0 million
during the third quarter of 2004. 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 25, 2004 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 2004 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 29




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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
25, 2004. The impact of inflation on both the Companys financial position and the
results of operations has been minimal and is not expected to adversely affect
our 2004 results. Our financial position enables us to meet our cash
requirements for operations and capital expansion programs. RELATED PARTY TRANSACTION Gregory Quiggle was hired by the Company as Executive Vice President of
Marketing on August 13, 2001. In connection with the recruitment of Mr.
Quiggle, the Company made a loan to Mr. Quiggle in the amount of $210,000
pursuant to a Promissory Note (the Note) with interest accruing at 5% per
annum. The remaining outstanding balance of $0.2 million is due and payable on
or before the earlier of (i) May 2, 2008, (ii) the date of termination of Mr.
Quiggles employment with the Company, or (iii) the date that Mr. Quiggle sells
or otherwise transfers ownership of all or a portion of 40,200 shares of common
stock of Acterna LLC, which shares are being held by the Company as collateral
for payment of the Note. Presently, the shares of stock being held as
collateral have no value. The Note has not been modified since its issuance. COMMITMENTS The Company leases office space and equipment under agreements that are
accounted for as operating leases. The office leases for the Cheswick facility,
the Bridgewater facility and the Sarasota facility expire on December 31, 2005,
January 1, 2005 and April 26, 2008, respectively. The Company is also involved
in various month-to-month leases for research and development equipment and
office equipment at all three locations. As discussed in Note 4, Tollgrade
entered into a third party license agreement in which the Company has an
obligation to pay royalties which may total $0.8 million, depending upon the
volume of sales of the underlying product which incorporates the technology.
Additionally, the Company has arrangements with certain manufacturing
subcontractors under which the Company is contingently obligated to purchase up
to $2.0 million of raw material parts in the event they would not be consumed by
the manufacturing process in the normal course of business. Minimum annual
future commitments are as follows: Leases
    
    Purchase Obligations
    
    Total2004 (Remaining three-months)
    
    
    403,000
    
    
    
    1,040,000
    
    
    
    1,443,0002005
    
    
    1,618,000
    
    
    
    894,000
    
    
    
    2,512,0002006
    
    
    897,000
    
    
    
    54,000
    
    
    
    951,0002007
    
    
    478,000
    
    
    
    
    
    
    
    478,0002008
    
    
    117,000
    
    
    
    
    
    
    
    117,000
 30




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KEY RATIOS The Companys days sales outstanding (DSO) in accounts receivable trade, based
on the past twelve months rolling revenue, were 57 days as of September 25,
2004 and December 31, 2003. The Companys inventory turnover ratio was 2.4 and
2.3 turns at September 25, 2004 and December 31, 2003, respectively. ACCOUNTING PRONOUNCEMENTS On January 17, 2003, the FASB issued FASB Interpretation No. 46, Consolidation
of Variable Interest Entities  an interpretation of ARB No. 51 (FIN 46).
FIN 46 clarifies the application of Accounting Research Bulletin No. 51,
Consolidated Financial Statements, to certain entities in which equity
investors do not have the characteristics of a controlling financial interest
or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other
parties. Certain provisions of FIN 46 were effective for the Company after
January 31, 2003 and did not have an impact on the Companys results of
operations or financial condition. FIN No. 46 was revised in December 2003
and is effective for the first financial reporting period ending after March
15, 2004. The Company adopted the provisions of FIN No. 46 for the fiscal
quarter ending March 27, 2004, which did not have an impact on the financial
statements. The Company has no interest in any variable interest entities. RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATING RESULTS AND FINANCIAL CONDITION We wish to caution each reader of this Form 10-Q to consider the following
factors and certain other factors discussed herein and in other past reports,
including but not limited to prior year Form 10-K and Form 10-Q reports and
annual reports filed with the SEC. Our business and results of operations could
be seriously impaired by any of the following risks. The factors discussed
herein may not be exhaustive. Therefore, the factors contained herein should be
read together with other reports and documents that we file with the SEC from
time to time, which may supplement, modify, supercede 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 majority of our revenues. We
expect to derive a significant portion of our revenues from a limited number of
customers in the future. The loss of any of these customers, or the
cancellation, delay or reduction in purchases of our products at historical
levels, would significantly reduce our revenues and net income. Furthermore,
decreases in the capital budgets of these customers could lead to their reduced
demand for our products, which could in turn have a material adverse affect on
our business and results of operation. The capital budgets of our RBOC
customers, as well as many of our other customers, are dictated by a number of
factors, most of which are beyond our control, including:  -
    
    the conditions of the telecommunications market and the economy in general;-
    
    subscriber line loss and related reduced demand for telecommunications services; 31




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-
    
    changes or shifts in the technology utilized in the networks;-
    
    labor disputes between our customers and their collective bargaining units;-
    
    the failure to meet established purchase forecasts and growth projections;-
    
    competition among the RBOCs, competitive exchange
carriers and wireless telecommunications and cable providers; and-
    
    reorganizations, including management changes, at one or
more of our customers or potential customers. If the financial strength of one or more of our major customers should
deteriorate, or if they have difficulty acquiring investment capital due to any
of these or other factors, a substantial decrease in our revenues would likely
result. Our operating results may vary from quarter to quarter, causing our stock price
to fluctuate. Our operating results have in the past been subject to quarter to quarter
fluctuations, and we expect that these fluctuations will continue, and may
increase in magnitude, in future periods. Demand for our products is driven by
many factors, including the availability of funding in customers capital
budgets. There is a trend for some of our customers to place large orders near
the end of a quarter or fiscal year, in part to spend remaining available
capital budget funds. Seasonal fluctuations in customer demand for our products
driven by budgetary and other reasons can create corresponding fluctuations in
period-to-period revenues, and we therefore cannot assure you that our results
in one period are necessary indicative of our revenues in any future period.
In addition, the number and timing of large individual sales has been difficult
for us to predict, and large individual sales have, in some cases, occurred in
quarters subsequent to those we anticipated, or have not occurred at all. The
loss or deferral of one or more significant sales in a quarter could harm our
operating results. It is possible that in some quarters our operating results
will be below the expectations of public market analysts or investors. In such
events, or in the event adverse conditions prevail, the market price of our
common stock may decline significantly. The sales cycle for our software products is long, and the delay or failure to
complete one or more large license transactions in a quarter could cause our
operating results to fall below our expectations. The sales cycle is highly customer specific and can vary from a few weeks
to many months. The software requirements of customers is highly dependent on
many factors, including but not limited to their projections of business
growth, capital budgets and anticipated cost savings from implementation of our
software. Our delay or failure to complete one or more large license
transactions in a quarter could harm our operating results. Our software
involves significant capital commitments by customers. Potential customers
generally commit significant resources to an evaluation of available enterprise
software and require us to expend substantial time, effort and money educating
them about the value of our solutions. Licensing of our software products often
requires an extensive sales effort throughout a customers organization because
decisions to license such software generally involve the evaluation of the
software by a significant number of customer personnel in various functional
and geographic areas, each often having specific and conflicting requirements.
A variety of factors, including actions by competitors and other factors over
which we have little or no control, may cause potential customers to favor a
particular supplier or to delay or forego a purchase. 32




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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 significant portion of our
revenues, but this product is maturing and may result in declining sales. 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
significant 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).
The current plans of our customers, if executed, to implement next generation
network improvements such as Fiber-to-the-Premise (FTTP), which does not
require the use of our MCU products as the present hybrid POTS network, could
materially impact our MCU sales. 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 future results would be materially and adversely affected. The sale of our products is dependent upon our ability to satisfy the
proprietary requirements of our customers and respond to rapid technological
change, including evolving industry-wide standards. We depend upon a relatively narrow range of products for the majority of
our revenue. Our success in marketing our products is dependent upon their
continued acceptance by our customers. In some cases, our customers require
that our products meet their own proprietary requirements. If we are unable to
satisfy such requirements, or forecast and adapt to changes in such
requirements, our business could be materially harmed. Rapid technological change, including evolving industry standards, could
also render our products obsolete. The adoption of industry-wide standards,
such as the HMS and DOCSIS® cable standards, may result in the elimination of
or reductions in the demand for many of our proprietary products, such as our
Cheetah head-end hardware products and other Cheetah products. Furthermore,
standards for new services and technologies continue to evolve, requiring us to
continually modify our products or to develop new versions to meet these new
standards. If we are unable to forecast the demand for, and to develop new
products or to adapt our existing products to meet, these evolving standards
and other technological innovations, or if our products and services do not
gain the acceptance of our customers, there could be a negative effect on our
future results. 33




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We recently emphasized our network assurance and testing software solutions and
cable status monitoring products, areas in which we have limited experience. We acquired the LoopCare software and Cheetah product lines in 2001 and
2003, respectively. As a result we have limited operating history in
developing, marketing and selling network assurance and testing software
solutions and cable status marketing products, which makes the prediction of
future operating results for these portions of our business very difficult. A
substantial portion of our research and development expenses currently relates
to these products. We have adjusted our business model to focus heavily on our
cable performance and status monitoring products. We are actively engaged in
research to improve and expand our cable products, including research and
development of VoIP solutions. Our cable hardware and software 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
sold to customers, 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. Our customers are subject to governmental regulations 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 34




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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 expect that we may be 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 PDICs on acceptable terms,
could have a material adverse effect on our business. Our reliance on third parties to manufacture certain aspects of our products
involves risks, including, delays in product shipments and reduced control over
product quality. We depend upon a limited number of third party subcontractors to
manufacture certain aspects of our products. Furthermore, the components of our
hardware products are procured from a limited number of outside suppliers. Our
reliance upon such third party contractors involve several additional risks,
including reduced control over manufacturing costs, delivery times, reliability
and quality components. Although our products generally use industry standard
products, some parts, such as ASICs, are custom made to our specifications. If
we were to encounter a shortage of key manufacturing components from limited
sources of supply, or experience manufacturing delays caused by reduced
manufacturing capacity or integration issues related to our acquisition of the
Cheetah product line, the loss of key assembly subcontractors or other factors,
we could experience lost revenues, increased costs, delays in, cancellations or
rescheduling of orders or shipments, any of which would materially harm our
business. We have completed, and may pursue additional acquisitions, which will
complicate our management tasks and could result in substantial expenditures,
and the failure of acquired assets to meet expectations could result in
impairment of intangible assets. 35




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We have completed, and we may pursue additional acquisitions of companies,
product lines and technologies as part of our efforts to enhance our existing
products, to introduce new products and to fulfill changing customer
requirements. Acquisitions involve numerous risks, including the disruption of
our business, exposure to assumed or unknown liabilities of the acquired
target, and the failure to integrate successfully the operations and products
of acquired businesses. Goodwill arising from acquisitions may result in
significant charges against our operating results in one or more future
periods. Furthermore, we may never achieve the anticipated results or benefits
of an acquisition, such as increased market share or the successful development
and sales of a new product. The effects of any of these risks could materially
harm our business and reduce our future results of operations. In addition, the carrying value of certain of our intangible assets,
consisting primarily of goodwill related to our LoopCare software and Cheetah
product line acquisitions from Lucent Technologies, Inc. and Acterna, LLC,
could be impaired by changing market conditions. We are required under
generally accepted accounting principles to review our amortizable intangible
assets for impairment when events or changes in circumstances indicate the
carrying value may not be recoverable. Goodwill is required to be tested for
impairment at least annually. Factors that may indicate that the carrying
value of our intangible assets may not be recoverable include a decline in
stock price and market capitalization and lower than anticipated cash flows
produced by such intangible assets. If our stock price and market
capitalization decline, or if we do not realize the expected revenues from an
intangible asset, we may be required to record a significant charge to earnings
in our financial statements during the period in which any impairment of that
intangible asset is determined. Our future sales in international markets are subject to numerous risks and
uncertainties. We have limited experience selling our products internationally, and 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. Reductions 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. Although we evaluate our disclosure controls and procedures as of the end of
each fiscal quarter, and are in the process of reviewing and establishing
internal control 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, we may not be able to prevent all instances of
accounting errors or fraud in the future. Our controls and procedures do not
provide absolute assurance that all deficiencies in design or operation of
these control systems, or all instances of errors or fraud, will be prevented
or detected. These control systems are designed to provide reasonable assurance
of achieving the goals of these systems in light of legal requirements, our
resources and nature of our business operations. These control systems remain
subject to risks of human error and the risk that controls can be circumvented
for wrongful purposes by one or more individuals in management or
non-management positions. Our business could be seriously harmed by any
material failure of these control systems. 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. 36




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Our products are complex, and despite extensive testing, may contain
defects or undetected errors or failures that may become apparent only after
our products have been shipped to our customer and installed in their network
or after product features or new versions are released. Any such defect, error
or failure could result in failure of market acceptance of our products or
damage to our reputation or relations with our customers, resulting in
substantial costs for both the Company and our customers as well as the
cancellation of orders, warranty costs and product returns. In addition, any
defects, errors, misuse of our products or other potential problems within or
out of our control that may arise from the use of our products could result in
financial or other damages to our customers. Our customers could seek to have
us pay for these losses. Although we maintain product liability insurance, it
may not be adequate. Our future results are dependent on our ability to establish, maintain and
expand our distribution channels and our existing third-party distributors. We market and sell certain of our products, including our DigiTest and
Cheetah product lines, through domestic and international OEM relationships.
Our future results are dependent on our ability to establish, maintain and
expand third party relationships with OEM as well as other marketing and sales
distribution partners. If, however, the third parties with whom we have entered
into such OEM and other partnerships should fail to meet their own performance
objectives, customer demand for our products could be adversely affected, which
would have an adverse effect on our revenues. We face intense competition, which could result in our losing market share or
experiencing a decline in our gross margins. The markets for some of our products are very competitive. Some of our
competitors may have greater technological, financial, manufacturing, sales and
marketing, and personnel resources than we have. As a result, these competitors
may have an advantage in responding more rapidly or effectively to changes in
industry standards or technologies. Moreover, better financed competitors may
be better able to withstand the pricing pressures that increased competition
may bring. If our introduction of improved products or services is not timely
or well received, or if our competitors reduce their prices for products that
are comparable to ours, demand for our products and services could be adversely
affected. We may also compete directly with our customers. Generally, we sell our
products either directly, or indirectly through OEM channels and other means,
to end-user telecommunications and cable television providers. It is possible
that our customers, as the result of bankruptcy or other rationales for
dismantling network equipment, could attempt to resell our products. The
successful development of such a secondary market for our products by a third
party could negatively affect demand for our products, reducing our future
revenues. We are dependent upon our ability to attract, retain and motivate our key
personnel. Our success depends on our ability to attract, retain and motivate the key
management and technical personnel necessary to implement our business plan and
to grow our business. Despite the adverse economic conditions of the past
several years, competition for certain specific technical and management skill
sets is intense. If we are unable to identify and hire the personnel that we
need to succeed, or if one or more of our present key employees were to cease
to be associated with the Company, our future results could be adversely
affected. Consolidations in, or a continued slowdown in, the telecommunications industry
could harm our business. 37




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We have derived a substantial amount of our revenues from sales of
products and related services to the telecommunications industry. The
telecommunications industry has experienced significant growth and
consolidation in the past few years, although, over recent years, trends
indicate that capital spending by this industry has decreased and may continue
to decrease in the future as a result of a general decline in economic growth
in local and international markets. In particular, RBOC and large ILEC
customers have been adversely affected by subscriber line losses and the
after-effects of overspending in 1999 and 2000 as well as by competition from
cable and wireless carriers and other carriers entering the local telephone
service market. Certain emerging carriers also continue to be hampered by
financial instability caused in large part by a lack of access to capital. In
the event of further significant slowdown in capital spending of the
telecommunications industry, our business would be adversely affected.
Furthermore, as a result of industry consolidation, there may be fewer
potential customers requiring our software in the future. Larger, consolidated
telecommunications companies may also use their purchasing power to create
pressure on the prices and the margins we could realize. We cannot be certain
that consolidations in, or a slowdown in the growth of, the telecommunication
industry will not harm our business. Our expenses are relatively fixed in the short term, and we may be unable to
adjust spending to compensate for unexpected revenue shortfalls. We base our expense levels in part on forecasts of future orders and
sales, which are extremely difficult to predict. A substantial portion of our
operating expenses is related to personnel, facilities and sales and marketing.
The level of spending for such expenses cannot be adjusted quickly and is,
therefore, relatively fixed in the short term. Accordingly, our operating
results will be harmed if revenues fall below our expectations in a particular
quarter. Our restructuring plan may be ineffective or may limit our ability to compete. We have recently undertaken a reduction in work force in response to our
evolving business model These actions could have long term adverse effects on
our business. There are several risks inherent in our efforts to bring our
cost base in line with the current environment by reducing our workforce.
These include the risk that we will not be successful in achieving our planned
cost reductions, and that even if we are successful in doing so, we will still
not be able to reduce expenditures quickly enough to see a positive
profitability effect and may have to undertake further restructuring
initiatives that would entail additional charges and create additional risks.
In addition, there is the risk that cost-cutting initiatives will impair our
ability to effectively develop and market products and remain competitive.
Each of the above measures could have long-term effects on our business by
reducing our pool of talent, decreasing or slowing improvements in our
products, making it more difficult for us to respond to customers, limiting our
ability to increase production quickly if and when the demand for our products
increases and limiting our ability to hire and retain key personnel. These
circumstances could cause our earnings to be lower than they otherwise might
be. We rely on software that we have licensed from third-party developers to
perform key functions in our products. We rely on software that we license from third parties, including software
that is integrated with internally developed software and used in our products
to perform key functions. We could lose the right to use this software or it
could be made available to us only on commercially unreasonable terms. Although
we believe that alternative software is available from other third-party
suppliers or internal developments, the loss of or inability to maintain any of
these software licenses or the inability of the 38




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third parties to enhance in a timely and cost-effective manner their products
in response to changing customer needs, industry standards or technological
developments could result in delays or reductions in product shipments by us
until equivalent software could be developed internally or identified, licensed
and integrated, which would harm our business. We are affected by a pattern of product price decline in certain markets, which
can harm our business. Because our cable products generate lower margins for us than our
proprietary MCU and software offerings, an increase in the percentage of our
sales of cable-related products relative to our traditional products will
result in lower profitability. Furthermore, as consolidations within the cable
industry and the adoption of the DOCSIS standards have caused and could
continue to cause pricing pressure as competitors lower product pricing, our
revenues have been and may continue to be adversely affected. Although we have
developed DOCSIS compliant hardware and our relationship with Alpha is one that
we believe will prominently position us to succeed in the marketing of DOCSIS
products, these DOCSIS products will likely generate lower margins than have
historically been generated by our proprietary technology. As a result, as our
business shifts from our higher margin proprietary products to lower margin
cable offerings and standardized products for which we have competition, we
will need to sell greater volumes of our products to maintain our
profitability. Our common stock price may be extremely volatile. Our common stock price has been and is likely to continue to be highly
volatile. The market price may vary in response to many factors, some of which
are outside our control, including:  
    
    General market and economic conditions;
    
    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 39




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future materially and adversely affect our stock price, regardless of
our operating results. In the past, following periods of volatility in the
market price of a companys securities, securities class action litigation has
often been initiated against such company. Such litigation could result in
substantial costs and a diversion of our managements attention and resources
that could harm our business. We may be subject from time to time to legal proceedings, and any adverse
determinations in these proceedings could materially harm our business. We may from time to time be involved in various lawsuits and legal
proceedings, which arise in the ordinary course of business. Litigation matters
are inherently unpredictable, and we cannot predict the outcome of any such
matters. If we ultimately lose or settle a case, we may be liable for monetary
damages and other costs of litigation. Even if we are entirely successful in a
lawsuit, we may incur significant legal expenses and our management may expend
significant time in the defense. An adverse resolution of a lawsuit or legal
proceeding could negatively impact our financial position and results of
operations. 
 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Companys current investment policy limits its investments in financial
instruments to cash and cash equivalents, individual municipal bonds, and
corporate and government bonds. The use of financial derivatives and preferred
and common stocks is strictly prohibited. The Company believes it minimizes
its risk through proper diversification along with the requirements that the
securities must be of investment grade with an average rating of A or better
by Standard & Poors. The Company holds its investment securities to maturity
and believes that earnings and cash flows will not be materially affected by
changes in interest rates, due to the nature and short-term investment horizon
for which these securities are invested. 
 Item 4. CONTROLS AND PROCEDURES The Chief Executive Officer and the Chief Financial Officer of the Company
(its principal executive officer and principal financial officer, respectively)
have concluded, based on their evaluation as of the end of the period covered
by this report, that the Companys disclosure controls and procedures 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 that occurred during our most recent fiscal quarter that have
materially affected or are reasonably likely to materially affect these
controls. 40




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PART II. OTHER INFORMATION 
 Item 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES  (e)
    
    On January 21, 2004, our Board of Directors authorized the continuation
through December 31, 2004 of a share repurchase program which expired on
December 31, 2003. Under this extension, we may repurchase a total of one
million shares of our common stock before December 31, 2004. Since the
initial repurchase program was instituted in April 1997, and as of
September 25, 2004, the Company has repurchased 461,800 shares of common
stock. The repurchased shares are authorized to be utilized under certain
employee benefit programs. At our discretion we will determine the number
of shares and the timing of such purchases, which will be made using
existing cash and short-term investments. No shares were repurchased under
this program in the nine months ended September 25, 2004. 
 Item 6. EXHIBITS AND REPORTS FILED ON FORM 8-K  (a)
    
    Exhibits:The following exhibits are being filed with this report: ExhibitNumber
    
    Description10.55
    
    Change in Control Agreement, dated as of August 19, 2004 between
the Company and Jennifer M. Reinke, filed herewith10.56
    
    Extension Agreement dated July 21, 2004 to Supply Agreement dated
July 25, 2002, between the Company and the Electrical
Manufacturing Services Division of Dictaphone Corporation (the
Supply Agreement), filed herewith10.57
    
    Second Extension Agreement dated August 16, 2004 to the Supply
Agreement, filed herewith10.58
    
    Third Extension Agreement dated September 23, 2004 to the Supply
Agreement, filed herewith15
    
    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
 41




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(b)
    
    Reports on Form 8-K:  1.
    
    A Report Form 8-K was filed on July 9, 2004 relating to a
press release dated July 8, 2004 announcing preliminary results for
the quarter ended June 26, 2004.2.
    
    A Report on Form 8-K was filed on July 21, 2004 under Items
7 and 12, which contained our results of operations for the second
quarter ended June 26, 2004.3.
    
    A Report on Form 8-K was filed on August 5, 2004 under Item
9 of Regulation FD, which contained as an exhibit an investor
presentation.  EDGE is a trademark of Tollgrade Communications, Inc.
LoopCare is a trademark of Tollgrade Communications, Inc.
Cheetah is a trademark of Tollgrade Communications, Inc.
®DigiTest is a registered trademark of Tollgrade Communications, Inc.
®MCU 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. 42




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. Tollgrade Communications, Inc.
(Registrant)Dated: November 4, 2004
    /s/ Christian L. AllisonChristian L. AllisonChairman and Chief Executive Officer Dated: November 4, 2004
    /s/ Samuel C. KnochSamuel C. KnochChief Financial Officer and Treasurer Dated: November 4, 2004
    /s/ Sean M. ReillySean M. ReillyController 43




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##### Table of Contents



EXHIBIT INDEX  ExhibitNumber
    
    Description10.55
    
    Change in Control Agreement, dated as of August 19, 2004 between
the Company and Jennifer M. Reinke, filed herewith10.56
    
    Extension Agreement dated July 21, 2004 to Supply Agreement dated
July 25, 2002, between the Company and the Electrical
Manufacturing Services Division of Dictaphone Corporation (the
Supply Agreement), filed herewith10.57
    
    Second Extension Agreement dated August 16, 2004 to the Supply
Agreement, filed herewith10.58
    
    Third Extension Agreement dated September 23, 2004 to the Supply
Agreement, filed herewith15
    
    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
 44