##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549
 _______________________________
FORM 10-Q (Mark One) þ
    
    Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934For the quarterly period ended March 26, 2005o
    
    Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934For the transition period from  to
 Commission file number 000-27312 TOLLGRADE COMMUNICATIONS, INC.  Pennsylvania
(State or other jurisdiction
of incorporation or organization)
    
    25-1537134
(I.R.S. Employer
Identification No.)
 493 Nixon Rd.
Cheswick, PA 15024
(Address of principal executive offices, including zip code) 412-820-1400
(Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ                              No o Indicate by check mark whether the Registrant is an accelerated filer (as defined by Rule
12b-2 of the Exchange Act). Yes þ                              No o As of March 31, 2005, 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




---



TOLLGRADE COMMUNICATIONS, INC. Quarterly Report on Form 10-Q
For the Quarter Ended March 26, 2005 Table of Contents PAGE NO.PART I. FINANCIAL INFORMATIONItem 1 Condensed Consolidated Financial Statements (unaudited):Condensed Consolidated Balance Sheets as of March 26, 2005 and
December 31, 2004
    
    
    3Condensed Consolidated Statements of Operations for the three month
periods ended March 26, 2005 and March 27, 2004
    
    
    4Condensed Consolidated Statement of Changes in Shareholders Equity for the
three month period ended March 26, 2005
    
    
    5Condensed Consolidated Statements of Cash Flows for the three month
periods ended March 26, 2005 and March 27, 2004
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Report of Independent Registered Public Accounting Firm
    
    
    14Item 2 Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    15Item 3 Quantitative and Qualitative Disclosures about Market Risk
    
    
    37Item 4 Controls and Procedures
    
    
    37PART II. OTHER INFORMATIONItem 2 Changes in Securities, Use of Proceeds and
Issuer Purchases of Equity Securities
    
    
    37Item 6 Exhibits and Reports Filed on Form 8-K
    
    
    38SIGNATURES
    
    
    39EXHIBIT INDEX
    
    
    40Exhibit 15Exhibit 31.1Exhibit 31.2Exhibit 32
  2




---



##### Table of Contents



PART I. FINANCIAL INFORMATION 
 Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (Unaudited)
 March 26, 2005
    
    
    December 31, 2004 *ASSETSCurrent assets:Cash and cash equivalents
    
    $
    23,134,305
    
    
    $
    32,622,135Short-term investments
    
    
    28,427,758
    
    
    
    18,537,310Accounts receivable:Trade, net of allowance for doubtful
accounts of $737,425 in 2005 and $754,598
in 2004
    
    
    8,860,634
    
    
    
    10,690,695Other
    
    
    706,320
    
    
    
    106,484Inventory
    
    
    14,110,177
    
    
    
    12,940,878Prepaid expenses and other current assets
    
    
    1,792,242
    
    
    
    2,542,565Refundable income taxes
    
    
    651,684
    
    
    
    964,171Deferred tax assets
    
    
    1,784,878
    
    
    
    1,143,410Total current assets
    
    
    79,467,998
    
    
    
    79,547,648Property and equipment, net
    
    
    7,514,540
    
    
    
    7,859,709Deferred tax assets
    
    
    226,997
    
    
    
    176,464Intangibles, net
    
    
    45,072,000
    
    
    
    45,107,750Goodwill
    
    
    19,339,682
    
    
    
    19,339,682Capitalized software costs, net
    
    
    5,984,692
    
    
    
    6,452,749Receivable from officer
    
    
    157,194
    
    
    
    156,392Other assets
    
    
    181,940
    
    
    
    194,081Total assets
    
    $
    157,945,043
    
    
    $
    158,834,475LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,321,022
    
    
    $
    1,086,818Accrued warranty
    
    
    2,060,719
    
    
    
    2,081,238Accrued expenses
    
    
    2,626,523
    
    
    
    1,771,930Accrued salaries and wages
    
    
    599,102
    
    
    
    717,540Accrued royalties payable
    
    
    152,591
    
    
    
    414,408Income taxes payable
    
    
    181,224
    
    
    
    168,501Deferred income
    
    
    1,286,813
    
    
    
    2,461,728Total current liabilities
    
    
    8,227,994
    
    
    
    8,702,163Deferred tax liabilities
    
    
    2,939,264
    
    
    
    2,623,377Total liabilities
    
    
    11,167,258
    
    
    
    11,325,540Commitments and contingent liabilities
    
    
    
    
    
    
    Shareholders equity:Preferred stock, $1.00 par value;
Authorized shares, 10,000,000; issued shares, -0-
In 2005 and 2004
    
    
    
    
    
    
    Common stock, $.20 par value; authorized shares,
50,000,000; issued shares, 13,622,940 in 2005 and 2004
    
    
    2,724,588
    
    
    
    2,724,588Additional paid-in capital
    
    
    71,134,745
    
    
    
    71,134,745Retained earnings
    
    
    77,709,235
    
    
    
    78,440,385Treasury stock, at cost, 461,800 shares in 2005 and 2004
    
    
    (4,790,783
    )
    
    
    (4,790,783
    )Total shareholders equity
    
    
    146,777,785
    
    
    
    147,508,935Total liabilities and shareholders equity
    
    $
    157,945,043
    
    
    $
    158,834,475
    The accompanying notes are an integral part of the condensed consolidated financial statements. 3




---



##### Table of Contents



TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
  Three Months EndedMarch 26, 2005
    
    
    March 27, 2004Revenues:Products
    
    $
    11,979,987
    
    
    $
    14,454,630Services
    
    
    2,294,637
    
    
    
    3,152,519Total revenues:
    
    
    14,274,624
    
    
    
    17,607,149Cost of sales:Products
    
    
    6,052,575
    
    
    
    6,014,468Services
    
    
    795,589
    
    
    
    859,825Amortization of intangibles
    
    
    539,704
    
    
    
    473,3337,387,868
    
    
    
    7,347,626Gross profit
    
    
    6,886,756
    
    
    
    10,259,523Operating expenses:Selling and marketing
    
    
    2,237,616
    
    
    
    2,471,588General and administrative
    
    
    1,834,634
    
    
    
    1,934,174Research and development
    
    
    3,396,528
    
    
    
    4,191,788Retirement expense
    
    
    775,213
    
    
    
    Total operating expense
    
    
    8,243,991
    
    
    
    8,597,550(Loss) income from operations
    
    
    (1,357,235
    )
    
    
    1,661,973Other income:Interest income (including interest
income from officer receivable of
$1,800 and $1,900 in 2005 and 2004)
    
    
    262,743
    
    
    
    90,182(Loss) income before taxes
    
    
    (1,094,492
    )
    
    
    1,752,155(Benefit) provision for income taxes
    
    
    (363,342
    )
    
    
    672,129Net (loss) income
    
    $
    (731,150
    )
    
    $
    1,080,026(Loss) earnings per share information:Weighted average shares of common stock and equivalents:Basic
    
    
    13,161,140
    
    
    
    13,120,356Diluted
    
    
    13,161,140
    
    
    
    13,351,902Net (loss) income per common share:Basic
    
    $
    (0.06
    )
    
    $
    0.08Diluted
    
    $
    (0.06
    )
    
    $
    0.08
 The accompanying notes are an integral part of the condensed consolidated financial
statements. 4




---



##### Table of Contents



TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS EQUITY
 For the Three Months Ended March 26, 2005
 (Unaudited) AdditionalPreferred Stock
    
    
    Common Stock
    
    
    Paid-In
    
    
    RetainedShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Capital
    
    
    Earnings
    
    
    Treasury
    
    
    TotalBalance at December
31, 2004
    
    
    
    
    
    $
    
    
    
    
    13,622,940
    
    
    $
    2,724,588
    
    
    $
    71,134,745
    
    
    $
    78,440,385
    
    
    $
    (4,790,783
    )
    
    $
    147,508,935Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (731,150
    )
    
    
    
    
    
    
    (731,150
    )Balance at March
26, 2005
    
    
    
    
    
    $
    
    
    
    
    13,622,940
    
    
    $
    2,724,588
    
    
    $
    71,134,745
    
    
    $
    77,709,235
    
    
    $
    (4,790,783
    )
    
    $
    146,777,785
 The accompanying notes are an integral part of the condensed consolidated financial statements. 5




---



##### Table of Contents



TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
  Three Months EndedMarch 26, 2005
    
    
    March 27, 2004Cash flows from operating activities:Net (loss) income
    
    $
    (731,150
    )
    
    $
    1,080,026Adjustments to reconcile net (loss) income to net cash provided by
operating activities:Depreciation and amortization
    
    
    1,193,649
    
    
    
    1,099,161Tax benefit from exercise of stock options
    
    
    
    
    
    
    15,083Deferred income taxes
    
    
    (376,114
    )
    
    
    280,456Provision for losses on inventory
    
    
    57,356
    
    
    
    (157,900
    )(Reversal) provision for allowance for doubtful accounts
    
    
    (17,173
    )
    
    
    80,820Changes in assets and liabilities:Decrease (increase) in accounts receivable-trade
    
    
    1,847,234
    
    
    
    (921,508
    )Increase in accounts receivable-other
    
    
    (599,836
    )
    
    
    (50,665
    )Increase in inventory
    
    
    (1,226,655
    )
    
    
    (991,503
    )Decrease (increase) in prepaid expenses and other assets
    
    
    761,662
    
    
    
    (374,650
    )Decrease in refundable taxes
    
    
    312,487
    
    
    
    273,278Increase in accounts payable
    
    
    234,204
    
    
    
    16,107(Decrease) increase in accrued warranty
    
    
    (20,519
    )
    
    
    72,760(Decrease) increase in accrued expenses and deferred income
    
    
    (320,322
    )
    
    
    337,225(Decrease) increase in accrued royalties payable
    
    
    (261,817
    )
    
    
    85,570(Decrease) increase in accrued salaries and wages
    
    
    (118,438
    )
    
    
    83,600Increase in income taxes payable
    
    
    12,723
    
    
    
    374,569Net cash provided by operating activities
    
    
    747,291
    
    
    
    1,302,429Cash flows from investing activities:Purchase of short-term investments
    
    
    (10,390,448
    )
    
    
    (6,284,272
    )Redemption/maturity of short-term investments
    
    
    500,000
    
    
    
    1,508,883Capital expenditures, including capitalized software
    
    
    (344,673
    )
    
    
    (486,243
    )Net cash used in investing activities
    
    
    (10,235,121
    )
    
    
    (5,261,632
    )Cash flows from financing activities:Proceeds from exercise of stock options
    
    
    
    
    
    
    32,633Net cash provided by financing activities
    
    
    
    
    
    
    32,633Net decrease in cash and cash equivalents
    
    
    (9,487,830
    )
    
    
    (3,926,570
    )Cash and cash equivalents at beginning of period
    
    
    32,622,135
    
    
    
    31,059,972Cash and cash equivalents at end of period
    
    $
    23,134,305
    
    
    $
    27,133,402
 The accompanying notes are an integral part of the condensed financial statements 6




---



##### Table of Contents



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
period ended March 26, 2005 should be read in conjunction with the Companys consolidated financial
statements (and notes thereto) included in the Companys Annual Report on Form 10-K for the year
ended December 31, 2004. Accordingly, the accompanying condensed consolidated financial statements
do not include all of the information and footnotes required by accounting principles generally
accepted in the United States of America for complete financial statements, although the Company
believes that the disclosures are adequate to make the information presented not misleading. In the
opinion of Company management, all adjustments considered necessary for a fair statement of the
accompanying condensed consolidated financial statements have been included, and all adjustments
are of a normal and recurring nature. Operating results for the three-month period ended March 26,
2005 are not necessarily indicative of the results that may be expected for the year ending
December 31, 2005. With respect to the unaudited financial information of the Company for each of the three-month
periods ended March 26, 2005 and March 27, 2004, included in this Form 10-Q, PricewaterhouseCoopers
LLP reported that they have applied limited procedures in accordance with professional standards
for a review of such information. However, their separate report dated May 3, 2005 appearing
herein, states that they did not audit and they do not express an opinion on that unaudited
financial information. Accordingly, the degree of reliance on their report on such information
should be restricted in light of the limited nature of the review procedures applied.
PricewaterhouseCoopers LLP is not subject to the liability provisions of Section 11 of the
Securities Act of 1933 (Act) for their report on the unaudited financial information because that
report is not a report within the meaning of Sections 7 and 11 of the Act. 2. ACCOUNTING FOR STOCK-BASED COMPENSATION The Company has two stock-based employee compensation plans. The Company accounts for stock-based
awards to employees and directors using the intrinsic value method of accounting in accordance with
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees.
Under these provisions, stock-based employee compensation cost is not reflected in net income for
any year, as all options granted under the plans had an exercise price equal to the market value of
the underlying common stock on the date of grant. If the Company had elected to recognize
compensation cost for these stock options based on the fair value method set forth in Statement of
Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, net
(loss) income and (loss) earnings per share would have reflected the pro forma amounts indicated
below: 7




---



##### Table of Contents



Three Months EndedMarch 26, 2005
    
    
    March 27, 2004Net (loss) income, as reported
    
    ($
    731,150
    )
    
    $
    1,080,026Add/ deduct: Total stock-based
compensation expense based on the
fair value method for all awards,
net of related tax effects
    
    
    1,653
    
    
    
    74,771Pro forma net (loss) income
    
    ($
    732,803
    )
    
    $
    1,005,255(Loss) earnings per share:Basic  as reported
    
    ($
    0.06
    )
    
    $
    0.08Basic  pro forma
    
    ($
    0.06
    )
    
    $
    0.08Diluted  as reported
    
    ($
    0.06
    )
    
    $
    0.08Diluted  pro forma
    
    ($
    0.06
    )
    
    $
    0.08
 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. As of March 26, 2005, we were still negotiating the earn-out
payment and the current calculation indicates that amounts due under this provision are immaterial.
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. 8




---



##### Table of Contents



4. INTANGIBLE ASSETS The following information is provided regarding the Companys intangible assets and goodwill: As of March 26, 2005
    
    
    As of December 31, 2004Gross
    
    
    
    
    
    
    GrossCarrying
    
    
    Accumulated
    
    
    Carrying
    
    
    AccumulatedAmount
    
    
    Amortization
    
    
    Amount
    
    
    AmortizationAmortized intangible assets:Cheetah sales order backlog,
included in inventory
    
    $
    543,273
    
    
    $
    543,273
    
    
    $
    543,273
    
    
    $
    543,273Exclusivity agreement
    
    
    715,000
    
    
    
    143,000
    
    
    
    715,000
    
    
    
    107,250Total Amortized Intangibles
    
    $
    1,258,273
    
    
    $
    686,273
    
    
    $
    1,258,273
    
    
    $
    650,523Non-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
    
    
    $
    686,273
    
    
    $
    45,758,273
    
    
    $
    650,523Capitalized software:Developed product software
    
    $
    7,627,070
    
    
    $
    5,196,793
    
    
    $
    7,591,173
    
    
    $
    4,817,234Base software  Cheetah
    
    
    2,900,000
    
    
    
    628,333
    
    
    
    2,900,000
    
    
    
    555,833Proprietary technology
    
    
    1,000,000
    
    
    
    216,667
    
    
    
    1,000,000
    
    
    
    191,667Cheswick product software
    
    
    537,900
    
    
    
    38,485
    
    
    
    537,900
    
    
    
    11,590Total capitalized software
(long term)
    
    $
    12,064,970
    
    
    $
    6,080,278
    
    
    $
    12,029,073
    
    
    $
    5,576,324Goodwill
    
    $
    19,339,682
    
    
    $
    
    
    
    $
    19,339,682
    
    
    $
    
 Estimated amortization expense for the years ended: 2005 (Remaining 9 months)
    
    $
    1,624,4952006
    
    $
    1,800,9932007
    
    $
    701,8962008
    
    $
    681,7312009
    
    $
    543,282Thereafter
    
    $
    1,204,295
 9




---



##### Table of Contents



5. INVENTORY At March 26, 2005 and December 31, 2004, inventory consisted of the following: March 26, 2005
    
    
    December 31, 2004Raw materials
    
    $
    6,615,504
    
    
    $
    7,631,246Work in process
    
    
    5,655,882
    
    
    
    4,441,737Finished goods
    
    
    3,315,858
    
    
    
    2,287,60615,587,244
    
    
    
    14,360,589Reserve for slow moving and obsolete inventory
    
    
    (1,477,067
    )
    
    
    (1,419,711
    )$
    14,110,177
    
    
    $
    12,940,878
 6. SHORT-TERM INVESTMENTS Short-term investments at March 26, 2005 and December 31, 2004 consisted of individual municipal
bonds stated at cost, which approximated market value. These securities have maturities of one year
or less at date of purchase and/or contain a callable provision in which the bonds can be called
within one year from date of purchase. The primary investment purpose is to provide a reserve for
future business purposes, including acquisitions and capital expenditures. Realized gains and
losses are computed using the specific identification method. The Company classifies its investment in all debt securities as held to maturity, as the Company
has the intent and ability to hold the securities to maturity. The estimated fair values of the Companys financial instruments are as follows: March 26, 2005
    
    
    December 31, 2004Carrying Amount
    
    
    Fair Value
    
    
    Carrying Amount
    
    
    Fair ValueFinancial assets:Cash and cash equivalents
    
    $
    23,134,305
    
    
    $
    23,134,305
    
    
    $
    32,622,135
    
    
    $
    32,622,135Short-term investments
    
    
    28,427,758
    
    
    
    28,428,402
    
    
    
    18,537,310
    
    
    
    18,538,275$
    51,562,063
    
    
    $
    51,562,707
    
    
    $
    51,159,445
    
    
    $
    51,160,410
 7. RETIREMENT EXPENSE On January 17, 2005, the Company entered into an Agreement with Christian L. Allison, the Companys
Former Chief Executive Officer and former member of the Board of the Company (the Agreement).
Under the terms of the Agreement, Mr. Allison resigned effective as of January 18, 2005 (the
Retirement Date), as director and executive officer of the Company and any and all other
positions he held with the Company or its subsidiaries or other affiliates. Mr. Allison received the following separation payments: (a) an amount equal to the sum of (i) Mr.
Allisons base salary through the Retirement Date to the extent not then paid and (ii) any vacation
pay and other cash entitlements accrued by Mr. Allison as of the Retirement Date to the extent not
then paid; (b) two times his contractual base salary of $315,000 for a total of $630,000; and (c) a
lump sum payment of $75,000. The Company will pay all premiums on behalf of Mr. Allison to
continue medical insurance for his immediate family through the second anniversary of the
Retirement Date. Additionally, the Company has agreed to continue to indemnify, to the fullest
extent permitted by applicable law, and to provide directors and officers liability insurance, if
available in the directors and officers liability insurance market, through the sixth 10




---



##### Table of Contents



anniversary of the Retirement Date, for Mr. Allisons actions taken or omissions occurring at or
prior to the Retirement Date. The Company also agreed to pay up to $50,000 of the reasonable fees
and expenses of Mr. Allisons legal counsel incurred in connection with the negotiation and
execution of the Agreement. The Company recorded a total charge in the first quarter of 2005
related to Mr. Allisons retirement of approximately $775,000. Mr. Allison also will be entitled to receive any vested benefits payable to him under the terms of
any employee benefit plan or program of the Company in accordance with the terms of such plan or
program. Under the terms of the Agreement and the Companys 1995 Long-Term Incentive Compensation
Plan (as amended through January 24, 2002), all options to acquire shares of the Companys common
stock held by Mr. Allison were fully vested prior to the Retirement Date and will remain
exercisable by Mr. Allison for at least one year following the Retirement Date. 8. COST ALIGNMENT On July 8, 2004 and July 21, 2004, the Company announced a cost alignment program which eliminated,
in two phases, approximately 50 positions. The majority of the reductions impacted the research
and development, manufacturing, and related overhead areas of the Company. The cost alignment
initiative resulted in a pre-tax severance expense of $268,637. 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 first quarter of 2005. 9. 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 March 26, 2005 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 MonthsEnded
    
    
    EndedMarch 26, 2005
    
    
    March 27, 2004Net (loss) income
    
    $
    (731,150
    )
    
    $
    1,080,026Common and common equivalent shares:Weighted average common shares outstanding
    
    
    13,161,140
    
    
    
    13,120,356Effect of dilutive securities  stock options
    
    
    
    
    
    
    231,54613,161,140
    
    
    
    13,351,902(Loss) earnings per share:Basic
    
    ($
    0.06
    )
    
    $
    0.08Diluted
    
    ($
    0.06
    )
    
    $
    0.08
 11




---



##### Table of Contents



Unexercised stock options to purchase our capital stock of 1.3 million and 0.9 million
shares for the three months ended March 26, 2005 and March 27, 2004, respectively, are not included
in the computation of diluted earnings per share because the option exercise price for these shares
was greater than the average market price. 10. RECEIVABLE FROM OFFICER The Company extended a loan for $210,000 under a promissory note to an officer of the Company in
July 2001. The note provides for interest at 5% per annum with repayment under various conditions
but no later than May 20, 2008. The loan was originally secured by collateral which currently has
no value. The balance of the loan at March 26, 2005 and December 31, 2004 was $157,194 and
$156,392, respectively. 11. PRODUCT WARRANTY The Company records estimated warranty costs on the accrual basis of accounting. These reserves
are based on applying historical returns to the current level of product shipments and the cost
experience associated therewith. In the case of software, the reserves are based on the expected
cost of providing services within the agreed-upon warranty period. Activity in the warranty accrual is as follows: Three Months Ended
    
    
    Year EndedMarch 26, 2005
    
    
    December 31, 2004Balance at the beginning of the
period
    
    $
    2,081,000
    
    
    $
    2,150,000Accruals for warranties issued
during the period
    
    
    390,000
    
    
    
    1,435,000Settlements
during the period
    
    
    (410,000
    )
    
    
    (1,504,000
    )Balance at the end of the
period
    
    $
    2,061,000
    
    
    $
    2,081,000
 12. CONTINGENCIES AND COMMITMENTS The Company is, from time to time, party to various legal claims and disputes, either asserted or
unasserted, which arise in the ordinary course of business. While the final resolution of these
matters cannot be predicted with certainty, the Company does not believe that the outcome of any of
these claims will have a material adverse effect on the Companys consolidated financial position,
or annual results of operations or cash flow. 13. ACCOUNTING PRONOUNCEMENTS In December 2004, the FASB issued Statement No. 123(R), Shared-Based Payment. Statement 123(R)
requires the measurement of all employee stock-based compensation awards using a fair value method
as of the date of the grant and recording such expense in the consolidated financial statements.
In addition, the adoption of Statement 123(R) will require additional accounting related to the
income tax effects and additional disclosure regarding the cash flow effects resulting from
share-based payment arrangements. In April of 2005, the SEC approved a rule that delayed the
effective date of FASB Statement No. 123(R). Statement 123(R) is now effective for public
companies for annual periods that begin after June 15, 2005. We are currently evaluating the
impact of the adoption of Statement 123(R). See Note 2 to the financial statements. 12




---



##### Table of Contents



In December 2004, the FASB issued FASB Staff Position No. FAS 109-1 (FAS 109-1), Application of
FASB Statement No.109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production
Activities Provided by the American Jobs Creation Act of 2004. The AJCA introduces a special 9%
tax deduction on qualified production activities. FAS 109-1 clarifies that this tax deduction
should be accounted for as a special tax deduction in accordance with Statement 109. We do not
expect the adoption of these new tax provisions to have a material impact on our consolidated
financial position, results of operations or cash flows. In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151 (SFAS 151),
Inventory Costs, an amendment of ARB No. 43, Chapter 4. This statement amends the guidance in ARB
No. 43 Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle
facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43,
Chapter 4, previously stated that ...under some circumstances, items such as idle facility
expense, excessive spoilage, double freight, and rehandling costs may be so abnormal to require
treatment as a current period charges... This statement requires that those items be recognized as
current-period charges regardless of whether they meet the criterion of so abnormal. In addition,
this statement requires that allocation of fixed production overheads to the costs of conversion be
based on the normal capacity of the production facilities. The provisions of this statement will be
effective for inventory costs during the fiscal years beginning after June 15, 2005. We do not
believe that the adoption of this statement will have a material impact on its financial condition
or results of operations. In March 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment
(SAB 107), which provides interpretive guidance related to the interaction between SFAS No. 123R
and certain SEC rules and regulations, as well as provides the SEC staffs views regarding the
valuation of share-based payment arrangements. The Company is currently assessing the impact of SAB
No. 107 on its implementation and adoption of SFAS No. 123R. 13




---



##### Table of Contents



Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders
of Tollgrade Communications, Inc.: We have reviewed the accompanying condensed consolidated balance sheet of Tollgrade Communications,
Inc. as of March 26, 2005 and March 27, 2004, and the related condensed consolidated statements of
income and changes in shareholders equity for each of the three-month periods ended March 26, 2005
and March 27, 2004 and the condensed consolidated statement of cash flows for the three month
periods ended March 26, 2005 and March 27, 2004. These interim financial statements are the
responsibility of the Companys management. We conducted our review in accordance with the standards of the Public Company Accounting Oversight
Board (United States). A review of interim financial information consists principally of
applying analytical procedures and making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted in accordance with
the standards of the Public Company Accounting Oversight Board, the objective of which is the
expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do
not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the
accompanying condensed consolidated interim financial statements for them to be in conformity with
accounting principles generally accepted in the United States of America. We have previously audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheet as of December 31, 2004, and the
related consolidated statement of operations and statement of changes in shareholders equity, and
of cash flows for the year then ended, managements assessment of the effectiveness of the
Companys internal control over financial reporting as of December 31, 2004 and the effectiveness
of the Companys internal control over financial reporting as of December 31, 2004; and in our
report dated March 2, 2005, we expressed unqualified opinions thereon. The consolidated financial
statements and managements assessment of the effectiveness of internal control over financial
reporting referred to above are not presented herein. In our opinion, the information set forth in
the accompanying consolidated balance sheet as of December 31,
2004 is fairly stated in all
material respects in relation to the consolidated balance sheet from which it has been derived. PricewaterhouseCoopers LLP
Pittsburgh, Pennsylvania
May 2, 2005 14




---



##### Table of Contents



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 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 and the Companys plans for the development of new cable products, circumstances surrounding
our LoopCare sales, the potential revenue opportunities under our contract with Lucent
Technologies International for the project in Saudi Arabia, the results of the Companys efforts to
obtain certain product certifications and the effect of such results on future sales, the
maturation of our legacy cable products and the lower expected margins for our cable products
resulting from increased sales of our DOCSIS® certified transponders, certain cost alignment
initiatives, projected cash flows which are used in the valuation of intangible assets, the
anticipated results of negotiations for our remaining RBOC maintenance agreement and the accounting
treatment of fees arising thereunder, changes in our backlog, the amount of backlog that may be
recognized as revenue in future periods, the Companys anticipated short-term borrowings and
expected 2005 capital expenditures, 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, certain international sales opportunities, circumstances surrounding our LoopCare
sales, 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. 15




---



##### Table of Contents



OVERVIEW About the Company Tollgrade Communications, Inc. (the Company) was organized in 1986, began operations in 1988 and
completed its initial public offering in 1995. The Company is a leading provider of hardware and software network assurance testing solutions for
the telecommunications and cable broadband industries. We design, engineer, market and support test
and management systems which enable telephone and cable operators to efficiently manage their
networks in an age of increased competition, continually evolving technology and ongoing pressure
to control or reduce costs. We provide equipment that enables telephone companies to remotely qualify, verify provisioning and
isolate troubles for POTS and broadband local access networks. When these networks are not
functioning properly, our products help to isolate the problem to the customers premises, local
copper and fiber network, central office and/or core data network segments. In doing so, our
solutions add value to our customers by improving mean-time-to-repair and technician dispatch
efficiency. In addition, our products help telephone companies assess whether existing POTS lines
are suitable for Digital Subscriber Line (DSL) service for the delivery of Internet and other
broadband services, such as IP Voice and Video. For broadband cable networks, the outside plant segment of the network is a hybrid of fiber and
coaxial facilities which is highly dependent upon standby power for network reliability. If
commercial power fails, such standby power supplies must sustain the network, or services such as
video, data and voice become inoperable. We provide products to cable companies that monitor the
status of those power supplies and associated fiber nodes, thereby enabling cable operators to
proactively isolate network troubles among customer premises, coaxial, fiber and Hub office network
segments. As cable operators expand their current broadband service offerings to include IP Voice,
our solutions can be upgraded to enable the remote isolation of DOCSIS®, Internet and IP Voice
troubles among those same network segments. Similarly, our solutions also add value to our cable
customers by improving mean-time-to-repair and technician dispatch efficiency. About its customers The Companys primary customers for its telecommunications products and services are the four
Regional Bell Operating Companies (RBOCs), certain major independent telephone companies and
several digital loop carrier (DLC) equipment manufacturers. Of these major customer groups, the
RBOCs are the most significant; for the first quarter ended March 26, 2005, sales to the RBOCs
accounted for approximately 32.6% of the Companys total revenue, compared to approximately 51% of
total revenue for the first quarter of 2004. Sales to two of the four RBOC customers (BellSouth
and SBC) individually exceeded 10% of the Companys total revenue (12% and 13%, respectively), and
on a combined basis, comprised 25% of the Companys total revenue for the first quarter of 2005.
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 changes in the
Companys product mix from our legacy MCU products to our cable hardware and software products.
During fiscal year 2004, the Company also expanded sales of its LoopCare and DigiTest®/DigiTest
EDGE® test system to non-RBOC independent local exchange carriers (LECs). 16




---



##### Table of Contents



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
first quarter of 2005, approximately 17.6% of the Companys total revenue related to sales to one
cable Original Equipment Manufacturer (OEM) customer. No individual sales to the Companys cable
customers exceeded 10% of the Companys total revenue during 2004. PRODUCTS TELECOMMUNICATION TEST SYSTEMS Our proprietary telecommunications test and measurement products enable the telephone companies to
use their existing line test systems to remotely diagnose problems in Plain Old Telephone Service
(POTS) lines containing both copper and fiber optics as well as qualify and troubleshoot problems
on broadband DSL lines. POTS lines provide traditional voice service as well as connections for
popular communication devices such as computer modems and fax machines. POTS excludes non-switched
and private lines, such as data communications service lines, commonly referred to as special
services. POTS lines still comprise the vast majority lines in service today throughout the
world. The Company also sells LoopCare and DigiTest to carriers that do not yet have POTS and DSL
test systems, as well as those seeking to replace older generation test systems. The objective is
for the carrier to eliminate false dispatches while providing high quality troubleshooting of
problems for its subscribers. DigiTest and LoopCare Our DigiTest system electrically measures the characteristics of a copper telephone circuit and
reports those measurements to our LoopCare Operation Support System (OSS). The LoopCare OSS, in
turn, analyzes that measurement data and creates an easy-to-understand fault description. At the
same time, the LoopCare system can generate a dispatch to a work center so that a repairman can fix
the problem. LoopCare and DigiTest also can determine whether the customer line is suitable for DSL
services. DigiTest can also serve as a replacement for aging Loop Test Systems (LTS) equipment
ubiquitously deployed in current POTS networks. In addition, upgrades to DigiTest hardware can
provide troubleshooting for DSL service problems. LoopCare is the major incumbent OSS utilized by the RBOCs for over twenty-five years to test the
integrity and quality of their POTS network infrastructure. The LoopCare OSS, which we offer both
as part of the DigiTest system and as a stand-alone software product that can interface with
certain other test heads on the market, currently manages testing operations for more than 75% of
the copper pairs in the United States, and is the qualification, installation and maintenance tool
used to troubleshoot more than 150 million POTS, ISDN and DSL subscribers worldwide. The DigiTest system includes direct Ethernet connectivity to Digital Measurement Node (DMN) test
heads and our next generation broadband test platform, DigiTest EDGE®. Through Ethernet
connections, the LoopCare OSS can communicate directly with remotely deployed DigiTest hardware,
allowing it to manage up to four DMNs and eight simultaneous test sessions through a single
Internet Protocol (IP) address. DigiTest EDGE provides a global platform for broadband test
applications, by combining a narrowband and wideband metallic testing platform with DSL,
Asynchronous Transfer Mode (ATM), IP and Hypertext Transfer Protocol (HTTP) performance tests. In
2004, we announced a new LoopCare feature and new DigiTest hardware that uses innovative insertion
loss measures to provide a customer with highly accurate predictions of potential DSL Connection
Speed. These test capabilities, when managed by our LoopCare OSS, enable service providers to
accurately isolate a DSL problem between 17




---



##### Table of Contents



the customers premises, the local exchange carriers local loop and Digital Subscriber Line Access
Multiplexer (DSLAM) serving network, and the Internet service providers data network. In addition to the LoopCare OSS software sold as part of the DigiTest system, we also sell new
LoopCare features to existing customers and the base LoopCare OSS as a stand-alone product to LECs
for use with test heads other than our DigiTest hardware. LoopCare feature products include:  
    the Common Object Request Broker Architecture (CORBA)-based Application Programming
Interface;
    Benchmark Data Base;
    DSL Testing;
    the Advanced Testhead Feature Package;
    Batch Testing;
    Fax Unalert;
    Loop Length Reporting;
    Enabling Flow Through by Re-Classification of VER 55-58 Codes;
    LoopCare TCP/IP Communications Network; and
    Testing Voice Services in a Broadband Passive Optical Network (bPON). MCU Our core MCU products plug into DLC systems, the large network transmission systems used by
telephone companies to link the copper and fiber-optic portions of the local loop. MCU products
allow our customers to extend their line testing capabilities to all of their POTS lines served by
a DLC system regardless of whether the system is fed by a copper or fiber optic link. DLC systems,
which are located at telephone companies central offices and at remote sites within local user
areas, effectively multiplex the services of a single fiber-optic line into multiple copper lines.
In many instances, several DLC systems are located at a single remote site to create multiple local
loops that serve several thousand different end-user homes and businesses. Generally, for every DLC
remote site, customers will deploy at least two MCU line-testing products. CABLE TESTING PRODUCTS The Companys Cheetah performance and status monitoring products provide a broad network assurance
solution for the Broadband Hybrid Fiber Coax (HFC) distribution system found in the cable
television industry. Our Cheetah products gather status information and report on critical
components within the cable network. The Companys monitoring systems include complete hardware
and software solutions that enable efficient HFC plant status monitoring. By providing a constant,
proactive view of the health and status of outside plant transmission systems, the products can
reduce operating costs and increase subscriber satisfaction. Our direct sales cable offerings currently consist of our CheetahLight (formerly LIGHTHOUSE®) and
CheetahNet (formerly NetMentor) software systems and maintenance, head-end controllers, return
path switch hardware, transponders and other equipment which gather status and performance reports
from power supplies, line amplifiers and fiber optic nodes. In addition, we manufacture and sell,
primarily on an OEM basis, transponders which meet the DOCSIS® standards, allowing customers the
flexibility to utilize those transponders in either our proprietary monitoring systems or those
offered by other vendors. 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 18




---



##### Table of Contents



service. The Company is currently engaged in research and development efforts for network
assurance products that address quality problems related to these advanced services. During 2004,
we introduced our DOCSIS certified transponders which can provide internet protocol (IP) band
monitoring. The Company intends to leverage its experience in delivering network assurance
technologies to telecom providers by developing more advanced performance management solutions for
once-traditional cable suppliers. The Company is actively engaged in research and development of
Voice Over Internet Protocol (VoIP) solutions, as well as data network integrity technologies. As
part of this strategy, we have entered into certain third party license agreements to augment our
next generation technology, including VoIP technology. SERVICES Our Services offerings include software maintenance as well as our professional services, which are
designed to assist our customers in ensuring the proper operation of all of the components of their
voice test systems. The scope of our Services business was considerably expanded upon the
acquisition of software maintenance relationships related to the LoopCare and CheetahNet software
product lines. Offsetting this expansion, however, is a trend toward a decrease in the demand for
our professional services caused by a decline in our RBOC customers capital investment in their
traditional voice services, which tends to drive the professional services. BACKLOG Our backlog consists of firm customer purchase orders and signed software maintenance agreements.
As of March 26, 2005, the Company had backlog of approximately $14.1 million compared to $14.7
million as of December 31, 2004 and $13.6 million as of March 27, 2004. The slight decrease in the
backlog from December 31, 2004 is attributed to lower hardware and software orders, offset by a
higher maintenance backlog. The backlog at March 26, 2005 and December 31, 2004 include
approximately $6.1 million and $5.5 million, respectively, related to software maintenance
contracts, which are earned and recognized as income on a straight-line basis during the remaining
term of the underlying agreements. The Companys policy is to include a maximum of twelve months
revenue from multi-year maintenance agreements in reported backlog. We have entered into LoopCare software maintenance agreements with three of the four RBOCs, all
three of these agreements expire December 31, 2005. We are also currently in negotiations with the
remaining RBOC regarding renewal of its software maintenance agreement. We anticipate the
agreement will be signed in the second quarter of 2005. We have not recorded any revenue related
to services performed for that RBOC during the quarter ended March 26, 2005. Upon signing of the
contract, the appropriate amount of earned revenue will be recorded, while the remaining portion of
the unearned revenue will be added to the maintenance backlog. Management expects that approximately 56.1% of the current backlog will be recognized as revenue in
the second quarter of 2005. Periodic fluctuations in customer orders and backlog result from a
variety of factors, including but not limited to the timing of significant orders and shipments.
Although these fluctuations could impact short-term results, they are not necessarily indicative of
long-term trends in sales of our products. 19




---



##### Table of Contents



REPORTING SEGMENT We have determined that our business has one reporting and operating segment, the test assurance
industry. All product sales are considered components of the business of testing infrastructure and
networks for the telecommunications and cable television industries. Although we internally develop
historical sales information associated with the various product categories, this information is
not considered to be sufficient for segment reporting purposes as only sales data is accumulated
and provided to the Chief Operating Decision Maker. Our products and services have similar economic
characteristics and the same or similar production processes, and are sold through similar
distribution channels and means to similar types and classes of customers already in, or entering
into, the telecommunications and cable businesses. INTERNATIONAL SALES International sales represented approximately $2.6 million, or 18.2%, of the Companys total
revenue for the quarter ended March 26, 2005, compared to $1.4 million, or 8.0%, in the March 27,
2004 quarter. 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 has been limited, due in part to
incompatibility of certain of our telecommunications products with networks employed abroad. We
continue to evaluate opportunities in the international market that will enhance our international
presence and growth. Through our original equipment manufacturer (OEM) relationship with Lucent,
our LoopCare products have been sold internationally in conjunction with purchases of Lucent
hardware. Of particular note is our recent success with Lucent Technologies International (LTI) in
successfully bidding and obtaining an agreement with the Saudi Telecom Company (STC) in Saudi
Arabia to purchase the Companys broadband offerings in addition to LoopCare software customization
and an operating platform update effort. Although this is an as ordered contract that has no
minimum purchase commitments, we are cautiously optimistic regarding the revenue opportunities
under this agreement. We have recorded approximately $0.7 million in revenue in the first quarter
of 2005 on sales to LTI. However, this is a unique project and requires the support of a number of
parties which can impact its progress throughout the term of the project, and may not provide a
significant revenue contribution in any particular fiscal quarter. APPLICATION OF CRITICAL ACCOUNTING POLICIES The Companys financial statements are prepared in conformity with accounting principles generally
accepted in the United States of America. Certain of these accounting principles are more critical
than others in gaining an understanding of the basis upon which the Companys financial statements
have been prepared. A comprehensive review of these policies is contained in the Companys 2004
Annual Report on Form 10-K filed on March 3, 2005. Management believes the Companys critical
accounting policies are those related to Staff Accounting Bulletin (SAB 104), Revenue
Recognition; AICPAs Statement of Position (SOP) 97-2  Software Revenue Recognition, and
Emerging Issues Task Force (EITF) Issue 00-21, Accounting for Revenue Arrangements with Multiple
Deliverables; Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations;
SFAS No. 142, Goodwill and Other Intangible Assets; SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets; and SFAS No. 109, Accounting for Income Taxes. Additionally,
we believe inventory valuations, allowances for doubtful accounts and warranty reserves are also
critical accounting policies. Management believes these policies to be critical because they are
both important to the portrayal of the Companys financial condition and results and they require
management to make judgments and estimates based on 20




---



##### Table of Contents



matters that are inherently uncertain. There were no significant changes in these policies or the
application thereof during 2005. 21




---



##### Table of Contents



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 FIRST QUARTER OF 2005 COMPARED TO FIRST QUARTER OF 2004 Revenues The Companys revenues for the first quarter of 2005 were $14.3 million, a decrease of $3.3 million
or 18.9%, compared to revenues of $17.6 million reported for the first quarter of 2004. Sales of MCUs during the first quarter of 2005 were $3.4 million, a decrease of $3.6 million
compared to the first quarter of 2004. As a result, MCU sales represented 23.8% of total first
quarter 2005 revenues compared to 39.8% for the first quarter of 2004. MCU sales in the first
quarter of 2004 were particularly strong due to above normal year-end 2003 RBOC orders that carried
forward into 2004. However, decreases from the first quarter of 2004
compared to the same period in 2005
were also attributable to a decline in overall North American market demand for digital loop
carrier systems and restricted POTS capital spending by the RBOCs. We expect MCU sales for the foreseeable future to continue to account for a meaningful portion of
the Companys revenue. However, as a result of the continuing maturation of this product line, the
RBOCs trend of limiting capital spending in their traditional POTS networks and the evolution of
the transmission network toward end to end fiber, the Company believes revenues from this product
line will continue to decline over time. Sales of the Companys DigiTest system products, which include LoopCare software, were $2.9 million
in the first quarter of 2005, an increase of $2.0 million, compared to the first quarter of 2004 of
$0.9 million. DigiTest revenue was favorably affected by LEC customers continuing to purchase
DigiTest products to augment their expanding networks as well as RBOC LTS modernization initiatives
and rollout of DSL pre-qualification programs. DigiTest system sales accounted for 20.3% and 5.1%
of total revenues for the first quarter of 2005 and 2004, respectively. We currently have active
DigiTest and LoopCare 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 $0.9
million in the first quarter of 2005 compared with $1.6 million recorded in the first quarter of
2004. The LoopCare software product line, which involves software license fees that individually
are significant in amount, typically has long and unpredictable sales, purchase approval and
acceptance cycles. When making a purchase decision for LoopCare software, our customers generally
must complete a full technical evaluation of the software and develop a favorable business case
within their organization. As a result, revenue from this product line can fluctuate significantly
on a quarter by quarter basis. LoopCare software product sales comprised 6.3% of total revenues
during the first quarter of 2005 compared to 9.1% in the first quarter of 2004. Overall sales of cable hardware and software products decreased $0.1 million from $4.9 million
during the first quarter of 2004 to $4.8 million in the first quarter of 2005. During the first
quarter of 2005, we experienced strong sales of our DOCSIS certified transponders. Shipment and
revenue recognition of this product was initially delayed in the fourth quarter of 2004 pending
resolution of a certain end user 22




---



##### Table of Contents



customers specification requirements. As many customers demand products that meet the DOCSIS
standards, they are reducing their purchases of legacy cable equipment, while increasing their
purchases of the DOCSIS certified products. We expect our DOCSIS certified transponders, which are
primarily sold on an OEM basis, will generate lower margins than have historically been achieved
with our legacy cable equipment. We are in the process of taking a number of steps intended to
reduce this impact, which include attempting to effect design and manufacturing efficiencies,
reducing the cost of raw materials and redesigning the software that is used in the DOCSIS product.
Additionally, we continue to design differentiating technologies that we believe will increase the
value and revenue opportunities for our related software and enhanced VoIP service assurance
products. Cable hardware and software product sales amounted to 33.6% and 27.8% of total first
quarter 2005 and 2004 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, decreased $0.8
million to $2.4 million in the first quarter of 2005. Service revenues amounted to 16.8% and 18.2%
of total first quarter 2005 and 2004 revenue, respectively. The decrease is primarily attributed
to the delay in the execution of a software maintenance agreement with one of our RBOC customers. Gross Profit Gross profit for the first quarter of 2005 decreased $3.4 million or 32.9% to $6.9 million. The
decrease in gross profit is attributed primarily to changes in the product mix caused by lower
LoopCare software and MCU revenue and increased shipments on an OEM basis of DOCSIS certified cable
products, which carry substantially lower margins than our legacy cable products. Additionally,
margins were negatively impacted by the delay beyond the end of the first quarter 2005 in executing
the extension of a maintenance agreement with one of our RBOC customers. As a percentage of sales,
gross profit for the quarter was 48.2% versus 58.3% for the year ago period. Gross margin, as a
percentage of sales, decreased in the first quarter compared to the previous years first quarter
due to the factors mentioned above. Selling and Marketing Expense Selling and marketing expense, which consists primarily of payroll related costs, consulting
expense and travel costs, decreased $0.3 million to $2.2 million for the first quarter of 2005 from
$2.5 million in 2004. The decrease is associated with a decrease in salaries and wages, travel
costs and incentive compensation costs in the current quarter. As a percentage of revenues,
selling and marketing expenses increased from 14.0% in the first quarter of 2004 to 15.7% in the
first quarter of 2005. General and Administrative Expense General and administrative expense, which consists primarily of payroll related costs, insurance
expense and professional services, for the first quarter of 2005 was $1.8 million, a decrease of
$0.1 million, or 5.1%, from the $1.9 million recorded in the first quarter of 2004. The decrease
is primarily attributed to a decrease in incentive compensation costs and a decrease 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 11.0% in the first
quarter of 2004 to 12.9% in the first quarter of 2005. 23




---



##### Table of Contents



Research and Development Expense Research and development expense, which consists primarily of payroll related costs and
depreciation expense decreased by $0.8 million or 19.0% to $3.4 million in the first quarter of
2005 from $4.2 million in the first quarter of 2004. The decrease in research and development
expense is associated with lower salaries and wages as well as a decrease in incentive compensation
costs during the period. During 2004, the Company announced a cost alignment program in which we
eliminated approximately 50 positions, primarily impacting research and development. The reduction
in salaries and wages in the first quarter of 2005 is attributable to this program. As a
percentage of revenues, research and development expense remained flat at 23.8%. Retirement Expense On January 17, 2005, the Company entered into an Agreement with Christian L. Allison, the Companys
Former Chief Executive Officer and former member of the Board of the Company (the Agreement).
Under the terms of the Agreement, Mr. Allison resigned effective as of January 18, 2005 (the
Retirement Date), as director and executive officer of the Company and any and all other
positions he held with the Company or its subsidiaries or other affiliates. Mr. Allison received the following separation payments: (a) an amount equal to the sum of (i) Mr.
Allisons base salary through the Retirement Date to the extent not then paid and (ii) any vacation
pay and other cash entitlements accrued by Mr. Allison as of the Retirement Date to the extent not
then paid; (b) two times his contractual base salary of $315,000 for a total of $630,000; and (c) a
lump sum payment of $75,000. The Company will pay all premiums on behalf of Mr. Allison to
continue medical insurance for his immediate family through the second anniversary of the
Retirement Date. Additionally, the Company has agreed to continue to indemnify, to the fullest
extent permitted by applicable law, and to provide directors and officers liability insurance, if
available in the directors and officers liability insurance market, through the sixth anniversary
of the Retirement Date, for Mr. Allisons actions taken or omissions occurring at or prior to the
Retirement Date. The Company also agreed to pay up to $50,000 of the reasonable fees and expenses
of Mr. Allisons legal counsel incurred in connection with the negotiation and execution of the
Agreement. The Company recorded a total charge in the first quarter of 2005 related to Mr.
Allisons retirement of approximately $775,000. Mr. Allison also will be entitled to receive any vested benefits payable to him under the terms of
any employee benefit plan or program of the Company in accordance with the terms of such plan or
program. Under the terms of the Agreement and the Companys 1995 Long-Term Incentive Compensation
Plan (as amended through January 24, 2002), all options to acquire shares of the Companys common
stock held by Mr. Allison were fully vested prior to the Retirement Date and will remain
exercisable by Mr. Allison for at least one year following the Retirement Date. Interest and Other Income Interest and other income, comprised primarily of interest income in both quarterly periods, for
the first quarter of 2005 was $0.3 million, an increase of $0.2 million, from the $0.1 million
recorded in the first quarter of 2004. The increase is due to higher yields on our investments and
an increase in the amount of short term investments. 24




---



##### Table of Contents



Provision (Benefit) for Income Taxes Income taxes for the first quarter of 2005 included a benefit of ($0.4) million due to the current
quarter pretax loss. The provision for income taxes in the first quarter of 2004 was a charge of
$0.7 million. The effective income tax rate for the first quarter of 2005 was a benefit of 33.2%
compared to a charge of 38.4% in the first quarter of 2004. The decrease in the effective rate is
attributed to the proportional impact of certain permanent items on the calculation, including
those created by tax exempt interest and international sales. While we have made our best estimate
of our effective rate for 2005, based on the Companys operating results and permanent differences,
we believe it is possible that our effective income tax rate could vary during the remainder of
2005. Net (Loss) Income and (Loss) Earnings Per Share As a result of the above factors, the net loss for the first quarter of 2005 was ($0.7) million
compared to net income in the first quarter of 2004 of $1.1 million. For the first quarter of
2005, our basic and diluted loss per common share was ($0.06) compared to net income of $0.08 per
common share recorded in the prior year quarter. Basic and diluted weighted average common and
common equivalent shares outstanding were 13,161,140 in the first quarter of 2005 compared to
13,120,356 and 13,351,902, respectively, in the first quarter of 2004. The three months ended
March 26, 2005 do not include the effect of dilutive securities due to the current quarter net loss
which would make those securities anti-dilutive to the earnings per share calculation. 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 up to $2.4
million based on certain 2003 performance targets. Our calculation indicates that amounts due
under the earn-out provision are immaterial. To date, these sums have not been paid, as we
continue to negotiate the earn-out and post closing purchase price adjustments with Acterna. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities for the three months ended March 26, 2005, was $0.8
million compared to $1.3 million for the same period in the prior year. The decrease is attributed
to a 2005 first quarter operating loss compared to 2004 net income and changes in working capital.
The Company had working capital of $71.2 million at March 26, 2005, an increase of $0.4 million,
from $70.8 million of working capital as of December 31, 2004. Cash used in investing activities
increased from $5.3 million for the three months ended March 27, 2004 to $10.2 million for the
three months ended March 26, 2005. The change is attributed to purchases of short-term
investments. As of March 26, 2005, the Company had $51.6 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 25




---



##### Table of Contents



annual basis. A maximum leverage ratio restricts our total borrowings to approximately $10.7
million during the first quarter of 2005. Commitment fees are payable quarterly at an annual rate
of 0.25% of the unused commitment. The Facility was amended in February 2003 in connection with our
acquisition of the Cheetah product line to adjust the determination of base net worth. As of March
26, 2005 and currently, there are no outstanding borrowings under the Facility, and we are in
compliance with all debt covenants. We do not anticipate any short-term borrowings for working
capital as we believe our cash reserves and internally generated funds will be sufficient to
sustain working capital requirements for the foreseeable future. The Company expects to incur
capital expenditures totaling approximately $3.5 million in 2005 including projects for test
fixtures related to the manufacturing process and purchases of computer and office equipment . The Company has in place a stock repurchase program, which is more fully described in Part II,
Item 2(e) of this Report. At managements discretion, the Company may repurchase shares under this
program, however, the number of shares and the timing of such purchases has not presently been
determined. Any such purchases would be made using existing cash and short-term investments. No
shares were repurchased under this program in the three months ended March 26, 2005. The impact of inflation on both the Companys financial position and the results of operations has
been minimal and is not expected to adversely affect our 2005 results. Our financial position
enables us to meet our cash requirements for operations and capital expansion programs. RELATED PARTY TRANSACTION Gregory Quiggle was hired by the Company as Executive Vice President of Marketing on August 13,
2001. In connection with the recruitment of Mr. Quiggle, the Company made a loan to Mr. Quiggle in
the amount of $210,000 pursuant to a Promissory Note (the Note) with interest accruing at 5% per
annum. The remaining outstanding balance of $157,000 is due and payable on or before the earlier of
(i) May 2, 2008, (ii) the date of termination of Mr. Quiggles employment with the Company, or
(iii) the date that Mr. Quiggle sells or otherwise transfers ownership of all or a portion of
40,200 shares of common stock of Acterna LLC, which shares are being held by the Company as
collateral for payment of the Note. Presently, the shares of stock being held as collateral have no
value. The Note has not been modified since its issuance. KEY RATIOS The Companys days sales outstanding (DSO) in accounts receivable trade, based on the past twelve
months rolling revenue, was 59 and 67 days as of March 26, 2005 and December 31, 2004,
respectively. The Companys inventory turnover ratio was 2.1 and 2.3 turns at March 26, 2005 and
December 31, 2004, respectively. ACCOUNTING PRONOUNCEMENTS In December 2004, the FASB issued Statement No. 123(R), Shared-Based Payment. Statement 123(R)
requires the measurement of all employee stock-based compensation awards using a fair value method
as of the date of the grant and recording such expense in the consolidated financial statements.
In addition, the adoption of Statement 123(R) will require additional accounting related to the
income tax effects and additional disclosure regarding the cash flow effects resulting from
share-based payment arrangements. In April of 2005, the SEC approved a rule that delayed the
effective date of FASB Statement No. 123. Statement 123(R) is now effective for public companies
for annual periods that begin after June 15, 2005. 26




---



##### Table of Contents



We are currently evaluating the impact of the adoption of Statement 123(R). See Note 2 to the
financial statements. In December 2004, the FASB issued FASB Staff Position No. FAS 109-1 (FAS 109-1), Application of
FASB Statement No.109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production
Activities Provided by the American Jobs Creation Act of 2004. The AJCA introduces a special 9%
tax deduction on qualified production activities. FAS 109-1 clarifies that this tax deduction
should be accounted for as a special tax deduction in accordance with Statement 109. We do not
expect the adoption of these new tax provisions to have a material impact on our consolidated
financial position, results of operations or cash flows. In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151 (SFAS 151),
Inventory Costs, an amendment of ARB No. 43, Chapter 4. This statement amends the guidance in ARB
No. 43 Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle
facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43,
Chapter 4, previously stated that ...under some circumstances, items such as idle facility
expense, excessive spoilage, double freight, and rehandling costs may be so abnormal to require
treatment as a current period charges... This statement requires that those items be recognized as
current-period charges regardless of whether they meet the criterion of so abnormal. In addition,
this statement requires that allocation of fixed production overheads to the costs of conversion be
based on the normal capacity of the production facilities. The provisions of this statement will be
effective for inventory costs during the fiscal years beginning after June 15, 2005. We do not
believe that the adoption of this statement will have a material impact on its financial condition
or results of operations. In March 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment
(SAB 107), which provides interpretive guidance related to the interaction between SFAS No. 123R
and certain SEC rules and regulations, as well as provides the SEC staffs views regarding the
valuation of share-based payment arrangements. The Company is currently assessing the impact of SAB
No. 107 on its implementation and adoption of SFAS No. 123R. RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATING RESULTS AND FINANCIAL CONDITION We wish to caution each reader of this Form 10-Q to consider the following factors and certain
other factors discussed herein and in other past reports, including but not limited to prior year
Form 10-K and Form 10-Q reports and annual reports filed with the SEC. Our business and results of
operations could be seriously impaired by any of the following risks. The factors discussed herein
may not be exhaustive. Therefore, the factors contained herein should be read together with other
reports and documents that we file with the SEC from time to time, which may supplement, modify,
supersede or update the factors listed in this document. 27




---



##### Table of Contents



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;-
    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. 28




---



##### Table of Contents



The sales cycle for our software products is long, and the delay or failure to complete one or more
large license transactions in a quarter could cause our operating results to fall below our
expectations. The sales cycle is highly customer specific and can vary from a few weeks to many months. The
software requirements of customers is highly dependent on many factors, including but not limited
to their projections of business growth, capital budgets and anticipated cost savings from
implementation of our software. Our delay or failure to complete one or more large license
transactions in a quarter could harm our operating results. Our software involves significant
capital commitments by customers. Potential customers generally commit significant resources to an
evaluation of available enterprise software and require us to expend substantial time, effort and
money educating them about the value of our solutions. Licensing of our software products often
requires an extensive sales effort throughout a customers organization because decisions to
license such software generally involve the evaluation of the software by a significant number of
customer personnel in various functional and geographic areas, each often having specific and
conflicting requirements. A variety of factors, including actions by competitors and other factors
over which we have little or no control, may cause potential customers to favor a particular
supplier or to delay or forego a purchase. Many of the Companys products must comply with significant governmental and industry-based
regulations, certifications, standards and protocols, some of which evolve as new technologies are
deployed. Compliance with such regulations, certifications, standards and protocols may prove
costly and time-consuming for the Company, and the Company cannot provide assurance that its
products will continue to meet these standards in the future. In addition, regulatory compliance
may present barriers to entry in particular markets or reduce the profitability of the Companys
product offerings. Such regulations, certifications, standards and protocols may also adversely
affect the industries in which we compete, limit the number of potential customers for the
Companys products and services or otherwise have a material adverse effect on its business,
financial condition and results of operations. Failure to comply, or delays in compliance, with
such regulations, standards and protocols or delays in receipt of such certifications could delay
the introduction of new products or cause the Companys existing products to become obsolete. We depend on sales of our MCU products for a 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. Although we are unable to predict future prices for our MCU products, we expect that prices
for these products will continue to be subject to significant downward pressure in certain markets
for the reasons described above. Accordingly, our ability to maintain or increase revenues will be
dependent on 29




---



##### Table of Contents



our ability to expand our customer base, increase unit sales volumes of these products and to
successfully, develop, introduce and sell new products such as our cable and software products. We
cannot assure you that we will be able to expand our customer base, increase unit sales volumes of
existing products or develop, introduce and/or sell new products. We recently emphasized our network assurance and testing software solutions and cable status
monitoring products. We acquired the LoopCare software and Cheetah product lines in 2001 and 2003, respectively. A
substantial portion of our research and development expenses currently relates to these products.
We have adjusted our business model to focus heavily on our cable performance and status monitoring
products. We are actively engaged in research to improve and expand our cable products, including
research and development of VoIP solutions. Our cable products have lower margins than our MCU,
LoopCare and DigiTest system products. If sales of our cable testing products do not increase or
are not accepted in the marketplace, or if our research and development activities do not produce
marketable products that are both competitive and accepted by our customers, our overall revenues
and profitability will be adversely affected. In addition, although software products generally generate higher margin returns for us than
our hardware products, the initial development costs of software applications, coupled with the
inherent problems with pricing software 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. The sale of our products is dependent upon our ability to satisfy the proprietary requirements of
our customers and to respond to rapid technological change, including evolving industry-wide
standards. We depend upon a relatively narrow range of products for the majority of our revenue. Our
success in marketing our products is dependent upon their continued acceptance by our customers. In
some cases, our customers require that our products meet their own proprietary requirements. If we
are unable to satisfy such requirements, or forecast and adapt to changes in such requirements, our
business could be materially harmed. Rapid technological change, including evolving industry standards, could also render our
products obsolete. The adoption of industry-wide standards, such as the HMS and DOCSIS cable
standards, may result in the elimination of or reductions in the demand for many of our proprietary
products, such as our Cheetah head-end hardware products and other Cheetah products. Furthermore,
standards for new services and technologies continue to evolve, requiring us to continually modify
our products or to develop new versions to meet these new standards. Certain of these
certifications are limited in scope, which may require that the product be recertified if any
modifications to hardware or firmware are made. If we are unable to forecast the demand for, and
to develop new products or to adapt our existing products to meet, these evolving standards and
other technological innovations, or if our products and services do not gain the acceptance of our
customers, there could be a negative effect on our revenues for sales of such products. 30




---



##### Table of Contents



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 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 31




---



##### Table of Contents



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. Product quality, performance and reliability problems could disrupt our business and harm our
financial condition. Our customers demand that our products meet stringent quality, performance and reliability
standards. We have, from time to time, experienced product quality, performance or reliability
problems. For example, in 2004, we were unable to ship certain of our transponder products to a
customer due to delays in both the CableLabs DOCSIS certification of these products and the
manufacturing of the product until final engineering enhancements were completed. Though we
received CableLabs certification in the third quarter of 2004, and resolved these technological
issues for the current product design and configuration, defects or failures have in the past, and
may in the future occur relating to our product quality, performance and reliability. If these
failures or defects occur or become significant, we could experience lost revenues, increased
costs, including inventory write-offs, warranty expense and costs associated with customer support,
delays in or cancellations or rescheduling of orders or shipments and product returns or discounts,
any of which would harm our business. We have completed, and may pursue additional acquisitions, which will complicate our management
tasks and could result in substantial expenditures, and the failure of acquired assets to meet
expectations could result in impairment of intangible assets. 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 32




---



##### Table of Contents



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 annually reviewing and evaluating our internal controls over financial reporting in order
to comply with SEC rules relating to internal control over financial reporting adopted pursuant to
the Sarbanes-Oxley Act of 2002, 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. 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, 33




---



##### Table of Contents



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. 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 34




---



##### Table of Contents



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 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. 35




---



##### Table of Contents



We are affected by a pattern of product price decline in certain markets, which can harm our
business. Because our cable products generate lower margins for us than our proprietary MCU and software
offerings, an increase in the percentage of our sales of cable-related products relative to our
traditional products will result in lower profitability. Furthermore, as consolidations within the
cable industry and the adoption of the DOCSIS standards have caused and could continue to cause
pricing pressure as our competitors lower product pricing, our revenues have been and may continue
to be adversely affected. Although we have developed DOCSIS compliant hardware and our relationship
with our OEM partner is one that we believe will prominently position us to succeed in the
marketing of DOCSIS products, these DOCSIS products will likely generate lower margins than have
historically been generated by our proprietary technology. As a result, as our business shifts from
our higher margin proprietary products to lower margin cable offerings and standardized products
for which we have competition, we will need to sell greater volumes of our products to maintain our
profitability. Our common stock price may be extremely volatile. Our common stock price has been and is likely to continue to be highly volatile. The market
price may vary in response to many factors, some of which are outside our control, including:  
    General market and economic conditions;
    Actual or anticipated variations in operating results;
    Announcements of technological innovations, new products or new
services by us or by our competitors or customers;
    Changes in financial estimates or recommendations by stock market
analysts regarding us or our competitors;
    Announcements by us or our competitors of significant acquisitions,
strategic partnerships, joint ventures or capital commitments;
    Announcements by our customers regarding end market conditions and the
status of existing and future infrastructure network deployments;
    Additions or departures of key personnel; and
    Future equity or debt offerings or our announcements of these offerings. In addition, in recent years, the stock market in general, and The NASDAQ National Market and
the securities of technology companies in particular, have experienced extreme price and volume
fluctuations. These fluctuations have often been unrelated or disproportionate to the operating
performance of individual companies. These broad market fluctuations have in the past and may in
the future materially and adversely affect our stock price, regardless of our operating results.
In the past, following periods of volatility in the market price of a companys securities,
securities class action litigation has often been initiated against such company. Such litigation
could result in substantial costs and a diversion of our managements attention and resources that
could harm our business. 36




---



##### Table of Contents



We may be subject from time to time to legal proceedings, and any adverse determinations in these
proceedings could materially harm our business. We may from time to time be involved in various lawsuits and legal proceedings, which arise in
the ordinary course of business. Litigation matters are inherently unpredictable, and we cannot
predict the outcome of any such matters. If we ultimately lose or settle a case, we may be liable
for monetary damages and other costs of litigation. Even if we are entirely successful in a
lawsuit, we may incur significant legal expenses and our management may expend significant time in
the defense. An adverse resolution of a lawsuit or legal proceeding could negatively impact our
financial position and results of operations. 
 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Companys current investment policy limits its investments in financial instruments to cash and
cash equivalents, individual municipal bonds, and corporate and government bonds. The use of
financial derivatives and preferred and common stocks is strictly prohibited. The Company believes
it minimizes its risk through proper diversification along with the requirements that the
securities must be of investment grade with an average rating of A or better by Standard &
Poors. The Company holds its investment securities to maturity and believes that earnings and
cash flows will not be materially affected by changes in interest rates, due to the nature and
short-term investment horizon for which these securities are invested. 
 Item 4. CONTROLS AND PROCEDURES The Chief Executive Officer and the Chief Financial Officer of the Company (its principal
executive officer and principal financial officer, respectively) have concluded, based on their
evaluation as of the end of the period covered by this report, that the Companys disclosure
controls and procedures pursuant
to Rule 13a-15 of the Securities Exchange Act of 1934 are effective to ensure that information
required to be disclosed by the Company in the reports filed or submitted by it under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within
the time periods specified in the SECs rules and forms, and include controls and procedures
designed to ensure that information required to be disclosed by the Company in such reports is
accumulated and communicated to the Companys management, including the Chief Executive Officer and
Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. There were no changes in the Companys internal controls over financial reporting (as defined
in Rule 13a-15(f) under the Securities Exchange Act of 1934) that occurred during the fiscal
quarter ended March 26, 2005 that have materially affected or are reasonably likely to materially
affect these controls. 
 PART II. OTHER INFORMATION 
 Item 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES On January 27, 2005, our Board of Directors authorized the continuation through December 31, 2005
of a share repurchase program which expired on December 31, 2004. Under this extension, we may
repurchase a total of one million shares of our common stock before December 31, 2005. Since the
initial repurchase program was instituted in April 1997, and as of March 26, 2005, the Company has
repurchased 461,800 shares of common stock. The repurchased shares are authorized to be utilized
under certain employee benefit programs. At our discretion, we will determine the number of shares
and the 37




---



##### Table of Contents



timing of such purchases, which will be made using existing cash and short-term
investments. No shares were repurchased under this program in the three months ended March 26,
2005. 
 Item 6. EXHIBITS AND REPORTS FILED ON FORM 8-K  (a)
    Exhibits: The following exhibits are being filed with this report: ExhibitNumber
    
    Description15
    
    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
  (b)
    Reports on Form 8-K:  1.
    A Report Form 8-K was filed on January 21, 2005 relating to (i) the Company
entering into an Agreement with Christian L. Allison, the Companys former Chief
Executive Officer (ii) termination of an existing agreement with Mr. Allison; (iii)
the attachment of an exhibit which was a press release announcing the Companys
preliminary financial results for the quarter ended December 31, 2004; (iv) the
resignation of Mr. Allison as Chief Executive
Officer and as a Director and the appointment of Mark B. Peterson as Chief Executive
Officer and to the Board of Directors to fill the vacancy created by Mr. Allisons
resignation and the election of Daniel P. Barry as Chairman of the Board; and (v)
certain amendments to the Companys Bylaws.2.
    A Report Form 8-K was filed on January 27, 2005 which contained as an
exhibit the Companys Earning Release for the quarter and year ended December 31,
2004.3.
    A Report Form 8-K was filed on March 11, 2005 relating to the Company
entering into an Extension and Amendment of Agreement (each, an Agreement) with
each of Carol M. Franklin, Joseph G. OBrien, Gregory Quiggle, Roger A. Smith and
Jeffery J. Tatusko, executives of the Company.    Cheetah is a trademark of Tollgrade Communications, Inc. ®DigiTest is a registered trademark of Tollgrade Communications, Inc. ®EDGE is a registered trademark of Tollgrade Communications, Inc. ®MCU is a registered trademark of Tollgrade Communications, Inc. ®LIGHTHOUSE is a registered trademark of Tollgrade Communications, Inc. ®DOCSIS is a registered trademark of Cable Television Laboratories, Inc. All other trademarks are the property of their respective owners. 38




---



##### Table of Contents



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:
May 4, 2005
    
    /s/ Mark B. PetersonMark B. PetersonChairman and Chief Executive OfficerDated:
May 4, 2005
    
    /s/ Samuel C. KnochSamuel C. KnochChief Financial Officer and TreasurerDated:
May 4, 2005
    
    /s/ Sean M. ReillySean M. ReillyController
 39




---



##### Table of Contents



EXHIBIT INDEX  ExhibitNumber
    
    Description15
    
    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
 40