##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, DC 20549
 FORM 10-Q
  þ
    
    Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the quarterly period ended September 30, 2006
 o
    
    Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the transition period from  to
 Commission file number 000-27312
 TOLLGRADE COMMUNICATIONS, INC.
  Pennsylvania
    
    25-1537134(State or other jurisdiction 
of incorporation or organization)
    
    (I.R.S. Employer
Identification No.)
 493 Nixon Rd.
Cheswick, PA 15024
 412-820-1400
  þ o
  o þ o
  o þ




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##### Table of Contents



TOLLGRADE COMMUNICATIONS, INC.
 Quarterly Report on Form 10-Q
For the Quarter Ended September 30, 2006  Table of Contents
 PAGE NO.PART I. FINANCIAL INFORMATIONItem 1 Condensed Consolidated Financial Statements (unaudited):Condensed Consolidated Balance Sheets as of September 30, 2006 and
December 31, 2005
    
    
    3Condensed Consolidated Statements of Operations for the three and
nine month periods ended September 30, 2006 and September 24, 2005
    
    
    4Condensed Consolidated Statement of Changes in Shareholders
Equity for the nine month period ended September 30, 2006
    
    
    5Condensed Consolidated Statements of Cash Flows for the nine month
periods ended September 30, 2006 and September 24, 2005
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Report of Independent Registered Public Accounting Firm
    
    
    20Item 2 Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    21Item 3 Quantitative and Qualitative Disclosures about Market Risk
    
    
    42Item 4 Controls and Procedures
    
    
    43PART II. OTHER INFORMATIONItem 1A Risk Factors
    
    
    43Item 2 Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    54Item 6 Exhibits
    
    
    55SIGNATURES
    
    
    56EXHIBIT INDEX
    
    
    57Exhibit 10.1Exhibit 10.2Exhibit 15Exhibit 31.1Exhibit 31.2Exhibit 32EX-10.1EX-10.2EX-15EX-31.1EX-31.2EX-32
 2




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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value) (Unaudited)
 September 30, 2006
    
    December 31, 2005*ASSETSCurrent assets:Cash and cash equivalents
    
    $
    51,169
    
    
    $
    49,421Short-term investments
    
    
    7,245
    
    
    
    18,010Accounts receivable:Trade, net of allowance for doubtful accounts of
$432 in 2006 and $465 in 2005
    
    
    15,100
    
    
    
    9,456Other
    
    
    1,292
    
    
    
    1,406Inventories
    
    
    10,953
    
    
    
    9,934Prepaid expenses and other current assets
    
    
    847
    
    
    
    1,397Deferred tax assets and refundable income tax
    
    
    3,445
    
    
    
    1,803Assets held for sale
    
    
    1,190
    
    
    
    Total current assets
    
    
    91,241
    
    
    
    91,427Property and equipment, net
    
    
    3,549
    
    
    
    6,390Deferred tax assets
    
    
    207
    
    
    
    46Intangibles and capitalized software, net
    
    
    42,020
    
    
    
    43,616Goodwill
    
    
    23,857
    
    
    
    21,562Receivable from officer
    
    
    149
    
    
    
    153Other assets
    
    
    119
    
    
    
    135Total assets
    
    $
    161,142
    
    
    $
    163,329LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,473
    
    
    $
    1,262Accrued warranty
    
    
    2,133
    
    
    
    2,220Accrued expenses
    
    
    3,605
    
    
    
    2,579Accrued salaries and wages
    
    
    158
    
    
    
    660Accrued royalties payable
    
    
    160
    
    
    
    581Income taxes payable
    
    
    441
    
    
    
    869Deferred income
    
    
    2,836
    
    
    
    2,450Total current liabilities
    
    
    10,806
    
    
    
    10,621Deferred tax liabilities
    
    
    2,615
    
    
    
    2,447Total liabilities
    
    
    13,421
    
    
    
    13,068Contingencies and commitmentsShareholders equity:Preferred stock, $1.00 par value; Authorized
shares, 10,000; issued shares, -0- in 2006 and 2005
    
    
    
    
    
    
    Common stock, $.20 par value; authorized shares,
50,000; issued shares, 13,709 in 2006 and 13,664
in 2005
    
    
    2,742
    
    
    
    2,733Additional paid-in capital
    
    
    72,338
    
    
    
    71,469Treasury stock, at cost, 462 shares in 2006 and 2005
    
    
    (4,791
    )
    
    
    (4,791
    )Retained earnings
    
    
    77,432
    
    
    
    80,850Total shareholders equity
    
    
    147,721
    
    
    
    150,261Total liabilities and shareholders equity
    
    $
    161,142
    
    
    $
    163,329
 *
    
    Amounts derived from audited financial statements presented in the Companys Annual
Report on Form 10-K for the year ended December 31, 2005.
  3




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TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data) (Unaudited)
 Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 24,
    
    
    September 30,
    
    
    September 24,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues:Products
    
    $
    12,053
    
    
    $
    13,573
    
    
    $
    38,828
    
    
    $
    38,412Services
    
    
    2,896
    
    
    
    3,229
    
    
    
    9,982
    
    
    
    9,757Total revenues:
    
    
    14,949
    
    
    
    16,802
    
    
    
    48,810
    
    
    
    48,169Cost of product sales:Products
    
    
    5,454
    
    
    
    5,987
    
    
    
    19,238
    
    
    
    18,210Services
    
    
    982
    
    
    
    911
    
    
    
    3,601
    
    
    
    2,643Amortization of intangibles
    
    
    962
    
    
    
    718
    
    
    
    2,853
    
    
    
    2,147Inventory restructuring writedown
    
    
    4,346
    
    
    
    
    
    
    
    4,346
    
    
    
    Write-down of acquired software
    
    
    
    
    
    
    424
    
    
    
    
    
    
    
    42411,744
    
    
    
    8,040
    
    
    
    30,038
    
    
    
    23,424Gross Profit:
    
    
    3,205
    
    
    
    8,762
    
    
    
    18,772
    
    
    
    24,745Selling and marketing
    
    
    2,459
    
    
    
    1,918
    
    
    
    8,081
    
    
    
    6,594General and administrative
    
    
    1,751
    
    
    
    1,910
    
    
    
    5,935
    
    
    
    5,640Research and development
    
    
    3,233
    
    
    
    3,465
    
    
    
    10,484
    
    
    
    10,554Restructuring
    
    
    1,500
    
    
    
    
    
    
    
    1,500
    
    
    
    Retirement Expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    775Total operating expenses
    
    
    8,943
    
    
    
    7,293
    
    
    
    26,000
    
    
    
    23,563(Loss) income from operations
    
    
    (5,738
    )
    
    
    1,469
    
    
    
    (7,228
    )
    
    
    1,182Interest and other income, net
    
    
    729
    
    
    
    313
    
    
    
    1,984
    
    
    
    827(Loss) income before income taxes
    
    
    (5,009
    )
    
    
    1,782
    
    
    
    (5,244
    )
    
    
    2,009(Benefit) provision for income taxes
    
    
    (1,759
    )
    
    
    311
    
    
    
    (1,826
    )
    
    
    328Net (loss) income
    
    $
    (3,250
    )
    
    $
    1,471
    
    
    $
    (3,418
    )
    
    $
    1,681(Loss) earnings per share information:Weighted average shares of common
stock and equivalents:Basic
    
    
    13,247
    
    
    
    13,162
    
    
    
    13,236
    
    
    
    13,162Diluted
    
    
    13,247
    
    
    
    13,221
    
    
    
    13,236
    
    
    
    13,202Net (loss) income per common and
common equivalent shares:Basic
    
    $
    (0.25
    )
    
    $
    0.11
    
    
    $
    (0.26
    )
    
    $
    0.13Diluted
    
    $
    (0.25
    )
    
    $
    0.11
    
    
    $
    (0.26
    )
    
    $
    0.13
  4




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TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS EQUITY
For the Nine Months Ended September 30, 2006
(In thousands) (Unaudited)
 AdditionalPreferred Stock
    
    
    Common Stock
    
    
    Paid-In
    
    
    Treasury
    
    
    RetainedShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Capital
    
    
    Stock
    
    
    Earnings
    
    
    TotalBalance at
December 31, 2005
    
    
    
    
    
    $
    
    
    
    
    13,664
    
    
    $
    2,733
    
    
    $
    71,469
    
    
    $
    (4,791
    )
    
    $
    80,850
    
    
    $
    150,261Exercise of common
stock options
    
    
    
    
    
    
    
    
    
    
    45
    
    
    
    9
    
    
    
    397
    
    
    
    
    
    
    
    
    
    
    
    406Tax benefit from
exercise of stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    94
    
    
    
    
    
    
    
    
    
    
    
    94Stock-based
compensation
expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    378
    
    
    
    
    
    
    
    
    
    
    
    378Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,418
    )
    
    
    (3,418
    )Balance at
September 30, 2006
    
    
    
    
    
    
    
    
    
    
    13,709
    
    
    $
    2,742
    
    
    $
    72,338
    
    
    $
    (4,791
    )
    
    $
    77,432
    
    
    $
    147,721
 The accompanying notes are an integral part of the condensed consolidated financial statements.
 5




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TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands) (Unaudited)
 Nine Months EndedSeptember 30,
    
    September 24,2006
    
    2005Cash flows from operating activities:Net (loss) income
    
    $
    (3,418
    )
    
    $
    1,681Adjustments to reconcile net (loss) income to net cash (used
in) provided by operating activities:Depreciation and amortization
    
    
    4,483
    
    
    
    4,038Compensation expense related to stock plans
    
    
    378
    
    
    
    Deferred income taxes
    
    
    (2,280
    )
    
    
    408Restructuring and asset impairment
    
    
    5,338
    
    
    
    Provision for losses on inventory
    
    
    (44
    )
    
    
    237Write-down of acquired software
    
    
    
    
    
    
    424Provision for allowance for doubtful accounts
    
    
    (47
    )
    
    
    80Changes in assets and liabilities (net of acquired business):Accounts receivable-trade
    
    
    (3,770
    )
    
    
    (2,688
    )Accounts receivable-other
    
    
    114
    
    
    
    (875
    )Inventory
    
    
    (4,208
    )
    
    
    2,425Prepaid expenses and other assets
    
    
    570
    
    
    
    1,629Refundable taxes
    
    
    645
    
    
    
    212Accounts payable
    
    
    (425
    )
    
    
    (146
    )Accrued warranty
    
    
    (87
    )
    
    
    (14
    )Accrued expenses and deferred income
    
    
    1,089
    
    
    
    63Accrued royalties payable
    
    
    (421
    )
    
    
    (226
    )Accrued salaries and wages
    
    
    (502
    )
    
    
    (274
    )Income taxes payable
    
    
    (428
    )
    
    
    10Net cash (used in) provided by operating activities
    
    
    (3,013
    )
    
    
    6,984Cash flows from investing activities:Purchase of Emerson product line
    
    
    (5,501
    )
    
    
    Purchase of short-term investments
    
    
    (7,589
    )
    
    
    (15,479
    )Redemption/maturity of short-term investments
    
    
    18,354
    
    
    
    12,490Capital expenditures, including capitalized software
    
    
    (1,003
    )
    
    
    (903
    )Net cash provided by (used in) investing activities
    
    
    4,261
    
    
    
    (3,892
    )Cash flows from financing activities:Proceeds from exercise of stock options
    
    
    406
    
    
    
    65Tax benefit from exercise of stock options
    
    
    94
    
    
    
    8Net cash provided by financing activities
    
    
    500
    
    
    
    73Net increase in cash and cash equivalents
    
    
    1,748
    
    
    
    3,165Cash and cash equivalents at beginning of period
    
    $
    49,421
    
    
    $
    32,622Cash and cash equivalents at end of period
    
    $
    51,169
    
    
    $
    35,787
 
 6




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




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NEW ACCOUNTING STANDARDS
   Fair Value Measurements
 2.
    
    RESTRUCTURING
  8




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Balance at
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance atJuly 1, 2006
    
    Expense
    
    Cash payments
    
    Asset write-downs
    
    September 30, 2006Facility Rationalization
including employee
costs
    
    $
    
    
    
    $
    1,078
    
    
    $
    (159
    )
    
    $
    (570
    )
    
    $
    349Inventory write-down
    
    
    
    
    
    
    4,346
    
    
    
    
    
    
    
    (4,346
    )
    
    
    Real Estate impairment
    
    
    
    
    
    
    422
    
    
    
    
    
    
    
    (422
    )
    
    
    Total
    
    $
    
    
    
    $
    5,846
    
    
    $
    (159
    )
    
    $
    (5,338
    )
    
    $
    349
  EMERSON INTEGRATION PROGRAM
   Balance at
    
    Adjustment to
    
    
    
    
    
    Balance atJuly 1, 2006
    
    Goodwill
    
    Cash payments
    
    September 30, 2006Relocation Costs
    
    $
    320
    
    
    
    ($219
    )
    
    $
    (7
    )
    
    $
    94Facility Rationalization
    
    
    46
    
    
    
    
    
    
    
    (9
    )
    
    
    37Total
    
    $
    366
    
    
    
    ($219
    )
    
    $
    (16
    )
    
    $
    131
  3.
    
    ACCOUNTING FOR STOCK-BASED COMPENSATION
  9




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Stock-Based Compensation Expense
    10




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Pro forma information under SFAS 123 for periods prior to January 1, 2006
  Three Months Ended
    
    Nine Months EndedSeptember 24, 2005(in thousands)
    
    September 24, 2005(in thousands)Net income
    
    $
    1,471
    
    
    $
    1,681Less: Total
stock-based
compensation
determined under
the fair value
method for all
awards, net of
related tax
    
    
    73
    
    
    
    81Pro forma net income
    
    $
    1,398
    
    
    $
    1,600Income per share:Basic
    
    $
    0.11
    
    
    $
    0.13Basic  pro forma
    
    $
    0.11
    
    
    $
    0.12Diluted
    
    $
    0.11
    
    
    $
    0.13Diluted  pro forma
    
    $
    0.11
    
    
    $
    0.12
  11




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Stock Options
 Three Months Ended
    
    Nine Months EndedSeptember 30, 2006
    
    September 24, 2005(A)
    
    September 30, 2006
    
    September 24, 2005 (A)Weighted average
estimated values
    
    $
    4.90
    
    
    $
    4.14
    
    
    $
    4.90
    
    
    $
    4.14Expected life (in years)
    
    
    5.0
    
    
    
    4.0
    
    
    
    5.0
    
    
    
    4.0Risk free interest rate
    
    
    4.7
    %
    
    
    4.0
    %
    
    
    4.7
    %
    
    
    4.0
    %Volatility
    
    
    56.59
    %
    
    
    57.62
    %
    
    
    56.59
    %
    
    
    57.62
    %
 
 (A)
    
    Assumptions used in the calculation of fair value according to original provisions of SFAS
No. 123.   Number of
    
    
    
    
    
    Weighted AverageShares
    
    Range of Options Price
    
    Exercise PriceOutstanding, December 31, 2005
    
    
    1,780,037
    
    
    $
    7.28  159.19
    
    
    $
    26.87Granted
    
    
    20,000
    
    
    
    9.19
    
    
    
    9.19Exercised
    
    
    (44,984
    )
    
    
    7.56  12.55
    
    
    
    9.02
    (A)Cancelled
    
    
    (337,834
    )
    
    
    7.28  117.34
    
    
    
    15.94Outstanding, September 30, 2006
    
    
    1,417,219
    
    
    $
    7.28  159.19
    
    
    $
    29.79
 Number of SharesOptions exercisable at:December 31, 2005
    
    
    1,605,113September 30, 2006
    
    
    1,246,296
 
 (A)
    
    The intrinsic value associated with exercised options which was $271,483 represents the
difference between the exercise price and the value of Tollgrade stock at the time of exercise. 12




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Stock Options Outstanding
    
    
    Stock Options ExercisableWeighted AverageRange of Exercise
    
    Number Outstanding
    
    
    Remaining
    
    
    Weighted Average
    
    
    Aggregate Intrinsic
    
    
    Number Exercisable
    
    
    Weighted Average
    
    
    Aggregate IntrinsicPrices
    
    as of 09/30/06
    
    
    Contractual Life
    
    
    Exercise Price
    
    
    Value
    
    
    as of 09/30/06
    
    
    Exercise Price
    
    
    Value (A)$7.28
    
    
    51,000
    
    
    
    2.21
    
    
    $
    7.28
    
    
    $
    85,104
    
    
    
    51,000
    
    
    $
    7.28
    
    
    $
    85,1047.29  9.49
    
    
    441,252
    
    
    
    7.08
    
    
    
    8.54
    
    
    
    218,185
    
    
    
    270,329
    
    
    
    8.47
    
    
    
    157,8969.50  12.55
    
    
    128,717
    
    
    
    4.50
    
    
    
    11.34
    
    
    
    
    
    
    
    128,717
    
    
    
    11.34
    
    
    
    12.56  15.84
    
    
    119,000
    
    
    
    3.70
    
    
    
    13.81
    
    
    
    
    
    
    
    119,000
    
    
    
    13.81
    
    
    
    15.85  21.70
    
    
    159,500
    
    
    
    5.03
    
    
    
    19.15
    
    
    
    
    
    
    
    159,500
    
    
    
    19.15
    
    
    
    21.71  28.70
    
    
    172,000
    
    
    
    5.03
    
    
    
    27.93
    
    
    
    
    
    
    
    172,000
    
    
    
    27.92
    
    
    
    28.71  55.90
    
    
    191,700
    
    
    
    4.60
    
    
    
    44.73
    
    
    
    
    
    
    
    191,700
    
    
    
    44.74
    
    
    
    55.91  103.59
    
    
    10,000
    
    
    
    3.96
    
    
    
    97.25
    
    
    
    
    
    
    
    10,000
    
    
    
    97.25
    
    
    
    103.60  117.34
    
    
    128,000
    
    
    
    3.88
    
    
    
    117.34
    
    
    
    
    
    
    
    128,000
    
    
    
    117.34
    
    
    
    $117.35  159.19
    
    
    16,050
    
    
    
    3.78
    
    
    
    159.19
    
    
    
    
    
    
    
    16,050
    
    
    
    159.19
    
    
    
    Total
    
    
    1,417,219
    
    
    
    5.22
    
    
    $
    29.79
    
    
    $
    303,289
    
    
    
    1,246,296
    
    
    $
    32.69
    
    
    $
    243,000
 
 (A)
    
    The aggregate intrinsic value in the preceding table represents the difference between the
exercise price and the value of Tollgrade stock on September 30, 2006 of $8.95. The total
number of in-the-money options exercisable as of September 30, 2006 was 251,309. Weighted Average Exercise
    
    
    Weighted Average Remaining
    
    
    Aggregate IntrinsicNo. of Shares
    
    
    Price
    
    
    Contractual Term
    
    
    Value1Vested
    
    
    1,246,296
    
    
    $
    32.69
    
    
    
    3.8
    
    
    $
    243,000Expected to Vest
    
    
    170,923
    
    
    
    8.64
    
    
    
    8.9
    
    
    
    60,289Total
    
    
    1,417,219
    
    
    $
    29.79
    
    
    
    5.2
    
    
    $
    303,289
 
 (1)
    
    The aggregate intrinsic value in the preceding table represents the difference between the
exercise price and the value of Tollgrade stock on September 30, 2006 of $8.95.  4. ACQUISITION
  13




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Accounts Receivable
    
    $
    1,827Inventories
    
    
    1,113Property and Equipment
    
    
    112Intangible Assets:Customer Relationship
    
    
    193Tradename
    
    
    62Purchased Technology
    
    
    761Sales Order Backlog
    
    
    97Goodwill
    
    
    2,295Total Assets Acquired
    
    
    6,460Deferred Income
    
    
    175Accounts Payable
    
    
    636Restructuring
    
    
    148Total Liabilities
    
    
    959Net Assets Acquired
    
    $
    5,501
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##### Table of Contents



(In Thousands, Except Per Share Data)Unaudited Pro Forma
    
    Unaudited Pro FormaThree Months Ended
    
    Three Months EndedSeptember 30, 2006
    
    September 24, 2005Revenues
    
    $
    14,949
    
    
    $
    18,744(Loss) income from operations
    
    $
    (5,738
    )
    
    $
    1,481Net (loss) income
    
    $
    (3,250
    )
    
    $
    1,481Diluted (loss) earnings per
share
    
    $
    (0.25
    )
    
    $
    0.11
 (In Thousands, Except Per Share Data)Unaudited Pro Forma
    
    Unaudited Pro FormaNine Months Ended
    
    Nine Months EndedSeptember 30, 2006
    
    September 24, 2005Revenues
    
    $
    50,376
    
    
    $
    55,812(Loss) income from operations
    
    $
    (7,218
    )
    
    $
    1,625Net (loss) income
    
    $
    (3,412
    )
    
    $
    2,052Diluted (loss) earnings per
share
    
    $
    (0.26
    )
    
    $
    0.16
 5. INTANGIBLE ASSETS
  September 30, 2006
    
    December 31, 2005Useful
    
    
    
    
    
    Accumulated
    
    
    
    
    
    
    
    
    
    AccumulatedLife (Years)
    
    Gross
    
    Amortization
    
    Net
    
    Gross
    
    Amortization
    
    NetAmortizing
Intangible Assets:Post Warranty
Service Agreements
    
    
    50
    
    
    $
    32,000
    
    
    $
    640
    
    
    $
    31,360
    
    
    $
    32,000
    
    
    $
    160
    
    
    $
    31,840Technology
    
    
    5-10
    
    
    
    17,878
    
    
    
    11,733
    
    
    
    6,145
    
    
    
    16,973
    
    
    
    9,698
    
    
    
    7,275Customer
Relationships
    
    
    5-10
    
    
    
    2,843
    
    
    
    672
    
    
    
    2,171
    
    
    
    2,650
    
    
    
    449
    
    
    
    2,201Purchased Backlog
    
    
    1
    
    
    
    97
    
    
    
    97
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Tradename
    
    
    3
    
    
    
    62
    
    
    
    18
    
    
    
    44
    
    
    
    
    
    
    
    
    
    
    
    Non-Amortizing
Intangible Assets:Tradenames
    
    
    
    
    
    
    2,300
    
    
    
    
    
    
    
    2,300
    
    
    
    2,300
    
    
    
    
    
    
    
    2,300Total Intangible
Assets
    
    
    
    
    
    $
    55,180
    
    
    $
    13,160
    
    
    $
    42,020
    
    
    $
    53,923
    
    
    $
    10,307
    
    
    $
    43,616Goodwill
    
    
    
    
    
    $
    23,857
    
    
    
    
    
    
    $
    23,857
    
    
    $
    21,562
    
    
    
    
    
    
    $
    21,562
 15




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##### Table of Contents



Customer Relationship (useful life of 5 years)
    
    $
    193Purchased Technology (useful life of 5 years)
    
    $
    761Tradename (useful life of 3 years)
    
    $
    62Backlog (useful life of 6 months)
    
    $
    97Goodwill
    
    $
    2,295
   6.
    
    INVENTORY
  September 30, 2006
    
    
    December 31, 2005Raw materials
    
    $
    7,520
    
    
    $
    6,966Work in process
    
    
    3,326
    
    
    
    3,448Finished goods
    
    
    2,734
    
    
    
    1,61513,580
    
    
    
    12,029Reserve for slow moving and obsolete inventory
    
    
    (2,627
    )
    
    
    (2,095
    )$
    10,953
    
    
    $
    9,934
  16




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7.
    
    SHORT-TERM INVESTMENTS
  8.
    
    RETIREMENT EXPENSE
  9.
    
    PER SHARE INFORMATION
 
 Three Months Ended
    
    
    Nine Months EndedSeptember 24, 2005
    
    
    September 24, 2005Net Income
    
    $
    1,471
    
    
    $
    1,681Common and common equivalent shares:Weighted average common shares outstanding
    
    
    13,162
    
    
    
    13,162Effect of dilutive securities- stock options
    
    
    59
    
    
    
    4013,221
    
    
    
    13,202Income per share:Basic
    
    $
    0.11
    
    
    $
    0.13Diluted
    
    $
    0.11
    
    
    $
    0.13
 10.
    
    RECEIVABLE FROM OFFICER
  17




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11.
    
    PRODUCT WARRANTY
   Nine Months Ended
    
    
    Year EndedSeptember 30, 2006
    
    
    December 31, 2005Balance at the beginning of the period
    
    $
    2,220
    
    
    $
    2,081Accruals for warranties issued during the period
    
    
    1,050
    
    
    
    1,502Settlements during the period
    
    
    (1,137
    )
    
    
    (1,363
    )Balance at the end of the period
    
    $
    2,133
    
    
    $
    2,220
  12.
    
    CONTINGENCIES AND COMMITMENTS
   13.
    
    MAJOR CUSTOMERS AND INTERNATIONAL SALES
  18




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14.
    
    SERIES A JUNIOR PARTICIPATING PREFERRED STOCK PURCHASE RIGHTS
  19




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20




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Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 The following discussion should be read in conjunction with the Condensed Consolidated Financial
Statements and Notes thereto appearing elsewhere in this report.
 CAUTIONARY STATEMENT FOR PURPOSES OF THE SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995.
 will, believes, intends, expects, plans, could or may,
  OVERVIEW
 About the Company
 ®
 21




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About its customers
   PRODUCTS
 TELECOMMUNICATION TEST SYSTEMS
  22




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®
 DigiTest and LoopCare; N(x)Test, N(x)DSL-3 and LTSC
   ®
  23




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
    
    the Common Object Request Broker Architecture (CORBA)-based
Application Programming Interface;
    
    Benchmark Data Base;
    
    DSL Testing;
    
    the Advanced Testhead Feature Package;
    
    Batch Testing;
    
    Fax Unalert;
    
    Loop Length Reporting;
    
    Enabling Flow Through by Re-Classification of VER 55-58 Codes;
    
    LoopCare TCP/IP Communications Network;
    
    Testing Voice Services in a Broadband Passive Optical Network (bPON);
    
    Multi-DSL Prequalification Features; and
    
    Breakthrough CPE and Fast Answering CPA Suppression.
  MCU
  24




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CABLE TESTING PRODUCTS
  ® ®
 SERVICES
  BACKLOG
  25




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OPERATING SEGMENT
  INTERNATIONAL SALES
    26




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SERIES A JUNIOR PARTICIPATING PREFERRED STOCK PURCHASE RIGHTS
  APPLICATION OF CRITICAL ACCOUNTING POLICIES
  Revenue Recognition
   27




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Goodwill and Intangible Assets
  28




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29




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Sensitivity Analysis
  YearsTwelve-monthRemaining Life at
    
    Carrying Value at
    
    Rolling ProjectedAsset Description
    
    Original Life
    
    9/30/06
    
    9/30/06
    
    Amortization(in millions)LoopCareBase Software
    
    
    10
    
    
    
    5.0
    
    
    
    2.2
    
    
    $
    0.5Post-WarrantyMaintenance ServiceAgreements
    
    
    50
    
    
    
    49.0
    
    
    
    31.4
    
    
    
    0.6CheetahBase Software
    
    
    10
    
    
    
    6.25
    
    
    
    1.8
    
    
    
    0.3Proprietary Technology
    
    
    10
    
    
    
    6.0
    
    
    
    0.6
    
    
    
    0.1Customer Base
    
    
    15
    
    
    
    11.0
    
    
    
    2.0
    
    
    
    0.3EmersonProprietary Technology
    
    
    5
    
    
    
    4.5
    
    
    
    0.7
    
    
    
    0.2Customer Relationship
    
    
    5
    
    
    
    4.5
    
    
    
    0.2
    
    
    
    0.1Other
    
    
    3-5
    
    
    
    2.5
    
    
    
    0.5
    
    
    
    0.239.4
    
    
    $
    2.3
  Reviews for Impairment:
  30




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Inventory Valuation
  31




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Allowance for Doubtful Accounts
   Income Taxes
  Warranty
  32




---



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RESULTS OF OPERATIONS
 THIRD QUARTER OF 2006 COMPARED TO THIRD QUARTER OF 2005
 Revenues
     33




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Gross Profit
  34




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Selling and Marketing Expense
  General and Administrative Expense
 .
 Research and Development Expense
  Restructuring
  35




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Balance at
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance atJune 30, 2006
    
    Expense
    
    Cash payments
    
    Asset Write-Downs
    
    September 30, 2006Facility
Rationalization
including employee
costs
    
    $
    
    
    
    $
    1,078
    
    
    $
    (159
    )
    
    $
    (570
    )
    
    $
    349Inventory write-down
    
    
    
    
    
    
    4,346
    
    
    
    
    
    
    
    (4,346
    )
    
    
    Real Estate impairment
    
    
    
    
    
    
    422
    
    
    
    
    
    
    
    (422
    )
    
    
    Total
    
    $
    
    
    
    $
    5,846
    
    
    $
    (159
    )
    
    $
    (5,338
    )
    
    $
    349
  Emerson Integration Program
    Interest and Other Income
  36




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Income Taxes
  Net (Loss) Income and (Loss) Income Per Share
  NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO NINE MONTHS ENDED SEPTEMBER 24, 2005
 Revenues
    37




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Gross Profit
  38




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Selling and Marketing Expense
  General and Administrative Expense
  Research and Development Expense
  Retirement Expense
  39




---



##### Table of Contents



Interest and Other Income
  Income Taxes
  Net (Loss) Income and (Loss) Earnings Per Share
  LIQUIDITY AND CAPITAL RESOURCES
   40




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RELATED PARTY TRANSACTION
  41




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KEY RATIOS
  NEW ACCOUNTING STANDARDS
   Fair Value Measurements
 
 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  42




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Item 4. CONTROLS AND PROCEDURES
   
 PART II. OTHER INFORMATION
 
 Item 1A. RISK FACTORS
  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.
  43




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##### Table of Contents




    
    the conditions of the telecommunications market and the economy in general;
    
    subscriber line loss and related reduced demand for wireline telecommunications services;
    
    changes or shifts in the technology utilized in the networks;
    
    labor disputes between our customers and their collective bargaining units;
    
    the failure to meet established purchase forecasts and growth projections;
    
    competition among the RBOCs, competitive exchange carriers and wireless
telecommunications and cable providers; and
    
    reorganizations, including management changes, at one or more of our customers or
potential customers.
  Our operating results may vary from quarter to quarter, causing our stock price to fluctuate.
  Our restructuring and cost reduction plans may be ineffective or may limit our ability to compete.
  44




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Our Services business is subject to a trend of compressed margins and reduced capital spending by
our major customers.
  The failure of acquired assets to meet expectations, or a decline on our fair value determined by
market prices of our stock, could indicate impairment of our intangible assets and result in
impairment charges.
  The sales cycle for our system products is long, and the delay or failure to complete one or more
large transactions in a quarter could cause our operating results to fall below our expectations.
  45




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We depend on sales of our MCU products for a meaningful portion of our revenues, but this product
is mature and its sales will continue to decline.
   46




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We have emphasized our network assurance and testing solutions and cable status monitoring
products.
   The sale of our products is dependent upon our ability to satisfy the proprietary requirements of
our customers, to respond to rapid technological change, including evolving industry-wide
standards, and to develop and implement product strategies as customers migrate to new network
technologies.
   47




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Our customers are subject to an evolving governmental regulatory environment that could
significantly reduce the demand for our products or increase our costs of doing business.
   Our limited ability to protect our proprietary information and technology may adversely affect our
ability to compete.
  48




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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.
   Our reliance on third parties for critical components and to manufacture certain aspects of our
products involves risks, including delays in product shipments and reduced control over product
quality.
  If we are unable to satisfy our customers specific product quality, certification or network
 49




---



##### Table of Contents



requirements, our business could be disrupted and our financial condition could be harmed.
  We have completed, and may pursue additional acquisitions, which will complicate our management
tasks and could result in substantial expenditures.
   Our future sales in international markets are subject to numerous risks and uncertainties.
  50




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If our accounting controls and procedures are circumvented or otherwise fail to achieve their
intended purposes, our business could be seriously harmed.
  If we ship products that contain defects, the market acceptance of our products and our reputation
will be harmed and our customers could seek to recover their damages from us.
  Our future results are dependent on our ability to establish, maintain and expand our distribution
channels and our existing third-party distributors.
  We face intense competition, which could result in our losing market share or experiencing a
decline in our gross margins.
  51




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We are dependent upon our ability to attract, retain and motivate our key personnel.
  Consolidations in, or a continued slowdown in, the telecommunications industry could harm our
business.
  52




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Our expenses are relatively fixed in the short term, and we may be unable to adjust spending to
compensate for unexpected revenue shortfalls.
  We rely on software that we have licensed from third-party developers to perform key functions in
our products and we rely on certain hardware sourced through OEM channels.
  We are affected by a pattern of product price decline in certain markets, which can harm our
business.
  Our common stock price may be extremely volatile.
  53




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
    
    General market and economic conditions;
    
    Changes in the telecommunications industry;
    
    Actual or anticipated variations in operating results;
    
    Announcements of technological innovations, new products or new
services by us or by our competitors or customers;
    
    Changes in financial estimates or recommendations by stock market
analysts regarding us or our competitors;
    
    Announcements by us or our competitors of significant acquisitions,
strategic partnerships, joint ventures or capital commitments;
    
    Announcements by our customers regarding end market conditions and the
status of existing and future infrastructure network deployments;
    
    Additions or departures of key personnel; and
    
    Future equity or debt offerings or our announcements of these offerings.
  We may be subject from time to time to legal proceedings, and any adverse determinations in these
proceedings could materially harm our business.
  
 Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
  54




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Item 6. EXHIBITS
 (a)
    
    Exhibits:
  ExhibitNumber
    
    Description10.1
    
    
    Extension Agreement, dated September 26, 2006, between the Company
and Bulova Technologies EMS LLC, filed herewith10.2
    
    
    Form of Stock Option Agreement for Non-Statutory Stock Options
granted under the 2006 Long-Term Incentive Compensation Plan,
filed herewith15
    
    
    Letter re audited interim financial information31.1
    
    
    Certification of Chief Executive Officer, filed herewith31.2
    
    
    Certification of Chief Financial Officer, filed herewith32
    
    
    Certification of Chief Executive Officer and Chief Financial
Officer pursuant to 18.U.S.C. Section 350, filed herewith
 ®  ®  ®  ®  ®
 55




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SIGNATURES
  Tollgrade Communications, Inc.
(Registrant)Dated: October 27, 2006
    /s/ Mark B. PetersonMark B. PetersonChief Executive OfficerDated: October 27, 2006
    /s/ Samuel C. KnochSamuel C. KnochChief Financial Officer and TreasurerDated: October 27, 2006
    /s/ Sean M. ReillySean M. ReillyController 56




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EXHIBIT INDEX
 ExhibitNumber
    
    Description10.1
    
    
    Extension Agreement, dated September 26, 2006, between the Company
and Bulova Technologies EMS LLC, filed herewith10.2
    
    
    Form of Stock Option Agreement for Non-Statutory Stock Options
granted under the 2006 Long-Term Incentive Compensation Plan,
filed herewith15
    
    
    Letter re audited interim financial information31.1
    
    
    Certification of Chief Executive Officer, filed herewith31.2
    
    
    Certification of Chief Financial Officer, filed herewith32
    
    
    Certification of Chief Executive Officer and Chief Financial
Officer pursuant to 18.U.S.C. Section 350, filed herewith
 57