##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
   WASHINGTON, DC 20549
   FORM 10-Q
 (Mark One) [X]
    
    Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the quarterly period ended March 27, 2004 [   ]
    
    Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the transition period from  to Commission file number 000-27312 TOLLGRADE COMMUNICATIONS, INC.  Pennsylvania
(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   [X]  No  [   ] Indicate by check mark whether the Registrant is an accelerated filer (as
defined by Rule 12b-2 of the Exchange Act). Yes   [X]  No  [   ] As
of April 30, 2004, there were 13,584,404 shares of the Registrants
Common Stock, $0.20 par value per share, and no shares of the Registrants
Preferred Stock, $1.00 par value per share, outstanding. 1




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TABLE OF CONTENTS  PART I. FINANCIAL INFORMATIONItem 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTSTOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETSTOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONSTOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITYTOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSREPORT OF INDEPENDENT ACCOUNTANTSItem 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSItem 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKItem 4. CONTROLS AND PROCEDURESPART II. OTHER INFORMATIONItem 1. LEGAL PROCEEDINGSItem 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIESItem 6. EXHIBITS AND REPORTS FILED ON FORM 8-KSIGNATURESEXHIBIT INDEXExhibit 15Exhibit 31.1Exhibit 31.2Exhibit 32    Table of Contents  TOLLGRADE COMMUNICATIONS, INC. Quarterly Report on Form 10-Q
For the Quarter Ended March 27, 2004 Table of Contents PAGE NO.PART I. FINANCIAL INFORMATIONItem 1
    
    Condensed Consolidated Financial Statements (unaudited):Condensed Consolidated Balance Sheets as of March 27, 2004 and
December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the three-month
period ended March 27, 2004 and March 29, 2003
    
    
    4Condensed Consolidated Statements of Changes in Shareholders Equity for the
three-month period ended March 27, 2004
    
    
    5Condensed Consolidated Statements of Cash Flows for the three-month period
ended March 27, 2004 and March 29, 2003
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Report of Independent Accountants
    
    
    13Item 2
    
    Managements Discussion and Analysis of Financial Condition and Results
of Operations
    
    
    14Item 3
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    34Item 4
    
    Controls and Procedures
    
    
    34PART II. OTHER INFORMATIONItem 1
    
    Legal Proceedings
    
    
    35Item 2
    
    Changes in Securities, Use of Proceeds and
Issuer Purchases of Equity Securities
    
    
    35Item 6
    
    Exhibits and Reports Filed on Form 8-K
    
    
    35SIGNATURES
    
    
    36EXHIBIT INDEX
    
    
    37
 2




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##### Table of Contents



PART I. FINANCIAL INFORMATION 
 Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 
 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited) March 27, 2004
    
    December 31, 2003 *ASSETSCurrent assets:Cash and cash equivalents
    
    $
    27,133,402
    
    
    $
    31,059,972Short-term investments
    
    
    22,400,057
    
    
    
    17,624,668Accounts receivable:Trade
    
    
    10,095,406
    
    
    
    9,254,718Other
    
    
    172,896
    
    
    
    122,231Inventories
    
    
    12,304,079
    
    
    
    11,154,676Prepaid expenses and other current assets
    
    
    1,912,676
    
    
    
    1,534,034Refundable income taxes
    
    
    110,426
    
    
    
    383,704Deferred tax assets
    
    
    1,329,450
    
    
    
    1,361,947Total current assets
    
    
    75,458,392
    
    
    
    72,495,950Property and equipment, net
    
    
    8,152,827
    
    
    
    8,292,412Deferred tax assets
    
    
    1,134,671
    
    
    
    1,152,846Intangibles
    
    
    44,500,000
    
    
    
    44,500,000Goodwill
    
    
    19,339,682
    
    
    
    19,339,682Capitalized software costs, net
    
    
    7,240,950
    
    
    
    7,712,624Receivable from officer
    
    
    160,297
    
    
    
    160,940Other assets
    
    
    169,512
    
    
    
    174,520Total assets
    
    $
    156,156,331
    
    
    $
    153,828,974LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,023,285
    
    
    $
    1,007,178Accrued warranty
    
    
    2,222,665
    
    
    
    2,149,905Accrued expenses
    
    
    763,993
    
    
    
    589,215Accrued salaries and wages
    
    
    995,325
    
    
    
    911,725Accrued royalties payable
    
    
    481,280
    
    
    
    395,710Income taxes payable
    
    
    1,392,799
    
    
    
    1,018,230Deferred income
    
    
    642,682
    
    
    
    480,235Total current liabilities
    
    
    7,522,029
    
    
    
    6,552,198Deferred tax liabilities
    
    
    1,677,474
    
    
    
    1,447,690Total liabilities
    
    
    9,199,503
    
    
    
    7,999,888Commitments and contingent liabilities
    
    
    
    
    
    
    Shareholders equity:Preferred stock, $1.00 par value;Authorized shares, 10,000,000; issue shares, -0-In 2003 and 2004
    
    
    
    
    
    
    Common
stock, $.20 par value; authorized shares,
50,000,000; issued shares, 13,580,370 in 2003 and
13,584,404 in 2004
    
    
    2,716,881
    
    
    
    2,716,074Additional paid-in capital
    
    
    70,855,493
    
    
    
    70,808,584Treasury stock, at cost, 461,800 shares
    
    
    (4,790,783
    )
    
    
    (4,790,783
    )Retained earnings
    
    
    78,175,237
    
    
    
    77,095,211Total shareholders equity
    
    
    146,956,828
    
    
    
    145,829,086Total liabilities and shareholders equity
    
    $
    156,156,331
    
    
    $
    153,828,974
 * Amounts derived from audited financial statements The accompanying notes are an integral part of the condensed consolidated
financial statements. 3




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TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited) Three Months EndedMarch 27, 2004
    
    March 29, 2003Revenues:Products
    
    $
    14,454,630
    
    
    $
    11,571,101Services
    
    
    3,152,519
    
    
    
    2,972,322Total revenues:
    
    
    17,607,149
    
    
    
    14,543,423Cost of sales:Products
    
    
    6,014,468
    
    
    
    5,292,128Services
    
    
    859,825
    
    
    
    789,570Amortization of intangibles
    
    
    473,333
    
    
    
    892,5787,347,626
    
    
    
    6,974,276Gross profit
    
    
    10,259,523
    
    
    
    7,569,147Operating expenses:Selling and marketing
    
    
    2,471,588
    
    
    
    1,970,654General and administrative
    
    
    1,934,174
    
    
    
    1,737,003Research and development
    
    
    4,191,788
    
    
    
    3,321,218Total operating expense
    
    
    8,597,550
    
    
    
    7,028,875Income from operations
    
    
    1,661,973
    
    
    
    540,272Other income:Interest income (including
interest income from
officer receivable of
$1,900 and $2,000 in 2004
and 2003)
    
    
    90,182
    
    
    
    147,422Income before taxes
    
    
    1,752,155
    
    
    
    687,694Provision for income taxes
    
    
    672,129
    
    
    
    261,324Net income
    
    $
    1,080,026
    
    
    $
    426,370Earnings per share information:Weighted average shares of common
stock and equivalents:Basic
    
    
    13,120,356
    
    
    
    13,090,936Diluted
    
    
    13,351,902
    
    
    
    13,211,883Net income per common share:Basic
    
    $
    .08
    
    
    $
    .03Diluted
    
    $
    .08
    
    
    $
    .03
 The accompanying notes are an integral part of the condensed consolidated financial statements. 4




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TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY
For the Three Months Ended March 27, 2004 (Unaudited) AdditionalPreferred Stock
    
    Common Stock
    
    Paid-In
    
    Treasury
    
    RetainedShares
    
    Amount
    
    Shares
    
    Amount
    
    Capital
    
    Stock
    
    Earnings
    
    TotalBalance at
December 31, 2003
    
    
    
    
    
    $
    
    
    
    
    13,580,370
    
    
    $
    2,716,074
    
    
    $
    70,808,584
    
    
    $
    (4,790,783
    )
    
    $
    77,095,211
    
    
    $
    145,829,086Exercise of common
Stock options
    
    
    
    
    
    
    
    
    
    
    4,034
    
    
    
    807
    
    
    
    31,826
    
    
    
    
    
    
    
    
    
    
    
    32,633Tax benefit from
exercise of stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    15,083
    
    
    
    
    
    
    
    
    
    
    
    15,083Net Income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,080,026
    
    
    
    1,080,026Balance at
March 27, 2004
    
    
    
    
    
    $
    
    
    
    
    13,584,404
    
    
    $
    2,716,881
    
    
    $
    70,855,493
    
    
    $
    (4,790,783
    )
    
    $
    78,175,237
    
    
    $
    146,956,828
 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
(Unaudited) Three Months EndedMarch 27, 2004
    
    March 29, 2003Cash flows from operating activities:Net income
    
    $
    1,080,026
    
    
    $
    426,370Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization
    
    
    1,099,161
    
    
    
    1,441,233Tax benefit from exercise of stock options
    
    
    15,083
    
    
    
    Refund and utilization of income taxes paid
    
    
    273,278
    
    
    
    Deferred income taxes
    
    
    280,456
    
    
    
    (124,935
    )Provision for losses on inventory
    
    
    (14,231
    )
    
    
    133,377Disposition of slow moving and obsolete inventory
    
    
    (143,669
    )
    
    
    (122,169
    )Provision for allowance for doubtful accounts
    
    
    80,820
    
    
    
    200,000Changes in assets and liabilities:(Increase) decrease in accounts receivable-trade
    
    
    (921,508
    )
    
    
    873,166Increase in accounts receivable-other
    
    
    (50,665
    )
    
    
    (37,967
    )(Increase) decrease in inventory
    
    
    (991,503
    )
    
    
    521,445(Increase) decrease in prepaid expenses and other assets
    
    
    (374,650
    )
    
    
    249,211Increase in accounts payable
    
    
    16,107
    
    
    
    1,167,846Increase in accrued warranty
    
    
    72,760
    
    
    
    448,373Increase in accrued expenses and deferred income
    
    
    337,225
    
    
    
    178,098Increase in accrued salaries and wages
    
    
    83,600
    
    
    
    365,113Increase (decrease) in accrued royalties payable
    
    
    85,570
    
    
    
    (18,513
    )Increase in income taxes payable
    
    
    374,569
    
    
    
    412,056Net cash provided by operating activities
    
    
    1,302,429
    
    
    
    6,112,704Cash flows from investing activities:Purchase of Cheetah
    
    
    
    
    
    
    (14,899,010
    )Redemption/maturity of short-term investments
    
    
    1,508,883
    
    
    
    2,620,452Purchase of short-term investments
    
    
    (6,284,272
    )
    
    
    (875,000
    )Capital expenditures
    
    
    (486,243
    )
    
    
    (722,188
    )Net cash used in investing activities
    
    
    (5,261,632
    )
    
    
    (13,875,746
    )Cash Flows from financing activities:Proceeds from exercise of stock options
    
    
    32,633
    
    
    
    Net cash provided by financing activities
    
    
    32,633
    
    
    
    Net decrease in cash and cash equivalents
    
    
    (3,926,570
    )
    
    
    (7,763,042
    )Cash and cash equivalents at beginning of period
    
    
    31,059,972
    
    
    
    33,799,284Cash and cash equivalents at end of period
    
    $
    27,133,402
    
    
    $
    26,036,242
 The accompanying notes are an integral part of the condensed financial statements 6




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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements included
herein have been prepared by Tollgrade Communications, Inc. (the Company) in
accordance with accounting principles generally accepted in the United States
of America for interim financial information and Article 10 of Regulation S-X.
The condensed consolidated financial statements as of and for the three-month
period ended March 27, 2004 should be read in conjunction with the Companys
consolidated financial statements (and notes thereto) included in the Companys
Annual Report on Form 10-K for the year ended December 31, 2003. Accordingly,
the accompanying condensed consolidated financial statements do not include all
of the information and footnotes required by accounting principles generally
accepted in the United States of America for complete financial statements,
although the Company believes that the disclosures are adequate to make the
information presented not misleading. In the opinion of Company management, all
adjustments considered necessary for a fair presentation of the accompanying
condensed consolidated financial statements have been included, and all
adjustments are of a normal and recurring nature. Operating results for the
three-month period ended March 27, 2004 are not necessarily indicative of the
results that may be expected for the year ending December 31, 2004. 2. ACCOUNTING FOR STOCK-BASED COMPENSATION The Company has two stock-based employee compensation plans. The Company
accounts for these plans under the recognition and measurement provisions of
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued
to Employees. Under these provisions, stock-based employee compensation cost
is not reflected in net income for any year, as all options granted under the
plans had an exercise price equal to the market value of the underlying common
stock on the date of grant. If the Company had elected to recognize
compensation cost for these stock options based on the fair value method set
forth in Statement of Financial Accounting Standards (SFAS) No. 123,
Accounting for Stock-Based Compensation, net income and earnings per share
would have reflected the pro forma amounts indicated below: Three Months endedMarch 27, 2004
    
    March 29, 2003Net income, as reported
    
    $
    1,080,026
    
    
    $
    426,370Deduct: Total stock-based
compensation expense based on the fair
value method for all awards, net of related
tax effects
    
    
    74,771
    
    
    
    558,309Pro forma net income
    
    $
    1,005,255
    
    
    $
    (131,939
    )Earnings (loss) per share:Basic  as reported
    
    $
    0.08
    
    
    $
    0.03Basic  pro forma
    
    $
    0.08
    
    
    $
    (0.01
    )Diluted  as reported
    
    $
    0.08
    
    
    $
    0.03Diluted  pro forma
    
    $
    0.08
    
    
    $
    (0.01
    )
 7




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3. ACQUISITION On February 13, 2003, the Company acquired certain assets and assumed certain
liabilities of the Cheetah(TM)status and performance monitoring product line
(Cheetah) from Acterna, LLC (Acterna) for approximately $14,300,000 in
cash. In addition, acquisition-related costs of approximately $599,000 were
capitalized for a total cost of approximately $14,899,000. The transaction
provided for an earn-out to be paid in the first half of 2004 of up to
$2,400,000 based on certain 2003 performance targets. The current calculation
indicates that amounts due under this provision are immaterial. The acquired
assets consist principally of existing sales order backlog, product inventory,
intellectual property, software and related computer equipment, while the
assumed liabilities principally relate to deferred software maintenance,
warranty and other obligations. The $14,300,000 due at closing and related
acquisition expenses were paid from available cash and short-term investments.
The Company believes that the acquired product line complements its current
cable operations and positions the Company as a leading supplier of testing
equipment and software for the cable industry. The acquisition was recorded
under the purchase method of accounting in accordance with the provisions of
SFAS No. 141, Business Combinations and SFAS No. 142, Goodwill and Other
Intangible Assets, and accordingly, the results of operations of the acquired
product line from February 14, 2003 forward are included in the consolidated
financial statements of the Company. The Company has made an allocation of the Cheetah purchase price to the fair
value of assets acquired and liabilities assumed. The purchase price remains
subject to change pending resolution between the parties of outstanding
contingencies regarding the earn-out provision, remaining purchase price
adjustments or other matters. Any changes to the purchase price arising from
the resolution of these matters are expected to be accounted for as adjustments
to goodwill and may be material. The following condensed proforma results of operations reflect the
proforma combination of the Company and the acquired Cheetah product line as if
the combination occurred on January 1, 2003. (In Thousands, Except Per Share Data)Three Months EndedMarch 29, 2003ProformaRevenues
    
    $
    15,906Income from operations
    
    
    1,168Net income
    
    
    801Diluted earnings per share
    
    $
    0.06
 These adjustments were made to reflect significant changes to operations made
by the Company since the acquisition. This proforma financial information is
presented for comparative purposes only and is not necessarily indicative of
the operating results that actually would have occurred had the Cheetah product
line acquisition been consummated on January 1, 2003. In addition, these
results are not intended to be a projection of future results. 8




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4. INTANGIBLE ASSETS The following information is provided regarding the Companys intangible assets
and goodwill: As of March 27, 2004
    
    As of December 31, 2003Gross
    
    
    
    
    
    GrossCarrying
    
    Accumulated
    
    Carrying
    
    AccumulatedAmount
    
    Amortization
    
    Amount
    
    AmortizationAmortized intangible assets:Current:Cheetah Sales order
backlog
    
    $
    543,273
    
    
    $
    541,101
    
    
    $
    543,273
    
    
    $
    539,442Capitalized Software:Developed product software
    
    
    7,483,483
    
    
    
    3,687,532
    
    
    
    7,483,483
    
    
    
    3,313,359Base
software - Cheetah
    
    
    2,900,000
    
    
    
    338,334
    
    
    
    2,900,000
    
    
    
    265,833Proprietary technology
    
    
    1,000,000
    
    
    
    116,667
    
    
    
    1,000,000
    
    
    
    91,667Total
Capitalized
Software (long
term)
    
    $
    11,383,483
    
    
    $
    4,142,533
    
    
    $
    11,383,483
    
    
    $
    3,670,859Non-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 Intangibles
    
    $
    44,500,000
    
    
    $
    
    
    
    $
    44,500,000
    
    
    $
    Goodwill:Loopcare
    
    $
    15,949,808
    
    
    $
    
    
    
    $
    15,949,808
    
    
    $
    Cheetah
    
    
    3,389,874
    
    
    
    
    
    
    
    3,389,874
    
    
    
    Total Goodwill
    
    $
    19,339,682
    
    
    $
    
    
    
    $
    19,339,682
    
    
    $
    
 Estimated amortization expense for the years ended: December 31, 2004
    
    $
    1,890,533December 31, 2005
    
    
    1,886,701December 31, 2006
    
    
    1,521,701December 31, 2007
    
    
    422,604December 31, 2008
    
    
    402,413
 9




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5. INVENTORIES At March 27, 2004 and December 31, 2003, inventories consisted of the
following: March 27,
    
    December 31,2004
    
    2003Raw materials
    
    $
    6,541,318
    
    
    $
    7,398,419Work in process
    
    
    5,039,952
    
    
    
    3,723,409Finished goods
    
    
    2,029,908
    
    
    
    1,497,84813,611,178
    
    
    
    12,619,676Reserve for slow moving and
obsolete inventory
    
    
    (1,307,099
    )
    
    
    (1,465,000
    )$
    12,304,079
    
    
    $
    11,154,676
 6. SHORT-TERM INVESTMENTS Short-term investments at March 27, 2004 and December 31, 2003 consisted of
individual municipal bonds stated at cost, which approximated market value.
These securities have maturities of one year or less at date of purchase and/or
contain a callable provision in which the bonds can be called within one year
from date of purchase. The primary investment purpose is to provide a reserve
for future business purposes, including acquisitions and capital expenditures.
Realized gains and losses are computed using the specific identification
method. The Company classifies its investment in all debt securities as held to
maturity, as the Company has the intent and ability to hold the securities to
maturity. The estimated fair values of the Companys financial instruments are as
follows: March 27,
    
    December 31,2004
    
    2003Carrying
    
    Fair
    
    Carrying
    
    FairAmount
    
    Value
    
    Amount
    
    ValueFinancial assets:Cash and cash equivalents
    
    $
    27,133,402
    
    
    $
    27,133,402
    
    
    $
    31,059,972
    
    
    $
    31,059,972Short-term investments
    
    
    22,400,057
    
    
    
    22,442,550
    
    
    
    17,624,668
    
    
    
    17,609,031$
    49,533,459
    
    
    $
    49,575,952
    
    
    $
    48,684,640
    
    
    $
    48,669,003
 10




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7. PER SHARE INFORMATION Net 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, as defined. Basic earnings per share are
calculated on the actual number of weighted average common shares outstanding
for the period, while diluted earnings per share must include the effect of any
dilutive securities. A reconciliation of earnings per share is as follows: Three Months
    
    Three MonthsEnded
    
    EndedMarch 27, 2004
    
    March 29, 2003Net income
    
    $
    1,080,026
    
    
    $
    426,370Common and common equivalent shares:Weighted average common shares outstanding
    
    
    13,120,356
    
    
    
    13,090,936Effect of dilutive securities  stock options
    
    
    231,546
    
    
    
    120,94713,351,902
    
    
    
    13,211,883Earnings per share:Basic
    
    $
    .08
    
    
    $
    .03Diluted
    
    $
    .08
    
    
    $
    .03
 8. ACCOUNTING PRONOUNCEMENTS On January 17, 2003, the FASB issued FASB Interpretation No. 46, Consolidation
of Variable Interest Entities  an interpretation of ARB No. 51 (FIN 46).
FIN 46 clarifies the application of Accounting Research Bulletin No. 51,
Consolidated Financial Statements, to certain entities in which equity
investors do not have the characteristics of a controlling financial interest
or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other
parties. Certain provisions of FIN 46 were effective for the Company after
January 31, 2003 and did not have an impact on the Companys results of
operations or financial condition. FIN No. 46 was revised in December 2003
and is effective for the first financial reporting period ending after March
15, 2004. The Company adopted the provisions of FIN No. 46 for the fiscal
quarter ending March 27, 2004, which did not have an impact on the financial
statements. The Company has no interest in any variable interest entities. 9. 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 11




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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 27, 2004
    
    December 31, 2003Balance at the beginning of the period
    
    $
    2,150,000
    
    
    $
    1,981,000Accruals for warranties issued
during the period
    
    
    104,000
    
    
    
    872,000Accruals related to pre-existing warranties
    
    
    
    
    
    
    (182,000
    )Cheetah opening accrual
    
    
    
    
    
    
    225,000Settlements during the period
    
    
    (31,000
    )
    
    
    (746,000
    )Balance at the end of the period
    
    $
    2,223,000
    
    
    $
    2,150,000
 10. CONTINGENCIES We are currently 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, and although the
outcome could be material to interim results of operations or cash
flow, we do not believe that the
outcome of any of these claims will have a material adverse effect on our
consolidated financial position, or annual results of operations, or cash flow. 12




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REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of
Tollgrade Communications, Inc. and subsidiaries: We have reviewed the accompanying condensed consolidated balance sheet of
Tollgrade Communications, Inc. and its subsidiaries as of March 27, 2004, and
the related condensed consolidated statements of operations for each of the
three-month period ended March 27, 2004 and March 29, 2003 and the condensed
consolidated statement of cash flows for the three-month period March 27, 2004
and March 29, 2003 and the statement of changes in shareholders equity for the
three-month period ended March 27, 2004. These financial statements are the
responsibility of the Companys management. We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data and making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted
in accordance with generally accepted auditing standards, the objective of
which is the expression of an opinion regarding the financial statements taken
as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should
be made to the accompanying condensed consolidated interim financial statements
for them to be in conformity with accounting principles generally accepted in
the United States of America. We previously audited in accordance with auditing standards generally accepted
in the United States of America, the consolidated balance sheet as of December
31, 2003, and the related consolidated statements of operations, shareholders
equity and of cash flows for the year then ended (not presented herein), and in
our report dated January 21, 2004 we expressed an unqualified opinion on those
consolidated financial statements. In our opinion, the information set forth
in the accompanying condensed consolidated balance sheet as of December 31,
2003 is fairly stated in all material respects in relation to the consolidated
balance sheet from which it has been derived. /s/ PricewaterhouseCoopers LLP Pittsburgh, Pennsylvania
April 15, 2004 13




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Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the Condensed
Consolidated Financial Statements and Notes thereto appearing elsewhere in this
report. CAUTIONARY STATEMENT FOR PURPOSES OF THE SAFE HARBOR PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. The statements contained in this Quarterly Report on Form 10-Q, including, but
not limited to those contained in Item 2- Managements Discussion and Analysis
of Results of Operations and Financial Condition, along with statements in
other reports filed with the Securities and Exchange Commission (the SEC),
external documents and oral presentations, which are not historical facts are
considered forward-looking statements within the meaning of Section 27A of
the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. These statements, which may be expressed in
a variety of ways, including the use of forward-looking terminology such as
"will, believes, intends, expects, plans, could or may,or the
negatives thereof, other variations thereon or comparable terminology, relate
to, among other things, projected cash flows which are used in the valuation of
intangible assets, the anticipated results of negotiations for purchase orders
and other customer purchase agreements, changes in our backlog, the
amount of backlog that may be recognized as revenue in future periods, the ability to
utilize deferred and refundable tax assets, opportunities which the Services
group offers to customers, the potential loss of certain customers, the timing
of orders from customers, the effect of consolidations in the markets to which
we sell, the significant portion of our revenues generated from MCU sales and
the expected consequences of the maturation of this market, the opportunities
developing in the cable broadband market, certain international sales
opportunities, circumstances surrounding our LoopCare sales, the impact of the
acquisition of the Cheetah product line on our position in the cable industry,
the effects of the economic slowdown in the telecommunications and cable
industries, the possibility of future provisions for slow moving and obsolete
inventory, and the effect on earnings and cash flows of changes in interest
rates. The Company does not undertake any obligation to publicly update any
forward-looking statements. These forward-looking statements and other forward-looking statements contained
in other public disclosures of the Company which make reference to the
cautionary factors contained in this Form 10-Q are based on assumptions that
involve risks and uncertainties and are subject to change. These risks,
uncertainties and other factors may cause actual results, performance or
achievements to differ materially from anticipated future results, performance
or achievements expressed or implied by such forward looking statements. The
Company wishes to caution each reader of this Form 10-Q to consider the factors
described below and certain other factors discussed herein and in other past
reports including, but not limited to, prior year Annual Reports and Form 10-K
and Form 10-Q reports filed with the SEC. The factors discussed herein may not
be exhaustive. Therefore, the factors discussed herein should be read together with other
reports and documents that are filed by the Company with the SEC from time to
time, which may supplement, modify, supersede or update the factors listed in
this document. 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 provides hardware and software network assurance testing solutions for
the telecommunications and cable broadband industries. Our primary
telecommunications test products are (1) the MCU®, which allows customers to
extend line-testing capabilities from the copper to the fiber optic portions of
the local loop and (2) Digitest® and Loopcare, 14




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which electronically measure
the characteristics of a telephone copper circuit, analyze the data and report
an easy to understand fault condition. In 2001, the Company purchased certain
assets of the LoopCare product line from Lucent Technologies, Inc.. Our primary cable products are the Cheetah performance and status monitoring
products, which gather status information and reports on critical components
within the Broadband Hybrid Fiber Coax (HFC) distribution system. In February,
2003, the Company acquired the Cheetah status and performance monitoring
product line to complement its legacy LIGHTHOUSE products. Today, as a result, the Company operates as 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
systems, test access and status monitoring products 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 repair
their wire telephone lines when they are not functioning properly. When the
telephone lines are out of service, our products help to diagnose the problem.
In addition, our products can assess whether the lines are suitable for Digital
Subscriber Line (DSL) service. Cable networks are highly dependent on other
equipment manufacturers power supplies, which serve as backup power for the
utility power; if such power supplies fail, the cable operators run the risk of
service interruptions to their customers. We provide products to cable
companies that monitor the status of those power supplies. About its customers The Companys primary customers for its telecommunication 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 27, 2004, sales to the RBOCs
accounted for approximately 51% of total revenue, compared to approximately 61%
of total revenue for the first quarter of 2003. Sales to two of the four RBOC customers (SBC and Verizon) individually exceeded
10% of consolidated revenues (19.4% and 16.0%, respectively), and on a combined
basis, comprised 35.4% of the Companys total revenues for the period. 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 2004 and 2003, none of the Companys cable
customers individually accounted for more than 10% of the Companys total
revenues reported for there respective periods. The Company continues to be
highly dependent on the four RBOCs for a significant portion of its total
revenue. Such dependency has generally declined in recent years due to growth
in, and acquisition of, certain Cheetah cable product lines. However, due to
their continuing significance, the potential loss of one or more of them as a
customer or the reduction in orders for the Companys products could materially
and adversely affect the Company. PRODUCTS: TELECOMMUNICATION TEST SYSTEMS Our proprietary telecommunications test access products enable telephone
companies to use their existing line test systems to remotely diagnose problems
in Plain Old Telephone Service (POTS) lines containing both copper and fiber
optics. POTS lines comprise the vast majority of lines in service today
throughout the world. In addition to traditional voice service, POTS lines
provide connections for popular devices such as computer modems and fax
machines. POTS excludes non-switched and private lines, such as data
communications service lines, commonly referred to as special services. 15




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MCU Our core MCU products plug into Digital Loop Carrier (DLC) systems, the large
network transmission systems used by telephone companies to link the copper and
fiber-optic portions of the local loop. MCU products allow our customers to
extend their line testing capabilities to all of their POTS lines, including
copper and fiber-optic lines linked by DLCs. DLC systems, which are located at
telephone companies central offices and at remote sites within local user
areas, effectively multiplex the services of a single fiber-optic line into
multiple copper lines. In many instances, several DLC systems are located at a
single remote site to create multiple local loops that serve several thousand
different end-user homes and businesses. Generally, for every DLC remote site,
customers will deploy at least two MCU line-testing products. DigiTest® and
LoopCare(TM) Our DigiTest system electrically measures the characteristics of a copper
telephone circuit and reports those measurements to our LoopCare Operation
Support System (OSS). The LoopCare OSS, in turn, analyzes that measurement data
and creates an easy-to-understand fault condition. At the same time, the
LoopCare system can generate a dispatch to a work center so that a repairman
can fix the problem. LoopCare and DigiTest also have the capability to tell the
telephone company whether the customer line is suitable for DSL service. In
addition, upgrades to DigiTest hardware can provide troubleshooting for DSL
service problems. In 2003, we announced several enhancements and additions to the DigiTest
system, including the availability of direct Ethernet connectivity to Digital
Measurement Node (DMN) test heads and the introduction of our next generation
broadband test platform, DigiTest EDGE(TM). Through Ethernet connections, the
LoopCare OSS can communicate directly with remotely deployed DigiTest hardware,
allowing it to manage up to four DMNs and eight simultaneous test sessions
through a single Internet Protocol (IP) address. DigiTest EDGE
provides a global platform for broadband test applications, by combining a
narrowband and wideband metallic testing platform with DSL, Asynchronous
Transfer Mode (ATM), IP and Hypertext Transfer Protocol (HTTP) performance
tests. This combination of test capabilities, when managed by our LoopCare OSS,
enables service providers to accurately isolate a DSL problem between the
customers premises, the local exchange carriers local loop and Digital
Subscriber Line Access Multiplexer (DSLAM) serving network, and the Internet
service providers data network. LoopCare, which we acquired from Lucent in 2001, has remained the major OSS
utilized by the Regional Bell Operating Companies (RBOCs) for over twenty-five
years to test the integrity and quality of their POTS network infrastructure.
The LoopCare OSS, which we offer both as part of the DigiTest system and as a
stand-alone software product,
currently manages more than 75% of the copper pairs in the United States, and
is the qualification, installation and maintenance process for more than 150
million POTS, ISDN and DSL subscribers
worldwide. In addition to the LoopCare OSS software sold as part of the DigiTest system,
we also sell new LoopCare features to existing customers and the base LoopCare
OSS as a stand-alone product to Competitive Local Exchange Carriers (CLECs) 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,
and LoopCare TCP/IP Communications Network. In addition, in December 2003, we
released a new LoopCare feature called Testing Voice Services in a Broadband
Passive Optical Network (bPON), which provides support for customer deployment
of Fiber-to-the-Premises (FTTP) solutions. 16




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CABLE TESTING PRODUCTS The Companys cable 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. On February 13, 2003, we acquired the Cheetah product line from
Acterna, LLC, for $14.3 million in cash plus the assumption of certain related
liabilities. As a result of this acquisition, our cable offerings now consist
of our CheetahLight(TM) (formerly LIGHTHOUSE(R)) and CheetahNet(TM) (formerly
NetMentor(TM)) software systems and maintenance, head-end controllers, return
path switch hardware, transponders and other equipment which gather status and
performance reports from power supplies, line amplifiers and fiber optic nodes. Cable television service providers continue to evolve their offerings from
traditional one-way video delivery to bi-directional services, including the
communications triple play of voice, video and data service. The Company
will seek to evaluate, develop and to market network assurance products that
address quality problems related to these advanced services. In addition to
providing internet protocol (IP) based monitoring equipment, such as its line
of DOCSIS-compatible transponders and next generation software
platforms, 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. Of particular
interest are Voice Over Internet Protocol (VoIP) solutions, as well as data network
integrity technologies. As part of this strategy, we have entered into certain third party license
agreements to augment our next generation technology. During the first quarter
of 2004, the Company entered into a License Agreement (Initial Agreement) with
a third party software vendor for certain VoIP technology, pursuant to which
the Company obtained a non-exclusive license to use, further develop and
incorporate into certain of its products such technology. In conjunction with
this agreement, we prepaid approximately $0.3 million in services, license and
royalty fees, which is reflected, as a prepaid asset, in the accompanying
financial statements as of March 27, 2004. The Initial Agreement was replaced and superseded by a second license agreement
during the second quarter of 2004, pursuant to which the Company obtained a
perpetual worldwide right and license to use, further develop and incorporate
into any of its products the technology. Additionally, the agreement
provides that during the term of the agreement, the Company is the sole and
exclusive licensee for particular applications of this technology. The
agreement is for a period of five years. In conjunction with this agreement
the Company paid approximately $0.7 million for the exclusivity right and
prepaid approximately $0.1 million of additional royalty fees. Including the
fees paid in connection with the initial agreement, total fees paid under this
agreement during 2004 were approximately $1.1 million. In addition, there is a
continuing obligation for the Company to pay additional royalties which may
total $0.8 million or less, depending upon the volume of sales of the
underlying product which incorporates the technology. Royalty expense will be
recognized based on the underlying related product sales. The exclusivity fee
will be amortized on a straight line basis over the five year contract period
starting on April 1, 2004. 17




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SERVICES Our Services offerings include software maintenance as well as our professional
services, which are designed to assist our customers in ensuring the proper
operation of all of the components of their voice test systems. The Services
business was considerably expanded upon the acquisition of software maintenance
relationships related to the LoopCare and CheetahNet software product lines. 18




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BACKLOG Our backlog consists of firm customer purchase orders and signed software
maintenance agreements. As of March 27, 2004, the Company had backlog of
approximately $13.6 million compared to $15.3 million as of December 31, 2003. We have completed negotiations and entered into extended LoopCare software
maintenance agreements with all four RBOCs. Three of these agreements have
terms which expire on December 31, 2004, (one can be extended for another year)
while the fourth RBOC maintenance agreement will expire December 31, 2005. The
backlog at March 27, 2004 included approximately $7.4 million related to
software maintenance contracts, which will be earned and recognized as income
on a straight-line basis during the remaining terms of the underlying
agreements. We have adopted a policy to include a maximum of twelve months
revenue from multi-year agreements in reported backlog. Software maintenance
revenue is deemed to be earned and recognized as income on a straight-line
basis over the terms of the underlying agreements. Also included in the backlog is a blanket purchase order for $1.4 million from
a customer which covers that customers MCU requirements for the remainder of
calendar year 2004. The backlog also includes a non-cancelable order received
in 2003 for $1.8 million related to a cable product which is currently under
development. Development had not been completed at March 27, 2004, and the
Company did not ship any of that product during the first quarter of 2004.
Management expects that approximately 34% of the current backlog will be
recognized as revenue in the second quarter of 2004. Periodic fluctuations in
customer orders and backlog result from a variety of factors, including but not
limited to the timing of significant orders and shipments. Although these
fluctuations could impact short-term results, they are not necessarily
indicative of long-term trends in sales of our products. REPORTING SEGMENT We have determined that our business has one reporting segment, the test
assurance industry. All product sales are considered components of the business
of testing infrastructure and networks for the telecommunications and cable
television industries. Although we internally develop historical sales
information associated with the various product categories, this information is
not considered to be sufficient for segment reporting purposes. Our products
and services have similar economic characteristics and the same or similar
production processes, and are sold through comparable distribution channels and
means to similar types and classes of customers already in, or entering into,
the telecommunications and cable businesses. INTERNATIONAL SALES International sales represented approximately 8% of the Companys total revenue
for the quarter ended March 27, 2004, a percentage slightly higher than the
portion of our revenue attributable to international sales for the
corresponding period in 2003. Our 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 in
networks employed abroad. We continue to evaluate opportunities in the
international market that will enhance our international presence and growth.
As part of the effort to expand our international sales, we periodically
receive and respond to requests for proposals from certain international
telephone and cable service providers. During the first quarter of 2004, we
were notified that we were selected as a vendor for an international project.
However, the commercial terms and conditions, which will be significant to the
Company, have not been agreed upon, nor has the final scope
of work or schedule for completion been 19




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finalized. As a result, the
opportunity presented is still being fully evaluated and does have significant
risk of not being consummated, and therefore is not included in the backlog. 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 2003 Annual Report on Form 10-K filed on March 15, 2004. Management
believes the Companys critical accounting policies are those related to Staff
Accounting Bulletin (SAB 104), Revenue Recognition; AICPAs Statement of
Position (SOP) 97-2  Software Revenue Recognition, and Emerging Issues Task
Force (EITF) Issue 00-21, Accounting for Revenue Arrangements with Multiple
Deliverables; Statement of Financial Accounting Standards (SFAS) No. 141,
Business Combinations; SFAS No. 142, Goodwill and Other Intangible
Assets; SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets; and SFAS No. 109, Accounting for Income Taxes.
Management believes these policies to be critical because they are both
important to the portrayal of the Companys financial condition and results and
they require management to make judgments and estimates based on matters that
are inherently uncertain. There were no significant changes in these policies
or the application thereof during the first quarter of 2004. RESULTS OF OPERATIONS THE FOLLOWING DISCUSSION OF THE RESULTS OF OPERATIONS AND FINANCIAL
CONDITION OF THE COMPANY SHOULD BE READ IN CONJUNCTION WITH THE RESPONSE TO
PART I, ITEM 1 OF THIS REPORT FIRST QUARTER OF 2004 COMPARED TO FIRST QUARTER OF 2003 Revenues The Companys revenues for the first quarter of 2004 were $17.6 million, an
increase of $3.1 million or 21.1% over revenues of $14.5 reported for the first
quarter of 2003. The first quarter 2003 results include revenues for the
Cheetah product line from the February 13, 2003 acquisition date through March
29, 2003. The first quarter results for 2004 include the operations of
Cheetah for the entire period. MCUs, which are sold primarily to the RBOCs, accounted for $7.0 million in
the first quarter of 2004 revenues, an increase of $2.5 million in revenue over
the year earlier quarter. As a result, MCU sales were 39.7% of total first
quarter 2004 revenues compared to 30.7% for the first quarter of 2003. The
increase between periods was due primarily to carryover 2003 capital budgeting
availability at SBC as they continued with their DSL footprint expansion
program in 2004, as well as strong OEM sales to Advanced Fiber Communications
(AFC). We expect MCU sales for the foreseeable future to continue to account
for a substantial portion of the Companys revenue. However, as a result of
the continuing maturation of this product line, the RBOCs desire to limit
capital spending in their traditional POTS networks and the evolution of the
transmission network towards end to end fiber, we expect revenues from the MCU
product line will continue to be very lumpy and on an overall basis decline
over time. Sales of the Companys DigiTest system products, which include LoopCare
software, decreased $0.9 million, or 48.4%, to $0.9 million in the first
quarter of 2004. Sales of new Digitest System products
declined in the first quarter of 2004 as RBOCs continue to restrain capital
spending in traditional POTS testing projects due to budget tightening and
network evolution considerations. Additionally, the first quarter of 2003
benefited from 20




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a large deployment of Digitest to a Competitive Local Exchange
Carrier (CLEC) customer, which was not repeated in the first quarter of this
year. DigiTest system sales accounted for 5.3% and 12.5% of total revenues for
the first quarter of 2004 and 2003, respectively. Sales of LoopCare software products separate and unrelated to DigiTest system
products decreased $0.3 million, or 14.3%, to $1.6 million 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. As a result, the
current quarter revenue was negatively affected by this process. The Company
believes that the decline in LoopCare software sales in the first quarter of
2004 is not necessarily reflective of a trend, but is attributable to the
uneven nature of the software sales process. LoopCare software product sales
comprised 9.1% and 12.9% of total revenues during the first quarter of 2004 and
2003, respectively. Overall sales of cable hardware and software products increased $1.5 million or
44%, to $4.9 million in the first quarter of 2004. The increase in the first
quarter of 2004 is attributable to Cheetah results included for the entire
first quarter of the current year and to increased buying by Brighthouse
Networks of legacy Lighthouse cable equipment. Cable hardware and software
sales amounted to 28.0% and 23.5% of total first quarter 2004 and 2003 revenue,
respectively. Services revenues, which include installation oversight and project management
services provided to RBOC and other customers and fees for LoopCare and Cheetah
software maintenance, increased $0.2 million to $3.2 million in the first
quarter of 2004. The increase is primarily attributed to the inclusion of
Services revenue from the Cheetah product line in the results for the entire
2004 first quarter. Service revenues amounted to 17.9% and 20.4% of total first
quarter 2004 and 2003 revenue, respectively. Service revenues as a percentage
of total revenue decreased due to the increased MCU sales levels. Periodic fluctuations in customer orders and backlog result from a variety of
factors, including but not limited to the timing of significant orders from,
shipments to, and acceptance of software by RBOC customers, and are not
necessarily indicative of long-term trends in sales of the Companys products. We experienced some improvement in our core equipment markets in the latter
part of 2003 and during the first quarter of 2004 but remain uncertain as to
continuing strength in this area in the foreseeable future as key customers are
expected to continue to restrict their capital budgets. Events at several key
RBOC customers could stall product field trails, testability projects and
network system deployment. These events include a customers potential work
stoppage, as well as a management reorganization at another customer. We
continue to focus on product diversity through research and development and
acquisitions. In 2003, we introduced our next generation DigiTest EDGE test
head for the evolving broadband network and continue to invest in research to
develop new and improved products to stimulate demand for our hardware and
software products. Our acquisition of Cheetah on February 13, 2003,
substantially strengthened our CATV product market position. We continually
search, and from time to time evaluate, new acquisition opportunities which
will complement and strengthen our core equipment product offerings. Gross Profit Gross profit for the first quarters of 2004 and 2003 was $10.3 million and $7.6
million, respectively, representing an increase of $2.7 million, or 35.5%. The
increase in gross profit is attributed primarily to
additional sales volume of our higher margin MCU channel units. As a percentage
of sales, gross profit for the quarter was 58.3% versus 52.0% for the year ago
period. The gross margin percentage also benefited from a reduction in
amortization expense and warranty costs. Amortization expense decreased $.4
million from $0.9 21




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million in the first quarter of 2003 to $0.5 million. The
first quarter of 2003 included amortization related to the Cheetah purchased
sales order backlog which was amortized during the first and second quarters of
2003. Warranty costs were $0.1 million versus $0.5 million in the first
quarter of 2003. This decrease is primarily attributed to favorable actual
warranty experience in the first quarter of 2004. Selling and Marketing Expense Selling and marketing expense, which consists primarily of payroll related
costs, consulting expense and travel costs, for the first quarter of 2004 was
$2.5 million compared to $2.0 million for the first quarter of 2003. The
increase of $0.5 million, or 25.4%, is primarily due to increased incentive
compensation and sales commissions related to operating performance and
additional costs related to the CheetahNet and CheetahLight product lines. As
a percentage of revenues, selling and marketing expenses increased from 13.6%
in the first quarter of 2003 to 14.0% in the first quarter of 2004. 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
2004 was $1.9 million, an increase of $0.2 million, or 11.4%, from the $1.7
million recorded in the first quarter of 2003. The increase is primarily due
to additional costs related to the CheetahNet and CheetahLight product lines.
As a percentage of revenues, general and administrative expenses decreased to
11.0% in the first quarter of 2004 from 11.9% in the first quarter of 2003. Research and Development Expense Research and development expense, which consists primarily of payroll related
costs, depreciation expense and rent expense in the first quarter of 2004 was
$4.2 million, an increase of $0.9 million, or 26.2%, from the $3.3 million
recorded in the first quarter of 2003. The increase is primarily due to
additional costs related to the CheetahNet and CheetahLight product lines. As
a percentage of revenues, research and development expense increased to 23.8%
in the first quarter of 2004 from 22.8% in the prior year quarter. Interest and Other Income Interest and other income, composed primarily of interest income in both
quarterly periods, decreased by $0.1 million. This decrease was the result of
lower market yields on short-term interest bearing investments compared with
the prior year quarter. Provision for Income Taxes The provision for income taxes for the first quarter of 2004 was $0.7 million,
an increase of $0.4 million from the $0.3 recorded for the first quarter of
2003. The effective income tax rate for both periods is approximately 38% of
pretax income. Net Income and Earnings Per Share As a result of the above factors, net income for the first quarter of 2004 was
$1.1 million, an increase of $0.7 million over the $0.4 million recorded in the
first quarter of 2003. Basic and diluted earnings per common share of $0.08 for
the first quarter of 2004 were $0.05 above the prior year quarter of $0.03.
Basic and diluted weighted average common and common equivalent shares
outstanding were 13,120,356 and 13,351,902 respectively, in the first quarter
of 2004 compared to 13,090,936 and 13,211,883, respectively, in the first 22




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quarter of 2003. As a percentage of revenues, net income for the first quarter
of 2004 increased to 6.1% from 2.9% for the first quarter of 2003. CHEETAH ACQUISITION On February 13, 2003, we acquired certain assets and assumed certain
liabilities of the Cheetah Status and Performance Monitoring Product Line from
Acterna, LLC for approximately $14.3 million in cash. We also capitalized
acquisition related costs of approximately $0.6 million for a total cost of
approximately $14.9 million. The transaction provided for an earn-out to be
paid in the first half of 2004 of up to $2.4 million based on certain 2003
performance targets. The current calculation indicates that amounts due under
this provision are immaterial. The acquired assets consisted principally of
existing sales order backlog, product inventory, intellectual property,
software and related computer equipment, while the assumed liabilities
principally related to deferred software maintenance, warranty and other
obligations. The $14.3 million due at closing and related acquisition expenses
were paid from available cash and short-term investments. We believe that the
acquired product line complements our existing cable offering and positions the
Company as a leading supplier of testing equipment and software for the cable
industry. The acquisition was recorded under the purchase method of accounting
and, accordingly, the results of operations of the acquired product line from
February 14, 2003 forward are included in our consolidated financial
statements. The purchase price remains subject to change pending
resolution
between the parties of outstanding contingencies regarding the earn-out provision and post closing purchase
price adjustments. LIQUIDITY AND CAPITAL RESOURCES As of March 27, 2004, the Company had working capital of $67.9 million, an
increase of $2.0 million, or 3%, from $65.9 million of working capital as
of December 31, 2003. The increase in working capital is primarily the result
of operating cash flow in excess of purchases of property and equipment.
Significant changes in the composite elements of working capital during the
first quarter of 2004 include a $0.8 million increase in accounts receivable
and an $1.1 million increase in inventories. These increases in working
capital were partially offset by a $0.4 million increase in income taxes
payable, both of these factors due in part to strong sales in the first
quarter. As of March 27, 2004, the Company had $49.5 million of cash, cash
equivalents and short-term investments that are unrestricted and available for
corporate purposes, including acquisitions and other general working capital
requirements. The Company has in place a five-year $25.0 million Unsecured Revolving Credit
Facility (the Facility) with a bank. Under the terms of the Facility, the
proceeds must be used for general corporate purposes, working capital needs,
and in connection with certain acquisitions. The Facility contains certain
standard covenants with which we must comply, including a minimum fixed charge
ratio, a minimum defined level of tangible net worth and a restriction on the
amount of capital expenditures that can be made on an annual basis. A maximum
leverage ratio restricts our total borrowings to approximately $21.7 million
during the second quarter of 2004. Commitment fees are payable quarterly at an
annual rate of 0.25% of the unused commitment. The Facility was amended in
February 2003 in connection with our acquisition of the Cheetah product line to
adjust the determination of base net worth. As of March 27, 2004 and currently,
there are no outstanding borrowings under the Facility, and we are in
compliance with all debt covenants. We do not anticipate any short-term
borrowings for working capital as we believe our cash reserves and internally
generated funds will be sufficient to sustain working capital requirements for
the foreseeable future. The Company expects to incur capital expenditures totaling
approximately $3.0 million in 2004 including projects for test fixtures and development
system 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 in the 23




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foreseeable future, 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 first quarter of 2004. The impact of inflation on both the Companys financial position and the
results of operations has been minimal and is not expected to adversely affect
our 2004 results. Our financial position enables us to meet our cash
requirements for operations and capital expansion programs. RELATED PARTY TRANSACTION Gregory Quiggle was hired by the Company as Executive Vice President of
Marketing on August 13, 2001. In connection with the recruitment of Mr.
Quiggle, the Company made a loan to Mr. Quiggle in the amount of $210,000
pursuant to a Promissory Note (the Note) with interest accruing at 5% per
annum. The remaining outstanding balance of $160,297 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. 24




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COMMITMENTS The Company leases office space and equipment under agreements that are
accounted for as operating leases. The office lease for the Cheswick facility
expired December 31, 2003 but was extended to December 31, 2005. The equipment
leases expire in August 2005 for the Cheswick facility and January 2007 for the
Bridgewater facility. On February 18, 2003, the Company entered into a lease
for office space to house the Cheetah product line in Sarasota, Florida under a
lease expiring on April 26, 2008. The Company is also involved in various
month-to-month leases for research and development equipment. Minimum annual
future rental commitments under non-cancelable leases are as follows: 2004 (Remaining nine- months)
    
    
    1,200,0002005
    
    
    1,598,0002006
    
    
    867,0002007
    
    
    438,0002008
    
    
    104,000
 KEY RATIOS The Companys days sales outstanding (DSO) in accounts receivable trade, based
on the past twelve months rolling revenue, were 65 and 57 days as of March 27,
2004 and December 31, 2003, respectively. This increase is due primarily to the
fact that a much higher percentage of total quarterly revenue was recorded in
March of the first quarter of 2004 compared to December in the fourth quarter
of 2003. The Companys inventory turnover ratio was 2.1 and 2.3 turns at March
27, 2004 and December 31, 2003, respectively. ACCOUNTING PRONOUNCEMENTS On January 17, 2003, the FASB issued FASB Interpretation No. 46, Consolidation
of Variable Interest Entities  an interpretation of ARB No. 51 (FIN 46).
FIN 46 clarifies the application of Accounting Research Bulletin No. 51,
Consolidated Financial Statements, to certain entities in which equity
investors do not have the characteristics of a controlling financial interest
or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other
parties. Certain provisions of FIN 46 were effective for the Company after
January 31, 2003 and did not have an impact on the Companys results of
operations or financial condition. FIN No. 46 was revised in December 2003
and is effective for the first financial reporting period ending after March
15, 2004. The Company adopted the provisions of FIN No. 46 for the fiscal
quarter ending March 27, 2004, which did not an impact on the financial
statements. The Company has no interest in any variable interest entities. RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATING RESULTS AND FINANCIAL CONDITION We wish to caution each reader of this Form 10-Q to consider the following
factors and certain other factors discussed herein and in other past reports,
including but not limited to prior year Form 10-K and Form 10-Q reports and
annual reports filed with the SEC. Our business and results of operations could
be seriously impaired by any of the following risks. The factors discussed
herein may not be exhaustive. Therefore, the factors contained herein should be
read together with other reports and documents that we file with the SEC from
time to time, which may supplement, modify, supercede or update the factors
listed in this document. 25




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We depend upon a few major customers for a majority of our revenues, and the
loss of any of these customers, or the substantial reduction in the products
that they purchase from us, would significantly reduce our revenues and net
income. 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;
    
    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 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. 26




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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. We depend on sales of our MCU products for a significant portion of our
revenues. A large portion of our sales have historically attributable to our MCU
products. We expect that our MCU products will continue to account for a
substantial percentage of our revenues for the foreseeable future. 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
like the present hybrid POTS network, could materially impact our MCU sales. If
our major customers fail to continue to build-out their DSL networks and other
projects requiring DLC deployments, or if we otherwise satisfy the domestic
telecommunications markets demand for MCUs, our future results would be
materially and adversely affected. The sale of our products is dependent upon our ability to satisfy the
proprietary requirements of our customers and respond to rapid technological
change, including evolving industry-wide standards. We depend upon a relatively narrow range of products for the majority of
our revenue. Our success in marketing our products is dependent upon their
continued acceptance by our customers. In some cases, our customers require
that our products meet their own proprietary requirements. If we are unable to
satisfy such requirements, or forecast and adapt to changes in such
requirements, our business could be materially harmed. Rapid technological change, including evolving industry standards, could
also render our products obsolete. The adoption of industry-wide standards,
such as the HMS and DOCSIS® cable standards, may result in the elimination of
or reductions in the demand for many of our proprietary products, such as our
Cheetah head-end hardware products and other Cheetah products. Furthermore,
standards for new services and technologies continue to evolve, requiring us to
continually modify our products or to develop new versions to meet these new
standards. If we are unable to forecast the demand
for, and to develop new products or to adapt our existing products to meet,
these evolving standards and other technological innovations, or if our
products and services do not gain the acceptance of our customers, there could
be a negative effect on our future results. 27




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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 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 28




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competitive or other conditions. The loss of these PDIC license agreements, or
our inability to maintain an adequate supply of PDICs on acceptable terms,
could have a material adverse effect on our business. Our reliance on third parties to manufacture certain aspects of our products
involves risks, including, delays in product shipments and reduced control over
product quality. We depend upon a limited number of third party subcontractors to
manufacture certain aspects of our products. Furthermore, the components of our
hardware products are procured from a limited number of outside suppliers. Our
reliance upon such third party contractors involve several additional risks,
including reduced control over manufacturing costs, delivery times, reliability
and quality components. Although our products generally use industry standard
products, some parts, such as ASICs, are custom made to our specifications. If
we were to encounter a shortage of key manufacturing components from limited
sources of supply, or experience manufacturing delays caused by reduced
manufacturing capacity or integration issues related to our acquisition of the
Cheetah product line, the loss of key assembly subcontractors or other factors,
we could experience lost revenues, increased costs, delays in, cancellations or
rescheduling of orders or shipments, any of which would materially harm our
business. We have recently completed, and may pursue additional, acquisitions, which will
complicate our management tasks and could result in substantial expenditures. We have recently completed, and we may pursue additional, acquisitions of
companies, product lines and technologies as part of our efforts to enhance our
existing products, to introduce new products and to fulfill changing customer
requirements. Acquisitions involve numerous risks, including the disruption of
our business, exposure to assumed or unknown liabilities of the acquired
target, and the failure to integrate successfully the operations and products
of acquired businesses. Goodwill arising from acquisitions may result in
significant charges against our operating results in one or more future
periods. Furthermore, we may never achieve the anticipated results or benefits
of an acquisition, such as increased market share or the successful development
and sales of a new product. The effects of any of these risks could materially
harm our business and reduce our future results of operations. In addition, the carrying value of certain of our intangible assets,
consisting primarily of goodwill related to our LoopCare software and Cheetah
product line acquisitions from Lucent Technologies, Inc. and Acterna, LLC,
could be impaired by changing market conditions. We are required under
generally accepted accounting principles to review our amortizable intangible
assets for impairment when events or changes in circumstances indicate the
carrying value may not be recoverable. Goodwill is required to be tested for
impairment at least annually. Factors that may indicate that the carrying
value of our intangible assets may not be recoverable include a decline in
stock price and market capitalization and lower than anticipated cash flows
produced by such intangible assets. If our stock price and market
capitalization decline, or if we do not realize the expected revenues from an
intangible asset, we may be required to
record a significant charge to earnings in our financial statements during the
period in which any impairment of that intangible asset is determined. Our future sales in international markets are subject to numerous risks and
uncertainties. We have limited experience selling our products internationally, and our
future sales in international markets are subject to numerous risks and
uncertainties, including local economic and labor conditions, political
instability including terrorism and other acts of war or hostility, unexpected
changes in the regulatory environment, trade protection measures, tax laws, our
ability to market current or develop new products suitable for international
markets, 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. 29




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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, 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. 30




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We recently emphasized our network assurance and testing software solutions and
cable status monitoring products, areas in which we have limited experience. We acquired the LoopCare software and Cheetah product lines in 2001 and
2003, respectively. As a result we have a very limited operating history in
developing, marketing and selling network assurance and testing software
solutions and cable status marketing products, which makes the prediction of
future operating results for these portions of our business very difficult. A
substantial portion of our research and development expenses is expected to
relate to these products. Demand for these product lines may not increase. If
we fail to increase sales in these products, our future revenue and net income,
as well as the prospects for these critical portions of our business, will be
materially and 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. 31




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Consolidations in, or a continued slowdown in, the telecommunications industry
could harm our business. We have derived a substantial amount of our revenues from sales of
products and related services to the telecommunications industry. The
telecommunications industry has experienced significant growth and
consolidation in the past few years, although, over recent years, trends
indicate that capital spending by this industry has decreased and may continue
to decrease in the future as a result of a general decline in economic growth
in local and international markets. In particular, RBOC and large ILEC
customers have been adversely affected by subscriber line losses and the
after-effects of overspending in 1999 and 2000 as well as by competition from
cable and wireless carriers and other carriers entering the local telephone
service market. Certain emerging carriers also continue to be hampered by
financial instability caused in large part by a lack of access to capital. In
the event of further significant slowdown in capital spending of the
telecommunications industry, our business would be adversely affected.
Furthermore, as a result of industry consolidation, there may be fewer
potential customers requiring our software in the future. Larger, consolidated
telecommunications companies may also use their purchasing power to create
pressure on the prices and the margins we could realize. We cannot be certain
that consolidations in, or a slowdown in the growth of, the telecommunication
industry will not harm our business. Our expenses are relatively fixed in the short term, and we may be unable to
adjust spending to compensate for unexpected revenue shortfalls. We base our expense levels in part on forecasts of future orders and
sales, which are extremely difficult to predict. A substantial portion of our
operating expenses is related to personnel, facilities and sales and marketing.
The level of spending for such expenses cannot be adjusted quickly and is,
therefore, relatively fixed in the short term. Accordingly, our operating
results will be harmed if revenues fall below our expectations in a particular
quarter. We rely on software that we have licensed from third-party developers to
perform key functions in our products. 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. We are affected by a pattern of product price decline in certain markets, which
can harm our business. Because our cable products generate lower margins for us than our
proprietary MCU and software offerings, an increase in the percentage of our
sales of cable-related products relative to our traditional products will
result in lower profitability. Furthermore, as consolidations within the cable
industry and the adoption of the DOCSIS standards have caused and could
continue to cause pricing pressure as competitors lower product pricing, our
revenues have been and may continue to be adversely affected. Although we are
developing DOCSIS-compatible hardware and our relationship with Alpha is one
that we believe will prominently position us to succeed in the marketing of DOCSIS
products, these DOCSIS products will likely generate lower margins than have
historically been generated by our proprietary technology. As a result, as our
business shifts from our 32




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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. 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. 33




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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Companys current investment policy limits its investments in financial
instruments to cash and cash equivalents, individual municipal bonds, and
corporate and government bonds. The use of financial derivatives and preferred
and common stocks is strictly prohibited. The Company believes it minimizes
its risk through proper diversification along with the requirements that the
securities must be of investment grade with an average rating of A or better
by Standard & Poors. The Company holds its investment securities to maturity
and believes that earnings and cash flows will not be materially affected by
changes in interest rates, due to the nature and short-term investment horizon
for which these securities are invested. 
 Item 4. CONTROLS AND PROCEDURES The Chief Executive Officer and the Chief Financial Officer of the Company
(its principal executive officer and principal financial officer, respectively)
have concluded, based on their evaluation as of the end of the period covered
by this report, that the Companys disclosure controls and procedures are
effective to ensure that information required to be disclosed by the Company in
the reports filed or submitted by it under the Securities Exchange Act of 1934,
as amended, is recorded, processed, summarized and reported within the time
periods specified in the SECs rules and forms, and include controls and
procedures designed to ensure that information required to be disclosed by the
Company in such reports is accumulated and communicated to the Companys
management, including the Chief
Executive Officer and Chief Financial Officer, as appropriate to allow timely
decisions regarding required disclosure. There were no changes in the
Companys internal controls over financial
reporting that occurred during our most recent fiscal quarter that
have materially affected or are reasonably likely to materially affect these controls. 34




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PART II. OTHER INFORMATION 
 Item 1. LEGAL PROCEEDINGS. We recently received a dispute notice from one of our distributors
relating to the purchase of certain hardware and software from us.
The distributor has not filed a complaint against us, and we continue to
attempt to resolve this dispute amicably. We believe the distributors claims are without merit, and if a
complaint is filed against us we intend to defend the case and assert our
defenses vigorously. While the final resolution of this matter cannot be predicted with
certainty, and although the outcome could be material to interim
results of operations or cash flow, we do not believe that the outcome of this claim will have a
material adverse effect on our consolidated financial position, or
annual results of
operations or cash flow. 
 Item 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES  (e)
    
    On January 21, 2004, our Board of Directors authorized the continuation
thru December 31, 2004 of a share repurchase program which expired on
December 31, 2003. Under this extension, we may repurchase a total of one
million shares of our common stock before December 31, 2004. Since the
initial repurchase program was instituted in April 1997, and as of March
27, 2004, the Company has repurchased 461,800 shares of common stock. The
repurchased shares are authorized to be utilized under certain employee
benefit programs. At our discretion we will determine the number of shares
and the timing of such purchases, which will be made using existing cash
and short-term investments. No shares were repurchased under this program
in the first quarter of 2004. 
 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 unaudited interim financial information31.1
    
    
    Certification of Chief Executive Officer, filed herewith31.2
    
    
    Certification of Chief Financial Officer, filed herewith32
    
    
    Certifications 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 on Form 8-K was filed on January 23, 2004 under
Item 7 and 12, which contained our results of operations for our
fourth quarter and fiscal year ended December 31, 2003. 35




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. Tollgrade Communications, Inc.(Registrant)Dated: May 6, 2004
    
    /s/ Christian L. AllisonChristian L. AllisonChairman and Chief Executive OfficerDated: May 6, 2004
    
    /s/ Samuel C. KnochSamuel C. KnochChief Financial Officer and TreasurerDated: May 6, 2004
    
    /s/ Sean M. ReillySean M. ReillyController
 36




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##### Table of Contents



EXHIBIT INDEX  ExhibitNumber
    
    Description15
    
    Letter re unaudited interim financial information31.1
    
    Rule 13a  14(a) Certification of Chief Executive Officer, filed herewith31.2
    
    Rule 13a  14(a) Certification of Chief Financial Officer, filed herewith32
    
    Rule 13a  14(b) Certifications of Chief Executive Officer
and Chief Financial Officer, filed herewith
 37