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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 June 26, 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 July 30, 2004, there were 13,144,540 shares of the Registrants
Common Stock, $0.20 par value per share, and no shares of the Registrants
Preferred Stock, $1.00 par value per share, outstanding. 1




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TOLLGRADE COMMUNICATIONS, INC. Quarterly Report on Form 10-Q
For the Quarter Ended June 26, 2004 Table of Contents PAGE NO.PART I. FINANCIAL INFORMATIONItem 1 Condensed Consolidated Financial Statements (unaudited):Condensed Consolidated Balance Sheets as of June 26, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the three-month and six-month periods ended June 26, 2004 and June 28, 2003
    
    
    4Condensed Consolidated Statements of Changes in Shareholders Equity for the six month period ended June 26, 2004
    
    
    5Condensed Consolidated Statements of Cash Flows for the six month periods ended June 26, 2004 and June 28, 2003
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Report of Independent Registered Public Accounting Firm
    
    
    13Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14Item 3 Quantitative and Qualitative Disclosures about Market Risk
    
    
    36Item 4 Controls and Procedures
    
    
    37PART II. OTHER INFORMATIONItem 1 Legal Proceedings
    
    
    38Item 2 Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    38Item 5 Submission of Matters to a Vote of Security Holders
    
    
    38Item 6 Exhibits and Reports Filed on Form 8-K
    
    
    38SIGNATURES
    
    
    40EXHIBIT INDEX
    
    
    41Exhibit 10.48Exhibit 10.49Exhibit 10.50Exhibit 10.51Exhibit 10.52Exhibit 10.53Exhibit 10.54Exhibit 15Exhibit 31.1Exhibit 31.2Exhibit 32
  2




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PART I. FINANCIAL INFORMATION 
 Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (Unaudited)
 June 26, 2004
    
    December 31, 2003 *ASSETSCurrent assets:Cash and cash equivalents
    
    $
    28,549,469
    
    
    $
    31,059,972Short-term investments
    
    
    19,963,705
    
    
    
    17,624,668Accounts receivable:Trade
    
    
    9,910,247
    
    
    
    9,254,718Other
    
    
    83,836
    
    
    
    122,231Inventory
    
    
    12,118,696
    
    
    
    11,154,676Prepaid expenses and other current assets
    
    
    1,987,129
    
    
    
    1,534,034Refundable income taxes
    
    
    424,752
    
    
    
    383,704Deferred tax assets
    
    
    1,524,649
    
    
    
    1,361,947Total current assets
    
    
    74,562,483
    
    
    
    72,495,950Property and equipment, net
    
    
    8,448,561
    
    
    
    8,292,412Deferred tax assets
    
    
    1,397,929
    
    
    
    1,152,846Intangibles
    
    
    45,179,250
    
    
    
    44,500,000Goodwill
    
    
    19,339,682
    
    
    
    19,339,682Capitalized software costs, net
    
    
    6,804,575
    
    
    
    7,712,624Receivable from officer
    
    
    158,947
    
    
    
    160,940Other assets
    
    
    247,966
    
    
    
    174,520Total assets
    
    $
    156,139,393
    
    
    $
    153,828,974LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,693,619
    
    
    $
    1,007,178Accrued warranty
    
    
    2,116,725
    
    
    
    2,149,905Accrued expenses
    
    
    619,676
    
    
    
    589,215Accrued salaries and wages
    
    
    222,614
    
    
    
    911,725Accrued royalties payable
    
    
    277,400
    
    
    
    395,710Income taxes payable
    
    
    1,074,155
    
    
    
    1,018,230Deferred income
    
    
    1,036,950
    
    
    
    480,235Total current liabilities
    
    
    7,041,139
    
    
    
    6,552,198Deferred tax liabilities
    
    
    2,122,172
    
    
    
    1,447,690Total liabilities
    
    
    9,163,311
    
    
    
    7,999,888Commitments and contingent liabilities
    
    
    
    
    
    
    Shareholders equity:Preferred stock, $1.00 par value;
Authorized shares, 10,000,000; issued shares, -0-
In 2003 and 2004
    
    
    
    
    
    
    Common stock, $.20 par value; authorized shares,
50,000,000; issued shares, 13,580,370 in 2003 and
13,604,404 in 2004
    
    
    2,720,881
    
    
    
    2,716,074Additional paid-in capital
    
    
    71,005,294
    
    
    
    70,808,584Treasury stock, at cost, 461,800 shares
    
    
    (4,790,783
    )
    
    
    (4,790,783
    )Retained earnings
    
    
    78,040,690
    
    
    
    77,095,211Total shareholders equity
    
    
    146,976,082
    
    
    
    145,829,086Total liabilities and shareholders equity
    
    $
    156,139,393
    
    
    $
    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
  For the
    
    For theThree Months Ended
    
    Six Months EndedJune 26, 2004
    
    June 28, 2003
    
    June 26, 2004
    
    June 28, 2003Revenues:Products
    
    $
    12,267,500
    
    
    $
    13,914,800
    
    
    $
    26,722,130
    
    
    $
    25,485,901Services
    
    
    3,198,311
    
    
    
    3,218,747
    
    
    
    6,350,830
    
    
    
    6,191,069Total revenues:
    
    
    15,465,811
    
    
    
    17,133,547
    
    
    
    33,072,960
    
    
    
    31,676,970Cost of product sales:Products
    
    
    6,266,456
    
    
    
    6,232,192
    
    
    
    12,280,924
    
    
    
    11,524,320Services
    
    
    997,479
    
    
    
    976,477
    
    
    
    1,857,304
    
    
    
    1,766,047Amortization of intangibles
    
    
    510,194
    
    
    
    510,306
    
    
    
    983,527
    
    
    
    1,402,8847,774,129
    
    
    
    7,718,975
    
    
    
    15,121,755
    
    
    
    14,693,251Gross Profit:
    
    
    7,691,682
    
    
    
    9,414,572
    
    
    
    17,951,205
    
    
    
    16,983,719Selling and marketing
    
    
    2,383,142
    
    
    
    2,420,786
    
    
    
    4,854,730
    
    
    
    4,391,440General and administrative
    
    
    1,661,246
    
    
    
    1,828,262
    
    
    
    3,595,420
    
    
    
    3,565,265Research and development
    
    
    4,114,965
    
    
    
    3,906,563
    
    
    
    8,306,753
    
    
    
    7,227,781Total operating expenses
    
    
    8,159,353
    
    
    
    8,155,611
    
    
    
    16,756,903
    
    
    
    15,184,486(Loss) income from operations
    
    
    (467,671
    )
    
    
    1,258,961
    
    
    
    1,194,302
    
    
    
    1,799,233Interest and other income, net
    
    
    68,195
    
    
    
    85,071
    
    
    
    158,377
    
    
    
    232,493(Loss) income before income taxes
    
    
    (399,476
    )
    
    
    1,344,032
    
    
    
    1,352,679
    
    
    
    2,031,726(Benefit) provision for income taxes
    
    
    (264,929
    )
    
    
    510,732
    
    
    
    407,200
    
    
    
    772,056Net (loss) income
    
    $
    (134,547
    )
    
    $
    833,300
    
    
    $
    945,479
    
    
    $
    1,259,670(Loss) earnings per share information:Weighted average shares of common stock and equivalents:Basic
    
    
    13,131,835
    
    
    
    13,103,801
    
    
    
    13,126,231
    
    
    
    13,097,319Diluted
    
    
    13,258,595
    
    
    
    13,335,006
    
    
    
    13,309,961
    
    
    
    13,276,042Net(loss) income per common and common equivalent shares:Basic
    
    $
    (0.01
    )
    
    $
    .06
    
    
    $
    .07
    
    
    $
    .10Diluted
    
    $
    (0.01
    )
    
    $
    .06
    
    
    $
    .07
    
    
    $
    .09
 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 Six Months Ended June 26, 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
    
    
    
    
    
    
    
    
    
    
    24,034
    
    
    
    4,807
    
    
    
    147,826
    
    
    
    
    
    
    
    
    
    
    
    152,633Tax benefit from
exercise of stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    48,884
    
    
    
    
    
    
    
    
    
    
    
    48,884Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    945,479
    
    
    
    945,479Balance at June 26, 2004
    
    
    
    
    
    $
    
    
    
    
    13,604,404
    
    
    $
    2,720,881
    
    
    $
    71,005,294
    
    
    $
    (4,790,783
    )
    
    $
    78,040,690
    
    
    $
    146,976,082
 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
  Six Months EndedJune 26, 2004
    
    June 28, 2003Cash flows from operating activities:Net income
    
    $
    945,479
    
    
    $
    1,259,670Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization
    
    
    2,266,035
    
    
    
    2,542,747Tax benefit from exercise of stock options
    
    
    48,884
    
    
    
    55,200Income taxes paid
    
    
    273,278
    
    
    
    376,041Deferred income taxes
    
    
    (47,629
    )
    
    
    130,175Provision for losses on inventory
    
    
    130,204
    
    
    
    180,599Disposition of slow moving and obsolete inventory
    
    
    (217,092
    )
    
    
    (278,432
    )Provision for allowance for doubtful accounts
    
    
    38,698
    
    
    
    343,000Changes in assets and liabilities:Increase in accounts receivable-trade
    
    
    (694,227
    )
    
    
    (3,235,005
    )Decrease in accounts receivable-other
    
    
    38,395
    
    
    
    61,874(Increase) decrease in inventory
    
    
    (877,132
    )
    
    
    1,588,083(Increase) decrease in prepaid expenses and other assets
    
    
    (528,380
    )
    
    
    290,798Increase in accounts payable
    
    
    686,441
    
    
    
    695,251(Decrease) increase in accrued warranty
    
    
    (33,180
    )
    
    
    524,991Increase in accrued expenses and deferred income
    
    
    587,176
    
    
    
    666,063(Decrease) increase in accrued royalties payable
    
    
    (118,310
    )
    
    
    140,980(Decrease) increase in accrued salaries and wages
    
    
    (689,111
    )
    
    
    89,722Increase in income taxes payable
    
    
    55,925
    
    
    
    226,283Net cash provided by operating activities
    
    
    1,865,454
    
    
    
    5,658,040Cash flows from investing activities:Purchase of Cheetah
    
    
    
    
    
    
    (14,899,010
    )Purchase of short-term investments
    
    
    (7,733,938
    )
    
    
    (878,077
    )Redemption/maturity of short-term investments
    
    
    5,394,901
    
    
    
    6,025,734Capital expenditures, including capitalized software
    
    
    (1,474,553
    )
    
    
    (1,843,903
    )Investments in other assets
    
    
    (715,000
    )
    
    
    Net cash used in investing activities
    
    
    (4,528,590
    )
    
    
    (11,595,256
    )Cash flows from financing activities:Proceeds from exercise of stock options
    
    
    152,633
    
    
    
    197,802Net cash provided by financing activities
    
    
    152,633
    
    
    
    197,802Net decrease in cash and cash equivalents
    
    
    (2,510,503
    )
    
    
    (5,739,414
    )Cash and cash equivalents at beginning of period
    
    
    31,059,972
    
    
    
    33,799,284Cash and cash equivalents at end of period
    
    $
    28,549,469
    
    
    $
    28,059,870
 The accompanying notes are an integral part of the condensed financial statements 6




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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements included
herein have been prepared by Tollgrade Communications, Inc. (the Company) in
accordance with accounting principles generally accepted in the United States
of America for interim financial information and Article 10 of Regulation S-X.
The condensed consolidated financial statements as of and for the three-month
and six-month periods ended June 26, 2004 should be read in conjunction with
the Companys consolidated financial statements (and notes thereto) included in
the Companys Annual Report on Form 10-K for the year ended December 31, 2003.
Accordingly, the accompanying condensed consolidated financial statements do
not include all of the information and footnotes required by accounting
principles generally accepted in the United States of America for complete
financial statements, although the Company believes that the disclosures are
adequate to make the information presented not misleading. In the opinion of
Company management, all adjustments considered necessary for a fair
presentation of the accompanying condensed consolidated financial statements
have been included, and all adjustments are of a normal and recurring nature.
Operating results for the three-month and six-month periods ended June 26, 2004
are not necessarily indicative of the results that may be expected for the year
ending December 31, 2004. With respect to the unaudited financial information of Tollgrade
Communications, Inc. for each of the three-month and six-month periods ended
June 26, 2004 and June 28, 2003, included in this Form 10-Q,
PricewaterhouseCoopers LLP reported that they have applied limited procedures
in accordance with professional standards for a review of such information.
However, their separate report dated August 5, 2004 appearing herein, states
that they did not audit and they do not express an opinion on that unaudited
financial information. Accordingly, the degree of reliance on their report on
such information should be restricted in light of the limited nature of the
review procedures applied. PricewaterhouseCoopers LLP is not subject to the
liability provisions of Section 11 of the Securities Act of 1933 (Act) for
their report on the unaudited financial information because that report is not
a report within the meaning of Sections 7 and 11 of the Act. 2. ACCOUNTING FOR STOCK-BASED COMPENSATION The Company has two stock-based employee compensation plans. The Company
accounts for these plans under the recognition and measurement provisions of
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued
to Employees. Under these provisions, stock-based employee compensation cost
is not reflected in net income for any year, as all options granted under the
plans had
an exercise price equal to the market value of the underlying common stock on
the date of grant. If the Company had elected to recognize compensation cost
for these stock options based on the fair value method set forth in Statement
of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based
Compensation, net (loss)income and (loss)earnings per share would have
reflected the pro forma amounts indicated below: Three Months ended
    
    Six Months endedJune 26, 2004
    
    June 28, 2003
    
    June 26, 2004
    
    June 28, 2003Net (loss)income, as reported
    
    $
    (134,547
    )
    
    $
    833,300
    
    
    $
    945,479
    
    
    $
    1,259,670Deduct: Total stock-based
compensation expense based
on the fair value method for
all awards, net of related
tax effects
    
    
    43,627
    
    
    
    443,367
    
    
    
    176,715
    
    
    
    1,006,680Pro forma net (loss)income
    
    $
    (178,174
    )
    
    $
    389,933
    
    
    $
    768,764
    
    
    $
    252,990Earnings (loss) per share:Basic  as reported
    
    $
    (0.01
    )
    
    $
    0.06
    
    
    $
    0.07
    
    
    $
    0.10Basic  pro forma
    
    $
    (0.01
    )
    
    $
    0.03
    
    
    $
    0.06
    
    
    $
    0.02Diluted  as reported
    
    $
    (0.01
    )
    
    $
    0.06
    
    
    $
    0.07
    
    
    $
    0.09Diluted  pro forma
    
    $
    (0.01
    )
    
    $
    0.03
    
    
    $
    0.06
    
    
    $
    0.02
 7




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3. ACQUISITION On February 13, 2003, the Company acquired certain assets and assumed certain
liabilities of the Cheetah status and performance monitoring product line
(Cheetah) from Acterna, LLC (Acterna) for approximately $14,300,000 in
cash. In addition, acquisition-related costs of approximately $599,000 were
capitalized for a total cost of approximately $14,899,000. The transaction
provided for an earn-out to be paid in the first half of 2004 of up to
$2,400,000 based on certain 2003 performance targets. The current calculation
indicates that amounts due under this provision are immaterial. The acquired
assets consist principally of existing sales order backlog, product inventory,
intellectual property, software and related computer equipment, while the
assumed liabilities principally relate to deferred software maintenance,
warranty and other obligations. The $14,300,000 due at closing and related
acquisition expenses were paid from available cash and short-term investments.
The Company believes that the acquired product line complements its legacy
LIGHTHOUSE® cable products and positions the Company as a leading supplier of
testing equipment and software for the cable industry. The acquisition was
recorded under the purchase method of accounting in accordance with the
provisions of SFAS No.
141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible
Assets, and accordingly, the results of operations of the acquired product
line from February 14, 2003 forward are included in the consolidated financial
statements of the Company. The Company has made an allocation of the Cheetah purchase price to the fair
value of assets acquired and liabilities assumed. The purchase price remains
subject to change pending resolution between the parties of outstanding
contingencies regarding the earn-out provision and remaining purchase price
adjustments. Any changes to the purchase price arising from the resolution of
these matters are expected to be accounted for as adjustments to goodwill and
may be material. The following condensed proforma results of operations reflect the
proforma combination of the Company and the acquired Cheetah product line as if
the combination occurred on January 1, 2003. (In Thousands, Except Per Share Data)Six Months EndedJune 28, 2003ProformaRevenues
    
    $
    33,040Income from operations
    
    
    2,470Net income
    
    
    1,677Diluted earnings per share
    
    $
    0.13
 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 June 26, 2004
    
    As of December 31, 2003Gross
    
    
    
    
    
    GrossCarrying
    
    Accumulated
    
    Carrying
    
    AccumulatedAmount
    
    Amortization
    
    Amount
    
    AmortizationAmortized intangible assets:Cheetah sales order backlog
    
    $
    543,273
    
    
    $
    543,273
    
    
    $
    543,273
    
    
    $
    539,442Exclusivity agreement
    
    
    715,000
    
    
    
    35,750
    
    
    
    
    
    
    
    $
    1,258,273
    
    
    $
    579,023
    
    
    $
    543,273
    
    
    $
    539,442Capitalized software:Developed product software
    
    
    7,519,380
    
    
    
    4,062,305
    
    
    
    7,483,483
    
    
    
    3,313,359Base software  Cheetah
    
    
    2,900,000
    
    
    
    410,833
    
    
    
    2,900,000
    
    
    
    265,833Proprietary technology
    
    
    1,000,000
    
    
    
    141,667
    
    
    
    1,000,000
    
    
    
    91,667Total capitalized
software (long
term)
    
    $
    11,419,380
    
    
    $
    4,614,805
    
    
    $
    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
    
    $
    2,001,974December 31, 2005
    
    
    2,036,881December 31, 2006
    
    
    1,671,881December 31, 2007
    
    
    572,784December 31, 2008
    
    
    552,593
 We have entered into certain third party license agreements to augment our next generation technology. During the first quarter of
2004, the Company entered into a License Agreement (Initial Agreement) with a third party software vendor for certain Voice Over
Internet Protocol (VoIP) technology, pursuant to which the Company obtained a  non-exclusive  license to use, further develop and
incorporate into certain of  its products such technology.  In conjunction with this agreement during the first quarter of 2004, we
prepaid approximately $0.3 million in services, license and royalty fees. 9




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The Initial Agreement was replaced and superseded by a second license agreement
during the second quarter of 2004, pursuant to which the Company obtained a
perpetual worldwide right and license to use, further develop and incorporate
such technology into any of its products. Additionally, the agreement
provides that during the term of the agreement, the Company is the sole and
exclusive licensee for particular applications of this technology. The
agreement is for a period of five years. In conjunction with this agreement
the Company paid approximately $0.7 million for the exclusivity right and
prepaid approximately $0.1 million of additional royalty fees. Including the
fees paid in connection with the initial agreement, total fees paid under this
agreement during 2004 were approximately $1.1 million. In addition, there is a
continuing obligation for the Company to pay additional royalties which may
total $0.8 million or less, depending upon the volume of sales of the underlying product which incorporates
the technology. Royalty expense will be recognized based on the underlying
related product sales. The exclusivity fee will be amortized on a straight
line basis over the five year contract period effective April 1, 2004.  5.
    
    INVENTORY At June 26, 2004 and December 31, 2003, inventory consisted of the following: June 26,
    
    December 31,2004
    
    2003Raw materials
    
    $
    7,057,368
    
    
    $
    7,398,419Work in process
    
    
    4,622,552
    
    
    
    3,723,409Finished goods
    
    
    1,816,888
    
    
    
    1,497,84813,496,808
    
    
    
    12,619,676Reserve for slow moving and
obsolete inventory
    
    
    (1,378,112
    )
    
    
    (1,465,000
    )$
    12,118,696
    
    
    $
    11,154,676
  6.
    
    SHORT-TERM INVESTMENTS Short-term investments at June 26, 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: June 26,
    
    December 31,2004
    
    2003Carrying
    
    Fair
    
    Carrying
    
    FairAmount
    
    Value
    
    Amount
    
    ValueFinancial assets:Cash and cash equivalents
    
    $
    28,549,469
    
    
    $
    28,549,469
    
    
    $
    31,059,972
    
    
    $
    31,059,972Short-term investments
    
    
    19,963,705
    
    
    
    20,051,728
    
    
    
    17,624,668
    
    
    
    17,609,031$
    48,513,174
    
    
    $
    48,601,197
    
    
    $
    48,684,640
    
    
    $
    48,669,003
   10




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##### Table of Contents



7.
    
    PER SHARE INFORMATION Net (loss) income per share has been computed in accordance with the provisions
of SFAS No. 128, Earnings Per Share for all periods presented. SFAS No. 128
requires companies with complex capital structures to report earnings per share
on a basic and diluted basis. Basic earnings per share is computed using the
weighted average number of shares outstanding during the period, while diluted
earnings per share is calculated to reflect the potential dilution that occurs
related to issuance of capital stock option grants. The difference between
basic and diluted earnings per share relates solely to the effect of capital
stock options. A reconciliation of (loss) earnings per share is as follows: Three Months
    
    Three Months
    
    Six Months
    
    Six MonthsEnded
    
    Ended
    
    Ended
    
    EndedJune 26, 2004
    
    June 28, 2003
    
    June 26, 2004
    
    June 28, 2003Net (loss) income
    
    $
    (134,547
    )
    
    $
    833,300
    
    
    $
    945,479
    
    
    $
    1,259,670Common and common equivalent shares:Weighted average common shares outstanding
    
    
    13,131,835
    
    
    
    13,103,801
    
    
    
    13,126,231
    
    
    
    13,097,319Effect of dilutive securities  stock options
    
    
    126,760
    
    
    
    231,205
    
    
    
    183,730
    
    
    
    178,72313,258,595
    
    
    
    13,335,006
    
    
    
    13,309,961
    
    
    
    13,276,042(Loss) earnings per share:Basic
    
    $
    (0.01
    )
    
    $
    .06
    
    
    $
    .07
    
    
    $
    .10Diluted
    
    $
    (0.01
    )
    
    $
    .06
    
    
    $
    .07
    
    
    $
    .09
 Unexercised stock options to purchase our capital stock of 1.1 million and
0.9 million shares for the three months ended June 26, 2004 and June 28, 2003,
respectively, and 0.9 million shares for both the six months ended June 26,
2004 and June 28, 2003, are not included in the computation of diluted earnings
per share because the option exercise price was greater than the average market
price.  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 46 was revised in December 2003 and is
effective for the first financial reporting period ending after March 15, 2004.
The Company adopted the provisions of FIN 46 for the first half of 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
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: 11




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##### Table of Contents



Six Months Ended
    
    Year EndedJune 26, 2004
    
    December 31, 2003Balance at the beginning of the period
    
    $
    2,150,000
    
    
    $
    1,981,000Accruals for warranties issued
during the period
    
    
    170,000
    
    
    
    690,000Cheetah opening accrual
    
    
    
    
    
    
    225,000Settlements during the period
    
    
    (203,000
    )
    
    
    (746,000
    )Balance at the end of the period
    
    $
    2,117,000
    
    
    $
    2,150,000
 During the second quarter of 2004, we sold $1,253,000 of our new
Internet-addressable monitoring probes. This product has undergone
certification testing by an independent third party lab to establish compliance
with certain industry standards. The Company has been notified that the
product was not in compliance with certain of these standards. Although such
compliance was not required by the Companys customer as part of the sale of
the units during the second quarter of 2004, the Company has evaluated the
scope of the modifications required to meet these standards, and has determined
it appropriate to make certain minor modifications to the product. The
modified product has been re-submitted to the independent third party lab for
testing. The costs associated with such modifications are presently reflected
in the accompanying financial statements.  10.
    
    CONTINGENCIES AND COMMITMENTS The Company was party to a dispute that arose with a distributor in the first
quarter of 2004. During the second quarter, although we continue to believe
the claims were without merit, the Company negotiated a settlement with the
distributor which resulted in the return of $395,000 of DigiTest and related
access equipment the distributor purchased in the prior year. The return was
recorded as a reduction in revenue and cost of goods sold. The impact on gross
margin was a reduction of $257,000. No significant legal fees or other costs
were incurred in negotiating the settlement. Additionally, the Company has
arrangements with certain manufacturing subcontractors under which the Company
is contingently obligated to purchase up to $2.4 million of raw material parts
in the event they would not be consumed by the manufacturing process in the
normal course of business. In addition, the Company is, from time to time, party to various legal claims
and disputes, either asserted or unasserted, which arise in the ordinary course
of business. While the final resolution of these matters cannot be predicted
with certainty, and although the outcome could be material to interim results
of operations or cash flow, the Company does not believe that the outcome of
any of these claims will have a material adverse effect on the Companys
consolidated financial position, or annual results of operations, or cash flow.  11.
    
    SUBSEQUENT EVENTS On July 8, 2004, the Company announced a cost alignment initiative that
included a reduction of 30 positions, primarily in research and development to
reflect its evolving business model. In addition, on July 21, 2004, the
Company further aligned its costs by eliminating approximately 20 additional
positions, primarily in the manufacturing and related overhead areas. The
Company expects to record a charge, in the third quarter of 2004, for severance
and benefit costs, on a pre-tax basis, of approximately $275,000. 12




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##### Table of Contents



Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of
Tollgrade Communications, Inc. and subsidiaries: We have reviewed the accompanying condensed consolidated balance sheet of
Tollgrade Communications, Inc. and its subsidiaries as of June 26, 2004, and
the related condensed consolidated statements of operations for each of the
three-month and six-month periods ended June 26, 2004 and June 28, 2003 and the
condensed consolidated statement of cash flows for the six-month periods ended
June 26, 2004 and June 28, 2003. These interim financial statements are the
responsibility of the Companys management. We conducted our review in accordance with the standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board, the objective of
which is the expression of an opinion regarding the financial statements taken
as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should
be made to the accompanying condensed consolidated interim financial statements
for them to be in conformity with accounting principles generally accepted in
the United States of America. We previously audited in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheet as
of December 31, 2003, and the related consolidated statements of operations,
shareholders equity and of cash flows for the year then ended (not presented
herein), and in our report dated January 21, 2004 we expressed an unqualified
opinion on those consolidated financial statements. In our opinion, the
information set forth in the accompanying condensed consolidated balance sheet
as of December 31, 2003, is fairly stated in all material respects in relation
to the consolidated balance sheet from which it has been derived. PricewaterhouseCoopers LLP
Pittsburgh, Pennsylvania
August 5, 2004 13




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##### Table of Contents



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




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##### Table of Contents



OVERVIEW About the Company Tollgrade Communications, Inc. (the Company) was organized in 1986, began
operations in 1988 and completed its initial public offering in 1995. The
Company provides hardware and software network assurance testing and monitoring
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, which
electronically measure the characteristics of a telephone copper circuit,
analyze the data and report an easy to understand fault condition. The Companys 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 the Companys 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 telecommunications products and
services are the four Regional Bell Operating Companies (RBOCs), certain major
independent telephone companies and several digital loop carrier (DLC)
equipment manufacturers. Of these major customer groups, the RBOCs are the most
significant; for the second quarter ended June 26, 2004, sales to the RBOCs
accounted for approximately 40.1% of total revenue, compared to approximately
51% of total revenue for the first quarter of 2004 and 52.4% of total revenue
for the second quarter ended June 28, 2003. Sales to two of the four RBOC
customers (Bell South and Verizon) individually exceeded 10% of consolidated
revenues (14.1% and 13.4%, respectively), and on a combined basis, comprised
27.5% of the Companys total revenues for the second quarter of 2004. The
Company continues to be highly dependent on the four RBOCs for a significant
portion of its total revenue but such dependency has generally declined in
recent years due to relative increases in sales of our cable hardware and
software products. 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 second
quarter of 2004, one of the Companys cable customers (Alpha Technologies,
Inc.) individually accounted for more than 10% of the Companys total revenues
(14.1%). 15




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##### Table of Contents



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 as well as qualify and troubleshoot broadband DSL lines. POTS lines
comprise the vast majority of lines in service today throughout the world. In
addition to traditional voice service, POTS lines provide connections for
popular devices such as computer modems and fax machines. POTS excludes
non-switched and private lines, such as data communications service lines,
commonly referred to as special services. DSL provides the ability to
transmit high speed data over traditional copper lines. MCU Our 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(R) 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. 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. 16




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##### Table of Contents



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,
LoopCare TCP/IP Communications Network, and Testing Voice Services in a
Broadband Passive Optical Network (bPON). 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 transaction costs of $0.6 million.
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 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 Internet-addressable monitoring probes 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. The
Company is actively engaged in research and development of Voice Over Internet
Protocol (VoIP) solutions, as well as data network integrity technologies. As part of this strategy, we have entered into certain third party license
agreements to augment our next generation technology. During the first 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 during the first
quarter of 2004, we prepaid approximately $0.3 million in services, license and
royalty fees. 17




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##### Table of Contents



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 products
which incorporate the licensed technology. Royalty expense will be recognized
based on the underlying related product sales. The exclusivity fee will be
amortized on a straight line basis over the five year contract period effective
April 1, 2004. 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. BACKLOG Our backlog consists of firm customer purchase orders and signed software
maintenance agreements. As of June 26, 2004, the Company had backlog of
approximately $7.8 million compared to $15.3 million as of December 31, 2003
and $8.1 million as of June 28, 2003. The decrease in the backlog from December
31, 2003 is attributed to a large volume of shipments of cable hardware
products in the second quarter of 2004, selected customers purchasing current
year requirements in the fourth quarter of 2003 and first quarter of 2004, as
well as the negotiated cancellation of certain MCU orders totaling $0.7 million
associated with a second quarter incentive purchase. Our current forecast
calls for additional orders of cable hardware and software products and
deployments of DigiTest which we anticipate will help mitigate the decrease in
the backlog. We have entered into LoopCare software maintenance agreements with all four
RBOCs. Three of these agreements have terms which expire on December 31, 2004
(one can be extended for another year) while the fourth RBOC maintenance
agreement will expire December 31, 2005. The backlog at June 26, 2004 included
approximately $5.6 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. Management expects that approximately 55% of the current backlog will be
recognized as revenue in the third 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. 18




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##### Table of Contents



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 6.4%, or $1.0 million, of the
Companys total revenue for the quarter ended June 26, 2004, compared to 4.8%,
or $0.8 million, in the June 28, 2003 quarter. International sales represented
approximately 7.3% of the Companys total revenue for the six months ended June
26, 2004, compared to 4.8% for the six month period ended June 28, 2003.
Although our international sales have increased year over year, and our
marketing activity in international markets has expanded, our overall success
in marketing and selling our telecommunications products in international
markets remains limited, due in part to incompatibility of certain of our
telecommunications products in networks employed abroad. We continue to
evaluate opportunities in the international market that will enhance our
international presence and growth. As part of the effort to expand our
international sales, we periodically receive and respond to requests for
proposals from certain international telephone and cable service providers.
During the first quarter of 2004, we were notified that we were selected as a
vendor for an international project. However, the commercial terms and
conditions, which will be significant to the Company, have not been agreed
upon, nor has the final scope of work or schedule for completion been
finalized. As a result, the opportunity presented is still being 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 second quarter of 2004. 19




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RESULTS OF OPERATIONS THE FOLLOWING DISCUSSION OF THE RESULTS OF OPERATIONS AND FINANCIAL
CONDITION OF THE COMPANY SHOULD BE READ IN CONJUNCTION WITH PART I, ITEM 1 OF
THIS REPORT SECOND QUARTER OF 2004 COMPARED TO SECOND QUARTER OF 2003 Revenues The Companys revenues for the second quarter of 2004 were $15.5 million, a
decrease of $1.7 million, or 9.7%, from revenues of $17.1 million reported for
the second quarter of 2003. Sales of MCUs, which are sold primarily to the RBOCs, during the second quarter
of 2004 were $4.2 million, a decrease of $2.2 million compared to the second
quarter of 2003. As a result, MCU sales were 26.9% of total second quarter
2004 revenues compared to 37.3% for the second quarter of 2003. The decrease
between periods is primarily attributed to restricted capital spending by RBOC
customers and purchases by certain customers of their current year requirements
in the fourth quarter of 2003 and in the first quarter of 2004, which resulted
in a reduction of their purchase requirements for the second quarter of 2004. We expect MCU sales for the foreseeable future to continue to account for
a significant portion of the Companys revenue. However, as a result of the
continuing maturation of this product line, the RBOCs trend of limiting
capital spending in their traditional POTS networks and the evolution of the
transmission network towards end to end fiber, the Company believes this
product line is meaningful but mature and on an overall basis we expect it to
decline over time. The significant purchases made in the fourth quarter of
2003 and first quarter of 2004 coupled with the mature nature of the MCU
products have resulted in lower year over year comparative sales in the second
quarter of 2004 and it is expected that this trend will continue in the second
half of 2004. Gross sales of the Companys DigiTest system products, which include LoopCare
software, were $1.6 million in the second quarter of 2004. DigiTest revenue
was favorably affected by purchases made by
CLEC customers as well as continuing RBOC LTS modernization initiatives. Gross
sales were reduced by $0.4 million related to a negotiated settlement of a
dispute with a distributor which resulted in the return of equipment that the
distributor purchased in the prior year. The settlement resulted in net
DigiTest sales of $1.2 million. Sales of DigiTest system products for the
second quarter of 2003 were $1.2 million and there were no similar returns
offsetting revenue in the prior year. Including the impact of the negotiated
settlement, DigiTest system sales accounted for 7.6% and 7.2% of total revenues
for the second quarter of 2004 and 2003, respectively. We currently have
DigiTest field trial activity in a number of our large customers, in some
situations the sales process will extend into 2005 and thus may not offset the
weaker outlook for MCU products for the second half of 2004. Sales of LoopCare software products separate and unrelated to DigiTest system
products decreased $0.4 million, or 41.6%, to $0.5 million in the second
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 second
quarter of 2004, as compared to the second quarter of 2003, is not necessarily
reflective of a trend, but is attributable to the uneven nature of the software
sales process. LoopCare software product sales comprised 3.5% and 5.4% of
total revenues during the second quarter of 2004 and 2003, respectively. 20




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Overall sales of cable hardware and software products increased $1.0 million or
19%, to $6.4 million in the second quarter of 2004. Included in cable hardware
and software product revenue is an initial sale to one of our OEM partners of
$1.3 million of our Internet-addressable monitoring probes. This product has
undergone certification testing by an independent third party laboratory to
establish compliance with certain industry standards. The Company has been
notified that the product was not in compliance with certain of these
standards. Although such compliance was not required by the Companys customer
as part of the sale of the units, the Company has evaluated the scope of the
modifications required to meet these standards, and has determined that it is
appropriate to make certain minor modifications to the products. The modified
product has been re-submitted to the independent third party laboratory for
testing. The cost of these modifications are presently reflected in the
accompanying financial statements and we believe that these modifications will
not impact the sale of Internet-addressable monitoring probes during the
remainder of fiscal 2004. The sales of the new Internet-addressable monitoring
probes is reflective of a significant commitment by cable companies to leverage
their hybrid fiber coaxial infrastructure to deliver voice, data and video
services through a single conduit. Cable hardware and software sales amounted
to 41.3% and 31.3% of total second 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, remained flat at $3.2 million in the second quarter of
2004 and 2003. Service revenues amounted to 20.7% and 18.8% of total second
quarter 2004 and 2003 revenue, respectively. Periodic fluctuations in customer orders and backlog result from a variety of
factors, including but not limited to the timing of significant orders from,
shipments to, and acceptance of software by RBOC customers, and are not
necessarily indicative of long-term trends in sales of the Companys products. We experienced some improvement in our core equipment markets in the latter
part of 2003 and during the first quarter of 2004. However our financial
performance for the second quarter of 2004 was negatively affected by several
factors relating to our customers. Certain of our key customers were subject
to restricted capital budgets, during the second quarter of 2004, which
resulted in lower purchasing levels. Additionally, because certain of our
customers made bulk purchases in the latter part of 2003 and first quarter of
2004, they had lower purchasing requirements for the second quarter of 2004.
Growth in the cable-related product lines outpacing the lagging recovery of the
traditional telecom products however, this growth is at lower margins than the
traditional MCU business. All of these factors have contributed to a
challenging business environment and has forced Tollgrade to adjust the
Companys business model by examining the current cost structure. A pending
labor contract negotiation at one of our RBOC customers could further stall
product field trials, testability projects and network system deployment. To
proactively address these short term and long term trends, we implemented, in
the third quarter of 2004, a cost alignment program which eliminated, in two
phases, approximately 50 positions. The majority of the terminations impacted
research and development, manufacturing and related overhead areas of the
Company. As a result of the cost alignment program we will record, in the third
quarter, a restructuring charge of $0.3 million. We expect the restructuring
program to result in a gross pre-tax savings of $0.8 million in the third
quarter of 2003 and $1.0 million in the fourth quarter of 2004. The gross
pre-tax savings of $0.8 million for the third quarter of 2004, will be reduced
by the restructuring charge of $0.3 million to produce a net pre-tax benefit of
$0.5 million. Management will continue to diligently look at further cost
reductions consistent with its evolving business model. 21




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Additionally, we have experienced positive field trial activity for our new
telecom products in a number of our large customers, our cable and software
products continue to generate growth and the deployment of DigiTest Edge to new
customers have all helped to mitigate the current softness in the MCU
environment. 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 the Cheetah product line
on February 13, 2003, substantially strengthened our CATV product market
position. We continually seek to identify, and from time to time evaluate, new
acquisition opportunities to complement and strengthen our core equipment
product offerings. Gross Profit Gross profit for the second quarter of 2004 decreased $1.7 million or 18.3% to
$7.7 million. The decrease in gross profit is attributed primarily to reduced
sales of MCU channel units and LoopCare software. As a percentage of sales,
gross profit for the quarter was 49.7% versus 54.9% for the year ago period.
Gross margin declined in the second quarter compared to the previous years
second quarter due to lower MCU and software sales, the negotiated settlement
discussed above, incentive discounting and lower absorption of manufacturing
overhead costs. Additionally, although we experienced positive growth in cable
hardware and software, these products have a lower margin than the MCU,
LoopCare and DigiTest system products. As discussed above, we have modified
our business model to recognize the growth in cable hardware and software
through the implementation of a cost alignment program that is intended to have
a positive impact on gross profit margins. Selling and Marketing Expense Selling and marketing expense, which consists primarily of payroll related
costs, consulting expense and travel costs, remained consistent at $2.4 million
for the second quarter of 2004 and 2003. Salaries and wages increased
approximately $0.1 million and commissions increased by $0.1 million from the
prior year quarter. These increases were offset by the reversal of $0.1
million related to the incentive compensation accrual recorded in the first
quarter of 2004 and a decrease in consulting fees of $0.1
million. As a percentage of revenues, selling and marketing expenses increased
from 14.1% in the second quarter of 2003 to 15.4% in the second quarter of
2004. On July 8, 2004 and July 21, 2004 we announced two cost alignment
programs that are anticipated to have a positive future impact on selling and
marketing expense. General and Administrative Expense General and administrative expense, which consists primarily of payroll related
costs, insurance expense and
professional services, for the second quarter of 2004 was $1.7 million, a
decrease of $0.1 million, or 9.1%, from the $1.8 million recorded in the second
quarter of 2003. The decrease is primarily due to the $0.1 million reversal
of the incentive compensation accrual, due to current and expected future
operating performance, recorded in the first quarter of 2004 and a reduction in
bad debt expense of $0.2 million. These benefits were offset by increased
salary costs of $0.1 million and increased professional services of $0.1
million. As a percentage of revenues, general and administrative expenses
remained constant at 10.7% in the second quarter of 2004 and 2003. 22




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Research and Development Expense Research and development expense, which consists primarily of payroll related
costs, depreciation expense and rent expense in the second quarter of 2004 was
$4.1 million, an increase of $0.2 million, or 5.3%, from the $3.9 million
recorded in the second quarter of 2003. The increase is attributed to
increased salary and benefit costs of $0.2 million and increased consulting and
professional services of $0.2 million related to research and development
related to Cheetah products. These increases were mitigated by the reversal of
$0.2 million associated with the incentive compensation accrual, due to current
and expected future operating performance, recorded in the first quarter of
2004. As a percentage of revenues, research and development expense increased
to 26.6% in the second quarter of 2004 from 22.8% in the prior year quarter.
As previously discussed, on July 8, 2004 and July 21, 2004 we announced two
cost alignment programs that are anticipated to have a positive future impact
on research and development expense. Interest and Other Income Interest and other income, composed primarily of interest income in both
quarterly periods, remained flat at $0.1 million. Provision for Income Taxes The provision for income taxes for the second quarter of 2004 included a
benefit of $0.3 million due to the current quarter pretax loss. The provision
for income taxes in the second quarter of 2003 was a charge of $0.5 million.
The effective income tax rate for the second quarter of 2004 was a
benefit of 66% compared
to a charge of 38% in the second quarter of 2003. The change in the effective rate is
attributed to permanent book basis versus tax basis differences as a result of
the current quarter pre-tax loss. While we have made our best
estimate of our effective rate for 2004, based on the Companys operating results and
permanent differences, it is reasonably possible our effective income tax rate could vary during the
remainder of 2004. Net (Loss) Income and (Loss) Earnings Per Share As a result of the above factors, net loss for the second quarter of 2004 was
$(0.1) million compared to net income in the second quarter of 2003 of $0.8
million. For the second quarter of 2004, our basic and diluted loss per common
share was $(0.01) compared to net income of $0.06 per common share recorded in
prior year quarter. Basic and diluted weighted average common and common
equivalent shares outstanding were 13,131,835 and 13,258,595 respectively, in
the second quarter of 2004 compared to 13,103,801 and 13,335,006, respectively,
in the second quarter of 2003. SIX MONTHS ENDED JUNE 26, 2004 COMPARED TO SIX MONTHS ENDED JUNE 28, 2003 Revenues The Companys revenues for the six months ended June 26, 2004 were $33.1
million, an increase of $1.4 million, or 4.4%, over revenues of $31.7 million
reported for the six months ended June 28, 2003. Revenue for the period ended
June 28, 2003 included the Cheetah product line from the February 13, 2003
acquisition date through June 28, 2003. The revenue for the period ended June
26, 2004 include the operations of Cheetah for the entire period. 23




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MCU revenues for the six months ended June 26, 2004 was $11.1 million, an
increase of $0.3 million over the first six months of 2003. The increase in
the first six months of 2004 compared to 2003 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) and BellSouth. These benefits were mitigated by
reduced spending by our RBOC customers in the second quarter of 2004. The
effect of carryover budgeting and selected customers purchasing current year
requirements in the fourth quarter of 2003 and in the first quarter of 2004 is
expected to have an unfavorable impact on the full year results. Sales of MCUs accounted for 33.7% of total revenue for the first six months of
2004 compared to 34.2% for the same period in the prior year and 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 trend of limiting capital spending
in their traditional POTS networks and the evolution of the transmission
network towards end to end fiber, we believe this product line is meaningful
but mature and on an overall basis, as a percentage of our total revenue, we
expect it to continue to decline over time. Gross sales of the Companys DigiTest system products, which include LoopCare
software, were $2.5 million in the first six months of 2004. This amount was
reduced by $0.4 million related to a negotiated settlement of a dispute with a
distributor which resulted in the return of equipment that the distributor
purchased in the prior year, resulting in net DigiTest sales of $2.1 million.
Sale of DigiTest system products for the first six months of 2003 were $3.2
million and there was not a similar return offsetting revenue in the prior
year. The decrease in DigiTest revenue is primarily attributed to the
negotiated settlement and restraint in capital spending by RBOCs in traditional
POTS testing projects due to budget tightening and network evolution
considerations. Additionally, the first quarter of 2003 benefited from a
large deployment of DigiTest to a Competitive Local Exchange Carrier (CLEC)
customer, which was not repeated in 2004. Including the impact of the
negotiated settlement, DigiTest system sales accounted for 6.2% and 9.9% of
total revenues for the first six months of 2004 and 2003, respectively. Sales of LoopCare software products separate and unrelated to DigiTest system
products decreased $0.5 million, or 18.4%, to $2.2 million for the six months
ended June 26, 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, revenue for the first six months
of 2004 was negatively affected by this process. The Company believes that the
decline in LoopCare software sales is not necessarily reflective of a trend,
but is attributable to the uneven nature of the software sales process.
LoopCare software product sales comprised 6.7% and 8.5% of total revenues
during the first six months revenue of 2004 and 2003, respectively. Overall sales of cable hardware and software products increased $2.5 million or
28.7%, to $11.3 million for the first six months of 2004 compared to the same
period in the prior year. The increase is attributable to Cheetah results
included for the entire first six months of the current year and sales of our
Internet-addressable monitoring probes as discussed in the Revenue section
above. The sales of the new Internet-addressable monitoring probes is
reflective of a significant commitment by cable companies to leverage their
hybrid fiber coaxial infrastructure to deliver voice, data and video services
through a single conduit. Cable hardware and software sales amounted to 34.2%
and 27.7% of the first six months revenue of 2004 and 2003, respectively. Services revenues, which include installation oversight and project management
services provided to RBOC and other customers and fees for LoopCare and Cheetah
software maintenance, increased for the first six months of 2004 by $0.2
million or 2.6% over the same period in the prior year. Service revenues
amounted to 19.2% and 19.5% for the first six months in 2004 and 2003 revenue,
respectively. 24




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Gross Profit Gross profit for the six months ended June 26, 2004 was $18.0 million an
increase of $1.0 million or 5.7% compared with $17.0 million in the first six
months of 2003. The increase in gross profit is attributed primarily to strong
sales of MCUs during the first quarter of 2004. As a percentage of sales, gross
profit for the first six months of 2004 was 54.3% versus 53.6% for the year ago
period. Gross margin increased compared to the prior year period due to higher
MCU sales offset by lower software sales, the negotiated settlement, incentive
discounting and lower absorption of manufacturing overhead costs. Although we
experienced positive growth in cable hardware and software, these products have
a lower margin than the MCU, LoopCare and DigiTest system products and we would
expect the increase in sales of these products as a percentage of overall sales
to negatively affect our gross margin in future periods. Selling and Marketing Expense For the six months ended June 26, 2004, selling and marketing expense, which
consists primarily of payroll related costs, consulting expense and travel
costs, increased by $0.5 million or 10.5% to $4.9 million. The increase is
attributed to salaries and wages which increased by approximately $0.3 million,
commissions which increased by $0.2 million and additional costs related to the
CheetahNet and CheetahLight product lines. These increases were offset by
lower incentive compensation expense of $0.1 million and decrease in consulting
fees of $0.2 million. As a percentage of revenues, selling and marketing
expenses were 14.7% in the first six months of 2004 compared to 13.9% in the
first six months of 2003. General and Administrative Expense General and administrative expense, which consists primarily of payroll related
costs, insurance expense and
professional services, remained flat at $3.6 million for the first six months
of 2004 and 2003. A decline in the incentive compensation expense of $0.1
million and bad debt expense of $0.3 million were offset by additional costs
related to CheetahNet and CheetahLight product lines, increased salary costs of
$0.2 million and consulting costs of $0.1 million. As a percentage of
revenues, general and administrative expenses decreased from 11.3% for the
first six months of 2003 to 10.9% for the first six months of 2004. Research and Development Expense Research and development expense, which consists primarily of payroll related
costs, depreciation expense and rent expense in the six months ended June 26,
2004 was $8.3 million, an increase of $1.1 million, or 14.9%, from the $7.3
million recorded in the first six months of 2003. The increase is attributed
to increased salary and benefit costs of $0.5 million and increased consulting,
professional services of $0.3 million related to research and development
related to Cheetah products and increased depreciation. These increases
reflect additional costs year over year due to the Cheetah acquisition. These
increases were mitigated by a reduction of $0.2 million in incentive
compensation. As a percentage of revenues, research and development expense
increased to 25.1% in the first six months of 2004 from 22.8% during the same
period in the prior year. Interest and Other Income Interest and other income, composed primarily of interest income in both
periods, decreased by $0.1 million from the six months ended June 28, 2003,
due to lower market yields on short-term interest bearing investments. 25




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Provision for Income Taxes The provision for income taxes for the six months ended June 26, 2004 was $0.4
million compared to the six months ended June 28, 2003 of $0.8 million. The
effective income tax rate for the first six months of 2004 was 30% compared to
38% in the same period in the prior year. The change in the effective rate is
attributed to permanent book basis versus tax basis differences as a result of
the second quarter 2004 pre-tax loss. While we have made our best
estimate of our effective rate for 2004, based on the Companys operating results
and permanent differences, it is reasonably possible our effective income tax rate could vary during the
remainder of 2004. Net Income and Earnings Per Share As a result of the above factors, net income for the first six months of 2004
was $0.9 million compared to $1.3 million in the first six months of 2003. For
the first six months of 2004, our basic and diluted earnings per common share
was $0.07. For the first six months of 2003 the basic earnings per share was
$0.10 and the diluted earnings per share was $0.09. Basic and diluted weighted
average common and common equivalent shares outstanding were 13,126,231 and
13,309,961 respectively, for the six months ended June 26, 2004 compared to
13,097,319 and 13,276,042, respectively, in the six months ended June 28, 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 legacy LIGHTHOUSE cable offering and
positions the Company as a leading supplier of testing equipment and software
for the cable industry. The acquisition was recorded under the purchase method
of accounting and, accordingly, the results of operations of the acquired
product line from February 14, 2003 forward are included in our consolidated
financial statements. The purchase price remains subject to change pending
resolution between the parties of outstanding contingencies regarding the
earn-out provision and post closing purchase price adjustments. LIQUIDITY AND CAPITAL RESOURCES As of June 26, 2004, the Company had working capital of $67.5 million, an
increase of $1.6 million, or 2.4%, 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 six
months ended June 26, 2004 include a $0.7 million increase in accounts
receivable and a $1.0 million increase in inventories. These increases in
working capital were partially offset by a $0.7 million increase in accounts
payable and $0.6 million increase in deferred income. As of June 26, 2004, the
Company had $48.5 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. 26




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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 $17.2 million
during the third quarter of 2004. Commitment fees are payable quarterly at an
annual rate of 0.25% of the unused commitment. The Facility was amended in
February 2003 in connection with our acquisition of the Cheetah product line to
adjust the determination of base net worth. As of June 26, 2004 and currently,
there are no outstanding borrowings under the Facility, and we are in
compliance with all debt covenants. We do not anticipate any short-term
borrowings for working capital as we believe our cash reserves and internally
generated funds will be sufficient to sustain working capital requirements for
the foreseeable future. The Company expects to incur capital expenditures
totaling approximately $3.0 million in 2004 including projects for test
fixtures related to the manufacturing process and purchases of computer and
office equipment. The Company has in place a stock repurchase program, which is more fully
described in Part II, Item 2(e) of this Report. At managements discretion,
the Company may repurchase shares under this program in the 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 six months ended June 26, 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 $158,947 is due and payable on or
before the earlier of (i) May 2, 2008, (ii) the date of termination of Mr.
Quiggles employment with the Company, or (iii) the date that Mr. Quiggle sells
or otherwise transfers ownership of all or a portion of 40,200 shares of common
stock of Acterna LLC, which shares are being held by the Company as collateral
for payment of the Note. Presently, the shares of stock being held as
collateral have no value. The Note has not been modified since its issuance. COMMITMENTS The Company leases office space and equipment under agreements that are
accounted for as operating leases. The office lease for the Cheswick facility
expires 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.As discussed in note 4, Tollgrade entered
into a third party license agreement in which the Company has an obligation to
pay royalties which may total $0.8 million, depending upon the volume of sales of the underlying product
which incorporates the technology. Additionally, the Company has arrangements
with certain manufacturing subcontractors under which the Company is
contingently obligated to purchase up to $2.4 million of raw material parts in
the event they would not be consumed by the manufacturing process in the normal
course of business. Minimum annual future commitments are as follows: Leases
    
    Purchase Obligations
    
    Total2004 (Remaining six-months)
    
    
    829,000
    
    
    
    2,160,000
    
    
    
    2,989,0002005
    
    
    1,598,000
    
    
    
    84,000
    
    
    
    1,682,0002006
    
    
    867,000
    
    
    
    136,000
    
    
    
    1,003,0002007
    
    
    438,000
    
    
    
    
    
    
    
    438,0002008
    
    
    104,000
    
    
    
    
    
    
    
    104,000
 27




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KEY RATIOS The Companys days sales outstanding (DSO) in accounts receivable trade, based
on the past twelve months rolling revenue, were 60 and 57 days as of June 26,
2004 and December 31, 2003, respectively. This increase is due primarily to the
timing of sales during the respective quarters. The Companys inventory
turnover ratio was 2.6 and 2.3 turns at June 26, 2004 and December 31, 2003,
respectively. ACCOUNTING PRONOUNCEMENTS On January 17, 2003, the FASB issued FASB Interpretation No. 46, Consolidation
of Variable Interest Entities  an interpretation of ARB No. 51 (FIN 46).
FIN 46 clarifies the application of Accounting Research Bulletin No. 51,
Consolidated Financial Statements, to certain entities in which equity
investors do not have the characteristics of a controlling financial interest
or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other
parties. Certain provisions of FIN 46 were effective for the Company after
January 31, 2003 and did not have an impact on the Companys results of
operations or financial condition. FIN No. 46 was revised in December 2003
and is effective for the first financial reporting period ending after March
15, 2004. The Company adopted the provisions of FIN No. 46 for the fiscal
quarter ending March 27, 2004, which did not have an impact on the financial
statements. The Company has no interest in any variable interest entities. RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATING RESULTS AND FINANCIAL CONDITION We wish to caution each reader of this Form 10-Q to consider the following
factors and certain other factors discussed herein and in other past reports,
including but not limited to prior year Form 10-K and Form 10-Q reports and
annual reports filed with the SEC. Our business and results of operations could
be seriously impaired by any of the following risks. The factors discussed
herein may not be exhaustive. Therefore, the factors contained herein should be
read together with other reports and documents that we file with the SEC from
time to time, which may supplement, modify, supercede or update the factors
listed in this document. We depend upon a few major customers for a majority of our revenues, and the
loss of any of these customers, or the substantial reduction in the products
that they purchase from us, would significantly reduce our revenues and net
income. 28




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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. 29




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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
significant 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. 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 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. We have adjusted our business model to focus heavily
on our cable performance and status monitoring products. We are actively
engaged in research to improve and expand our cable products, including
research and development of VoIP solutions. Our cable hardware and software
products have lower margins than our MCU, LoopCare and DigiTest system
products. If sales of our cable testing products do not increase or are not
accepted in the marketplace, or if our research and development activities do
not produce marketable products that are both competitive and accepted by our
customers, our overall revenues and profitability will be adversely affected. In addition, although software products generally generate higher margin
returns for us than our hardware products, the initial development costs of
software applications, coupled with the inherent problems with pricing software
sold to customers, can make it difficult to assess the potential profitability
of new software products. Unless we acquire proprietary software, we must
internally develop any new software products. Software development is a
relatively expensive and lengthy process. In addition, because it is customary
in our industry to sell perpetual enterprise licenses that cover an entire
customers operations, it can be difficult to assess at the time of sale the
exact price that we should charge for a particular license. Our customers are subject to governmental regulations that could significantly
reduce the demand for our products or increase our costs of doing business. Our customers have historically been subject to a number of governmental
regulations, many of which have been repealed or amended as a result of the
passage of The Telecommunications Act of 1996. Deregulatory efforts have
affected and likely will continue to affect our customers in several ways,
including the introduction of competitive forces into the local telephone
markets and the imposition (or removal) of controls on the pricing of services.
These and other regulatory changes may limit the scope of our customers
deployments of future services and budgets for capital expenditures, which
could significantly reduce the demand for our products. Moreover, as the Federal Communications Commission (FCC) adopts new and
amends existing regulations, and as the courts analyze the FCCs authority to
do so, our customers cannot accurately predict the rules by which they will be
able to compete in their respective markets. Changes in the telecommunications
regulatory environment could, among other results, increase our costs of doing
business, require our customers to share assets with competitors or prevent the
Company or our customers from engaging in business activities they may wish to
conduct, which could adversely affect our future results. 31




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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
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. 32




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We have completed, and may pursue additional acquisitions, which will
complicate our management tasks and could result in substantial expenditures. We have completed, and we may pursue additional acquisitions of
companies, product lines and technologies as part of our efforts to enhance our
existing products, to introduce new products and to fulfill changing customer
requirements. Acquisitions involve numerous risks, including the disruption of
our business, exposure to assumed or unknown liabilities of the acquired
target, and the failure to integrate successfully the operations and products
of acquired businesses. Goodwill arising from acquisitions may result in
significant charges against our operating results in one or more future
periods. Furthermore, we may never achieve the anticipated results or benefits
of an acquisition, such as increased market share or the successful development
and sales of a new product. The effects of any of these risks could materially
harm our business and reduce our future results of operations. In addition, the carrying value of certain of our intangible assets,
consisting primarily of goodwill related to our LoopCare software and Cheetah
product line acquisitions from Lucent Technologies, Inc. and Acterna, LLC,
could be impaired by changing market conditions. We are required under
generally accepted accounting principles to review our amortizable intangible
assets for impairment when events or changes in circumstances indicate the
carrying value may not be recoverable. Goodwill is required to be tested for
impairment at least annually. Factors that may indicate that the carrying
value of our intangible assets may not be recoverable include a decline in
stock price and market capitalization and lower than anticipated cash flows
produced by such intangible assets. If our stock price and market
capitalization decline, or if we do not realize the expected revenues from an
intangible asset, we may be required to record a significant charge to earnings
in our financial statements during the period in which any impairment of that
intangible asset is determined. Our future sales in international markets are subject to numerous risks and
uncertainties. We have limited experience selling our products internationally, and our
future sales in international markets are subject to numerous risks and
uncertainties, including local economic and labor conditions, political
instability including terrorism and other acts of war or hostility, unexpected
changes in the regulatory environment, trade protection measures, tax laws, our
ability to market current or develop new products suitable for international
markets, obtaining and maintaining successful distribution and resale channels and foreign currency exchange rates. Reductions in the
demand for or the sales of our products in international markets could
adversely affect future results. If 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. 33




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Our future results are dependent on our ability to establish, maintain and
expand our distribution channels and our existing third-party distributors. We market and sell certain of our products, including our DigiTest and
Cheetah product lines, through domestic and international OEM relationships.
Our future results are dependent on our ability to establish, maintain and
expand third party relationships with OEM as well as other marketing and sales
distribution partners. If, however, the third parties with whom we have entered
into such OEM and other partnerships should fail to meet their own performance
objectives, customer demand for our products could be adversely affected, which
would have an adverse effect on our revenues. We face intense competition, which could result in our losing market share or
experiencing a decline in our gross margins. The markets for some of our products are very competitive. Some of our
competitors may have greater technological, financial, manufacturing, sales and
marketing, and personnel resources than we have. As a result, these competitors
may have an advantage in responding more rapidly or effectively to changes in
industry standards or technologies. Moreover, better financed competitors may
be better able to withstand the pricing pressures that increased competition
may bring. If our introduction of improved products or services is not timely
or well received, or if our competitors reduce their prices for products that
are comparable to ours, demand for our products and services could be adversely
affected. We may also compete directly with our customers. Generally, we sell our
products either directly, or indirectly through OEM channels and other means,
to end-user telecommunications and cable television providers. It is possible
that our customers, as the result of bankruptcy or other rationales for
dismantling network equipment, could attempt to resell our products. The
successful development of such a secondary market for our products by a third
party could negatively affect demand for our products, reducing our future
revenues. We are dependent upon our ability to attract, retain and motivate our key
personnel. Our success depends on our ability to attract, retain and motivate the key
management and technical personnel necessary to implement our business plan and
to grow our business. Despite the adverse economic conditions of the past several years, competition for certain
specific technical and management skill sets is intense. If we are unable to
identify and hire the personnel that we need to succeed, or if one or more of
our present key employees were to cease to be associated with the Company, our
future results could be adversely affected. Consolidations in, or a continued slowdown in, the telecommunications industry
could harm our business. We have derived a substantial amount of our revenues from sales of
products and related services to the telecommunications industry. The
telecommunications industry has experienced significant growth and
consolidation in the past few years, although, over recent years, trends
indicate that capital spending by this industry has decreased and may continue
to decrease in the future as a result of a general decline in economic growth
in local and international markets. In particular, RBOC and large ILEC
customers have been adversely affected by subscriber line losses and the
after-effects of overspending in 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. 34




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Our expenses are relatively fixed in the short term, and we may be unable to
adjust spending to compensate for unexpected revenue shortfalls. We base our expense levels in part on forecasts of future orders and
sales, which are extremely difficult to predict. A substantial portion of our
operating expenses is related to personnel, facilities and sales and marketing.
The level of spending for such expenses cannot be adjusted quickly and is,
therefore, relatively fixed in the short term. Accordingly, our operating
results will be harmed if revenues fall below our expectations in a particular
quarter. Our restructuring plan may be ineffective or may limit our ability to compete. We have recently announced a reduction in work force taken in response to
the recent decrease in our revenues in our telecom business. These actions
could have long term adverse effects on that portion of our business. There
are several risks inherent in our efforts to bring our cost base in line with
the current environment by reducing our telecom workforce. These include the
risk that we will not be successful in achieving our planned cost reductions,
and that even if we are successful in doing so, we will still not be able to
reduce expenditures quickly enough to see a positive profitability effect and
may have to undertake further restructuring initiatives that would entail
additional charges and create additional risks. In addition, there is the risk
that cost-cutting initiatives will impair our ability to effectively develop
and market products and remain competitive in the telecom business. Each of
the above measures could have long-term effects on our business by reducing our
pool of talent, decreasing or slowing improvements in our products, making it
more difficult for us to respond to customers, limiting our ability to increase
production quickly if and when the demand for our products increases and
limiting our ability to hire and retain key personnel. These circumstances
could cause our earnings to be lower than they otherwise might be. We rely on software that we have licensed from third-party developers to
perform key functions in our products. We rely on software that we license from third parties, including software
that is integrated with internally developed software and used in our products
to perform key functions. We could lose the right to use this software or it
could be made available to us only on commercially unreasonable terms. Although
we believe that alternative software is available from other third-party
suppliers or internal developments, the loss of or inability to maintain any of
these software licenses or the inability of the third parties to enhance in a
timely and cost-effective manner their products in response to changing
customer needs, industry standards or technological developments could result
in delays or reductions in product shipments by us until equivalent software
could be developed internally or identified, licensed and integrated, which
would harm our business. 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 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. 35




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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. 
 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. 36




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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. 37




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PART II. OTHER INFORMATION 
 Item 1. LEGAL PROCEEDINGS. During the quarter ended June 26, 2004, we negotiated a settlement with a
distributor which resulted in the return of equipment that the distributor
purchased in the prior year which caused a reduction in revenue of $0.4
million. Although we continue to believe the claims were without merit, we
negotiated a settlement to eliminate any further costs of defending the case. 
 Item 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES  (e)
    
    On January 21, 2004, our Board of Directors authorized the continuation
through December 31, 2004 of a share repurchase program which expired on
December 31, 2003. Under this extension, we may repurchase a total of one
million shares of our common stock before December 31, 2004. Since the
initial repurchase program was instituted in April 1997, and as of June
26, 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 six months ended June 26, 2004. 
 Item 5. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On May 5, 2004, the Company held its annual shareholders meeting. At the
meeting, Richard H. Heibel and Robert W. Kampmeinert were elected to the Board
of Directors for three-year terms expiring at the annual meeting of
shareholders in 2007. The terms of Directors James J. Barnes and Brian C.
Mullins continued after the meeting and will expire at the annual meeting of
shareholders in 2006. The terms of Directors Christian L. Allison, Daniel P.
Barry and David S. Egan also continued after the meeting and will expire at the
annual meeting of shareholders in 2005. The results of the voting were as
follows: Nominee for Director
    
    Total Votes Cast
    
    For
    
    Against
    
    Withheld
    
    AbstainedRichard H. Heibel
    
    
    12,829,342
    
    
    
    11,470,288
    
    
    
    
    
    
    
    1,359,054
    
    
    
    Robert W.
Kampmeinert
    
    
    12,829,342
    
    
    
    6,859,441
    
    
    
    
    
    
    
    5,969,901
    
    
    
    
 
 Item 6. EXHIBITS AND REPORTS FILED ON FORM 8-K  (a)
    
    Exhibits:The following exhibits are being filed with this report: ExhibitNumber
    
    Description10.48
    
    Change in Control Agreement, dated as of June 18, 2004, by
and between the Company and Sean M.
Reilly, filed herewith10.49
    
    Extension and Amendment of Agreement, dated as of February
8, 2004, between the Company and Sara M.
Antol, filed herewith10.50
    
    Extension and Amendment of Agreement, dated as of February
8, 2004, between
the Company and Ruth Dilts,
filed herewith10.51
    
    Extension and Amendment of Agreement, dated as of February
8, 2004, between the Company and Samuel C. Knoch, filed
herewith10.52
    
    Extension and Amendment of Agreement, dated as of February
9, 2004, between
the Company and
Rocco L. Flaminio, filed herewith
 38




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ExhibitNumber
    
    Description10.53
    
    Extension and Amendment of
Agreement, dated as of February 13, 2004,
between the Company and Matthew J. Rosgone, filed herewith10.54
    
    Extension and Amendment of
Agreement, dated as of May 19, 2004, between the
Company and Stephen M. Garda, filed
herewith15
    
    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 April 16, 2004 under
Item 7 and 12, which contained our results of operations for our
first quarter ended March 27, 2004. 39




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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: August 5, 2004
    
    /s/ Christian L. AllisonChristian L. AllisonChairman and Chief Executive OfficerDated: August 5, 2004
    
    /s/ Samuel C. KnochSamuel C. KnochChief Financial Officer and TreasurerDated: August 5, 2004
    
    /s/ Sean M. ReillySean M. ReillyController
 40




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##### Table of Contents



EXHIBIT INDEX  ExhibitNumber
    
    Description10.48
    
    Change in Control Agreement, dated as of June 18, 2004, by
and between the Company and Sean M.
Reilly, filed herewith10.49
    
    Extension and Amendment of Agreement, dated as of February
8, 2004, between the Company and Sara M.
Antol, filed herewith10.50
    
    Extension and Amendment of Agreement, dated as of February
8, 2004, between
the Company and Ruth Dilts,
filed herewith10.51
    
    Extension and Amendment of Agreement, dated as of February
8, 2004, between the Company and Samuel C. Knoch, filed
herewith10.52
    
    Extension and Amendment of Agreement, dated as of February
9, 2004, between
the Company and
Rocco L. Flaminio, filed herewith10.53
    
    Extension and Amendment of
Agreement, dated as of February 13, 2004,
between the Company and Matthew J. Rosgone, filed herewith10.54
    
    Extension and Amendment of
Agreement, dated as of May 19, 2004, between the
Company and Stephen M. Garda, filed
herewith15
    
    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
 41