##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, DC 20549
 FORM 10-Q
  þ
    
    Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the quarterly period ended April 1, 2006
 o
    
    Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the transition period from  to
 Commission file number 000-27312
 TOLLGRADE COMMUNICATIONS, INC.
  Pennsylvania
(State or other jurisdiction
of incorporation or organization)
    
    25-1537134
(I.R.S. Employer
Identification No.)
 493 Nixon Rd.
Cheswick, PA 15024
 412-820-1400
  þ o
  o þ o
  o þ




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##### 



TOLLGRADE COMMUNICATIONS, INC.
  
 Quarterly Report on Form 10-Q
For the Quarter Ended April 1, 2006  Table of Contents
 PAGE NO.PART I. FINANCIAL INFORMATIONItem 1 Condensed Consolidated Financial Statements (unaudited):Condensed Consolidated Balance Sheets as of April 1, 2006 and December 31, 2005
    
    
    3Condensed Consolidated Statements of Operations for the three month periods ended April 1, 2006 and March 26, 2005
    
    
    4Condensed Consolidated Statement of Changes in Shareholders Equity for the three month period ended April 1, 2006
    
    
    5Condensed Consolidated Statements of Cash Flows for the three month periods ended April 1, 2006 and March 26, 2005
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Report of Independent Registered Public Accounting Firm
    
    
    17Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    18Item 3 Quantitative and Qualitative Disclosures about Market Risk
    
    
    33Item 4 Controls and Procedures
    
    
    33PART II. OTHER INFORMATIONItem 1A Risk Factors
    
    
    34Item 2 Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    45Item 6 Exhibits
    
    
    45SIGNATURES
    
    
    46EXHIBIT INDEX
    
    
    47Exhibit 10.1Exhibit 10.2Exhibit 15Exhibit 31.1Exhibit 31.2Exhibit 32EX-10.1EX-10.2EX-15EX-31.1EX-31.2EX-32
  2




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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (In thousands except par value) (Unaudited)
 April 1, 2006
    
    
    December 31, 2005*ASSETSCurrent assets:Cash and cash equivalents
    
    $
    41,190
    
    
    $
    49,421Short-term investments
    
    
    17,576
    
    
    
    18,010Accounts receivable:Trade, net of allowance for doubtful accounts of
$477 in 2006 and $465 in 2005
    
    
    15,659
    
    
    
    9,456Other
    
    
    1,451
    
    
    
    1,406Inventories
    
    
    11,974
    
    
    
    9,934Prepaid expenses and other current assets
    
    
    1,417
    
    
    
    1,397Deferred tax assets and refundable income tax
    
    
    1,356
    
    
    
    1,803Total current assets
    
    
    90,623
    
    
    
    91,427Property and equipment, net
    
    
    6,376
    
    
    
    6,390Deferred tax assets
    
    
    48
    
    
    
    46Intangibles, net
    
    
    44,150
    
    
    
    43,616Goodwill
    
    
    23,335
    
    
    
    21,562Receivable from officer
    
    
    152
    
    
    
    153Other assets
    
    
    127
    
    
    
    135Total assets
    
    $
    164,811
    
    
    $
    163,329LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    2,904
    
    
    $
    1,262Accrued warranty
    
    
    2,247
    
    
    
    2,220Accrued expenses
    
    
    1,659
    
    
    
    2,579Accrued salaries and wages
    
    
    266
    
    
    
    660Accrued royalties payable
    
    
    618
    
    
    
    581Income taxes payable
    
    
    197
    
    
    
    869Deferred income
    
    
    3,655
    
    
    
    2,450Total current liabilities
    
    
    11,546
    
    
    
    10,621Deferred tax liabilities
    
    
    2,463
    
    
    
    2,447Total liabilities
    
    
    14,009
    
    
    
    13,068Commitments and contingent liabilities
    
    
    
    
    
    
    Shareholders equity:Preferred stock, $1.00 par value; Authorized
shares, 10,000; issued shares, -0- in 2006 and 2005
    
    
    
    
    
    
    Common stock, $.20 par value; authorized shares,
50,000; issued shares, 13,708 in 2006 and 13,664
in 2005
    
    
    2,742
    
    
    
    2,733Additional paid-in capital
    
    
    72,065
    
    
    
    71,469Treasury stock, at cost, 462 shares in 2006 and 2005
    
    
    (4,791
    )
    
    
    (4,791
    )Retained earnings
    
    
    80,786
    
    
    
    80,850Total shareholders equity
    
    
    150,802
    
    
    
    150,261Total liabilities and shareholders equity
    
    $
    164,811
    
    
    $
    163,329
 
 *
    
    Amounts derived from audited financial statements presented in the Companys Annual Report on
Form 10-K for the year ended December 31, 2005  3




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##### Table of Contents



TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except per share data) (Unaudited)
 Three Months EndedApril 1, 2006
    
    
    March 26, 2005Revenues:Products
    
    $
    14,497
    
    
    $
    11,980Services
    
    
    3,110
    
    
    
    2,295Total revenues:
    
    
    17,607
    
    
    
    14,275Cost of sales:Products
    
    
    7,625
    
    
    
    6,052Services
    
    
    1,059
    
    
    
    796Amortization of intangibles
    
    
    977
    
    
    
    714Total cost of sales
    
    
    9,661
    
    
    
    7,562Gross profit
    
    
    7,946
    
    
    
    6,713Operating expenses:Selling and marketing
    
    
    2,686
    
    
    
    2,238General and administrative
    
    
    2,320
    
    
    
    1,835Research and development
    
    
    3,659
    
    
    
    3,396Retirement expense
    
    
    
    
    
    
    775Total operating expense
    
    
    8,665
    
    
    
    8,244Loss from operations
    
    
    (719
    )
    
    
    (1,531
    )Other income:Interest income:
    
    
    627
    
    
    
    262Loss before taxes
    
    
    (92
    )
    
    
    (1,269
    )Benefit from income taxes
    
    
    (28
    )
    
    
    (424
    )Net loss
    
    $
    (64
    )
    
    $
    (845
    )Loss per share information:Weighted average shares of common stock
and equivalents:Basic
    
    
    13,214
    
    
    
    13,161Diluted
    
    
    13,214
    
    
    
    13,161Net loss per common share:Basic
    
    $
    0.00
    
    
    $
    (0.06
    )Diluted
    
    $
    0.00
    
    
    $
    (0.06
    )
  4




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##### Table of Contents



TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS EQUITY
For the Three Months Ended April 1, 2006
(In thousands) (Unaudited)
 AdditionalPreferred Stock
    
    
    Common Stock
    
    
    Paid-In
    
    
    Treasury
    
    
    RetainedShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Capital
    
    
    Stock
    
    
    Earnings
    
    
    TotalBalance at
December 31, 2005
    
    
    
    
    
    $
    
    
    
    
    13,664
    
    
    $
    2,733
    
    
    $
    71,469
    
    
    $
    (4,791
    )
    
    $
    80,850
    
    
    $
    150,261Exercise of common
stock options
    
    
    
    
    
    
    
    
    
    
    44
    
    
    
    9
    
    
    
    390
    
    
    
    
    
    
    
    
    
    
    
    399Tax benefit from
exercise of stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    91
    
    
    
    
    
    
    
    
    
    
    
    91Stock-based
compensation
expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    115
    
    
    
    
    
    
    
    
    
    
    
    115Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (64
    )
    
    
    (64
    )Balance at
April 1, 2006
    
    
    
    
    
    $
    
    
    
    
    13,708
    
    
    $
    2,742
    
    
    $
    72,065
    
    
    $
    (4,791
    )
    
    $
    80,786
    
    
    $
    150,802
  5




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##### Table of Contents



TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands) (Unaudited)
 Three Months EndedApril 1, 2006
    
    
    March 26, 2005Cash flows from operating activities:Net loss
    
    $
    (64
    )
    
    $
    (845
    )Adjustments to reconcile net loss to net cash provided by
operating activities:Depreciation and amortization
    
    
    1,520
    
    
    
    1,368Compensation expense related to stock plans
    
    
    115
    
    
    
    Deferred income taxes
    
    
    (190
    )
    
    
    (437
    )Provision for losses on inventory
    
    
    (18
    )
    
    
    57Provision (credit) for allowance for doubtful accounts
    
    
    12
    
    
    
    (17
    )Changes in assets and liabilities (net of acquired business):(Increase) decrease in accounts receivable-trade
    
    
    (4,388
    )
    
    
    1,847Increase in accounts receivable-other
    
    
    (45
    )
    
    
    (600
    )Increase in inventory
    
    
    (922
    )
    
    
    (1,226
    )(Increase) decrease in prepaid expenses and other assets
    
    
    (11
    )
    
    
    762Decrease in refundable taxes
    
    
    651
    
    
    
    312Increase in accounts payable
    
    
    1,015
    
    
    
    234Increase (decrease) in accrued warranty
    
    
    27
    
    
    
    (20
    )Increase (decrease) in accrued expenses and deferred income
    
    
    110
    
    
    
    (282
    )Increase (decrease) in accrued royalties payable
    
    
    37
    
    
    
    (299
    )Decrease in accrued salaries and wages
    
    
    (394
    )
    
    
    (119
    )(Decrease) increase in income taxes payable
    
    
    (672
    )
    
    
    12Net cash (used in) provided by operating activities
    
    
    (3,217
    )
    
    
    747Cash flows from investing activities:Purchase of Emerson test system business
    
    
    (5,501
    )
    
    
    Purchase of short-term investments
    
    
    (2,136
    )
    
    
    (10,391
    )Redemption/maturity of short-term investments
    
    
    2,570
    
    
    
    500Capital expenditures, including capitalized software
    
    
    (437
    )
    
    
    (344
    )Net cash used in investing activities
    
    
    (5,504
    )
    
    
    (10,235
    )Cash flows from financing activities:Proceeds from exercise of stock options
    
    
    399
    
    
    
    Tax benefit from exercise of stock options
    
    
    91
    
    
    
    Net cash provided by financing activities
    
    
    490
    
    
    
    Net decrease in cash and cash equivalents
    
    
    (8,231
    )
    
    
    (9,488
    )Cash and cash equivalents at beginning of period
    
    
    49,421
    
    
    
    32,622Cash and cash equivalents at end of period
    
    $
    41,190
    
    
    $
    23,134
  6




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




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##### Table of Contents



NEW ACCOUNTING STANDARDS
   2. ACCOUNTING FOR STOCK-BASED COMPENSATION
 Stock-Based Compensation Expense
    8




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##### Table of Contents



Pro forma information under SFAS 123 for periods prior to January 1, 2006
  9




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##### Table of Contents



Three Months EndedMarch 26, 2005(in thousands)Net loss
    
    $
    (845
    )Less: Total stock-based compensation
determined under the fair value method for all
awards, net of related tax
    
    
    (2
    )Pro forma net loss
    
    $
    (847
    )Loss per share:Basic
    
    $
    (0.06
    )Basic  pro forma
    
    $
    (0.06
    )Diluted
    
    $
    (0.06
    )Diluted  pro forma
    
    $
    (0.06
    )
 Stock Compensation Plans
   Shares Authorized But Not GrantedApril 1, 2006
    
    
    December 31, 20051995 Long-Term Incentive Compensation Plan
    
    
    N/A
    
    
    
    N/A1998 Employee Incentive Compensation Plan
    
    
    108,388
    
    
    
    107,054
  10




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##### Table of Contents



Number of
    
    
    
    
    
    
    Weighted AverageShares
    
    
    Range of Options Price
    
    
    Exercise PriceOutstanding, December 31, 2005
    
    
    1,780,137
    
    
    $
    7.28  159.19
    
    
    $
    26.87Granted
    
    
    
    
    
    
    
    
    
    
    Exercised
    
    
    (44,318
    )
    
    $
    7.56  12.55
    
    
    
    9.01Cancelled
    
    
    (261,684
    )
    
    
    7.28  55.90
    
    
    
    12.80Outstanding, April 1, 2006
    
    
    1,474,135
    
    
    
    7.28  159.19
    
    
    
    29.90Number of SharesOptions exercisable at:December 31, 2004
    
    
    
    
    
    
    1,629,607December 31, 2005
    
    
    
    
    
    
    1,605,113April 1, 2006
    
    
    
    
    
    
    1,299,211
  Stock Options Outstanding
    
    
    Stock Options ExercisableWeightedNumber
    
    
    Average
    
    
    Weighted
    
    
    Number
    
    
    WeightedRange of
    
    Outstanding as
    
    
    Remaining
    
    
    Average
    
    
    Exercisable
    
    
    AverageExercise Prices
    
    of 04/01/06
    
    
    Contractual Life
    
    
    Exercise Price
    
    
    As of 04/01/06
    
    
    Exercise Price7.28
    
    
    51,000
    
    
    
    2.71
    
    
    
    7.28
    
    
    
    51,000
    
    
    
    7.287.29  9.49
    
    
    428,918
    
    
    
    7.36
    
    
    
    8.53
    
    
    
    254,660
    
    
    
    8.459.50  12.55
    
    
    139,467
    
    
    
    5.11
    
    
    
    11.41
    
    
    
    138,801
    
    
    
    11.4112.56  15.84
    
    
    127,100
    
    
    
    4.34
    
    
    
    13.94
    
    
    
    127,100
    
    
    
    13.9415.85  21.93
    
    
    195,000
    
    
    
    5.52
    
    
    
    19.64
    
    
    
    195,000
    
    
    
    19.6421.94  28.40
    
    
    162,250
    
    
    
    5.56
    
    
    
    27.87
    
    
    
    162,250
    
    
    
    27.8728.41  55.90
    
    
    211,350
    
    
    
    5.10
    
    
    
    43.56
    
    
    
    211,350
    
    
    
    43.5655.91  103.59
    
    
    10,000
    
    
    
    4.46
    
    
    
    97.25
    
    
    
    10,000
    
    
    
    97.25103.60  117.34
    
    
    133,000
    
    
    
    4.38
    
    
    
    117.34
    
    
    
    133,000
    
    
    
    117.34117.35  159.19
    
    
    16,050
    
    
    
    4.28
    
    
    
    159.19
    
    
    
    16,050
    
    
    
    159.19Total
    
    
    1,474,135
    
    
    
    5.64
    
    
    
    29.90
    
    
    
    1,299,211
    
    
    
    32.77
 3. ACQUISITION
  11




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Accounts Receivable
    
    
    
    
    
    $
    1,825Inventories
    
    
    
    
    
    
    1,100Property and Equipment
    
    
    
    
    
    
    129Intangible Assets:Customer Relationship
    
    
    724Tradename
    
    
    120Purchased Technology
    
    
    475Sales Order Backlog
    
    
    156Goodwill
    
    
    1,773Total Assets Acquired
    
    
    
    
    
    
    6,302Deferred Income
    
    
    
    
    
    
    175Accounts Payable
    
    
    
    
    
    
    626Total Liabilities
    
    
    
    
    
    
    801Net Assets Acquired
    
    
    
    
    
    $
    5,501
  (In Thousands, Except Per Share Data).Unaudited Pro Forma
    
    
    Unaudited Pro FormaApril 1, 2006
    
    
    March 26, 2005Revenues
    
    $
    19,173
    
    
    $
    17,647Loss from Operations
    
    $
    (981
    )
    
    $
    (1,663
    )Net Loss
    
    $
    (236
    )
    
    $
    (934
    )Diluted earnings per share
    
    $
    (0.02
    )
    
    $
    (0.07
    )
 12




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##### Table of Contents



4. INTANGIBLE ASSETS
  Useful
    
    
    
    
    
    
    April 1, 2006
    
    
    
    
    
    
    
    
    
    
    December 31, 2005Life
    
    
    
    
    
    
    Accumulated
    
    
    
    
    
    
    
    
    
    
    Accumulated(Years)
    
    
    Gross
    
    
    Amortization
    
    
    Net
    
    
    Gross
    
    
    Amortization
    
    
    NetAmortizing Intangible
Assets:Post Warranty Service Agreements
    
    
    50
    
    
    $
    32,000
    
    
    $
    320
    
    
    $
    31,680
    
    
    $
    32,000
    
    
    $
    160
    
    
    $
    31,840Technology
    
    
    5-10
    
    
    
    17,998
    
    
    
    10,857
    
    
    
    7,141
    
    
    
    17,487
    
    
    
    10,212
    
    
    
    7,275Customer Relationships
    
    
    5-10
    
    
    
    3,374
    
    
    
    531
    
    
    
    2,843
    
    
    
    2,650
    
    
    
    449
    
    
    
    2,201Purchased Backlog
    
    
    1
    
    
    
    156
    
    
    
    86
    
    
    
    70
    
    
    
    
    
    
    
    
    
    
    
    Tradename
    
    
    3
    
    
    
    120
    
    
    
    4
    
    
    
    116
    
    
    
    
    
    
    
    
    
    
    
    Non-Amortizing Intangible
Assets:Tradenames
    
    
    
    
    
    
    2,300
    
    
    
    
    
    
    
    2,300
    
    
    
    2,300
    
    
    
    
    
    
    
    2,300Total Intangible Assets
    
    
    
    
    
    $
    55,948
    
    
    $
    11,798
    
    
    $
    44,150
    
    
    $
    54,437
    
    
    $
    10,821
    
    
    $
    43,616Goodwill
    
    
    
    
    
    $
    23,335
    
    
    
    
    
    
    $
    23,335
    
    
    $
    21,562
    
    
    
    
    
    
    $
    21,562
    13




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##### Table of Contents



5. INVENTORY
  April 1, 2006
    
    
    December 31, 2005Raw materials
    
    $
    5,963
    
    
    $
    5,712Work in process
    
    
    4,415
    
    
    
    3,449Finished goods
    
    
    3,673
    
    
    
    2,86814,051
    
    
    
    12,029Reserve for slow moving and obsolete inventory
    
    
    (2,077
    )
    
    
    (2,095
    )$
    11,974
    
    
    $
    9,934
 6. SHORT-TERM INVESTMENTS
  7. RETIREMENT EXPENSE
  8. PER SHARE INFORMATION
  14




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Three Months Ended
    
    
    Three Months EndedApril 1, 2006
    
    
    March 26, 2005Net loss
    
    $
    (64
    )
    
    $
    (845
    )Common and common equivalent shares:Weighted average common shares outstanding
    
    
    13,214
    
    
    
    13,161Effect of dilutive securities  stock options
    
    
    
    
    
    
    13,214
    
    
    
    13,161Loss per share:Basic
    
    $
    0.00
    
    
    $
    (0.06
    )Diluted
    
    $
    0.00
    
    
    $
    (0.06
    )
 9. RECEIVABLE FROM OFFICER
  10. PRODUCT WARRANTY
   Three Months Ended
    
    
    Year EndedApril 1, 2006
    
    
    December 31, 2005Balance at the beginning of the period
    
    $
    2,220
    
    
    $
    2,081Accruals for warranties issued during the period
    
    
    366
    
    
    
    1,502Settlements during the period
    
    
    (339
    )
    
    
    (1,363
    )Balance at the end of the period
    
    $
    2,247
    
    
    $
    2,220
  11. CONTINGENCIES AND COMMITMENTS
  15




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##### Table of Contents



12. MAJOR CUSTOMERS AND INTERNATIONAL SALES
   16




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Report of Independent Registered Public Accounting Firm
 
     
 17




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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.
 will, believes, intends, expects, plans, could or may,
  OVERVIEW
 About the Company
  18




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##### Table of Contents



About its customers
 ®
  PRODUCTS
 TELECOMMUNICATION TEST SYSTEMS
 ®
 DigiTest and LoopCare; N(x)Test, N(x)DSL-3 and LTSC
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®
   
    
    the Common Object Request Broker Architecture (CORBA)-based
Application Programming Interface;
    
    Benchmark Data Base;
    
    DSL Testing;
    
    the Advanced Testhead Feature Package;
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
    
    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).
    
    Multi-DSL Prequalification Features; and
    
    Breakthrough CPE and Fast Answering CPA Suppression.
  MCU
  CABLE TESTING PRODUCTS
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® ®
 SERVICES
  BACKLOG
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OPERATING SEGMENT
  INTERNATIONAL SALES
  APPLICATION OF CRITICAL ACCOUNTING POLICIES
  Revenue Recognition
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Goodwill and Intangible Assets
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Sensitivity Analysis
  YearsTwelve-monthOriginal
    
    
    Remaining Life at
    
    
    Carrying Value at
    
    
    Rolling ProjectedAsset Description
    
    Life
    
    
    4/1/06
    
    
    4/1/06
    
    
    AmortizationLoopCareBase Software
    
    
    10
    
    
    
    5.50
    
    
    $
    2.5
    
    
    $
    0.5Post-WarrantyMaintenance ServiceAgreements
    
    
    50
    
    
    
    49.50
    
    
    
    31.7
    
    
    
    0.6CheetahBase Software
    
    
    10
    
    
    
    6.75
    
    
    
    2.0
    
    
    
    0.3Proprietary Technology
    
    
    10
    
    
    
    6.75
    
    
    
    0.7
    
    
    
    0.1Customer Base
    
    
    15
    
    
    
    11.75
    
    
    
    2.1
    
    
    
    0.3EmersonProprietary Technology
    
    
    5
    
    
    
    5
    
    
    
    0.5
    
    
    
    0.1Customer Relationship
    
    
    5
    
    
    
    5
    
    
    
    0.7
    
    
    
    0.2Other
    
    
    3-5
    
    
    
    3
    
    
    
    0.5
    
    
    
    0.1$
    40.7
    
    
    $
    2.2
  Reviews for Impairment:
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Inventory Valuation
   Allowance for Doubtful Accounts
   Income Taxes
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Warranty
   RESULTS OF OPERATIONS
 FIRST QUARTER OF 2006 COMPARED TO FIRST QUARTER OF 2005
 Revenues
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Gross Profit
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Selling and Marketing Expense
  General and Administrative Expense
 .
 Research and Development Expense
  Retirement Expense
  Interest and Other Income
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Benefit from Income Taxes
  Net Loss and Loss Per Share
  LIQUIDITY AND CAPITAL RESOURCES
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RELATED PARTY TRANSACTION
  KEY RATIOS
  NEW ACCOUNTING STANDARDS
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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  
 Item 4. CONTROLS AND PROCEDURES
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PART II. OTHER INFORMATION
 
 Item 1A. RISK FACTORS
  We depend upon a few major customers for a majority of our revenues, and the loss of any of these
customers, or the substantial reduction in the products that they purchase from us, would
significantly reduce our revenues and net income.
  
 
 
 
 
 
 
  Our operating results may vary from quarter to quarter, causing our stock price to fluctuate.
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The sales cycle for our system products is long, and the delay or failure to complete one or more
large transactions in a quarter could cause our operating results to fall below our expectations.
   We depend on sales of our MCU products for a meaningful portion of our revenues, but this product
is mature and its sales will continue to decline.
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Our Services business is subject to a trend of reduced capital spending by our major customers.
  We have emphasized our network assurance and testing solutions and cable status monitoring
products.
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The sale of our products is dependent upon our ability to satisfy the proprietary requirements of
our customers and to respond to rapid technological change, including evolving industry-wide
standards.
   Our customers are subject to an evolving governmental regulatory environment that could
significantly reduce the demand for our products or increase our costs of doing business.
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Our limited ability to protect our proprietary information and technology may adversely affect our
ability to compete.
  Our products could infringe the intellectual property rights of others, and resulting claims
against us could be costly and require us to enter into disadvantageous license or royalty
arrangements.
   Our reliance on third parties for critical components and to manufacture certain aspects of our
products involves risks, including delays in product shipments and reduced control over product quality.
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If we are unable to satisfy our customers specific product quality, certification or network
requirements, our business could be disrupted and our financial condition could be harmed.
  We have completed, and may pursue additional acquisitions, which will complicate our management
tasks and could result in substantial expenditures.
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The failure of acquired assets to meet expectations, or a decline on our fair value determined by
market prices of our stock, could indicate impairment of our intangible assets and result in
impairment charges.
  Our future sales in international markets are subject to numerous risks and uncertainties.
  If our accounting controls and procedures are circumvented or otherwise fail to achieve their
intended purposes, our business could be seriously harmed.
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If we ship products that contain defects, the market acceptance of our products and our reputation
will be harmed and our customers could seek to recover their damages from us.
  Our future results are dependent on our ability to establish, maintain and expand our distribution
channels and our existing third-party distributors.
  We face intense competition, which could result in our losing market share or experiencing a
decline in our gross margins.
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We are dependent upon our ability to attract, retain and motivate our key personnel.
  Consolidations in, or a continued slowdown in, the telecommunications industry could harm our
business.
  Our expenses are relatively fixed in the short term, and we may be unable to adjust spending to
compensate for unexpected revenue shortfalls.
  Our restructuring and cost reduction plans may be ineffective or may limit our ability to compete.
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We rely on software that we have licensed from third-party developers to perform key functions in
our products and we rely on certain hardware sourced through OEM channels.
  We are affected by a pattern of product price decline in certain markets, which can harm our
business.
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Our common stock price may be extremely volatile.
  
    
    General market and economic conditions;
    
    Changes in the telecommunications industry;
    
    Actual or anticipated variations in operating results;
    
    Announcements of technological innovations, new products or new
services by us or by our competitors or customers;
    
    Changes in financial estimates or recommendations by stock market
analysts regarding us or our competitors;
    
    Announcements by us or our competitors of significant acquisitions,
strategic partnerships, joint ventures or capital commitments;
    
    Announcements by our customers regarding end market conditions and the
status of existing and future infrastructure network deployments;
    
    Additions or departures of key personnel; and
    
    Future equity or debt offerings or our announcements of these offerings.
  We may be subject from time to time to legal proceedings, and any adverse determinations in these
proceedings could materially harm our business.
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Item 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
  
 Item 6. EXHIBITS
   ExhibitNumber
    
    Description10.1
    
    Management Incentive Compensation Plan, filed herewith10.2
    
    Extension Agreement, dated March 22, 2006, between Tollgrade
Communications, Inc. and Bulova Technologies EMS, LLC, filed
herewith15
    
    Letter re audited interim financial information31.1
    
    Certification of Chief Executive Officer, filed herewith31.2
    
    Certification of Chief Financial Officer, filed herewith32
    
    Certification of Chief Executive Officer and Chief Financial
Officer pursuant to 18.U.S.C. Section 350, filed herewith
       ®
 ®
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SIGNATURES
  Tollgrade Communications, Inc.(Registrant)Dated: May 10, 2006
    
    /s/ Mark B. PetersonMark B. PetersonChief Executive OfficerDated: May 10, 2006
    
    /s/ Samuel C. KnochSamuel C. KnochChief Financial Officer and TreasurerDated: May 10, 2006
    
    /s/ Sean M. ReillySean M. ReillyController
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EXHIBIT INDEX
  ExhibitNumber
    
    Description10.1
    
    Management Incentive Compensation Plan, filed herewith10.2
    
    Extension Agreement, dated March 22, 2006, between Tollgrade
Communications, Inc. and Bulova Technologies EMS, LLC, filed
herewith15
    
    Letter re audited interim financial information31.1
    
    Certification of Chief Executive Officer, filed herewith31.2
    
    Certification of Chief Financial Officer, filed herewith32
    
    Certification of Chief Executive Officer and Chief Financial
Officer pursuant to 18.U.S.C. Section 350, filed herewith
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