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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-K þ
    
    Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the fiscal year ended December 31, 2004
 Commission file number 000-27312
 TOLLGRADE COMMUNICATIONS, INC.  PENNSYLVANIA
    
    25-1537134(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)493 Nixon Road, Cheswick, Pennsylvania
    
    15024(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code: 412-820-1400 Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.20 per share
(Title of Class) Indicate by a check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.
Yes þ No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§
229.405 of this chapter) is not contained herein, and will not be contained, to the best of
registrants knowledge, in definitive proxy or information statements incorporated by reference in
Part III of this Form 10-K or any amendment to this Form 10-K. o Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of
the Act). Yes þ No o The registrant estimates that as of the close of trading on June 24, 2004, the last business day of
the Registrants most recently completed second fiscal quarter, the aggregate market value of the
shares of the registrants Common Stock held by non-affiliates (excluding, for purposes of this
calculation only 1,122,300 shares of Common Stock held by affiliates of the registrant as a group)
of the registrant was $133,184,050. As of January 31, 2005, the registrant had outstanding 13,161,140 shares of its Common Stock.




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DOCUMENTS INCORPORATED BY REFERENCE Part of Form 10-K into whichDocument
    
    Document is incorporatedPortions of the Proxy Statement to be
distributed in connection with the 2005
Annual Meeting of Shareholders
    
    III
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TABLE OF CONTENTS Part IItem 1. Business
    
    
    4Item 2. Properties
    
    
    18Item 3. Legal Proceedings
    
    
    18Item 4. Submission of Matters to a Vote of Security Holders
    
    
    18Part IIItem 5. Market for the Registrants Common Stock and Related Security Holder Matters
    
    
    18Item 6. Selected Financial Data
    
    
    18Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    20Item 7A. Quantitative and Qualitative Disclosures About Market Risk
    
    
    33Item 8. Financial Statements and Supplementary Data
    
    
    34Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    55Item 9A. Controls and Procedures
    
    
    55Part IIIItem 10. Directors and Executive Officers of the Registrant
    
    
    56Item 11. Executive Compensation
    
    
    56Item 12. Security Ownership of Certain Beneficial Owners and Management
    
    
    56Item 13.
Certain Relationships and Related Transactions
    
    
    57Item 14. Principal Accounting Fees and Services
    
    
    57Part IVItem 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
    
    
    58SIGNATURES
    
    
    62EX-10.41EX-21.1EX-23.1EX-31.1EX-31.2EX-32
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PART I CAUTIONARY STATEMENT FOR PURPOSES OF THE SAFE HARBOR PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995. The statements contained in this Annual Report on Form 10-K, including, but not limited to those
contained in Item 1, Business and Item 7, Managements Discussion and Analysis of Financial
Condition and Results of Operations, 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 to be 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 believes, expects, may, will, should,
estimates, plans, or anticipates or the negatives thereof, other variations thereon or
compatible terminology, relate to, among other things, projected cash flows which are used in the
valuation of intangible assets, the anticipated results of negotiations for purchase orders and
other customer purchase agreements, our ability to utilize current deferred and refundable tax
assets, service opportunities offered to customers, the potential loss of certain customers, the
timing of orders from customers, the effect of consolidations in the markets to which Tollgrade
Communications, Inc. (the Company, us or we) sells, the effects of the economic slowdown in
the telecommunications and cable industries, the possibility of future provisions for slow moving
inventory, and the effect on earnings and cash flows of changes in interest rates. We do not
undertake any obligation to publicly update any forward-looking statements. These forward-looking statements, and any forward-looking statements contained in other public
disclosures of the Company which make reference to the cautionary factors contained in this Form
10-K, are based on assumptions that involve risks and uncertainties and are subject to change based
on the considerations described below. We discuss many of these risks and uncertainties in greater
detail in Part I, Item I of this Annual Report on Form 10-K under the heading Risk Factors That
Might Affect Future Operating Results and Financial Condition. These and other risks and
uncertainties may cause our actual results, performance or achievements to differ materially from
anticipated future results, performance or achievements expressed or implied by such
forward-looking statements. The following discussion should be read in conjunction with our Managements Discussion and
Analysis of Financial Condition and Results of Operations, and our financial statements and
related notes contained in this Annual Report on Form 10-K. 
 Item 1. Business. Tollgrade Communications, Inc. is a leading provider of hardware and software network
assurance testing solutions for the telecommunications and cable broadband industries. We design,
engineer, market and support test systems, test access, performance management 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 evaluate problems so
they can ultimately 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
for the delivery of Internet and other broadband services. For broadband cable networks, the
outside plant segment of the network is highly dependent upon standby power for network
reliability; if commercial power fails, such standby power supplies must sustain the network
or services such as video, data and voice become inoperable. We provide products to cable
companies that monitor and test the status of physical network elements (power supplies, fiber
nodes) as well as to measure the performance of services (voice, video and data) within the outside
plant. We were incorporated in Pennsylvania in 1986, began operations in 1988 and completed our
initial public offering in 1995. Our principal offices are located at 493 Nixon Road, Cheswick,
Pennsylvania 15024 and our telephone number is (412) 820-1400. We make available free of charge on our Internet website (www.tollgrade.com) our annual
reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all
amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange
Act of 1934, as amended, as soon as reasonably practicable after we electronically file such
material with, or otherwise furnish it to, the SEC. Products Telecommunication Test Systems Our proprietary telecommunications test and measurement 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 provide traditional voice service as well as connections for popular
communication devices such as computer modems and fax machines. POTS excludes non-switched and
private lines, such as data communications service lines, commonly referred to as special
services. POTS lines still comprise the vast majority of lines in service today throughout the
world. An important aspect of maintaining a POTS network is the ability to remotely test, diagnose
and locate any problems within the network. POTS line test systems are generally located at
telephone companies central offices, and help local exchange carriers conduct a full range of
fault diagnostics in the local loop, the portion of the telephone network that connects end users
to the central office. In addition, line test systems provide the capability to remotely qualify,
deploy and maintain next generation services including DSL and Integrated Services Digital Network
(ISDN) services which are carried over POTS lines. These test systems reduce the time - 4 -




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needed to identify and resolve problems, eliminating or reducing the costs of dispatching a
technician to the problem site. Most POTS line test systems, however, were designed only for use
over copper wire line; as a result, traditional test systems cannot access local loops in which
fiber-optic technology has been introduced. Our proprietary Metallic Channel Unit (MCUâ) products solve this problem by mimicking a
digital bypass pair, which is essentially a telephone circuit that connects central test and
measurement devices to the copper circuits close to the customer, known as the last mile. We
believe our DigiTest® system represents the future of telecommunication network testing, combining
our line test system with a next generation test platform to provide complete hardware testing for
POTS and local loop prequalification and in-service testing for DSL service. DigiTest® and LoopCare Our DigiTest system electrically measures the characteristics of a copper telephone circuit
and reports those measurements to our LoopCare Operation Support System (OSS). The LoopCare OSS, in
turn, analyzes that measurement data and creates an easy-to-understand fault description. At the
same time, the LoopCare system can generate a dispatch to a work center so that a repairman can fix
the problem. LoopCare and DigiTest also can determine whether the customer line is suitable for
DSL service. DigiTest can also serve as a replacement for aging Loop Test System (LTS) equipment
ubiquitously deployed in current POTS networks. In addition, upgrades to DigiTest hardware can
provide troubleshooting for DSL service problems. LoopCare 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 that can interface with other test heads on the market, currently manages testing
operations for more than 75% of the copper pairs in the United States, and is the qualification,
installation and maintenance tool used to troubleshoot for more than 150 million POTS, ISDN and DSL
subscribers worldwide. We acquired LoopCare from Lucent in 2001. 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 for DSL,
Asynchronous Transfer Mode (ATM), IP and Hypertext Transfer Protocol (HTTP) performance tests. In
addition, in 2004 we announced a new LoopCare feature that, working in conjunction with the
DigiTest hardware, and using innovative insertion loss measurements, provides a customer with
highly accurate predictions of potential DSL connect speeds. These 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. We market and sell our DigiTest products directly to customers as well as through certain
continuing original equipment manufacturer (OEM) arrangements with Lucent and Nortel Networks. The
Lucent agreement, which expired under its original terms in September 2003 but has been extended
through March 31, 2005 and is currently under renegotiation, allows Lucent to resell LoopCare
software on an OEM basis. We also have an OEM agreement in place with Electrodata, Inc. to supply a communications card
for our DigiTest EDGE product. This agreement also contains automatic renewal terms, unless
earlier terminated. We are also a party to a number of third party software license agreements
that allow us to incorporate third party software products and features into the LoopCare software. We have licensing arrangements with Nortel, Acterna, LLC and Aware, Inc. for certain
technology related to our DigiTest products and pay royalties and license fees for the use of such
technology on a fixed per unit basis. The license agreement with Acterna, which is currently under
negotiation regarding the termination rights of the parties, expires by its terms in 2008, unless
earlier terminated, and the agreements with Aware and Nortel contain automatic renewal terms,
unless earlier terminated. Sales of the DigiTest product line (including sales with LoopCare software) accounted for
approximately 14%, 10% and 12% of the Companys revenue for the years ended December 31, 2002, 2003
and 2004, respectively. 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) - 5 -




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Sales of stand-alone LoopCare software and enhancements accounted for approximately 13%, 5%
and 7% of the Companys revenue for the years ended December 31, 2002, 2003 and 2004, respectively. MCU Our core MCU products plug into Digital Loop Carrier (DLC) systems, the large network
transmission systems used by telephone companies to link the copper and fiber-optic portions of the
local loop. MCU products allow our customers to extend their line testing capabilities to all of
their POTS lines served by a DLC system regardless of whether the system is fed by a copper or
fiber optic link. DLC systems, which are located at telephone companies central offices and at
remote sites within local user areas, effectively multiplex the services of a single fiber-optic
line into multiple copper lines. In many instances, several DLC systems are located at a single
remote site to create multiple local loops that serve several thousand different end-user homes and
businesses. Generally, for every DLC remote site, customers will deploy at least two MCU
line-testing products. We market and sell our MCU products directly to customers as well as through certain OEM
agreements, as described below. To ensure the compatibility of our MCU products with the major DLC
systems produced by various telecommunication equipment manufacturers, we have entered into license
agreements and, in most cases, pay royalties for the use of the proprietary design integrated
circuits (PDICs) unique to each DLC system. We maintain royalty-based PDIC license agreements with
Lucent Technologies, Inc., Fujitsu Network Transmission Systems, Inc., Zhone Technologies, Inc.,
Tellabs, Inc. (formerly, Advanced Fibre Access Communications) and Adtran, Inc., the terms of all
but one of which automatically renew (unless earlier terminated) for periods of between one and
five years; the other agreement has a perpetual term. We paid $847,000, $835,000 and 800,000 in
2002, 2003 and 2004, respectively, in royalties under these license agreements, which are
calculated either as a percentage of the list price of MCU products sold or as a fixed amount per
MCU unit that incorporates the licensed technology. We also maintain PDIC license agreements that
do not contain royalty provisions with Tellabs, Inc., Alcatel USA Sourcing, L.P. (formerly DSC
Technologies Corporation), UTSTARCOM, Inc., Motorola, Inc. (formerly, Next Level Communications)
and SAGEM SA; the expiration dates of these agreements range from November 2004 to May 2007, with
renewal provisions for periods of one or more years, unless earlier terminated. We also employ our MCU technology in connection with home and business alarm systems. As with
POTS line testing, home alarm systems must be monitored from the alarm companys headquarters along
a hybrid copper and fiber-optic line. Our alarm-related MCU products, which are installed at both
central office and remote locations, facilitate the transport of analog alarm signals from
subscribers homes to alarm company monitoring stations across the hybrid telephone network. Sales of MCU products and related hardware accounted for approximately 48%, 39% and 34% of our
revenue in the years ended December 31, 2002, 2003 and 2004, respectively. See Managements
Discussion and Analysis for a discussion of this trend. Cable Testing Products The Companys CheetahTM 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. Cheetah Cable Monitoring The Companys monitoring systems include complete hardware and software solutions that enable
efficient HFC plant status monitoring. By providing a constant, proactive view of the health and
status of outside plant transmission systems, the products can reduce operating costs and increase
subscriber satisfaction. Our cable offerings consist of our CheetahLight (formerly LIGHTHOUSE®) and CheetahNet
(formerly NetMentor) software systems and maintenance, head-end controllers, return path switch
hardware, transponders and other equipment which gather status and performance reports from power
supplies, line amplifiers and fiber optic nodes. We acquired the Cheetah product line from
Acterna, LLC on February 13, 2003. For a summary of the terms of this transaction, please see
Managements Discussion and Analysis and Results of Operations-Cheetah Acquisition. We have entered into license agreements with C-COR.net Corp. (formerly C-COR Electronics,
Inc.) and Alpha Technologies, Inc., through which we provide status monitoring transponder
technology incorporated into those companies cable network management systems. In 2003, we also
entered into a separate agreement with Alpha, the leading supplier of power management products to
the cable industry, to serve as Alphas exclusive provider of IP-based Data Over Cable Service
Interface Specifications (DOCSIS) status monitoring equipment for its power supply systems; this
agreement contains an initial term which expires in November 2007 and automatically renews on an
annual basis thereafter unless terminated. We also have in place a number of third party software
license agreements that allow us to incorporate third party software products and features into our
Cheetah software. CheetahIP HFC Service Assurance Our CheetahIP/HFC service assurance solution provides remote visibility into IP efficiency.
This fully integrated solution allows cable operators to proactively test and monitor Voice over
Internet Protocol (VoIP) and Video on Demand (VoD) using hardware test probes and software analysis
tools. We have also entered into an OEM agreement with Brix Networks, Inc. under which Brix supplies
us with hardware and software for the cable broadband market. This agreement contains an initial
term which expires in September 2008 and automatically renews on an annual basis thereafter, unless
earlier terminated. During 2004, we also entered into a license agreement with a third - 6 -




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party software vendor for a perpetual right to use certain VoIP technology on an exclusive
basis, for certain applications. This agreement expires in 2009. Sales of the Cheetah product line (excluding Services) accounted for approximately 5%, 27% and
27% of the Companys revenue of the years ended December 31, 2002, 2003 and 2004, respectively. Services Our Services offerings include software maintenance as well as our professional services,
which are designed to make sure that all of the components of our customers voice test systems
operate properly. The Services business was considerably expanded upon the acquisition of software
maintenance relationships related to the LoopCare and CheetahNet software product lines. Including
software maintenance, Services revenue accounted for approximately 18%, 19% and 21% of the
Companys revenue for the years ended December 31, 2002, 2003 and 2004, respectively. 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 do internally develop
sales results associated with the various product categories, this information is not considered to
be sufficient for segment reporting purposes and our chief operating decision maker does not base
critical decisions or allocate assets based solely on this information. 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. Sales and Competition We market our products and services primarily through our direct sales organization with
offices in Cheswick, Pennsylvania, and Sarasota, Florida. Additionally, we have a growing channel
of OEMs, value-added resellers and distributors, both domestic and international. Domestic Sales The primary customers for our products and services are the four Regional Bell Operating
Companies (RBOCs), Verizon Communications, Inc., BellSouth Corporation, SBC Communications Inc. and
Qwest Communications International, Inc., as well as major independent telephone companies and most
of the major cable operators. Sales in 2004 to SBC, Verizon and BellSouth accounted for
approximately 15%, 15%, and 20%, respectively, or 50% collectively, of our total revenue for the
year. Sales generated from these three RBOC customers has remained consistent at 50% in 2004 and
48% in 2003, however, this is a significant decrease from the 70% of 2002 revenues that these three
RBOCs comprised. Sales in 2004 to Qwest did not exceed 10% of our total revenue, nor do we expect
it to for the near future. We have continued to focus on reducing our dependency on RBOC customers and, in 2003, we
purchased Cheetah to help accomplish this goal. Sales of the Cheetah Product-line accounted for
approximately 27% of 2004 revenue, none of which was comprised of any individual customer exceeding
10%. Because of our continued dependency on the four RBOCs, however, the potential loss of one or
more of them as customers, or the reduction of orders for our products by one or more of them,
could materially and adversely affect our results. International Sales International sales represented approximately 8% of the Companys total revenue for the year
ended December 31, 2004, compared with 6% for the year ended December 31, 2003. Although our
international sales have increased year over year, our success in marketing and selling our
telecommunications products in international markets has been limited, due in part to
incompatibility of certain of our telecommunications products with networks employed abroad. See
the discussion in our Managements Discussion and Analysis of Financial Condition and Results of
Operations section of this Form 10-K for a further examination of our strategies relating to
international sales and our signing of an agreement during the fourth quarter of 2004 with Lucent
Technologies International, Inc. for deployment of our products internationally. Competitive Conditions The market for telecommunications and cable television testing equipment is highly
competitive. Primary competitive factors in the Companys market include price, product features,
performance, reliability, service and support, breadth of product line, technical documentation and
prompt delivery. We believe that we compete favorably with regard to all of these factors. The traditional competitors for our POTS telecommunications products include Fluke (formerly
Harris Corporation), Porta Systems Corp., Teradyne, Inc., Nortel Networks, Ltd. and Emerson Network
Power. Each of these companies provides centralized test and management solutions for POTS
networks. Historically, we have successfully positioned ourselves against these offerings by
leveraging patented technologies, entering into partnerships with telecommunications equipment
providers and creating incumbent positions within our customers networks. As we extend our product offerings to address DSL, FTTP, IP, and ATM test applications for
emerging next generation networks, this list of traditional competitors is expanding to include
Spirent Communications, Acterna Corporation, Telcordia, Micromuse and Consultronics Ltd. We
believe that our ability to test these next generation networks by upgrading our existing, - 7 -




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highly automated incumbent infrastructure provides an advantage over these new competitors in
terms of upfront deployment costs and long term operational efficiency. As our customers networks continue to evolve, we also face competition as testing functions
that our products might provide can be built into network elements of other providers, such as
Infineon, Legerity, Broadcom, Texas Instruments and Aware. With respect to our cable products,
traditional status/performance monitoring competitors include AM Communications, CableWare,
Scientific Atlanta and Electroline. Historically, we have maintained an advantage over these
competitors through the mass deployment of proprietary technology within the major cable operators.
In recent years the cable industry has adopted open, non-proprietary standards for
status/performance monitoring systems, such as Hybrid Management Sub-layer (HMS) and DOCSIS, which
has created pricing pressures as all providers of monitoring transponders have reduced price points
to meet customer demands. As a result, we have modified our competitive strategies in an attempt
to better leverage exclusive partnerships with premier cable equipment providers and to enhance our
incumbent systems for the support of Internet protocol- based service assurance testing. As with the telecommunications products, the extension of our cable products to address
Internet protocol test applications expands our list of traditional competitors to now include
Micromuse, Aprisma, Auspice, C-CORnet.net, Agilent, and Acterna Corporation. We feel that our
ability to seamlessly integrate technology partners, such as Brix Networks and Telchemy, with our
incumbent solutions provides an advantage over these competitors when positioning ourselves for
Internet protocol testing opportunities within the major cable operators. Manufacturing Our manufacturing operations consist primarily of quality control, functional testing, final
assembly, burn-in and shipping. We are ISO 9001:2000 registered with the British Standards
Institution, Inc. ISO 9000 is a harmonized set of standards that define quality assurance
management. Written by the International Organization for Standardization (ISO), ISO 9000 is
recognized throughout the United States, Canada, the European Union and Japan. To be registered,
the Company develops and maintains internal documentation and processes to support the production
of quality products to ensure customer satisfaction. For our telephony products, we utilize two key independent subcontractors to perform a
majority of the circuit board assembly and in-circuit testing work. We also employ other
subassembly contractors for our telephony products on a more limited basis. For our Cheetah
hardware, we primarily use a single turnkey manufacturer, Dictaphone Corporations Electronic
Manufacturing Services Division, to procure the components and assemble and test the products. The
loss of any of these subcontractors could cause delays in our ability to meet our customers orders
and could have a material adverse effect on our results of operations. In addition, shortages of
raw materials delivered to, or production capacity constraints at, the Companys subcontractors
could negatively affect our ability to meet our production obligations and result in increased
prices for affected parts. Any such reduction may result in delays in shipments of the Companys
products or increases in the price of components, either of which could have a material adverse
impact on us. Generally, our products use industry standard components; however, application specific
integrated circuits (ASICs) are also a key component of our products and are custom made to the
Companys specifications. Although we have generally been able to obtain ASICs on a timely basis,
a delay in the delivery of these components could have a material adverse impact on the Company. Product and Technology Development Our product development personnel, many of whom are Bell Labs trained, are organized into
teams dedicated to one or more specific product lines or technologies. We continuously monitor
developing technologies in order to introduce new or improved products as defined standards and
markets emerge. During 2003, we committed much of our research and development resources to the
development of DigiTest EDGE, which was introduced during the year. In addition, we continue to
investigate the development of new applications for our MCU and Cheetah technologies, as well as
develop enhancements and new features to our LoopCare software product line, DigiTest hardware and
other technologies to service the telecommunications and cable industries. For the years ended
December 31, 2002, 2003 and 2004, research and development expenses were approximately $13,839,000,
$14,925,000, and $15,756,000 respectively. Proprietary Rights Intellectual property rights that apply to our various products include patents, copyrights,
trade secrets, trademarks and maskwork rights. We maintain an active program to protect our
investment in technology by enforcing our intellectual property rights. The extent of the legal
protection given to different types of intellectual property rights varies under different
countries legal systems. The names Tollgradeâ, MCUâ, LIGHTHOUSEâ, EDGE®, DigiTest®,
Telaccord®, Clearview® MICRO-BANKâ, our previous corporate logo and our LIGHTHOUSE®
logo are registered trademarks of the Company. The names LoopCare, MLT, Cheetah,
CheetahNet, CheetahIP, CheetahLight, CheetahXD, ObjectArchitect , BatteryAnalyst ,
ProofAnalyst , NetMentor, Clear, the Clear logo, Early Warning, ReportCard,
CircuitView, Network Assurance Simplified, and our new corporate logoare common
law trademarks of the Company. Team TollgradeSM is a common law service mark of the
Company. We have obtained three United States patents on the MCU products with expiration dates
ranging from 2010 to 2014, two United States and one Canadian patent on cable technology with
expiration dates of 2017, 2019 and 2018, respectively and one Canadian patent, one Taiwanese
patent and seven United States patents on other telecommunications technology, with expiration in
dates ranging from 2017 to 2022. In addition, we have five United States and five Canadian patent
applications pending and one European patent and ten international patent cooperation treaty patent
applications which have been filed. We will seek additional patents from time to time related to
our research and development - 8 -




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activities. We protect our trademarks, patents, inventions, trade secrets, and other
proprietary rights by contract, trademark, copyright and patent registration, and internal
security. Although we believe that patents are an important element of our success, we do not believe
that our business, as a whole, is materially dependent on any one patent. Backlog Our backlog consists of firm customer purchase orders and signed software maintenance
agreements. As of December 31, 2004, we had a backlog of approximately $14,710,000, all of which
is expected to be filled in 2005, as compared to approximately $15,347,000 of backlog at December
31, 2003. We currently have LoopCare software maintenance agreements with three of the four RBOCs. Two
were entered into in 2004 and have terms of one year expiring December 31, 2005. The third
contract is for a three year term expiring on December 31, 2005. We are also currently in
negotiations with the remaining RBOC regarding renewal of its software maintenance agreement. Our
backlog at December 31, 2004 includes approximately $5,487,000 related to software maintenance
contracts. 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. 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. Government Regulation The telecommunications industry is subject to regulation in the United States and other
countries. Federal and state regulatory agencies, including the Federal Communications Commission
(FCC) and various state public utility and service commissions, regulate the activities of most of
our domestic customers. Although such regulation does not typically affect the Company directly,
the effects of such regulations on our customers may, in turn, adversely impact our business and
operating results. Governmental authorities have also promulgated regulations which, among other
things, set installation and equipment standards for private telecommunications systems and require
that all newly installed hardware be registered and meet certain government standards. Employees As of December 31, 2004, we had 262 full-time employees, all of whom were located in the
United States. None of our employees are represented by a collective bargaining agreement, and we
believe that our relations with our employees are good. Executive Officers of the Company The executive officers of the Company as of January 31, 2005 and their biographical information is set forth below. Mark B. Peterson
    
    Chief Executive Officer of the Company since January 2005; President
of the Company since January 2001; Executive Vice President, Sales
and Marketing, of the Company from November 1999 until January 2001;
Executive Vice President, Sales, of the Company from October 1997
until November 1999; prior thereto, Testing Application Group
product manager (MLT and Switched Access Remote Test Systems
(SARTS) product lines) of Lucent Technologies, a manufacturer of
communication systems, software and products (formerly AT&T Bell
Laboratories), from October 1995 until October 1997; Age 43.Sara M. Antol
    
    General Counsel of the Company since December 2000; Secretary of the
Company since April 1996; Chief Counsel of the Company from April
1996 until December 2000; prior thereto, attorney at Babst, Calland,
Clements & Zomnir, P.C., a law firm; Age 43.Richard A. Bair, Jr.
    
    Executive Vice President, Engineering/Testing, of the Company since
August 2000; Vice President Engineering, DigiTest, of the Company
from June 2000 until August 2000; Engineering Manager of the Company
from April 1999 until August 2000; prior thereto, Senior Design
Engineer of the Company from March 1996 until April 1999; Age 42.David J. Breiter
    
    Mr. Breiter, who served in his position as of January 31, 2005, has
since left the employ of the Company. General Manager, Cable
Products, of the Company since February 2003; prior thereto, Vice
President, Systems Support with Acterna Corporation from August
2000 to February 2003; prior thereto, Senior Vice President,
Superior Electronics Group, Inc., d/b/a Cheetah Technologies from
December 1998 to August 2000; Age 57.Robert E. Butter
    
    Director of Corporate Communications since January 2004; also,
Principal, Veritas Communication Advisors since January 2004; prior
thereto, Senior Vice President and Associate Director, Ketchum,
Inc.; Age 48.Wylie E. Estcheid
    
    Executive Vice President, Business Development, OSS, of the Company
since September 2001; Senior Vice President and General Manager of
Telco Access Products, a manufacturer of
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telecommunications products, from October 2000 until September 2001; Vice
President, Network Engineering, Midwest Division, of SBC, a provider of
telecommunication services, from December 1999 until October 2000; prior
thereto, Vice President, Service Integration and Delivery, of Ameritech, a
provider of telecommunication services, from February 1996 until December
1999; Age 55.Carol M. Franklin
    
    Executive Vice President, Research and Development,
of the Company since January 2004; Executive Vice
President, Software Products Division, of the Company
from January 2003 until January 2004; General
Manager, Software Products from July 2001 to January
2003; Director of Order Management Development of
Lucent Technologies, a manufacturer of communication
systems, software and products (formerly AT&T Bell
Laboratories), from May 2000 until July 2001;
Director for Integration Test of Lucent from
September 1999 until May 2000; Director for Starter
Solutions for Emerging Carriers and Internet Customer
Care of Lucent Technologies from February 1999 until
August 1999; prior thereto, Product Realization
Leader of Lucent Technologies from February 1996
until January 1999; Age 53.Samuel C. Knoch
    
    Chief Financial Officer of the Company since August
1996; Treasurer since April 1997; prior thereto,
Controller of AMSCO International, Inc., a
manufacturer of health care equipment, from October
1994 until August 1996; Age 48.Joseph G. OBrien
    
    Senior Vice President, Human Resources of the Company
since October 1997; Director of Employee Development
of the Company from April 1997 until October 1997;
prior thereto, Coordinator, Elderberry Junction,
Goodwill Industries, a charitable organization, from
May 1995 until April 1997; Age 45.Gregory L. Quiggle
    
    Executive Vice President, Marketing, of the Company
since August 2001; Director of Marketing, Loop
Products, of Acterna LLC (formerly,
Telecommunications Techniques Corporation (TTC)), a
global communications equipment company, from May
1998 until August 1998; prior thereto, Product Line
Manager, TTC from May 1996 until May 1998; Age 36.Matthew J. Rosgone
    
    Executive Vice President, Operations, of the Company
since September 2001; Senior Vice President,
Purchasing/Manufacturing, of the Company from July
1998 until September 2001; prior thereto, Vice
President, Purchasing, of the Company from July 1996
until July 1998; Age 36.Roger A. Smith
    
    Executive Vice President, Technology, of the Company
since June 2000; Senior Vice President, Test Systems,
of the Company from July 1998 until June 2000; prior
thereto, Senior Software Development Engineer of
Caldon Inc., a manufacturer of ultrasonic flow meters
for nuclear power industry; Age 44.Eric B. Sucharski
    
    Senior Vice President, RBOC Sales, of the Company
since September 2003; Vice President, Eastern RBOC
Sales, of the Company from January 2003 until
September 2003; Assistant Vice President, Sales, from
October 2002 to January 2003; Regional Sales Manager
of the Company from December 1998 to October 2002;
Product Line Manager of the Company from 1998 until
1999; Age 37.Jeffrey J. Tatusko
    
    Chief Information Officer of the Company since April
2003; prior thereto, Director of Management
Information Systems of the Company from October 1997
until April 2003; Age 40.Stephanie M. Wedge
    
    Vice President, Professional Services, of the Company
since November 1999; Sales Executive, Professional
Services, of Inacom Corporation, a reseller and
integrator of client/server solutions for messaging,
from February 1998 until November 1999; prior
thereto, Sales Manager, Business Development, of
Digital Equipment Corporation, a manufacturer and
integrator of main-frame computers; Age 48.
 Subsequent Event On January 17, 2005, the Company entered into an Agreement with Christian L. Allison, the Companys
former Chief Executive Officer, a former member of the Board of the Company, as well as a
shareholder of the Company (the Agreement). Under the terms of the Agreement, Mr. Allison
resigned effective as of January 18, 2005 (the Retirement Date), as director and executive
officer of the Company and any and all other positions he held with the Company or its subsidiaries
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Mr. Allison received the following separation payments: (a) an amount equal to the sum of (i) Mr.
Allisons base salary through the Retirement Date to the extent not then paid and (ii) any vacation
pay and other cash entitlements accrued by Mr. Allison as of the Retirement Date to the extent not
then paid; (b) two times his contractual base salary of $315,000 for a total of $630,000; and (c) a
lump sum payment of $75,000. The Company will pay all premiums on behalf of Mr. Allison to
continue medical insurance for his immediate family for a period specified in the Agreement.
Additionally, the Company has agreed to continue to indemnify, to the fullest extent permitted by
applicable law, and to provide directors and officers liability insurance, if available in the
directors and officers liability insurance market, for the periods specified in the Agreement for
Mr. Allisons actions taken or omissions occurring at or prior to the Retirement Date. The Company
also has agreed to pay up to $50,000 of the reasonable fees and expenses of Mr. Allisons legal
counsel incurred in connection with the negotiation and execution of the Agreement. The Company
expects total charges in the first quarter of 2005 related to Mr. Allisons retirement to be
approximately $780,000. Mr. Allison also will be entitled to receive any vested benefits payable to him under the terms of
any employee benefit plan or program of the Company in accordance with the terms of such plan or
program. Under the terms of the Agreement and the Companys 1995 Long-Term Incentive Compensation
Plan (as amended through January 24, 2002), all options to acquire shares of the Companys common
stock held by Mr. Allison were fully vested prior to the Retirement Date and will remain
exercisable by Mr. Allison for at least one year following the Retirement Date. Risks Factors That Might Affect Future Operating Results and Financial Condition We wish to caution each reader of this Form 10-K 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. We depend upon a few major customers for a majority of our revenues. We expect to derive a
significant portion of our revenues from a limited number of customers in the future. The loss of
any of these customers, or the cancellation, delay or reduction in purchases of our products at
historical levels, would significantly reduce our revenues and net income. Furthermore, decreases
in the capital budgets of these customers could lead to their reduced demand for our products,
which could in turn have a material adverse affect on our business and results of operation. The
capital budgets of our RBOC customers, as well as many of our other customers, are dictated by a
number of factors, most of which are beyond our control, including:  
    the conditions of the telecommunications market and the economy in general;
    subscriber line loss and related reduced demand for telecommunications services;
    changes or shifts in the technology utilized in the networks;
    labor disputes between our customers and their collective bargaining units;
    the failure to meet established purchase forecasts and growth projections;
    competition among the RBOCs, competitive exchange carriers and wireless telecommunications and cable providers; and
    reorganizations, including management changes, at one or more of our customers or potential customers. If the financial strength of one or more of our major customers should deteriorate, or if they
have difficulty acquiring investment capital due to any of these or other factors, a substantial
decrease in our revenues would likely result. Our operating results may vary from quarter to quarter, causing our stock price to fluctuate. Our operating results have in the past been subject to quarter to quarter fluctuations, and we
expect that these fluctuations will continue, and may increase in magnitude, in future periods.
Demand for our products is driven by many factors, including the availability of funding in
customers capital budgets. There is a trend for some of our customers to place large orders near
the end of a quarter or fiscal year, in part to spend remaining available capital budget funds.
Seasonal fluctuations in customer demand for our products driven by budgetary and other reasons can
create corresponding fluctuations in period-to-period revenues, and we therefore cannot assure you
that our results in one period are necessary indicative of our revenues in any future period. In
addition, the number and timing of large individual sales has been difficult for us to predict, and
large individual sales have, in some cases, occurred in quarters subsequent to those we
anticipated, or have not occurred at all. The loss or deferral of one or more significant sales in
a quarter could harm our operating results. It is possible that in some quarters our operating
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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. The sales cycle for our software products is long, and the delay or failure to complete one or more
large license transactions in a quarter could cause our operating results to fall below our
expectations. The sales cycle is highly customer specific and can vary from a few weeks to many months. The
software requirements of customers is highly dependent on many factors, including but not limited
to their projections of business growth, capital budgets and anticipated cost savings from
implementation of our software. Our delay or failure to complete one or more large license
transactions in a quarter could harm our operating results. Our software involves significant
capital commitments by customers. Potential customers generally commit significant resources to an
evaluation of available enterprise software and require us to expend substantial time, effort and
money educating them about the value of our solutions. Licensing of our software products often
requires an extensive sales effort throughout a customers organization because decisions to
license such software generally involve the evaluation of the software by a significant number of
customer personnel in various functional and geographic areas, each often having specific and
conflicting requirements. A variety of factors, including actions by competitors and other factors
over which we have little or no control, may cause potential customers to favor a particular
supplier or to delay or forego a purchase. Many of the Companys products must comply with significant governmental and industry-based
regulations, certifications, standards and protocols, some of which evolve as new technologies are
deployed. Compliance with such regulations, certifications, standards and protocols may prove
costly and time-consuming for the Company, and the Company cannot provide assurance that its
products will continue to meet these standards in the future. In addition, regulatory compliance
may present barriers to entry in particular markets or reduce the profitability of the Companys
product offerings. Such regulations, certifications, standards and protocols may also adversely
affect the industries in which we compete, limit the number of potential customers for the
Companys products and services or otherwise have a material adverse effect on its business,
financial condition and results of operations. Failure to comply, or delays in compliance, with
such regulations, standards and protocols or delays in receipt of such certifications could delay
the introduction of new products or cause the Companys existing products to become obsolete. We depend on sales of our MCU products for a significant portion of our revenues, but this product
is maturing and may result in declining sales. A large portion of our sales have historically been attributable to our MCU products. We
expect that our MCU products may continue to account for a significant percentage of our revenues
for the foreseeable future. However, these sales are declining. MCU sales largely depend upon the
rate of deployment of new, and the retrofitting of existing, Digital Loop Carrier (DLC) systems in
the United States. Installation and replacement of DLC systems are, in turn, driven by a number of
factors, including the availability of capital resources and the demand for new or better Plain Old
Telephone Service (POTS). The current plans of our customers, if executed, to implement next
generation network improvements such as Fiber-to-the-Premise (FTTP), which does not require the use
of our MCU products as the present hybrid POTS network, could materially impact our MCU sales. If
our major customers fail to continue to build out their DSL networks and other projects requiring
DLC deployments, or if we otherwise satisfy the domestic telecommunications markets demand for
MCUs, our future results would be materially and adversely affected. Although we are unable to predict future prices for our MCU products, we expect that prices
for these products will continue to be subject to significant downward pressure in certain markets
for the reasons described above. Accordingly, our ability to maintain or increase revenues will be
dependent on our ability to expand our customer base, increase unit sales volumes of these products
and to successfully, develop, introduce and sell new products such as our cable and software
products. We cannot assure you that we will be able to expand our customer base, increase unit
sales volumes of existing products or develop, introduce and/or sell new products. We recently emphasized our network assurance and testing software solutions and cable status
monitoring products. We acquired the LoopCare software and Cheetah product lines in 2001 and 2003, respectively. A
substantial portion of our research and development expenses currently relates to these products.
We have adjusted our business model to focus heavily on our cable performance and status monitoring
products. We are actively engaged in research to improve and expand our cable products, including
research and development of VoIP solutions. Our cable products have lower margins than our MCU,
LoopCare and DigiTest system products. If sales of our cable testing products do not increase or
are not accepted in the marketplace, or if our research and development activities do not produce
marketable products that are both competitive and accepted by our customers, our overall revenues
and profitability will be adversely affected. In addition, although software products generally generate higher margin returns for us than
our hardware products, the initial development costs of software applications, coupled with the
inherent problems with pricing software sold to customers, can make it difficult to assess the
potential profitability of new software products. Unless we acquire proprietary software, we must
internally develop any new software products. Software development is a relatively expensive and
lengthy process. In addition, because it is - 12 -




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customary in our industry to sell perpetual enterprise licenses that cover an entire customers
operations, it can be difficult to assess at the time of sale the exact price that we should charge
for a particular license. The sale of our products is dependent upon our ability to satisfy the proprietary requirements of
our customers and respond to rapid technological change, including evolving industry-wide
standards. We depend upon a relatively narrow range of products for the majority of our revenue. Our
success in marketing our products is dependent upon their continued acceptance by our customers. In
some cases, our customers require that our products meet their own proprietary requirements. If we
are unable to satisfy such requirements, or forecast and adapt to changes in such requirements, our
business could be materially harmed. Rapid technological change, including evolving industry standards, could also render our
products obsolete. The adoption of industry-wide standards, such as the HMS and DOCSIS® cable
standards, may result in the elimination of or reductions in the demand for many of our proprietary
products, such as our Cheetah head-end hardware products and other Cheetah products. Furthermore,
standards for new services and technologies continue to evolve, requiring us to continually modify
our products or to develop new versions to meet these new standards. Certain of these
certifications are limited in scope, which may require that the product be recertified if any
modifications to hardware or firmware are made. If we are unable to forecast the demand for, and
to develop new products or to adapt our existing products to meet, these evolving standards and
other technological innovations, or if our products and services do not gain the acceptance of our
customers, there could be a negative effect on our revenues for sales of such products. Our customers are subject to governmental regulations that could significantly reduce the demand
for our products or increase our costs of doing business. Our customers have historically been subject to a number of governmental regulations, many of
which have been repealed or amended as a result of the passage of The Telecommunications Act of
1996. Deregulatory efforts have affected and likely will continue to affect our customers in
several ways, including the introduction of competitive forces into the local telephone markets and
the imposition (or removal) of controls on the pricing of services. These and other regulatory
changes may limit the scope of our customers deployments of future services and budgets for
capital expenditures, which could significantly reduce the demand for our products. Moreover, as the Federal Communications Commission (FCC) adopts new and amends existing
regulations, and as the courts analyze the FCCs authority to do so, our customers cannot
accurately predict the rules by which they will be able to compete in their respective markets.
Changes in the telecommunications regulatory environment could, among other results, increase our
costs of doing business, require our customers to share assets with competitors or prevent the
Company or our customers from engaging in business activities they may wish to conduct, which could
adversely affect our future results. Our limited ability to protect our proprietary information and technology may adversely affect our
ability to compete. Many of our products consist entirely or partly of proprietary technology owned by us.
Although we seek to protect our technology through a combination of copyrights, trade secret laws,
contractual obligations and patents, these protections many not be sufficient to prevent the
wrongful appropriation of our intellectual property, nor will they prevent our competitors from
independently developing technologies that are substantially equivalent or superior to our
proprietary technology. In addition, the laws of some foreign countries do not protect our
proprietary rights to the same extent as the laws of the United States, and certain vendors have
become more sophisticated and aggressive in reverse engineering even complex technology and then
mass producing such technology at a lower cost than we might be able to achieve. 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
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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. Product quality, performance and reliability problems could disrupt our business and harm our
financial condition. Our customers demand that our products meet stringent quality, performance and reliability
standards. We have, from time to time, experienced product quality, performance or reliability
problems. For example, in 2004, we were unable to ship certain of our transponder products to a
customer due to delays in both the CableLabs DOCSIS® certification of these products and the
manufacturing of the product until final engineering enhancements were completed. Though we
received CableLabs certification in the third quarter of 2004, we are still working to resolve
final technological product matters which continue to delay our manufacturing and deployment of
this product. As a result, defects or failures have in the past, and may in the future occur
relating to our product quality, performance and reliability. If these failures or defects occur or
become significant, we could experience lost revenues, increased costs, including inventory
write-offs, warranty expense and costs associated with customer support, delays in or cancellations
or rescheduling of orders or shipments and product returns or discounts, any of which would harm
our business. We have completed, and may pursue additional acquisitions, which will complicate our management
tasks and could result in substantial expenditures, and the failure of acquired assets to meet
expectations could result in impairment of intangible assets. We have completed, and we may pursue additional acquisitions of companies, product lines and
technologies as part of our efforts to enhance our existing products, to introduce new products and
to fulfill changing customer requirements. Acquisitions involve numerous risks, including the
disruption of our business, exposure to assumed or unknown liabilities of the acquired target, and
the failure to integrate successfully the operations and products of acquired businesses. Goodwill
arising from acquisitions may result in significant charges against our operating results in one or
more future periods. Furthermore, we may never achieve the anticipated results or benefits of an
acquisition, such as increased 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 which could have a negative effect on our financial condition. Our future sales in international markets are subject to numerous risks and uncertainties. We have limited experience selling our products internationally, and our future sales in
international markets are subject to numerous risks and uncertainties, including local economic and
labor conditions, political instability including terrorism and other acts of war or hostility,
unexpected changes in the regulatory environment, trade protection measures, tax laws, our ability
to market current or develop new products suitable for international markets, difficulties with
deployments and acceptances of products, - 14 -




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obtaining and maintaining successful distribution and resale channels and foreign currency exchange
rates. Reductions in the demand for or the sales of our products in international markets could
adversely affect future results. If our accounting controls and procedures are circumvented or otherwise fail to achieve their
intended purposes, our business could be seriously harmed. Although we evaluate our disclosure controls and procedures as of the end of each fiscal
quarter, and have completed the process of reviewing and establishing internal control over
financial reporting for the year ended December 31, 2004 in order to comply with SEC rules relating
to internal control over financial reporting adopted pursuant to the Sarbanes-Oxley Act of 2002, we
may not be able to prevent all instances of accounting errors or fraud in the future. Our controls
and procedures do not provide absolute assurance that all deficiencies in design or operation of
these control systems, or all instances of errors or fraud, will be prevented or detected. These
control systems are designed to provide reasonable assurance of achieving the goals of these
systems in light of legal requirements, our resources and nature of our business operations. These
control systems remain subject to risks of human error and the risk that controls can be
circumvented for wrongful purposes by one or more individuals in management or non-management
positions. Our business could be seriously harmed by any material failure of these control systems. If we ship products that contain defects, the market acceptance of our products and our reputation
will be harmed and our customers could seek to recover their damages from us. Our products are complex, and despite extensive testing, may contain defects or undetected
errors or failures that may become apparent only after our products have been shipped to our
customer and installed in their network or after product features or new versions are released. Any
such defect, error or failure could result in failure of market acceptance of our products or
damage to our reputation or relations with our customers, resulting in substantial costs for both
the Company and our customers as well as the cancellation of orders, warranty costs and product
returns. In addition, any defects, errors, misuse of our products or other potential problems
within or out of our control that may arise from the use of our products could result in financial
or other damages to our customers. Our customers could seek to have us pay for these losses.
Although we maintain product liability insurance, it may not be adequate. Our future results are dependent on our ability to establish, maintain and expand our distribution
channels and our existing third-party distributors. We market and sell certain of our products, including our DigiTest and Cheetah product lines,
through domestic and international OEM relationships. Our future results are dependent on our
ability to establish, maintain and expand third party relationships with OEM as well as other
marketing and sales distribution partners. If, however, the third parties with whom we have entered
into such OEM and other partnerships should fail to meet their own performance objectives, customer
demand for our products could be adversely affected, which would have an adverse effect on our
revenues. We face intense competition, which could result in our losing market share or experiencing a
decline in our gross margins. The markets for some of our products are very competitive. Some of our competitors may have
greater technological, financial, manufacturing, sales and marketing, and personnel resources than
we have. As a result, these competitors may have an advantage in responding more rapidly or
effectively to changes in industry standards or technologies. In addition, we face competition from
overseas manufacturers, who might reverse engineer our proprietary technology and manufacture such
products at a lower cost than we can achieve. 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. Further, if key employees that cease
to be associated with the Company become associated with our competitors in violation of
restrictions on competition or confidentiality, it could adversely affect future results. - 15 -




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Consolidations in, or a continued slowdown in, the telecommunications industry could harm our
business. We have derived a substantial amount of our revenues from sales of products and related
services to the telecommunications industry. The telecommunications industry has experienced
significant growth and consolidation in the past few years. 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. Consolidations could cause our customers to
divert spending from our products to acquisition and integration costs. Furthermore, as a result
of industry consolidation, there may be fewer potential customers requiring our software in the
future. Larger, consolidated telecommunications companies may also use their purchasing power to
create pressure on the prices and the margins we could realize. We cannot be certain that
consolidations in, or a slowdown in the growth of, the telecommunication industry will not harm our
business. Our expenses are relatively fixed in the short term, and we may be unable to adjust spending to
compensate for unexpected revenue shortfalls. We base our expense levels in part on forecasts of future orders and sales, which are
extremely difficult to predict. A substantial portion of our operating expenses is related to
personnel, facilities and sales and marketing. The level of spending for such expenses cannot be
adjusted quickly and is, therefore, relatively fixed in the short term. Accordingly, our operating
results will be harmed if revenues fall below our expectations in a particular quarter. Our restructuring plan may be ineffective or may limit our ability to compete. We have recently undertaken a reduction in work force in response to our evolving business
model These actions could have long term adverse effects on our business. There are several risks
inherent in our efforts to bring our cost base in line with the current environment by reducing our
workforce. These include the risk that we will not be successful in achieving our planned cost
reductions, and that even if we are successful in doing so, we will still not be able to reduce
expenditures quickly enough to see a positive profitability effect and may have to undertake
further restructuring initiatives that would entail additional charges and create additional risks.
In addition, there is the risk that cost-cutting initiatives will impair our ability to effectively
develop and market products and remain competitive. Each of the above measures could have long-term
effects on our business by reducing our pool of talent, decreasing or slowing improvements in our
products, making it more difficult for us to respond to customers, limiting our ability to increase
production quickly if and when the demand for our products increases and limiting our ability to
hire and retain key personnel. These circumstances could cause our earnings to be lower than they
otherwise might be. We rely on software that we have licensed from third-party developers to perform key functions in
our products. We rely on software that we license from third parties, including software that is integrated
with internally developed software and used in our products to perform key functions. We could lose
the right to use this software or it could be made available to us only on commercially
unreasonable terms. Although we believe that alternative software is available from other
third-party suppliers or internal developments, the loss of or inability to maintain any of these
software licenses or the inability of the third parties to enhance in a timely and cost-effective
manner their products in response to changing customer needs, industry standards or technological
developments could result in delays or reductions in product shipments by us until equivalent
software could be developed internally or identified, licensed and integrated, which would harm our
business. 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 have developed DOCSIS compliant 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. - 16 -




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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. - 17 -




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Item 2. Properties. Our headquarters and principal administrative, engineering, manufacturing, warehouse and
maintenance operations are located in Cheswick, Pennsylvania. We occupy an 111,600 square foot
facility which is under a lease that expires in December 2005. We are currently in negotiations to
modify and extend our current lease agreement. We have acquired certain land parcels that surround
this facility for the possible expansion of parking and/or new building structures that we believe
will provide adequate space to support future operations and sales growth, if necessary. In addition, we lease 18,778 square feet of space in Bridgewater, New Jersey. The lease will
expire on January 21, 2007. This facility provides workspace for the administrative and engineering
personnel of our LoopCare product line. We also lease 22,122 square feet of space in Sarasota, Florida, to provide workspace for the
personnel of our Cheetah product line that we acquired in February 2003. This lease expires on
April 28, 2008, and may be extended, at our option, for an additional five-year period. 
 Item 3. Legal Proceedings. There are currently no outstanding or pending material legal proceedings with respect to the Company or our business. 
 Item 4. Submission of Matters to a Vote of Security Holders. There were no matters submitted to a vote of security holders through solicitation of proxies
or otherwise during the fourth quarter of 2004. 
 PART II 
 Item 5. Market for the Registrants Common Stock and Related Security Holder Matters. Our Common Stock has been included for quotation on The Nasdaq National Market System under
the Nasdaq symbol TLGD since its initial public offering in December 1995. The following table
sets forth, by quarter, the high and low sales prices for our Common Stock for the years ended
December 31, 2004 and December 31, 2003. 2004
    
    
    2003High
    
    
    Low
    
    
    High
    
    
    LowFirst Quarter
    
    $
    19.69
    
    
    $
    14.84
    
    
    $
    14.94
    
    
    $
    10.11Second Quarter
    
    $
    16.45
    
    
    $
    9.75
    
    
    $
    21.22
    
    
    $
    12.92Third Quarter
    
    $
    11.08
    
    
    $
    7.57
    
    
    $
    21.60
    
    
    $
    12.64Fourth Quarter
    
    $
    12.63
    
    
    $
    8.35
    
    
    $
    18.75
    
    
    $
    14.50
 On January 31, 2005, there were 175 holders of record and 13,161,140 shares outstanding of the
Companys Common Stock. We have never paid any dividends on our Common Stock and do not expect to pay cash dividends
in the foreseeable future. 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 could
have repurchased 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 September 25, 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 year ended December 31, 2004. On
January 27, 2005, the Board of Directors again authorized the continuation of the share repurchase
program that expired December 31, 2004, under the same terms. 
 Item 6. Selected Financial Data. The following selected consolidated financial data of the Company as of December 31, 2000,
2001, 2002, 2003 and 2004 and for the years then ended is derived from our audited consolidated
financial statements. The following selected consolidated financial data should be read in
conjunction with the consolidated financial statements, the notes to the consolidated financial
statements, and Managements Discussion and Analysis of Financial Condition and Results of
Operations, which are included elsewhere in this report. - 18 -




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(IN THOUSANDS, EXCEPT PER SHARE DATA AND
NUMBER OF EMPLOYEES) YEARS ENDED DECEMBER 31,2000
    
    
    2001
    
    
    2002
    
    
    2003
    
    
    2004Revenues:Products
    
    $
    111,957
    
    
    $
    77,612
    
    
    $
    48,146
    
    
    $
    52,802
    
    
    $
    49,770Services
    
    
    2,469
    
    
    
    4,627
    
    
    
    10,428
    
    
    
    12,298
    
    
    
    13,048114,426
    
    
    
    82,239
    (1)
    
    
    58,574
    
    
    
    65,100
    (2)
    
    
    62,818Cost of sales:Products
    
    
    40,680
    
    
    
    33,134
    
    
    
    20,800
    
    
    
    22,966
    
    
    
    22,191Services
    
    
    1,958
    
    
    
    2,555
    
    
    
    3,319
    
    
    
    3,766
    
    
    
    3,768Amortization
    
    
    
    
    
    
    365
    
    
    
    1,464
    
    
    
    2,381
    
    
    
    2,01742,638
    
    
    
    36,054
    
    
    
    25,583
    
    
    
    29,113
    
    
    
    27,976Gross profit
    
    
    71,788
    
    
    
    46,185
    
    
    
    32,991
    
    
    
    35,987
    
    
    
    34,842Operating expenses:Selling and marketing
    
    
    12,289
    
    
    
    9,160
    
    
    
    8,766
    
    
    
    9,388
    
    
    
    9,483General and administrative
    
    
    6,216
    
    
    
    4,827
    
    
    
    5,489
    
    
    
    6,997
    
    
    
    7,346Research and development
    
    
    12,456
    
    
    
    12,428
    
    
    
    13,839
    
    
    
    14,925
    
    
    
    15,755Severance and related expense
    
    
    
    
    
    
    291
    
    
    
    176
    
    
    
    
    
    
    
    269Total operating expenses
    
    
    30,961
    
    
    
    26,706
    
    
    
    28,270
    
    
    
    31,310
    
    
    
    32,853Income from operations
    
    
    40,827
    
    
    
    19,479
    
    
    
    4,721
    
    
    
    4,677
    
    
    
    1,989Other income, net
    
    
    2,525
    
    
    
    2,796
    
    
    
    693
    
    
    
    400
    
    
    
    447Income before income taxes
    
    
    43,352
    
    
    
    22,275
    
    
    
    5,414
    
    
    
    5,077
    
    
    
    2,436Provision for income taxes
    
    
    15,857
    
    
    
    8,600
    
    
    
    2,057
    
    
    
    1,929
    
    
    
    1,091Net income
    
    $
    27,495
    
    
    $
    13,675
    
    
    $
    3,357
    
    
    $
    3,148
    
    
    $
    1,345EARNINGS PER SHARE INFORMATION:Net income per common share:Basic
    
    $
    2.18
    
    
    $
    1.05
    
    
    $
    0.26
    
    
    $
    0.24
    
    
    $
    0.10Diluted
    
    $
    2.06
    
    
    $
    1.02
    
    
    $
    0.25
    
    
    $
    0.24
    
    
    $
    0.10Weighted average shares
of common stock equivalents:Basic
    
    
    12,636
    
    
    
    13,038
    
    
    
    13,095
    
    
    
    13,106
    
    
    
    13,141Diluted
    
    
    13,359
    
    
    
    13,412
    
    
    
    13,314
    
    
    
    13,313
    
    
    
    13,253
 AS OF DECEMBER 31,2000
    
    
    2001
    
    
    2002
    
    
    2003
    
    
    2004BALANCE SHEET DATA:Working Capital
    
    $
    111,135
    
    
    $
    68,078
    
    
    $
    73,638
    
    
    $
    65,944
    
    
    $
    70,845Total Assets
    
    
    131,275
    
    
    
    145,886
    
    
    
    147,918
    
    
    
    153,829
    
    
    
    158,834Shareholders Equity
    
    
    122,760
    
    
    
    140,139
    
    
    
    142,356
    
    
    
    145,829
    
    
    
    147,509
 2000
    
    
    2001
    
    
    2002
    
    
    2003
    
    
    2004OTHER DATA:(3)Number of employees at year end
    
    
    411
    
    
    
    341
    
    
    
    250
    
    
    
    304
    
    
    
    262
   (1)
    
    Includes $4,453 related to the LoopCare product line which was acquired on September 30, 2001.(2)
    
    Includes $14,826 related to the Cheetah product line which was acquired on February 13, 2003.(3)
    
    Data is unaudited and not derived from the Companys audited consolidated financial statements. - 19 -




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Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations . This MD&A should be read in conjunction with the other sections of this annual report on Form
10-K, including Item 1: Business, Item 6: Selected Financial Data and Item 8: Financial
Statements. Certain statements contained in this MD&A and elsewhere in this report are
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, that involve risks and
uncertainties. These statements relate to future events or our future financial performance. In
some cases, forward-looking statements can be identified by terminology such as may, will,
should, expect, anticipate, intend, plan, believe, estimate, potential, or
continue, the negative of these terms or other comparable terminology. These statements involve a
number of risks and uncertainties. Actual events or results may differ materially from any
forward-looking statement as a result of various factors, including those described in Item 1 above
under Risk Factors. Overview Communication plays an integral part of our society; it is, in reality, a necessity of life.
Telecommunication services provide people with a means to communicate with people across the street
and around the globe, through diverse channels ranging from traditional wired telephone service to
wireless telephones to electronic means such as e-mail and other Internet-based offerings. As a
leading producer of network assurance and monitoring systems for wired networks, our products
permit service providers to supply their customers with consistent and high quality
telecommunications offerings, allowing, for example, telephone companies to diagnose and assess
problems within their networks and cable operators to monitor the power supplies necessary to
operate their systems. As a result of the rapid technological, regulatory and economic evolution of the
telecommunications marketplace (which we define to include cable television service) over the past
several years, we believe that it is our challenge, and our opportunity, to leverage our embedded
base of customers and dominant market position to address the testing and monitoring needs of new
system architectures by offering products addressing such needs that represent relatively small
incremental investments in customers existing testing and monitoring systems. We want to provide
our customers with the ability to seamlessly transition from one network to another with
comparatively minimal capital investments in existing testing solutions. The downturn in the telecommunications industry revealed several trends that we expect will
continue to impact our business:  
    incumbent telephone carriers continue to lose customers and revenue to smaller,
independent carriers many of whom are developing their own networks and intend to compete
on price;
    although cable providers have taken the lead in the broadband service market, primarily
because cable modem technology was perfected before DSL technology and because telephone
providers are regulated much more than cable companies, the rate of adoption of DSL
technology is quickly growing; and
    both cable and telephone companies (as well as the providers of satellite, wireless and
other information mediums) are eager to market the so-called triple-play of voice, data
and video broadband services. As a result of these trends, our traditional customer base of incumbent telephone carriers
(especially the RBOCs) have considerably slowed their investments in plain old telephone service
(POTS) line capacity relative to their capital investment patterns of the late 1990s through 2001.
Instead, some of these providers, from which we derive a large percentage of our revenue, are
focusing their capital spending on wireless and next generation wireline projects such as DSL
service and fiber-to-the-premises (FTTP) or fiber-to-the-node (FTTN) (collectively, FTTx).
Additionally, cable companies have sought to capitalize on their present technological advantages
by aggressively marketing their broadband services; in fact, due in part to the advent of wireless
telephone service and Internet-based services, such as Voice-over Internet Protocol (VoIP), cable
providers are well positioned to promote the utility of cable broadband service over the need to
maintain both wired telephone and cable services. Although we remained generally profitable during the industry downturn, during that period we
analyzed, and continue to analyze, our product offerings relative to the needs of the marketplace.
Over the past several years, in addition to reorganizing our workforce, we have diversified our
product offerings both through our acquisitions and development of new products, especially those
aimed at the broadband test market. As a result of our acquisition in 2003 of our Cheetah cable
product line, we believe that we have become a leading provider of status monitoring products for
the cable industry. Including Services, approximately 29% of our 2004 revenue was generated by
cable product sales. This is consistent with 2003 cable revenue which was approximately 29% of
revenue. We believe that the recently consummated alliance with Alpha, the leading provider of
cable power management products, should position us to sustain our leading position in the cable
field in the wake of the recent adoption of the standardized HMS and Data Over Cable Service
Interface Specifications (DOCSIS) protocols for transponders that may in the future render some of
our proprietary cable hardware products obsolete. With respect to our telephony products, although we do not predict that our sales of our core
MCU products will reach the levels seen in 2000, we continue to be encouraged by recent MCU sales
in conjunction with large scale projects, most notably the building out of both POTS networks by
competitive service providers and DSL systems by the RBOCs. With regard to DSL, we plan to market
our DigiTest system as a tool to measure a networks capacity to offer DSL service. We have also
in the past several years placed a greater emphasis on developing and marketing software
applications that conform to industry needs, such as DOCSIS and fiber-optic only networks. - 20 -




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The result of our expanded cable and software offerings and changes in the industry generally
is that our customer mix has changed and will continue to change, a factor which we expect will
make us much less susceptible to the capital spending habits of a few select large customers.
However, despite our relative success in remaining profitable during the past several years, we
believe that there is still too much uncertainty in the marketplace to allow us to accurately
predict the eventual direction that the telecommunications industry will take, or how our business
might fit within that new model. Moreover, given the lower margins generated by our cable products
relative to our proprietary MCU and software offerings, changes in our product mix may cause our
overall profitability to decrease. Industry and Market Trends In the past, consumers had little choice in the range of available telecommunication services
(which was limited primarily to hardwire telephone lines) or the number of providers of such
services (almost exclusively restricted to incumbent local exchange carriers). This combination of
limited services and providers, coupled with governmental regulation of the industry, meant that if
consumers wanted telephone service, they bought it from the company designated by the government at
a price approved by the government. Over the past several years, the telecommunications market (which we define to include cable
television service) has undergone a rapid technological, regulatory and economic evolution.
Contemporaneously with the downturn in the telecommunications industry, several trends emerged that
we expect to continue to affect our business. Intense Competition Among Telecommunications Service Providers The continuing evolution of the telecommunications marketplace, driven by advances in
technology as well as the deregulation of the industry, among other factors, has resulted, and will
continue to result, in intense competition among telecommunications and cable service providers.
Many consumers now have the ability to choose among a variety of comparable telecommunication
services offered by a number of different providers. Although many of interconnection and
unbundling provisions of the Telecommunications Act of 1996 were struck down in 2004 by the U.S.
Court of Appeals, the deregulation of the industry over the past eight years has allowed certain
consumers to obtain local telephone service from either their incumbent local exchange carrier,
which in the old regulatory environment possessed the exclusive right to provide that service, or
by one or more competitive service providers, which may actually provide telephone service over the
network owned by that same local exchange carrier but at a lower cost. Moreover, consumers may
choose from a growing list of communications options that provide the same level of service once
reserved to the local telephone company. The proliferation of wireless telephone service, for
instance, now allows a consumer to place calls from nearly any location in the United States, and
from most parts of the world. Using VoIP, a person may place a call from a VoIP phone either to
another VoIP customer or to a hardwired or wireless telephone number. As a result, the provision
of telecommunication services in certain markets today is highly competitive, and the industry, in
general, is rapidly transforming from a highly regulated monopolistic model to more of a free
market model. Although these evolutionary factors have adversely affected our business to varying degrees
over the past three years, we believe that it is still too early to adequately assess the long-term
effect of these changes on the Company. Because our products are sold primarily to telephone and
cable television companies, of which there are still a relatively limited number, the loss of any
of our customers could translate into reduced demand for our offerings, especially our test system
and test access hardware products. Conversely, the introduction of competition into the
marketplace has helped to bring new customers to us, including the increasing number of competitive
service providers which are building out new networks instead of leasing capacity on incumbent
carrier networks and cable companies which are expanding or upgrading their systems to meet the
increasing demand for broadband and telephone services. Telephone companies, especially the RBOCs,
have also been attempting to meet the demand for broadband services, with the build-out of their
DSL networks, which in some instances has resulted in increased demand for our MCU products. The
result, however, of the expansion of the broadband market will likely be the continued reduction in
demand for POTS service, potentially depressing overall MCU sales. Downturn in Telecommunications Industry The downturn in the telecommunications industry, began in early 2001 and persisted into 2004.
The downturn was caused by a number of factors, including the general slowdown of the U.S. and
global economies during the period, network overcapacity, constrained capital markets and financial
difficulties among certain telecommunication providers, especially Competitive Local Exchange
Carriers (CLECs) whose business models did not produce the profitability necessary to justify their
significant ongoing capital consumption, a problem due in part to continuing regulatory hurdles
during the downturn that impeded competitive access to the telecommunications infrastructure. Many
CLECs as a result were forced to seek bankruptcy protection, a number of which remain there today.
Some CLECs are being purchased and consolidated in the process, while others are emerging or set to
emerge with stronger capital structures to meet the competitive challenge. Those independent CLECs
which are in or have currently emerged from bankruptcy protection now must face an even tougher
competitive landscape in light of the 2004 U.S. Court of Appeals decision to strike down many of
the competitive advantages in interconnection and unbundling rules that were granted to the CLECs
under the Telecommunications Act of 1996. The ultimate effect however has been that many CLECs
must now build their own switched networks to survive, and that in turn may create demand for
LoopCare and DigiTest products which can serve as the testing back bone for these build-outs. As a
result, we are making additional investments in this market. We benefited greatly from the increased capital spending of telecommunication providers during
the late 1990s and into 2000. As the RBOCs and others built-out new and upgraded existing networks
during the period, tremendous demand for our products resulted in very high levels of
profitability. Although we remained generally profitable during the industry downturn that
followed, during that period we analyzed, and continue to analyze, our product offerings relative
to the needs of the marketplace. Over the past several years, in addition to reorganizing our
workforce, we have diversified our product offerings both through our acquisitions of the LoopCare
software and cable-based Cheetah product lines and through our development of new products, - 21 -




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especially those aimed at the broadband test market, such as DigiTest EDGE. We believe that our
ongoing diversification efforts, some of which have had the secondary effect of bringing new
customers to the Company thus reducing our reliance on the RBOCs, will strategically position us to
compete in the evolving marketplace. Complicating our ability to assess our market space in the telecommunications industry is the
uncertainty driven by the deregulatory efforts of various government entities, especially at the
Federal level. Deregulation has actually resulted in the imposition of additional regulations that
affect certain telecommunications services and providers, including changes to pricing, access by
competitive vendors and other broad changes to data and telecommunications networks and services.
As the Federal Communications Commission (FCC) and other government agencies continue to enact new
or amend existing regulations, especially relating to The Telecommunications Act of 1996, our
customers cannot always accurately interpret or predict the rules by which they will be required to
compete in the marketplace. These changes in the regulation of the telecommunications industry
in the United States have had a major impact on our customers, especially on their pricing of
services, and may affect their deployment of future services. We do not believe that we can
accurately predict when these issues will be resolved, or that this deregulatory effort will
continue in the future. Consolidation in Telecommunications Market Competition in the telecommunications market, encouraged and affected by these deregulatory
efforts, has had the secondary effect of resulting in the consolidation of many of the
telecommunications service providers. In some ways, we have benefited from the increased
competition in the industry; competition has brought more providers into the market that may need
our products to provide consistent and quality telecommunications services. However, as a result
of industry consolidations, including those in the CLEC market, we have experienced and could
continue to experience disruption of our existing customer relationships, delays or loss of
customer orders and pricing pressures caused by the reduction in the number of customers desiring
our products. These trends cause decreased revenues and lower net income. As stated above,
however, we believe that it is too early to predict the course that industry consolidations will
take in the future, or how such consolidations might affect our revenues. Further, our major
customers are currently actively pursuing acquisitions to add to their product offerings, such as
the RBOCs acquiring wireless capabilities. We do not currently sell products to wireless carriers;
accordingly, these acquisitions could cause our customers to decrease spending in traditional areas
as they divert funding to these acquisitions and integrations. Slowdown in Build-Out of POTS Networks The most evident market trend to affect our results in the years from 2001 through 2004
compared to 2000 was the general slowdown in the build-out of POTS networks by the RBOCs and other
independent local exchange carriers. In the years immediately preceding 2001, companies expanded
their POTS line capacity at the rate of approximately 5% per year. This line growth resulted in
extremely high demand for our MCU products. Beginning in 2001, however, a number of factors
converged to slow the growth of POTS networks. Perhaps the most important factor was the declining
demand for wired telephone service, known as, line loss; in essence, telephone companies were,
and still are, losing more customer lines than they are adding. Line loss has resulted from a
number of trends, including competition from wireless telephone providers and the reduction in the
need for multiple telephone lines, driven in part by the increasing popularity of DSL (which is
normally accessed though a households primary hardwire telephone line) and cable modems for
broadband access to the Internet. Although we do not believe that wireless service will entirely
supplant the need for wired telephone service, we do expect that wireless telephones, as well as
other alternatives to traditional telephones such as VoIP, will continue to erode the demand for
POTS service; the extent of such reduced demand, however, is difficult to predict at this time.
However, many cable operators are deploying or intend to deploy VoIP, which may serve to stimulate
additional sales of our cable status monitoring products. Investment in New Network Infrastructure and Technologies Although telephone companies are not focusing on their POTS networks as much as they once did,
they are still investing in their network infrastructure. Generally, the combination of increased
competition and reduced revenues in recent years has left the telephone companies with less funds
available for capital investment. We are encouraged, however, by several trends, including the
previously discussed movement by competitive carriers to build POTS networks rather than leasing
network space from incumbent carriers; additional POTS capacity may result in telecommunications
test equipment sales. Furthermore, a majority of the RBOCs have, at present, announced varying
increases in their capital budgets for 2005 over 2004. Rather than investing in POTS, however,
increasing portions of these capital budgets are being allocated to other projects, such as
wireless, DSL rollouts, ATM switches and FTTx projects. We have benefited from certain DSL
projects in the past, such as SBCs DSL Footprint Expansion initiative, which resulted in increased
demand for our MCU products. If implemented on a large scale, FTTP projects, which would provide broadband services through
a direct fiber-optic link between a telephone companys central office and the end user (i.e.,
individual households and businesses), will reduce demand for our MCU and DigiTest products.
Unlike traditional hybrid networks in which our MCU products are deployed, fiber-optic systems can
be tested and managed with appropriate software (including variations of our LoopCare software).
We remain confident, based on recent announcements by certain of our RBOC customers, that their
existing hybrid fiber-optic/copper line networks will continue to be the medium through which the
majority of POTS services are delivered in the United States for the foreseeable future. In
addition, these RBOCs are currently spending significant resources on upgrading these hybrid
fiber-optic/copper line networks to provide broadband and eventually video signals. Although
certain of our telephone company customers are indicating an interest in FTTP projects, it still is
not clear that FTTP will be implemented on a large scale basis. In fact, certain other of our RBOC
customers have indicated they will implement FTTN projects rather than FTTP. In FTTN projects, the
fiber link will not extend to the customers premises, rather, it will extend to the nodes in the
network, by necessity leaving a portion of the copper network intact. Given the size and breadth
of the present hybrid networks, including the billions of dollars invested in them, coupled with
the billions of dollars required to replace them with all fiber-optic lines, we believe that the
copper portion of the network will remain an important part of - 22 -




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the telecommunications system in the United States. As long as that copper portion remains,
as is contemplated in FTTN projects, some need for traditional testing methods should continue. Unlike most of the existing telephone network, the hybrid fiber coaxial (HFC) networks
maintained by the cable television companies are capable of providing broadband services with
little additional capital investments. In general, cable companies have been quite successful with
their deployments of high bandwidth Internet services. Since 1996, we have offered our legacy
cable (formerly LIGHTHOUSE) hardware products to cable companies for the status monitoring of their
networks; our recently acquired Cheetah hardware products offer a similar proprietary system for
the monitoring of hybrid fiber coax distribution systems. The adoption of the HMS standard and,
increasingly, the DOCSIS standard for cable modems by a growing number of cable companies, however,
has the potential to eliminate the demand for certain of our proprietary Cheetah head-end hardware
products, and to reduce demand for other proprietary Cheetah offerings. Our Responses to These Industry Trends Although we are confident that we offer superior test system and status and performance
monitoring products, the evolution of the telecommunication and cable networks requires us to
constantly evaluate our product offerings relative to the needs of the industry. We have taken a
number of steps to attempt to position the Company to take advantage of our leading position in
certain of our markets, including the continued expansion of our cable television network
monitoring and operations support system (OSS) software product lines, each of which has served to
expand our customer base. Expansion of Cable Status Monitoring Product Line Since 1996, we have offered our legacy cable (formerly LIGHTHOUSE) hardware and software
products to cable companies for status monitoring of their networks. In order to grow our cable
status monitoring product line, on February 13, 2003 we purchased the Cheetah product line from
Acterna, LLC. We believe that these products coupled with our LIGHTHOUSE platform, represent the
dominant monitoring products in the cable marketplace. With the addition of the Cheetah product
line, we have become the supplier of status monitoring hardware and software to nearly every major
cable company. We believe our Cheetah products complement and augment our other cable product
offerings and strategically positions the Company to be the leading supplier of testing equipment
and software for the cable industry. Moreover, we have taken a proactive approach to the increasing adoption of the DOCSIS
standards by cable providers. We have developed DOCSIS monitoring hardware, which has been
certified by CableLabs in certain configurations and is in the final stages of certain specific
customer certifications. Additionally, in 2003, we entered into an agreement with Alpha
Technologies to be the exclusive supplier of IP-based DOCSIS status monitoring equipment for Alpha
power supplies used in hybrid-fiber coax (HFC) networks. By joining with Alpha, we have aligned
with the primary provider of power supply products to the cable industry to offer fully compatible
and integrated DOCSIS transponders. We believe that as cable companies continue to leverage their
growing DOCSIS-based HFC infrastructure to deliver voice, data and video services through a single
conduit, we are well positioned to provide the range of quality assurance and testing products
necessary to maintain our leading position in the cable marketplace. Further, much of the IP-based
network infrastructure is similar, whether implemented in a telephony or cable network. As a
result, we believe our development efforts for IP-based testing solutions in the cable market may
translate well to the telecommunications network. Development and Marketing of Software Solutions Along with our growing focus on the cable market, we have also increased our emphasis on
developing and marketing software solutions for network assurance and testing. Given the
increasing interest of the RBOCs in FTTx projects and the importance of software products to cable
monitoring systems, we believe that our development of new software solutions will be an important
determinant of our future success. Our LoopCare software is already the dominant OSS software for
copper line networks. Because fiber-only networks require primarily software solutions for network
testing, we have actively promoted our ability to adapt our existing LoopCare OSS to serve FTTx
systems. Although we believe that it is much too early to determine the extent to which FTTx
projects will be implemented, we will continue to analyze the capital spending trends in the
industry and will attempt to adjust our product offerings accordingly. From 2001 to 2004, we reorganized our internal structure to de-emphasize existing hardware
development efforts and, through our acquisitions, added significant capability in software
engineering. The most recent reorganizations occurred on July 8, 2004 and July 21, 2004 when we
announced a cost alignment program which eliminated, in two phases, approximately 50 positions.
The majority of the reduction affected our research and development, manufacturing, and related
overhead areas. On September 30, 2002, we announced a cost reduction initiative which included
the elimination of 47 positions, primarily in research and development. We had additional cost
alignment programs during 2001 that resulted in the elimination of 80 positions. Of the nearly 200
original positions eliminated, many related to hardware engineering and production activities.
Conversely, many of the new employees are involved in software or system development. As a result
of these changes, we believe that we are now better prepared to develop the software products that
we believe will in the future comprise a large component of the test assurance market. 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 a new software product. Unlike our MCU products, which are comprised of
proprietary technology that requires little modification, unless we acquire proprietary software,
we must internally develop any new software products. Software development is a relatively
expensive process, especially considering the human costs involved, and can be a lengthy process.
Pricing presents another challenge; 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. Initial pricing
issues are somewhat lessened by the stream of revenue generated by the software maintenance - 23 -




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agreements we normally enter into with our software customers; maintenance arrangements related to
our LoopCare and Cheetah acquisitions in particular have elevated the revenues and importance of
Services business to our future success. Furthermore, the sales process for our software products, especially to our RBOC customers,
can be cumbersome. The increasing trend is for strict business case scrutiny by RBOCs relating to
software sales, and for evidence of a shorter return on investment than was traditionally required
to support a software purchase. In addition, to ensure compatibility with their respective
networks, these customers can require significant periods of time to test our software products
prior to agreeing to purchase them. This delay, coupled with the enterprise license nature of the
software licenses that we typically offer, can lead to what we call lumpy software sales, meaning
that software sales in one period are not necessarily indicative of future sales in the next
period; our software revenues can follow unpredictable patterns, as our software products represent
primarily one-time purchases that gain the approval of our customers at varying rates. As a
result, although we are hopeful that our increased emphasis on software products will position us
to meet the needs of the changing telecommunications marketplace, it is difficult to predict the
markets acceptance of our software offerings or the rate at which such products will generate
revenue for us. We have placed this increasing emphasis on cable and software products as an avenue to replace
the revenue historically generated by our core MCU products. As the life cycle for MCU products
continues to mature, and certain RBOCs and other customers focus their capital spending on network
improvements such as FTTx rather than hybrid networks, demand for our MCU and existing DigiTest
products will likely diminish. As a result, even though we are confident because of the prominence
of copper lines in telecommunications networks there will still be a market for MCU products, we
expect that in general, sales of MCU products will decline over time. Nevertheless, we expect that
MCU sales will continue to comprise a significant portion of our revenues for the foreseeable
future. Our DigiTest product line, introduced in 1999 following development efforts with Lucent and
Nortel, was originally targeted at Sprint for its rollout of DSL service in several U.S. markets.
DigiTest products initially produced substantial revenues for us. Between 1999 and 2001, Sprint
purchased approximately $22 million in DigiTest test heads. In 2001, however, Sprint discontinued
this project and curtailed its DigiTest purchases, resulting in a material decline in overall
DigiTest sales since then. To increase DigiTest sales, we are actively marketing the system as a replacement for, or
upgrade to, the existing loop testing systems (LTS) employed by the RBOCs to target problems in
their POTS networks; we believe that DigiTest is a good replacement product for the existing LTSs,
which are decades old. Replacement parts for them are no longer produced. Despite our marketing
efforts, however, except for small-scale deployments in certain selected markets, the RBOCs have
yet to allocate significant capital resources to LTS replacement projects, and we expect that in
the current competitive environment, they will continue to attempt to utilize the existing LTS
equipment as long as possible. As a result, we expect this market to develop over a longer period
of time and on a more incremental basis than we originally anticipated. Increased Features for our Telecommunications Products We have taken a number of steps to increase our presence in the telephony testing market
space. Since its introduction, our POTS DigiTest test head has undergone several significant
developmental changes. With the integration of the LoopCare software, which we acquired in 2001,
with the DigiTest hardware, we now offer a complete integrated testing system to smaller customers
such as competitive exchange carriers and international customers. Furthermore, as a result of
extensive research and development efforts in 2002 and 2003, we now offer our DigiTest EDGE
product, which combines the reliability of our DigiTest POTS testing system with our new Broadband
Services Option (BSO) test capability. The EDGE product is primarily targeted at the RBOC DSL
market, but does have applications in the competitive domestic and international markets. We
expect that once the DSL customer base of the RBOCs reaches a level of maturity that supports
higher measures of centralized testing, the EDGE will compete favorably with similar offerings in
the market. We remain hopeful that demand for the EDGE product, combined with increasing
opportunities for sales of DigiTest POTS systems to competitive carriers and RBOCs for LTS
replacement projects, will represent a replacement revenue stream for declining MCU sales. The continuing general trends of reduced MCU sales and increasing software and cable-related
product revenues, has resulted in the broadening of our customer base. Although we still rely on
the RBOCs for a large portion of our revenues, the percentage of our overall revenues generated
from RBOC customers has dropped from 77% in 2002 and 56% in 2003 to 54% in 2004. This decrease is
due in part to the reduced capital spending of the RBOCs. More importantly to us, however, have
been our increasing sales to new customers, primarily cable companies and CLECs. As our cable
monitoring products become more fully entrenched, CLECs build out their own networks, and sales of
our software to new customers increase, we expect that our dependence on the RBOCs for a large
portion of our revenue will continue to decrease in 2005 and beyond. 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 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. Even with the adoption of DOCSIS by many cable providers, we believe that there still is value
in our proprietary Cheetah status monitoring systems, especially for those customers who have
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Nevertheless, the further evolution of cable industry standards could and likely will
eliminate the need for some of these proprietary products. Increased International Sales Because of the incompatibility of some of our products with the various technological
standards employed abroad, including the MCU, our revenues from international sources historically
have been immaterial. In response, during 2003, we reduced our international marketing staff.
Since our MCU products are designed to meet the specifications of the hybrid copper-fiber network
in the United States, they have limited applications in the international markets. Our LoopCare
software products used in combination with DigiTest or EDGE, however, do have utility for
international customers. Through our original equipment manufacturer (OEM) relationship with
Lucent, our LoopCare products have been sold internationally in conjunction with purchases of
Lucent hardware. Of particular note is our recent success with Lucent Technologies International
in successfully bidding and obtaining a substantial piece of business with the Saudi Telecom
Company (STC) in Saudi Arabia. Although it is an as ordered contract, it contemplates the
purchase of all of the Companys broadband offerings in addition to LoopCare software customization
and an operating platform update effort. Product flow and acceptance, and therefore revenues, are
currently largely expected to benefit 2005, with some revenue into early 2006. Furthermore, the Company enjoys a stream of software maintenance revenue from international
sources. Our Cheetah product lines are also marketed internationally through OEM relationships.
As demand for cable service internationally increases, we believe that our cable products in
particular may offer an avenue to increasing our international sales, as worldwide cable standards
do not differ materially from those supported by our products. In the short term, the success of
our LoopCare, DigiTest and Cheetah offerings will primarily be dependent on the efforts of our OEM
partners and in the competitiveness of our OEM pricing model. Other Company Trends In addition to the industry and product trends that we have already discussed, our operating
results have fluctuated and may continue to fluctuate from time to time as a result of various
other factors, including the timing of orders from, shipments to, and acceptance of software by,
the RBOC customers and significant independent telephone companies. This timing is particularly
sensitive to various business factors unique to each of our larger customers, including their
relationships with various organized labor groups and a continuing tendency to place large orders
for shipment of hardware and software toward the end of a quarter, which may result in orders
placed in one quarter not being filled until the next period. In addition, the markets for some of
our products, such as LoopCare and DigiTest, are highly competitive. Due to the rapidly evolving
market in which these products compete, additional competitors with significant market presence and
financial resources could further intensify the competition for these products. We believe that the changes outlined above and others within the telecommunications
marketplace, industry consolidation, as well as our continuing efforts to expand our customer base
and product offerings, have required us to grant more favorable terms to some of our customers.
Furthermore, certain customers have consolidated product purchases among their various divisions,
translating into large bulk orders for our products. There is a continuing trend, which is in part
a result of our discounting programs, for these customers to place large bulk orders for large
quantities of hardware and software products. Although we will continue to strive to meet the
demands of our customers, which include delivery of quality products at an acceptable price on
acceptable terms, we can provide no assurance that we will be successful in negotiating acceptable
terms and conditions with our customers or that these continuing efforts by our RBOC customers to
consolidate their inventory and product procurement systems will not cause fluctuations or delays
in our order patterns. Application of Critical Accounting Policies Our financial statements are prepared in conformity with accounting principles generally
accepted in the United States of America. The application of certain of these accounting
principles is more critical than others in gaining an understanding of the basis upon which our
financial statements have been prepared. We deem the following accounting policies to involve
critical accounting estimates. Revenue Recognition We market and sell test system hardware and related software to the telecommunications and
cable television industries. The Company follows Staff Accounting Bulletin (SAB) 104, Revenue
Recognition for hardware and software sales. This bulletin requires, among other things, that
revenue should be recognized only when title has transferred and risk of loss has passed to a
customer with the capability to pay, and that there are no significant remaining obligations of the
Company related to the sale. The bulk of our hardware sales are made to RBOCs and other large
customers. Terms of these hardware sales are predominantly FOB shipping point. Revenue is
recognized for these customers upon shipment against a valid purchase order. The timing of revenue
recognition may require the judgment of management. We reduce collection risk by requiring letters
of credit or other payment guarantees for significant sales to new customers and/or those in weak
financial condition. For software perpetual license fee and maintenance revenue, we follow not only SAB 104, but
also the 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. These statements require that software license fee revenue be recorded only when
evidence of a sales arrangement exists, the software has been delivered, and a customer with the
capacity to pay has accepted the software, leaving no significant obligations on the part of the
Company to perform. We require a customer purchase order or other written agreement to document
the terms of a software order and written, unqualified acceptance from the customer prior to
revenue recognition. In certain limited cases, however, agreements provide for automatic customer
acceptance after the passage of time from a pre-determined event and we have relied on these
provisions for an indication of the timing of revenue recognition. In isolated cases for orders of
custom software, or orders that require significant software customization, such as that associated
with our contract with Lucent for test gear deployment in Saudi Arabia, we employ contract
accounting using the percentage-of-completion method, whereby - 25 -




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revenue is recognized based on costs incurred to date compared to total estimated contract
cost. The revenue for orders with multiple deliverables such as hardware, software and/or
installation or other services may be separated into stand-alone fair values if not already
documented in the purchase order or agreement and where list prices or other objective evidence of
fair value exists to support such allocation, in accordance with the provisions of EITF Issue
00-21. Revenue will not be recognized for any single element until all essential elements are
delivered and accepted. Our LoopCare and other software customers usually enter into separate agreements for software
maintenance upon expiration of the stated software warranty period. Maintenance agreements include
software upgrades and bug fixes as they become available; however, newly developed features must be
purchased separately. Post-warranty maintenance for new features is either included under the
current maintenance agreement without additional charge, and is considered in the maintenance
agreement fees, or is separately charged upon expiration of the warranty. Depending upon the
timing of the enhancement purchase and the length of the maintenance agreement, we must evaluate
whether or not a portion of a perpetual right to use fee should be treated as post contract support
to be deferred and recognized over the remaining life of the maintenance agreement. Software maintenance revenue is recognized on a straight-line basis over the period the
respective arrangements are in effect. Revenue recognition, especially for software products,
involves critical judgments and decisions that can result in material effects to reported net
income. Intangible Assets and Goodwill We had net intangible assets and Goodwill of $70.9 million at December 31, 2004 primarily
resulting from the acquisitions of the LoopCare and Cheetah product lines in September 2001 and
February 2003, respectively. In connection with these acquisitions, we utilized the transitional
guidance of Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations and
SFAS No. 142, Goodwill and Other Intangible Assets, which were issued in July 2001. SFAS No. 141
requires that the purchase method of accounting be used for all business combinations initiated
after June 30, 2001 and that goodwill, as well as any intangible assets believed to have an
indefinite useful life, shall not be amortized for financial reporting purposes. An independent
valuation consultant assisted the Company in identifying and valuing both the LoopCare and Cheetah
intangible assets. In connection with the assets acquired in the LoopCare transaction, intangible assets of $45.8
million were identified. Capitalized software valued at $7.3 million was determined to have a
definite useful life of five years and is being amortized over that period. Also identified were
intangible assets related to the LoopCare trade name of $1.3 million, LoopCare base software of
$5.2 million, and post-warranty service agreements of $32.0 million. Because of the longevity of
the LoopCare trade name, the fact that over 80% of the original base software code that was
developed in the 1970s is still in use in the RBOCs today and strong sales and resultant cash
flows are expected indefinitely into the future, both of these related identified intangible assets
were determined to have indefinite useful lives. With regard to the post-warranty service
agreements, these arrangements have been in place for many years and we believe that these annual
agreements will be renewed into perpetuity due to their critical importance in the operations of
the customers. At the end of 2003 and 2004, we had executed maintenance agreements with two of the
four RBOCs while negotiating agreements with the other two customers. Early in 2005, we signed a
two year agreement with one of the remaining RBOCs. We intend to maintain fixed fee arrangements
for all maintenance contracts. Therefore, we believe that the non-amortizing characteristics of
these intangible assets will be preserved. However, in the event negotiations would result in
substantially less revenue to us than the current fixed fee agreements, the current fair value of
these maintenance service agreements may be determined to be less than the $32.0 million carrying
value, perhaps materially so, resulting in a non-cash charge against operating income and/or
commencement of amortization of the remaining fair value over its then determined useful life. A
similar analysis of the fair value of the maintenance service agreements would be required if any
of our RBOC customers would terminate or indicate a definite life for their respective maintenance
service agreement for any reason. In the Cheetah acquisition, intangible assets of $10.5 million were identified, of which base
software valued at $2.9 million and proprietary technology valued at $1.0 million were determined
to have a definite useful life of ten years and are being amortized over that period. Sales order
backlog acquired in the transaction was valued at $0.5 million and was substantially amortized at
December 31, 2003 and fully amortized as of March 27, 2004. This product line has three or four
dominant customers who have purchased and supported Cheetah products for many years. This provides
a dominant market position for this product line. As a result, the remaining identified intangible
assets of customer base valued at $5.0 million and Cheetah trademark valued at $1.0 million have
been determined to have an indefinite useful life and, along with goodwill of $3.3 million, are not
being amortized. As of January 1, 2002, we fully adopted the provisions of SFAS No. 142. We have determined
that we have only one reporting unit and have completed tests for goodwill impairment as of
December 31, 2004 by comparing the aggregate market value of the Companys stock with our book
carrying value, including goodwill. These tests indicated that there was no impairment of the
goodwill carrying value. From time to time, the market value of our stock temporarily declined to
an amount below the book carrying value. We believe that these instances were reflective of then
current conditions in the telecommunications and general markets and not an indication of fair
value. However, future changes in circumstances, including a sustained decline in the aggregate
market value of our stock, could necessitate a reconsideration of whether an impairment of goodwill
carrying value has occurred, requiring an alternate testing of our fair value under guidance of
SFAS No. 142. In that event, impairment in value up to the full amount of the goodwill could be
determined, resulting in an impairment loss to be recorded in our financial statements. All other intangible assets were tested for impairment of carrying value as of December 31,
2004 using assumptions and techniques employed in the original valuation and following the guidance
of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Specifically,
the sum of the projected future cash flows to be derived from the LoopCare developed product
software was compared with the net book carrying value. The impairment test for non-amortizable
intangible assets other than goodwill consisted of a comparison of the estimated fair value with
carrying amounts. The values of the LoopCare trade name - 26 -




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and Cheetah trademark were measured using the relief-from-royalty method and discounted cash
flow analyses were employed to test the value of the LoopCare base software and post warranty
maintenance service agreements and the value of the Cheetah customer base. These tests indicated
that none of the intangible assets had impairment in carrying value. The Company plans to retest
these assets annually as of December 31 or more frequently if events or changes in circumstances
indicate that assets might be impaired. This testing relative to impairments involves critical accounting estimates. We relied upon
our financial plan for 2005 and best estimates of revenues and cash flows for later years in
measuring current values; however, these expectations may not be realized and future events and
market conditions might indicate material impairment of value that could result in material charges
to net income. Such a future situation would not, however, in and of itself affect our cash flow
or liquidity. Inventory Valuation We utilize a standard cost system that approximates first-in, first-out costing of the
products. Standards are monitored monthly and changes are made on individual parts if warranted;
otherwise standard costs are updated on all parts annually, normally in November of each year.
Excess capacity is not included in the standard cost of inventory. We evaluate our inventories on
a monthly basis for slow moving, excess and obsolete stock on hand. The carrying value of such
inventory that is determined not to be realizable is reduced, in whole or in part, by a charge to
cost of sales and reduction of the inventory value in the financial statements. The evaluation
process, which has been consistently followed, relies in large part on a review of inventory items
that have not been sold, purchased or used in production within a one-year period. Management also
reviews, where appropriate, inventory products that do not meet this threshold but which may be
unrealizable due to discontinuance of products, evolving technologies, loss of certain customers or
other known factors. As a result of this comprehensive review process, an adjustment to the
reserve for slow moving and obsolete inventory is normally made monthly. Inventory identified as
obsolete is also discarded from time to time when circumstances warrant. Inventory realization is considered a critical accounting estimate since it relies in large
part on management judgments as to future events and differing judgments could materially affect
reported net income. The expense for slow moving and obsolete inventory was $2.5 million, $0.2 million and $0.3
million for 2002, 2003 and 2004, respectively. The valuation reserves increased $1.2 million in
2002, decreased by $0.9 million in 2003 and remained flat in 2004 to a balance of $1.4 million at December 31, 2004. Inventory physically scrapped was
$1.3 million, $1.1 million and $0.3 million in 2002, 2003 and 2004, respectively. Allowance for Doubtful Accounts Our accounts receivable balance, net of allowance for doubtful accounts was $10.7 million as
of December 31, 2004, compared with $9.3 million as of December 31, 2003. The allowance for
doubtful accounts as of December 31, 2004 was $0.8 million, compared with $0.9 million as of
December 31, 2003. The allowance is based on our assessment of the collectibility of customer
accounts. We regularly review the allowance by considering factors such as historical experience,
credit quality, age of the accounts receivable balances, and current conditions that may affect a
customers ability to pay. Our (credit) provision for doubtful accounts was ($0.2) million, $0.4 million, and $0.1
million for fiscal 2004, 2003, and 2002, respectively. In fiscal 2004, we recorded a credit for
doubtful accounts as a result of the improvement in collectibility of specific customer accounts
due to increased credit quality and resolution of disputes. If a major customers creditworthiness
deteriorates, or if actual defaults are higher than our historical experience, or if other
circumstances arise, our estimates of the recoverability of amounts due to us could be overstated,
and an additional allowance could be required, which could have an adverse impact on our revenue. Income Taxes We follow the provisions of SFAS No. 109, Accounting for Income Taxes, in reporting the
effects of income taxes in our consolidated financial statements. Deferred tax assets and
liabilities are determined based on the temporary differences between the financial statement
carrying amounts and the tax basis of assets and liabilities using enacted tax rates in effect in
the years in which the differences are expected to reverse. As of December 31, 2004, we had
recorded net deferred tax liability of $1.3 million. As of December 31, 2003, we had a net
deferred tax asset of $1.1 million. The change is related to a charge of $1.1 million related to
state net operating loss carryforwards, a full valuation allowance against certain state net
operating losses and due to amortization of intangible assets for tax purposes. We have evaluated
all remaining deferred tax assets based on our current outlook and believe all remaining assets
will be utilized. Additionally, during 2004, we reviewed the components of our tax contingency
reserve and reduced the liability by $0.8 million. This represented a change in estimate based on
a tax audit of earlier years and on evaluation of current circumstances. The impact of the state
net operating loss carryforwards, state valuation allowance and the review of our tax contingency
reserves resulted in a net charge of $0.3 million. Net deferred tax assets are expected to
continue to decrease in future years. The timing of the reversal of the deferred tax liabilities
and to a large extent the deferred tax assets are dependent upon uncertain future events and cannot
be assumed to occur in the same tax years. The state net operating loss carryforward relates primarily to tax losses arising in 2000, a
year in which the Company had significant tax deductions arising from stock option exercises. The
majority of this carryforward is subject to state laws that allow a 20-year carry forward period
with a $2.0 million limit on deductions in each year. Future realization of the recorded tax
assets resulting from both timing differences and carryforward losses is dependent upon the
existence of sufficient taxable income in future years. During 2004, we evaluated our ability to
use net operating losses in the states of Pennsylvania and New York. Based on our review and
expectations of future state losses we have established 100% reserve against these state net
operating losses. SFAS No. 109 requires that a valuation allowance be recorded against a deferred tax asset when
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some or all of that deferred tax asset will not be realized and, accordingly, a valuation
allowance of $1.8 million has been recorded against the state tax carryforward deferred tax assets.
We believe that the recent business climate in the telecommunications industry is not permanent,
however, based on our current tax structure we believe it is more likely than not that these net
operating losses will not be realized in future years. The Company had a federal taxable loss in
2004 and will be able to carry this loss back to 2002 and should receive a refund of $0.6 million.
We expect to have federal taxable income in future years. Warranty We provide warranty coverage on our various products. Terms of coverage range from up to one
year on software to two to five years for hardware products. We review products returned for repair
under warranty on a quarterly basis and adjust the accrual for future warranty costs based upon
cumulative returns experience. We also evaluate special warranty problems for products with high
return rates to correct the underlying causes and, where deemed necessary, to provide additional
warranty expense for expected higher returns of these products. Warranty costs associated with
software sales are also accrued based on the projected hours to be incurred during the warranty
period (normally three months). The accounting for warranty costs involves critical estimates and
judgments that can have a material effect on net income. The warranty accrual decreased by $0.1
million in 2002, increased by $0.2 million in 2003, and decreased by $0.1 million in 2004 to a
balance of $2.1 million at December 31, 2004. These areas involving critical accounting estimates are periodically reviewed and discussed
with the Audit Committee of our Board of Directors. Results of Operations for the Year Ended December 31, 2004 Compared to the Year Ended December 31,
2003 Revenue Revenue for the year ended December 31, 2004 was $62.8 million, a decrease of $2.3 million or
3.5% from our revenue of $65.1 million for the year ended December 31, 2003. The decrease in
revenue resulted primarily from further erosion in unit volume sales of traditional MCU products,
partially offset by an increase in DigiTest products and LoopCare software sales and maintenance
services. Sales of our MCU product line in 2004 were $21.1 million, a decrease of approximately
$4.3 million, or 17.0%, from the results of the previous year. This decrease in sales was
associated primarily with two of the four RBOC customers. Qwest purchased $2.2 million less from
us in 2004 than in 2003, and SBC purchased $1.7 million less in 2004 than 2003. Although
declining, we do expect MCU sales for the foreseeable future to continue to account for a
meaningful portion of the Companys revenue. 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 are the key reasons we expect it to decline over
time. The MCU product line accounted for approximately 33.5% of 2004 revenue, down from 39.0% of
our 2003 revenue. Sales of the Companys DigiTest product line in 2004, including $1.1 million of LoopCare
software, were approximately $7.7 million, an increase of approximately $1.1 million, or 16.9%,
from the prior year. This increase in DigiTest sales was primarily the result of the RBOC LTS
modernization initiatives. DigiTest sales accounted for approximately 12.3% of 2004 revenue, up
from 10.1% of our 2003 revenue. Sales of stand-alone LoopCare software products in 2004 were approximately $4.4 million,
representing a 27.4% increase over 2003. The increase in revenue is associated with deployments at
Qwest and SBC. Services revenue consists of installation oversight and product management services provided
to customers and fees from LoopCare and Cheetah software maintenance agreements. Service revenues
were approximately $13.0 million in 2004 an increase of $0.7 million over the results of the
previous year due to LoopCare services and Cheetah services. Services revenues accounted for
approximately 20.7% of 2004 revenues, up from 18.9 % of our 2003 revenue. Overall sales of cable hardware and software products were $16.7 million in 2004, a decrease
of $0.7 million or 4.2% from the prior year. The decrease is associated with CableLabs DOCSIS®
certification of our transponder products which was received in the third quarter of 2004; however,
it delayed the manufacturing of the product until final engineering enhancements were completed.
Though we received CableLabs Certification, we are still working to resolve final technological
product matters which continue to delay our manufacturing and deployment of this product. Overall
sales of cable hardware and software products were 26.6% of 2004 revenue, down from 27.0% of 2003
revenue. Gross Profit Gross profit for 2004 was $34.8 million compared to $36.0 million for 2003, a decrease of $1.1
million, or 3.2%, from the previous year. The overall decrease is gross profit resulted primarily
from decreased sales levels and product sales mix. Gross profit as a percentage of revenue
remained relatively stable at 55.5% for 2004 compared to 55.3% for 2003. Despite the decline in
revenue from 2003, gross margin in 2004 as a percentage of sales remained level due to several
offsetting factors including increased LoopCare RTU sales and the nature of the product mix of
hardware sales. Selling and Marketing Expenses Selling and marketing expenses consist primarily of personnel costs as well as commissions and
travel expenses of direct sales and marketing personnel, and costs associated with various
promotions and related marketing programs. Selling and marketing expenses for 2004 were $9.5
million, or 15.1% of revenues, compared to $9.4 million, or 14.4% of revenues for 2003. The
increase in selling and marketing expenses is related to commission costs which increased $0.4
million and salaries which increased $0.2 million, partially offset by a decrease in consulting
costs of $0.5 million. The increase in commissions is associated with our increased use of sales
representatives for various international sales efforts. The decrease in consulting costs is the
result of discontinuing our association with several consultants associated with penetration into
various international markets. - 28 -




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General and Administrative Expenses General and administrative expenses consist primarily of personnel costs for finance,
administrative and general management personnel as well as accounting, legal and insurance
expenses. General and administrative expenses for 2004 were $7.3 million, or 11.7% of revenue,
compared to $7.0 million, or 10.7% of revenues for 2003. The increase of $0.3 million, or 5.0%, is
primarily attributed to an increase of $0.5 million in salaries and wages, a $0.7 million increase
in professional services, partially offset by a $0.1 million decrease in incentive compensation and
a $0.7 million decrease in bad debt expense. The increase in professional services is attributed
to audit fees and consulting costs associated with Sarbanes Oxley 404 compliance. The decrease in
bad debt expenses is associated with better than expected collection efforts and due to a charge of
$0.5 million in 2003 associated with the Cheetah acquisition. Research and Development Expenses Research and development expenses consist primarily of personnel and other costs associated
with the development of new products and technologies, including DigiTest, next generation Cheetah
hardware and software and LoopCare software. Research and development expenses for 2004 were $15.8
million, or 25.1% of revenue, compared to $14.9 million, or 22.9% of revenue for 2003. This
increase of $0.8 million was due to an increase in consulting costs of $0.2 million, depreciation
expenses of $0.3 million and health insurance of $0.2 million. Severance and related expenses During the third quarter of 2004, we implemented a cost reduction program that eliminated
approximately 50 positions and resulted in a charge of $0.3 million in 2004. The cost reduction
program was the result of a slowing MCU sales environment due primarily to the maturing of its
product life cycle, a decrease in deployment of DLC systems as a result of loss of lines to
competitors, as well as a shift of spending away from traditional POTS to new fiber-based network.
Additionally, the delay in deployment of DigiTest and DigiTest EDGE and product mix to those
products with lower gross margins were additional factors in the cost reduction programs. Other Income Other income, which consisted primarily of interest income, was $0.4 million for 2004 and
2003. Provisions for Income Taxes The Companys effective tax rate for 2004 was 44.8% of pre-tax income, compared to a 38.0%
rate in 2003. The significant change in the effective rate is related to state net operating loss
carryforwards and the establishment of a full valuation allowance against certain state net
operating losses. The state net operating loss carryforwards and valuation allowance resulted in a
charge of $1.1 million to income tax expense. This was offset by our review of the components of
our tax contingency reserve which resulted in a $0.8 million reduction of the reserve. This
represented a change in estimate based on a tax audit of earlier years. The net impact of the
state net operating loss carryforwards, state valuation allowances and review of our tax
contingency reserves resulted in a net charge to income tax expense of $0.3 million. Net Income and Earnings Per Share For the year ended December 31, 2004, net income was $1.3 million compared to $3.1 million for
the year ended December 31, 2003, a decrease of $1.8 million, or 57.3%. Diluted earnings per common
share were $0.10 for 2004 verses $0.24 for 2003. Diluted weighted average shares of common stock
and equivalents outstanding were 13,253,294 in 2004 compared to 13,312,597 in 2003. The decrease in
the diluted weighted average shares of common stock and equivalents outstanding is primarily the
result of a reduction in the dilutive effect of outstanding stock options related to the decrease
in weighted average share price of the Companys common stock. As a percentage of revenues, net
income for 2004 decreased to 2.1% from 4.8% in 2003. Results of Operations for the Year Ended December 31, 2003 Compared to the Year Ended December 31,
2002 Revenue Revenue for the year ended December 31, 2003 was $65.1 million, an increase of $6.5 million or
11.1% over the revenue of $58.6 million recorded for the year ended December 31, 2002. The increase
in revenue resulted primarily from the February 2003 acquisition of the Cheetah product line. This
new revenue was partially offset by lower LoopCare software sales and reduced MCU and DigiTest
sales. Sales of the MCU product line in 2003 decreased by $2.7 million, or 9.5%, from the results of
the previous year. This decrease in sales, which was primarily associated with reduced sales to two
RBOC customers, was partially offset by strong sales to AFC and another original equipment
manufacturer. As the life cycle for the MCU product continues to mature, there is an increasing
possibility that customer requirements for certain legacy MCU products will be satisfied. The MCU
product line accounted for approximately $25.4 million, or 39.0%, of our 2003 revenue. Overall sales of cable hardware and software products were $17.4 million in 2003, or 27% of
2003 revenue, of which $13.6 million was contributed by Cheetah hardware and CheetahNet (formerly
NetMentor) software products and $3.8 million were attributable to the Companys legacy cable
status monitoring products (formerly LIGHTHOUSE®). The legacy cable product sales were $3.1
million in the year earlier period. Sales of the Companys DigiTest product line, including $1.2 million of related LoopCare
software sales, decreased in 2003 by $1.7 million, or 20.5%, from our results for 2002. This
decrease was primarily the result of both the inclusion in our 2002 results of the completion of a
major centralized test head replacement and augmentation program by an RBOC and lower sales to
Nortel Networks in 2003. DigiTest sales were made to each of the RBOCs in 2003 for modest loop test
system initiatives and to both independent and competitive carriers for new installations and
expansions of existing DigiTest systems. DigiTest product sales in 2003 represented $6.6 million,
or 10.1%, of our 2003 revenues. - 29 -




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Sales of stand-alone LoopCare software products in 2003 were $3.4 million, a decrease of $4.1
million or 54.7% from the prior year. Revenues for 2003 were affected by a lack of large dollar
RBOC sales and a slowdown in international orders. Stand-alone LoopCare software product sales in
2003 were 5.2% of our total revenue for the year. Revenue from services, which includes installation oversight and project management services
provided to RBOC customers and fees from LoopCare and Cheetah software maintenance arrangements,
was $12.3 million in 2003, representing 18.9% of our total revenue for the year. Services revenue
for 2003 increased $2.0 million over the results for 2002, due primarily to the addition of $1.2
million in CheetahNet maintenance fees and an increase or $0.6 million in LoopCare software
maintenance largely as a result of additional maintenance fees related to new sales of software
features. Gross Profit Gross profit for 2003 was $36.0 million compared to $33.0 million for 2002, representing an
increase of 9.1%. Gross profit as a percentage of revenue decreased to 55.3% for 2003 compared to
56.3% for 2002. The increase in gross profit resulted primarily from the overall higher sales
levels which in turn were primarily related to the Cheetah products that we acquired in 2003. The
decrease in gross margin as a percentage of sales resulted in large part from lower sales of higher
margin MCU and DigiTest hardware and LoopCare software, with such sales being substantially
replaced by the addition of lower margin Cheetah cable product sales. Amortization expense of $0.9
million associated with the Cheetah acquisition also negatively affected margins in 2003; this
expense included $0.5 million of amortization of purchased sales order backlog which was
substantially amortized at December 31, 2003. Partially offsetting these negative factors was $2.3
million in reduced expense for slow moving and obsolete inventory compared to 2002. Selling and Marketing Expenses Selling and marketing expenses for 2003 was $9.4 million, or 14.4% of revenue, compared to
$8.8 million, or 15.0% of revenue in 2002. This increase of $0.6 million, or 6.8%, is attributable
to the addition of $1.4 million in expenses as a result of the Cheetah acquisition and higher
expenses in other areas of the business including $0.4 million for consulting and evaluation costs,
offset, in part, by cost reductions largely associated with budget tightening, such as $0.6 million
for salaries and wages, $0.3 million for commissions and $0.2 million for travel expenses. General and Administrative Expense General and administrative expenses for 2003 were $7.0 million, or 10.8% of revenue, compared
to $5.5 million, or 9.4% of revenue for 2002. The increase of $1.5 million, or 27.3%, is
attributable primarily to the addition of $0.9 million in expenses as a result of the Cheetah
acquisition, including a $0.5 million provision for bad debts. General and administrative expenses
also increased due to higher business insurance costs of $0.3 million and legal and professional
fees of $0.2 million. Research and Development Expenses Research and development expenses for 2003 were $14.9 million, or 22.9% of revenue, compared
to $13.8 million, or 23.6%, of revenue for 2002. The $1.1 million increase is attributable
primarily to the addition of $2.7 million in expenses related to the Cheetah acquisition,
consisting largely of salaries and benefits. The Cheetah expenses were offset in part by cost
reductions in other areas of the business including a $1.5 million savings in salaries and benefits
brought about largely by a reduction in work force at the beginning of the fourth quarter of 2002.
The Company expenses research and development costs as they are incurred. Other Income Other income, which consisted primarily of interest income, was $0.4 million for 2003 compared
to $0.7 million for 2002. The decrease of $0.3 million, or 42.9%, is primarily attributable to both
a decrease in funds available for investment resulting from the $14.3 million Cheetah acquisition
in February of 2003 and to the current low market yields on short term interest bearing
investments. Provisions for Income Taxes The Companys effective tax rate was 38.0% of income before income taxes in both 2003 and
2002. Net Income and Earnings Per Share Net income for the year ended December 31, 2003 was $3.1 million compared to $3.4 million for
the year ended December 31, 2002, a decrease of $0.3 million or 8.8%, due to a small compression of
margin, including the effect of acquisition-related intangible asset amortization. As a percentage
of revenue, net income for 2003 decreased to 4.8% from 5.7% in 2002. Correspondingly, diluted
earnings per common share of $0.24 for 2003 decreased by 4.0%, or $0.01, from the $0.25 earned in
2002. Diluted weighted average shares of common stock and equivalents outstanding were 13,312,597
in 2003 compared to 13,313,676 in 2002. 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 earnout to be paid in
the first half of 2004 of up to $2.4 million based on certain 2003 performance targets. Our
calculation indicates that amounts due under the earnout provision are immaterial. To date, these
sums have not been paid, as we continue to negotiate the earnout and post closing purchase price
adjustment with Acterna. 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. 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 of the continuing negotiations regarding the earn-out
provision and post closing purchase price adjustments. - 30 -




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Liquidity and Capital Resources Cash and cash equivalents and short-term investments increased from $48.7 million at December
31, 2003 to $51.2 million at December 31, 2004. We have continued to generate sufficient cash flow
from the operations to sustain our capital spending and to fund our business acquisitions. The
$51.2 million of cash, cash equivalents and short-term investments are unrestricted and available
for corporate purposes, including acquisitions, research and development and other general working
capital requirements. We had working capital of $70.8 million as of December 31, 2004, a increase
of $4.9 million or 7.4% from the $65.9 million of working capital as of December 31, 2003. The
increase in working capital is largely a result of a $2.5 million increase cash and short term
investments generated from our operating performance and an increase in accounts receivable and
inventory partially offset by a $3.2 million increase in accrued expenses and deferred income. Overall, we generated cash from operating activities of $5.7 million in 2004 compared to $13.0
million in 2003. The decrease in cash flow is attributed to a $5.1 million decrease in inventory
during 2003 due to strong sales in the fourth quarter of 2003 that drove inventory levels lower.
Net cash used in investing activities decreased from a use of $16.0 million in 2003 to $4.5 million
in 2004 due to the Cheetah acquisition in 2003. As discussed previously, during 2004, we made a
$0.8 million investment for an exclusivity right and prepaid royalties related to certain
technology. We made capital expenditures including capitalized software of $1.8 million, $2.8
million and $2.8 million in the three years ended December 31, 2002, 2003 and 2004, respectively.
Our 2004 expenditures were primarily related to ongoing business requirements. Our 2003
expenditures were primarily related to providing supplies, office and computer equipment for our
Sarasota location. Expenditures in 2002 included the acquisition of land adjacent to the Companys
current manufacturing facility. Planned capital expenditures for 2005 are approximately $3.5
million, including projects for test fixtures, development system, and computer and office
equipment. 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, among others. A maximum leverage ratio
restricts our total borrowings to approximately $15.0 million during the first quarter of 2005.
Commitment fees are payable quarterly at an annual rate of 0.25% of the unused commitment. The
Facility was amended in February 2003 in connection with our acquisition of the Cheetah product
line to adjust the determination of base net worth. As of December 31, 2003 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. On January 21, 2004, our Board of Directors authorized the continuation 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, 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. The impact of inflation on both the Companys financial position and the results of operations
has been minimal and did not adversely affect our 2004 results and is not expected to adversely
affect our 2005 results. Our financial position enables us to meet our cash requirements for
operations and capital expansion programs. Off-Balance Sheet Arrangements We do not engage in transactions or arrangements with unconsolidated or other special purpose
entities. 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. On August 20, 2001, Mr. Quiggle made a payment toward the principal balance of
the Note in the amount of $48,000, thereby reducing the outstanding principal balance of the Note
to $162,000. Beginning in 2003, Mr. Quiggle has made payments of principal and interest that
further reduced the balance of the Note to $156,392 as of December 31, 2004. Effective January 1,
2005, in accordance with the options under the agreement, Mr. Quiggle elected to stop payment of
principal and is only scheduled to make annual interest payments. The remaining outstanding
balance of the Note 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 and Contractual Obligations The Company has commitments under various non-cancelable leases related primarily to real
estate in Cheswick, Pennsylvania, Bridgewater, New Jersey and Sarasota, Florida, which house the
Companys operations. Annual rentals due beyond December 31, 2004 under these agreements are $1.6
million in 2005, $0.9 million in 2006, $0.5 million in 2007, $0.1 million in 2008 and no commitment
in 2009 as all current leases terminate in 2008. Our lease agreements include provisions for rent
increases during the lease period; these increases are based on changes in the consumer price index
and based on increases in our annual lease commitments and are not material. We are obligated to
pay commitment fees under a credit facility as discussed in the Liquidity and Capital Resources
section above. We also have commitments to provide software maintenance services under agreements
which are generally one to three years in length and we have warranty obligations on products sold
in prior periods, which are not reflected in the following table. Additionally, the Company has
arrangements with certain manufacturing subcontractors under which the Company is contingently
obligated to purchase raw material parts in the event they would not be consumed by the
manufacturing - 31 -




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process in a normal course of business. The Company entered into these commitments in order
to secure components that can only be purchase on a non-cancelable, non-refundable basis and to
assure availability of components that have long lead times. The following table sets forth our aggregate contractual obligations as of December 31, 2004. Payments due by periodLess than 1
    
    
    
    
    
    
    
    
    
    
    More than 5Total
    
    
    year
    
    
    1-3 years
    
    
    3-5 years
    
    
    yearsContractual ObligationsLong Term Debt Obligations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Capital Lease Obligations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Operating Lease Obligations
    
    $
    3,072,041
    
    
    $
    1,583,347
    
    
    $
    1,342,976
    
    
    $
    145,718
    
    
    
    Purchase Obligations
    
    $
    1,326,001
    
    
    $
    1,282,586
    
    
    $
    43,415
    
    
    
    
    
    
    
    Other Long-Term
Liabilities Reflected on
Companys Balance Sheet
Under GAAP
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    4,398,042
    
    
    $
    2,865,933
    
    
    $
    1,386,391
    
    
    $
    145,718
    
    
    
    
 Key Ratios The Companys days sales outstanding in trade accounts receivable were 67 and 57 days at
December 31, 2004 and 2003, respectively. The Companys inventory turnover ratio was 2.3 at
December 31, 2004 and 2003. Both of these ratios are determined based on twelve month moving
averages. RECENT ACCOUNTING PRONOUNCEMENTS In January 2003, the Financial Accounting Standards Board (FASB) FASB issued FASB
Interpretations No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation
of Accounting Research Bulletin No. 51. FIN 46 requires certain variable interest entities to be
consolidated by the primary beneficiary of the entity if the equity investors in the entity 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. FIN 46 is effective for all new variable interest entities created or acquired
after January 31, 2003. For variable interest entities created or acquired prior to February 1,
2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning
after December 15, 2003. The adoption of this standard had no impact on our financial condition
or results of operations. In March 2004, the FASB approved Emerging Issues Task Force (EITF) Issue No. 03-1, The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The
objective of this issue is to provide guidance for identifying other-than-temporarily impaired
investments. EITF No. 03-1 also provides new disclosure requirements for investments that are
deemed to be temporarily impaired. In September 2004, the FASB issued EITF No. 03-1-1, which
delayed the effective date of EITF No. 03-1, with the exception of certain disclosure requirements.
We do not believe that EITF No. 03-1 will have a material impact on its financial condition and
results of operations. In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151 (SFAC
151), Inventory Costs, an amendment of ARB No. 43, Chapter 4. This statement amends the
guidance in ARB No. 43 Chapter 4, Inventory Pricing, to clarify the accounting for abnormal
amounts of idle facility expense, freight, handling costs, and wasted material (spoilage).
Paragraph 5 of ARB 43, Chapter 4, previously stated that ...under some circumstances, items such as
idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal
to require treatment as a current period charges... This statement requires that those items be
recognized as current-period charges regardless of whether they meet the criterion of so
abnormal. In addition, this statement requires that allocation of fixed production overheads to
the costs of conversion be based on the normal capacity of the production facilities. The
provisions of this statement will be effective for inventory costs during the fiscal years
beginning after June 15, 2005. We do not believe that the adoption of this statement will have a
material impact on its financial condition or results of operations. In December 2004, the FASB issued Statement No. 123(R), Shared-Based Payment.Statement
123(R) requires the measurement of all employee stock-based compensation awards using a fair value
method as of the date of the grant and recording such expense in the consolidated financial
statements. In addition, the adoption of Statement 123(R) will require additional accounting
related to the income tax effects and additional disclosure regarding the cash flow effects
resulting from share-based payment arrangements. Statement 123(R) is effective beginning in our
third quarter of fiscal 2005. We are currently evaluating the impact of the adoption of Statement
123(R). In December 2004, the FASB issued Statement No. 153, Exchanges of Nonmonetary Assets,an
amendment of APB Opinion No. 29. Statement 153 addresses the measurement of exchanges of
nonmonetary assets and redefines the scope of transactions that should be measured based on the
fair value of the assets exchanged. Statement 153 is effective for nonmonetary asset exchanges
occurring n fiscal periods beginning after June 15, 2005. We do not believe adoption of
Statement 153 will have a material effect on - 32 -




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our consolidated financial position, results of
operations or cash flows. In December 2004, the FASB issued FASB Staff Position No. FAS 109-1 (FAS 109-1), Application
of FASB Statement No. 109. Accounting for Income Taxes, to the Tax Deduction on Qualified
Production Activities Provided by the American Jobs Creation Act of 2004. The AJCA introduces a
special 9% tax deduction on qualified production activities. FAS 109-1 clarifies that this tax
deduction should be accounted for as a special tax deduction in accordance with Statement 109. We
do not expect the adoption of these new tax provisions to have a material impact on our
consolidated financial position, results of operations or cash flows. In December 2004, the FASB issued FASB Staff Position No FAS 109-2, Accounting and Disclosure
Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of
2004.The American Jobs Creation Act introduces a special one-time dividends received deduction on
the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided
certain criteria are met. FSP FAS 109-2 provides accounting and disclosure guidance for the
repatriation provision. We do not believe the Foreign Earnings Repatriation Provision within the
American Jobs Creation Act of 2004 nor will the FASB Staff Position have a material impact on our
financial condition or results of operations. 
 Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Our current investment policy limits our 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. We believe that our risk is
minimized 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. We hold our
investment securities to maturity and believe that earnings and cash flows are not materially
affected by changes in interest rates, due to the nature and short-term investment horizon for
which these securities are invested. - 33 -




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Item 8. Financial Statements and Supplementary Data Statements of Operations Data by Quarter (Unaudited) (in Thousands) The following table presents unaudited quarterly operating results for each of the Companys last
eight fiscal quarters. This information has been prepared by the Company on a basis consistent with
the Companys audited financial statements and includes all adjustments (consisting only of normal
recurring adjustments) that the Company considers necessary for a fair presentation of the data.
Such quarterly results are not necessarily indicative of the future results of operations. March 29,
    
    
    June 28
    
    
    Sept. 27
    
    
    Dec. 31
    
    
    March 27,
    
    
    June 26
    
    
    Sept. 25
    
    
    Dec. 312003
    
    
    2003
    
    
    2003
    
    
    2003
    
    
    2004
    
    
    2004
    
    
    2004
    
    
    2004Revenues:Products
    
    $
    11,571
    
    
    $
    13,890
    
    
    $
    12,529
    
    
    $
    14,812
    
    
    $
    14,455
    
    
    $
    12,268
    
    
    $
    10,236
    
    
    $
    12,810Services
    
    
    2,972
    
    
    
    3,244
    
    
    
    3,087
    
    
    
    2,994
    
    
    
    3,152
    
    
    
    3,198
    
    
    
    3,402
    
    
    
    3,29614,543
    
    
    
    17,134
    
    
    
    15,616
    
    
    
    17,806
    
    
    
    17,607
    
    
    
    15,466
    
    
    
    13,638
    
    
    
    16,106Cost of sales:Products
    
    
    5,292
    
    
    
    6,232
    
    
    
    5,528
    
    
    
    5,910
    
    
    
    6,014
    
    
    
    6,266
    
    
    
    4,556
    
    
    
    5,354Services
    
    
    790
    
    
    
    976
    
    
    
    1,010
    
    
    
    990
    
    
    
    860
    
    
    
    998
    
    
    
    945
    
    
    
    965Amortization of intangibles
    
    
    893
    
    
    
    510
    
    
    
    490
    
    
    
    490
    
    
    
    473
    
    
    
    510
    
    
    
    510
    
    
    
    5236,975
    
    
    
    7,718
    
    
    
    7,028
    
    
    
    7,390
    
    
    
    7,347
    
    
    
    7,774
    
    
    
    6,011
    
    
    
    6,842Gross profit
    
    
    7,568
    
    
    
    9,416
    
    
    
    8,588
    
    
    
    10,416
    
    
    
    10,260
    
    
    
    7,692
    
    
    
    7,627
    
    
    
    9,264Operating expenses:Selling and marketing
    
    
    1,971
    
    
    
    2,421
    
    
    
    2,320
    
    
    
    2,677
    
    
    
    2,472
    
    
    
    2,383
    
    
    
    2,198
    
    
    
    2,431General and administrative
    
    
    1,737
    
    
    
    1,828
    
    
    
    1,665
    
    
    
    1,767
    
    
    
    1,934
    
    
    
    1,661
    
    
    
    1,849
    
    
    
    1,901Research and development
    
    
    3,321
    
    
    
    3,907
    
    
    
    3,754
    
    
    
    3,943
    
    
    
    4,192
    
    
    
    4,115
    
    
    
    3,853
    
    
    
    3,596Severance and related expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    269
    
    
    
    Total operating expense
    
    
    7,029
    
    
    
    8,156
    
    
    
    7,739
    
    
    
    8,387
    
    
    
    8,598
    
    
    
    8,159
    
    
    
    8,169
    
    
    
    7,928Income (loss) from operations
    
    
    539
    
    
    
    1,260
    
    
    
    849
    
    
    
    2,029
    
    
    
    1,662
    
    
    
    (467
    )
    
    
    (542
    )
    
    
    1,336Other income, net
    
    
    147
    
    
    
    85
    
    
    
    76
    
    
    
    92
    
    
    
    90
    
    
    
    67
    
    
    
    109
    
    
    
    180Income (loss) before taxes
    
    
    686
    
    
    
    1,345
    
    
    
    925
    
    
    
    2,121
    
    
    
    1,752
    
    
    
    (400
    )
    
    
    (433
    )
    
    
    1,516Provision for income taxes
    
    
    261
    
    
    
    511
    
    
    
    351
    
    
    
    806
    
    
    
    672
    
    
    
    (265
    )
    
    
    (159
    )
    
    
    842Net income (benefit)
    
    $
    425
    
    
    $
    834
    

    
    $
    574
    
    
    $
    1,315
    
    
    $
    1,080
    
    
    $
    (135
    )
    
    $
    (274
    )
    
    $
    674Earnings (Loss) Per Share
Information:Weighted average sharesBasic
    
    
    13,091
    
    
    
    13,104
    
    
    
    13,113
    
    
    
    13,116
    
    
    
    13,120
    
    
    
    13,132
    
    
    
    13,148
    
    
    
    13,141Diluted
    
    
    13,212
    
    
    
    13,335
    
    
    
    13,346
    
    
    
    13,347
    
    
    
    13,352
    
    
    
    13,132
    
    
    
    13,148
    
    
    
    13,225Net income (loss) per common share:Basic
    
    $
    0.03
    
    
    $
    0.06
    
    
    $
    0.04
    
    
    $
    0.10
    
    
    $
    0.08
    
    
    $
    (0.01
    )
    
    $
    (0.02
    )
    
    $
    0.05Diluted
    
    $
    0.03
    
    
    $
    0.06
    
    
    $
    0.04
    
    
    $
    0.10
    
    
    $
    0.08
    
    
    $
    (0.01
    )
    
    $
    (0.02
    )
    
    $
    0.05
 - 34 -




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##### Table of Contents



Financial Statements and Supplementary Data. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report
of Independent Registered Accounting FirmConsolidated Balance SheetsConsolidated Statements of OperationsConsolidated Statements of Changes in Shareholders EquityConsolidated Statements of Cash FlowsNotes to Consolidated Financial StatementsStatements of Operations Data by Quarter*Schedule
II - Valuation and Qualifying Accounts*Not part of audited financial information
 - 35 -




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Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of Tollgrade Communications, Inc.: We have completed an integrated audit of Tollgrade Communications, Inc.s 2004 consolidated
financial statements and of its internal control over financial reporting as of December 31, 2004
and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards
of the Public Company Accounting Oversight Board (United States). Our opinions, based on our
audits, are presented below. Consolidated financial statements and financial statement schedule In our opinion, the consolidated financial statements listed in the accompanying index present
fairly, in all material respects, the financial position of Tollgrade Communications, Inc. and its
subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2004 in conformity with
accounting principles generally accepted in the United States of America. In addition, in our
opinion, the financial statement schedule listed in the accompanying indexpresents
fairly, in all material respects, the information set forth therein when read in conjunction with
the related consolidated financial statements. These financial statements and financial statement
schedule are the responsibility of the Companys management. Our responsibility is to express an
opinion on these financial statements and financial statement schedule based on our audits. We
conducted our audits of these statements in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit of financial statements includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a reasonable basis for our
opinion. Internal control over financial reporting Also, in our opinion, managements assessment, included in Managements Report on Internal Control
Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal
control over financial reporting as of December 31, 2004 based on criteria established in Internal
Control  Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO), is fairly stated, in all material respects, based on those criteria.
Furthermore, in our opinion, the Company maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2004, based on criteria established in
Internal Control  Integrated Frameworkissued by COSO. The Companys management is responsible
for maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility is to express
opinions on managements assessment and on the effectiveness of the Companys internal control
over financial reporting based on our audit. We conducted our audit of internal control over
financial reporting in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. An audit of internal control over financial reporting
includes obtaining an understanding of internal control over financial reporting, evaluating
managements assessment, testing and evaluating the design and operating effectiveness of internal
control, and performing such other procedures as we consider necessary in the circumstances. We
believe that our audit provides a reasonable basis for our opinions. - 36 -




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##### Table of Contents



A companys internal control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles. A
companys internal control over financial reporting includes those policies and procedures that (i)
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that
transactions are recorded as necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and expenditures of the company
are being made only in accordance with authorizations of management and directors of the company;
and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the companys assets that could have a material effect on the
financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or
detect misstatements. Also, projections of any evaluation of effectiveness to future periods are
subject to the risk that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate. PricewaterhouseCoopers LLP
Pittsburgh, Pennsylvania
March 2, 2005 - 37 -




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##### Table of Contents



Tollgrade Communications, Inc. and Subsidiaries 
 Consolidated Balance Sheets
 December 31,
    
    
    December 31,2003
    
    
    2004ASSETSCurrent assets:Cash and cash equivalents
    
    $
    31,059,972
    
    
    $
    32,622,135Short-term investments
    
    
    17,624,668
    
    
    
    18,537,310Accounts receivable:Trade, net of allowance for doubtful accounts at $916,307 in 2003 and $754,598 in 2004
    
    
    9,254,718
    
    
    
    10,690,695Other
    
    
    122,231
    
    
    
    106,484Inventories
    
    
    11,154,676
    
    
    
    12,940,878Prepaid expenses and deposits
    
    
    1,534,034
    
    
    
    2,542,565Refundable income taxes
    
    
    383,704
    
    
    
    964,171Deferred tax assets
    
    
    1,361,947
    
    
    
    1,143,410Total current assets
    
    
    72,495,950
    
    
    
    79,547,648Property and equipment, net
    
    
    8,292,412
    
    
    
    7,859,709Deferred tax assets
    
    
    1,152,846
    
    
    
    176,464Intangibles
    
    
    44,500,000
    
    
    
    45,107,750Goodwill
    
    
    19,339,682
    
    
    
    19,339,682Capitalized Software Costs, net
    
    
    7,712,624
    
    
    
    6,452,749Receivable from officer
    
    
    160,940
    
    
    
    156,392Other assets
    
    
    174,520
    
    
    
    194,081Total assets
    
    $
    153,828,974
    
    
    $
    158,834,475LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,007,178
    
    
    $
    1,086,818Accrued warranty
    
    
    2,149,905
    
    
    
    2,081,238Accrued expenses
    
    
    589,215
    
    
    
    1,771,930Accrued salaries and wages
    
    
    911,725
    
    
    
    717,540Accrued royalties payable
    
    
    395,710
    
    
    
    414,408Income taxes payable
    
    
    1,018,230
    
    
    
    168,501Deferred income
    
    
    480,235
    
    
    
    2,461,728Total current liabilities
    
    
    6,552,198
    
    
    
    8,702,163Deferred tax liabilities
    
    
    1,447,690
    
    
    
    2,623,377Total liabilities
    
    
    7,999,888
    
    
    
    11,325,540Commitments and contingencies
    
    
    
    
    
    
    Shareholders equity:Preferred stock, $1.00 par value;
authorized shares, 10,000,000; issues shares, -0- in 2003 and 2004
    
    
    
    
    
    
    Common
stock, $ .20 par valueauthorized shares, 50,000,000; issued shares, 13,580,370 in 2003 and 13,622,940 in 2004
    
    
    2,716,074
    
    
    
    2,724,588Additional Paid-in Capital
    
    
    70,808,584
    
    
    
    71,134,745Treasury stock, at cost, 461,800 shares in 2003 and 2004
    
    
    (4,790,783
    )
    
    
    (4,790,783
    )Retained Earnings
    
    
    77,095,211
    
    
    
    78,440,385Total shareholders equity
    
    
    145,829,086
    
    
    
    147,508,935Total liabilities and shareholders equity
    
    $
    153,828,974
    
    
    $
    158,834,475
 The accompanying notes are an integral part of the consolidated financial statements. - 38 -




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##### Table of Contents



Tollgrade Communications, Inc. and Subsidiaries 
 Consolidated Statements of Operations
 Years Ended December 31,2002
    
    
    2003
    
    
    2004Revenues:Products
    
    $
    48,146,350
    
    
    $
    52,802,488
    
    
    $
    49,769,630Services
    
    
    10,428,165
    
    
    
    12,297,199
    
    
    
    13,048,10958,574,515
    
    
    
    65,099,687
    
    
    
    62,817,739Cost of sales:Products
    
    
    20,799,976
    
    
    
    22,965,791
    
    
    
    22,190,686Services
    
    
    3,319,441
    
    
    
    3,766,047
    
    
    
    3,768,184Amortization
    
    
    1,464,098
    
    
    
    2,381,203
    
    
    
    2,016,54725,583,515
    
    
    
    29,113,041
    
    
    
    27,975,417Gross profit
    
    
    32,991,000
    
    
    
    35,986,646
    
    
    
    34,842,322Operating expenses:Selling and marketing
    
    
    8,766,207
    
    
    
    9,388,004
    
    
    
    9,483,442General and administrative
    
    
    5,489,163
    
    
    
    6,997,131
    
    
    
    7,346,081Research and development
    
    
    13,838,719
    
    
    
    14,924,797
    
    
    
    15,755,580Severance and related expense
    
    
    175,723
    
    
    
    
    
    
    
    268,637Total operating expense
    
    
    28,269,812
    
    
    
    31,309,932
    
    
    
    32,853,740Income from operations
    
    
    4,721,188
    
    
    
    4,676,714
    
    
    
    1,988,582Other income:Interest income (including interest
income from officer receivable of
$8,000 in 2003 and 2004)
    
    
    692,592
    
    
    
    400,682
    
    
    
    447,075Total other income
    
    
    692,592
    
    
    
    400,682
    
    
    
    447,075Income Before Taxes
    
    
    5,413,780
    
    
    
    5,077,396
    
    
    
    2,435,657Provision for income taxes
    
    
    2,057,236
    
    
    
    1,929,410
    
    
    
    1,090,483Net income
    
    $
    3,356,544
    
    
    $
    3,147,986
    
    
    $
    1,345,174EARNINGS PER SHARE INFORMATION:Weighted average shares of common stock and equivalents:Basic
    
    
    13,095,068
    
    
    
    13,105,779
    
    
    
    13,140,871Diluted
    
    
    13,313,676
    
    
    
    13,312,597
    
    
    
    13,253,294Net income per common share:Basic
    
    $
    0.26
    
    
    $
    0.24
    
    
    $
    0.10Diluted
    
    $
    0.25
    
    
    $
    0.24
    
    
    $
    0.10
 The accompanying notes are an integral part of the consolidated financial statements. - 39 -




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##### Table of Contents



Tollgrade Communications, Inc. and Subsidiaries 
 Consolidated Statements of Changes in Shareholders Equity
 AdditionalPreferred Stock
    
    
    Common Stock
    
    
    Paid-In
    
    
    Treasury
    
    
    RetainedShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Capital
    
    
    Stock
    
    
    Earnings
    
    
    TotalBalance at
December 31, 2001
    
    
    
    
    
    
    
    
    
    
    13,513,119
    
    
    $
    2,702,624
    
    
    $
    70,010,254
    
    
    $
    (3,164,975
    )
    
    $
    70,590,681
    
    
    $
    140,138,584Exercise of common
stock options
    
    
    
    
    
    
    
    
    
    
    39,617
    
    
    
    7,923
    
    
    
    270,252
    
    
    
    
    
    
    
    
    
    
    
    278,175Tax benefit from
exercise of stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    208,519
    
    
    
    
    
    
    
    
    
    
    
    208,519Purchase of
treasury stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,625,808
    )
    
    
    
    
    
    
    (1,625,808
    )Net Income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,356,544
    
    
    
    3,356,544Balance at
December 31, 2002
    
    
    
    
    
    
    
    
    
    
    13,552,736
    
    
    
    2,710,547
    
    
    
    70,489,025
    
    
    
    (4,790,783
    )
    
    
    73,947,225
    
    
    
    142,356,014Exercise of common
stock options
    
    
    
    
    
    
    
    
    
    
    27,634
    
    
    
    5,527
    
    
    
    242,767
    
    
    
    
    
    
    
    
    
    
    
    248,294Tax benefit from
exercise of stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    76,792
    
    
    
    
    
    
    
    
    
    
    
    76,792Net Income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,147,986
    
    
    
    3,147,986Balance 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
    
    
    
    
    
    
    
    
    
    
    42,570
    
    
    
    8,514
    
    
    
    261,198
    
    
    
    
    
    
    
    
    
    
    
    269,712Tax benefit from
exercise of stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    64,963
    
    
    
    
    
    
    
    
    
    
    
    64,963Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,345,174
    
    
    
    1,345,174Balance at December
31, 2004
    
    
    
    
    
    
    
    
    
    
    13,622,940
    
    
    $
    2,724,588
    
    
    $
    71,134,745
    
    
    $
    (4,790,783
    )
    
    $
    78,440,385
    
    
    $
    147,508,935
 The accompanying notes are an integral part of the consolidated financial statements. - 40 -




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##### Table of Contents



Tollgrade Communications, Inc. and Subsidiaries 
 Consolidated Statements of Cash Flows
 Years Ended December 31,2002
    
    
    2003
    
    
    2004Cash flows from operating activities:Net income
    
    $
    3,356,544
    
    
    $
    3,147,986
    
    
    $
    1,345,174Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation and amortization
    
    
    3,799,353
    
    
    
    4,749,399
    
    
    
    4,629,896Tax benefit from exercise of stock options
    
    
    208,519
    
    
    
    76,792
    
    
    
    64,963Refund (utilization) of income taxes paid
    
    
    1,166,007
    
    
    
    253,452
    
    
    
    (580,467
    )Deferred income taxes
    
    
    540,391
    
    
    
    1,260,095
    
    
    
    2,370,606Provision for losses on inventory
    
    
    1,231,833
    
    
    
    (877,832
    )
    
    
    (45,289
    )Provision for allowance for doubtful accounts
    
    
    100,000
    
    
    
    441,307
    
    
    
    (161,709
    )Changes in assets and liabilities:(Increase) decrease in accounts receivable  trade
    
    
    1,250,275
    
    
    
    (1,749,749
    )
    
    
    (1,274,268
    )Decrease in accounts receivable  other
    
    
    300,711
    
    
    
    30,059
    
    
    
    15,747(Increase) decrease in inventories
    
    
    6,859,187
    
    
    
    5,117,203
    
    
    
    (1,740,913
    )Increase in prepaid expenses deposits and other assets
    
    
    (613,245
    )
    
    
    (93,579
    )
    
    
    (1,027,375
    )Increase (decrease) in accounts payable
    
    
    (305,756
    )
    
    
    507,535
    
    
    
    79,640Decrease in accrued warranty
    
    
    (87,480
    )
    
    
    (55,615
    )
    
    
    (68,667
    )Increase (decrease) in accrued expenses and deferred income
    
    
    (82,408
    )
    
    
    (568,225
    )
    
    
    3,164,208Increase (decrease) in accrued royalties payable
    
    
    (75,071
    )
    
    
    73,330
    
    
    
    18,698(Decrease) increase in accrued salaries and wages
    
    
    214,213
    
    
    
    368,386
    
    
    
    (194,185
    )(Decrease) increase in income taxes payable
    
    
    (292,261
    )
    
    
    326,937
    
    
    
    (849,729
    )Net cash provided by operating activities:
    
    
    17,570,812
    
    
    
    13,007,481
    
    
    
    5,746,330Cash flows from investing activities:Purchase of investments
    
    
    (23,057,447
    )
    
    
    (4,935,500
    )
    
    
    (15,245,845
    )Redemption/maturity of investment
    
    
    10,367,887
    
    
    
    6,639,715
    
    
    
    14,333,203Capital expenditures, including capitalized software
    
    
    (1,829,679
    )
    
    
    (2,800,292
    )
    
    
    (2,826,237
    )Investments in other assets
    
    
    (10,501
    )
    
    
    
    
    
    
    (715,000
    )Purchase of Cheetah
    
    
    
    
    
    
    (14,899,010
    )
    
    
    Net cash used in investing activities:
    
    
    (14,529,740
    )
    
    
    (15,995,087
    )
    
    
    (4,453,879
    )Cash flows from financing activities:Purchase of treasury stock
    
    
    (1,625,808
    )
    
    
    
    
    
    
    Proceeds from the exercise of stock options
    
    
    278,175
    
    
    
    248,294
    
    
    
    269,712Net cash provided by (used in) financing activities:
    
    
    (1,347,633
    )
    
    
    248,294
    
    
    
    269,712Net increase (decrease) in cash and cash equivalents
    
    
    1,693,439
    
    
    
    (2,739,312
    )
    
    
    1,562,163Cash and cash equivalents at beginning of period
    
    $
    32,105,845
    
    
    $
    33,799,284
    
    
    $
    31,059,972Cash and cash equivalents at end of period
    
    $
    33,799,284
    
    
    $
    31,059,972
    
    
    $
    32,622,135Supplemental disclosure of cash flow information:Cash paid during the year for income taxes
    
    $
    1,898,379
    
    
    $
    13,523
    
    
    $
    29,467Supplemental disclosure of non-cash financing activity:Final purchase price adjustment
    
    
    
    
    
    $
    211,955
    
    
    
    
 The accompanying notes are an integral part of the consolidated
financial statements. - 41 -




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TOLLGRADE COMMUNICATIONS,
INC. AND SUBSIDIARIES 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION, BUSINESS AND BASIS OF PRESENTATION Tollgrade Communications, Inc. (the Company) designs, engineers, markets and supports test
system, test access and status monitoring products and test software for the telecommunications and
cable television industries primarily in the United States. The Companys telecommunications
proprietary 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. The Companys test system products, specifically the DigiTest test platform,
focus on helping local exchange carriers conduct the full range of fault diagnosis along with the
ability to pre-qualify, deploy and maintain next-generation services including Digital Subscriber
Line service. The Companys cable products consist of a complete cable status monitoring system
that provides a comprehensive testing solution for the Broadband Hybrid Fiber Coax distribution
system. The status monitoring system consists of a host for user interface, control and
configuration; a headend controller for managing network communications; and transponders that are
strategically located within the cable network to gather status reports from power supplies, line
amplifiers and fiber-optic nodes. The Company was organized in 1986 and began operations in 1988. USE OF ESTIMATES The preparation of financial statements and related disclosures in conformity with generally
accepted accounting principles in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure
of contingent assets and liabilities at the date of the financial statements and the reported
amounts of income and expense during the reporting period. The actual results experienced by the
Company could differ from those estimates. PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiaries. All significant intercompany transactions have been eliminated. CASH AND CASH EQUIVALENTS The Company considers highly liquid investments with a maturity of three months or less when
purchased to be cash equivalents. Substantially all of the Companys cash and cash equivalents are
maintained at one financial institution. No collateral or security is provided on these deposits,
other than $100,000 of deposits per financial institution which is insured by the Federal Deposit
Insurance Corporation. INVESTMENTS Short-term investments at December 31, 2004 and 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 positive intent and ability to hold the securities to maturity. ALLOWANCE FOR DOUBTFUL ACCOUNTS The allowance for doubtful accounts is based on the Companys assessment of the collectibility of
customer accounts. The Company regularly reviews the allowance by considering factors such as
historical experience, credit quality, age of the accounts receivable balances, and current
economic conditions that may affect a customers ability to pay. INVENTORIES Inventories are stated at the lower of cost or market, with cost determined on the first-in,
first-out method. The Company provides appropriate reserves for any inventory deemed slow moving or
obsolete. PROPERTY AND EQUIPMENT Property and equipment is stated at cost and depreciated on a straight-line method over the
estimated useful lives. Leasehold improvements are amortized over the related lease period or the
estimated useful life, whichever is shorter. The cost of renewals and betterments that extend the lives or productive capacities of properties
is capitalized. Expenditures for normal repairs and maintenance are charged to operations as
incurred. The cost of property and equipment retired or otherwise disposed of and the related
accumulated depreciation or amortization are removed from the accounts, and any resulting gain or
loss is reflected in current operations. RECEIVABLE FROM OFFICER The Company extended a loan for $210,000 under a promissory note to an officer of the Company in
July 2001. The note provides for interest at 5% per annum with repayment under various conditions
but no later than May 20, 2008. The loan was originally secured by collateral which currently has
no value. The balance of the loan at December 31, 2004 and 2003 was $156,392, and $160,940
respectively. The principal and interest were current at December 31, 2004 and 2003. - 42 -




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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: 2003
    
    
    2004Balance at the beginning of the year
    
    $
    1,981,000
    
    
    $
    2,150,000Accruals for warranties issued during the year
    
    
    872,000
    
    
    
    1,435,000Cheetah opening accrual  See Note 2
    
    
    225,000
    
    
    
    Settlements during the year
    
    
    (928,000
    )
    
    
    (1,504,000
    )Balance at the end of the year
    
    $
    2,150,000
    
    
    $
    2,081,000
 REVENUE RECOGNITION We market and sell test system hardware and related software to the telecommunications and
cable television industries. The Company follows Staff Accounting Bulletin (SAB) 104, Revenue
Recognition for hardware and software sales. This bulletin requires, among other things, that
revenue should be recognized only when title has transferred and risk of loss has passed to a
customer with the capability to pay, and that there are no significant remaining obligations of the
Company related to the sale. The bulk of our hardware sales are made to RBOCs and other large
customers. Terms of these hardware sales are predominantly FOB shipping point. Revenue is
recognized for these customers upon shipment against a valid purchase order. For software perpetual license fee and maintenance revenue, we follow not only SAB 104, but
also the 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. These statements require that software license fee revenue be recorded only when
evidence of a sales arrangement exists, the software has been delivered, and a customer with the
capacity to pay has accepted the software, leaving no significant obligations on the part of the
Company to perform. We require a customer purchase order or other written agreement to document
the terms of a software order and written, unqualified acceptance from the customer prior to
revenue recognition. In certain limited cases, however, agreements provide for automatic customer
acceptance after the passage of time from a pre-determined event and we have relied on these
provisions for an indication of the timing of revenue recognition. In isolated cases for orders of
custom software, or orders that require significant software customization over a long period of
time, such as that associated with our contract with Lucent for test gear deployment in Saudi
Arabia, we employ contract accounting using the percentage-of-completion method, whereby revenue is
recognized based on costs incurred to date compared to total estimated contract cost. Revenue
recognized under the percentage of completion method during 2004, 2003, and 2002 was not
significant. The revenue for orders with multiple deliverables such as hardware, software and/or
installation or other services may be separated into stand-alone fair values if not already
documented in the purchase order or agreement and where list prices or other objective evidence of
fair value exists to support such allocation, in accordance with the provisions of EITF Issue
00-21. Revenue will not be recognized for any single element until all essential elements are
delivered and accepted. Revenue from Services (testability consulting) is recognized upon services
being rendered. Reimbursement for out-of-pocket costs is recognized as revenue and simultaneously
recognized as the cost of product sales. All fees billed to customers for shipping and handling are
classified as a component of product revenue and simultaneously recognized as the cost to product
sales. Revenue from Services also includes revenue from maintenance agreements. Maintenance
revenue is generally recognized on a straight-line basis over the life of the related agreement,
which is typically one year. Customer advances and amounts due from customers in excess of revenue
recognized are recorded as deferred income. Revenue for license and royalty fees is recognized
when earned. GOODWILL AND PURCHASED AND OTHER INTANGIBLES Goodwill and intangible assets is reviewed for impairment whenever events or changes in
circumstances indicate that the carrying value of such assets may not be recoverable. Statement of
Financial Accounting Standards No. 142 (SFAS 142) requires goodwill and intangible assets with
indefinite useful lives to be reviewed at least annually. Determination of recoverability for
indefinite lived assets is based on an estimate of the undiscounted future cash flows resulting
from the use of the asset and its eventual disposition. We have determined that we only have one
operating unit and test goodwill for impairment by comparing the aggregate market value of the
Companys stock with our book carrying value. SFAS 142 also required that intangible assets with
definite lives and other long lived assets to be amortized over their estimated useful life and
reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144
(SFAS 144), Accounting for the Impairment or Disposal of Long-Live Assets. No impairments have
been recorded to date. RESEARCH AND DEVELOPMENT COSTS Research and development costs to develop or improve hardware-related products are charged to
operations as incurred. CAPITALIZED SOFTWARE DEVELOPMENT COSTS Any costs incurred to establish the technological feasibility of software to be sold or otherwise
marketed are expensed as research and development costs. Costs incurred subsequent to the
establishment of technological feasibility, and prior to the general availability of the product to
the public are capitalized and subsequently amortized under the straight-line method. The Company
defines technological feasibility as coding and testing in accordance with detailed program
designs. Internally generated software development costs that have been capitalized were, $68,100
in 2002, $115,383 in 2003, and $107,690 in 2004. Such costs are being amortized over five years. - 43 -




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INCOME TAXES The Company follows the provisions of SFAS No. 109, Accounting for Income Taxes. Under SFAS No.
109, deferred tax liabilities and assets are determined based on the temporary differences
between the financial statement carrying amounts and the tax basis of assets and liabilities using
enacted tax rates in effect in the years in which the differences are expected to reverse.
Valuation allowances are established when necessary to reduce deferred tax assets to the amount
expected to be realized. SEGMENT INFORMATION The Company follows the provisions of SFAS No. 131, Disclosures about Segments of an Enterprise
and Related Information, Financial Reporting for Segments of a Business. This statement
establishes standards for reporting information about operating segments, products and services,
geographic areas and major customers in annual and interim financial statements. The Company
manages and operates its business as one segment. International sales were 7.6% of revenue in 2004,
5.8% in 2003 and 6.3% in 2002. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES In June 1998, the Financial Accounting Standards Board (FASB) issued SFAS No. 133, Accounting
for Derivative Instruments and Hedging Activities, as amended by SFAS No. 138, Accounting for
Certain Instruments and Certain Hedging Activities, and SFAS No, 149, Amendment of Statement 133
on Derivative Instruments and Hedging. This statement establishes standards for reporting
information about various derivative financial instruments and accounting for their change in fair
value. The Company does not hold or issue derivative instruments for hedging purposes and,
therefore, this standard does not have a material effect on the consolidated financial position or
results of operations of the Company. RECLASSIFICATIONS Certain reclassifications have been made to prior year amounts to conform with the current year
presentation. These reclassifications were related to the consolidated statement of cash flows and
did not result in a change to net cash provided (used) in operating, investing or financing
activities and had no effect on reported net income. ACCOUNTING FOR STOCK-BASED COMPENSATION The Company has two stock-based employee compensation plans which are described more fully in Note
6. The Company accounts for stock-based awards to employees and directors using the intrinsic
value method of accounting in accordance with Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25). 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 SFAS No. 123, Accounting for Stock-Based
Compensation, net income (loss) and earnings (loss) per share would have reflected the pro forma
amounts indicated in the following table: Years Ended December 31,2002
    
    
    2003
    
    
    2004Net income, as reported
    
    $
    3,356,544
    
    
    $
    3,147,986
    
    
    $
    1,345,174Deduct: Total stock-based
employee compensation
expense based on the fair
value method for all
awards, net of related tax
effects.
    
    
    4,626,927
    
    
    
    1,854,554
    
    
    
    340,394Pro forma net (loss) income
    
    $
    (1,270,383
    )
    
    $
    1,293,432
    
    
    
    1,004,780Earnings (loss) per share:Basic - as reported
    
    $
    0.26
    
    
    $
    0.24
    
    
    $
    0.10Basic - pro forma
    
    $
    (0.10
    )
    
    $
    0.10
    
    
    $
    0.08Diluted - as reported
    
    $
    0.25
    
    
    $
    0.24
    
    
    $
    0.10Diluted - pro forma
    
    $
    (0.10
    )
    
    $
    0.10
    
    
    $
    0.08
 2. ACQUISITIONS 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 earnout to be paid in the first half of 2004 of up to $2,400,000 based on certain 2003
performance targets. As of December 31, 2004 we were still negotiating the earnout payment and 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
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. - 44 -




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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
of the continuing negotiations regarding the earn-out provision and post closing purchase price
adjustments. Any changes to the purchase price are expected to be accounted for as adjustments to
goodwill and may be material. The following summarizes the current estimated fair values as of the date of the Cheetah
acquisition: Inventories
    
    
    
    
    
    $
    1,301,000Property and Equipment, net
    
    
    
    
    
    
    537,000Deferred Tax Assets
    
    
    
    
    
    
    88,000Intangible Assets:Customer Base
    
    $
    5,000,000Cheetah Trademark
    
    
    1,000,000Base Software
    
    
    2,900,000Proprietary Technology
    
    
    1,000,000Sales Order Backlog
    
    
    543,000
    
    
    
    10,443,000Goodwill
    
    
    
    
    
    
    3,390,000Total Assets Acquired
    
    
    
    
    
    $
    15,759,000Deferred Income
    
    
    
    
    
    
    (625,000
    )Other Liabilities
    
    
    
    
    
    
    (235,000
    )Total Liabilities Assumed
    
    
    
    
    
    $
    (860,000
    )Net Assets Acquired of Cheetah
    
    
    
    
    
    $
    14,899,000
 An independent valuation consultant assisted management in its initial determination of fair value
assigned to certain intangible assets other than goodwill. Discounted future cash flow models were
utilized where appropriate. The Cheetah product line has maintained a significant market share in cable status and performance
monitoring equipment for more than 25 years and has a large installed customer base, including many
of the largest multiple system cable operators. The Company has assumed that, on average,
approximately 85% of future revenues attributable to Cheetah products will be derived from this
customer base and, based on prior experience, does not anticipate turnover or loss of these
customers. Therefore, the Company has concluded that the customer base and Cheetah trademark
intangible assets have an indefinite life. Consequently, in accordance with SFAS No. 142,
Goodwill and Other Intangible Assets, the values assigned to customer base and the Cheetah
trademark, as well as to related goodwill, are not being amortized for financial reporting
purposes. The Company intends that the base software will be used in future releases of CheetahNet (formerly
NetMentor) and other software products with little change into the foreseeable future. Similarly,
the proprietary technology embedded in transponder hardware is designed to have a relatively long
useful life. Therefore, the Company has determined that the base software and proprietary software
have a remaining useful life of ten years and are being amortized for financial reporting purposes
over that period. For tax purposes, the Company is amortizing all intangible assets over 15 years. Goodwill deducted
for tax purposes amounted to $1,077,000 in 2002, $1,265,000 in 2003 and $1,308,000 in 2004. 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, 2002: (In Thousands, Except Per Share Data)Unaudited
    
    
    
    UnauditedProforma
    
    
    
    ProformaDecember 31, 2002
    
    
    
    December 31, 2003Revenues
    
    
    $
    80,159
    
    
    
    $
    66,463Income from operations
    
    
    $
    10,373
    
    
    
    $
    5,347Net income
    
    
    $
    6,692
    
    
    
    $
    3,565Diluted earnings per share
    
    
    $
    0.50
    
    
    
    $
    0.27
 Revenues for 2002, cost of sales and operating expenses for proforma determinations were based on
historical information provided by Acterna with proforma adjustments made to adjust gross margins
to 50% of revenues and to adjust operating expenses based upon the Companys financial plan for
Cheetah for 2003. These adjustments were made to reflect significant changes to operations made by
the Company since the acquisition. This proforma financial information is presented for
comparative purposes only and is not necessarily indicative of the operating results that actually
would have incurred had the Cheetah product line acquisition been consummated on January 1, 2002.
In addition, these results are not intended to be a projection of future results. - 45 -




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3. INTANGIBLE ASSETS SFAS No. 142 provides that entities evaluate the remaining useful lives of intangible assets
determined to have indefinite useful lives periodically to determine whether events and
circumstances continue to support an indefinite useful life and that such assets be tested at least
annually for impairment of value. The Companys policy is to test all intangible assets for
impairment in value as of December 31 of each year or more frequently if events or changes in
circumstances indicate that assets might be impaired.
The Company has determined that it has only one reporting unit and has completed a test for
goodwill impairment as of December 31, 2004 by comparing the aggregate market value of the
Companys stock with the Companys book carrying value, including goodwill. This test indicated
that there was no impairment of the goodwill carrying value. All other intangible assets were tested for impairment of carrying value as of December 31, 2004
using assumptions and techniques employed in the original valuations and following the guidance of
SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Specifically, the
sum of the projected future cash flows to be derived from assets with definite lives was compared
with the net book carrying value. The impairment test for non-amortizable intangible assets other
than goodwill consisted of a comparison of the estimated fair value with carrying amounts. The
values of the LoopCare trade name and Cheetah trademark were measured using the relief-from-royalty
method and discounted cash flow analyses were employed to test the value of the LoopCare base
software and post warranty maintenance service agreements and the value of the Cheetah customer
base. These tests indicated that none of the intangible assets had impairment in carrying value.
The Company will retest these assets annually as of December 31 or more frequently if events or
changes in circumstances indicate that assets might be impaired. The following information is provided regarding the Companys intangible assets and goodwill: As of December 31, 2003
    
    
    As of December 31, 2004Gross
    
    
    
    
    
    
    GrossCarrying
    
    
    Accumulated
    
    
    Carrying
    
    
    AccumulatedAmount
    
    
    Amortization
    
    
    Amount
    
    
    AmortizationAmortized intangible assets:Cheetah sales order backlog,
Included in Inventory
    
    $
    543,273
    
    
    $
    539,442
    
    
    $
    543,273
    
    
    $
    543,273Exclusivity agreement
    
    
    
    
    
    
    
    
    
    
    715,000
    
    
    
    107,250Total Amortized Intangibles
    
    
    543,273
    
    
    $
    539,442
    
    
    $
    1,258,273
    
    
    $
    650,523Non-amortized intangible assets:LoopCare trade name
    
    $
    1,300,000
    
    
    $
    
    
    
    $
    1,300,000
    
    
    $
    Base software - LoopCare
    
    
    5,200,000
    
    
    
    
    
    
    
    5,200,000
    
    
    
    Post warranty maintenanceservice agreements
    
    
    32,000,000
    
    
    
    
    
    
    
    32,000,000
    
    
    
    Customer Base - Cheetah
    
    
    5,000,000
    
    
    
    
    
    
    
    5,000,000
    
    
    
    Cheetah Trademark
    
    
    1,000,000
    
    
    
    
    
    
    
    1,000,000
    
    
    
    Total Non-amortized Intangibles
    
    $
    44,500,000
    
    
    
    
    
    
    $
    44,500,000
    
    
    
    Total Intangibles
    
    $
    45,043,273
    
    
    $
    539,442
    
    
    $
    45,758,273
    
    
    $
    650,523Capitalized software:Developed product software
    
    $
    7,483,483
    
    
    $
    3,313,359
    
    
    $
    7,591,173
    
    
    $
    4,817,234Base software - Cheetah
    
    
    2,900,000
    
    
    
    265,833
    
    
    
    2,900,000
    
    
    
    555,833Proprietary technology
    
    
    1,000,000
    
    
    
    91,667
    
    
    
    1,000,000
    
    
    
    191,667Clear Software Purchase
    
    
    
    
    
    
    
    
    
    
    537,900
    
    
    
    11,590Total capitalized software
(long term)
    
    $
    11,383,483
    
    
    $
    3,670,859
    
    
    $
    12,029,073
    
    
    $
    5,576,324Goodwill
    
    $
    19,339,682
    
    
    $
    
    
    
    $
    19,339,682
    
    
    $
    
 Estimated amortization expense for the years ended: December 31, 2005
    
    $
    2,158,815December 31, 2006
    
    $
    1,793,814December 31, 2007
    
    $
    694,717December 31, 2008
    
    $
    674,552December 31, 2009
    
    $
    536,102Thereafter
    
    $
    1,202,499
 Actual amortization expense for the years ended: December 31, 2002
    
    $
    1,464,098December 31, 2003
    
    $
    2,381,203December 31, 2004
    
    $
    2,016,547
 - 46 -




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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 non-refundable royalty fees. 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 non-refundable royalty fees.
Royalty expense will be recognized based on the underlying related products sales. The
exclusivity fee will be amortized on a straight line basis over the five year contract period
effective April 1, 2004. Additionally, during the fourth quarter of 2004, we purchased certain software from a third party
for $0.5 million, the value of what is recorded as capitalized software in the accompanying balance
sheet. The Company is currently modifying the software for sale in the latter part of 2005. 4. INVENTORIES Inventories consisted of the following: December 31, 2003
    
    
    December 31, 2004Raw Materials
    
    $
    7,398,419
    
    
    $
    7,631,246Work in Process
    
    
    3,723,409
    
    
    
    4,441,737Finished Goods
    
    
    1,497,848
    
    
    
    2,287,60612,619,676
    
    
    
    14,360,589Reserves for slow moving and obsolete inventory
    
    
    (1,465,000
    )
    
    
    (1,419,711
    )$
    11,154,676
    
    
    $
    12,940,878
 5. PROPERTY AND EQUIPMENT Property and equipment consisted of the following: Years
    
    
    December 31, 2003
    
    
    December 31, 2004Test equipment and tooling
    
    
    3-5
    
    
    $
    8,543,299
    
    
    $
    9,810,622Office equipment and fixtures
    
    
    5-7
    
    
    
    7,747,768
    
    
    
    8,438,048Leasehold improvements
    
    
    1-6
    
    
    
    2,353,626
    
    
    
    2,476,704Building
    
    
    20
    
    
    
    141,637
    
    
    
    141,63718,786,330
    
    
    
    20,867,011Less accumulated depreciation and amortization
    
    
    
    
    
    
    (11,989,075
    )
    
    
    (14,502,459
    )Subtotal
    
    
    
    
    
    
    6,797,255
    
    
    
    6,364,552Land
    
    
    
    
    
    
    1,495,157
    
    
    
    1,495,157$
    8,292,412
    
    
    $
    7,859,709
 Depreciation expense was $2,335,255 for 2002, $2,368,196 for 2003, and $2,613,349 for 2004. 6. SHAREHOLDERS EQUITY COMMON STOCK The Company has 50,000,000 authorized shares which have a par value of $.20 per share. As of
December 31, 2003 and 2004, there were 13,118,570 and 13,161,140 outstanding shares, respectively. STOCK REPURCHASE PROGRAM Under previously authorized share repurchase programs, the Company had repurchased 461,800 shares
of Tollgrade common stock as of December 31, 2002. These purchases of treasury stock were intended
to make those shares available under the Companys long term incentive compensation plans. On
January 22, 2003, the Board of Directors authorized the continuation of the share repurchase
program to repurchase a total of one million shares of the Companys common stock before December
31, 2003. During 2003, the Company did not repurchase any common stock. - 47 -




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##### Table of Contents



On January 21, 2004, the Board of Directors authorized the continuation of the share repurchase
program under which the Company may repurchase a total of one million shares of its common stock
before December 31, 2004. During 2004, the Company did not purchase any common stock. On January
27, 2005, The Board of Directors authorized the continuation of the share repurchase program under
which the Company may repurchase up to a total of one million shares of its common stock before
December 31, 2005. STOCK COMPENSATION PLANS Under the Companys stock compensation plans, directors, officers and other employees may be
granted options to purchase shares of the Companys common stock. The option price on all
outstanding options is equal to the fair market value of the stock at the date of the grant, as
defined. The options generally vest ratably over a two-year period, with one-third vested upon
grant and expire ten years from the date of grant. The Companys option programs cover all
employees and are used to attract and retain qualified personnel in all positions. On February 19, 1999, the Board of Directors approved a proposal to increase the number of shares
under the 1995 Long-Term Incentive Compensation Plan (the 1995 Plan) by 230,000 shares, with a
corresponding cancellation of a similar number of shares under the 1998 Employee Incentive
Compensation Plan (the 1998 Plan). The shareholders approved this action on May 6, 1999. On
December 14, 2000, the Board of Directors of the Company approved a proposal to increase the number
of shares available under the 1998 Plan by 200,000 shares, from 740,000 to 940,000 shares. On May
23, 2001, the shareholders approved an amendment to the Companys 1995 Plan, as adopted by the
Board of Directors on January 25, 2001, to increase the number of shares available under the Plan
by 275,000 shares, from 2,210,000 to 2,485,000. The aggregate number of shares of the Companys
Common Stock which may be issued under the 1995 Plan and the 1998 Plan is 2,485,000 and 940,000
shares, respectively, subject to proportionate adjustment in the event of stock splits and similar
events. On January 24, 2002, the Board of Directors approved a proposal to increase the number of
shares available under the 1998 Plan by 50,000 shares, from 940,000 to 990,000 shares. That same
date, the Board also approved a proposal to increase the number of shares available under the 1995
Plan by 200,000. On May 7, 2002, the shareholders approved an amendment to the 1995 Plan, as
adopted by the Board of Directors on January 24, 2002, to increase the number of shares available
by 200,000 from 2,485,000 to 2,685,000. The maximum number of shares which may be awarded under
the 1995 Plan to any one Named Executive Officer during any calendar year of the life of the plan
is 200,000 shares. All full-time active employees of the Company, excluding officers and
directors, are eligible to participate in the 1998 Plan. Amendments to the 1998 Plan do not
require the approval of the shareholders, but are approved by the Board of Directors. The Company
has 2,061,767 total shares reserved under the option plans. The shares authorized but not granted
under these plans at December 31, 2003 and 2004 were as follows: Shares Authorized But Not GrantedDecember 31, 2003
    
    
    December 31, 20041995 Long-Term Incentive Compensation Plan
    
    
    238,778
    
    
    
    251,7791998 Employee Incentive Compensation Plan
    
    
    27,223
    
    
    
    69,468Total
    
    
    266,001
    
    
    
    321,247
 The fair value of the stock options used to compute pro forma net income and earnings per share
disclosures is the estimated present value at grant date using the Black-Scholes option-pricing
model with the following weighted average assumptions for 2002, 2003 and 2004: expected volatility
of 93.2% in 2002, 96.7% in 2003 and 71.8% in 2004; a risk-free interest rate of 2.67% in 2002,
2.44% in 2003, and 3.21% in 2004; and an expected holding period of four years. We have never paid
any dividends on our common stock and do not expect to pay cash dividends in the foreseeable
future. Using the Black-Scholes option-pricing model, the weighted average fair value of stock
options granted during 2002, 2003 and 2004, is $9.52, $9.61and $6.85 per share, respectively. Transactions involving stock options under the Companys various stock option plans and
otherwise are summarized below: Number of
    
    
    
    
    
    
    Weighted AverageShares
    
    
    Range of Options Price
    
    
    Exercise PriceOutstanding, December 31, 2001
    
    
    1,673,630
    
    
    $
    6.00000-159.18750
    
    
    $
    34.55Granted
    
    
    152,000
    
    
    
    9.48500 - 24.21000
    
    
    
    14.39Exercised
    
    
    (39,617
    )
    
    
    6.00000 - 28.39500
    
    
    
    7.02Cancelled
    
    
    (83,307
    )
    
    
    6.00000 - 159.18750
    
    
    
    41.29Outstanding, December 31, 2002
    
    
    1,702,706
    
    
    
    6.00000 - 159.18750
    
    
    
    33.06Granted
    
    
    120,700
    
    
    
    12.14500 - 159.18750
    
    
    
    14.07Exercised
    
    
    (27,634
    )
    
    
    14.01000 - 21.22000
    
    
    
    8.99Cancelled
    
    
    (42,640
    )
    
    
    6.00000 - 159.18750
    
    
    
    41.96Outstanding, December 31, 2003
    
    
    1,753,132
    
    
    
    6.00000 - 159.18750
    
    
    
    31.92Granted
    
    
    33,000
    
    
    
    9.19000 - 12.32000
    
    
    
    11.73Exercised
    
    
    (42,570
    )
    
    
    6.00000 - 12.55000
    
    
    
    6.34Cancelled
    
    
    (88,246
    )
    
    
    9.26570 - 159.18750
    
    
    
    61.97Outstanding, December 31, 2004
    
    
    1,655,316
    
    
    $
    6.00000-159.18750
    
    
    $
    30.57
 Options exercisable at:
    
    Number of SharesDecember 31, 2002
    
    
    1,454,464
    
    
    $
    34.90December 31, 2003
    
    
    1,657,364
    
    
    $
    32.97December 31, 2004
    
    
    1,629,607
    
    
    $
    30.85
 - 48 -




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##### Table of Contents



The following table summarizes the status of the stock options, outstanding and exercisable,
at December 31, 2004: Stock Options Outstanding
    
    
    Stock Options ExercisableNumber
    
    Weighted Average
    
    
    Weighted
    
    
    
    
    
    
    WeightedRange of Exercise
    
    
    Outstanding
    
    Remaining
    
    
    Average
    
    
    
    
    
    
    AveragePrices
    
    
    as of 12/31/04
    
    Contractual Life
    
    
    Exercise Price
    
    
    Shares
    
    
    Exercise Price$
    6.00000 - 7.28130
    
    
    186,200
    
    3.40
    
    
    
    7.04
    
    
    
    186,200
    
    
    
    7.04$
    7.50000 - 9.48500
    
    
    205,755
    
    4.51
    
    
    

    8.34
    
    
    
    205,089
    
    
    
    8.33$
    9.81250 - 12.55000
    
    
    243,916
    
    5.47
    
    
    
    11.16
    
    
    
    222,787
    
    
    
    11.03$
    12.79690 - 15.83500
    
    
    177,918
    
    4.56
    
    
    
    13.63
    
    
    
    177,502
    
    
    
    13.63$
    16.00000 - 21.92500
    
    
    200,668
    
    6.82
    
    
    
    19.54
    
    
    
    197,170
    
    
    
    19.60$
    22.51500 - 28.39500
    
    
    192,584
    
    6.81
    
    
    
    27.84
    
    
    
    192,584
    
    
    
    27.84$
    28.70000 - 55.89850
    
    
    265,450
    
    6.40
    
    
    
    42.30
    
    
    
    265,450
    
    
    
    42.30$
    71.87500 - 103.59375
    
    
    12,000
    
    5.72
    
    
    
    98.31
    
    
    
    12,000
    
    
    
    98.31$
    117.34400 - 117.34400
    
    
    154,000
    
    5.62
    
    
    
    117.34
    
    
    
    154,000
    
    
    
    117.34$
    159.18750 - 159.18750
    
    
    16,825
    
    5.53
    
    
    
    159.19
    
    
    
    16,825
    
    
    
    159.19Total
    
    1,655,316
    
    5.51
    
    
    
    30.57
    
    
    
    1,629,607
    
    
    
    30.85
 SERIES A JUNIOR PARTICIPATING PREFERRED STOCK PURCHASE RIGHTS In order to protect shareholder value in the event of an unsolicited offer to acquire the Company,
on July 23, 1996, the Board of Directors of the Company declared a dividend of one preferred stock
purchase right for each outstanding share of the Companys common stock. The dividend was payable
on August 15, 1996 to shareholders of record as of that date. The aforementioned rights are
exercisable only if a person or group acquires or announces an offer to acquire 20% or more of the
Companys common stock. In such an event, each right will entitle shareholders to buy
one-hundredth of a share of a new series of preferred stock at an exercise price of $115.00. Each
one-hundredth of a share of the new preferred stock has terms designed to make it the economic and
voting equivalent of one share of common stock. If a person or group acquires 20% or more of the Companys outstanding common stock, each right not
owned by the person or group will entitle its holder to purchase at the rights exercise price a
number of shares of the Companys common stock (or, at the option of the Company, the new preferred
stock) having a market value of twice the exercise price. Further, at any time after a person or
group acquires 20% or more (but less than 50%) of the outstanding common stock, the Board of
Directors may at its option, exchange part or all of the rights (other than rights held by the
acquiring person or group) for shares of the Companys common or preferred stock on a one-for-one
basis. Each right further provides that if the Company is acquired in a merger or other business
transaction, each right will entitle its holder to purchase, at the rights exercise price, a
number of the acquiring companys common shares having a market value at that time of twice the
exercise price. The Board of Directors is entitled to redeem the rights for one cent per right at any time before a
20% position has been acquired. The Board of Directors is also authorized to reduce the 20%
thresholds referred to above to not less than 10%. 7. LICENSE AND ROYALTY FEES The Company has entered into several technology license agreements with certain major Digital Loop
Carrier (DLC) vendors and major Operation Support System (OSS) equipment manufacturers under which
the Company has been granted access to the licensors patent technology and the right to
manufacture and sell the patent technology in the Companys product line. The Company is obligated
to pay royalty fees, as defined, through the terms of these license agreements. Under these
agreements, license and royalty fees are due only upon purchase of the technology or shipment of
units; there are no contingent payment provisions in any of these arrangements. Royalty fees of
$889,024, $966,715 and $1,187,500 were incurred in 2002, 2003 and 2004, respectively, and are
included in cost of product sales in the accompanying consolidated statements of operations. 8. INCOME TAXES The provision for income taxes consisted of the following: - 49 -




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##### Table of Contents



2002
    
    
    2003
    
    
    2004Current:Federal
    
    $
    1,491,245
    
    
    $
    652,249
    
    
    $
    (1,280,123
    )State
    
    
    25,600
    
    
    
    17,068
    
    
    
    1,516,845
    
    
    
    669,317
    
    
    
    (1,280,123
    )Deferred:Federal
    
    
    675,547
    
    
    
    1,250,132
    
    
    
    1,208,470State
    
    
    (135,156
    )
    
    
    9,961
    
    
    
    1,162,136540,391
    
    
    
    1,260,093
    
    
    
    2,370,606$
    2,057,236
    
    
    $
    1,929,410
    
    
    $
    1,090,483
 Reconciliation of the federal statutory rate to the effective tax rates are as follows: Years Ended December 31,2002
    
    2003

    
    2004Federal statutory tax rate
    
    
    34
    %
    
    
    34
    %
    
    
    34
    %State income taxes
    
    
    (1
    %)
    
    
    
    
    
    
    Valuation allowance for state net operating
losses
    
    
    8
    %
    
    
    
    
    
    
    46
    %Tax contingency reserve
    
    
    
    
    
    
    5
    %
    
    
    (35
    %)Other
    
    
    (3
    %)
    
    
    (1
    %)
    
    
    Effective tax rate
    
    
    38
    %
    
    
    38
    %
    
    
    45
    %
 The components of and changes in the deferred tax assets and liabilities recorded in the
accompanying balance sheets at December 31, 2003 and 2004 were as follows: Deferred
    
    
    
    
    
    
    
    
    
    
    DeferredDecember 31,
    
    
    Expense
    
    
    
    
    
    
    December 31,
    
    
    Expense
    
    
    
    
    
    
    December 31,2002
    
    
    (Credit)
    
    
    Other
    
    
    2003
    
    
    (Credit)
    
    
    Other
    
    
    2004Deferred Tax Assets:Excess of tax basis over book basis for:Property and equipment
    
    $
    349,552
    
    
    $
    (34,596
    )
    
    $
    
    
    
    $
    384,148
    
    
    $
    77,860
    
    
    $
    
    
    
    $
    306,288Inventory
    
    
    305,167
    
    
    
    (128,070
    )
    
    
    
    
    
    
    433,237
    
    
    
    53,861
    
    
    
    
    
    
    
    379,376Reserves recorded for:Warranty
    
    
    772,403
    
    
    
    21,690
    
    
    
    (87,750
    )
    
    
    838,463
    
    
    
    32,974
    
    
    
    
    
    
    
    805,489Inventory
    
    
    913,705
    
    
    
    342,355
    
    
    
    
    
    
    
    571,350
    
    
    
    71,425
    
    
    
    
    
    
    
    499,925Allowance for doubtful accounts
    
    
    185,250
    
    
    
    (172,110
    )
    
    
    
    
    
    
    357,360
    
    
    
    93,251
    
    
    
    
    
    
    
    264,109State net operating loss carryforward
    
    
    1,641,862
    
    
    
    (173,880
    )
    
    
    
    
    
    
    1,815,742
    
    
    
    (185,663
    )
    
    
    
    
    
    
    2,001,405Valuation Allowance
    
    
    (450,000
    )
    
    
    
    
    
    
    
    
    
    
    (450,000
    )
    
    
    1,312,257
    
    
    
    
    
    
    
    (1,762,257
    )Other
    
    
    5,756
    
    
    
    (19,584
    )
    
    
    
    
    
    
    25,340
    
    
    
    23,642
    
    
    
    
    
    
    
    1,698Total deferred tax assets
    
    
    3,723,695
    
    
    
    
    
    
    
    
    
    
    
    3,975,640
    
    
    
    
    
    
    
    
    
    
    
    2,496,033Deferred Tax Liabilities:Excess of book basis over tax basis for:Goodwill & Intangibles
    
    $
    (1,300,944
    )
    
    $
    1,022,897
    
    
    
    
    
    
    $
    (2,323,841
    )
    
    $
    906,943
    
    
    
    
    
    
    $
    (3,230,784
    )Property and equipment
    
    
    (173,355
    )
    
    
    401,391
    
    
    
    
    
    
    
    (574,746
    )
    
    
    8,480
    
    
    
    
    
    
    
    (583,226
    )Other
    
    
    (9,950
    )
    
    
    
    
    
    
    
    
    
    
    (9,950
    )
    
    
    (24,424
    )
    
    
    
    
    
    
    14,474Total deferred tax liabilities
    
    
    (1,484,249
    )
    
    
    
    
    
    
    
    
    
    
    (2,908,537
    )
    
    
    
    
    
    
    
    
    
    
    (3,799,536
    )Net deferred taxes
    
    $
    2,239,446
    
    
    $
    1,260,093
    
    
    $
    (87,750
    )
    
    $
    1,067,103
    
    
    $
    2,370,606
    
    
    $
    
    
    
    $
    (1,303,503
    )Reconciliation to the balance sheet:Deferred tax assets:
 - 50 -




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##### Table of Contents



Deferred
    
    
    
    
    
    
    
    
    
    
    DeferredDecember 31,
    
    
    Expense
    
    
    
    
    
    
    December 31,
    
    
    Expense
    
    
    
    
    
    
    December 31,2002
    
    
    (Credit)
    
    
    Other
    
    
    2003
    
    
    (Credit)
    
    
    Other
    
    
    2004Current
    
    $
    1,404,120
    
    
    
    
    
    
    
    
    
    
    $
    1,361,947
    
    
    
    
    
    
    
    
    
    
    $
    1,143,410Long-term
    
    
    1,146,152
    
    
    
    
    
    
    
    
    
    
    
    1,152,846
    
    
    
    
    
    
    
    
    
    
    
    176,464Deferred Tax Liabilities
    
    
    (310,826
    )
    
    
    
    
    
    
    
    
    
    
    (1,447,690
    )
    
    
    
    
    
    
    
    
    

    
    (2,623,377
    )Net Deferred Tax Asset (Liability)
    
    $
    2,239,446
    
    
    
    
    
    
    
    
    
    
    $
    1,067,103
    
    
    
    
    
    
    
    
    
    
    $
    (1,303,503
    )
 The deferred tax asset from net operating loss carryforwards is largely attributed to
Pennsylvania which presently allows a 20-year carryforward with a $2,000,000 limit on deductions
each year. Unused carryforward losses will expire through 2021. During 2004, we recorded state net
operating loss carryforwards and a full valuation allowance related to Pennsylvania and New York
state net operating losses which resulted in a charge of $1.1.
million. Additionally, during 2004, we
reduced certain tax contingency reserves by $0.8 million based on changes in estimates based on a
tax audit of certain earlier years and on an evaluation of current circumstances. The impact of
the change related to the state net operating loss carryforwards and state valuation allowances and
the reversal of certain tax
contingency reserves resulted in a net charge of $0.3 million during 2004. The Company had a
federal taxable loss for 2004 and will be able to carry this loss back to 2002 to recover prior
year cash taxes paid of $0.6 million. As of December 31, 2003, we had recorded a valuation
allowance of $0.5 million related to state net operating losses. 9. LINE OF CREDIT Effective December 20, 2001, and amended effective February 7, 2003, the Company executed a
five-year $25,000,000 Unsecured Revolving Credit Facility (the Facility) with a bank. In
accordance with the terms of the Facility, the proceeds must be used for general corporate
purposes, working capital needs, and in connection with certain acquisitions, as defined. The
Facility contains certain standard covenants with which the Company 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, among others. A maximum
leverage ratio restricts total borrowings of the Company to approximately $15.0 million during the
first quarter of 2005. Interest is payable on any amounts utilized under the Facility at prime, or
the prevailing Euro rate plus 1.0% to 1.5% depending on the fixed charge coverage ratio, at the
option of the Company. Commitment fees are paid quarterly at the rate of 0.25% per annum on the
average unused commitment. At December 31, 2004, there were no amounts outstanding under the
Facility. 10. COMMITMENTS and CONTINGENCIES The Company leases office space and equipment under agreements which are accounted for as operating
leases. The office lease for the Cheswick facility, the Bridgewater facility and the Sarasota
facility expire on December 31, 2005, January 21, 2007 and April 28, 2008, respectively. The
Company is also involved in various month-to-month leases for research and development and office
equipment at all three locations. In addition, all three of the office leases include provisions
for possible adjustments in annual future rental commitments relating to excess taxes, excess
maintenance costs that may occur and increases in rent based on the consumer price index and based
on increases in our annual lease commitments, none of these commitments are material.
Additionally, the Company has arrangements with certain manufacturing subcontractors under which
the Company is contingently obligated to purchase up to $2,323,000 of raw material parts in the
event they would not be consumed by the manufacturing process in the normal course of business.
Approximately $996,000 of the total commitment of $2,323,000 has been recorded in the consolidated
balance sheet as the Company has a legal obligation to purchase this inventory as of December 31,
2004. The recording of this obligation in the financial statements did not result in a change to
the Consolidated Statements of Operations. We fully expect to utilize this inventory during the
normal course of business and have not recorded any reserve related to this specific item. Minimum annual future commitments as of December 31 are: Lease
    
    
    Purchase Obligations
    
    
    Total2005
    
    $
    1,583,347
    
    
    $
    1,282,586
    
    
    $
    2,865,9332006
    
    
    878,168
    
    
    
    31,415
    
    
    
    909,5832007
    
    
    464,808
    
    
    
    12,000
    
    
    
    476,8082008
    
    
    145,718
    
    
    
    
    
    
    
    145,7182009
    
    
    
    
    
    
    
    
    
    
    
 The lease expense for all commitments was $1,170,101, $1,479,754 and $1,571,982 in 2002, 2003 and
2004, respectively. The increase in rent expense from 2002 to 2003 related to the Cheetah
acquisition. The increase in 2003 compared to 2004 is related to having twelve months of lease
expense related to our Sarasota location. 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, 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. MAJOR CUSTOMERS, REVENUE CONCENTRATION AND DEPENDENCE ON CERTAIN SUPPLIERS The Company designs, engineers, markets and supports test system, test access and status monitoring
products for the telecommunications and cable television industries. We have five product
categories which consist of our MCU products, DigiTest, LoopCare software, cable hardware and
software and services. Sales of our MCU product line were $21.1 million, $25.4 million and $28.1
million for the years ended December 31, 2004, 2003, and 2002, respectively. Sales of our DigiTest
product line were $7.7 million, $6.6 million and $8.3 million for the years ended December 31,
2004, 2003, and 2002, respectively. Sales of stand-alone LoopCare software products were $4.4
million, $3.4 million and $7.5 million for the years ended December 31, 2004, 2003, and 2002,
respectively. Sales of our cable hardware and software products were $16.7 million, $17.4 million,
and $3.1 million for the years ended December 31, 2004, 2003, and 2002, respectively. Service
revenues were $13.0 million, $12.3 million, and $10.3 million for the years ended December 31,
2004, 2003, and 2002, respectively Sales are concentrated primarily with the four Regional Bell - 51 -




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Operating Companies (RBOCs) as well as major independent telephone and cable companies and to
certain digital loop carrier equipment manufacturers. Sales are derived primarily from the
Companys metallic channel unit (MCU) product line which accounted for approximately 34% of the
Companys net sales for 2004. The cable television hardware and software product lines, which
include both CheetahLight (formerly LIGHTHOUSE) and the newly acquired CheetahNet lines,
contributed approximately 27% while DigiTest and LoopCare RTU sales accounted for approximately 12%
and 7%, respectively, of the Companys net sales for 2004. Revenue from Services, which includes
installation oversight and project management services provided to RBOCs and fees for LoopCare and
Cheetah software maintenance, accounted for approximately 21% of the Companys net sales for 2004. Sales to RBOC customers accounted for approximately 77%, 56%, and 54% of the Companys net product
sales for fiscal years 2002, 2003 and 2004, respectively. During 2002, 2003 and 2004, sales to
three RBOC customers individually exceeded 10% of consolidated revenues and, on a combined basis,
comprised 70% (individually, 38%, 18% and 14%), 48% (individually, 17%, 17% and 14%) and 50%
(individually, 20%, 15% and 15%) of the Companys net product sales, respectively. Due to the
Companys
present dependency on RBOC customers, the loss of one or more of the RBOCs as a customer, or the
reduction of orders for the Companys products by the RBOCs, could materially and adversely affect
the Company. The Company utilizes three key independent subcontractors to perform a majority of the circuit
board assembly and in-circuit testing work on its products. The Company also utilizes other
subassembly contractors on a more limited basis. The loss of the subcontractors could cause delays
in the Companys ability to meet production obligations and could have a material adverse effect on
the Companys results of operations. In addition, shortages of raw material or production capacity
constraints at the Companys subcontractors could negatively affect the Companys ability to meet
its production obligations and result in increased prices for affected parts. Any such reduction
may result in delays in shipments of the Companys products or increases in the price of
components, either of which could have a material adverse impact on the Company. 12. EMPLOYEE BENEFIT PLANS The Company has a 401(k) benefit plan. Eligible employees, as defined in the plan, may contribute
up to 20% of eligible compensation, not to exceed the statutory limit. The Company does not make
matching contributions to the plan. 13. SEVERANCE AND RELATED EXPENSE On July 8, 2004 and July 21, 2004, the Company announced a cost alignment program which eliminated,
in two phases, approximately 50 positions. The majority of the reductions impacted the research
and development, manufacturing, and related overhead areas of the Company. The cost alignment
initiative resulted in a pre-tax severance expense of $268,637. All costs associated with the
program were incurred and paid during the quarter ended September 25, 2004. Therefore, no
remaining obligations exist at the end of the period. On September 30, 2002, the Company announced
a cost reduction initiative which included the elimination of 47 positions, primarily in research
and development. The restructuring program resulted in a pre-tax charge for severance,
outplacement and other related costs of $175,723 in 2002. All amounts for the 2002 program were
paid during 2002. 14. RECENT ACCOUNTING PRONOUNCEMENTS In January 2003, the Financial Accounting Standards Board (FASB) FASB issued FASB Interpretations
No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of Accounting
Research Bulletin No. 51. FIN 46 requires certain variable interest entities to be consolidated
by the primary beneficiary of the entity if the equity investors in the entity 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. FIN 46 is effective for all new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003,
the provisions of FIN 46 must be applied for the first interim or annual period beginning after
December 15, 2003. The adoption of this standard had no impact on our financial condition or
results of operations. In March 2004, the FASB approved Emerging Issues Task Force (EITF) Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments. The objective of this
issue is to provide guidance for identifying other-than-temporarily impaired investments. EITF No.
03-1 also provides new disclosure requirements for investments that are deemed to be temporarily
impaired. In September 2004, the FASB issued EITF No. 03-1-1, which delayed the effective date of
EITF No. 03-1, with the exception of certain disclosure requirements. We do not believe that EITF
No. 03-1 will have a material impact on its financial condition and results of operations. In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151 (SFAC 151),
Inventory Costs, an amendment of ARB No. 43, Chapter 4. This statement amends the guidance in
ARB No. 43 Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle
facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43,
Chapter 4, previously stated that ...under some circumstances, items such as idle facility expense,
excessive spoilage, double freight, and rehandling costs may be so abnormal to require treatment as
a current period charges... This statement requires that those items be recognized as current-period
charges regardless of whether they meet the criterion of so abnormal. In addition, this
statement requires that allocation of fixed production overheads to the costs of conversion be
based on the normal capacity of the production facilities. The provisions of this statement will
be effective for inventory costs during the fiscal years beginning after June 15, 2005. We do not
believe that the adoption of this statement will have a material impact on its financial condition
or results of operations. In December 2004, the
FASB issued Statement No. 123(R), Shared-Based Payment.Statement 123(R)
requires the measurement of all employee stock-based compensation awards using a fair value method
as of the grant date and recording such expense in the consolidated financial statements. In
addition, the adoption of Statement 123(R) will require additional accounting related to the income
tax effects and additional disclosure regarding the cash flow effects resulting from share-based
payment arrangements. - 52 -




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Statement 123(R) is effective beginning in our third quarter of fiscal 2005.
We are currently evaluating the impact of the adoption of Statement 123(R). In December 2004, the FASB issued Statement No. 153, Exchanges of Nonmonetary Assets,an amendment
of APB Opinion No. 29. Statement 153 addresses the measurement of exchanges of nonmonetary assets
and redefines the scope of transactions that should be measured based on the fair value of the
assets exchanged. Statement 153 is effective for nonmonetary asset exchanges occurring in fiscal
periods beginning after June 15, 2005. We do not believe adoption of Statement 153 will have a
material effect on our consolidated financial position, results of operations or cash flows. In December 2004, the FASB issued FASB Staff Position No. FAS109-1 (FAS 109-1), Application of
FASB Statement No. 109. Accounting for Income Taxes, to the Tax Deduction on Qualified Production
Activities Provided by the American Jobs Creation Act of 2004. The AJCA introduces a special 9%
tax deduction on qualified production activities. FAS 109-1 clarifies that this tax
deduction should be accounted for as a special tax deduction in accordance with Statement 109. We
do not expect the adoption of these new tax provisions to have a material impact on our
consolidated financial position, results of operations or cash flows. In December 2004, the FASB issued FASB Staff Position No FAS 109-2, Accounting and Disclosure
Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of
2004.The American Jobs Creation Act introduces a special one-time dividends received deduction on
the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided
certain criteria are met. FSP FAS 109-2 provides accounting and disclosure guidance for the
repatriation provision. We do not believe the Foreign Earnings Repatriation Provision within the
American Jobs Creation Act of 2004 nor the FASB Staff Position will have a material impact on our
financial condition or results of operations. 15. SHORT-TERM INVESTMENTS The estimated fair values of the Companys financial instruments are as follows: December 31, 2003
    
    
    December 31, 2004Carrying Amount
    
    
    Fair Value
    
    
    Carrying Amount
    
    
    Fair ValueFinancial assets:Cash and cash equivalents
    
    $
    31,059,972
    
    
    $
    31,059,972
    
    
    $
    32,622,135
    
    
    $
    32,622,135Short-term investments
    
    
    17,624,668
    
    
    
    17,609,031
    
    
    
    18,537,310
    
    
    
    18,538,275$
    48,684,640
    
    
    $
    48,669,003
    
    
    $
    51,159,445
    
    
    $
    51,160,410
 16. PER SHARE INFORMATION Net income per share has been computed in accordance with the provisions of SFAS No. 128, Earnings
Per Share for all periods presented. As of December 31, 2004 and 2003, 1,129,950 and 910,536
equivalent shares respectively were anti-dilutive. SFAS No. 128 requires companies with complex
capital structures to report earnings per share on a basic and diluted basis, as defined. Basic
earnings per share are calculated on the actual number of weighted average common shares
outstanding for the period, while diluted earnings per share must include the effect of any
dilutive securities. All prior periods have been restated in accordance with SFAS No. 128. A reconciliation of earnings per share is as follows: December 31, 2002
    
    
    December 31, 2003
    
    
    December 31, 2004Net Income
    
    $
    3,356,544
    
    
    $
    3,147,986
    
    
    $
    1,345,174Weighted average common shares outstanding
    
    
    13,095,068
    
    
    
    13,105,779
    
    
    
    13,140,871Effect of
dilutive securities - stock options
    
    
    218,608
    
    
    
    206,818
    
    
    
    112,42313,313,676
    
    
    
    13,312,597
    
    
    
    13,253,294Earnings per share:Basic
    
    $
    0.26
    
    
    $
    0.24
    
    
    $
    0.10Diluted
    
    $
    0.25
    
    
    $
    0.24
    
    
    $
    0.10
 17. SUBSEQUENT EVENT On January 17, 2005, the Company entered into an Agreement with Christian L. Allison, the Companys
Former Chief Executive Officer, a former member of the Board of the Company, as well as a
shareholder of the Company (the Agreement). Under the terms of the Agreement, Mr. Allison
resigned effective as of January 18, 2005 (the Retirement Date), as director and executive
officer of the Company and any and all other positions he held with the Company or its subsidiaries
or other affiliates. Mr. Allison received the following separation payments: (a) an amount equal to the sum of (i) Mr.
Allisons base salary through the Retirement Date to the extent not then paid and (ii) any vacation
pay and other cash entitlements accrued by Mr. Allison as of the Retirement Date to the extent not
then paid; (b) two times his contractual base salary of $315,000 for a total of $630,000; and (c) a
lump sum payment of $75,000. The Company will pay all premiums on behalf of Mr. Allison to continue
medical insurance for his immediate family for the period specified in the Agreement. Additionally,
the Company has agreed to continue to indemnify, to the fullest extent permitted by applicable law,
and to provide directors and officers liability insurance, if available in the directors and - 53 -




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officers liability insurance market, for the periods specified in the Agreement for Mr. Allisons
actions taken or omissions occurring at or prior to the Retirement Date. The Company also has
agreed to pay up to $50,000 of the reasonable fees and expenses of Mr. Allisons legal counsel
incurred in connection with the negotiation and execution of the Agreement. The Company expects
total charges in the first quarter of 2005 related to Mr. Allisons retirement to be approximately
$780,000. Mr. Allison also will be entitled to receive any vested benefits payable to him under the terms of
any employee benefit plan or program of the Company in accordance with the terms of such plan or
program. Under the terms of the Agreement and the Companys 1995 Long-Term Incentive Compensation
Plan (as amended through January 24, 2002), all options to acquire shares of the Companys common
stock held by Mr. Allison were fully vested prior to the Retirement Date and will remain
exercisable by Mr. Allison for at least one year following the Retirement Date. 
 SCHEDULE II TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS
For the Years Ended December 31, 2002, 2003 and 2004
(In thousands) Col. B
    
    
    Col C.Balance at
    
    
    Additions
    
    
    Charged
    
    
    
    
    
    
    Col. EBeginning
    
    
    Charged to
    
    
    (benefits) to
    
    
    Col. D
    
    
    Balance atCol. A
    
    of Year
    
    
    Expense
    
    
    Other Accounts
    
    
    Deductions
    
    
    End of YearInventory reserves:Year ended December 31, 2002
    
    $
    1,111
    
    
    $
    2,547
    (a)
    
    $
    
    
    
    $
    (1,315
    )
    
    $
    2,343Year ended December 31, 2003
    
    
    2,343
    
    
    
    227
    
    
    
    
    
    
    
    (1,105
    )
    
    
    1,465Year ended December 31, 2004
    
    
    1,465
    
    
    
    265
    
    
    
    
    
    
    
    (310
    )
    
    
    1,420Allowance for doubtful
accounts:Year ended December 31, 2002
    
    $
    375
    
    
    $
    
    
    
    $
    100
    
    
    $
    
    
    
    $
    475Year ended December 31, 2003
    
    
    475
    
    
    
    517
    
    
    
    (76
    )
    
    
    
    
    
    
    916Year ended December 31, 2004
    
    
    916
    
    
    
    (151
    )
    
    
    
    
    
    
    (10
    )
    
    
    755Warranty reserve:Year ended December 31, 2002
    
    $
    2,068
    
    
    $
    540
    
    
    $
    
    
    
    $
    (627
    )
    
    $
    1,981Year ended December 31, 2003
    
    
    1,981
    
    
    
    690
    
    
    
    225
    (b)
    
    
    (746
    )
    
    
    2,150Year ended December 31, 2004
    
    
    2,150
    
    
    
    1,435
    
    
    
    
    
    
    
    (1,504
    )
    
    
    2,081
   (a)
    
    The increase in the inventory reserves was due to a significant decline in sales in 2001 and
2002.(b)
    
    Charges (benefits) to other accounts represents adjustments to these accounts as a result of
our acquisition of Cheetah. - 54 -




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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. 
 Item 9A. Controls and Procedures. Evaluation of Disclosure Controls and Procedures As of December 31, 2004, the Company has carried out an evaluation, under the supervision of,
and with the participation of, the Companys management, including the Companys chief executive
officer and principal financial officer, of the effectiveness of the design and operation of the
Companys disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange
Act of 1934, as amended. Based upon that evaluation, the chief executive officer and principal
financial officer concluded that the Companys disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are effective to ensure
that information required to be disclosed by the Company in the reports that it files or submits
under Exchange Act is recorded, processed, summarized and reported within the time periods
specified by the SECs rules and forms. Evaluation of Changes in Internal Control over Financial Reporting There were no changes in our internal control over financial reporting (as defined in Rule
13a-15(f) under the Securities Exchange Act of 1934) during the quarter ended December 31, 2004
that have materially affected, or are reasonably likely to materially affect our internal control
over financial reporting. Managements Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over
financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as
amended). Our internal control over financial reporting is a process designed to provide
reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent
or detect misstatements. Also, projections of any evaluation of effectiveness to future periods
are subject to the risk that controls may become inadequate because of changes in conditions, or
that the degree of compliance with the policies or procedures may deteriorate. Our management assessed the effectiveness of our internal control over financial reporting as
of December 31, 2004. In making this assessment, our management used the criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal
Control-Integrated Framework. Our management has concluded that, as of December 31, 2004, our
internal control over financial reporting was effective based on these criteria. Our independent registered public accounting firm, PricewaterhouseCoopers, LLP, has audited
our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 as
stated in their report, which is included herein. - 55 -




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PART III 
 Item 10. Directors and Executive Officers of the Registrant. Information related to our executive officers is included in Item I of this Form 10-K under
the caption Executive Officers of the Company. Information related to the directors appears in
the section entitled Election of Directors in the Companys definitive Proxy Statement filed with
the Securities and Exchange Commission relating to our 2005 Annual Meeting of Shareholders (the
2005 Proxy Statement), which section is incorporated herein by reference. Information regarding
compliance with Section 16(a) of the Securities Exchange Act of 1934 is included under the caption
Section 16(a) Beneficial Ownership Reporting Compliance in the 2005 Proxy Statement, which
section is incorporated herein by reference. We have adopted a Code of Ethics applicable to our chief executive officer, chief financial
officer, controller, and other individuals performing similar functions. A copy of the Companys
Code of Ethics is available on our website at www.tollgrade.com. 
 Item 11. Executive Compensation. Information relating to executive compensation is set forth beneath the caption Compensation
of Executive Officers in the 2005 Proxy Statement, which section is incorporated herein by
reference. 
 Item 12. Security Ownership of Certain Beneficial Owners and Management. Information relating to the security ownership of beneficial owners of 5% or more of the
Companys Common Stock and of our executive officers and directors of the Company is set forth
under the caption Stock Ownership of Certain Beneficial Owners and Management in the 2005 Proxy
Statement, which section is incorporated herein by reference. Securities Authorized for Issuance Under Equity Compensation Plans as of December 31, 2004 The following table provides information as of December 31, 2004, with respect to the shares of our
common stock that may be issued under our existing equity compensation plans: EQUITY COMPENSATION PLAN INFORMATION Number of securitiesremaining available forNumber of securities to be
    
    
    
    Weighted average exercise
    
    
    
    future issuance underissued upon exercise of
    
    
    
    price of outstanding
    
    
    
    equity compensation plansoutstanding options,
    
    
    
    options, warrants and
    
    
    
    (excluding securities listedPlan Category
    
    
    warrants and rights
    
    
    
    rights
    
    
    
    in column (a))Equity compensation
plans approved by
the securityholders
    
    
    
    1,253,964
    
    
    
    $
    32.859
    
    
    
    
    251,779Equity compensation
plans not approved
by the
securityholders (1)
    
    
    
    401,352
    
    
    
    $
    23.415
    
    
    
    
    69,468Total
    
    
    
    1,655,316
    
    
    
    
    
    
    
    
    
    321,247
   (1)   1998 Employee Incentive Compensation Plan. The Companys 1998 Employee Incentive
Compensation Plan (the Plan), which was adopted by the Companys Board of Directors and is
effective as of January 28, 1998, is intended, among other purposes, to help the Company to
motivate, attract and retain qualified employees (other than officers and directors of the
Company). The Plan is administered by the Compensation Committee of the Companys Board of
Directors (the Committee), which has full discretion to determine the employees who receive
awards under the Plan as well as the nature and size of such awards. The Committee may issue
nonqualified stock options, stock appreciation rights, restricted stock, performance shares and
performance units under the Plan. Award recipients (other than recipients of stock appreciation
rights) are subject to a non-competition arrangement with the Company. Upon a change of control in
the Company, all awards become exercisable, vested or fully earned, as applicable. The exercise
price of options and the sale price of restricted stock granted under the Plan is 100% of the fair
market value of the Companys common stock as of the date of grant. All options granted under the
plan expire not later than ten years after the date of grant and typically vest over two years.
There are currently 990,000 shares of the Companys common stock authorized under the Plan for
granting awards. See Note 6 to the
consolidated financial statements on pages 47 through 49 of this Annual Report on
Form 10-K to Shareholders for additional information regarding the Companys equity compensation
plans. - 56 -




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##### Table of Contents



Item 13. Certain Relationships and Related Transactions. Information relating to this Item is set forth beneath the caption Certain Relationships and
Related Transactions in the 2005 Proxy Statement, which section is incorporated herein by
reference. 
 Item 14. Principal Accounting Fees and Services. Information relating to this Item is set forth under the heading Principal Accounting Fees
and Services in the 2005 Proxy Statement, which section is incorporated herein by reference. - 57 -




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##### Table of Contents



PART IV 
 Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.  (a)
    The following documents have been filed as part of this report or, where noted, incorporated by
reference:  (1)
    Financial Statements The financial statements of the Company are listed in the Index to Consolidated Financial
Statements on Page 35.  (2)
    Financial Statement Schedule  The financial statement schedule filed in response to Item 8 and Item 15(d) of Form 10-K,
Schedule II (Valuation and Qualifying Accounts), is listed in the Index to Consolidated Financial
Statements on Page 35.  (3)
    The following exhibits are included herewith and made a part hereof: ExhibitNumber
    
    Description3.1
    
    Amended and Restated Articles of Incorporation of the Company, as amended through May 6, 1998 (conformed copy), incorporated herein by reference to Exhibit
3.1 to the Annual Report of Tollgrade Communications, Inc. (the Company) on Form 10-K (File No. 000-27312), filed with the Securities and Exchange
Commission (the SEC) on March 24, 1999 (the 1998 Form 10-K).3.1a
    
    Statement with Respect to Shares dated July 23, 1996 (conformed copy), incorporated herein by reference to Exhibit 3.1a to the 1998 Form 10-K.3.2
    
    Amended and Restated Bylaws of the Company, incorporated herein by reference to Exhibit 3(ii) to the Form on 8-K (File No. 000-27312), filed with the SEC on
January 21, 2005.4.1
    
    Rights Agreement, dated as of July 23, 1996, between the Company and Chase Mellon Shareholder Services, L.L.C., incorporated herein by reference to Exhibit
1 to the Registration Statement of the Company on Form 8-A (File No. 000-28852), filed with the SEC on August 9, 1996.10.1*
    
    1995 Long-Term Incentive Compensation Plan, amended and restated as of January 24, 2002, incorporated herein by reference to Exhibit B to the 2002 Proxy
Statement of the Company (File No. 000-27312), filed with the SEC on March 22, 2002.10.2
    
    License Agreement, dated August 24, 1993, between Fujitsu Network Transmission Systems, Inc. and the Company, incorporated herein by reference to
Exhibit 10.4 to the S-1.10.3
    
    License Agreement, dated September 26, 1994, between Zhone Technologies, Inc. (successor in interest to NEC America, Inc.) and the Company, incorporated
herein by reference to Exhibit10.5 to the S-1.10.4
    
    Interface License Agreement, dated
March 22, 1995, between Northern Telecom Inc. and the Company, incorporated herein by reference to Exhibit10.7 to the
S-1.10.5
    
    Technical Information Agreement, dated February1, 1993, between Lucent Technologies, Inc. (formerly American Telephone and Telegraph Company) and the
Company, incorporated herein by reference to Exhibit10.8 to the S-1.10.6
    
    Technology License Agreement, dated
November 16, 1994, between Alcatel USA (formerly DSC Technologies Corporation) and the Company, incorporated herein by
reference to Exhibit10.12 to the S-1.10.7
    
    License Agreement, dated August 24, 1993, between Marconi Communications, Inc. (formerly, Reliance Comm/Tec Corporation) and the Company, incorporated
herein by reference to Exhibit 10.13 to the S-1.10.8*
    
    Stock Option Agreement entered into
December 14, 1995 between the Company and R. Craig Allison, together with a schedule listing substantially identical
agreements with Gordon P. Anderson, Jeffrey Blake, John H. Guelcher, Richard H. Heibel, Joseph T. Messina and Douglas T. Halliday, incorporated herein by
reference to Exhibit 10.14 to the Annual Report of the Company
on Form 10-K (File No. 000-27312) filed with the SEC on March 20, 1996 (the 1995 Form 10-K).10.9*
    
    Form of Stock Option Agreement dated December 14, 1995 and December 29, 1995 for Non-Statutory Stock Options granted under the 1995 Long-Term Incentive
Compensation Plan, incorporated herein by reference to Exhibit 10.15 to the Annual Report of the Company on Form 10-K (File No. 000-27312), filed with the
SEC on March 19, 1997 (the 1996 Form 10-K).10.10*
    
    Form of Stock Option Agreement for Non-Statutory Stock Options granted under the 1995 Long-Term Incentive Compensation Plan, incorporated herein by
reference to Exhibit 10.2 to the Quarterly Report of the Company on Form 10-Q (File No. 000-27312), filed with the SEC on November 12, 1996.10.11
    
    Amendment, dated February 21, 1997, to Technical Information Agreement relating to Metallic Channel Units Types A and B, dated February 1,1993, between
American Telephone and Telegraph Company (AT&T) (licensor) and the Company (licensee) incorporated herein by reference to Exhibit 10.3 to the Quarterly
Report of the Company on Form 10-Q (File No. 000-27312), filed with the SEC on November 10, 1997.
 - 58 -




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##### Table of Contents



ExhibitNumber
    
    Description10.12*
    
    Form of Non-employee Director Stock Option Agreement with respect to the Companys 1995 Long-Term Incentive Compensation Plan, incorporated herein by
reference to Exhibit 10.25 to the Annual Report of the Company on Form 10-K (File No. 000-27312) filed with the SEC on March 25, 1998 (the 1997 Form
10-K).10.13*
    
    Change in Control Agreement, entered into February 9, 2000 between the Company and Sara M. Antol, together with a schedule listing substantially identical
agreements with Robert Cornelia, Ruth Dilts, Bradley Dinger, Rocco Flamino, Mark Frey, Samuel Knoch, James Price, and Matthew Rosgone, incorporated herein
by reference to Exhibit 10.26 to the Annual Report of the Company on Form 10-K (File No. 000-27312) filed with the SEC on March 27, 2000 (the 1999 Form
10-K).10.14*
    
    Change in Control Agreement, entered into August 10, 2000 between the Company and Stephen M. Garda, incorporated herein by reference to Exhibit 10.30 to the
Quarterly Report of the Company on Form 10-Q (File No. 000-27312), filed with the SEC on November 13, 2000.10.15*
    
    Change in Control Agreement, entered into January 19, 2001 between the Company and Joseph G. OBrien, together with a schedule listing substantially
identical agreements with Lawrence J. Fey, William J. Gumbert, Gary L. Gump, Michael D. McSparrin, Timothy D. OBrien, Mark B. Peterson, Roger A. Smith and
Jeffrey J. Tatusko, incorporated herein by reference to Exhibit 10.24 to the Annual Report of the Company on Form 10-K (File No. 000-27312) filed with the
SEC on March 23, 2001 (the  2000 Form 10-K).10.16*
    
    1998 Employee Incentive Compensation Plan, amended and restated as of January 24, 2002, incorporated herein by reference to Exhibit 10.25 to the Annual
Report of the Company on Form 10-K (File No. 000-27312), filed with the SEC on March 22, 2002 (the 2001 Form 10-K).10.17
    
    Asset Purchase Agreement by and between Lucent Technologies, Inc. and Tollgrade Communications, Inc. dated September 28, 2001, incorporated herein by
reference to Exhibit 2.1 to the Current Report of the Company on Form 8-K (File No. 000-27312) filed with the SEC on October 15, 2001.10.18*
    
    Change in Control Agreement, entered into October 30, 2001 between the Company and Richard Skaare, together with a schedule listing substantially identical
agreements with Wylie Etscheid, Carol M. Franklin and Gregory Quiggle, incorporated herein by reference to Exhibit 10.28 to the 2001 Form 10-K.10.19*
    
    Change in Control Agreement, entered into January 2, 2002 between the Company and Charles L. Geier, Jr., incorporated herein by reference to Exhibit 10.29
to the 2001 Form 10-K.10.20*
    
    Change in Control Agreement, entered into January 2, 2002 between the Company and James D. Coleman, incorporated herein by reference to Exhibit 10.30 to the
2001 Form 10-K.10.21*
    
    Change in Control Agreement, entered into December 20, 2002 between the Company and Eric Sucharski, incorporated herein by reference to Exhibit 10.29 of the
Annual Report of the Company on Form 10-K (File No. 000-27312) filed with the SEC on March 26, 2003 (the  2002 Form 10-K).10.22
    
    Purchase and Sale Agreement, entered into February 13, 2003, between the Company and Acterna, LLC, incorporated herein by reference to Exhibit 2.1 to the
Current Report of the Company on Form 8-K (File No. 000-27312), filed with the SEC on February 27, 2003.10.23
    
    Lease, dated February 18, 2003, between Lakewood Ranch Properties, L.L.C. and the Company, incorporated herein by reference to Exhibit 10.32 to the 2002 Form
10-K.10.24
    
    Lease and Lease Agreement, dated as of October 24, 2001, between Route 206 Associates and the Company (as successor by merger to Tollgrade Acquisition
Company), incorporated herein by reference to Exhibit 10.33 to the 2002 Form 10-K.10.25
    
    Lease Agreement, dated as of August 5, 1993, between Regional Industrial Development Corporation of Southwestern Pennsylvania and the Company, incorporated
herein by reference to Exhibit 10.34 to the 2002 Form 10-K.10.26
    
    First Amendment of Lease Agreement, dated as of March 15, 1994, between Regional Industrial Development Corporation of Southwestern Pennsylvania and the
Company, incorporated herein by reference to Exhibit 10.35 to the 2002 Form 10-K.10.27
    
    Second Amendment of Lease Agreement, dated as of July 1, 1994, between Regional Industrial Development Corporation of Southwestern Pennsylvania and the
Company, incorporated herein by reference to Exhibit 10.36 to the 2002 Form 10-K.10.28
    
    Third Amendment of Lease Agreement, dated as of September 15, 1994, between Regional Industrial Development Corporation of Southwestern Pennsylvania and the
Company, incorporated herein by reference to Exhibit 10.37 to the 2002 Form 10-K.10.29
    
    Fourth Amendment of Lease Agreement, dated as of September 15, 1994, between Regional Industrial Development Corporation of Southwestern Pennsylvania and the
Company, incorporated herein by reference to Exhibit 10.38 to the 2002 Form 10-K.10.30
    
    Fifth Amendment of Lease Agreement, dated as of March 6, 1995, between Regional Industrial Development Corporation of Southwestern Pennsylvania and the
Company, incorporated herein by reference to Exhibit 10.39 to the 2002 Form 10-K.
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##### Table of Contents



ExhibitNumber
    
    Description10.31
    
    Sixth Amendment to Lease, dated as of September 18, 1995, between Regional Industrial Development Corporation of Southwestern Pennsylvania and the Company,
incorporated herein by reference to Exhibit 10.40 to the 2002 Form 10-K.10.32
    
    Seventh Amendment to Lease, dated as of July 9, 1996, between Regional Industrial Development Corporation of Southwestern Pennsylvania and the Company,
incorporated herein by reference to Exhibit 10.41 to the 2002 Form 10-K10.33
    
    Eighth Amendment to Lease, dated as of May 13, 1997, between Regional Industrial Development Corporation of Southwestern Pennsylvania and the Company,
incorporated herein by reference to Exhibit 10.42 to the 2002 Form 10-K.10.34
    
    Ninth Amendment to Lease, dated as of December 8, 1998, between Regional Industrial Development Corporation of Southwestern Pennsylvania and the Company,
incorporated herein by reference to Exhibit 10.43 to the 2002 Form 10-K.10.35
    
    Tenth Amendment to Lease, dated as of March 15, 2000, between Regional Industrial Development Corporation of Southwestern Pennsylvania and the Company,
incorporated herein by reference to Exhibit 10.44 to the 2002 Form 10-K.10.36
    
    Eleventh Amendment to Lease, dated as of July 19, 2000, between Regional Industrial Development Corporation of Southwestern Pennsylvania and the Company
(exhibits omitted), incorporated herein by reference to Exhibit 10.45 to the 2002 Form 10-K.10.37
    
    Supply Agreement, dated July 25, 2002, between Tollgrade Communications, Inc. (as successor in interest to Acterna Cable Networks Division) and the
Electronic Manufacturing Services Division of Dictaphone Corporation (the Supply Agreement)(exhibits omitted), filed as Exhibit 10.45 to the Annual Report
of the Company on Form 10-K (File No. 000-27312), filed with the SEC on March 15, 2004 ( the 2003 Form 10-K).10.38
    
    Extension Agreement dated July 21, 2004 to Supply Agreement, filed as Exhibit 10.56 to the Quarterly Report on Form 10-Q of the Company (file No.
000-27312), filed with the SEC on November 2004 (the Third Quarter 2004 10-Q).10.39
    
    Second Extension Agreement dated August 16, 2004 to the Supply Agreement, filed as Exhibit 10.57 to the Third Quarter 2004 10-Q.10.40
    
    Third Extension Agreement dated September 23, 2004 to the Supply Agreement, filed as Exhibit 10.58 to the Third Quarter 2004 10-Q.10.41
    
    Fourth Extension Agreement dated December 14, 2004 to the Supply Agreement, filed herewith.10.42*
    
    Agreement entered into as of January 17, 2005 between the Company and Christian L. Allison, filed as Exhibit 10.1 to the Report on Form 8-K, (File No.
000-27312), filed with the SEC on January 21, 2005.10.48*
    
    Change in Control Agreement dated as of June 18, 2004, by and between the Company and Sean M. Reilly, filed as Exhibit 10.48 to the Quarterly Report of the
Company on Form 10-Q (File No. 000-27312), filed with the SEC on August 5, 2004 (the Second Quarter 2004 10-Q).10.49*
    
    Extension and Amendment of Agreement, dated as of February 4, 2004, between the Company and Sara M. Antol, filed as Exhibit 10.49 to the Second Quarter 2004
10-Q.10.50*
    
    Extension and Amendment of Agreement, dated as of February 8, 2004, between the Company and Ruth Dilts, filed as Exhibit 10.50 to the Second Quarter 2004
10-Q.10.51*
    
    Extension and Amendment of Agreement, dated as of February 8, 2004, between the Company and Samuel C. Knoch, filed as Exhibit 10.51 to the Second Quarter
2004 10-Q.10.52*
    
    Extension and Amendment of Agreement, dated as of February 8, 2004, between the Company and Matthew J. Rosgone, filed as Exhibit 10.53 to the Second Quarter
2004 10-Q.10.53*
    
    Extension and Amendment of Agreement, dated as of February 8, 2004, between the Company and Steven M. Garda, filed as Exhibit 10.54 to the Second Quarter
2004 10-Q.10.54*
    
    Change in Control Agreement dated as of August 19, 2004, by and between the Company and Jennifer M. Reinke, filed as Exhibit 10.55 to the Third Quarter 2004
10-Q.21.1
    
    List of subsidiaries of the Company, filed herewith.23.1
    
    Consent of PricewaterhouseCoopers LLP, filed herewith.31.1
    
    Certification of Chief Executive Officer, filed herewith.31.2
    
    Certification of Chief Financial Officer, filed herewith.32
    
    Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 350.
   *
    
    Management contract or compensatory plan, contract or arrangement required to be filed by Item
601(b)(10)(iii) of Regulation S-K. - 60 -




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##### Table of Contents



Copies of the exhibits filed as part of this Form 10-K are available at a cost of $.20 per
page to any shareholder of record upon written request to the Secretary, Tollgrade Communications,
Inc., 493 Nixon Road, Cheswick, Pennsylvania 15024.  (b)
    Reports on Form 8-K filed during the quarter ended December 31, 2004:A Report on Form 8-K was filed on October 21, 2004 which contained as an exhibit the Companys
Earnings Release for the third quarter of 2004.A Report on Form 8-K was filed on October 22, 2004 which contained as an exhibit the
transcript of the conference call for the third quarter 2004 Earnings Release.A Report on Form 8-K was filed on November 10, 2004 pursuant to Regulation FO (17 CFR
243.100-243.103) which contained as an exhibit a investor presentation.A Report on Form 8-K/A was filed on November 10, 2004 to amend an erroneous submission
heading.®EDGE is a registered trademark of Tollgrade Communications, Inc.
LoopCare is a trademark of Tollgrade Communications, Inc.
Cheetah is a trademark of Tollgrade Communications, Inc.
®DigiTest is a registered trademark of Tollgrade Communications, Inc.
®MCU is a registered trademark of Tollgrade Communications, Inc.
®DOCSIS is a registered trademark of Cable Television Laboratories, Inc.
All other trademarks are the property of their respective owners. - 61 -




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the
Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized as of February 28, 2005. TOLLGRADE COMMUNICATIONS, INC.By   /s/Mark B. PetersonMark B. PetersonChief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the Company and in the capacities indicated as
of February 28, 2005. Signature
    
    Title/s/Mark B. Peterson
    
    Chief Executive OfficerMark B. Peterson
    
    (Principal Executive Officer)/s/James J. Barnes
    
    DirectorJames J. Barnes/s/Daniel P. Barry
    
    DirectorDaniel P. Barry/s/David S. Egan
    
    DirectorDavid S. Egan/s/Richard H. Heibel, M.D.
    
    DirectorRichard H. Heibel, M.D./s/Robert W. Kampmeinert
    
    DirectorRobert W. Kampmeinert/s/Brian C. Mullins
    
    DirectorBrian C. Mullins/s/Samuel C. Knoch
    
    Chief Financial Officer and TreasurerSamuel C. Knoch
    
    (Principal Financial Officer)/s/Sean M. Reilly
    
    ControllerSean M. Reilly
    
    (Principal Accounting Officer)
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EXHIBIT INDEX
(Pursuant to Item 601 of Regulation S-K) ExhibitNumber
    
    Description3.1
    
    Amended and Restated Articles of Incorporation of the Company, as amended through May 6, 1998
(conformed copy), incorporated herein by reference to Exhibit 3.1 to the Annual Report of Tollgrade
Communications, Inc. (the Company) on Form 10-K (File No. 000-27312), filed with the Securities and
Exchange Commission (the SEC) on March 24, 1999 (the 1998 Form 10-K).3.1a
    
    Statement with Respect to Shares dated July 23, 1996 (conformed copy), incorporated herein by reference
to Exhibit 3.1a to the 1998 Form 10-K.3.2
    
    Amended and Restated Bylaws of the Company, incorporated herein by reference to Exhibit 3(ii) to the
Form on 8-K (File No. 000-27312), filed with the SEC on January 21, 2005.4.1
    
    Rights Agreement, dated as of July 23, 1996 between the Company and Chase Mellon Shareholder Services,
L.L.C., filed as Exhibit 1 to the Registration Statement of the Company on Form 8-A (File No.
000-28852), filed with the SEC on August 9, 1996.10.1*
    
    1995 Long-Term Incentive Compensation Plan, amended and restated as of January 24, 2002, incorporated
herein by reference to Exhibit B to the 2002 Proxy Statement of the Company (File No. 000-27312), filed
with the SEC on March 22, 2002.10.2
    
    License Agreement, dated August 24, 1993, between Fujitsu Network Transmission Systems, Inc. and the
Company, incorporated herein by reference to Exhibit 10.4 to the S-1.10.3
    
    License Agreement, dated September 26, 1994, between Zhone Technologies, Inc. (as successor in interest
to NEC America, Inc.) and the Company, incorporated herein by reference to Exhibit 10.5 to the S-1.10.4
    
    Interface License Agreement, dated March 22, 1995, between Northern Telecom Inc. and the Company,
incorporated herein by reference to Exhibit 10.7 to the S-1.10.5
    
    Technical Information Agreement, dated February 1, 1993, between Lucent Technologies, Inc. (formerly
American Telephone and Telegraph Company) and the Company, incorporated herein by reference to Exhibit
10.8 to the S-1.10.6
    
    Technology License Agreement, dated November 16, 1994, between Alcatel USA (formerly DSC Technologies
Corporation) and the Company, incorporated herein by reference to Exhibit 10.12 to the S-1.10.7
    
    License Agreement, dated August 24, 1993, between Marconi Communications, Inc. (formerly Reliance
Comm/Tec Corporation) and the Company, incorporated herein by reference to Exhibit 10.13 to the S-1.10.8
    
    Stock Option Agreement entered into December 14, 1995 between the Company and R. Craig Allison,
together with a schedule listing substantially identical agreements with Gordon P. Anderson, Jeffrey
Blake, John H. Guelcher, Richard H. Heibel, Joseph T. Messina and Douglas T. Halliday, incorporated
herein by reference to Exhibit 10.14 to the Annual Report of the Company on Form 10-K (File No.
000-27312) filed with the SEC on March 20, 1996 (the 1995 Form 10-K).10.9
    
    Form of Stock Option Agreement dated December 14, 1995 and December 29, 1995 for Non-Statutory Stock
Options granted under the 1995 Long-Term Incentive Compensation Plan, incorporated herein by reference
to Exhibit 10.15 to the Annual Report of the Company on Form 10-K (File No. 000-27312), filed with the
SEC on March 19, 1997) (the 1996 Form 10-K).10.10
    
    Form of Stock Option Agreement for Non-Statutory Stock Options granted under the 1995 Long-Term
Incentive Compensation Plan, incorporated herein by reference to Exhibit 10.2 to the Quarterly Report
of the Company on Form 10-Q (File No. 000-27312) filed with the SEC on November 12, 1996.10.11
    
    Amendment, dated February 21, 1997, to Technical Information Agreement relating to Metallic Channel
Units Types A and B, dated February 1,1993, between American Telephone and Telegraph Company (AT&T)
(licensor) and the Company (licensee) incorporated herein by reference to Exhibit 10.3 to the Quarterly
Report of the Company on Form 10-Q (File No. 000-27312), filed with the SEC on November 10, 1997.10.12
    
    Form of Non-employee Director Stock Option Agreement with respect to the Companys 1995 Long-Term
Incentive Compensation Plan, incorporated herein by reference to Exhibit 10.25 to Annual Report of the
Company on Form 10-K (File No. 000-27312) filed with the SEC on March 25, 1998 (the 1997 Form 10-K).10.13
    
    Change in Control Agreement, entered into February 9, 2000 between the Company and Sara M. Antol,
together with a schedule listing substantially identical agreements with Robert Cornelia, Ruth Dilts,
Bradley Dinger, Rocco Flamino, Mark Frey, Samuel Knoch, James Price, and Matthew Rosgone, incorporated
herein by reference to Exhibit 10.26 to the Annual Report of the Company on Form 10-K (File No.
000-27312) filed with the SEC on
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##### Table of Contents



ExhibitNumber
    
    DescriptionMarch 27, 2000 (the 1999 Form 10-K).10.14
    
    Change in Control Agreement, entered into August 10, 2000 between the Company and Stephen M. Garda,
incorporated herein by reference to Exhibit 10.30 to the Quarterly Report of the Company on Form 10-Q
(File No. 000-27312), filed with the SEC on November 13, 2000.10.15
    
    Change in Control Agreement, entered into January 19, 2001 between the Company and Joseph G. OBrien,
together with a schedule listing substantially identical agreements with Lawrence J. Fey, William J.
Gumbert, Gary L. Gump, Michael D. McSparrin, Timothy D. OBrien, Mark B. Peterson, Roger A. Smith and
Jeffrey J. Tatusko, incorporated herein by reference to Exhibit 10.24 to the Annual Report of the
Company on Form 10-K (File No. 000-27312) filed with the SEC on March 23, 2001 (the 2000 Form 10-K).10.16
    
    1998 Employee Incentive Compensation Plan, amended and restated as of January 24, 2002, incorporated
herein by reference to Exhibit 10.25 to the Annual Report of the Company on Form 10-K (File No.
000-27312), filed with the SEC on March 22, 2002 (the 2001 Form 10-K).10.17
    
    Asset Purchase Agreement by and between Lucent Technologies, Inc. and Tollgrade Communications, Inc.
dated September 28, 2001, incorporated herein by reference to Exhibit 2.1 to the Current Report of the
Company on Form 8-K (File No. 000-27312), filed with the SEC on October 15, 2001.10.18
    
    Change in Control Agreement, entered into October 30, 2001 between the Company and Richard Skaare,
together with a schedule listing substantially identical agreements with Wylie Etscheid, Carol M.
Franklin and Gregory Quiggle, incorporated herein by reference to Exhibit 10.28 to the 2001 Form 10-K.10.19
    
    Change in Control Agreement, entered into January 2, 2002 between the Company and Charles L. Geier,
Jr., incorporated herein by reference to Exhibit 10.29 to the 2001 Form 10-K.10.20
    
    Change in Control Agreement, entered into January 2, 2002 between the Company and James D. Coleman,
incorporated herein by reference to Exhibit 10.30 to the 2001 Form 10-K.10.21
    
    Change in Control Agreement, entered into December 20, 2002 between the Company and Eric Sucharski,
incorporated herein by reference to Exhibit 10.29 of the Annual Report of the Company on Form 10-K
(File No. 000-27312) filed with the SEC on March 26, 2003 (the 2002 Form 10-K).10.22
    
    Purchase and Sale Agreement, entered into February 13, 2003, between the Company and Acterna, LLC,
incorporated herein by reference to Exhibit 2.1 to the Current Report of the Company on Form 8-K (File
No. 000-27312), filed with the SEC on February 27, 2003.10.23
    
    Lease, dated February 18, 2003, between Lakewood Ranch Properties, L.L.C. and the Company, incorporated
herein by reference to Exhibit 10.32 to the 2002 Form 10-K.10.24
    
    Lease and Lease Agreement, dated as of October 24, 2001, between Route 206 Associates and Tollgrade
Acquisition Company (as successor by merger to Tollgrade Acquisition Company), incorporated herein by
reference to Exhibit 10.33 to the 2002 Form 10-K.10.25
    
    Lease Agreement, dated as of August 5, 1993, between Regional Industrial Development Corporation of
Southwestern Pennsylvania and the Company, incorporated herein by reference to Exhibit 10.34 to the
2002 Form 10-K.10.26
    
    First Amendment of Lease Agreement, dated as of March 15, 1994, between Regional Industrial Development
Corporation of Southwestern Pennsylvania and the Company, incorporated herein by reference to Exhibit
10.35 to the 2002 Form 10-K.10.27
    
    Second Amendment of Lease Agreement, dated as of July 1, 1994, between Regional Industrial Development
Corporation of Southwestern Pennsylvania and the Company, incorporated herein by reference to Exhibit
10.36 to the 2002 Form 10-K.10.28
    
    Third Amendment of Lease Agreement, dated as of September 15, 1994, between Regional Industrial
Development Corporation of Southwestern Pennsylvania and the Company, incorporated herein by reference
to Exhibit 10.37 to the 2002 Form 10-K.10.29
    
    Fourth Amendment of Lease Agreement, dated as of September 15, 1994, between Regional Industrial
Development Corporation of Southwestern Pennsylvania and the Company, incorporated herein by reference
to Exhibit 10.38 to the 2002 Form 10-K.10.30
    
    Fifth Amendment of Lease Agreement, dated as of March 6, 1995, between Regional Industrial Development
Corporation of Southwestern Pennsylvania and the Company, incorporated herein by reference to Exhibit
10.39 to the 2002 Form 10-K.10.31
    
    Sixth Amendment to Lease, dated as of September 18, 1995, between Regional Industrial Development
Corporation of Southwestern Pennsylvania and the Company, incorporated herein by reference to Exhibit
10.40 to the 2002  Form 10-K.10.32
    
    Seventh Amendment to Lease, dated as of July 9, 1996, between Regional Industrial Development
Corporation of Southwestern Pennsylvania and the Company, incorporated herein by reference to Exhibit
10.41 to the 2002 Form 10-K.
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##### Table of Contents



ExhibitNumber
    
    Description10.33
    
    Eighth Amendment to Lease, dated as of May 13, 1997, between Regional Industrial Development
Corporation of Southwestern Pennsylvania and the Company, incorporated herein by reference to Exhibit
10.42 to the 2002 Form 10-K.10.34
    
    Ninth Amendment to Lease, dated as of December 8, 1998, between Regional Industrial Development
Corporation of Southwestern Pennsylvania and the Company, incorporated herein by reference to Exhibit
10.43 to the 2002 Form 10-K.10.35
    
    Tenth Amendment to Lease, dated as of March 15, 2000, between Regional Industrial Development
Corporation of Southwestern Pennsylvania and the Company, incorporated herein by reference to Exhibit
10.44 to the 2002 Form 10-K.10.36
    
    Eleventh Amendment to Lease, dated as of July 19, 2000, between Regional Industrial Development
Corporation of Southwestern Pennsylvania and the Company (exhibits omitted), incorporated herein by
reference to Exhibit 10.45 to the 2002 Form 10-K.10.37
    
    Supply Agreement, dated July 25, 2002, between Tollgrade Communications, Inc. (as successor in interest
to Acterna Cable Networks Division) and the Electronic Manufacturing Services Division of Dictaphone
Corporation (the Supply Agreement)(exhibits omitted), filed as Exhibit 10.45 to the Annual Report of
the Company on Form 10-K (File No, 000-27312) filed with the SEC on March 15, 2004 (the 2003 Form
10-K).10.38
    
    Extension Agreement dated July 21, 2004 to the Supply Agreement, filed as Exhibit 10.56 to the
Quarterly Report on Form 10-Q of the Company (File No. 000-27312), filed with the SEC on November 2004
(the Third Quarter 2004 10-Q).10.39
    
    Second Extension Agreement dated August 16, 2004 to the Supply Agreement, filed as Exhibit 10.57 to the
Third Quarter 2004 10-Q.10.40
    
    Third Extension Agreement dated September 23, 2004 to the Supply Agreement, filed as Exhibit 10.58 to
the Third Quarter 2004 10-Q.10.41*
    
    Fourth Extension Agreement dated December 14, 2004 to the Supply Agreement, filed herewith.10.42
    
    Agreement entered into as of January 17, 2005 between the Company and Christian L. Allison, filed as
Exhibit 10.1 to the Report on Form 8-K, (File No. 000-27312), filed with the SEC on January 21, 2005.10.48
    
    Change in Control Agreement dated as of June 18, 2004, by and between the Company and Sean M. Reilly,
filed as Exhibit 10.48 to the Quarterly Report of the Company on Form 10-Q (File No. 000-27312), filed
with the SEC on August 5, 2004 (the Second Quarter 2004 10-Q).10.49
    
    Extension and Amendment of Agreement, dated as of February 4, 2004, between the Company and Sara M.
Antol, filed as Exhibit 10.49 to the Second Quarter 2004 10-Q.10.50
    
    Extension and Amendment of Agreement, dated as of February 4, 2004, between the Company and Ruth Dilts,
filed as Exhibit 10.50 to the Second Quarter 2004 10-Q.10.51
    
    Extension and Amendment of Agreement, dated as of February 8, 2004, between the Company and Samuel C.
Knoch, filed as Exhibit 10.51 to the Second Quarter 2004 10-Q.10.52
    
    Extension and Amendment of Agreement, dated as of February 8, 2004, between the Company and Matthew J.
Rosgone, filed as Exhibit 10.53 to the Second Quarter 2004 10-Q.10.53
    
    Extension and Amendment of Agreement, dated as of February 8, 2004, between the Company and Steven M.
Garda, filed as Exhibit 10.54 to the Second Quarter 2004 10-Q.10.54
    
    Change in Control Agreement dated as of August 19, 2004, by and between the Company and Jennifer M.
Reinke, filed as Exhibit 10.55 to the Third Quarter 2004 10-Q.21.1
    
    List of subsidiaries of the Company.23.1
    
    Consent of PricewaterhouseCoopers LLP.31.1
    
    Certification of Chief Executive Officer.31.2
    
    Certification of Chief Financial Officer.32
    
    Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 350.
   *
    
    Filed herewith - 65 -