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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, 2006******Commission file number 000-27312****TOLLGRADE COMMUNICATIONS, INC.**(Exact name of registrant as specified in its charter)   **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(b) of the Act:**   **Common Stock, par value $.20 per share** **The NASDAQ Stock Market LLC**(Title of Class) (Exchange on which registered)Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.Yes o    No þIndicate by check mark if the registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act.Yes o    No þIndicate by a check mark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.Yes þ    No oIndicate 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 ofregistrant’s knowledge, in definitive proxy or information statements incorporated by reference inPart III of this Form 10-K or any amendment to this Form 10-K. Yes o    No þIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act. (Check one):Large accelerated filer o       Accelerated filer þ      Non-accelerated filer oIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).Yes o    No þTheaggregate market value of the voting and non-voting Common Stock ofthe registrant held by non-affiliates of the registrant, calculatedbased on the closing price as of June 30, 2006 on the NASDAQNational Market, was approximately $125,785,000.As of January 31, 2007, the registrant had outstanding 13,246,974 shares of its Common Stock.**DOCUMENTS INCORPORATED BY REFERENCE**     Part of Form 10-K into whichDocument Document is incorporated   Portions of the Proxy Statement to be distributed in   connection with the 2007 Annual Meeting of Shareholders III  
 

 
**TABLE OF CONTENTS**     **Part I**         Item 1. Business   4      Item 1A. Risk Factors   11      Item 1B. Unresolved Staff Comments   17      Item 2. Properties   17      Item 3. Legal Proceedings   17      Item 4. Submission of Matters to a Vote of Security Holders   17      **Part II**         Item 5. Market for the Registrant’s Common Stock, Related Security Holder Mattersand Issuer Purchases of Equity Securities   17      Item 6. Selected Financial Data   19      Item 7. Management’s Discussion and Analysis of Financial Condition and Results ofOperations   20      Item 7A. Quantitative and Qualitative Disclosures About Market Risk   35      Item 8. Financial Statements and Supplementary Data   36      Item 9. Changes in and Disagreements with Accountants on Accounting and FinancialDisclosure   60      Item 9A. Controls and Procedures   60      Item 9B. Other Information   60      **Part III**         Item 10. Directors, Executive Officers and Corporate Governance   61      Item 11. Executive Compensation   61      Item 12. Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters   61      Item 13. Certain Relationships and Related Transactions and Director Independence   62      Item 14. Principal Accounting Fees and Services   62      **Part IV**         Item 15. Exhibits and Financial Statement Schedules   62      SIGNATURES   65  EX-21.1 EX-23.1 EX-31.1 EX-31.2 EX-32
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**PART I***CAUTIONARY STATEMENT FOR PURPOSES OF THE “SAFE HARBOR” PROVISIONS OF THE PRIVATESECURITIES LITIGATION REFORM ACT OF 1995.*The statements contained in this Annual Report on Form 10-K of Tollgrade Communications, Inc.(“Tollgrade,” the “Company,” “us,” or “we”), including, but not limited to those contained in Item1, “Business,” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations,” along with statements in other reports filed with the Securities and ExchangeCommission (the “SEC”), external documents and oral presentations, which are not historical factsare considered to be “forward-looking statements” within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, asamended. These statements, which may be expressed in a variety of ways, including the use offorward-looking terminology such as “believes,” “expects,” “may,” “will,” “should,” “estimates,”“plans,” or “anticipates,” or the negatives thereof, other variations thereon or compatibleterminology, relate to, among other things, the inability to complete sales, or possible delays indeployment, of products under international projects due to inability to complete or possibledelays in completing the legal and commercial terms for such projects, project delays orcancellations, political instability, inability to obtain proper acceptances or other unforeseenobstacles or delays, projected cash flows which are used in the valuation of intangible assets, theanticipated results of negotiations for purchase orders and other customer purchase agreements, ourability to utilize current deferred and refundable tax assets, service opportunities offered tocustomers, the potential loss of certain customers, the timing of orders from customers, includingthe timing of international sales, the effect of consolidations in the markets to which Tollgradesells, the effects of the economic slowdown in the telecommunications and cable industries, thepossibility of future provisions for slow moving inventory, the Company’s expectations with regardto its contract manufacturer, and the effect on earnings and cash flows of changes in interestrates. 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 publicdisclosures of the Company which make reference to the cautionary factors contained in this Form10-K, are based on assumptions that involve risks and uncertainties and are subject to change basedon the considerations described below. We discuss many of these risks and uncertainties in greaterdetail in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.” These andother risks and uncertainties may cause our actual results, performance or achievements to differmaterially from anticipated future results, performance or achievements expressed or implied bysuch forward-looking statements.     The following discussion should be read in conjunction with our “Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” and our financial statements andrelated notes contained in this Annual Report on Form 10-K.**Item 1. Business.**     Tollgrade designs, engineers, markets and supports test system, test access and statusmonitoring products and test software for the telecommunications and cable television industries inthe United States and in certain international markets. The Company’s telecommunicationsproprietary test access products enable telephone companies to use their existing line test systemsto remotely diagnose problems in Plain Old Telephone Service (“POTS”) lines containing both copperand 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 theability to pre-qualify, deploy and maintain services offerings including Digital Subscriber Line(“DSL”) service. The Company’s cable products consist of a complete cable status monitoring systemthat provides a comprehensive testing solution for the Broadband Hybrid Fiber Coax distributionsystem. The status monitoring system consists of a host for user interface, control andconfiguration; a headend controller for managing network communications; and transponders that arestrategically located within the cable network to gather status reports from power supplies, lineamplifiers and fiber-optic nodes.     We were incorporated in Pennsylvania in 1986, began operations in 1988 and completed ourinitial 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 annualreports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and allamendments to those reports filed or furnished pursuant to Section 13(a) of the Securities ExchangeAct of 1934, as amended, as soon as reasonably practicable after we electronically file suchmaterial with, or otherwise furnish it to, the SEC.**Products*****Telecommunication Test Systems***     Our proprietary telecommunications test and measurement products enable telephone companies touse their existing line test systems to remotely diagnose problems in POTS lines containing bothcopper and fiber optics as well as qualify and troubleshoot broadband DSL and IP services. POTSlines provide traditional voice service as well as connections for communication devices such ascomputer modems and fax machines. POTS excludes non-switched and private lines, such as datacommunications service lines, commonly referred to as “special services.” POTS lines stillcomprise 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, diagnoseand locate any problems within the network. POTS line test systems are generally located attelephone companies’ central offices, and help local exchange carriers conduct a full range offault diagnostics in the “local loop,” the portion of the telephone network that connects end usersto the central
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office. In addition, line test systems provide the capability to remotely qualify, deploy andmaintain services such as DSL and Integrated Services Digital Network (“ISDN”) services which arecarried over POTS lines. These test systems reduce the time needed to identify and resolveproblems, eliminating or reducing the costs of dispatching a technician to the problem site. MostPOTS line test systems, however, were designed only for use over copper wire line; as a result,traditional test systems could not access local loops in which fiber-optic technology had beenintroduced.     Our legacy MCUâ products solved this problem by mimicking a digital bypass pair, whichis essentially a telephone circuit that connects central test and measurement devices to the coppercircuits close to the customer, known as “the last mile.” We believe our DigiTest® systemrepresents the future of telecommunication network testing, combining our line test system with anext generation test platform to provide complete hardware testing for POTS and local loopprequalification and in-service testing for DSL service.*DigiTest® and LoopCareTM ; N(x) TestTM, N(x) DSL-3TM and LTSCTM*     Our DigiTest product family, including DigiTest EDGE®, DigiTest HUBTM, and DigiTest ICETM,electrically measures the characteristics and connection performance of copper POTS and broadbandcircuits and reports those measurements to our LoopCare Operation Support System (“OSS”). TheLoopCare OSS, in turn, analyzes that measurement data and creates an easy-to-understand faultdescription. At the same time, the LoopCare system can generate a dispatch to a work center sothat a repairman can fix the problem. The DigiTest product family can also serve as a replacementfor aging Loop Test System (“LTS”) equipment ubiquitously deployed in current POTS networks. Inaddition, LoopCare and the DigiTest product family can be used to prequalify, verify installation,and remotely isolate troubles for various DSL services.     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 networkinfrastructure. The LoopCare OSS, which we offer both as part of the DigiTest system and as astand-alone software product that can interface with other test heads on the market, currentlymanages testing operations for more than 75% of the copper pairs in the United States, and is thequalification, installation and maintenance tool used to troubleshoot more than 150 million POTS,ISDN and DSL subscribers worldwide. We acquired LoopCare from Lucent Technologies Inc. in 2001.     DigiTest EDGE provides a global platform for POTS and broadband test applications, bycombining a narrowband and wideband metallic testing platform with a multi-layered DSL serviceassurance platform. These test capabilities, when managed by our LoopCare OSS, enable serviceproviders to accurately isolate a DSL problem between the customer’s premises, the local exchangecarrier’s local loop and Digital Subscriber Line Access Multiplexer (“DSLAM”) serving network, andthe Internet service provider’s data network.     Our DigiTest product family also includes the DigiTest HUBTM, our next generation centraloffice test platform designed to support multiple testing environments. The DigiTest HUB addressesemerging broadband testing requirements, but also retains interfaces to legacy equipment, allowingfor a seamless migration from traditional to packet-based delivery of services and allowing serviceproviders to continue automated, mass-market processes. The DigiTest HUB is a modular 12-slotchassis for medium to large central office applications from which a variety of services emanate.Plug-in modules can be added, as required to support POTS and DSL Layer 1-7. Test plug-in resourcescan be shared to multiple network elements by the use of a module that multiplexes the test accesspath. This includes sharing a test resource to remote access elements as fiber is driven furtherout into the network in topologies such as FTTx. When coupled with our LoopCare OSS, the DigiTestHUB serves the testing needs of both legacy and evolving broadband networks to facilitate alow-cost, asset-preserving transition.     Our most recent addition to the DigiTest product family is the DigiTest ICE. Optimized fordeployment at remote DSLAM locations, DigiTest ICE provides both metallic and multi-layered DSLtesting to help service providers install and maintain broadband triple play services within theiremerging FTTx networks. We expect this product to be generally available in the third quarter of2007.     We have original equipment manufacturer (“OEM”) agreements in place with Electrodata, Inc., tosupply a communications card for our DigiTest EDGE product, and Comtest Networks, Inc., to providean access device for that product line. These agreements both contain automatic renewal terms,unless earlier terminated. We are also a party to a number of third party software licenseagreements that allow us to incorporate third party software products and features into theLoopCare software.     We have licensing arrangements with Nortel, JDS Uniphase Corporate (formerly, Acterna LLC) andAware, Inc. for certain technology related to our DigiTest products and pay royalties and licensefees for the use of such technology on a fixed per unit basis. The license agreement with JDSUniphase, which was renegotiated in September 2005 as part of settlement of legal disputes, nowcontains limited license rights for specified customers, which licenses expire by their terms in2008, unless earlier terminated. The license agreements with Aware and Nortel contain automaticrenewal terms, unless earlier terminated.     We market and sell our DigiTest products primarily through our direct sales force as well asthrough certain reseller and distributor agreements. Sales of the DigiTest product line (includingsales with LoopCare software) accounted for approximately 23%, 27% and 12% of the Company’s revenuefor the years ended December 31, 2006, 2005 and 2004, respectively.     In addition to the LoopCare OSS software sold as part of the DigiTest system, we also sell newLoopCare features to existing customers and the base LoopCare OSS as a stand-alone product toCompetitive Local Exchange Carriers (“CLECs”) for use with test heads other than our DigiTesthardware. LoopCare feature products include: **•** the Common Object Request Broker Architecture (“CORBA”)-based Application Programming Interface;
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 **•** Benchmark Data Base;  **•** DSL Testing;  **•** the Advanced Testhead Feature Package;  **•** Batch Testing;  **•** Fax Unalert;  **•** Loop Length Reporting;  **•** Enabling Flow Through by Re-Classification of VER 55-58 Codes;  **•** LoopCare TCP/IP Communications Network;  **•** Testing Voice Services in a Broadband Passive Optical Network (“bPON”);  **•** Multi-DSL Prequalification Feature; and  **•** Breakthrough CPE and Fast Answering CPE Suppression.     Sales of stand-alone LoopCare software and enhancements accounted for approximately 3%, 4% and7% of the Company’s revenue for the years ended December 31, 2006, 2005 and 2004, respectively.     On February 24, 2006, Tollgrade acquired certain assets and assumed certain liabilitiesassociated with the test systems business unit of Emerson Network Power, Energy Systems, NorthAmerica, Inc. (“Emerson”). The products purchased were the N(x)Test, N(x)DSL-3, and Line TestSystem Controller (“LTSC”). The N(x)Test product is a modular, subscriber loop measurement unit,which utilizes an open architecture, standard interfaces and Digital Signal Processor (“DSP”)measurement technology. The N(x)Test unit can address broadband testing, standard demand andinteractive testing and OSS-controlled ALT batch processing on subscriber loops, as well asexpanded testing capability related to the pre-qualification of loops for DSL services through thenetwork element. The N(x)DSL-3 test unit provides higher layer testing capability for various DSLservices a customer may deploy. N(x)DSL-3 can be coupled with N(x)Test, providing the ability toconduct a full range of POTS and DSL testing, or used as a stand-alone, DSL-only test head. OurLTSC, Line Test Systems Controller, is a software package with multi-tasking capabilities that canstand alone or become an integrated process to an existing OSS in order to provide a totallyintegrated line testing platform for the customer’s operations. Designed with an open architecture,the LTSC system provides client/server access to the N(x)Test/N(x)DSL-3 systems deployed within thecustomer’s network in order to maintain the Quality of Service for typical POTS as well as DSLservices as the customer migrates towards a next generation network. We sell our N(x)Test productsprimarily through our direct sales force, almost exclusively to customers outside of the UnitedStates. Sales of our N(x)Test product systems accounted for 9% of the Company’s revenue for theyear ended December 31, 2006.*MCU*     Our legacy MCU products plug into Digital Loop Carrier (“DLC”) systems, the large networktransmission systems used by telephone companies to link the copper and fiber-optic portions of thelocal loop. MCU products allow our customers to extend their line testing capabilities to all oftheir POTS lines served by a DLC system regardless of whether the system is fed by a copper orfiber optic link. DLC systems, which are located at telephone companies’ central offices and atremote sites within local user areas, effectively multiplex the services of a single fiber-opticline into multiple copper lines. In many instances, several DLC systems are located at a singleremote site to create multiple local loops that serve several thousand different end-user homes andbusinesses. Generally, for every DLC remote site, customers will deploy at least two MCUline-testing products.     We market and sell our MCU products directly to customers as well as through certain OEMagreements, as described below. To ensure the compatibility of our MCU products with the major DLCsystems produced by various telecommunication equipment manufacturers, we have entered into licenseagreements and, in most cases, pay royalties for the use of the proprietary design integratedcircuits (“PDICs”) unique to each DLC system. We maintain royalty-based PDIC license agreementswith Lucent Technologies, Inc., Fujitsu Network Transmission Systems, Inc., Zhone Technologies,Inc., Tellabs, Inc. (formerly, Advanced Fibre Access Communications) and Adtran, Inc., the terms ofwhich automatically renew (unless earlier terminated) for periods of between one and five years,except for one which has a perpetual term. Under these license agreements, royalties arecalculated either as a percentage of the list price of MCU products sold or as a fixed amount perMCU unit that incorporates the licensed technology. We also maintain PDIC license agreements thatdo not contain royalty provisions with Calix Networks, Inc., Tellabs, Inc., Alcatel USA Sourcing,L.P., UTSTARCOM, Inc., Motorola Wireline Networks, Inc. and SAGEM SA, the terms of whichautomatically renew 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 withPOTS line testing, home alarm systems must be monitored from the alarm company’s headquarters alonga hybrid copper and fiber-optic line. Our alarm-related MCU products, which are installed at bothcentral office and remote locations, facilitate the transport of analog alarm signals fromsubscribers’ homes to alarm company monitoring stations across the hybrid telephone network.     Sales of MCU products and related hardware accounted for approximately 20%, 24% and 33% of ourrevenue for the years ended December 31, 2006, 2005 and 2004, respectively. See Management’sDiscussion and Analysis for a discussion of this trend.***Cable Testing Products***     The Company’s CheetahTM performance and status monitoring products provide a broadnetwork assurance solution for the Broadband Hybrid Fiber Coax (“HFC”) distribution system found inthe cable television industry. Our Cheetah products gather status information and report oncritical components within the cable network.
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*Cheetah Cable Monitoring*     The Company’s monitoring systems include complete hardware and software solutions that enableefficient HFC plant status monitoring. By providing a constant, proactive view of the health andstatus of outside plant transmission systems, the products can reduce operating costs and increasesubscriber satisfaction.     Our cable offerings consist of our proprietary CheetahLightTM (formerly LIGHTHOUSE®) andCheetahNetTM (formerly NetMentorTM) software systems and maintenance, our CheetahXDTM Broadbandassurance software and maintenance, head-end controllers, return path switch hardware, bothproprietary and DOCSIS®-based and Euro-DOCSISTM-based transponders and other equipmentwhich gather status and performance reports from power supplies, line amplifiers and fiber opticnodes.     We have entered into license agreements with C-COR, Alpha Technologies, Inc. (“Alpha”), andGeneral Instrument Corp. d/b/a The Broadband Communications Sector of Motorola, Inc., through whichwe provide status monitoring transponder technology incorporated into those companies’ cablenetwork management systems. In 2003, we also entered into a separate agreement with Alpha, theleading supplier of power management products to the cable industry, initially to serve as theexclusive provider of IP-based, DOCSIS-based status monitoring equipment for its power supplysystems. This agreement contains an initial term which expires in November 2007 and automaticallyrenews on an annual basis thereafter unless terminated. In November 2005, this agreement wasmodified to make our right to sell the external version of the product to Alpha non-exclusive,while allowing us to sell that product directly to end customers. Since the modification of thisagreement, we have experienced a decline in orders of DOCSIS-based transponders from Alpha, as theyhave also expanded their transponder purchases from the Company’s competitors. This decline hasbeen partially offset by an increase in direct sales of our DOCSIS-based transponders to customers.We also have a number of third party software license agreements that allow us to incorporate thirdparty software products and features into our Cheetah product offerings.     We have licensing arrangements with Telchemy Incorporated, Wind River Systems, Inc. andAdventNet, Inc. for certain technology related to our cable products and pay royalties and licensefees for the use of such technology on a fixed per unit basis.*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 overInternet Protocol (“VoIP”) and Video on Demand (“VoD”) using hardware test probes and softwareanalysis tools.     We also have a reseller agreement with Brix Networks, Inc. under which we are able to purchasehardware and software for the cable broadband market. This agreement contains an initial termwhich expires in September 2008 and automatically renews on an annual basis thereafter, unlessearlier terminated. We also have a license agreement which expires in 2009 with a third partysoftware vendor for a perpetual right to use certain VoIP technology on an exclusive basis, forcertain applications.     On June 6, 2006 we entered into an interoperability and co–marketing agreement with MinacomLabs, Inc. (“Minacom”) (which was assigned to Tektronix Canada Inc. upon its acquisition ofMinacom). Additionally, on October 24, 2006, we entered into a reseller agreement with Minacom (nowTektronix) that gives Tollgrade a non-exclusive right to sell certain VoIP Testing hardware andsoftware in Mexico and Central America. Both agreements are for one year and automatically renewannually.     Sales of the Cheetah product line (excluding Services) accounted for approximately 25%, 24%and 27% of the Company’s revenue for the years ended December 31, 2006, 2005 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’ test systems operateproperly. Including software maintenance, Services revenue accounted for approximately 20%, 21%and 21% of the Company’s revenue for the years ended December 31, 2006, 2005 and 2004,respectively.**Operating Segment**     We have determined that our business has one operating segment, test assurance. All productsales relate to the business of testing infrastructure and networks for the telecommunications andcable industries. Our products have similar production processes, and are sold through comparabledistribution channels and means to similar types and classes of customers already in, or enteringinto, the telecommunications and cable businesses. Operating results are regularly reviewed by theCompany’s chief operating decision maker regarding decisions about the allocation of resources andto assess performance.**Sales and Competition**     We market our products and services primarily through our direct sales organization withoffices in Cheswick, Pennsylvania. Additionally, we have a growing channel of OEMs, value-addedresellers and distributors, both domestic and international.***Revenue Concentrations***     The primary customers for our telecommunications products and services are the RBOCs (VerizonCommunications, Inc., AT&T, Inc., BellSouth Corporation, which became a wholly-owned subsidiary ofAT&T, Inc. by merger completed in December, 2006, and Qwest Communications International, Inc.), aswell as major independent telephone companies and most of the major cable operators. Sales in 2006to AT&T and BellSouth accounted for 13% and 11%, respectively, or 24% collectively, of our totalrevenue for the year. Sales in 2005 to AT&T and BellSouth accounted for approximately 11% and 17%,respectively, or 28% collectively, of
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our total revenue for the year. Sales generated from RBOC customers were 31%, 37% and 54% ofour total revenue in 2006, 2005 and 2004, respectively. Through acquisitions and growth in ourinternational customer base, we have been able to reduce our dependency on RBOC customers. Sales toone cable OEM customer, Alpha, were 10.9% and 11.3% of our totalrevenue in 2006 and 2005,respectively. During 2005, sales to our telecom OEM customer, Lucent Technologies International,Inc., were 11.9% of total revenue.     Because of our continued dependency on certain RBOCs and certain significant MSOs, thepotential loss of one or more of these customers, or the reduction of orders for our products byone or more of these customers, could materially and adversely affect our results.     We distinguish revenue from external customers by geographic area based on customer location.Domestic sales represented approximately 73%, 77%, and 92% of the Company’s total revenue for theyears ended December 31, 2006, 2005, and 2004, respectively. International sales representedapproximately 27% of the Company’s total revenue for the year ended December 31, 2006, comparedwith 23% and 8% for the years ended December 31, 2005 and 2004, respectively. This increase isprimarily attributable to sales related to the Company’s N(x)Test system product, acquired fromEmerson on February 24, 2006 and the deployment of products into South Africa, offset, in part, bya decrease in our deployment of products into Saudi Arabia. Our international sales are primarilyin three geographic areas: the Americas (excluding the United States of America); Europe, theMiddle East and Africa (“EMEA”); and Asia. Sales for the Americas were approximately $3.9 millionor 22% of international sales, sales for EMEA were $11.8 million or 66% of international sales andsales in Asia were $2.2 million or 12% of international sales for the year ended December 31, 2006.Sales for the Americas, excluding the United States of America, were approximately $4.2 million or27% of international sales, sales for EMEA were $10.7 million or 70% of international sales andsales in Asia were $0.4 million or 3% of international sales for the year ended December 31, 2005.See the discussion in Item 7, “Management’s Discussion and Analysis of Financial Condition andResults of Operations,” of this Form 10-K for a further description of our international salesstrategies.***Competitive Conditions***     The market for telecommunications and cable testing equipment is highly competitive. Primarycompetitive factors in the Company’s market include price, product features, performance,reliability, service and support, breadth of product line, technical documentation and promptdelivery. We believe that we compete favorably with regard to all of these factors.     The traditional competitors for our POTS telecommunications products include Fluke Corporation(formerly Harris Corporation), Teradyne, Inc. and Nortel. Each of these companies providescentralized test and management solutions for POTS networks. Historically, we have successfullypositioned ourselves against these offerings by leveraging our patented technologies, entering intopartnerships with telecommunications equipment providers, and investing in ongoing research anddevelopment for emerging broadband technologies and applications.     As we extend our product offerings to address broadband technologies and applications foremerging next generation networks, this list of traditional competitors has expanded to includeSpirent Communications PLC, Huawei Technologies Co., Ltd., JDS Uniphase, and EXFO Electro-OpticalEngineering Inc. (formerly Consultronics Ltd.). We believe that by leveraging our existingincumbent infrastructure and core competencies to test these broadband next generation networks, wewill be well positioned to compete against these competitors on the basis of lower upfrontdeployment costs and long-term operational efficiency.     As our customers’ networks continue to evolve, we also face new competition as testingfunctions that were once only available with purpose-built test systems are now available asintegrated components of network elements provided by manufacturers such as Alcatel-Lucent, OccamNetworks, Inc. and Tellabs. These network element manufacturers historically have not providedtesting functions, however, they now do so with the integration of new chipsets into theirproducts. These integrated testing functions are often offered to the marketplace as individualcomponents of an overall turn-key solution. Although these offerings reduce the overall costassociated with centralized test system deployments, we believe the added features and valueassociated with an independent test system like the Company’s, such as improved measurementperformance, continue to provide Tollgrade with a strong competitive position.     With respect to our cable products, status/performance monitoring competitors include AMCommunications, Inc., Cisco (formerly Scientific Atlanta, Inc.), Alpha and Electroline.Historically, we have maintained an advantage over these competitors through the mass deployment ofproprietary technology within the major cable operators. In recent years the cable industry hasadopted open, non-proprietary standards for status/performance monitoring systems, such as HybridManagement Sub-layer (“HMS”) and DOCSIS. These open standards have created pricing pressures asall providers of monitoring transponders and associated software have reduced price points to meetcustomer demands. During 2005, Alpha introduced a DOCSIS-based transponder which competes with theproducts we supply to the market both directly and through our supply agreement with Alpha. As aresult, we have modified our strategies in an attempt to reduce product costs while increasingcooperation with Alpha channel relationships. Additionally, we continue to leverage our incumbentposition of proprietary technology by offering unique solutions for established customers tomigrate to open standards as well as enhancements for the support of Internet protocol- basedservice assurance testing.     As with the telecommunications products, the extension of our cable products to addressInternet protocol test applications expands our list of traditional competitors to now includeEmpirix, JDS Uniphase, Tektronix (which recently acquired the assets of Minacom Labs, Inc.), BrixNetworks and Agilent Technologies. We believe that our ability to support Internet protocol testapplications, such as VoIP, from permanently deployed locations in the HFC plant provide Tollgradewith a strong value proposition and competitive position.
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**Manufacturing**     Our manufacturing operations consist primarily of quality control, functional testing, finalassembly, burn-in and shipping. We are ISO 9001:2000 registered with the British StandardsInstitution, Inc. ISO 9000 is a harmonized set of standards that define quality assurancemanagement. Written by the International Organization for Standardization (“ISO”), ISO 9000 isrecognized 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 productionof quality products to ensure customer satisfaction.     For our telephony products, we utilize three key independent subcontractors to perform amajority of the circuit board assembly and in-circuit testing work. We also employ othersubassembly contractors for our telephony products on a more limited basis. For our Cheetahhardware, we primarily use a single turnkey manufacturer, Bulova Technologies – EMS, LLC (formerly,Dictaphone Corporation’s Electronic Manufacturing Services Division), a wholly-owned subsidiary ofBulova Technologies, LLC, to procure the components and assemble and test the products. The lossof any of these subcontractors or inability of such subcontractors to meet our manufacturing needscould cause delays in our ability to meet our customers’ orders and could have a material adverseeffect on our results of operations. In addition, shortages of raw materials delivered to, orproduction capacity constraints at, the Company’s subcontractors could negatively affect ourability to meet our production obligations and result in increased prices for affected parts. Anysuch reduction may result in delays in shipments of the Company’s products or increases in theprice of components, either of which could have a material adverse impact on us. During 2006, wepurchased raw materials from one of our contract manufacturers in order to provide it withtemporary liquidity, and, in 2007, we expect to purchase additional raw materials on behalf of thiscontract manufacturer to help ensure timely product deliveries. Based on discussions and reviewwith the contract manufacturer, we believe that it is taking the appropriate steps necessary toresolve its internal funding matters and we expect it to return tofull turnkey vendor status during 2007.     Generally, our products use industry standard components; however, application specificintegrated circuits (“ASICs”) are also a key component of some of our products and are custom madeto the Company’s specifications. Although we have generally been able to obtain ASICs on a timelybasis, a delay in the delivery of these components could have a material adverse impact on theCompany.**Product and Technology Development**     Our product development personnel, many of whom are Bell Labs trained, are organized intoteams dedicated to one or more specific product lines or technologies. We continuously monitordeveloping technologies in order to introduce new or improved products as defined standards andmarkets emerge. We continue to investigate the development of new applications for our MCU andCheetah technologies, as well as develop enhancements and new features to our LoopCare softwareproduct line, DigiTest hardware and other technologies to service the telecommunications and cableindustries. For the years ended December 31, 2006, 2005 and 2004, research and development expenseswere approximately $13.3 million, $14.1 million and $15.8 million, 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 ourinvestment in technology by enforcing our intellectual property rights. The extent of the legalprotection given to different types of intellectual property rights varies under differentcountries’ legal systems.     The names “Tollgradeâ”, “MCUâ”, “LIGHTHOUSEâ”, “EDGE®”, “DigiTest®”,“Telaccord®”, “MITS®”“Clearview®” “MICRO-BANKâ”, and our LIGHTHOUSE`® logo are registeredtrademarks of the Company. The names “LoopCareTM”, “MLTTM”, “CheetahTM”, “CheetahNetTM”, “CheetahIPTM”,“CheetahLightTM”, “CheetahXDTM”, “ICETM”, “ObjectArchitectTM”, , BatteryAnalystTM”, ProofAnalystTM”,“NetMentorTM”, “ClearTM”, the Clear logo, “Early WarningTM”, “ReportCardTM”, “CircuitViewTM”, “NetworkAssurance SimplifiedTM”, N(x)TestTM, N(x)DSLTM, LTSCTM and our corporate logoare common lawtrademarks of the Company. “Team TollgradeSM” is a common law service mark of theCompany. We have obtained three United States patents on the MCU products with expiration datesranging from 2010 to 2014, two United States and one Canadian patent on cable technology withexpiration dates of 2017, 2019 and 2020, respectively, and two Canadian patents, one Taiwanesepatent and ten United States patents on other telecommunications technology, with expiration indates ranging from 2017 to 2023. In addition, we have eight United States, four Canadian, twointernational Patent Cooperation Treaty patent applications pending. We will seek additionalpatents from time to time related to our research and development activities. We protect ourtrademarks, 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 business, we do not believethat our business, as a whole, is materially dependent on any one patent.**Backlog**     Our backlog consists of firm customer purchase orders and signed software maintenanceagreements. As of December 31, 2006, we had a backlog of approximately $10.0 million, compared toapproximately $14.7 million of backlog at December 31, 2005. We expect revenues related to theentire backlog at December 31, 2006, to be recognized in 2007. The decrease is primarilyattributable to the 2005 backlog containing a significant bulk order for DOCSIS-based products andthe completion in 2006 of significant milestones for certain large projects initiated in 2005. Thebacklog at December 31, 2006 does not include any amounts attributable to the international projectwins announced by the Company in December 2006, as the commercial terms for those projects had notyet been finalized. The Company has since recently entered into an agreement which establishes theinitial terms for one of those projects.
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     We currently have LoopCare software maintenance agreements with all of the RBOCs, includingBellSouth Corporation, now a wholly-owned subsidiary of AT&T. One of the agreements expires onDecember 31, 2007, a second agreement expires on December 31, 2008 while a third extends through2011. The fourth, which was signed in January 2007, expires on December 31, 2008. Our backlog atDecember 31, 2006 and 2005 included approximately $5.7 million and $6.2 million respectfully,related to software maintenance agreements. We have adopted a policy to include a maximum oftwelve months revenue from multi-year software maintenance agreements in reported backlog.Software maintenance revenue is deemed to be earned and recognized as income on a straight-linebasis 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 thesefluctuations could impact short-term results, they are not necessarily indicative of long-termtrends in sales of our products.**Government Regulation**     The telecommunications industry is subject to regulation in the United States and othercountries. Federal and state regulatory agencies, including the Federal Communications Commission(“FCC”) and various state public utility and service commissions, regulate the activities of mostof our domestic customers. Although such regulation does not typically affect the Companydirectly, the effects of such regulations on our customers may, in turn, adversely impact ourbusiness and operating results. Governmental authorities have also promulgated regulations which,among other things, set installation and equipment standards for private telecommunications systemsand require that all newly installed hardware be registered and meet certain government standards.Further information concerning the effects of government regulation on our business is set forthunder the caption “Industry and Market Trends.”**Employees**     As of December 31, 2006, we had 225 full-time employees, all of whom were located in theUnited States. None of our employees are represented by a collective bargaining agreement, and webelieve that our relations with our employees are good.**Executive Officers of the Company**     The executive officers of the Company as of January 31, 2007 and their biographical information are set forth below.   Mark B. Peterson Chief Executive Officer of the Company since January 2005; Presidentof the Company since January 2001; Executive Vice President, Salesand Marketing, of the Company from November 1999 until January 2001;Executive Vice President, Sales, of the Company from October 1997until November 1999; prior thereto, Testing Application Groupproduct manager (MLT and Switched Access Remote Test Systems(“SARTS”) product lines) of Lucent Technologies, a manufacturer ofcommunication systems, software and products, from October 1995until October 1997; Age 46.   Sara M. Antol General Counsel of the Company since December 2000; Secretary of theCompany since April 1996; Chief Counsel of the Company from April1996 until December 2000; prior thereto, attorney at Babst, Calland,Clements & Zomnir, P.C., a law firm; Age 45.   Carol M. Franklin Vice President, Research and Development, of the Company sinceJanuary 2004; Executive Vice President, Software Products Division,of the Company from January 2003 until January 2004; GeneralManager, Software Products from July 2001 to January 2003; Directorof Order Management Development of Lucent Technologies, amanufacturer 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 untilMay 2000; Director for Starter Solutions for Emerging Carriers andInternet Customer Care of Lucent Technologies from February 1999until August 1999; prior thereto, Product Realization Leader ofLucent Technologies from February 1996 until January 1999; Age 55.   Samuel C. Knoch Chief Financial Officer of the Company since August 1996; Treasurersince April 1997; prior thereto, Controller of AMSCO International,Inc., a manufacturer of health care equipment, from October 1994until August 1996; Age 50.   Joseph G. O’Brien Vice President, Human Resources of the Company since October 1997;Director of Employee Development of the Company from April 1997until October 1997; prior thereto, Coordinator, Elderberry Junction,Goodwill Industries, a charitable organization, from May 1995 untilApril 1997; Age 47.   Gregory L. Quiggle Vice President, Marketing, of the Company since August 2001;Director of Marketing, Loop Products, of Acterna, LLC, a globalcommunications equipment company, from May 1998 until August 1998;prior thereto, Product Line Manager, TTC from May 1996 until May1998; Age 38.
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   Matthew J. Rosgone Vice President, Operations, of the Company since September 2001;Senior Vice President, Purchasing/Manufacturing, of the Company fromJuly 1998 until September 2001; prior thereto, Vice President,Purchasing, of the Company from July 1996 until July 1998; Age 38.   Gail M. Walsh Vice President, Global Sales, of the Company since January 16, 2006;prior thereto, Sales Director, Lucent Technologies from November2000 to January 2006; prior thereto, Director, Software ProductsGroup at Lucent; Age 46.**Item 1A. Risk Factors**     We wish to caution each reader of this Form 10-K to consider the following factors and otherfactors discussed herein and in other past reports, including but not limited to prior year Form10-K and quarterly Form 10-Q reports filed with the SEC. Our business and results of operationscould be materially affected by any of the following risks. The factors discussed herein are notexhaustive. Therefore, the factors contained herein should be read together with other reports anddocuments that we file with the SEC from time to time, which may supplement, modify, supersede orupdate 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 thesecustomers, or the substantial reduction in the products that they purchase from us, wouldsignificantly reduce our revenues and net income.**We currently depend upon a few major customers for a significant portion of our revenues and weexpect to continue to derive a significant portion of our revenues from a limited number ofcustomers in the future. The loss of any of these customers would significantly reduce our revenuesand net income. Furthermore, decreases in the capital budgets of these customers could lead totheir reduced demand for our products, which could in turn have a material adverse affect on ourbusiness and results of operation. The capital budgets of our RBOC customers, as well as many ofour other customers and potential customers, are dictated by a number of factors, most of which arebeyond our control, including:**•** the conditions of the communications market and the economy in general; **•** subscriber line loss and related reduced demand for wireline telecommunications services; **•** changes or shifts in the technology utilized in the networks; **•** labor disputes between our customers and their collective bargaining units; **•** the failure of our customers to meet established purchase forecasts and growth projections; **•** competition among the RBOCs, competitive exchange carriers and wireless telecommunications and cableproviders; and **•** reorganizations, including management changes, at one or more of our customers or potential customers.If the financial condition of one or more of our major customers should deteriorate, or if theyhave difficulty acquiring investment capital due to any of these or other factors, a substantialdecrease 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 weexpect 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 incustomers’ capital budgets. There is a trend for some of our customers to place large orders nearthe 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 cancreate corresponding fluctuations in period-to-period revenues, and we therefore cannot assure youthat our results in one period are necessarily indicative of our revenues in any future period. Inaddition, the number and timing of large individual sales has been difficult for us to predict, andlarge individual sales have, in some cases, occurred in quarters subsequent to those weanticipated, or have not occurred at all. The loss or deferral of one or more significant sales ina quarter could harm our operating results. It is possible that in some quarters our operatingresults will be below the expectations of public market analysts or investors. In such events, orin the event adverse conditions prevail, the market price of our common stock may declinesignificantly.**The sale of our products is dependent upon our ability to satisfy the proprietary requirements ofour customers.**We depend upon a relatively narrow range of products for the majority of our revenue. Our successin marketing our products is dependent upon their continued acceptance by our customers. In somecases, our customers require that our products meet their own proprietary requirements. If we areunable to satisfy such requirements, or forecast and adapt to changes in such requirements, ourbusiness could be materially harmed.**The sale of our products is dependent on our ability to respond to rapid technological change,including evolving industry-wide standards, and may be adversely affected by the development, andacceptance by our customers, of new technologies which may compete with or reduce the demand forour products.**Rapid technological change, including evolving industry standards, could render our productsobsolete. Sales of our legacy cable products are declining, and demand for these products mayfurther decline or be eliminated, as the market for these products transitions to industry-widestandards, such as the HMS and DOCSIS cable standards. Furthermore, standards for new services andtechnologies continue to evolve, requiring us to continually modify our products or to develop newversions to meet these new
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standards. Certain of these certifications are limited in scope, which may require that the productbe recertified if any modifications to hardware or firmware are made. If we are unable to forecastthe demand for, or develop new products or adapt our existing products to meet, these evolvingstandards and other technological innovations, or if our products and services do not gain theacceptance of our customers, our overall revenues and profitability will be adversely affected.In addition, the development of new technologies which compete with or reduce the demand for ourproducts, and the adoption of such technologies by our customers, could adversely affect sales ofour products. For example, as our products generally serve the wireline marketplace, to the extentwireline customers migrate to wireless technologies, there may be reduced demand for our products.In addition, we face new competition as testing functions that were once only available withpurpose-built test systems are now available as integrated components of network elements. To theextent our customers adopt such new technology in place of our telecommunications products, thesales of our telecommunications products may be adversely affected. Such competition may alsoincrease pricing pressure for our telecommunications products and adversely affect the revenuesfrom such products.**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 contract manufacturers to manufacture certainelements of our products. Furthermore, the components of our hardware products are procured from alimited number of outside suppliers. Our reliance upon such third party contractors involve severaladditional risks, including reduced control over manufacturing costs, delivery times, reliabilityand quality of components. Although our products generally use industry standard products, someparts, such as ASICs, are custom-made to our specifications. If we were to encounter a shortage ofkey manufacturing components from limited sources of supply, or experience manufacturing delayscaused by reduced manufacturing capacity, inability of our contract manufactures to procure rawmaterials, or integration issues related to our acquisition of the Emerson test systems business,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 whichwould materially harm our business.**Our future sales in international markets are subject to numerous risks and uncertainties.**Our future sales in international markets are subject to numerous risks and uncertainties,including local economic and labor conditions, political instability including terrorism and otheracts of war or hostility, unexpected changes in the regulatory environment, trade protectionmeasures, tax laws, our ability to market current or develop new products suitable forinternational markets, difficulties with deployments and acceptances of products, obtaining andmaintaining successful distribution and resale channels and foreign currency exchange rates. Theserisks are evident with the customer contracts that we assumed as part of the acquisition of theEmerson test systems business, which are subject to a number of specific risks and uncertainties,such as potential political instability, difficulty in deployment of products, risks fromcustomized product requirements, difficulty of obtaining proper acceptances and delays caused bythird party elements of the project. These specific risks, or an overall reduction in the demandfor or the sales of our products in international markets, could adversely affect future results.InDecember 2006, we announced that the Company had been awarded, through in-country partnerships,two international projects to supply our multi-layered testing solutions for country-wide networks.The definitive agreement relating to one of these projects has not been finalized as of the filingof this report. The deployment of products in connection with that project may be delayed if weare unable to timely complete the negotiation and agreement with respect to such terms, orcancelled if we are unable to reach such agreement. In addition, product deployments under eitheror both of these projects could be delayed due to a variety of other factors including politicalinstability, inability to obtain proper acceptances, difficulty in securing cooperation from ordefects in the performance of our in-country partners or other unforeseen obstacles or delays.**Our future results are dependent on our ability to establish, maintain and expand our distributionchannels and our existing third-party distributors.**We market and sell certain of our products, including our DigiTest and Cheetah product lines andcertain of the newly acquired Emerson test systems products, through domestic and international OEMrelationships. Our future results are dependent on our ability to establish, maintain and expandthird party relationships with OEM as well as other marketing and sales distribution channels. If,however, the third parties with whom we have entered into such OEM and other arrangements shouldfail to meet their contractual obligations, cease doing, or reduce the amount of their businesswith us or otherwise fail to meet their own performance objectives, customer demand for ourproducts could be adversely affected, which would have an adverse effect on our revenues. Inconnection with one of our international projects announced in December 2006, we have contractedwith two new in-country partners with which we have not previously conducted business, which maycreate additional risks and uncertainties relating to our limited familiarity with these partners.**The sales cycle for our system products is long, and the delay or failure to complete one or morelarge license transactions in a quarter could cause our operating results to fall below ourexpectations.**The sales cycle for our system products is highly customer specific and can vary from a few weeksto many months. The system requirements of customers is highly dependent on many factors, includingbut not limited to their projections of business growth, capital budgets and anticipated costsavings from implementation of our software. Our delay or failure to complete one or more largelicense transactions in a quarter could harm our operating results. Our systems involve significantcapital commitments by customers. Potential customers generally commit significant resources to anevaluation of available enterprise software and require us to expend substantial time, effort andmoney educating them about the value of our solutions. System sales often require an extensivesales effort
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throughout a customer’s organization because decisions to acquire software licenses and associatedsystem hardware involve the evaluation of the products by a significant number of customerpersonnel in various functional and geographic areas, each often having specific and conflictingrequirements. A variety of factors, including actions by competitors and other factors over whichwe have little or no control, may cause potential customers to favor a particular supplier or todelay or forego a purchase.Many of the Company’s products must comply with significant governmental and industry-basedregulations, certifications, standards and protocols, some of which evolve as new technologies aredeployed. Compliance with such regulations, certifications, standards and protocols may provecostly and time-consuming for the Company, and the Company cannot provide assurance that itsproducts will continue to meet these standards in the future. In addition, regulatory compliancemay present barriers to entry in particular markets or reduce the profitability of the Company’sproduct offerings. Such regulations, certifications, standards and protocols may also adverselyaffect the industries in which we compete, limit the number of potential customers for theCompany’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, withsuch regulations, standards and protocols or delays in receipt of such certifications could delaythe introduction of new products or cause the Company’s existing products to become obsolete.**We depend on sales of our MCU products for a meaningful portion of our revenues, but this productis mature and its sales will continue to decline.**A large portion of our sales have historically been attributable to our MCU products. We expectthat our MCU products may continue to account for a meaningful percentage of our revenues for theforeseeable future. However, these sales are declining. MCU sales largely depend upon the rate ofdeployment of new, and the retrofitting of existing, DLC systems in the United States. Installationand replacement of DLC systems are, in turn, driven by a number of factors, including theavailability of capital resources and the demand for new or better POTS. Our customers have begunto implement next generation network improvements such as Fiber-to-the-Premises (“FTTP”), which donot require the use of our MCU products as does the present hybrid POTS network. If our majorcustomers fail to continue to build out their DSL networks and other projects requiring DLCdeployments, or if we otherwise satisfy the domestic telecommunications market’s demand for MCUs,our MCU sales will continue to decline and our future results would be materially and adverselyaffected.Although we are unable to predict future prices for our MCU products, we expect that prices forthese products will continue to be subject to significant downward pressure in certain markets forthe reasons described above. Accordingly, our ability to maintain or increase revenues will bedependent on our ability to expand our customer base, increase unit sales volumes of these productsand to successfully, develop, introduce and sell new products such as our cable and softwareproducts. We cannot assure you that we will be able to expand our customer base, increase unitsales volumes of existing products or develop, introduce and/or sell new products.**Our Services business is subject to a trend of reduced capital spending by our major customers.**Our Services business, which includes software maintenance as well as professional services, issensitive to the decline in our RBOC customers’ capital investment in their traditional voiceservices, which tends to drive the professional services. Furthermore, the timing of the extensionor renewal of certain of the more significant software maintenance agreements can have a majorimpact on the Company’s Services revenues for any particular fiscal quarter or year. We are alsoexperiencing intense pricing pressure from many of our larger software maintenance customers, asthey continue to attempt to reduce their own internal costs. Accordingly, our ability to maintainhistorical levels or increase levels of Services revenues cannot be assured, and in fact, suchlevels may continue to decrease.**Our continued emphasis on our network assurance and testing solutions and cable status monitoringproducts, and on software products in particular, could have a material adverse effect on ourprofitability.**We are actively engaged in research to improve and expand our cable products, including researchand development to reduce product costs while providing enhancements, such as VoIP serviceassurance; however, with the rise of industry-wide standards, among other factors, our cableproducts have lower margins than our MCU, LoopCare and DigiTest system products. If sales of ournetwork assurance and testing solutions and cable status monitoring products do not increase or arenot accepted in the marketplace, or if our research and development activities do not producemarketable products that are both competitive and accepted by our customers, our overall revenuesand profitability will be adversely affected.In addition, although software products generally generate higher margin returns for us than ourhardware products, the initial development costs of software applications, coupled with theinherent problems with pricing software, can make it difficult to assess the potentialprofitability of new software products. Unless we acquire proprietary software, we must internallydevelop any new software products. Software development is a relatively expensive and lengthyprocess. In addition, because it is customary in our industry to sell perpetual enterprise licensesthat cover an entire customer’s operations, it can be difficult to assess at the time of sale theexact price that we should charge for a particular license.**Our customers are subject to an evolving governmental regulatory environment that couldsignificantly 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 whichhave 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 severalways, including the introduction of competitive forces into the local telephone markets and theimposition (or removal) of controls on the pricing of services. These and other regulatory changesmay limit the scope of our customers’ deployments of future services and budgets for capitalexpenditures, which could significantly reduce the demand for our products.
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Moreover, as the FCC adopts new and amends existing regulations, and as the courts analyze theFCC’s authority to do so, our customers cannot accurately predict the rules which will regulatetheir conduct in their respective markets. Changes in the telecommunications regulatory environmentcould, among other results, increase our costs of doing business, require our customers to shareassets with competitors or prevent the Company or our customers from engaging in businessactivities 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 ourability to compete, and our products could infringe upon the intellectual property rights of others,resulting in claims against us the results of which could be costly.**Many of our products consist entirely or partly of proprietary technology owned by us. Although weseek to protect our technology through a combination of copyrights, trade secret laws, contractualobligations and patents, these protections many not be sufficient to prevent the wrongfulappropriation of our intellectual property, nor will they prevent our competitors fromindependently developing technologies that are substantially equivalent or superior to ourproprietary technology. In addition, the laws of some foreign countries do not protect ourproprietary rights to the same extent as the laws of the United States. In order to defend ourproprietary rights in the technology utilized in our products from third party infringement, we maybe required to institute legal proceedings. If we are unable to successfully assert and defend ourproprietary rights in the technology utilized in our products, our future results could beadversely affected.Although we attempt to avoid infringing known proprietary rights of third parties in our productdevelopment efforts, we may become subject to legal proceedings and claims for alleged infringementfrom time to time in the ordinary course of business. Any claims relating to the infringement ofthird-party proprietary rights, even if not meritorious, could result in costly litigation, divertmanagement’s attention and resources, require us to reengineer or cease sales of our products orrequire us to enter into royalty or license agreements which are not advantageous to us. Inaddition, parties making claims may be able to obtain an injunction, which could prevent us fromselling our products in the United States or abroad.**The success of some of our products is dependent on our ability to maintain licenses to technologyfrom the manufacturers of systems with which our products must be compatible.**Some of our products require that we license technology from manufacturers of systems with whichour products must be compatible. The success of our proprietary MCU products, in particular, relyupon our ability to acquire and maintain licensing arrangements with the various manufacturers ofDLC systems for the Proprietary Design Integrated Circuits (PDICs) unique to each. Although most ofour PDIC licensing agreements have perpetual renewal terms, all of them can be terminated by eitherparty. If we are unable to obtain the PDICs necessary for our MCU products to be compatible with aparticular DLC system, we may be unable to satisfy the needs of our customers. Furthermore, futurePDIC license agreements may contain terms comparable to, or materially different than, the terms ofexisting agreements, as dictated by competitive or other conditions. The loss of these PDIC licenseagreements, or our inability to maintain an adequate supply of PDICs on acceptable terms, couldhave a material adverse effect on our business.**If we are unable to satisfy our customers’ specific product quality, certification or networkrequirements, our business could be disrupted and our financial condition could be harmed.**Our customers demand that our products meet stringent quality, performance and reliabilitystandards. We have, from time to time, experienced problems in satisfying such standards. Defectsor failures have in the past, and may in the future occur relating to our product quality,performance and reliability. From time to time, our customers also require us to implement specificchanges to our products to allow these products to operate within their specific networkconfigurations. If we are unable to remedy these failures or defects or if we cannot affect suchrequired product modifications, we could experience lost revenues, increased costs, includinginventory write-offs, warranty expense and costs associated with customer support, delays in orcancellations or rescheduling of orders or shipments and product returns or discounts, any of whichwould harm our business.**We have completed, and may pursue additional acquisitions, which could result in the disruption ofour current business, difficulties related to the integration of acquired businesses, andsubstantial expenditures.**We have completed, and we may pursue additional acquisitions of companies, product lines andtechnologies as part of our efforts to enhance our existing products, to introduce new products andto fulfill changing customer requirements. Acquisitions involve numerous risks, including thedisruption of our business, exposure to assumed or unknown liabilities of the acquired target, andthe failure to integrate successfully the operations and products of acquired businesses. Goodwillarising from acquisitions may result in significant impairment charges against our operatingresults in one or more future periods. Furthermore, we may never achieve the anticipated results orbenefits of an acquisition, such as increased market share or the successful development and salesof a new product. The effects of any of these risks could materially harm our business and reduceour future results of operations.We recently completed our first significant acquisition involving international business andcustomers. In addition to the risks identified in the foregoing paragraph, the acquisition of theEmerson test systems business is subject to additional risks due to its international scope. Ourability to integrate this business may be particularly challenging due to the unique topology ofinternational telecommunications networks, as well as requirements of doing business in particularcountries. Further, our ability to sell certain productsinternationally depends upon our abilityto maintain certain key manufacturing relationships and we may not be able to continue thoserelationships. In addition, our ability to achieve our revenue forecasts for the Emerson testsystems business are dependant on the successful completion of a few large customer projects andcontracts, which bear significant deployment, acceptance
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and subsequent revenue recognition risks, which may all adversely affect the Company’s ability tomake this acquisition accretive in 2007.**The failure of acquired assets to meet expectations, or a decline on our fair value determined bymarket prices of our stock, could indicate impairment of our intangible assets and result inimpairment charges.**The carrying value of certain of our intangible assets, consisting primarily of goodwill related tobusinesses acquired from Lucent Technologies, JDS Uniphase and Emerson, could become impaired bychanging market conditions. Statement of Financial Accounting Standards No. 142 (“SFAS 142”)requires goodwill and intangible assets with indefinite lives to be measured for impairment atleast annually or more frequently if events and circumstances indicate that the carrying value ofsuch assets may not be recoverable. We perform annual impairment tests as of December 31 of eachyear. We have determined that we have one reporting unit and test goodwill for impairment bycomparing the fair value of the Company’s equity, which we estimate based on the quoted marketprice of our common stock and an estimated control premium, to the Company’s book value. Our lastrequired measurement date was December 31, 2006, at which time our test indicated no impairment.Interim impairment tests are required by SFAS 142 if certain events or changes in businessconditions occur and we could be required to record an impairment charge in the period in which anyimpairment is determined, which could adversely affect future results.**If our accounting controls and procedures are circumvented or otherwise fail to achieve theirintended purposes, our business could be seriously harmed.**We evaluate our disclosure controls and procedures as of the end of each fiscal quarter, and areannually reviewing and evaluating our internal controls over financial reporting in order to complywith SEC rules relating to internal control over financial reporting adopted pursuant to theSarbanes-Oxley Act of 2002. Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls may become inadequate becauseof changes in conditions, or that the degree of compliance with the policies or procedures maydeteriorate.**If we ship products that contain defects, the market acceptance of our products and our reputationwill 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 errorsor failures that may become apparent only after our products have been shipped to our customers andinstalled 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 ourreputation or relations with our customers, resulting in substantial costs for both the Company andour customers as well as the cancellation of orders, warranty costs and product returns. Inaddition, any defects, errors, misuse of our products or other potential problems within or out ofour control that may arise from the use of our products could result in financial or other damagesto our customers. Our customers could seek to have us pay for these losses. Although we maintainproduct liability insurance, it may not be adequate.**We face intense competition, which could result in our losing market share or experiencing adecline in our gross margins.**The markets for some of our products are very competitive. Some of our competitors have greatertechnological, 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 tochanges in industry standards or technologies. Competition is particularly difficult in the cablemarkets, due to the introduction of the DOCSIS standard, which allows customers to purchase systemcomponents from multiple vendors. Moreover, better financed competitors may be better able towithstand the pricing pressures that increased competition may bring. If our introduction ofimproved products or services is not timely or well received, or if our competitors reduce theirprices for products that are comparable to ours, demand for our products and services could beadversely affected. Recent competition from certain network element providers offering chip-basedtesting functionality may also intensify the pricing pressure for our telecommunications productsand adversely affect future revenues from such products. We also face increasing pressure fromcertain of our RBOC customers on software maintenance agreements, as they continue to divertspending from legacy networks to next generation network elements.We may also compete directly with our customers. Generally, we sell our products either directly orindirectly through OEM channels and other means, to end-user telecommunications and cabletelevision providers. It is possible that our customers, as the result of bankruptcy or otherrationales for dismantling network equipment, could attempt to resell our products. The successfuldevelopment of such a secondary market for our products by a third party could negatively affectdemand 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 our key management personnel,including the Company’s CEO and CFO, and key engineers, necessary to implement our business planand 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 unableto identify and hire the personnel that we need to succeed, or if one or more of our present keyemployees were to cease to be associated with the Company, our future results could be adverselyaffected.
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**Consolidations in, or a continued slowdown in, the telecommunications industry could harm ourbusiness.**We have derived a substantial amount of our revenues from sales of products and related services tothe telecommunications industry. The telecommunications industry has experienced significant growthand consolidation in the past few years, although, over recent years, trends indicate that capitalspending by this industry has decreased and may continue to decrease in the future as a result of ageneral decline in economic growth in local and international markets. In particular, RBOC andlarge ILEC customers have been adversely affected by subscriber line losses and the after-effectsof overspending in 1999 and 2000 as well as by competition from cable and wireless carriers andother carriers entering the local telephone service market. Certain emerging carriers also continueto be hampered by financial instability caused in large part by a lack of access to capital. In theevent of further significant slowdown in capital spending of the telecommunications industry, ourbusiness would be adversely affected. Furthermore, as a result of industry consolidation, there maybe fewer potential customers requiring our software in the future. Larger, consolidatedtelecommunications companies may also use their purchasing power to create pressure on the pricesand the margins we could realize. We cannot be certain that consolidations in, or a slowdown in thegrowth 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 tocompensate for unexpected revenue shortfalls.**We base our expense levels in part on forecasts of future orders and sales, which are extremelydifficult 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 adjustedquickly and is, therefore, relatively fixed in the short term. Accordingly, our operating resultswill be harmed if revenues fall below our expectations in a particular quarter.**Our restructuring and cost reduction plans may be ineffective or may limit our ability to compete.**We have substantially completed the restructuring program that we announced on July 27, 2006, whichincluded the consolidation of facilities and staff from the Company’s cable operations in Sarasota,Florida and a completion of integration plans from the recent acquisition of the Emerson testsystems business. In conjunction with the restructuring effort, we have identified certain productsand assets that no longer meet our long-term objectives and strategy. While we believe that theseactions will reduce costs, they may not be sufficient to achieve the required operationalefficiencies that will enable us to respond more quickly to changes in the market, and we may berequired to undertake further restructuring initiatives that would require us to incur additionalcharges. In addition, there is the risk that cost-cutting initiatives will impair our ability toeffectively develop and market products and remain competitive. Also, our attempts to reduce thebase costs of certain or our products may not be successful. Each of the above measures could havelong-term effects on our business by reducing our pool of talent, decreasing or slowingimprovements in our products, making it more difficult for us to respond to customers, limiting ourability to increase production quickly if and when the demand for our products increases andlimiting our ability to hire and retain key personnel. These circumstances could cause our earningsto be lower than they otherwise might be.**We rely on software that we have licensed from third-party developers to perform key functions inour products.**We rely on software that we license from third parties, including software that is integrated withinternally developed software and used in our products to perform key functions. We could lose theright to use this software or it could be made available to us only on commercially unreasonableterms. Although we believe that, in most cases, alternative software is available from otherthird-party suppliers or internal developments, the loss of or inability to maintain any of thesesoftware licenses or the inability of the third parties to enhance in a timely and cost-effectivemanner their products in response to changing customer needs, industry standards or technologicaldevelopments could delay or reduce our product shipments until equivalent software could bedeveloped 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 ourbusiness.**Because our cable products generate lower margins for us than our proprietary MCU and softwareofferings, an increase in the percentage of our sales of cable-related products relative to ourtraditional products will result in lower profit margins. Furthermore, consolidations within thecable industry and the adoption of the DOCSIS standards have caused and could continue to causepricing pressure as our competitors lower product pricing. As a result of these factors, ourrevenues have been and may continue to be adversely affected. Although we have developedDOCSIS-based hardware and we believe that our relationships with our OEM partners will prominentlyposition us to succeed in the marketing of DOCSIS-based products, these products will likelygenerate lower margins than have historically been generated by our proprietary technology. As aresult, as our business shifts from our higher margin proprietary products to lower margin cableofferings and standardized products for which there is greater competition, we will need to sellgreater volumes of our products to maintain our profitability.**Our common stock price may be extremely volatile.**Our common stock price has been and is likely to continue to be highly volatile. The market pricemay vary in response to many factors, some of which are outside our control, including:**•** General market and economic conditions; **•** Changes in the telecommunications industry; **•** Actual or anticipated variations in operating results;
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**•** Announcements of technological innovations, new products or new services by us or by our competitors orcustomers; **•** 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 venturesor capital commitments; **•** Announcements by our customers regarding end market conditions and the status of existing and futureinfrastructure 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 Global Market and thesecurities of technology companies in particular, have experienced extreme price and volumefluctuations. These fluctuations have often been unrelated or disproportionate to the operatingperformance of individual companies. These broad market fluctuations have in the past and may inthe future materially and adversely affect our stock price, regardless of our operating results. Inthe past, following periods of volatility in the market price of a company’s securities, securitiesclass action litigation has often been initiated against such company. Such litigation could resultin substantial costs and a diversion of our management’s attention and resources that could harmour business.**We may be subject from time to time to legal proceedings, and any adverse determinations in theseproceedings could materially harm our business.**We may from time to time be involved in various lawsuits and legal proceedings, which arise in theordinary course of business. Litigation matters are inherently unpredictable, and we cannot predictthe outcome of any such matters. If we ultimately lose or settle a case, we may be liable formonetary damages and other costs of litigation. Even if we are entirely successful in a lawsuit, wemay 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 financialposition and results of operations.**Item 1B. Unresolved Staff Comments.**None.**Item 2. Properties.**     Our headquarters and principal administrative, engineering, manufacturing, warehouse andmaintenance operations are located in Cheswick, Pennsylvania. We occupy an 111,600 square footfacility which is under a lease that has been extended to June 30, 2009. We acquired certain landparcels that surround this facility for possible expansion; however, during our 2006 restructuringprogram, we determined that this land is no longer required for our strategic needs and, therefore,it is currently being held for sale.     In addition, through February 28, 2007, we leased 18,778 square feet of space in Bridgewater,New Jersey. On November 27, 2006, we entered into a lease agreement for 11,429 square feet of spacein Piscataway, New Jersey, which lease commenced on March 1,2007. This space replaces thelease for the Bridgewater location. This facility provides workspace for the administrative andengineering personnel of our LoopCare product line.     We also lease 22,122 square feet of space in Sarasota, Florida. On July 27, 2006, we announceda restructuring program which included the closure of the Sarasota location. This lease expires onApril 28, 2008, and we have engaged a broker to sub-lease the facility. Currently, we still havecertain customer support personnel working in a small portion of this space and will likelycontinue to use this space for this purpose until the expiration date.**Item 3. Legal Proceedings.**     There are currently no outstanding or pending material legal proceedings to which the Companyor any of its subsidiaries is a party or of which any of their property is the subject.**Item 4. Submission of Matters to a Vote of Security Holders.**     There were no matters submitted to a vote of security holders through the solicitation ofproxies or otherwise during the fourth quarter of 2006.**PART II****Item 5. Market for the Registrant’s Common Stock, Related Security Holder Matters andIssuer Purchases of Equity Securities.**     Ourcommon stock is traded on the NASDAQ Global Select Market under the symbol “TLGD”. The following table sets forth, by quarter, the high and low salesprices for our common stock for the years ended December 31, 2006 and December 31, 2005.
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                   2006 2005  High Low High LowFirst Quarter $16.24  $9.50  $12.21  $7.07 Second Quarter $15.49  $8.66  $8.00  $6.64 Third Quarter $10.28  $7.22  $11.47  $7.28 Fourth Quarter $10.66  $7.74  $11.71  $8.03      On January 31, 2007, there were 135 holders of record and 13.2 million shares outstanding ofthe Company’s common stock.     We have never paid any dividends on our common stock and do not expect to pay dividends in theforeseeable future.     On December 31, 2006, our share repurchase program expired. Since the initial repurchaseprogram was instituted in April 1997, and as of December 31, 2006, the Company has repurchased461,800 shares of common stock. The repurchased shares were authorized to be utilized undercertain employee benefit programs. There were no shares repurchases made during 2006.
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**Item 6. Selected Financial Data.**     The following selected consolidated financial data of the Company has been derived from ouraudited consolidated financial statements. The following selected consolidated financial data maynot be representative of our future financial performance and should be read in conjunction withthe consolidated financial statements, the notes to the consolidated financial statements, and“Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which areincluded elsewhere in this report.                       **(IN THOUSANDS, EXCEPT PER SHARE DATA AND**   **NUMBER OF EMPLOYEES)**   **YEARS ENDED DECEMBER 31,**   **2006**  **2005**  **2004**  **2003**  **2002**  **Revenues:**                    Products $52,358  $52,544  $49,770  $52,802  $48,146 Services  13,036   13,775   13,048   12,298   10,428     65,394   66,319   62,818   65,100   58,574 **Cost of sales:**                    Products  25,277   24,326   22,191   22,966   20,800 Services  4,543   3,883   3,768   3,766   3,319 Amortization  3,419   3,004   2,624   2,919   1,915 Write-down of inventory/acquiredsoftware  4,308   424   —   —   —     37,547   31,637   28,583   29,651   26,034                       **Gross profit**  27,847   34,682   34,235   35,449   32,540                       **Operating expenses:**                    Selling and marketing  10,552   8,882   9,483   9,388   8,766 General and administrative  7,981   7,486   7,346   6,997   5,489 Research and development  13,276   14,079   15,756   14,925   13,839 Restructuring/retirement/severance  1,840   775   269   —   176  **Total operating expenses**  33,649   31,222   32,854   31,310   28,270                       **(Loss) income from operations**  (5,802)  3,460   1,381   4,139   4,270 **Other income, net**  2,755   1,359   447   400   693                       **(Loss) income before income taxes**  (3,047)  4,819   1,828   4,539   4,963                      **(Benefit) provision for income taxes**  (1,213)  1,301   914   1,719   1,886                       **(Loss) net income** $(1,834) $3,518  $914  $2,820  $3,077                       **EARNINGS PER SHARE INFORMATION:**                    **Net (loss) income per common share:**                    Basic $(0.14) $0.27  $0.07  $0.22  $0.23  Diluted $(0.14) $0.27  $0.07  $0.21  $0.23                       **Weighted average sharesof common stock equivalents:**                    Basic  13,239   13,168   13,141   13,106   13,095  Diluted  13,239   13,217   13,253   13,313   13,314                         **2006**  **2005**  **2004**  **2003**  **2002**  **BALANCE SHEET DATA:**                    Working Capital $83,186  $80,806  $70,845  $65,944  $73,639 Total Assets  162,352   163,329   157,145   152,777   147,354 Shareholders’ Equity  149,444   150,261   146,401   145,152   142,007                        **2006**  **2005**  **2004**  **2003**  **2002**  **OTHER DATA:**(1)                    Number of employees at year-end  225   253   262   304   250  (1) Data is unaudited and not derived from the Company’s audited consolidated financial statements.