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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
-------------------------------
FORM 10-Q
(Mark One)
[ X ] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended March 29, 2003
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the transition period from ___________ to ____________
Commission file number 0-27312
TOLLGRADE COMMUNICATIONS, INC.
(Exact Name of Registrant as Specified in its Charter)
PENNSYLVANIA 25-1537134
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification Number)
493 NIXON RD.
CHESWICK, PA 15024
(Address of Principal Executive Offices, including zip code)
412-820-1400
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
--- ---
Indicate by check mark whether the Registrant is an accelerated filer
(as defined by Rule 12b-2 of the Exchange Act).
Yes X No
--- ---
As of April 30, 2003, there were 13,554,736 shares of the Registrant's
Common Stock, $0.20 par value per share, and no shares of the Registrant's
Preferred Stock, $1.00 par value per share, outstanding.
This report consists of a total of 38 pages. The exhibit index is on page 35.
TOLLGRADE COMMUNICATIONS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED MARCH 29, 2003
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION PAGE NO.
- ------------------------------ --------
ITEM 1 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS:
CONDENSED CONSOLIDATED BALANCE SHEETS AS OF MARCH 29, 2003
AND DECEMBER 31, 2002 .............................................................. 3
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE-MONTH PERIODS
ENDED MARCH 29, 2003 AND MARCH 30, 2002............................................ 4
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER'S EQUITY
FOR THE THREE-MONTH PERIOD ENDED MARCH 29, 2003..................................... 5
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE
THREE-MONTH PERIODS ENDED MARCH 29, 2003 AND MARCH 30, 2002......................... 6
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS................................ 7
REPORT OF INDEPENDENT ACCOUNTANTS................................................... 15
ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION................................................................. 16
ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.......................... 30
ITEM 4 CONTROLS AND PROCEDURES............................................................. 30
PART II. OTHER INFORMATION
- ----------------------------
ITEM 6 EXHIBITS AND REPORTS FILED ON FORM 8-K.............................................. 31
SIGNATURES........................................................................................ 32
CERTIFICATIONS .................................................................................. 33
EXHIBIT INDEX..................................................................................... 35
2
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
MARCH 29, 2003 DECEMBER 31, 2002 *
--------------- -------------------
ASSETS (UNAUDITED)
CURRENT ASSETS:
Cash and cash equivalents $ 26,036,242 $ 33,799,284
Short-term investments 17,583,431 19,328,883
Accounts receivable:
Trade 6,873,110 7,946,276
Other 190,257 152,290
Inventories 14,840,783 14,092,596
Prepaid expenses and other current assets 1,355,267 1,529,968
Refundable income taxes 637,156 637,156
Deferred tax assets 1,575,955 1,404,122
- ----------------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 69,092,201 78,890,575
Property and equipment, net 8,113,611 7,438,870
Deferred tax assets 3,348,890 2,769,573
Intangibles 44,500,000 38,500,000
Goodwill 20,343,769 16,161,763
Capitalized software costs, net 9,057,146 5,539,002
Other assets 292,780 242,115
==========================================================================================================
TOTAL ASSETS $ 154,748,397 $ 149,541,898
==========================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 1,667,488 $ 499,642
Accrued warranty 3,046,393 1,980,520
Accrued expenses 1,375,471 748,576
Accrued salaries and wages 908,452 543,339
Accrued royalties payable 303,867 322,380
Income taxes payable 1,553,349 1,141,293
Deferred income 1,241,356 465,887
- ----------------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 10,096,376 5,701,637
Deferred tax liabilities 1,869,637 1,484,247
- ----------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 11,966,013 7,185,884
Commitments and contingent liabilities -- --
Shareholders' equity:
Common stock, $.20 par value; authorized shares,
50,000,000; issued shares, 13,552,736 2,710,547 2,710,547
Additional paid-in capital 70,489,025 70,489,025
Treasury stock, at cost, 461,800 shares (4,790,783) (4,790,783)
Retained earnings 74,373,595 73,947,225
- ----------------------------------------------------------------------------------------------------------
TOTAL SHAREHOLDERS' EQUITY 142,782,384 142,356,014
==========================================================================================================
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 154,748,397 $ 149,541,898
==========================================================================================================
* Amounts derived from audited financial statements
The accompanying notes are an integral part of the condensed consolidated
financial statements.
3
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
FOR THE THREE MONTHS ENDED
MARCH 29, 2003 MARCH 30, 2002
-------------- --------------
REVENUES:
Products $11,571,101 $14,929,379
Services 2,972,322 2,592,895
- ------------------------------------------------------------------------------------------------------------------------
14,543,423 17,522,274
COST OF SALES:
Products 5,292,128 6,062,344
Services 789,570 954,874
Amortization 892,578 365,040
- ------------------------------------------------------------------------------------------------------------------------
6,974,276 7,382,258
- ------------------------------------------------------------------------------------------------------------------------
GROSS PROFIT 7,569,147 10,140,016
- ------------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSES:
Selling and marketing 1,970,654 2,417,309
General and administrative 1,737,003 1,526,251
Research and development 3,321,218 3,994,641
- ------------------------------------------------------------------------------------------------------------------------
Total operating expenses 7,028,875 7,938,201
- ------------------------------------------------------------------------------------------------------------------------
INCOME FROM OPERATIONS 540,272 2,201,815
Interest and other income, net 147,422 237,999
- ------------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 687,694 2,439,814
Provision for income taxes 261,324 927,000
========================================================================================================================
NET INCOME $ 426,370 $ 1,512,814
========================================================================================================================
EARNINGS PER SHARE INFORMATION:
Weighted average shares of common stock and equivalents:
Basic 13,090,936 13,099,210
Diluted 13,211,883 13,421,307
- ------------------------------------------------------------------------------------------------------------------------
Net income per common and common equivalent shares:
Basic $ 0.03 $ 0.12
Diluted $ 0.03 $ 0.11
========================================================================================================================
The accompanying notes are an integral part of
the condensed consolidated financial statements.
4
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
FOR THE THREE MONTHS ENDED MARCH 29, 2003
(Unaudited)
ADDITIONAL
PREFERRED COMMON STOCK PAID-IN TREASURY RETAINED
SHARES AMOUNT SHARES AMOUNT CAPITAL STOCK EARNINGS TOTAL
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at
December 31, 2002 ---- $ ---- 13,552,736 $ 2,710,547 $ 70,489,025 $ (4,790,783) $ 73,947,225 $ 142,356,014
Net Income ---- ---- ---- ---- ---- ---- 426,370 426,370
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at
March 29, 2003 ---- $ ---- 13,552,736 $ 2,710,547 $ 70,489,025 $ (4,790,783) $ 74,373,595 $ 142,782,384
- -----------------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of
the condensed consolidated financial statements.
5
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended
March 29, 2003 March 30, 2002
- -------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 426,370 $ 1,512,814
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 1,441,233 933,921
Tax benefit from exercise of stock options --- 176,579
Refund and utilization of income taxes paid --- 900,000
Deferred income taxes (124,935) 463,560
Provision for losses on inventory 11,208 563,000
Provision for allowance for doubtful accounts 200,000 ---
Changes in assets and liabilities:
Decrease (increase) in accounts receivable-trade 873,166 (4,186,484)
Increase in accounts receivable-other (37,967) (152,353)
Decrease in inventory 521,445 269,065
Decrease (increase) in prepaid expenses and other assets 249,211 (57,540)
Increase (decrease) in accounts payable 1,167,846 (156,350)
Increase in accrued warranty 448,373 250,000
Increase in accrued expenses and deferred income 387,598 1,364,535
Increase in accrued salaries and wages 365,113 505,194
Decrease in accrued royalties payable (18,513) (18,728)
Increase in income taxes payable 412,056 189,377
- -------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 6,322,204 2,556,590
- -------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Cheetah (15,108,510) ---
Redemption/maturity of investments 2,620,452 2,317,930
Purchase of investments (875,000) (360,783)
Capital expenditures (722,188) (979,352)
Investments in other assets --- (32,922)
- -------------------------------------------------------------------------------------------------------------------------------
Net cash (used in) provided by investing activities (14,085,246) 944,873
- -------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Purchase of treasury stock --- (1,625,808)
Proceeds from exercise of stock options --- 244,469
- -------------------------------------------------------------------------------------------------------------------------------
Net cash used in financing activities --- (1,381,339)
- -------------------------------------------------------------------------------------------------------------------------------
Net (decrease) increase in cash and cash equivalents (7,763,042) 2,120,124
Cash and cash equivalents at beginning of period 33,799,284 32,105,845
- -------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 26,036,242 $ 34,225,969
==============================================================================================================================
The accompanying notes are an integral part of
the condensed consolidated financial statements.
6
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements included
herein have been prepared by Tollgrade Communications, Inc. (the "Company") in
accordance with accounting principles generally accepted in the United States of
America for interim financial information and Article 10 of Regulation S-X. The
condensed consolidated financial statements as of and for the three-month period
ended March 29, 2003 should be read in conjunction with the Company's
consolidated financial statements (and notes thereto) included in the Company's
Annual Report on Form 10-K for the year ended December 31, 2002. Accordingly,
the accompanying condensed consolidated financial statements do not include all
of the information and footnotes required by accounting principles generally
accepted in the United States of America for complete financial statements,
although the Company believes that the disclosures are adequate to make the
information presented not misleading. In the opinion of Company management, all
adjustments considered necessary for a fair presentation of the accompanying
condensed consolidated financial statements have been included, and all
adjustments are of a normal and recurring nature. Operating results for the
three-month period ended March 29, 2003 are not necessarily indicative of the
results that may be expected for the year ending December 31, 2003.
2. ACQUISITION AND INTANGIBLE ASSETS
On February 13, 2003, the Company acquired certain assets and assumed certain
liabilities of the Cheetah(TM) Status and Performance Monitoring Product Line
Business ("Cheetah") from Acterna, LLC for approximately $14,300,000 in cash.
The Company also incurred acquisition-related costs of approximately $809,000
for a total estimated cost of approximately $15,109,000. In addition, as part of
the acquisition, contingent purchase consideration of up to $2,400,000 in the
form of an earn-out, may be payable based on certain 2003 performance targets
for the acquired business. The acquired assets consist principally of existing
sales order backlog, product inventory, intellectual property, software and
related computer equipment, while the assumed liabilities principally relate to
deferred software maintenance, warranty and other obligations. The $14,300,000
due at closing and related acquisition expenses were paid from available cash
and short-term investments. The Company believes that the acquired business
complements its current cable operations and positions the Company as a leading
supplier of testing equipment and software for the cable industry. The
acquisition was recorded under the purchase method of accounting and
accordingly, the results of operations of the acquired business from February
14, 2003 forward are included in the consolidated financial statements of the
Company.
The Company has made a preliminary allocation of the purchase price to the fair
value of assets acquired and liabilities assumed. The allocation is subject to
change based upon continuing review and determinations. Further, the purchase
price may change due to the earn-out and other provisions in the purchase
agreement, which would require further adjustment to the allocation of purchase
price. Such adjustments may be material.
7
The following summarizes the estimated, current evaluation of the fair values at
the date of acquisition:
Inventories $ 1,131,000
Property and Equipment, net 537,000
Deferred Tax Assets 241,000
Intangible Assets:
Customer Base $ 5,000,000
Cheetah Trademark 1,000,000
Base Software 2,900,000
Proprietary Technology 1,000,000
Sales Order Backlog 600,000 10,500,000
--------------
Goodwill 4,182,000
------------------------------------------------------------------------------------------------------
Total Assets Acquired $ 16,590,000
------------------------------------------------------------------------------------------------------
Deferred Income (621,000)
Other Liabilities (860,000)
------------------------------------------------------------------------------------------------------
Total Liabilities Assumed $ (1,481,000)
------------------------------------------------------------------------------------------------------
NET ASSETS ACQUIRED $ 15,109,000
======================================================================================================
An independent valuation consultant assisted management in its initial
determination of fair value assigned to certain intangible assets other than
goodwill. Discounted future cash flow models were utilized where appropriate.
The Cheetah product line has maintained a significant market share in
cable status and performance monitoring equipment for more than 25 years and has
a large installed customer base, including many of the largest multiple system
cable operators. The Company expects that, on average, approximately 85% of
future revenues attributable to Cheetah products will be derived from this
customer base and, based on prior experience, does not anticipate turnover or
loss of these customers. Therefore, the Company has concluded that the customer
base and Cheetah trademark intangible assets have an indefinitely long life.
Consequently, in accordance with SFAS No. 142, "Goodwill and Other Intangible
Assets", the values assigned to customer base and the Cheetah trademark, as well
as to related goodwill, are not being amortized for financial reporting
purposes.
The Company believes that the base software will be used in future
releases of NetMentor(TM) and other software products with little change into
the foreseeable future. Similarly, the proprietary technology embedded in
transponder hardware is expected to have a relatively long useful life.
Therefore, the Company has determined that the base software and proprietary
software have a remaining useful life of ten years and will be amortized for
financial reporting purposes over that period.
The Company obtained a backlog of customer purchase orders totaling
approximately $2,383,000 in connection with the Cheetah acquisition. Using a
discounted cash flow analysis, the Company determined an acquired value of
$600,000 for this backlog. This asset is being amortized as the related orders
are being realized as sales revenue. Amortization of approximately $475,000 was
recognized in cost of sales in the first quarter of 2003 and it is expected that
the balance of $125,000, which is included in prepaid expenses and other current
assets, will be amortized in the second quarter of 2003.
For tax purposes, the Company is amortizing all intangible assets over
15 years.
SFAS No. 142 provides that entities evaluate the remaining useful lives
of intangible assets determined to have indefinite useful lives periodically to
determine whether events and circumstances continue to support an indefinite
useful life and that such assets be tested at least annually for impairment of
value. The
8
Company's policy is to test all intangible assets for impairment in value as of
December 31 of each year or more frequently if events or changes in
circumstances indicate that assets might be impaired.
The following condensed proforma results of operations reflect the
proforma combination of the Company and the acquired Cheetah product line as if
the combination occurred on January 1, 2002.
(In Thousands, Except Per Share Data )
Proforma - Three Months Ended
March 29, 2003 March 30, 2002
-------------- --------------
Revenues $ 15,906 $ 22,918
- ----------------------------------------------------------------------------------------------
Income from operations 1,168 5,474
- ----------------------------------------------------------------------------------------------
Net income 801 1,589
- ----------------------------------------------------------------------------------------------
Diluted earnings per share $ 0.06 $ 0.12
- ----------------------------------------------------------------------------------------------
The proforma results of operations for the quarter ended March 29, 2003 include
revenues of Acterna for the Cheetah product line through February 13, 2003, the
date of acquisition. Cost of sales and operating expenses for both quarterly
periods were based on information of Cheetah made available to the Company with
proforma adjustments made to adjust gross margins to 50% of revenues based upon
experience to date and to adjust operating expenses to reflect the Company's
financial plan for Cheetah for 2003. These adjustments were made to reflect
significant changes to operations made by the Company since acquisition. Both
periods also reflect proforma adjustments to include amortization of base
software and proprietary technology over a ten-year period, an amount of $97,500
per quarter. A proforma adjustment for the quarter ended March 30, 2002 results
in a $600,000 charge for total amortization of the purchased sales order backlog
while an adjustment in the quarter ended March 29, 2003 reverses the actual
amortization of the backlog in that period for $475,000. Also, the first quarter
of 2002 includes an estimated charge for warranty expense of $348,000 to adjust
the warranty accrual to a balance more in line with the Company's normalized
cable product warranty experience. Proforma adjustments were made to take into
account the cost of money in connection with the acquisition costs in both
periods. This was projected by reducing interest income at historical earning
rates for working capital deemed to have been used to pay for the acquisition
and related costs. Adjustments were also made to reflect the tax consequences of
the foregoing proforma adjustments.
This proforma financial information is presented for comparative purposes only
and is not necessarily indicative of the operating results that actually would
have incurred had the Cheetah product line acquisition been consummated on
January 1, 2002. In addition, these results are not intended to be a projection
of future results.
The following information is provided regarding the Company's intangible assets:
9
As of March 29, 2003 As of December 31, 2002
-------------------- -----------------------
Gross Gross
Carrying Accumulated Carrying Accumulated
Amount Amortization Amount Amortization
-------- ------------ -------- ------------
Amortized intangible assets:
Current:
Sales Order Backlog $ 600,000 $ 474,825 $ ---- $ ----
Long Term:
Developed product software 7,403,997 2,198,101 7,368,100 1,829,098
Base Software - Cheetah 2,900,000 36,250 ---- ----
Proprietary Technology 1,000,000 12,500 ---- ----
----------- ----------- ----------- ----------
$11,903,997 $ 2,721,676 $ 7,368,100 $1,829,098
=========== =========== =========== ==========
Unamortized intangible assets:
LoopCare trade name $ 1,300,000 $ ---- $ 1,300,000 $ ----
Base software - LoopCare 5,200,000 ---- 5,200,000 ----
Post warranty maintenance
service agreements 32,000,000 ---- 32,000,000 ----
Customer Base - Cheetah 5,000,000 ---- ---- ----
Cheetah Trademark 1,000,000 ---- ---- ----
----------- ----------- ----------- ----------
$44,500,000 $ ---- $38,500,000 $ ----
=========== =========== =========== ==========
Estimated amortization expense:
For year ended December 31, 2003 $ 2,420,853
For year ended December 31, 2004 1,870,799
For year ended December 31, 2005 1,870,799
For year ended December 31, 2006 1,505,799
For year ended December 31, 2007 406,702
Actual amortization expense:
For the three-month period ended March 30, 2002 $ 369,040
For the three-month period ended March 29, 2003 892,578
Actual net income:
For the three-month period ended March 30, 2002 $ 1,512,814
For the three-month period ended March 29, 2003 426,370
3. INVENTORIES
At March 29, 2003 and December 31, 2002, inventories consisted of the following:
10
(Unaudited)
March 29, December 31,
2003 2002
------------ ------------
Raw materials ............................................. $ 9,565,387 $ 9,726,789
Work in process ........................................... 5,364,983 4,518,164
Finished goods ............................................ 2,264,454 2,190,476
$ 17,194,824 $ 16,435,429
Allowance for slow moving and
obsolete inventory ..................................... (2,354,041) (2,342,833)
------------ ------------
$ 14,840,783 $ 14,092,596
============ ============
Raw materials as of March 29, 2003 includes inventory of $791,871
recorded at fair value that was acquired in February 2003 in connection with the
Cheetah acquisition. The Company has engaged a turn-key contractor to fully
manufacture the Cheetah products. This contractor has experience with most of
Cheetah's products and had manufactured the products prior to the 2000
acquisition of the business by Acterna. The contractor intends to purchase the
acquired inventory on an as-needed basis and thereafter will obtain materials
from other sources of supply, eliminating the need for the Company to carry
inventory for the Cheetah operations.
4. SHORT-TERM INVESTMENTS
Short-term investments at March 29, 2003 and December 31, 2002 consisted of
individual municipal bonds stated at cost, which approximated market value.
These securities have maturities of one year or less at date of purchase and/or
contain a callable provision in which the bonds can be called within one year
from date of purchase. The primary investment purpose is to provide a reserve
for future business purposes, including acquisitions and capital expenditures.
Realized gains and losses are computed using the specific identification method.
The Company classifies its investment in all debt securities as "held to
maturity," as the Company has the positive intent and ability to hold the
securities to maturity.
The estimated fair values of the Company's financial instruments are as follows:
(Unaudited)
March 29, December 31,
2003 2002
-------------------------------- --------------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
----------- ----------- ----------- -----------
Financial assets:
Cash and cash equivalents .................. $26,036,242 $26,036,242 $33,799,284 $33,799,284
Short-term investments ..................... 17,583,431 17,504,461 19,328,883 19,257,039
----------- ----------- ----------- -----------
$43,619,673 $43,540,703 $53,128,167 $53,056,323
=========== =========== =========== ===========
11
5. INCOME PER COMMON SHARE
Net income per share is calculated by dividing net income by the weighted
average number of common shares plus incremental common stock equivalent shares
(shares issuable upon exercise of stock options). Incremental common stock
equivalent shares are calculated for each measurement period based on the
treasury stock method, which uses the monthly average market price per share.
The calculation of net income per common and common equivalent shares follows
(unaudited):
Three Months Three Months
Ended Ended
March 29, 2003 March 30, 2002
- -----------------------------------------------------------------------------------------------------
Net income $ 426,370 $1,512,814
==================================================================================================
Common and common equivalent shares:
Weighted average number of
common shares outstanding
during the period ........................................ 13,090,936 13,099,210
Common shares issuable upon exercise
of outstanding stock options:
Diluted ............................................... 120,947 322,097
Common and common equivalent shares
outstanding during the period:
- --------------------------------------------------------------------------------------------------
Diluted ............................................... 13,211,883 13,421,307
==================================================================================================
Earnings per share data
Net income per common and common
equivalent shares:
Basic ................................................. $ .03 $ .12
Diluted ............................................... $ .03 $ .11
12
6. ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company has two stock-based employee compensation plans. The Company
accounts for these plans under the recognition and measurement provisions of APB
Opinion No. 25, "Accounting for Stock Issued to Employees." Under these
provisions, stock- based employee compensation cost is not reflected in net
income for any year, as all options granted under the plans had an exercise
price equal to the market value of the underlying common stock on the date of
grant. If the Company had elected to recognize compensation cost for these stock
options based on the fair value method set forth in SFAS No. 123, "Accounting
for Stock-Based Compensation," net income and earnings per share would have
reflected the pro forma amounts indicated below:
Quarter ended
March 29, 2003 March 30, 2002
-------------- --------------
Net income, as reported $ 426,370 $ 1,512,814
Deduct: Total stock-based compensation expense
based on the fair value method for all awards,
net of related tax 558,309 1,501,042
------------- -------------
effects
Pro forma net income $ (131,939) $ 11,772
============= =============
Earnings per share:
Basic - as reported $ 0.03 $ 0.12
Basic - pro forma $ (0.01) $ 0.00
Diluted - as reported $ 0.03 $ 0.11
Diluted - pro forma $ (0.01) $ 0.00
7. ACCOUNTING PRONOUNCEMENTS
On August 15, 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Accounting Standard (SFAS) No. 143, "Accounting for Asset
Retirement Obligations." On October 4, 2001, FASB issued SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets." The Company
adopted these statements on January 1, 2003 and such adoption did not have a
material effect on the Company's financial statements.
In June 2002, the FASB issued SFAS No. 146, "Accounting For Costs Associated
With Exit Or Disposal." SFAS No. 146 nullifies Emerging Tax Issues Task Forces
(EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred
in a Restructuring)." The new Statement requires that a liability for a cost
associated with an exit or disposal activity be recognized and measured
initially at fair value only when the liability is incurred. SFAS No. 146 is
effective for exit or disposal activities that are initiated after December 31,
2002. This statement did not have a material effect on the Company's financial
position or results of operations.
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires that upon
issuance of a guarantee, a guarantor must recognize a liability for the fair
value of an
13
obligation assumed under a guarantee. FIN 45 also requires additional
disclosures by a guarantor in its interim and annual financial statements about
the obligations associated with guarantees issued. The recognition provisions of
FIN 45 are effective for any guarantees issued or modified after December 31,
2002. The provisions of FIN 45 did not have a material impact on the Company's
results of operations or financial position.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure." This Statement amends SFAS No. 123,
Accounting for Stock-Based Compensation, to provide alternative methods of
transition to SFAS No. 123's fair value method of accounting for stock-based
employee compensation. This Statement also amends the disclosure provision of
SFAS No. 123 and APB No. 28, Interim Financial Reporting, to require disclosure
in the summary of significant accounting policies footnote in the financial
statements of the effects of an entity's accounting policy with respect to
stock-based employee compensation on reported net income and earnings per share
in annual and interim financial statements. The Company has elected to continue
to follow the disclosure-only provisions of SFAS No. 123 and adopted the
disclosure provisions of SFAS No. 148.
On January 17, 2003, the FASB issued FASB Interpretation No. 46, "Consolidation
of Variable Interest Entities - an interpretation of ARB No. 51" ("FIN 46"). FIN
46 clarifies the application of Accounting Research Bulletin No. 51,
"Consolidated Financial Statements", to certain entities in which equity
investors do not have the characteristics of a controlling financial interest or
do not have sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support from other parties. FIN 46 was
effective for the Company after January 31, 2003 and did not have a material
impact on the Company's results of operations or financial condition.
8. PRODUCT WARRANTY
The Company records estimated warranty costs on the accrual basis of accounting.
These reserves are based on applying historical returns to the current level of
product shipments and the cost experience associated therewith. In the case of
software, the reserves are based on the expected cost of providing services
within the agreed-upon warranty period. Activity in the warranty accrual is as
follows:
Quarter Ended
March 29, 2003 March 30, 2002
- --------------------------------------------------------------------------------------------------------------
Balance at the beginning of the period $ 1,981,000 $ 2,049,000
Accruals for warranties issued during the period 456,000 150,000
Accruals related to pre-existing warranties 13,000 95,000
Cheetah opening accrual 617,000 ----
Settlements during the period (21,000) (13,000)
- -------------------------------------------------------------------------------------------------------------
Balance at the end of the period $ 3,046,000 $ 2,281,000
=============================================================================================================
The Company has reflected a $617,000 entry on the Cheetah opening balance sheet
to provide an estimated accrual for pre-acquisition warranty costs for the
Cheetah products. The Company utilized the historical warranty experience of
LIGHTHOUSE(R) products to estimate applicable Cheetah warranty expense.
14
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of
Tollgrade Communications, Inc. and subsidiaries:
We have reviewed the accompanying condensed consolidated balance sheet of
Tollgrade Communications, Inc. and its subsidiaries as of March 29, 2003, and
the related condensed consolidated statements of operations for each of the
three-month periods ended March 29, 2003 and March 30, 2002 and the condensed
consolidated statement of cash flows for the three-month periods ended March 29,
2003 and March 30, 2002 and the statement of changes in shareholders' equity for
the three-month period ended March 29, 2003. These financial statements are the
responsibility of the Company's management.
We conducted our review in accordance with standards established by the American
Institute of Certified Public Accountants. A review of interim financial
information consists principally of applying analytical procedures to financial
data and making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in accordance
with generally accepted auditing standards, the objective of which is the
expression of an opinion regarding the financial statements taken as a whole.
Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to the accompanying condensed consolidated interim financial statements
for them to be in conformity with accounting principles generally accepted in
the United States of America.
We previously audited in accordance with auditing standards generally accepted
in the United States of America, the consolidated balance sheet as of December
31, 2002, and the related consolidated statements of operations, shareholders'
equity and of cash flows for the year then ended (not presented herein), and in
our report dated January 22, 2003 we expressed an unqualified opinion on those
consolidated financial statements. In our opinion, the information set forth in
the accompanying condensed consolidated balance sheet as of December 31, 2002,
is fairly stated in all material respects in relation to the consolidated
balance sheet from which it has been derived.
/s/ PricewaterhouseCoopers LLP
Pittsburgh, Pennsylvania
April 15, 2003
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF
OPERATIONS AND FINANCIAL CONDITION
The following discussion should be read in conjunction with the Condensed
Consolidated Financial Statements and Notes thereto appearing elsewhere in this
report.
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995.
The statements contained in this Quarterly Report on Form 10-Q, including, but
not limited to those contained in Item 2. Management's Discussion and Analysis
of Results of Operations, which are not historical facts are considered
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. These statements, which may be expressed in a variety of ways,
including the use of forward-looking terminology such as "will, believes,
intends, expects, plans, may" or the negatives thereof, other variations thereon
or comparable terminology, relate to, among other things, projected cash flows
which are used in the valuation of intangible assets, the anticipated results of
negotiations for new maintenance service agreements, as well as purchase orders
and other customer purchase agreements, the ability to utilize current deferred
and refundable tax assets, opportunities which the Services group offers to
customers, the potential loss of certain customers, the timing of orders from
customers, the effect of consolidations in the markets to which Tollgrade
Communications, Inc. (the "Company") sells, the effects of the economic slowdown
in the telecommunications and cable industries, the possibility of future
provisions for slow moving inventory, and the effect on earnings and cash flows
of changes in interest rates. The Company does not undertake any obligation to
publicly update any forward-looking statements.
These forward-looking statements and other forward-looking statements contained
in other public disclosures of the Company which make reference to the
cautionary factors contained in this Form 10-Q, are based on assumptions that
involve risks and uncertainties and are subject to change based on the
considerations described below. These risks, uncertainties and other factors may
cause actual results, performance or achievements to differ materially from
anticipated future results, performance or achievements expressed or implied by
such forward looking statements. Therefore, the Company wishes to caution each
reader of this Report on Form 10-Q to consider the following factors and certain
other factors discussed herein and in other past reports including, but not
limited to, prior year Annual Reports and Form 10-K and Form 10-Q reports filed
with the Securities and Exchange Commission ("SEC"). The factors discussed
herein may not be exhaustive. Therefore, the factors discussed herein should be
read together with other reports and documents that are filed by the Company
with the SEC from time to time, which may supplement, modify, supersede or
update the factors listed in this document.
General economic conditions and the economic conditions of the
telecommunications and cable industries, including the effect of subscriber line
loss and competition for the Company's RBOC customers from wireless, cable
providers and other carriers entering the local telephone service market can,
and has affected the capital budgets of the Company's customers. If such
conditions result in a further reduction of such budgets, the Company's revenues
could be adversely affected.
If the Company's customers find themselves unable to meet their established
purchase forecasts and their own growth projections, such customers may curtail
their purchase of the Company's products, which would adversely affect the
Company's revenues.
16
If the Company would be unable to establish customer or sales distribution or
original equipment manufacturer ("OEM") relationships relating to the Cheetah
cable status and performance monitoring product line, it could affect the rate
of incoming orders, which would adversely affect the Company's sales and
revenues.
If the financial strength of certain of the Company's major customers should
deteriorate or such customers encounter difficulties in accessing capital, the
ability of such customers to purchase and pay for the Company's products could
be impaired, with a corresponding adverse effect on the Company's revenues.
If third parties with whom the Company has entered into sales and marketing
partnerships should fail to meet their own performance objectives, customer
demand for the Company's products could be adversely affected, which would have
an adverse effect on the Company's revenues.
Seasonal fluctuations in customer demand for the Company's products can create
corresponding fluctuations in period-to-period revenues, and any increases in
the rate of order cancellation by customers could adversely affect future
revenues.
The carrying value of certain intangible assets, including goodwill, acquired by
the Company from Lucent Technologies, Inc. ("Lucent") and Acterna, LLC could be
impaired if changing market conditions indicate that lower than anticipated cash
flows will be produced by such intangible assets.
If the Company were to encounter a shortage of key manufacturing components from
limited sources of supply, or to experience manufacturing delays caused by
reduced manufacturing capacity or integration issues related to the acquisition
of the Cheetah product line, the loss of key assembly subcontractors or other
factors, the Company's ability to produce and ship its manufactured products
could be adversely affected, with an adverse effect upon revenues.
The introduction of improved products or services or reduced prices by the
Company's competitors could reduce the demand for the Company's products and
services and adversely affect revenues.
If the Company proves unable to respond effectively to technological change in
its industry, such as an evolution of the telephone network from circuit to
packet-based, by developing new products and services and obtaining customer
approval and acceptance of its products and services, demand for the Company's
products and services could be adversely affected, which would adversely affect
revenues.
The Company is dependent on a relatively narrow range of products and a small
number of large customers. As a result, the failure of one or a small number of
the Company's products to gain or maintain acceptance in the marketplace, or the
decision by one or a few of the Company's customers to curtail their purchases
of the Company's products could have an adverse effect on revenues.
If one or more of a small number of key employees of the Company were to cease
to be associated with the Company, the Company's future results could be
adversely affected.
If the Company is unable to successfully assert and defend its proprietary
rights in the technology utilized in its products, its future results could be
adversely affected. If third parties were able to successfully assert that the
Company's use of technology infringed upon the proprietary rights of others, the
future results of the Company could be adversely affected.
17
If one or more of the Company's products were to prove defective, the Company's
relationships with its customers could be jeopardized and the Company could be
subject to potential liability, adversely affecting the Company's future
results.
If for any reason demand for the Company's products should decrease, including
the successful development of a secondary market for the Company's products by a
third party, the Company could continue to find itself with excess inventory and
obsolete parts on hand, which could adversely affect future results.
Changes in government regulation, such as modification or repeal of The
Telecommunications Act of 1996, increasing the costs of doing business by the
Company or its customers, or preventing the Company or its customers from
engaging in business activities they may wish to conduct could adversely affect
the Company's future results.
The Company has recently completed certain acquisitions and expects to pursue
additional acquisitions and new business opportunities in the future as part of
its business strategy. If the Company fails to integrate successfully the
operations and products of acquired businesses, or if such acquisitions subject
the Company to unexpected liabilities and claims, the Company's future results
could be adversely affected.
The Company's future sales in international markets are subject to numerous
risks and uncertainties, including local economic and labor conditions,
political instability including terrorism and other acts of war or hostility,
unexpected changes in the regulatory environment, trade protection measures, tax
laws, the ability of the Company to market current or develop new products
suitable for international markets, obtaining and maintaining successful
distribution and resale channels and foreign currency exchange rates. Reductions
in the demand for or the sales of the Company's products in international
markets could adversely affect future results.
Overview
The Company was organized in 1986, began operations in 1988 and completed its
initial public offering in 1995. The Company designs, engineers, markets and
supports test system, test access and status and performance monitoring products
for the telecommunications and cable television industries. Effective September
30, 2001, the Company purchased certain assets of the LoopCare(TM) product
business from Lucent. The acquired assets consisted principally of LoopCare
software base code and developed enhancements, as well as the rights to existing
maintenance contracts for the LoopCare software, while the assumed liabilities
principally relate to deferred software maintenance and warranty obligations
under contract. Revenues from the sales of LoopCare software base code or
developed enhancements are either reported separately or as part of the
Company's revenues attributable to test system products to which they
synergistically relate, while the revenues from maintenance contracts are
reflected as part of the Company's Services revenues. On February 13, 2003, the
Company closed on a Purchase and Sale Agreement with Acterna, LLC to acquire
certain assets and assume certain liabilities related to the Cheetah(TM) Status
and Performance Monitoring Product Line. Acquired assets consist principally of
existing sales order backlog, product inventory, intellectual property, software
and related computer equipment, while the liabilities assumed principally relate
to deferred software maintenance, warranty and other obligations. The Company
has determined that its business has one reportable segment in the test
assurance industry. All product sales are considered components of the business
of testing infrastructure and networks for the telecommunications and cable
television industries. Although the Company does internally develop sales
results associated with the various product categories, this information is not
considered sufficient for segment reporting purposes nor does the chief
operating decision maker make critical decisions or allocate assets based solely
on this information. The Company's products and services have similar economic
characteristics, the same or similar production processes and are sold to
similar types or classes of customers in, or entering into,
18
the telecommunications and cable businesses through similar distribution means.
The LoopCare software product line was acquired by the Company to broaden its
DigiTest(R) test platform into a system level offering and as a competitive
defense to protect the Company's MCU(R) and DigiTest products' market share. The
Cheetah products were acquired to establish the Company as the market leader
within the global cable broadband marketplace. Cheetah and LIGHTHOUSE(R)
combined provide a complete line of solutions for customer's network monitoring
needs.
The Company's proprietary telecommunications test access products enable
telephone companies to use their existing line test systems to remotely diagnose
problems in "Plain Old Telephone Service" ("POTS") lines containing both copper
and fiber optics. The Company's MCU product line, which includes POTS line
testing as well as alarm-related products, represented approximately 31% of the
Company's revenue for the first quarter ended March 29, 2003. The Company's MCU
product line is expected to continue to account for a substantial portion of the
Company's revenues.
The Company's DigiTest centralized network test system platform, which includes
certain LoopCare software base code and developed enhancements, focuses on
helping local exchange carriers conduct the full range of fault diagnosis, along
with the ability to qualify, deploy and maintain next generation services that
include Digital Subscriber Line ("DSL") service and Integrated Services Digital
Network ("ISDN") service. The Company also sells LoopCare base code software
primarily to CLEC's to be used with test heads other than the Company's DigiTest
products. The Company's DigiTest system is designed to provide the complete
solution for testing POTS and performing local loop prequalification for DSL
services. The system currently consists of the comprehensive LoopCare diagnostic
software, as well as integrated pieces of hardware, including the Digital
Measurement Node ("DMN"), the Digital Measurement Unit ("DMU"), the Digital
Wideband Unit ("DWU") and the newly released Digital Wideband Node ("DWN"),
which is currently being brought to market. Revenues from DigiTest system
products for the first quarter of 2003 do not include DWN. When used in an
integrated fashion, the DigiTest system permits local exchange carriers to
perform a complete array of central office testing including POTS, DSL line
prequalification, bridged tap detection, data rate prediction, and in-service
wideband testing. Sales of the DigiTest product line accounted for approximately
13% of the Company's revenue for the first quarter of 2003.
The Company's LoopCare software products consist primarily of engineered
enhancements to the LoopCare base code software, which result in increased
connectivity and versatility of LoopCare within the customers' existing quality
assurance systems. Sales of LoopCare software products separate and unrelated to
DigiTest system products accounted for approximately 13% of total first quarter
2003 revenue.
The Company's cable products, which comprised approximately 24% of first quarter
2003 revenue, now include the LIGHTHOUSE(R) cable products as well as those of
the Cheetah brand group of products acquired on February 13, 2003. LIGHTHOUSE
products accounted for approximately 8% of the Company's first quarter 2003
revenue, while the new Cheetah products contributed approximately 16% of first
quarter 2003 revenue during the approximate six weeks it was owned and operated
by Tollgrade. The combined product lines, which will be more fully integrated in
the coming months, offer a complete cable status and performance monitoring
system that provides a broad testing solution for the broadband Hybrid Fiber
Coax distribution system. The offerings include the LIGHTHOUSE and NetMentor(TM)
software systems and maintenance, head-end controllers, return path switch
hardware, transponders and other equipment which gather status and performance
reports from power supplies, line amplifiers and fiber optic nodes.
The cornerstones of the Company's Services offerings are the Testability
Improvement Initiatives. These Services may offer the customer the opportunity
to make improvements in testability levels, while training their own staffs in
targeted geographic regions over a defined period of time. In this way, the
customers' internal repair technicians can make use of automated systems to
diagnose and repair subscriber loop
19
problems, thereby automatically eliminating the need for the involvement of
several highly trained people. The Services business was considerably expanded
upon the acquisition of software maintenance contracts related to the LoopCare
software product line and will be augmented by software maintenance and service
activities from Cheetah operations. Including the software maintenance revenues,
Services revenue accounted for approximately 20% of the Company's revenue for
the first quarter ended March 29, 2003.
The Company's primary customers for its telecommunication products and services
are the four Regional Bell Operating Companies ("RBOC") as well as major
independent telephone companies and certain digital loop carrier ("DLC")
equipment manufacturers. For the first quarter ended March 29, 2003,
approximately 61% of the Company's total revenue was generated from sales to
these four RBOC customers. During the first quarter of 2003, sales to three RBOC
customers (Verizon, Bell South and SBC) individually exceeded 10% of
consolidated revenues and on a combined basis, comprised approximately 51% (26%,
14% and 11%, respectively) of the Company's net sales. Due to the Company's
present dependency on these key customers, the potential loss of one or more of
them as a customer or the reduction of orders for the Company's products by them
could materially and adversely affect the Company.
The Company's operating results have fluctuated and may continue to fluctuate as
a result of various factors, including the timing of orders from, shipments to,
and acceptance of software by the RBOC customers and significant independent
telephone companies. This timing is particularly sensitive to various business
factors within each of the RBOC customers, including their relationships with
various organized labor groups and an increasing tendency for the RBOC customers
to place large orders for shipment of hardware and software toward the end of a
quarter. In addition, the markets for the Company's products, specifically,
LoopCare, DigiTest and LIGHTHOUSE and Cheetah, are highly competitive. Due to
the rapidly evolving market in which these products compete, additional
competitors with significant market presence and financial resources could
further intensify the competition for these products.
The Company believes that recent and continuing changes within the
telecommunication marketplace, including industry consolidation, as well as the
Company's ability to successfully penetrate certain new markets, have required
it to grant more favorable terms to some of its customers. In addition, certain
customers have consolidated product purchases that have translated into large
bulk orders. As stated earlier, there is an increasing trend, in part in
response to some of these discounting programs, for these customers to place
large bulk orders toward the end of a quarter for shipment of large quantities
of hardware and software in the last month of the quarter. Although the Company
will continue to strive to meet the demands of its customers, which include
delivery of quality products at an acceptable price and on acceptable terms,
there can be no assurance that the Company will be successful in negotiating
acceptable terms and conditions in customer purchase orders or customer purchase
agreements. Additionally, continuing consolidation efforts among the RBOC
customers, providing the RBOC customers the ability to consolidate their
inventory and product procurement systems, could cause fluctuations or delays in
the Company's order patterns. Consolidation in the cable industry, as well as
the adoption of industry standards to allow transponders to function among
various status monitoring systems, could and has caused pricing pressure as
competitors have begun lowering product pricing, which may adversely affect
revenues from sales of the Company's cable products. In addition, markets for
the Company's cable products have been and may continue to be highly competitive
and difficult for the foreseeable future. The Company cannot predict such future
events or business conditions and the Company's results could be adversely
affected by these industry trends in the primary markets its serves.
International sales were approximately 5% of total revenues in the first quarter
ended March 29, 2003. The Company believes that certain international markets
may offer further opportunities. The addition of the LoopCare software product
line, including the Lucent OEM resale arrangement for the LoopCare product, has
enhanced the Company's ability to penetrate these markets. The Company also
enjoys a stream of software
20
maintenance revenue from international sources, primarily from renewal of
contracts acquired through the business acquired from Lucent. However, the
international telephony markets differ from those found domestically due to the
different types and configurations of equipment used by those international
communication companies to provide services. In addition, certain competitive
elements are found internationally which do not exist in the Company's domestic
markets. These factors, when combined, have made entrance into these
international markets very difficult. From time to time, the Company has
utilized the professional services of various marketing consultants to assist in
defining the Company's international market opportunities. With the assistance
of these consultants and through direct marketing efforts by the Company, it has
been determined that its present MCU technology offers limited opportunities in
certain international markets for competitive and other technological reasons.
The Company continues to actively pursue opportunities for its other products
including its LoopCare software products in international markets. The newly
acquired Cheetah cable products have a presence and acceptance in Europe and
China and the Company intends to capitalize and expand upon that presence.
However, there can be no assurance that continued efforts by the Company will be
successful or that the Company will achieve significant international sales. In
addition, Lucent, while continuing to market its DSL services, has reduced its
research and development efforts in this area, which could have an adverse
effect on the Company's deployment of LoopCare internationally through the
Lucent OEM channel. Further, the international markets introduce the risk of
loss from currency fluctuations. While the Company endeavors to price its
products in U. S. dollars, this is not always possible and may be less so in the
future. Many international customers are also small and undercapitalized which
will present possible exposure to credit losses to a greater degree than has
historically been seen from domestic customers.
The Company believes that its future growth will continue to be affected by the
economic slowdown in the telecommunications industry as established RBOC and
large incumbent local exchange carrier ("ILEC") customers strive to further
reduce their capital and operating expense budgets, which will directly impact
RBOC and ILEC ordering patterns and quantities. The Company believes that the
RBOC and large ILEC customers are being adversely affected by subscriber line
losses and the after-effects of overspending in 1999 and 2000, as well as by
competition from cable and wireless carriers and other carriers entering the
local telephone service market. In addition, certain emerging carriers continue
to be hampered by financial instability caused in large part by a lack of access
to capital. Due to the effect of these adverse conditions, the Company will
continue to evaluate its investments in production, marketing and research and
development expenses and monitor, control or decrease expense levels, as
appropriate.
The Company also believes that future growth will depend, in part, on its
ability to design and engineer new products and, therefore, the Company spends a
significant amount on research and development. Research and development
expenses as a percentage of revenues were 23% in both the first quarter of 2003
and the first quarter of 2002.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
The Company's financial statements are prepared in conformity with accounting
principles generally accepted in the United States of America. The application
of certain of these accounting principles are more critical than others in
gaining an understanding of the basis upon which the Company's financial
statements have been prepared. The Company deems the following accounting
policies to involve critical accounting estimates.
REVENUE RECOGNITION -- The Company markets and sells POTS and broadband test
system hardware, and, since the September 30, 2001 acquisition of LoopCare,
related software. The Company follows Staff Accounting Bulletin 101, "Revenue
Recognition in Financial Statements" for hardware sales. This bulletin requires,
among other things, that revenue should be recognized only when title has
transferred and risk of loss has passed to a customer with the capability to
pay, and that there are no significant remaining obligations of the Company
related to the sale. The bulk of the Company's hardware sales are made to RBOCs
and other large customers. Terms of these hardware sales are predominantly FOB
shipping point. Revenue is recognized for these
21
customers upon shipment against a valid purchase order. The timing of revenue
recognition may require the judgment of management. The Company reduces
collection risk by requiring letters of credit or other payment guarantees for
significant sales to new customers and/or those in weak financial condition. The
Company follows the AICPA's Statement of Position "Software Revenue Recognition"
SOP 97-2 and related modifications for software perpetual license fee and
maintenance revenue. This statement requires that software license fee revenue
be recorded only when evidence of a sales arrangement exists, the software has
been delivered, and a customer with the capacity to pay has accepted the
software leaving no significant obligations on the part of the Company to
perform. The Company requires a customer purchase order or other written
agreement to document the terms of a software order and written, unqualified
acceptance from the customer prior to revenue recognition. In certain limited
cases, however, agreements provide for automatic customer acceptance after the
passage of time from a pre-determined event and the Company has relied on these
provisions for an indication of the timing of revenue recognition. For orders of
custom software, or orders that require significant software customization, the
Company employs contract accounting using the percentage-of-completion method,
whereby revenue is recognized based on costs incurred to date compared to total
estimated contract cost. The Company had one custom contract with a total price
of $1,500,000 in process during the first quarter of 2003 that is being
accounted for on the percentage of completion method. The revenue for orders
with multiple deliverables such as hardware, software and/or installation or
other services may be separated into stand-alone fair values if not already
documented in the purchase order or agreement and where list prices or other
objective evidence of fair value exists to support such allocation, in
accordance with the provisions of EITF 00-21, "Accounting for Revenue
Arrangements with Multiple Deliverables." Revenue will not be recognized for any
single element until all essential elements are delivered and accepted.
LoopCare, Cheetah and LIGHTHOUSE software customers generally enter into
agreements for software maintenance upon expiration of the stated software
warranty period. Maintenance agreements include software upgrades and bug fixes
as they become available; however, newly developed features must be purchased
separately. Post-warranty maintenance for new features is either included under
the current maintenance agreement without additional charge, and is considered
in the maintenance agreement fees, or is separately charged upon expiration of
the warranty. Depending on the timing of the enhancement purchase and the length
of the maintenance agreement, the Company must evaluate whether a portion of the
enhancement right to use fee should be treated as post contract support to be
deferred and recognized over the remaining life of the maintenance agreement.
Software maintenance revenue is recognized on a straight-line basis over the
period the respective arrangements are in effect. Revenue recognition,
especially for software products, involves critical judgments and decisions that
can result in material effects to reported net income.
INTANGIBLE ASSETS AND GOODWILL -- The Company had net intangible assets
of $74,026,090 at March 29, 2003, of which $59,867,659 resulted from the
acquisition of the LoopCare product line in September 2001 and $14,158,431
resulted from the acquisition of the Cheetah cable operations on February 13,
2003 (See "Acquisition" following). In connection with the LoopCare assets
acquired, intangible assets of $45,800,000 million were identified, of which
capitalized software valued at $7,300,000 was determined to have a definite
useful life of five years and is being amortized over that period. The remaining
identified intangible assets of $38,500,000 have been determined to have an
indefinite useful life and, along with goodwill of approximately $16,200,000,
are not being amortized.
In connection with the Cheetah assets acquired, intangible assets of $10,500,000
were tentatively identified, of which base software estimated at $2,900,000 and
proprietary technology estimated at $1,000,000 were determined to have a
definite useful life of ten years and are being amortized over that period. The
value of sales order backlog acquired from Acterna was estimated at $600,000 and
is being amortized as the related sales are realized. Amortization of this
backlog was $475,000 in the first quarter of 2003 and the remaining balance of
approximately $125,000 is expected to be amortized in the second quarter of
2003. The remaining identified intangible assets of customer base estimated at
$5,000,000 and "Cheetah" trademark estimated at
22
$1,000,000 have been determined to have an indefinite useful life and, along
with goodwill of approximately $4,182,000, are not being amortized. These
allocations are preliminary in nature and are subject to change as facts and
circumstances become known. Further, the purchase price may change due to the
earn-out and other provisions in the purchase agreement, which would require
further adjustment to the allocation of purchase price. Such adjustments may be
material.
The identification, valuation and estimate of useful lives of separate
intangible assets requires significant judgment by management and reliance on
projections of future results of operations which may be different than actual
future results. Independent valuation consultants assisted the Company in making
these judgments in connection with both acquisitions.
As of January 1, 2002, the Company fully adopted the provisions of SFAS No. 142
"Goodwill and Other Intangible Assets," issued in July 2001,which sets forth
standards for the recognition and measurement of an impairment loss related to
intangible assets and the accounting for goodwill. The Company has determined
that it has only one reporting segment and completed a test for goodwill
impairment as of June 29, 2002 and December 31, 2002 by comparing the aggregate
market value of the Company's stock with the Company's book carrying value,
including goodwill. These tests indicated that there was no impairment of the
goodwill carrying value. From time to time in 2002, after the initial impairment
test of goodwill at June 29, 2002 was completed, the market value of the
Company's stock temporarily declined to an amount below the Company's book
carrying value. Management believes that these cases are reflective of
conditions in the telecommunications and general markets. However, future
changes in circumstances, including a sustained decline in the aggregate market
value of the Company's stock, could necessitate a reconsideration of whether an
impairment of goodwill carrying value has occurred, requiring an alternate
testing of the fair value of the Company under guidance of SFAS No. 142. In that
event, impairment in value up to the full amount of the goodwill could be
determined, resulting in an impairment loss to be recorded in the Company's
financial statements.
All other intangible assets related to the LoopCare acquisition were tested for
impairment of carrying value as of December 31, 2002 using assumptions and
techniques employed in the original valuation and following the guidance of SFAS
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets."
Specifically, the sum of the projected future cash flows to be derived from the
developed product software was compared with the net book carrying value. The
impairment test for non-amortizable intangible assets other than goodwill
consisted of a comparison of the estimated fair value with carrying amounts. The
value of the LoopCare trade name was measured using the relief-from-royalty
method and discounted cash flow analyses were employed to test the value of the
base software and post warranty maintenance service agreements. These tests
indicated that none of the intangible assets had impairment in carrying value.
The Company plans to retest these assets as well as intangible assets resulting
from the Cheetah acquisition annually as of December 31 or more frequently if
events or changes in circumstances indicate that asset values might be impaired.
The testing relative to impairments involves critical accounting estimates. The
Company relies upon its financial plan and best estimates of revenues and cash
flows for later years in measuring current values; however, these expectations
may not be realized and future events and market conditions might indicate
material impairment of value at some point that could result in material charges
to net income. Such a future situation would not, however, in and of itself
affect the cash flow or liquidity of the Company.
The identified intangible assets include LoopCare RBOC service maintenance
agreements valued at $32,000,000. It is believed that these annual agreements
will be renewed into perpetuity due to their critical importance in the
operations of the customers. The Company has entered into new contracts for 2003
with three RBOC customers and is in negotiations with the remaining RBOC
customer whose agreement is under extension. One of these maintenance
agreements, although earlier terminable by the customer, enjoys a three year
term. The Company intends to maintain fixed fee arrangements for all contracts.
Therefore, the Company believes that the non-amortizing characteristics of these
intangible assets will be preserved. However, if a new maintenance agreement
with the remaining RBOC customer cannot ultimately be reached, or if an
agreement is reached with that customer which results in substantially less
revenue to the Company than the current fixed fee agreement, the current fair
value of the maintenance service agreements may be determined to be less than
the $32,000,000 carrying value, perhaps materially so, resulting in a non-cash
charge against
23
operating income in 2003 or beyond and/or commencement of amortization of the
remaining fair value over its determined useful life. A similar analysis of the
fair value of the maintenance service agreements would be required if any of the
Company's RBOC customers reduce or terminate their maintenance service
agreements for any reason.
INVENTORY VALUATION -- The Company utilizes a standard cost system that
approximates first-in, first-out costing of the products. Standards are
monitored monthly and changes are made on individual parts if warranted;
otherwise standard costs are updated on all parts annually; normally in November
of each year. The Company evaluates its inventories on a monthly basis for slow
moving, excess and obsolete stock on hand. The carrying value of such inventory
that is determined not to be realizable is reduced, in whole or in part, by a
charge to cost of sales and reduction of the inventory value in the financial
statements. The evaluation process, which has been consistently followed, relies
in large part on a review of inventory items that have not been sold, purchased
or used in production within a one-year period. Management also reviews, where
appropriate, inventory products that do not appear on the slow moving report but
which may be unrealizable due to discontinuance of products, evolving
technologies, loss of certain customers or other known factors. As a result of
this comprehensive review process, an adjustment to the reserve for slow moving
and obsolete inventory is normally made monthly. Inventory identified as
obsolete is also scrapped or discarded from time to time as circumstances
warrant. The Company acquired at fair value an estimated $1,131,000 of raw
material and finished goods inventory in February 2003 in connection with the
Cheetah acquisition. This inventory has been reduced to approximately $792,000
at March 29, 2003. The Company has engaged a turn-key contractor to fully
manufacture the Cheetah products. This contractor has experience with most of
Cheetah's products and had manufactured the products prior to the 2000
acquisition of the business by Acterna. The contractor intends to purchase the
acquired inventory on an as-needed basis and thereafter will obtain materials
from other sources of supply, eliminating the need for the Company to carry
inventory for the Cheetah operations. Inventory realization is considered a
critical accounting estimate since it relies in large part on management
judgments as to future events and differing judgments could materially affect
reported net income. Due to the decline in sales in 2001 and 2002, slow moving
inventory increased in volume but included many items believed to be active
inventory for active products. This trend resulted not only from slower sales
but also from the strong effort to reduce inventory levels in 2001 and 2002 that
resulted in reduced manufacturing activity and parts usage. The expense for slow
moving and obsolete inventory was $115,378 in the first quarter of 2003 compared
to $643,227 in the first quarter of 2002. The inventory valuation reserves
increased $11,208 in the first quarter of 2003 compared to an increase of
$563,000 in the year earlier period, to a balance at March 29, 2003 of
$2,354,041.
INCOME TAXES -- The Company follows the provisions of SFAS No. 109, "Accounting
for Income Taxes," in reporting the effects of income taxes in the Company's
consolidated financial statements. Deferred tax assets and liabilities are
determined based on the "temporary differences" between the financial statement
carrying amounts and the tax basis of assets and liabilities using enacted tax
rates in effect in the years in which the differences are expected to reverse.
As of March 29, 2003, the Company has recorded net deferred tax assets of
$3,055,208, comprised of an estimated $240,825 resulting from the Cheetah
acquisition, $1,665,262 resulting from carry forward of state net operating
losses and other tax assets of $3,018,759, net of deferred tax liabilities of
$1,869,638. Total net deferred tax assets increased by $124,935 in the first
quarter of 2003, exclusive of the deferred tax assets resulting from the Cheetah
acquisition, but are expected to decrease in future periods due to the
amortization of intangible assets for tax purposes. The timing of the reversal
of the deferred tax liabilities and to a large extent the deferred tax assets is
dependent upon uncertain future events and cannot be assumed to occur in the
same tax years.
The state net operating loss carryforward relates primarily to stock option
deductions in 2000. The majority of this carryforward is subject to state laws
that allow a 20-year carry forward period with a $2.0 million limit on
24
deductions in each year. Future realization of the recorded tax assets resulting
from both timing differences and carryforward losses is dependent upon the
existence of sufficient taxable income in future years. SFAS No. 109 requires
that a valuation allowance be recorded against deferred tax assets when it is
more likely than not that some or all of the deferred tax assets will not be
realized. Management believes that the current business climate in the
telecommunications industry is not permanent and that the recorded tax assets
will more likely than not be realized in future years, especially for federal
tax assets that comprise 90% of the non-carryforward amounts. The Company had
federal taxable income in the first quarter of 2003 and expects that will
continue.
WARRANTY -- The Company provides warranty coverage on its various products.
Terms of coverage range from up to one year on software to two to five years for
hardware products. The Company reviews products returned for repair under
warranty on a quarterly basis and adjusts the accrual for future warranty costs
based upon cumulative returns experience. The Company also evaluates special
warranty problems for products with a higher return rate to correct the
underlying causes and, where deemed necessary, to provide additional warranty
expense for expected higher returns of these products. In connection with the
Company's acquisition of the Cheetah product line, several new manufacturing
practices were established, including having a turn-key operator produce the
majority of all products and the establishment of several new post-manufacturing
test practices. In the absence of specific repair experience for Cheetah
products manufactured under these new conditions, the Company utilized the
historical warranty experience of LIGHTHOUSE products to estimate applicable
Cheetah warranty expense. The Company will develop specific historical warranty
data and account for Cheetah warranty expense consistent with other hardware
products. Warranty costs associated with software sales are also accrued based
on the projected hours to be incurred during the warranty period (normally three
months). The accounting for warranty costs involves critical estimates and
judgments that can have a material effect on net income. The Company recorded a
$617,000 acquisition entry as of February 13, 2003 to provide an estimated
accrual for pre-acquisition warranty costs for the Cheetah products. The
warranty accrual was also increased an additional $448,400 by a charge to cost
of sales in the first quarter of 2003; of which $219,500 related to first
quarter Cheetah sales and $94,500 resulted from new extended warranty programs.
Nevertheless, barring unforeseen circumstances, management expects that the
warranty accrual will begin to decrease since the moving time period of
shipments on which the accrual is based will include fewer shipped units due to
decreasing sales levels over the last several periods.
These areas involving critical accounting estimates are periodically reviewed
with the audit committee and, in the case of revenue recognition and valuation
of intangible assets, the Audit Committee of the Board of Directors has assisted
in the development of the corporate policies and procedures followed.
RESULTS OF OPERATIONS - FIRST QUARTER OF 2003 COMPARED TO FIRST QUARTER OF 2002
Revenues
Revenues for the first quarter of 2003 of $14,543,423 were $2,978,851 or 17%
lower than the revenues of $17,522,274 reported for the first quarter of 2002.
First quarter revenues included Cheetah product revenues for six weeks in the
2003 period that were not available in 2002. The revenue performance by product
line for the first quarter of 2003 compared to the prior year period follows.
The decrease in revenues for the first quarter of 2003 is due primarily to
slower deployments of the MCU product-line caused by the RBOC customers, who
continued to restrain capital spending in traditional POTS line areas such as
Digital Loop Carrier deployment due to continuing subscriber line losses. As the
product life cycle for the MCU product continues to mature, however, there is an
increasing possibility that customer requirements for certain legacy MCU
products may be satisfied, which would result in lower revenues to the Company.
MCU sales are expected to continue to account for a substantial portion of the
Company's revenues for the foreseeable future. Sales of MCU products were
$4,461,000 for the first quarter of 2003; a decrease of
25
$5,010,000 from the year earlier period. MCU sales comprised 30.7% of total
first quarter 2003 revenues compared to 54.1% for the first quarter of 2002.
Sales of the Company's DigiTest system products, which include LoopCare
software, decreased 10.2% between quarterly periods due largely to a reduction
in sales to international customers in the current quarter. DigiTest product
sales of $1,820,000 in the first quarter of 2003 decreased $207,000 from the
year earlier quarter and represented 12.5% of total revenue for the current
quarter compared to 11.6% for the first quarter of 2002. The 2003 quarter
included sales to an RBOC customer for LTS replacement and an initial DigiTest
system sale to a CLEC customer.
Sales of LoopCare software products separate and unrelated to DigiTest system
products were $1,871,000 in the first quarter of 2003, a reduction of $753,000
or 28.7% from the first quarter of 2002. The current quarter revenue included
$1,305,000 from a custom software sale to an RBOC customer which was accounted
for on the percentage of completion basis. These sales comprised 12.9% of total
revenues during the first quarter of 2003, compared to 15.0% for the
corresponding year earlier period.
Services revenues, which includes installation oversight and project management
services provided to RBOC and other customers and fees for LoopCare and Cheetah
software maintenance, were approximately $2,973,000 in the first quarter of
2003, or 20.4% of total quarterly revenues. Services revenues increased $380,000
over the first quarter of 2002.
Overall sales of cable hardware and software products of $3,418,000 increased
$2,748,000 or 410% from the prior year's quarter. The new Cheetah line, acquired
on February 13, 2003, contributed $2,275,000 to this increase. LIGHTHOUSE
product sales of $1,143,000 also increased during the 2003 quarter from $670,000
in the year earlier period due to the strength of increased shipments to Comcast
(formerly AT&T BIS) as well as continued deployments of the Company's V.5
software in RCN Corporation systems. Combined sales of cable status monitoring
system products amounted to 23.5% of total first quarter 2003 revenue.
Periodic fluctuations in customer orders and backlog result from a variety of
factors, including but not limited to, the timing of significant orders from,
shipments to, and acceptance of software by RBOC customers, and are not
necessarily indicative of long-term trends in sales of the Company's products.
Gross Profit
Gross profit for the first quarter of 2003 was $7,569,147 compared to
$10,140,016 for the first quarter of 2002; a decrease of $2,570,869 or 25.4%.
Gross profit as a percentage of revenues decreased to 52.0% in the first quarter
of 2003 compared to 57.9% in the same quarter last year. The decrease in gross
profit as a percentage of sales resulted primarily from lower hardware sales
volume as well as lower sales of higher margin LoopCare software in the first
quarter of 2003. There was improvement in Services margins in 2003 due primarily
to Services productivity gains. Also negatively affecting gross profit was
amortization expense, which increased $528,000 from the prior year quarter due
primarily to amortization of approximately $475,000 of the $600,000 intangible
asset related to sales order backlog purchased from Acterna as part of the
Cheetah acquisition. Management expects the balance of approximately $125,000 to
be amortized in the second quarter of 2003. Continuing incremental amortization
of approximately $97,500 per quarter from other amortizable intangible assets
related to this acquisition will be charged to cost of sales on a going forward
basis. The Company's gross margin is and will continue to be highly sensitive to
the mix of products shipped, the level of operations and the level of reserves
required for slow moving and obsolete inventory.
Selling and Marketing Expense
Selling and marketing expense for the first quarter of 2003 was $1,970,654
compared to $2,417,309 for the first quarter of 2002. The decrease of $446,655
or 18.5% is due primarily to fewer employees and lower commissions,
26
travel and discretionary expenses, partially offset by expenses related to the
Cheetah operations acquired February 13, 2003. As a percentage of revenues,
selling and marketing expenses decreased slightly from 13.8% in the first
quarter of 2002 to 13.6% in the first quarter of 2003.
General and Administrative Expense
General and administrative expense for the first quarter of 2003 was $1,737,003,
an increase of $210,752 or 13.8% from the $1,526,251 recorded in the first
quarter of 2002. The increase is attributable to a provision for doubtful
accounts of $200,000 and higher general and health insurance costs. As a
percentage of revenues, general and administrative expenses increased to 11.9%
in the first quarter of 2003 from 8.7% in the first quarter of 2002.
Research and Development Expense
Research and development expense in the first quarter of 2003 was $3,321,218, a
decrease of $673,423 or 16.9% from the $3,994,641 recorded in the first quarter
of 2002. The decrease results primarily from the general reduction in work force
at the end of the third quarter of 2002 and also from lower project related
costs, decreased consulting and computer software spending. These cost savings
were partially offset by the addition of research and development activities
related to the Cheetah operations acquired February 13, 2003. As a percentage of
revenues, research and development expense remained constant between quarterly
periods at 22.8%.
Interest and Other Income
Interest and other income is composed primarily of interest income in both
quarterly periods. Interest and other income was $147,422 in the first quarter
of 2003 compared to $237,999 for the first quarter of 2002, a decrease of
$90,577 or 38.1%. This decrease results from lower market yields on short-term
interest bearing investments compared with the prior year quarter. The Company
had greater funds available for investment in the first quarter of 2003 despite
the $14,300,000 paid for the Cheetah operations due to cash generated from
operations in 2002.
Provision for Income Taxes
The provision for income taxes for the first quarter of 2003 was $261,324, a
decrease of $665,676 or 71.8% from the $927,000 recorded for the first quarter
of 2002. The effective income tax rate for both periods was approximately 38% of
pretax income.
Net Income and Earnings Per Share
As a result of the above factors, net income for the first quarter of 2003 was
$426,370, a decrease of $1,086,444 or 71.8% from the $1,512,814 recorded in the
first quarter of 2002. Basic and diluted earnings per common share of three
cents for the first quarter of 2003 decreased by nine cents (75.0%) and eight
cents (72.7%), from the twelve and eleven cents, respectively, earned in the
first quarter of 2002. Basic and diluted weighted average common and common
equivalent shares outstanding were 13,090,936 and 13,211,883, respectively, in
the first quarter of 2003 compared to 13,099,210 and 13,421,307, respectively,
in the first quarter of 2002. As a percentage of revenues, net income for the
first quarter of 2003 decreased to 2.9% compared to 8.6% for the first quarter
of 2002.
ACQUISITION
On February 13, 2003, the Company acquired certain assets and assumed certain
liabilities of the Cheetah(TM) Status and Performance Monitoring Product Line
from Acterna, LLC for approximately $14,300,000 in cash. The Company also
incurred acquisition-related costs of approximately $809,000 for a total cost of
approximately $15,109,000. In addition, as part of the agreement, contingent
purchase consideration of up to $2,400,000 in the form of an earn-out, may be
payable based on certain 2003 performance targets for the acquired business. The
acquired assets consist principally of existing sales order backlog, product
inventory,
27
intellectual property, software and related computer equipment, while the
assumed liabilities principally relate to deferred software maintenance,
warranty and other obligations. The $14,300,000 due at closing and related
acquisition expenses were paid from available cash and short-term investments.
The Company believes the acquired business complements its current cable
operations and positions the Company as a leading supplier of testing equipment
and software for the cable industry. The acquisition was recorded under the
purchase method of accounting and accordingly, the results of operations of the
acquired business from February 14, 2003 forward are included in the
consolidated financial statements of the Company. The purchase price allocation
will be finalized when all relevant amounts have been determined. Adjustments
will be made to the various assets acquired and liabilities assumed based on
final evaluations, and such adjustments may be material.
LIQUIDITY AND CAPITAL RESOURCES
The Company had working capital of $58,995,825 as of March 29, 2003, a decrease
of $14,193,113 or 19.4%, from the $73,188,938 of working capital as of December
31, 2002. The decrease in working capital is a result of the purchase of the
Cheetah operations and related acquisition expenses for $15,108,510 in cash on
February 13, 2003, partially offset by working capital generated from operations
in excess of purchases of property and equipment. As of March 29, 2003, the
Company had $43,619,673 of cash, cash equivalents and short-term investments
that are unrestricted and available for corporate purposes, including
acquisitions and other general working capital requirements.
The Company has in place a five-year $25.0 million Unsecured Revolving Credit
Facility (the "Facility") with a bank. Under the terms of the Facility, the
proceeds must be used for general corporate purposes, working capital needs, and
in connection with certain acquisitions. The Facility contains certain standard
covenants with which the Company must comply, including a minimum fixed charge
ratio, a minimum defined level of tangible net worth and a restriction on the
amount of capital expenditures that can be made on an annual basis, among
others. Commitment fees are payable quarterly at a rate of 0.25% of the unused
commitment. The Facility was amended in February 2003 in connection with the
acquisition of the Cheetah operations. As of March 29, 2003 and currently, there
are no outstanding borrowings under the Facility, and the Company is in
compliance with all debt covenants. Borrowings for working capital are not
currently anticipated, as the Company believes its cash reserves and internally
generated funds will be sufficient to sustain working capital requirements for
the foreseeable future.
Excluding Cheetah, planned capital expenditures for 2003 are approximately
$3,000,000. These planned capital projects include test fixtures and development
systems, computer and office equipment. Startup capital for the new Cheetah
operations is expected to approximate $2,000,000, consisting of new MIS/IT
infrastructure as well as leasehold improvements.
The Board of Directors has authorized the continuation of a share repurchase
program initiated in 1997. Under the current extension, the Company may
repurchase a total of one million shares of its common stock before December 31,
2003. The Company has repurchased 461,800 shares of common stock since the
repurchase program was instituted. The repurchased shares are authorized for use
under certain employee benefit programs. The Company at its discretion will
determine the number of shares and the timing of such purchases, which will be
made using existing cash and short-term investments.
COMMITMENTS
The Company leases office space and equipment under agreements that are
accounted for as operating leases. The office lease for the Cheswick facility
expires December 31, 2003 and is extended to December 31, 2005. The equipment
leases expire in August 2005 for the Cheswick facility and January 2007 for the
Bridgewater
28
facility. On February 18, 2003, the Company entered into a lease for office
space to house the Cheetah operations in Sarasota, Florida under a five-year
lease expiring on April 30, 2008. The Company is also involved in various
month-to-month leases for research and development equipment. In addition, the
office lease includes provisions for possible adjustments in annual future
rental commitments relating to excess taxes and excess maintenance costs that
may occur. Minimum annual future rental commitments under non-cancelable leases
as of March 29 are:
2003 (Nine Months) $ 1,150,550
2004 1,594,344
2005 1,591,544
2006 860,317
2007 (Three Months) 431,939
KEY RATIOS
The Company's days sales outstanding (DSO) in accounts receivable trade, based
on the past twelve months rolling revenue, was 50 and 53 days as of March 29,
2003 and December 31, 2002, respectively. The Company's inventory turnover ratio
was 1.4 turns at both March 29, 2003 and December 31, 2002. Management believes
that operating cash flow and cash reserves are adequate to finance currently
planned capital expenditures and to meet the overall liquidity needs of the
Company.
OFF-BALANCE SHEET ARRANGEMENTS
The Company does not engage in transactions or arrangements with unconsolidated
or other special purpose entities.
BACKLOG
The Company's backlog consists of firm customer purchase orders and signed
software maintenance agreements. As of March 29, 2003, the Company had a backlog
of $10,698,000 compared to $7,179,000 at December 31, 2002 and $8,809,000 at
March 30, 2002. This increase is due to receipt of a blanket purchase order for
$3,200,000 from a customer which covers that customer's MCU unit requirements
for all of calendar year 2003. Negotiations are progressing on one LoopCare RBOC
annual software maintenance agreement, which is under extension. The backlog at
March 29, 2003 includes approximately $4,529,000 related to software maintenance
contracts, which will be earned and recognized as income on a straight-line
basis during the remaining terms of the underlying agreements. Including these
maintenance billings, the Company expects approximately 47% of current backlog
to be recognized as revenue in the second quarter of 2003. 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. While these
fluctuations could impact short-term results, they are not necessarily
indicative of long-term trends in sales of the Company's products.
29
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's current investment policy limits its investments in financial
instruments to cash and cash equivalents, individual municipal bonds, and
corporate and government bonds. The use of financial derivatives and preferred
and common stocks is strictly prohibited. The Company believes it minimizes its
risk through proper diversification along with the requirements that the
securities must be of investment grade with an average rating of "A" or better
by Standard & Poor's. The Company holds its investment securities to maturity
and believes that earnings and cash flows will not be materially affected by
changes in interest rates, due to the nature and short-term investment horizon
for which these securities are invested.
Item 4. CONTROLS AND PROCEDURES
The Chief Executive Officer and the Chief Financial Officer of the Company (its
principal executive officer and principal financial officer, respectively) have
concluded, based on their evaluation as of a date within 90 days prior to the
date of the filing of this Report, that the Company's disclosure controls and
procedures are effective to ensure that information required to be disclosed by
the Company in the reports filed or submitted by it under the Securities
Exchange Act of 1934, as amended, is recorded, processed, summarized and
reported within the time periods specified in the SEC's rules and forms, and
include controls and procedures designed to ensure that information required to
be disclosed by the Company in such reports is accumulated and communicated to
the Company's management, including the Chief Executive Officer and Chief
Financial Officer, as appropriate to allow timely decisions regarding required
disclosure.
There were no significant changes in the Company's internal controls or in other
factors that could significantly affect these controls subsequent to the date of
such evaluation.
30
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS FILED ON FORM 8-K
(a) Exhibits:
The following exhibits are being filed with this report:
Exhibit
Number Description
------- -----------
15 Letter re unaudited interim financial information
99.1 Certification of Chief Executive Officer, filed herewith
99.2 Certification of Chief Financial Officer, filed herewith
(b) Reports on Form 8-K:
The Company filed one current report on Form 8-K during the quarter
ended March 29, 2003. On February 27, 2003, the Company disclosed
certain information in the Form 8-K regarding its acquisition on
February 13, 2003 of certain assets and assumption of certain
liabilities of Acterna, LLC relating to the Cheetah cable status and
performance monitoring product line.
31
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
Tollgrade Communications, Inc.
(Registrant)
Dated: May 13, 2003 /s/ Christian L. Allison
--------------------------------------
Christian L. Allison
Chairman and Chief Executive Officer
Dated: May 13, 2003 /s/ Samuel C. Knoch
--------------------------------------
Samuel C. Knoch
Chief Financial Officer and Treasurer
Dated: May 13, 2003 /s/ Charles J. Shearer
--------------------------------------
Charles J. Shearer
Controller
32
CERTIFICATION
I, Christian L. Allison, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Tollgrade
Communications, Inc.
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
(a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function);
(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
(b) (b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: May 13, 2003
/s/ Christian L. Allison
- -------------------------
Name: Christian L. Allison
Title: Chief Executive Officer
33
CERTIFICATION
I, Samuel C. Knoch, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Tollgrade
Communications, Inc.
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
(a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function);
(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: May 13, 2003
/s/ Samuel C. Knoch
- -------------------
Name: Samuel C. Knoch
Title: Chief Financial Officer
34
EXHIBIT INDEX
(Pursuant to Item 601 of Regulation S-K)
Exhibit
Number Description
------- -----------
15 Letter re unaudited interim financial information
99.1 Certification of Chief Executive Officer, filed herewith
99.2 Certification of Chief Financial Officer, filed herewith
35