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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 September 27, 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 October 31, 2003, there were 13,574,820 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 34.
1
TOLLGRADE COMMUNICATIONS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 27, 2003
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION PAGE NO.
--------
ITEM 1 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED):
CONDENSED CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 27, 2003 AND
DECEMBER 31, 2002 .........................................................................3
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE-MONTH AND NINE-
MONTH PERIODS ENDED SEPTEMBER 27, 2003 AND SEPTEMBER 28, 2002..............................4
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER'S EQUITY FOR THE
NINE-MONTH PERIOD ENDED SEPTEMBER 27, 2003.................................................5
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE-MONTH PERIOD
ENDED SEPTEMBER 27, 2003 AND SEPTEMBER 28, 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................................31
ITEM 4 CONTROLS AND PROCEDURES...................................................................31
PART II. OTHER INFORMATION
ITEM 6 EXHIBITS AND REPORTS FILED ON FORM 8-K....................................................32
SIGNATURES..............................................................................................33
EXHIBIT INDEX...........................................................................................34
2
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
SEPTEMBER 27, 2003 DECEMBER 31, 2002*
- ----------------------------------------------------------------------------------------------------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 31,896,516 $ 33,799,284
Short-term investments 13,682,004 19,328,883
Accounts receivable:
Trade 10,094,445 7,946,276
Other 54,6909 152,290
Inventories 12,294,05 14,092,596
Prepaid expenses and other current assets 895,228 1,529,968
Refundable income taxes 424,720 637,156
Deferred tax assets 1,743,936 1,404,122
- ----------------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 71,085,598 78,890,575
Property and equipment, net 8,527,541 7,438,870
Deferred tax assets 3,055,476 2,769,573
Intangibles 44,500,000 38,500,000
Goodwill 19,835,083 16,161,763
Capitalized software costs, net 8,168,754 5,539,002
Other assets 336,696 242,115
==========================================================================================================
TOTAL ASSETS $ 155,509,148 $ 149,541,898
==========================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 1,125,606 $ 499,642
Accrued warranty 2,565,608 1,980,520
Accrued expenses 1,310,998 748,576
Accrued salaries and wages 1,002,533 543,339
Accrued royalties payable 272,533 322,380
Income taxes payable 1,352,451 1,141,293
Deferred income 810,693 465,887
- ----------------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 8,440,422 5,701,637
Deferred tax liabilities 2,623,866 1,484,247
- ----------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 11,064,288 7,185,884
Commitments and contingent liabilities -- --
Shareholders' equity:
Common stock, $.20 par value; authorized shares,
50,000,000; issued shares, 13,552,736 in
2002 and 13,574,820 in 2003 2,714,964 2,710,547
Additional paid-in capital 70,740,333 70,489,025
Treasury stock, at cost, 461,800 shares (4,790,783) (4,790,783)
Retained earnings 75,780,346 73,947,225
- ----------------------------------------------------------------------------------------------------------
TOTAL SHAREHOLDERS' EQUITY 144,444,860 142,356,014
==========================================================================================================
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 155,509,148 $ 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)
================================================================================================================================
THREE MONTHS ENDED NINE MONTHS ENDED
------------------------------- -------------------------------
SEPTEMBER 27, SEPTEMBER 28, SEPTEMBER 27, SEPTEMBER 28,
2003 2002 2003 2002
================================================================================================================================
REVENUES:
Products $12,529,421 $11,260,585 $38,015,322 $38,207,243
Services 3,086,812 2,691,611 9,277,881 7,851,137
- --------------------------------------------------------------------------------------------------------------------------------
TOTAL REVENUES: 15,616,233 13,952,196 47,293,203 46,058,380
- --------------------------------------------------------------------------------------------------------------------------------
COST OF PRODUCT SALES:
Products 5,528,304 5,645,694 17,055,017 16,577,424
Services 1,010,193 867,969 2,776,240 2,722,795
Amortization of intangibles 490,437 366,298 1,890,928 1,096,767
7,028,934 6,879,961 21,722,185 20,396,986
- --------------------------------------------------------------------------------------------------------------------------------
GROSS PROFIT 8,587,299 7,072,235 25,571,018 25,661,394
- --------------------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSES:
Selling and marketing 2,319,913 2,162,734 6,711,353 6,804,876
General and administrative 1,664,797 1,216,570 5,230,062 4,011,415
Research and development 3,754,154 3,370,548 10,981,935 10,761,258
- --------------------------------------------------------------------------------------------------------------------------------
TOTAL OPERATING EXPENSES 7,738,864 6,749,852 22,923,350 21,577,549
- --------------------------------------------------------------------------------------------------------------------------------
INCOME FROM OPERATIONS 848,435 322,383 2,647,668 4,083,845
Interest and other income, net 76,486 150,767 308,979 588,766
- --------------------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 924,921 473,150 2,956,647 4,672,611
Provision for income taxes 351,470 179,798 1,123,526 1,775,592
================================================================================================================================
NET INCOME $ 573,451 $ 293,352 $ 1,833,121 $ 2,897,019
================================================================================================================================
EARNINGS PER SHARE INFORMATION:
Weighted average shares of common stock and equivalents:
Basic 13,112,966 13,090,936 13,102,121 13,096,496
Diluted 13,345,743 13,216,502 13,300,250 13,340,724
Net income per common and common equivalent shares:
Basic $ .04 $ .02 $ .14 $ .22
Diluted $ .04 $ .02 $ .14 $ .22
================================================================================================================================
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 NINE MONTHS ENDED SEPTEMBER 27, 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
Exercise of common
Stock options -- -- 22,084 4,417 196,108 -- -- 200,525
Tax benefit from
exercise of stock
options -- -- -- -- 55,200 -- -- 55,200
Net Income -- -- -- -- -- -- 1,833,121 1,833,121
- ----------------------------------------------------------------------------------------------------------------------------
Balance at
September 27, 2003 -- $ -- 13,574,820 $2,714,964 $70,740,333 $(4,790,783) $75,780,346 $144,444,860
- ----------------------------------------------------------------------------------------------------------------------------
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)
Nine Months Ended
- -----------------------------------------------------------------------------------------------------------------------
Sept. 27, 2003 Sept. 28, 2002
-------------- --------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $1,833,121 $2,897,019
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 3,638,461 2,820,998
Tax benefit from exercise of stock options 55,200 113,769
Refund and utilization of income taxes paid 212,436 522,761
Deferred income taxes 629,732 569,004
Provision for losses on inventory 301,966 2,064,518
Disposition of slow moving and obsolete inventory (295,799) (756,518)
Provision for allowance for doubtful accounts 517,307 100,000
Changes in assets and liabilities:
Increase in accounts receivable-trade (2,665,476) (1,697,142)
Decrease (Increase) in accounts receivable-other 97,600 (106,317)
Decrease in inventory 2,952,488 4,705,849
Decrease in prepaid expenses and other assets 600,504 167,370
Increase (decrease) in accounts payable 625,964 (633,459)
Increase in accrued warranty 288,088 204,265
Increase in accrued expenses and deferred income 117,140 363,539
Increase in accrued salaries and wages 459,194 396,456
Decrease in accrued royalties payable (49,847) (290,277)
Increase (decrease) in income taxes payable 211,158 (77,618)
- -----------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 9,529,237 11,364,217
- -----------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Cheetah (14,899,010) ---
Redemption/maturity of investments 6,636,046 7,284,312
Purchase of investments (989,167) (14,590,032)
Capital expenditures (2,380,399) (1,729,818)
Investments in other assets -- (30,532)
- -----------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (11,632,530) (9,066,070)
- -----------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Purchase of treasury stock -- (1,625,808)
Proceeds from exercise of stock options 200,525 278,175
- -----------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) financing activities 200,525 (1,347,633)
- -----------------------------------------------------------------------------------------------------------------------
Net (decrease) increase in cash and cash equivalents (1,902,768) 950,514
Cash and cash equivalents at beginning of period 33,799,284 32,105,845
- -----------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $31,896,516 $33,056,359
=======================================================================================================================
The accompanying notes are an integral part of the condensed
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 and
nine-month periods ended September 27, 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 and nine-month periods ended September 27, 2003 are not necessarily
indicative of the results that may be expected for the year ending December 31,
2003.
2. ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company has two stock-based employee compensation plans. The Company
accounts for these plans under the recognition and measurement provisions of 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:
Three Months ended Nine Months ended
------------------------------- --------------------------------
Sept. 27, 2003 Sept. 28, 2002 Sept. 27, 2003 Sept. 28, 2002
-------------- -------------- -------------- --------------
Net income, as reported $ 573,451 $ 293,352 $ 1,833,121 $ 2,897,019
Deduct: Total stock-based compensation expense based
on the fair value method for all awards, net of
related tax effects 395,518 1,117,816 1,402,198 3,985,477
--------- ----------- ----------- ------------
Pro forma net income $ 177,933 $ (824,464) $ 430,923 $ (1,088,458)
========= =========== =========== ============
Earnings (loss) per share:
Basic - as reported $ 0.04 $ 0.02 $ 0.14 $ 0.22
Basic - pro forma $ 0.01 $ (0.06) $ 0.03 $ (0.08)
Diluted - as reported $ 0.04 $ 0.02 $ 0.14 $ 0.22
Diluted - pro forma $ 0.01 $ (0.06) $ 0.03 $ (0.08)
7
3. 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
("Cheetah") from Acterna, LLC ("Acterna") for approximately $14,300,000 in cash.
The Company also capitalized acquisition-related costs of approximately $599,000
for a total estimated cost of approximately $14,899,000. 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 product line. If made, such earn-out payment would be accounted for
as an addition to goodwill. The acquired assets consist principally of existing
sales order backlog, product inventory, intellectual property, software and
related computer equipment, while the assumed liabilities principally relate to
deferred software maintenance, warranty and other obligations. The $14,300,000
due at closing and related acquisition expenses were paid from available cash
and short-term investments. The acquisition was recorded under the purchase
method of accounting and accordingly, the results of operations of the acquired
product line from February 14, 2003 forward are included in the consolidated
financial statements of the Company.
The Company has made an allocation of the 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.
The following summarizes the current estimated fair values as of the
date of acquisition:
Inventories $ 1,160,000
Property and Equipment, net 537,000
Deferred Tax Assets 116,000
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 3,673,000
--------------------------------------------------------------------------------
Total Assets Acquired $ 15,986,000
--------------------------------------------------------------------------------
Deferred Income (625,000)
Other Liabilities (462,000)
--------------------------------------------------------------------------------
Total Liabilities Assumed $ (1,087,000)
--------------------------------------------------------------------------------
NET ASSETS ACQUIRED $ 14,899,000
--------------------------------------------------------------------------------
An independent valuation consultant assisted management in its initial
determination of fair value assigned to certain intangible assets other than
goodwill. Discounted future cash flow models were utilized where appropriate.
The Cheetah product line has maintained a significant market share in
cable status and performance monitoring equipment for more than 25 years and has
a large installed customer base, including many of the largest multiple system
cable operators. The Company 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
8
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 intends that the base software will be used in future
releases of CheetahNet (TM) (formerly NetMentor(TM)) and other software products
with little change into the foreseeable future. Similarly, the proprietary
technology embedded in transponder hardware is designed to have a relatively
long useful life. Therefore, the Company has determined that the base software
and proprietary software have a remaining useful life of ten years and are being
amortized for financial reporting purposes over that period.
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 $540,000 was
recognized in cost of sales from the date of the acquisition through September
27, 2003 and it is expected that the balance of $60,000, which is included in
prepaid expenses and other current assets, will be amortized in the fourth
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 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)
--------------------------------------------------------------
Three Months Ended Nine Months Ended
----------------------------- -----------------------------
Sept. 27, 2003 Sept 28, 2002 Sept. 27, 2003 Sept 28, 2002
Historical Proforma Proforma Proforma
-------------- ------------- -------------- -------------
Revenues $ 15,616 $ 19,348 $48,656 $ 62,246
- ----------------------------------------------------------------------------------------------------------------
Income from operations 848 1,972 3,318 8,086
- ----------------------------------------------------------------------------------------------------------------
Net income 573 1,274 2,250 5,252
- ----------------------------------------------------------------------------------------------------------------
Diluted earnings per share $ 0.04 $ 0.10 $ 0.17 $ 0.39
- ----------------------------------------------------------------------------------------------------------------
The proforma results of operations for the nine months ended September 27, 2003
include revenues of Acterna for the Cheetah product line through February 13,
2003, the date of acquisition. Revenues for 2002, cost of sales and operating
expenses for proforma determinations were based on historical information
provided by Acterna with proforma adjustments made to adjust gross margins to
50% of revenues and to adjust operating expenses based upon the Company's
financial plan for Cheetah for 2003. These adjustments were made to reflect
significant changes to operations made by the Company since the acquisition.
This proforma financial information is presented for comparative purposes only
and is not necessarily indicative of the operating results that actually
9
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:
As of September 27, 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 $ 539,655 $ -- $ --
Long Term:
Developed product software 7,452,714 2,940,210 7,368,100 1,829,098
Base Software - Cheetah 2,900,000 181,250 -- --
Proprietary Technology 1,000,000 62,500 -- --
----------------------------- -----------------------------
11,952,714 3,723,615 $ 7,368,100 $ 1,829,098
============================= =============================
Non-amortized intangible assets:
LoopCare trade name $ 1,300,000 $ -- $ 1,300,000 $ --
Base software - LoopCare 5,200,000 -- 5,200,000 --
Post warranty maintenance -- --
service agreements 32,000,000 -- 32,000,000 --
Customer Base - Cheetah 5,000,000 -- -- --
Cheetah Trademark 1,000,000 -- -- --
----------------------------- -----------------------------
$44,500,000 $ -- $38,500,000 $ --
============================= =============================
Estimated amortization expense for the years ended:
December 31, 2003 $ 2,424,699
December 31, 2004 1,880,543
December 31, 2005 1,880,543
December 31, 2006 1,515,543
December 31, 2007 416,446
10
4. INVENTORIES
At September 27, 2003 and December 31, 2002, inventories consisted of the
following:
September 27, December 31,
2003 2002
------------- ------------
Raw materials ............................................. $ 8,353,314 $ 9,726,789
Work in process ........................................... 4,515,342 4,518,164
Finished goods ............................................ 1,774,403 2,190,476
------------ ------------
$ 14,643,059 $ 16,435,429
Allowance for slow moving and
obsolete inventory ..................................... (2,349,000) (2,342,833)
------------ ------------
$ 12,294,059 $ 14,092,596
============ ============
5. SHORT-TERM INVESTMENTS
Short-term investments at September 27, 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:
September 27, December 31,
2003 2002
------------------------- -------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
-------- ----- --------- -----
Financial assets:
Cash and cash equivalents ..................... $31,896,516 $31,896,516 $33,799,284 $33,799,284
Short-term investments ........................ 13,682,004 13,681,855 19,328,883 19,257,039
----------- ----------- ----------- -----------
$45,578,520 $45,578,371 $53,128,167 $53,056,323
=========== =========== =========== ===========
6. 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.
11
The calculation of net income per common and common equivalent shares follows:
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
September 27, 2003 September 28, 2002 September 27, 2003 September 28, 2002
- --------------------------------------------------------------------------------------------------------------------------------
Net income $ 573,451 $ 293,352 $ 1,833,121 $ 2,897,019
- --------------------------------------------------------------------------------------------------------------------------------
Common and common equivalent shares:
Weighted average number of common shares
Outstanding during the period 13,112,966 13,090,936 13,102,121 13,096,496
Common shares issuable upon exercise
of outstanding stock options:
Diluted 232,777 125,566 198,129 244,228
Common and common equivalent shares
Outstanding during the period:
Diluted 13,345,743 13,216,502 13,300,250 13,340,724
================================================================================================================================
Earnings per share data
Net income per common and common
Equivalent shares:
Basic $ .04 $ .02 $ .14 $ .22
Diluted $ .04 $ .02 $ .14 $ .22
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.". The Company adopted this statement 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 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.
12
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 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 provisions 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. Certain
provisions of FIN 46 were 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. On October 8, 2003, the FASB issued FASB Staff Position No.
46-e, which allows public entities, who meet certain criteria, to defer the
effective date for applying the provisions of FIN 46 to interests held by the
public entity in certain variable interest entities or potential variable
interest entities created before February 1, 2003 until the end of the first
interim or annual period ending after December 15, 2003.
In April 2003, the FASB issued Statement No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging." This Statement amends and clarifies
financial accounting and reporting for derivative instruments, including certain
derivative instruments embedded in other contracts (collectively referred to as
derivatives) and for hedging activities under FASB Statement No. 133,
"Accounting for Derivative Instruments and Hedging Activities." This statement
was effective for the Company after April 30, 2003 and did not have a material
impact on the Company's results of operations or financial condition.
In May 2003, the FASB issued Statement No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." This
Statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability (or an asset in some circumstances). This
statement was effective for the Company after May 31, 2003 and did not have a
material impact on the Company's results of operations or financial condition.
The Company early adopted Emerging Issues Task Force (EITF) Issue 00-21,
"Accounting for Revenue Arrangements with Multiple Deliverables," which applies
to all deliverables within contractually binding arrangements that include
multiple revenue-generating activities. This issue was finalized in May of 2003
and did not have a material impact on the Company's results of operations or
financial condition.
13
8. PRODUCT WARRANTY
The Company records estimated warranty costs on the accrual basis of accounting.
Warranty accruals are determined by applying historical returns to the current
level of product shipments and the cost experience associated therewith. In the
case of software, accruals are based on the expected cost of providing services
within the agreed-upon warranty period. Activity in the warranty accrual is as
follows:
Three Months Ended Nine Months Ended
-------------------------------- -------------------------------
Sept. 27, 2003 Sept. 29, 2002 Sept. 27, 2003 Sept. 28, 2002
- --------------------------------------------------------------------------------------------------------------------------------
Balance at the beginning of the period $ 3,123,000 $ 2,275,000 $ 1,981,000 $ 2,068,000
Accruals for warranties
issued during the period 234,000 183,000 900,000 411,000
Accruals related to pre-existing warranties (264,000) (51,000) (56,000) 215,000
Cheetah opening accrual (321,000) -- 297,000 --
Settlements during the period (206,000) (135,000) (556,000) (422,000)
- ---------------------------------------------------------------------------------------------------------------------------------
Balance at the end of the period $ 2,566,000 $ 2,272,000 $ 2,566,000 $ 2,272,000
=================================================================================================================================
The Company had recorded $618,000 on the Cheetah opening balance sheet to
provide an estimated accrual for pre-acquisition warranty costs for the Cheetah
products. This accrual was decreased to $297,000 through an adjustment to
goodwill in the current quarter to finalize the opening balance sheet accrual.
This estimate utilizes actual warranty experience.
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 September 27, 2003,
and the related condensed consolidated statements of operations for each of the
three-month and nine-month periods ended September 27, 2003 and September 28,
2002 and the condensed consolidated statement of cash flows for the nine-month
periods September 27, 2003 and September 28, 2002 and the statement of changes
in shareholders' equity for the nine-month period ended September 27, 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
October 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 and Financial Condition, along with statements in other
reports filed with the Securities and Exchange Commission (the "SEC"), external
documents and oral presentations, which are not historical facts are considered
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. These statements, which may be expressed in a variety of ways,
including the use of forward-looking terminology such as "will," "believes,"
"intends," "expects," "plans," "could" or "may," or the negatives thereof, other
variations thereon or comparable terminology, relate to, among other things,
projected cash flows which are used in the valuation of intangible assets, the
anticipated results of negotiations for purchase orders and other customer
purchase agreements, the ability to utilize deferred and refundable tax assets,
opportunities which the Services group offers to customers, the potential loss
of certain customers, the timing of orders from customers, the effect of
consolidations in the markets to which 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 and
obsolete inventory, and the effect on earnings and cash flows of changes in
interest rates. The Company does not undertake any obligation to publicly update
any forward-looking statements.
These forward-looking statements and other forward-looking statements contained
in other public disclosures of the Company which make reference to the
cautionary factors contained in this Form 10-Q are based on assumptions that
involve risks and uncertainties and are subject to change 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. The Company wishes to caution each reader of
this Form 10-Q to consider the following factors and certain other factors
discussed herein and in other past reports including, but not limited to, prior
year Annual Reports and Form 10-K and Form 10-Q reports filed with the SEC. The
factors discussed herein may not be exhaustive. Therefore, the factors discussed
herein should be read together with other reports and documents that are filed
by the Company with the SEC from time to time, which may supplement, modify,
supersede or update the factors listed in this document.
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 Regional Bell Operating Company ("RBOC")
customers from wireless, cable providers and other carriers entering the local
telephone service market can and have 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 purchases of the Company's products, which would adversely affect the
Company's revenues.
16
If the Company would be unable to establish or maintain 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 should 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 cancellations 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.
Disputes between the Company's customers and their organized labor groups could
cause those customers to reduce or curtail their purchase of the Company's
products until the resolution of such disputes, which would adversely affect
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.
The Company's sales of its core Metallic Channel Unit ("MCU(R)") technology
largely depends on the rate of customer deployment of new, and retrofitting of
existing, Digital Loop Carrier ("DLC") systems in the United States. Any further
significant decline in the rate of DLC deployment, or saturation of existing
domestic markets or portions thereof, could have an adverse affect on the
Company's future results.
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 or the cable industry testing protocols from proprietary to
standardized, 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.
17
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, or 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.
If one or more of the Company's products were to prove to be defective, the
Company's relationships with its customers could be jeopardized and the Company
could be subject to potential liability, which would adversely affect 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 newly developed products
suitable for international markets, the ability of the Company to obtain and
maintain 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.
In 2001, the Company purchased certain assets of the LoopCare(TM) product line
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 in which the software is an essential functional
component, while the revenues from maintenance contracts are reflected as part
of the Company's Services revenues.
On February 13, 2003, the Company purchased certain assets and assumed certain
liabilities related to the Cheetah(TM) Status and Performance Monitoring Product
Line from Acterna, LLC. The acquired assets consisted principally of existing
sales order backlog, product inventory, intellectual property, software and
18
related computer equipment, while the assumed liabilities principally related to
deferred software maintenance, warranty and other obligations. The product line
consists of a full complement of system software and hardware designed to allow
cable television providers to test, monitor and maintain their operating
systems. The Cheetah offerings also include installation and maintenance
services.
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 and the chief operating
decision maker does not 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, 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, to contribute to the
Company's revenue base, and as a competitive defense to protect the Company's
MCU and DigiTest products' market share. The Cheetah products were acquired to
establish the Company as the market leader within the global cable broadband
marketplace. The combination of the newly acquired Cheetah operation and
CheetahLight(TM) (formerly LIGHTHOUSE(TM)) provide a complete line of solutions
for customers 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 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 diagnoses, 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 competitive local exchange carriers ("CLECs") 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 Digital
Wideband Node ("DWN"). The Company recently released the next generation of its
DigiTest products, the DigiTest EDGE(TM) test head, developed as a global
platform for broadband test applications. This new test head has been undergoing
field trials at RBOC and other customer sites. During the third quarter, the
Company had a modest, first sale of the DigiTest EDGE product to an incumbent
local exchange carrier ("ILEC"), which made a $79,000 contribution to revenues.
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.
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.
The Company's cable hardware and software products, which are being integrated,
offer a complete cable status and performance monitoring system that provides a
comprehensive testing solution for the broadband Hybrid Fiber Coax distribution
system. The offerings include the CheetahLight and CheetahNet(TM) (formerly
NetMentor(TM)) software systems and maintenance, head-end controllers, return
path switch hardware,
19
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 problems, thereby eliminating the need for
the involvement of several highly trained employees. The Services business was
considerably expanded upon the acquisition of software maintenance contracts
related to the LoopCare and CheetahNet software product lines.
The Company's primary customers for its telecommunication products and services
are the four RBOCs as well as major independent telephone companies and certain
digital loop carrier ("DLC") equipment manufacturers. For the third quarter
ended September 27, 2003, approximately 55.1% of the Company's total revenue was
generated from sales to these four RBOC customers. During the third quarter of
2003, sales to three RBOC customers (SBC, Bell South and Verizon) individually
exceeded 10% of consolidated revenues and on a combined basis, comprising
approximately 50.7% (21.8%, 14.5% and 14.4%, respectively) of the Company's net
sales for the period. Due in part to diversification in the Company's product
lines which resulted from the acquisition of the LoopCare and Cheetah product
lines, the percentage of revenue generated from the Company's RBOC customers has
declined from levels previously seen. Due to the Company's present dependency on
these key customers, the potential loss of one or more of them as a customer or
their reduction of orders for the Company's products 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 the availability of funds
in their capital and expense budgets, their relationships with various organized
labor groups and a tendency for the RBOC customers to place large orders for
shipment of hardware and software near the end of a quarter. In addition, the
markets for the Company's products, specifically LoopCare, DigiTest 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
telecommunications equipment 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, translating
into large bulk orders for the Company's products. These customers, partly in
response to discounting programs, tend to place these 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 the 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, efforts among the RBOC customers 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 have caused pricing pressure as competitors have begun
lowering product pricing, which may adversely affect revenues from sales of the
Company's cable products. Moreover, further evolution of cable industry
standards could eliminate the need for some of the
20
Company's customers to purchase certain status monitoring equipment otherwise
required for proprietary implementations, which could adversely affect revenues.
Further, a recent court decision may lead the Company's cable customers to share
their high-speed internet, or broadband, networks with competing internet
service providers. 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 2.6% of total revenues in the third
quarter ended September 27, 2003. The Company believes that certain
international markets may offer opportunities, however, the 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 international markets 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.
It has been determined that present MCU technology offers limited opportunities
in certain international markets for competitive and technological reasons. The
Company continues to actively pursue opportunities for its other products,
including its LoopCare software and DigiTest hardware products in international
markets. In order to fully pursue those opportunities, it will be necessary for
the Company to either undertake research and development efforts to overcome
technological barriers that exist in interfacing those products with existing
international telecommunications services equipment or acquire such technology.
The Cheetah cable products have a presence and acceptance in Europe and China
and the Company intends to capitalize and expand upon that presence.
Given these risks, there can be no assurance that continued efforts by the
Company will be successful or that the Company will achieve significant
international sales with any of its product lines. 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. The
Company's LoopCare OEM resale agreement with Lucent, which was scheduled to
expire on September 30, 2003, has been extended through December 31, 2003 as
renewal discussions continue. Although the Company expects to renew this
agreement, there can be no guarantee that such agreement will be completed which
could eliminate sales through this 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 presents 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 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 its RBOC and ILEC customers have
restricted their capital expenditure budgets in response to market conditions,
such as the loss of local telephone subscriber lines to cable and wireless
competitors, the after-effects of overspending in 1999 and 2000, indecision
regarding long-term network architectures and the impact of Federal
Communications Commission ("FCC") rule changes. In addition, sales of the
Company's core MCU technology to these RBOC and ILEC customers largely depends
on the rate of customer deployment of new and retrofitting Digital Loop Carrier
("DLC") systems. The rate of DLC deployment has declined from levels previously
seen in the market. Further decline in DLC deployment or
21
saturation of existing domestic markets or portions thereof, could cause demand
for the MCU products to decline going forward.
Emerging technologies, such as the development of packet-based internet voice
communication and the evolution in the cable industry toward
industry-standardized technology, may also reduce the demand for the Company's
current products. 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 will 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 incurs
significant research and development costs. Research and development expenses as
a percentage of revenues were approximately 24% in both the third quarter of
2003 and the third 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. Certain of these
accounting principles are more critical than others in gaining an understanding
of the basis upon which the Company's financial statements have been prepared. A
comprehensive review of these policies is contained in the Company's 2002 Annual
Report on Form 10-K filed on March 26, 2003 and in its Quarterly Reports on Form
10-Q for the periods ending March 29, 2003 and June 28, 2003 filed on May 13,
2003 and August 12, 2003, respectively. There were no significant changes in
these policies or the application thereof during the third quarter of 2003.
RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION OF THE RESULTS OF OPERATIONS AND FINANCIAL CONDITION OF
THE COMPANY SHOULD BE READ IN CONJUNCTION WITH THE RESPONSE TO PART I, ITEM 1 OF
THIS REPORT
THIRD QUARTER OF 2003 COMPARED TO THIRD QUARTER OF 2002
REVENUES
The Company's Revenues for the third quarter of 2003 were $15,616,000, an
increase of $1,664,000 or 11.9% over the revenues of $13,952,000 reported for
the third quarter of 2002. The third quarter 2003 results include revenues for
the Cheetah product line acquired on February 13, 2003.
MCU product line revenues were $6,559,000 in the third quarter of 2003, an
increase of $2,008,000 from revenues for the year earlier quarter of $4,551,000.
While RBOC customers are continuing to restrain capital spending in traditional
POTS line areas such as Digital Loop Carrier deployment, strength in the current
quarter came primarily from increased sales to an RBOC under a remote
measurement unit replacement program and to an original equipment manufacturer
under targeted marketing programs. MCU sales comprised 42.0% of total third
quarter 2003 revenues compared to 32.6% for the third quarter of 2002. MCU sales
are expected to continue to account for a substantial portion of the Company's
revenues for the foreseeable future.
22
Sales of the Company's DigiTest system products, which include LoopCare
software, decreased 42.0% between quarterly periods. In the third quarter of
2002, DigiTest revenues benefited from a major centralized test head replacement
program at an RBOC customer while no similar project was in progress in the
third quarter of 2003. The 2003 quarter included sales to both RBOC and CLEC
accounts for Loop Test System (LTS) modernization as well as initial DigiTest
system sales to new CLEC customers. DigiTest product sales for the third quarter
of 2003 were $2,433,000, a decrease of $1,760,000 from the year earlier quarter,
and represented 15.6% of total revenue for the current quarter compared to 30.0%
for the third quarter of 2002.
The Company had no sales of LoopCare software products separate and unrelated to
DigiTest system products during the third quarter of 2003, compared to revenues
of $686,000 in the third quarter of 2002. LoopCare software enhancement revenue
tends to be uneven from period to period due to the timing of feature
availability, extended business case approval and customer budget constraints.
The Company believes that the lack of LoopCare software sales in the present
quarter is not necessarily reflective of a trend, but is attributable to the
uneven nature of the software sales process. LoopCare software product sales
comprised 4.9% of total revenues during the third quarter of 2002.
Services revenues, which include installation oversight and project management
services provided to RBOC and other customers and fees for LoopCare and Cheetah
software maintenance, were approximately $3,086,000 in the third quarter of
2003, or 19.8% of total quarterly revenues compared to 19.4% for the prior year
quarter. Services revenues increased $379,000 over the results of the third
quarter of 2002 with revenue from CheetahNet software maintenance fees
contributing $339,000 to this increase. LoopCare software maintenance also
increased over the prior year period, substantially offset by a decrease of 29%
in the Company's traditional testability improvement services.
Overall sales of cable hardware and software products were $3,538,000 in the
third quarter of 2003, an increase of $2,764,000 or 357.1% from the prior year's
quarter. The new Cheetah line contributed $3,391,000 to the current quarter
revenues. CheetahLight (formerly LIGHTHOUSE) product sales were $147,000 in the
third quarter of 2003, a decrease of 81.0% from the $774,000 reported for the
year earlier period. The decrease is largely attributable to uneven ordering
patterns created by changes in procurement procedures related to the merger of
Comcast and AT&T. Combined sales of cable status monitoring system products
amounted to 22.6% of total third quarter 2003 revenue compared to 5.5% for the
prior year quarter. The Company's acquisition of the Cheetah product line has
given the Company a greater market share in this industry, and created
additional product diversification, causing cable product revenues to encompass
a greater share of total Company revenues.
During the third quarter of 2002, the Company recognized sales of $977,000 or
7.0% of revenues from a major central office test system upgrade package
delivery which included hardware resale and services and an additional 0.6% of
sales came from other products.
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 third quarters of 2003 and 2002 were $8,587,000 and
$7,072,000, respectively, representing an increase of $1,515,000 or 21.4% from
the results of the prior year's quarter and resulting primarily from additional
sales volume related to the Cheetah products. Gross profit as a percentage of
revenues increased to 55.0% in the third quarter of 2003 compared to 50.7% in
the same quarter last year. The increase in gross profit as a percentage of
sales resulted from a mix of factors. Valuation provisions in the third quarter
of 2002 for
23
inventory were $625,000 higher than in the corresponding current year quarter.
In addition, the third quarter of 2002 included $977,000 of revenues from a
relatively low margin resale of third party hardware. Margin improvement in the
third quarter of 2003 also resulted from $162,000 of reduced warranty costs.
These factors more than offset the lack of higher margin LoopCare software
revenue and the effect of the new Cheetah product sales that produce
comparatively lower margins due to competitive CATV markets. 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 third quarter of 2003 was $2,320,000
compared to $2,163,000 for the third quarter of 2002. The increase of $157,000
or 7.3% is due primarily to the inclusion of Cheetah expenses of $351,000 and
higher test and evaluation expenses of $92,000, partially offset by lower
salaries and wages of $170,000, and lower sales commissions of $117,000 in other
parts of the business. As a percentage of revenues, selling and marketing
expenses decreased from 15.5% in the third quarter of 2002 to 14.9% in the third
quarter of 2003.
GENERAL AND ADMINISTRATIVE EXPENSE
General and administrative expense for the third quarter of 2003 was $1,665,000,
an increase of $448,000 or 36.8% from the $1,217,000 recorded in the third
quarter of 2002. The increase is attributable primarily to the addition of
$272,000 of expenses related to the recently acquired Cheetah product line,
including a related provision for bad debts of $187,000, as well as higher
general business insurance and professional service costs. As a percentage of
revenues, general and administrative expenses increased to 10.7% in the third
quarter of 2003 from 8.7% in the third quarter of 2002.
RESEARCH AND DEVELOPMENT EXPENSE
Research and development expense in the third quarter of 2003 was $3,754,000, an
increase of $383,000 or 11.4% from the $3,371,000 recorded in the third quarter
of 2002. The increase resulted from the addition of Cheetah research and
development expenses of $823,000, partially offset by estimated savings of
$480,000 resulting from a general reduction in work force at the end of the
third quarter of 2002. As a percentage of revenues, research and development
expense decreased to 24.0% in the third quarter of 2003 from 24.2% in the year
earlier quarter.
INTEREST AND OTHER INCOME
Interest and other income, composed primarily of interest income in both
quarterly periods, was $76,000 in the third quarter of 2003 compared to $151,000
for the third quarter of 2002, representing a decrease of $75,000 or 49.7%. This
decrease was the result of both the lower market yields on short-term interest
bearing investments compared with the prior year quarter and fewer funds
available for investment due to the acquisition of the Cheetah product line in
February 2003.
PROVISION FOR INCOME TAXES
The provision for income taxes for the third quarter of 2003 was $351,000, an
increase of $171,000 or 95.0% from the $180,000 recorded for the third quarter
of 2002. The effective income tax rate for both periods was estimated at
approximately 38% of pretax income.
24
NET INCOME AND EARNINGS PER SHARE
As a result of the above factors, net income for the third quarter of 2003 was
$573,000, an increase of $280,000 or 95.6% over the $293,000 recorded in the
third quarter of 2002. Basic and diluted earnings per common share of $0.04 for
the third quarter of 2003 were double the $0.02 earned in the third quarter of
2002. Basic and diluted weighted average common and common equivalent shares
outstanding were 13,112,966 and 13,345,743, respectively, in the third quarter
of 2003 compared to 13,090,936 and 13,216,502, respectively, in the third
quarter of 2002. As a percentage of revenues, net income for the third quarter
of 2003 increased to 3.7% from 2.1% for the third quarter of 2002.
RESULTS OF OPERATIONS YEAR-TO-DATE
NINE MONTHS ENDED SEPTEMBER 27, 2003 COMPARED TO
NINE MONTHS ENDED SEPTEMBER 28, 2002
REVENUES
For the first nine months of 2003, revenues were $47,293,000 compared to
$46,058,000 for the same period of 2002, representing an increase of $1,235,000
or 2.7%. The third quarter 2003 results include revenues for the Cheetah product
line that the Company acquired on February 13, 2003.
Sales of the Company's MCU products were $17,407,000 in the current period, a
decrease of $4,203,000 or 19.4% from sales of $21,610,000 in the same period of
2002. MCU product line revenues decreased in the first nine months of 2003
compared with the prior year period due to the continuing budget restrictions of
the RBOCs and the effects from subscriber POTS line losses and reduced legacy
DLC deployment and utilization. This reduced demand in the period was partially
offset by increased MCU shipments to original equipment manufacturers of next
generation DLC systems which are being utilized to facilitate DSL broadband
rollout in the domestic RBOC market. MCU sales comprised 36.8% of total revenue
for the first nine months of 2003 compared to 46.9% for the year earlier period.
Sales of the Company's DigiTest system products, which include LoopCare system
software, were $5,584,000, a decrease of $1,273,000 or 18.6% between nine-month
periods due primarily to two factors, a reduction of DigiTest hardware sales to
an RBOC customer that had completed a major test head replacement program in the
2002 period and due to a reduction in sales to Sprint Canada. Sales of DigiTest
products represented 11.8% of total revenue for the first nine months of 2003
compared to 14.9% for the first nine months of 2002.
Sales of LoopCare software products separate and unrelated to DigiTest system
products were $2,699,000 in the first nine months of 2003, a reduction of
$3,412,000 or 55.8% between the nine-month periods. Sales in 2003 were made
primarily to two RBOC customers. In the first nine months of 2002, 66.9% of the
Company's LoopCare revenues resulted from significant software enhancement sales
to a third RBOC customer. LoopCare software enhancement revenue tends to be
uneven from period to period due to the timing of feature availability, extended
business case approval and customer budget constraints. LoopCare product
software sales comprised 5.7% of total revenues during the first nine months of
2003 compared to 13.3% in the year earlier period.
The Company's Services revenues for the first nine months of 2003 were
$9,323,000, an increase of $1,471,000 or 18.7% over the similar period in 2002.
The increase is due primarily to the inclusion of $823,000 from software
maintenance related to the new Cheetah product line and increased LoopCare
software maintenance of $613,000. Service revenues are derived primarily from
RBOC customers and include installation oversight
25
and project management services. These revenues represented 19.7% of total
revenue for the first nine months of 2003 compared to 17.0% in the year earlier
period.
Overall sales of CATV hardware and software products were $12,280,000, an
increase of $9,846,000 or 404.5% from results of the first nine months of 2002.
The new Cheetah line contributed $9,397,000 to this increase. CheetahLight
(formerly LIGHTHOUSE) product sales were $2,883,000, an increase of 18.4% from
the $2,434,000 reported for the year earlier period, primarily attributable to
shipments to a new domestic customer in 2003. Combined sales of cable status
monitoring system products amounted to 26.0% of total revenue for the first nine
months of 2003 compared to 5.3% for the same period of 2002.
During the first nine months of 2002, the Company recognized sales of $1,034,000
or 2.3% of revenues from a major central office test system upgrade package
delivery which included hardware resale and services and an additional 0.3% of
sales came from other products.
GROSS PROFIT
Gross profit for the first nine months of 2003 was $25,571,000 compared to
$25,661,000 for the first nine months of 2002, representing a decrease of
$90,000 or 0.4%. Gross profit as a percentage of revenues decreased to 54.1% in
the first nine months of 2003, compared to 55.7% in the same period last year.
The slight decline was caused mostly by lower sales of higher margin MCU and
DigiTest hardware and LoopCare software, with such sales being substantially
replaced by the addition of lower margin Cheetah and higher CheetahLight cable
product sales. Other factors that negatively affected margins in the 2003
nine-month period were greater amortization expense of $798,000 associated with
the Cheetah acquisition and higher provisions for warranty expense of $218,000.
Partially offsetting these negative factors is reduced expense for slow moving
and obsolete inventory of $1,815,000 in the first nine months of 2003 compared
to the first nine months of 2002. The amortization expense related to the
Cheetah acquisition included $540,000 of amortization of purchased sales order
backlog, of which only $60,000 remains to be amortized at September 27, 2003.
SELLING AND MARKETING EXPENSE
Selling and marketing expense for the first nine months of 2003 was $6,711,000
compared to $6,805,000 for the first nine months of 2002. This decrease of
$94,000 or 1.4% was attained despite the inclusion of $862,000 of expenses
related to the acquired Cheetah product line. Cost reductions in other areas of
the business resulted primarily from decreased salaries and wages of $621,000,
reduced travel expenses of $251,000 and reduced commissions of $251,000
commissions, offset by higher test and evaluation expenses of $180,000. As a
percentage of revenues, selling and marketing expenses decreased to 14.2% in the
first nine months of 2003 from 14.8% in the same period of 2002.
GENERAL AND ADMINISTRATIVE EXPENSE
General and administrative expense for the first nine months of 2003 was
$5,230,000, an increase of $1,219,000 or 30.4% from the $4,011,000 recorded in
the first nine months of 2002. The increase is attributable primarily to the
addition of $776,000 in expenses from the Cheetah product line, which includes a
$530,000 provision for bad debts. Expenses also increased due to higher business
insurance, incentive compensation and professional services costs. As a
percentage of revenues, general and administrative expenses increased to 11.1%
in the first nine months of 2003 from 8.7% in the same period of 2002.
26
RESEARCH AND DEVELOPMENT EXPENSE
Research and development expense for the first nine months of 2003 was
$10,982,000, an increase of $221,000 or 2.1%, from the $10,761,000 recorded in
the first nine months of 2002. The overall increase includes $1,870,000 of
additional expenses related to the acquired Cheetah product line, largely offset
by an estimated decrease of $1,440,000 of expenses associated with a general
reduction in work force at the end of the third quarter of 2002. As a percentage
of revenues, research and development expense decreased to 23.2% in the first
nine months of 2003 from 23.4% in the similar period of 2002.
INTEREST AND OTHER INCOME
Interest and other income is comprised primarily of interest income in both nine
month periods. For the first nine months of 2003, interest and other income was
$309,000 compared to $589,000 for the first nine months of 2002, a decrease of
$280,000 or 47.5%. This decrease is the result of both lower market yields on
short-term interest bearing investments compared with the prior year period and
fewer funds available for investment due to the acquisition for cash of Cheetah
in February 2003.
PROVISION FOR INCOME TAXES
The provision for income taxes for the first nine months of 2003 was $1,124,000,
a decrease of $652,000 or 36.7% from the $1,776,000 recorded for the first nine
months of 2002. The effective income tax rate for both periods was estimated at
approximately 38% of pretax income.
NET INCOME AND EARNINGS PER SHARE
As a result of the above factors, net income for the first nine months of 2003
was $1,833,000, a decrease of $1,064,000 or 36.7% from the $2,897,000 recorded
in the first nine months of 2002. Basic and diluted earnings per common share of
$0.14 for the first nine months of 2003 decreased by $0.08 or 36.4% from the
$0.22 earned in the first nine months of 2002. Basic and diluted weighted
average common and common equivalent shares outstanding were 13,102,121 and
13,300,250, respectively, in the first nine months of 2003 compared to
13,096,496 and 13,340,724, respectively, in the first nine months of 2002. As a
percentage of revenues, net income for the first nine months of 2003 decreased
to 3.9% from 6.3% for the first nine months of 2002.
CHEETAH 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
capitalized acquisition related costs of approximately $599,000 for a total cost
of approximately $14,899,000. 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 product line.
The acquired assets consisted principally of existing sales order backlog,
product inventory, intellectual property, software and related computer
equipment, while the assumed liabilities principally related to deferred
software maintenance, warranty and other obligations. The $14,300,000 due at
closing and related acquisition expenses were paid from available cash and
short-term investments. The Company believes that the acquired product line
complements its 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 product line 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. An adjustment was made in the current
quarter to reduce the estimated acquired warranty liability by $320,500
27
to $297,000 based upon experience to date. Adjustments will be made to the
various assets acquired and liabilities assumed based on final valuations, and
such adjustments may be material.
LIQUIDITY AND CAPITAL RESOURCES
The Company had working capital of $62,645,000 as of September 27, 2003, a
decrease of $10,544,000 or 14.4%, from the $73,189,000 of working capital as of
December 31, 2002. The decrease in working capital is primarily the result of
the purchase of the Cheetah product line and related acquisition expenses for
$14,899,000 in cash on February 13, 2003, partially offset by working capital
generated from operations in excess of purchases of property and equipment. As
of September 27, 2003, the Company had $45,579,000 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. A maximum leverage ratio restricts total borrowings of the Company to
approximately $17,550,000 during the fourth quarter of 2003. 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
product line to adjust the determination of base net worth. As of September 27,
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.
The Company expects to incur capital expenditures totaling approximately
$3,000,000 in 2003 including post-acquisition capital expenditures of $1,857,000
related to the acquired Cheetah product line. The Company's asset purchases
include test fixtures and development systems, computer and office equipment as
well as purchases of MIS/IT infrastructure and leasehold improvements for
Cheetah.
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. No such shares have been
acquired in 2003.
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 facility. On February 18, 2003, the Company entered into a lease for
office space to house the Cheetah product line in Sarasota, Florida under a
lease expiring on April 26, 2008. The Company is also involved in various
month-to-month leases for research and development equipment. Minimum annual
future rental commitments under non-cancelable leases as of September 27, 2003
are:
28
2003 (Three Months) $ 397,000
2004 1,594,000
2005 1,592,000
2006 860,000
2007 432,000
2008 (Nine Months) 102,000
KEY RATIOS
The Company's days sales outstanding (DSO) in accounts receivable trade, based
on the past twelve months rolling revenue, were 68 and 53 days as of September
27, 2003 and December 31, 2002, respectively. This increase is due primarily to
the fact that a much higher percentage of total quarterly revenue was recorded
in September of the third quarter of 2003 compared to December in the fourth
quarter of 2002. The Company's inventory turnover ratio was 1.9 turns as of
September 27, 2003 and 1.4 as of December 31, 2002. Management believes that
operating cash flow and cash reserves are adequate to both finance currently
planned capital expenditures and 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 September 27, 2003, the Company had a
backlog of $8,786,000, including approximately $6,545,000 related to software
maintenance contracts, compared to $8,122,000 as of June 28, 2003 and $7,179,000
at December 31, 2002.
The Company entered into extended term LoopCare software maintenance agreements
in 2003 with two RBOC customers; one of which is for a term of three years
expiring on December 31, 2005 and the second of which is for a term of one year
and nine months expiring on December 31, 2004. The Company has adopted a policy
to include a maximum of twelve months revenue from multi-year agreements in
reported backlog. Software maintenance revenue is deemed earned and recognized
as income on a straight-line basis over the terms of the underlying agreements.
The Company expects that approximately 47% of current backlog will be recognized
as revenue in the fourth 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.
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.". The Company adopted this statement on January 1, 2003
and such adoption did not have a material effect on the Company's financial
statements.
29
In June 2002, the FASB issued SFAS No. 146, "Accounting For Costs Associated
With Exit Or Disposal." SFAS No. 146 nullifies Emerging 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 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 provisions 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. Certain
provisions of FIN 46 were 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. On October 8, 2003, the FASB issued FASB Staff Position No.
46-e, which allows public entities, who meet certain criteria, to defer the
effective date for applying the provisions of FIN 46 to interests held by the
public entity in certain variable interest entities or potential variable
interest entities created before February 1, 2003 until the end of the first
interim or annual period ending after December 15, 2003.
In April 2003, the FASB issued Statement No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging." This Statement amends and clarifies
financial accounting and reporting for derivative instruments, including certain
derivative instruments embedded in other contracts (collectively referred to as
derivatives) and for hedging activities under FASB Statement No. 133,
"Accounting for Derivative Instruments and Hedging Activities." This statement
was effective for the Company after April 30, 2003 and did not have a material
impact on the Company's results of operations or financial condition.
In May 2003, the FASB issued Statement No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." This
Statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability (or an asset in some
30
circumstances). This statement was effective for the Company after May 31, 2003
and did not have a material impact on the Company's results of operations or
financial condition.
The Company early adopted Emerging Issues Task Force (EITF) Issue 00-21,
"Accounting for Revenue Arrangements with Multiple Deliverables," which applies
to all deliverables within contractually binding arrangements that include
multiple revenue-generating activities. This issue was finalized in May of 2003
and did not have a material impact on the Company's results of operations or
financial condition.
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 the end of the
period covered by this report, that the Company's disclosure controls and
procedures are effective to ensure that information required to be disclosed by
the Company in the reports filed or submitted by it under the Securities
Exchange Act of 1934, as amended, is recorded, processed, summarized and
reported within the time periods specified in the SEC's rules and forms, and
include controls and procedures designed to ensure that information required to
be disclosed by the Company in such reports is accumulated and communicated to
the Company's management, including the Chief Executive Officer and Chief
Financial Officer, as appropriate to allow timely decisions regarding required
disclosure.
There were no changes in the Company's internal control over financial reporting
or in other factors during the period covered by this report that have
materially affected or are likely to materially affect these controls.
31
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
31.1 Rule 13a - 14(a) Certification of Chief Executive Officer,
filed herewith
31.2 Rule 13a - 14(a) Certification of Chief Financial Officer,
filed herewith
32 Rule 13a -14(b) Certifications of Chief Executive Officer
and Chief Financial Officer, filed herewith
(b) Reports on Form 8-K:
1. A Report on Form 8-K was filed on July 21, 2003 under
Regulation FD, which contained as an exhibit the Company's
Earnings Release for the second quarter 2003.
2. A report on Form 8-K was filed on August 4, 2003 under
Regulation FD, which contained as an exhibit a shareholder
presentation.
3. A report on Form 8-K was filed on August 28, 2003 under
Regulation FD, which contained as an exhibit a shareholder
presentation.
32
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: November 11, 2003 /S/ CHRISTIAN L. ALLISON
-------------------------------------
CHRISTIAN L. ALLISON
CHAIRMAN AND CHIEF EXECUTIVE OFFICER
Dated: November 11, 2003 /S/ SAMUEL C. KNOCH
-------------------------------------
SAMUEL C. KNOCH
CHIEF FINANCIAL OFFICER AND TREASURER
Dated: November 11, 2003 /S/ CHARLES J. SHEARER
-------------------------------------
CHARLES J. SHEARER
CONTROLLER
33
EXHIBIT INDEX
(Pursuant to Item 601 of Regulation S-K)
Exhibit
Number Description
------- -----------
15 Letter re unaudited interim financial information
31.1 Rule 13a - 14(a) Certification of Chief Executive Officer,
filed herewith
31.2 Rule 13a - 14(a) Certification of Chief Financial Officer,
filed herewith
32 Rule 13a - 14(b) Certifications of Chief Executive Officer
and Chief Financial Officer, filed herewith
34