UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

þ		Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

TOLLGRADE COMMUNICATIONS, INC.

(Exact name of registrant as specified in its charter)

PENNSYLVANIA		25-1537134
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
3120 Unionville Road, Suite 400, Cranberry Twp., Pennsylvania		16066
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: 724-720-1400

Common Stock, par value $0.20 per share		The NASDAQ Stock Market LLC
(Title of Class)		(Exchange on which registered)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ

Indicate by a check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Yes o No þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o		Smaller reporting company o
				(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

The aggregate market value of the voting and non-voting Common Stock of the registrant held by non-affiliates of the registrant, calculated based on the closing price as of June 30, 2010 on the NASDAQ Global Select Market, was approximately $80 million.

As of February 28, 2011, the registrant had outstanding 13,007,388 shares of its Common Stock.

 

 

TABLE OF CONTENTS

Part I
Item 1. Business			3
Item 1A. Risk Factors			10
Item 1B. Unresolved Staff Comments			20
Item 2. Properties			20
Item 3. Legal Proceedings			21
Item 4. Reserved			21
Part II
Item 5. Market for the Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchases of Equity Securities			21
Item 6. Selected Financial Data			23
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations			24
Item 7A. Quantitative and Qualitative Disclosures About Market Risk			35
Item 8. Financial Statements and Supplementary Data			36
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure			63
Item 9A. Controls and Procedures			63
Item 9B. Other Information			63
Part III
Item 10. Directors, Executive Officers and Corporate Governance			64
Item 11. Executive Compensation			66
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters			81
Item 13. Certain Relationships and Related Transactions and Director Independence			84
Item 14. Principal Accountant Fees and Services			85
Part IV
Item 15. Exhibits and Financial Statement Schedules			86
SIGNATURES			89
EX-10.6
EX-10.16
EX-10.24
EX-10.26
EX-10.30
EX-10.31
EX-10.32
EX-10.34
EX-10.35
EX-10.37
EX-23.1
EX-23.2
EX-31.1
EX-31.2
EX-32

PART I

CAUTIONARY STATEMENT FOR PURPOSES OF THE “SAFE HARBOR” PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.

The statements contained in this Annual Report on Form 10-K of Tollgrade Communications, Inc. (“Tollgrade,” the “Company,” “us,” or “we”), including, but not limited to the statements contained in Item 1, “Business,” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” along with statements contained in other reports that we have filed with the Securities and Exchange Commission (the “SEC”), external documents and oral presentations, which are not historical facts are considered to be “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements, which may be expressed in a variety of ways, including the use of forward-looking terminology such as “believe,” “expect,” “intend,” “may,” “will,” “should,” “could,” “potential,” “continue,” “estimate,” “plan,” or “anticipate,” or the negatives thereof, other variations thereon or compatible terminology, relate to, among other things, our expectation that we will finalize a contract with a major British customer in early 2011 for a significant project, our belief that developments in our LightHouse product line will help to widen the gap that we believe exists between our products and those of our competitors, and our belief that our LightHouse product line and managed services offerings will provide us with growth opportunities, our merger agreement with affiliates of Golden Gate Capital and our anticipated completion of the transactions contemplated thereby. We do not undertake any obligation to publicly update any forward-looking statements.

These forward-looking statements, and any forward-looking statements contained in other public disclosures of the Company which make reference to the cautionary factors contained in this Form 10-K, are based on assumptions that involve risks and uncertainties and are subject to change based on the considerations described below. We discuss many of these risks and uncertainties in greater detail in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.” These and other risks and uncertainties may cause our actual results, performance or achievements to differ materially from anticipated future results, performance or achievements expressed or implied by such forward-looking statements.

The following discussion should be read in conjunction with our “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and our financial statements and related notes contained in this Annual Report on Form 10-K.

Item 1. Business.

Tollgrade designs, engineers, markets and supports test system and status monitoring hardware and software products for the telecommunications industry primarily in the United States and Europe. We are also actively testing and developing our Lighthouse smart grid monitoring, which service the utility marketplace.

Our products sold to telecommunications service providers enable them to remotely diagnose problems in Digital Subscriber Lines (“DSL”) and Plain Old Telephone Service (“POTS”) lines in Public Switched Telephone Network (“PSTN”), and broadband and Internet Protocol (“IP”) networks. By coupling our hardware and software offerings together, we provide proactive, centralized test solutions for our customers.

Our primary product offerings include the DigiTest^® and LDU™ measurement hardware and LoopCare™ and 4TEL^® centralized test software. These products enable local exchange carriers to conduct a full range of measurement and fault diagnosis for efficient dispatch of field staff to maintain and repair POTS and/or DSL services, along with the ability to pre-qualify and provide broadband DSL services offerings. We also sell and support proprietary test access products, such as the MCU^®, which extends line test capabilities to remote sites that are connected by fiber from the central office.

Our services and managed services business includes software maintenance and support for our operating systems, along with hardware maintenance for our test probes, and our professional services, which are designed to ensure that all of the components of our customers test systems operate properly. In addition, in 2009, we expanded our service capabilities to include managed services, offering those services to both our traditional telecommunications service provider customers and our telecommunications network equipment provider customers. In April 2009, we secured a managed services contract with Ericsson, Inc. (“Ericsson”), a large global network equipment provider, to provide customer support and engineering services. We also provide managed services capabilities as part of a number of our software maintenance contracts to our telecommunications customers.

Our LightHouse products are real-time Smart Grid Monitoring solutions, which will allow utility customers to continuously detect key circuit parameters, and communicate mission critical data wirelessly to a central location. Our LightHouse products enable visibility into the quality of power delivery, and the ability to identify key events that might impact reliability and efficiency. Our solutions will help utilities reveal network events and accurately track system condition information.

On May 27, 2009, we sold our cable product line to focus on our core telecommunications market and customers, and our financial statements now reflect the operating results of our cable product line as discontinued operations.

We were incorporated in Pennsylvania in 1986, and began operations in 1988. Our principal offices are located at 3120 Unionville Road, Suite 400, Cranberry Twp., Pennsylvania 16066 and our telephone number is (724) 720-1400.

We make available free of charge on our Internet website (www.tollgrade.com) our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or otherwise furnish it to, the SEC.

You may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site that contains our reports, proxy, information statements and other information that we file with the SEC (www.sec.gov). Copies of our filings are available free of charge to any shareholder of record upon written request to the Secretary of Tollgrade Communications, Inc.

Products and Services

Telecommunications Test and Measurement Products

Our proprietary telecommunications test and measurement products, which include our Systems Test and MCU products, enable telephone companies to qualify and troubleshoot broadband DSL and IP services and remotely diagnose problems in POTS lines. Most DSL lines today provide broadband Internet access for residential and business customers, fed from a central or remote office Digital Subscriber Line Access Multiplexer (DSLAM) or Multi-Service Access Node (MSAN). Our systems can be used to qualify loops for DSL service as well as ongoing maintenance and repair of the access lines. As telecommunications service providers move to all IP networks and services (voice, video and data), we have introduced products over time to enable IP services testing. At the end of 2009, we introduced additional products to test and monitor voice over IP (VoIP), video over IP (IPTV), and mobile voice services through a third party original equipment manufacturer (“OEM”) agreement.

An important aspect of efficiently maintaining a telecommunications network is the ability to remotely test, diagnose and locate any service-affecting problems within that network. Our Systems Test Products are made up of a centralized test operating system integrated into the customers’ repair handling database systems, and test hardware located at telephone companies’ central and remote offices. These systems enable a full range of fault diagnostics in the access network, the portion of the telephone network that connects end users to the central office or remote cabinet. In addition, line test systems provide the capability to remotely qualify, deploy and maintain DSL services which are carried over copper lines. These test systems reduce the time needed to identify and resolve problems, eliminating or reducing the costs of dispatching a technician to the problem site.

Most line test systems, however, were designed only for use over copper lines; as a result, traditional test systems could not access local loops in which fiber optic technology had been introduced. Our MCU product line, which is used primarily by large domestic carriers, solved this problem by extending line test capabilities from the central office to the fiber-fed remote Digital Loop Carrier (“DLC”) lines by mimicking a digital bypass pair, which is essentially a telephone circuit that connects central test and measurement devices to the copper circuits close to the customer.

Systems Test Products

Our Systems Test Products include the DigiTest product family, which includes our LoopCare software and DigiTest ICE^®, DigiTest EDGE^®, DigiTest HUB™ and DigiTest Measurement Units (DMU) hardware. Our Test Products perform physical and logical measurements to verify the connection performance of lines and circuits and reports those measurements to our LoopCare operating support systems (“OSS”). LoopCare, in turn, analyzes that measurement data and creates an easy-to-understand fault description. At the same time, LoopCare can automatically dispatch a technician to a work center in order to fix the problem. LoopCare and the DigiTest hardware are also used to pre-qualify, verify installation, and remotely isolate troubles for various DSL services, including testing the logical layers to verify modem synchronization “in” to the DSLAM or “out” to the customer. The DigiTest product family can also serve as a replacement for aging Loop Test System (“LTS”) equipment deployed in current domestic networks.

DigiTest ICE, our latest IP Service Assurance Test Probe, is aimed at testing Triple Play voice, video and data services over emerging fiber to the curb or cabinet broadband access networks. Because these remote sites have a lower line count, they require cost optimized test probes and greater IP test capabilities to fulfill the requirements of triple play testing. DigiTest ICE provides both metallic and multi-layered testing to help service providers install and maintain triple play services. With DigiTest ICE, the customer

will be able to quickly isolate VoIP, IPTV and high speed Internet access issues, verify their network performance, and synch with broadband equipment to validate connectivity and throughput. Coupled with our centralized software platforms, DigiTest ICE provides a comprehensive broadband test and dispatch solution.

Our Systems Test Products also include 4TEL and Celerity software products working with LDU hardware test probes. These products perform similar line test functions and test measurements as our other Systems Test Products, but have been optimized for operation in the international markets, and have extensive deployment in Europe. The 4TEL and LDU products have also been deployed on a more targeted basis in North America as well as in international markets outside of Europe.

In October 2009, we signed an agreement with Accanto Systems, SRL to provide mobile and VoIP protocol analyzers under the Tollgrade brand name. The agreement enables us to sell the Accanto protocol analyzer probes, and OSS platforms with exclusivity in certain territories. The protocol probes monitor signaling protocols and network traffic, allowing rapid resolution of difficult network and equipment problems.

We market and sell our Systems Test Products primarily through our direct sales force as well as through certain reseller and distributor agreements. Sales of the DigiTest Product line (including related software sales) accounted for approximately 26%, 31% and 37% of our total revenues for the years ended December 31, 2010, 2009 and 2008, respectively.

MCU Products

Our MCU products plug into DLC systems, the large network transmission systems used by telephone companies to link the copper and fiber-optic portions of the local loop. MCU products allow our customers to extend their line testing capabilities to all of their POTS lines served by a DLC system regardless of whether the system is fed by a copper or fiber optic link. DLC systems, which are located at telephone companies’ central offices and at remote sites within local user areas, effectively multiplex the services of a single fiber-optic line into multiple copper lines. In many instances, several DLC systems are located at a single remote site to create multiple local loops that serve several thousand different end-user homes and businesses. Generally, for every DLC remote site, customers will deploy at least two MCU line-testing products.

We market and sell our MCU products directly to customers as well as through certain OEM agreements. We have certain royalty-based license agreements in place to enable us to maintain capability with specific DLC systems. We paid royalties under these agreements in the amounts of $0.4 million, $0.2 million and $0.4 million during the years ended December 31, 2010, 2009 and 2008, respectively.

Sales of MCU products and related hardware accounted for approximately 15%, 13% and 18% of our revenue for the years ended December 31, 2010, 2009 and 2008, respectively.

Services and Managed Services

Our service offerings include three primary areas, including software maintenance and support for our OSS offerings and hardware maintenance for the test probes, professional services, and managed services. Our software and hardware support services are designed to ensure that all of the components of our customers’ test systems operate properly. The primary customers for our software and hardware support services are the large domestic and international service providers. We also offer professional services, such as installation, commissioning, and training to these same customers. Most of our support services are provided through yearly or multi-year service agreements, and can cover both software and hardware maintenance for our products.

Including software maintenance and support, services revenue accounted for approximately 58%, 56% and 45% of our total revenues for the years ended December 31, 2010, 2009 and 2008, respectively. Historically, our services business was comprised of the more traditional POTS-based testability services, and the revenue stream was largely project-based and as such, difficult to predict. During the last few years, our services business has moved toward more contract-based software maintenance services, the revenue from which is more predictable. We expect our service business to continue to comprise a large percentage of our revenue in the future.

On April 15, 2009, we entered into a multi-year managed services agreement with Ericsson, pursuant to which we will provide customer support and engineering services. We entered into this four year agreement as part of our continued strategic focus to grow our services business. In 2010 and 2009, revenues from this contract were approximately $7.0 and $5.1 million or approximately 15% and 11% of our total revenues, respectively. Managed services are an area of potential growth for us. We are focused on expanding our managed services business with both our telecommunications customers as well as larger network equipment and managed service providers.

Electric Utility Monitoring Products

In 2008, we launched a new product development effort, our LightHouse product line, which is designed to provide power grid monitoring capabilities to the electric utility market. Research and investment, which began in 2007 and continued into 2009, enabled

the general availability of the first release of the product line during the first quarter of 2009. The test system solution currently consists of line mounted sensors, aggregators, and centralized software providing an end to end solution for power providers to efficiently monitor their overhead distribution circuits in real time. The system is designed to improve the overall efficiency of energy delivery, improve customer satisfaction and improve the financial performance of the electric power utilities.

The market for power grid monitoring has been slower to evolve than we originally projected and to date, our efforts in the monitoring segment of the market have not produced the revenue results that we had anticipated. However, in 2010, we completed a successful field trial with a major US utility company and are expecting commercial orders in 2011. In addition, we secured a product trial with a major Canadian utility company as well as signing three other utilities to test our product. We believe that these new product trials along with the successful field trial with the major US utility customer, that we may begin to realize new revenues from this product line in 2011 and help us secure longer term organic revenue growth.

Operating Segment

We have determined that our business has one operating segment, test assurance. At this time, almost 100 percent of our product and service revenues relates to the business of testing infrastructure and networks for the telecommunications industry. Our products have similar production processes, and are sold through comparable distribution channels and means to similar types and classes of customers already in, or entering into, the telecommunications businesses. Operating results are regularly reviewed by our chief operating decision maker regarding decisions about the allocation of resources and to assess performance.

Research and Development

Our research and development activities are focused on improving our existing telecommunications product lines, investing in growth opportunities in the Telecommunications Service Assurance market, and leveraging our technology strengths in test and measurement into the utility industry.

We have made improvements to certain of our existing line test product lines, including enhanced measurement techniques that deliver more accurate service repair dispatches for our customers. Additionally, we have augmented these product lines with customer funded specified features, enhancing the usability, scalability, security, and resiliency of our current product lines. We enhanced the functionality of our products to be able to interface with third party equipment, thereby enabling migration with the evolving next generation networks. We also continue to stay current with the latest standards for Broadband Forum and ITU standard bodies.

Our Service Assurance product activities provide our customers an expanded reach of test technologies, utilizing our existing line test technology and augmenting the network analysis with next generation test technologies. This provides our customers more comprehensive results and analysis with which to resolve trouble points in the network. In addition, we continue to enhance our portfolio of test technologies working with semiconductor companies and equipment providers in order implement the emerging ITU Glt standards.

Leveraging our traditional strength in system test and our core competency in complex measurements and analytics, we have entered the utility Smart Grid market with a focus on measurements and faults in the distribution network. Our research and development activities in this market to date have focused on emerging standards, interoperability with complementary communication systems, and refining customer market requirements.

In 2010, we refocused our engineering efforts to align our human capital with projects that were we felt were capable of providing us with the best near term opportunities for revenue and profitability, as well as customer funded product and software enhancements. We also reduced or eliminated spending in areas that involved higher risk or required significant investment that were longer term in nature for possible returns on investment. We continue to support our broad product portfolio, from our DigiTest, LDU, and MCU hardware as well as our LoopCare, 4TEL and Celerity software platforms all the while assuring our customers receive the highest level of service. In addition, we have recently hired additional resources to help bolster our LightHouse product line for the potential revenue growth that we hope to realize in 2011 and beyond.

As of December 31, 2010, we had an engineering staff of 34 employees, representing 32% of our total employee workforce. As of December 31, 2009 and 2008, we had an engineering support staff of 55 and 62 employees which comprised 33% and 32% of our total workforce, respectively. Our engineering staff is primarily located in three locations, Cranberry Twp., Pennsylvania; Piscataway, New Jersey; and Bracknell, United Kingdom.

During the years ended December 31, 2010, 2009, and 2008, research and development expenses charged to operations were $6.8 million, $9.4 million and $10.8 million, respectively. In addition, because some of our contractual agreements require us to provide engineering development or repair services to our customers, a portion of our total engineering costs has been allocated to cost of sales. The amount allocated to cost of sales for each of the years ended December 31, 2010 and 2009 was $1.5 million, and for the year ended December 31, 2008 was $1.4 million.

Sales and Marketing

For our telecommunications offerings, our primary sales and marketing strategy is a direct approach to tier one and tier two service provider customers. We utilize our direct sales, marketing and service resources in North America and Europe to develop sales opportunities with our current customer base, as well as new customers. In territories outside North America and Europe, our primary route to market is through a network of value added reseller partners and distributors who provide in-country capabilities to complement our capabilities. We have sales and service offices in Cranberry Twp., Pennsylvania and Piscataway, New Jersey in the United States and Bracknell, United Kingdom and Wuppertal, Germany in Europe, as well as having personnel located in Belgium and Czech Republic.

For our LightHouse product line, we have been utilizing a direct sales approach using certain sales personnel that also call on some of our telecommunication customers. At the end of 2010, we added two additional employees to focus more heavily on marketing and business development to help further penetrate and enhance our focus on the utility marketplace.

As of December 31, 2010, we had a sales and marketing staff of 18 employees, representing 17% of our total employee workforce. As of December 31, 2009 and 2008, we had a marketing and sales staff of 27 and 28 people representing 16% of our total workforce for both of these years.

Competition

The market for telecommunications testing equipment is highly competitive. Primary competitive factors in our market include price, product features, performance, reliability, service and support, breadth of product line, technical documentation, prompt delivery and availability of alternative technologies.

The competitors for our traditional POTS telecommunications products and our broadband technologies and applications solution offerings include JDS Uniphase, EXFO Electro-Optical Engineering Inc., Spirent Communications PLC, Huawei Technologies Co., Ltd., Fluke Networks and Nortel. Historically, we have positioned ourselves against competitors’ offerings by leveraging our patented technologies, partnering with network equipment providers, and investing in next generation research and development. We also leverage our incumbent position with existing customers and core competencies to test broadband next generation networks to position ourselves against our competitors on the basis of lower deployment costs and long-term operational cost efficiencies.

We also face competition as a growing number of network equipment providers offer testing technology embedded into their products. Where testing was once only available in the form of multi-chip, circuit board-based designs like those found in our remote test system hardware products, integrated testing technology is now available in low-cost chipsets embedded into the products of these network equipment providers. Referred to as SELT and DELT (Single Ended Line Test and Double Ended Line Test), the testing technology available in this form has limited functionality and only provides partial views of faults in the network.

Another area of competition is from software solution providers and the internal Information Technology (“IT”) departments of our own carrier customers. In the past, we offered solutions consisting of hardware probes, coupled with a centralized software platform that analyzed the data pulled from the probes and determined the appropriate dispatch statement or issue identification statement. As the capabilities of new infrastructure equipment increases, test and monitoring software platforms are increasingly taking advantage of the available data from the infrastructure equipment. The new software platforms offer customers a lower upfront cost, but offer less robust capabilities as compared to solutions built with hardware and software combinations. Several network equipment providers (Alcatel-Lucent, Huawei, Adtran) have included test software platforms as part of the element management systems. At the same time, many of our larger customers have captive development capabilities in their own IT organizations. These IT teams can develop software systems that compete with our offerings. Because of our intimate knowledge of many carrier customers, we believe we have a strategic advantage over these internal groups based on our industry knowledge and the efficiency of our development resources in comparison to internal customer resources.

As with the telecommunications products, the extension of our IP service assurance and mobile and VoIP products to address IP and mobile test applications expands our list of traditional competitors to now include Empirix Inc., JDS Uniphase, Tektronix Canada Inc., EXFO (as successor to Brix Networks, Inc.), Agilent Technologies Inc, and IneoQuest.

Our Customers

Our customers include the top telecommunications providers and numerous independent telecommunications and broadband providers around the world. Our primary customers for our telecommunications products and services are large domestic and European telecommunications service providers. We track our telecommunications sales by two large groups, the first of which includes AT&T, Alcatel-Lucent, Verizon, and Qwest (referred to herein as the “large domestic carriers”), and the second of which includes certain large international telephone service providers in Europe, namely British Telecom, Royal KPN N.V., Belgacom S.A., Deutsche Telecom AG (T-Com) and Telefonica O2 Czech Republic, a.s. (collectively referred to herein as the “European Telcos”).

For the year ended December 31, 2010, sales to the large domestic carriers accounted for approximately 31% of our total revenue, compared to approximately 39% of our total revenue for the same 2009 and 2008 periods. Our largest customer, AT&T, comprised approximately 23% of our total revenue for both 2010 and 2009, while in 2008, they comprised approximately 27% of our total revenue. For the year ended December 31, 2010, sales to the European Telcos accounted for approximately 21% of our total revenue, compared to approximately 22% and 27% of our total revenue for the same 2009 and 2008 period, respectively.

In addition, in April 2009, we entered into a multi-year managed services agreement with Ericsson to provide customer support and engineering services. We entered into this agreement as part of our continued strategic focus to grow our services business. In 2010 and 2009, revenues from this contract were approximately $7.0 and $5.1 million or approximately 15% and 11% of our total revenues, respectively.

Manufacturing and Quality Control

During 2009, we began the process of outsourcing our in-house manufacturing and production capabilities to Express Manufacturing Inc. (“Express Manufacturing”), a global provider of subcontracting services located in Santa Ana, California. By outsourcing our manufacturing process, we created more of a variable cost manufacturing model for our business by negotiating fixed costs to supply our products to end customers on a “just-in-time” basis rather than have all the fixed costs associated with an in-house manufacturing process. Express Manufacturing now fulfills 100% of our manufacturing requirements, including the direct shipment of products to our end customers. Additionally, Express Manufacturing has an additional offshore site at which our requirements may also be fulfilled. We believe that the outsourcing of our manufacturing enables us to conserve our working capital, adjust better to fluctuations in demand and ensure a more timely delivery to our customers.

We are ISO 9001:2008 registered with the British Standards Institution, Inc. ISO 9000 is a harmonized set of standards that define quality assurance management. Written by the International Organization for Standardization (“ISO”), ISO 9000 is recognized throughout the United States, Canada, the European Union and Japan. We continue to develop and maintain internal documentation and processes to support the production of quality products to ensure customer satisfaction and have been ISO compliant since 1996.

Proprietary Rights

We have registered trademarks in the names Tollgrade^®, MCU^®, DigiTest^®, EDGE^®, ICE ^®, LightHouse^®, Telaccord^®, MITS^®, Clearview^®, MICRO-BANK^®, the names and logos for 4TEL^®, Celerity^® and NETFLARE^®. We have common law trademarks in the names LoopCare™, MLT™, Clear™, the Clear logo, Early Warning™, ReportCard™, CircuitView™, Network Assurance Simplified™, Service Assurance Simplified™, Continuous Grid Intelligence™, Minutes Mean Millions™, N(x)Test™, N(x)DSL™, LTSC™, and HyFi™, and our corporate logo. Team Tollgrade^SM is a common law service mark of the Company.

We have two United States patents on MCU products with expiration dates ranging from 2011 to 2014. In all, we have forty-three patents in the United States, three patents in Belgium, three patents in Germany, and four patents in the United Kingdom on other telecommunications technology with expiration dates ranging from 2011 to 2026. In addition, we have eights United States, six European, two German, and two United Kingdom patent applications pending on our products, some of which relate to our new LightHouse products.

We will apply for additional patents from time to time related to our research and development activities. We protect our trademarks, patents, inventions, trade secrets, and other proprietary rights by contract, trademark, copyright and patent registration, and internal security.

Although we believe that these patents, when aggregated, are an important element of our business, we do not believe that our business, as a whole, is materially dependent on any one patent or that the lapsing of any one patent will have a material adverse effect on our business as a whole.

Backlog

Our order backlog for firm customer purchase orders and signed software maintenance contracts was $19.1 million at December 31, 2010, compared to backlog of $15.6 million at December 31, 2009. The backlog at December 31, 2010 and December 31, 2009 includes approximately $13.4 million and $8.4 million, respectively, related to software maintenance contracts. In 2011, we expect to realize revenues related to the entire backlog at December 31, 2010.

In our reported backlog, we have adopted a policy to only include a maximum of twelve months revenue from multi-year software maintenance agreements. Software maintenance revenue is deemed to be earned and recognized as income on a straight-line basis over the terms of the underlying agreements.

Periodic fluctuations in customer orders and backlog result from a variety of factors, including but not limited to the timing of significant orders and shipments. Although these fluctuations could impact short-term results, they are not necessarily indicative of long-term trends in sales of our products.

Employees

As of December 31, 2010, we had 107 full-time employees, 85 of whom were located in the United States and 22 of whom were located in Europe. As of December 31, 2009 and 2008, we had 167 and 179 full time employees, of which 141 and 150 where located in the United States and 26 and 29 were located in Europe, respectively. None of our employees are represented by a collective bargaining agreement.

Executive Officers of the Company

The executive officers of the Company as of March 10, 2011 and their biographical information are set forth below.

Edward H. Kennedy		Chief Executive Officer, President and Board Member of Tollgrade since June 2009; has served as Chairman of the Board since March 2010 and was named Chief Executive Officer and President in June 2010; prior thereto served as the Chairman, Chief Executive Officer, and President of Rivulet Communications, Inc. from September 2007 until March 2010; prior thereto, served as Venture Partner at Columbia Capital from February 2004 until September 2007; prior thereto, from January 2002 until January 2004, served as President of Tellabs North American Operations and Executive Vice President of Tellabs. From March 1999 until January 2002, Mr. Kennedy was President and Chief Executive Officer (and Co-Founder) of Ocular Networks. He has also held various executive positions at leading telecom equipment companies, including Alcatel and Newbridge Networks Corporation. Mr. Kennedy previously served on the boards of directors of Visual Networks, a publicly-traded, Nasdaq-listed company until its acquisition by Fluke Networks, a division of Danaher Corporation, and Imagine Communications. Mr. Kennedy also currently serves on the board of directors of Hatteras Networks. Age 56.
Michael D. Bornak		Chief Financial Officer of the Company since November 2009; served as the Company’s interim Chief Financial Officer from September 2009 to November 2009; prior thereto served as Chief Financial Officer of Solar Power Industries, Inc. from June 2008 until July 2009; Chief Financial Officer for MHF Logistical Solutions, Inc. from February 2005 to June 2008; Vice President of Finance and Chief Financial Officer of Portec Rail Products, Inc. from January 1998 to February 2005. Mr. Bornak is also a Certified Public Accountant. Age 48.
Gregory M. Nulty		Vice President, Marketing and Business Development since June 2010; prior thereto served as Sr. Vice President of Product Management and Business Development at Rivulet from 2007 to 2010; Sr. Vice President of Strategic Direction and Business Development at Tellabs/Ocular Networks from 2000 to 2004. Previously, Mr. Nulty held executive technical, strategic planning and marketing positions at companies including Pulsecom, Sprint and Ameritech. Age 57.
David L. Blakeney		Vice President, Research and Development of the Company since October 2008; prior thereto consultant to the Company in the same capacity from March 2008 until October 2008; Vice President, Engineering, for Altrix Logic from December 2006 until October 2008; prior thereto, Vice President of Engineering for the Data Networks Division of Ericsson from April 1999 to October 2006. Age 50.

Jennifer M. Reinke		General Counsel of the Company since November 2009 and Secretary of the Company since December 2009; Assistant General Counsel of the Company from February 2009 to November 2009; Corporate Attorney for the Company from March 2003 to February 2009; served as the Company’s Assistant Secretary from March 2003 to December 2009; prior thereto, Associate Attorney with Reed Smith LLP, from August 1998 to March 2003. Age 38.
Robert H. King		Vice President, Global Sales and Professional Services since June 2010; Vice President, Global Sales and Marketing of the Company from February 2009 until June 2010; Executive Director, Business Development of the Company from December 2008 until February 2009; prior thereto President and General Manager of the Broadband Products Group at Sunrise Telecom Incorporated (“Sunrise”) from April 2006 until June 2008; Vice President, Sales at Sunrise from January 2000 until April 2006. Age 49.
Joseph G. O’Brien		Vice President, Human Resources of the Company since October 1997; Director of Employee Development of the Company from April 1997 until October 1997; prior thereto, Coordinator, Elderberry Junction, Goodwill Industries, a charitable organization, from May 1995 until April 1997. Age 51.
Thomas J. Kolb		Vice President, Operations of the Company since December 2010; prior thereto, Director, Operations Strategy of the Company from December 2008 until December 2010; prior thereto Director North America Trade Compliance for Ericsson Inc. from May 2007 until December 2008 and its Manager of Supply Chain Operations from January 2006 until May 2007; prior to held various supply chain management positions with Marconi and FORE Systems. Age 43

Item 1A. Risk Factors

We wish to caution each reader of this Form 10-K to consider the following factors and other factors discussed herein and in other past reports, including but not limited to prior year Form 10-K and quarterly Form 10-Q reports filed with the SEC. Our business and results of operations could be materially affected by any of the following risks. The factors discussed herein are not exhaustive. Therefore, the factors contained herein should be read together with other reports and documents that we file with the SEC from time to time, which may supplement, modify, supersede or update the factors listed in this document.

There are risks and uncertainties associated with our proposed merger with an affiliate of Golden Gate Capital.

On February 21, 2011, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Talon Holdings, Inc., a Delaware corporation (“Parent”), and Talon Merger Sub, Inc., a Pennsylvania corporation and a direct wholly-owned subsidiary of Parent (“Merger Sub”), providing for the merger of Merger Sub with and into the Company (the “Merger”), with the Company surviving the Merger as a wholly-owned subsidiary of Parent. Parent is owned by investment funds managed by Golden Gate Capital, a San Francisco based private equity firm.

There are a number of risks and uncertainties relating to the Merger. For example, the Merger may not be consummated or may not be consummated in the timeframe or manner currently anticipated, as a result of several factors, including, among other things, (a) the occurrence of any event, change or other circumstances that could give rise to the termination of the Merger Agreement, including a termination under circumstances that would require us to pay a termination fee; (b) Parent’s failure to obtain the necessary equity financing set forth in the equity commitment letter received in connection with the Merger, or alternative financing, or the failure of any such financing to be sufficient to complete the Merger and the transactions contemplated by the Merger Agreement; (c) our “net cash balance” and “minimum company cash” as such terms are defined in the Merger Agreement being less than the amounts set forth therein; (d) failure to obtain shareholder approval or the failure to satisfy other conditions to completion of the merger, including obtaining required regulatory approvals; (e) litigation relating to the Merger, including without limitation two actions which are currently pending and seek to enjoin the consummation of the Merger and other injunctive relief; (f) the failure of the Merger to close for any other reason.

If the Merger is not completed, the price of our common stock may decline to the extent that the current market price of our common stock reflects an assumption that the Merger will be consummated, and such decline may be material. Pending the closing of the Merger, the Merger Agreement also restricts us from engaging in certain actions without Parent’s consent, which could prevent us from pursuing opportunities that may arise prior to the closing of the Merger. Any delay in closing or a failure to close could have a negative impact on our business and stock price as well as our relationships with our customers, vendors or employees, as well as a negative impact on our ability to pursue alternative strategic transactions and/or our ability to implement alternative business plans. In addition, if the Merger Agreement is terminated, depending on the circumstances giving rise to termination, we may be required to (i) reimburse Parent the expenses incurred by Parent, Merger Sub and their affiliates in connection with the Merger Agreement, up to a maximum of $1 million, or (ii) pay a termination fee equal to $3 million, plus up to $1 million of the expenses incurred by Parent, Merger Sub and their affiliates in connection with the Merger Agreement.

Our business could be adversely impacted as a result of the proposed Merger.

The proposed Merger could cause disruptions to our business or business relationships, which could have an adverse impact on our financial condition, results of operations and cash flows. For example:

	•		the attention of our management may be directed to transaction-related considerations and may be diverted from the day-to-day operations of our business;
	•		employees may experience uncertainty about their future roles with us, which might adversely affect our ability to retain and hire key personnel and other employees; and
	•		vendors, customers or other parties with which we maintain business relationships may experience uncertainty about our future and seek alternative relationships with third parties or seek to alter their business relationships with us.

In addition, we have incurred, and will continue to incur, significant costs, expenses and fees for professional services and other transaction costs in connection with the Merger, and many of these fees and costs are payable by us regardless of whether or not the Merger is consummated.

Revenue from product sales may be subject to further declines due to the mature nature of many of our product lines and from customers transitioning their access network service assurance solutions.

Certain of our legacy products are primarily oriented towards POTS lines. As many customers implement next generation network improvements, such as fiber to the premises (“FTTP”), our continuing ability to sell our legacy technology or to maintain historic pricing levels for these products may be adversely affected. In particular, MCU sales largely depend upon the rate of deployment of new, and the retrofitting of existing, DLC systems in the United States. Installation and replacement of DLC systems are, in turn, driven by a number of factors, including the availability of capital resources and the demand for new or better POTS. Next generation network improvements such as FTTP do not require the use of our MCU products as does the present hybrid POTS network. If our major customers fail to continue to build out their DSL networks and other projects requiring DLC deployments, or if we otherwise satisfy the domestic telecommunications market’s demand for MCUs, our MCU sales may decline which could adversely affect our future results.

Certain of our larger customers are in the process of upgrading their access networks, as well as, their service assurance solutions for these networks. This has and may continue to adversely impact revenues from our testing products. Further, these customers may decide not to adopt our technologies for their service assurance needs, which would have a significant adverse affect on revenues for those products.

Our product sales have experienced continual declines over the past five years, with sales from continuing operations of $19.1 million for 2010, $19.9 million for 2009 and $27.0 million in 2008. If we are unable to continue to derive sales of our products to our existing customers due to their lower demand, capital constraints and a move towards other technologies, this could have a materially adverse impact on our future financial results.

Our ability to maintain or increase revenues will be dependent on our ability to expand our customer base, increase unit sales volumes of our existing products and to successfully, develop, introduce and sell new products.

Our service business may be negatively affected by a trend of reduced capital spending and by delays in our ability, or by our inability, to secure and extend long-term maintenance contracts with our existing or new customers, and by customer initiatives to consolidate services purchases with a single supplier.

Our Services business, which includes software maintenance and professional services, as well as our managed services offerings, is sensitive to the decline in our large carrier customers’ capital investment in their traditional voice services. This decline may lead to a decreasing demand for our professional services. In addition, if we are unsuccessful in renewing our software maintenance agreements, if we experience delays in the extension or renewal of certain of the more significant software maintenance agreements, or if we are unable to reach agreement as to any such renewal or extension on terms that are favorable to us, or at all, our revenues may be adversely affected.

In addition, in December 2009, one of our major customers for software maintenance, Verizon, allowed its maintenance contract to expire, deciding instead to purchase maintenance services through a third party vendor. We signed an interim contract with the third party vendor to provide for continuation of service while we negotiated the terms of our master agreement, and signed a master agreement with the third party vendor in April 2010 for our provision of maintenance services to Verizon. To the extent more of our customers seek to consolidate services purchases through a large vendor, and in so doing seek to purchase maintenance for our software products through a third-party vendor, we may likely experience significant downward pricing pressure for these services.

We are also experiencing pricing pressure from many of our other larger software maintenance customers, as they continue to attempt to reduce their own internal costs to substantiate the value of our long term service contracts. We believe that our services and our software systems provide significant value to our customers; however, each time a contract is scheduled for renewal, we must show our customers the value of the entire system and the costs saved by maintaining and even extending the system capabilities. To date, apart from the customer noted above, we have been able to renegotiate or have had contract extensions to most of our major contracts as they become subject to renewal. We have, however, had to reduce our pricing in some instances. Accordingly, our ability to maintain historical levels from traditional sources or increase levels of services revenues cannot be assured.

Our future growth depends to a large extent upon our success in developing and selling new products and service offerings. We have focused our growth efforts and are managing our investments. If we are unable to drive sales of new products and services to counter the expected declines in our legacy product lines, this could have a materially adverse impact on our future financial results.

We are actively selling and developing new product and service offerings. Our long term growth is dependent upon the success of these products and additional new products to be developed in the future. Our new products include enhanced hardware solutions and managed services offerings in the telecommunications market, and our LightHouse smart grid solutions for the power utility market. We continue to believe that there is a significant market opportunity for these products. However, there can be no assurance that these product offerings will be commercially successful in the near term or at all.

We continue to pursue product development initiatives to supplement our new offerings described above. There can be no assurance that we will be successful in marketing and selling our new product and services offerings or that the new offerings will result in the benefits and opportunities that we expect. The development of new solutions is an uncertain and potentially expensive process and requires that we accurately anticipate technological and market trends so that we can deliver products in a timely manner. We may not be successful in delivering the required product features to achieve success, or if we do so, we may not be able to commercialize the product in a timely manner or achieve market acceptance. If we fail to set appropriate prices for our products, our profitability could be adversely affected.

In addition, the potential market growth rate may not be as significant as we expect, may occur more slowly than we expect, or could develop in unforeseen directions. For example, the commercial availability of competing products may affect the extent or timing of market acceptance of our solutions. Furthermore, we may not be successful in forming the strategic alliances contemplated by our new strategy. We may not identify the right partners or our partners could fail to perform their obligations and the commercial relationship may fail to develop as expected. As a result of these and other factors, we may not be able to implement our strategy and our ability to exploit our incumbent position in certain markets in the manner contemplated, and we could be materially and adversely affected.

Our restructuring efforts and cost reduction plans may be ineffective or may limit our ability to compete.

During 2010, we significantly restructured our business operations, resulting in the elimination of 48 positions Company-wide. Previously, during 2009, we implemented restructuring initiatives which included the realignment of existing resources to new projects, reductions in staffing, as well as other reduction activities. Although we have experienced cost savings from these restructuring and cost reduction programs and initiatives and we expect that these actions will continue to reduce costs, such measures could have long-term effects on our business by reducing our pool of talent, decreasing or slowing improvements in our products, making it more difficult for us to respond to customers, limiting our ability to increase production quickly if and when the demand for our products increases and limiting our ability to hire and retain key personnel. These circumstances could cause our earnings to be lower than they otherwise might be.

Failure to achieve the maximum revenues under our managed services contract could have an adverse effect on our revenues and results of operations.

During the second quarter of 2009, we entered into a multi-year, managed services contract with Ericsson, a leading global network equipment provider, pursuant to which we provide customer support and engineering services capabilities. In connection with the agreement, we hired twenty-one employees. The inability to successfully integrate and/or retain the hired employees and to integrate the tools and resources acquired as part of the agreement into our services business would have an adverse impact on our ability to realize the potential revenue opportunities under the agreement. In addition, under the terms of the managed services contract, we may not achieve the full revenue potential of the contract in the event that (i) we fail to meet certain specified service level requirements in the contract, and subsequently, service level credits reducing payments to us are applied, (ii) the network equipment provider terminates the contract for our failure to perform in accordance with its terms; and (iii) fees payable to us are reduced due to revenues from the network equipment provider’s customer agreements declining more rapidly than anticipated. Additionally, our overall profitability may be negatively impacted in the event we are required to incur unanticipated expenses to satisfy obligations assumed under the managed services agreement.

A continuing downturn in the global economy may adversely affect our revenue, results of operations and financial condition.

Demand for our products and services are increasingly dependent upon the rate of growth in the global economy. If current economic conditions continue, customer demand for our products and services could be even more adversely affected than experienced to date, which in turn could adversely affect our revenue, results of operations and financial condition. Many factors could continue to adversely affect regional or global economic growth. Some of these factors include:

	•		Poor availability of credit,
	•		Continued recession in the United States economy and other countries that we serve,
	•		Fluctuation in the value of the U.S. dollar relative to foreign currencies in jurisdictions where we transact business,
	•		Significant act of terrorism which disrupts global trade or consumer confidence,
	•		Geopolitical tensions including war and civil unrest, and
	•		Reduced levels of economic activity or disruption of domestic or international transportation.

The recent challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased or otherwise constrict our customers’ spending on our products and services. As a result, revenue may decline and reserves for doubtful accounts and write-offs of accounts receivable may increase. We had to take such action in the third quarter of 2009 as we wrote off a significant receivable from an international customer that we have been unable to collect, and during 2010 we brought court action in a foreign jurisdiction in an attempt to enforce payment. Litigation is ongoing, and although we believe that the merits of the claim are in our favor, there can be no assurance of success in any litigation, and we may incur additional expenses in connection with the litigation and other collection efforts that we would be unable to recover. In addition, certain of our contracts are paid, in part or whole, in foreign currencies. A decrease in the exchange rate of the U.S. dollar relative to these currencies could further reduce our revenue, and such impact could be material.

We maintain an investment portfolio, consisting of cash, cash equivalents and investments. These investments are subject to general credit, liquidity, market, and interest rate risks. If the global credit market continues to deteriorate, our investment portfolio may be impacted and potentially creating an other-than-temporary decline in fair value, which would result in an impairment charge adversely impacting our financial results.

We are dependent upon our ability to attract, retain and motivate our key personnel.

Our success depends on our ability to attract, retain and motivate our key management personnel, including the Company’s CEO, CFO, senior management team members, and key engineers, necessary to implement our business plan and to grow our business. Despite the adverse economic conditions of the past several years, competition for certain specific technical and management skill sets is intense. If we are unable to identify and hire the personnel that we need to succeed, or if one or more of our key employees were to cease to be associated with the Company, our future results could be adversely affected.

We depend upon a few major customers for a majority of our revenues, and the loss of any of these customers, or the substantial reduction in the products or services that they purchase from us, would significantly reduce our revenues and net income.

We currently depend upon a few major customers for a significant portion of our revenues and we expect to continue to derive a significant portion of our revenues from a limited number of customers in the future. The loss of any of these customers or a substantial reduction in the products or services that they purchase from us or our inability to renew services agreements with customers and to do so upon terms at least as favorable to our current agreements would significantly reduce our revenues and net income. Furthermore, diversions in the capital spending of certain of these customers to new network elements have and could continue to lead to their reduced demand for our products, which could in turn have a material adverse affect on our business and results of operation. The capital spending of our large domestic carrier customers, as well as many of our other customers and potential customers, are dictated by a number of factors, most of which are beyond our control, including:

	•		Conditions of the telecommunications market and the economy in general;
	•		Subscriber line loss and related reduced demand for wireline telecommunications services;
	•		Changes or shifts in the technology utilized in the networks;

	•		Labor disputes between our customers and their collective bargaining units;
	•		Failure of our customers to meet established purchase forecasts and growth projections;
	•		Competition among the large domestic carriers, competitive exchange carriers and wireless telecommunications; and
	•		Reorganizations, including management changes, at one or more of our customers or potential customers.

If the financial condition of one or more of our major customers should deteriorate, or if they have difficulty acquiring investment capital or reduce their capital expenditures due to any of these or other factors, a substantial decrease in our revenues could likely result.

Our operating results may vary from quarter to quarter, causing our stock price to fluctuate.

Our operating results have in the past been subject to quarter to quarter fluctuations, and we expect that these fluctuations may continue in future periods. Demand for our products is driven by many factors, including the availability of funding for our products in customers’ capital budgets. Some of our customers place large orders near the end of a quarter or fiscal year, in part to spend remaining available capital budget funds. Seasonal fluctuations in customer demand for our products driven by budgetary and other reasons can create corresponding fluctuations in period-to-period revenues, and we therefore cannot assure you that our results in one period are necessarily indicative of our revenues in any future period. In addition, the number and timing of large individual sales and the ability to obtain acceptances of those sales, where applicable, has been difficult for us to predict, and large individual sales have, in some cases, occurred in quarters subsequent to those we anticipated, or have not occurred at all. The loss or deferral of one or more significant sales in a quarter could harm our operating results. It is possible that in some quarters our operating results will be below the expectations of investors. In such events, or in the event adverse conditions prevail, the market price of our common stock may decline significantly.

We have completed, and may pursue additional acquisitions, which could result in the disruption of our current business, difficulties related to the integration of acquired businesses, and substantial expenditures.

We have completed, and we may pursue additional acquisitions of companies, product lines and technologies as part of our strategic efforts to realign our resources around growth opportunities in current, adjacent and new markets, to enhance our existing products, to introduce new products and to fulfill changing customer requirements. The consideration for any such acquisition may be cash or stock, or a combination thereof, and the payment of such consideration may result in a reduction in our cash balance and/or the issuance of additional shares which may dilute the interest of our existing shareholders. Acquisitions involve numerous risks, including the disruption of our business, exposure to assumed or unknown liabilities of the acquired target, and the failure to integrate successfully the operations and products of acquired businesses. International acquisitions provide specific challenges due to the unique topology of international telecommunications networks, as well as requirements of doing business in particular countries. Further, our ability to sell certain products internationally depends upon our ability to maintain certain key manufacturing relationships and we may not be able to continue those relationships. Goodwill and acquired intangible assets arising from acquisitions may result in significant impairment charges against our operating results in one or more future periods. Furthermore, we may never achieve the anticipated results or benefits of an acquisition, such as increased market share or the successful development and sales of a new product. The effects of any of these risks could materially harm our business and reduce our future results of operations and cause our stock price to decline.

The failure of acquired assets to meet expectations, or a decline in our fair value determined by market prices of our stock, could indicate impairment of our intangible assets and result in impairment charges.

Accounting guidance for the impairment or disposal of long-lived assets addresses financial accounting and reporting for the impairment or disposal of long-lived assets and requires that these assets be measured for impairment whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. During 2010, 2009 and 2008, we performed the required recoverability tests and determined that certain long-lived assets were impaired in 2009 and 2008. No impairments occurred in 2010; however, the occurrence of any further triggering events could result in future impairments.

The sale of our products is dependent upon our ability to satisfy the proprietary requirements of our customers.

We depend upon a relatively narrow range of products for the majority of our revenue. Our success in marketing our products is dependent upon their continued acceptance by our customers. In some cases, our customers require that our products meet their own proprietary requirements. If we are unable to satisfy such requirements, or forecast and adapt to changes in such requirements, our business could be materially harmed.

The sale of our products is dependent on our ability to respond to rapid technological change and may be adversely affected by the development, and acceptance by our customers, of new technologies which may compete with or reduce the demand for our products.

Changes in network architecture experienced by our customers in the telephony market have and may continue to negatively affect our ability to sell products in these markets. Although we are addressing these changes with modifications to our existing products, if customers do not accept this new product technology, our revenues could be adversely affected. Further, we are experiencing competition from the internal Information Technology (“IT”) departments of our own carrier customers. In the past, we offered solutions consisting of hardware probes, coupled with a centralized software platform that analyzed the data pulled from the probes and determined the appropriate dispatch statement or issue identification statement. As the capabilities of new infrastructure equipment increases, test and monitoring software platforms are increasingly taking advantage of the available data from the infrastructure equipment. At the same time, many of our larger customers have captive development capabilities in their own IT organizations. These IT teams can develop competing software systems to our offerings, which could adversely affect our ability to sell our products to those customers, which could negatively impact overall revenues from such products.

Furthermore, the development of new technologies which compete with or reduce the demand for our products, and the adoption of such technologies by our customers, could adversely affect sales of our products. For example, as our products generally serve the wireline marketplace, to the extent wireline customers migrate to wireless technologies, there may be reduced demand for our products. In addition, we face new competition as testing functions that were once only available with purpose-built test systems are now available as integrated components of network elements. To the extent our customers adopt such new technology in place of our telecommunications products, the sales of our telecommunications products may be adversely affected. Such competition may also increase pricing pressure for our telecommunications products and adversely affect the revenues from such products.

We depend on a single contract manufacturer to produce close to 100% of our hardware customer product requirements. Changes to this relationship may result in delays or disruptions that could harm our business.

We depend on one independent contract manufacturer to manufacture, test and ship our products. We rely on purchase orders with our contract manufacturer to fulfill our product demands. Our contract manufacturer is not obligated to supply products to us for any specific period, quantity or price. It is time consuming and costly to qualify and implement a contract manufacturer relationship. Therefore, if our contract manufacturer suffers an interruption in its business, or experiences delays, disruptions or quality control problems in its manufacturing operations, or we have to change or add additional contract manufacturers, our ability to ship products to our customers would be delayed and our business, operating results and financial condition would be adversely affected.

We depend on single source component parts for certain product designs, and our reliance on third parties to manufacture certain aspects of our products involves risks, including delays in product shipments and reduced control over product quality.

Generally, our products use industry standard components. In addition, some parts, such as ASICS, are custom-made to our specifications. While there are multiple sources for most of the component parts of our products, some components are sourced from single sources or from a limited number of outside suppliers. We typically do not have a written agreement with any of these component manufacturers to guarantee the supply of the key components used in our products, and we do not require our contract manufacturer to have written agreements with these component manufacturers. We regularly monitor the supply of the component parts and the availability of alternative sources. We provide forecasts to our contract manufacturer so that it can source the key components in advance of their anticipated use, with the objective of maintaining an adequate supply for use in the manufacture of our products. Our reliance upon third party contractors involve several risks, including reduced control over manufacturing costs, delivery times, reliability and quality of components. If we were to encounter a shortage of key manufacturing components from limited sources of supply, or experience manufacturing delays caused by reduced manufacturing capacity, inability of our contract manufacturers to procure raw materials, the loss of key assembly subcontractors, or other factors, we could experience lost revenues, increased costs, delays in, cancellations or rescheduling of orders or shipments, any of which would materially harm our business.

If we fail to accurately predict our manufacturing requirements, we could incur additional costs or experience manufacturing delays that could harm our business.

We provide demand forecasts to our contract manufacturer. If we overestimate our requirements, our contract manufacturer may assess charges or we may have liabilities for excess inventory, each of which could negatively affect our gross margins. Conversely, because lead times for required materials and components vary significantly and depend on factors such as the specific supplier, contract terms and the demand for each component at a given time, if we underestimate our requirements, our contract manufacturer may have inadequate materials and components required to produce our products, which could interrupt manufacturing of our products and result in delays in shipments and deferral or loss of revenues.

Our future sales in international markets are subject to numerous risks and uncertainties.

Our business is becoming more dependent upon international markets. Our future sales in international markets are subject to numerous risks and uncertainties, including local economic and labor conditions, political instability including terrorism and other acts of war or hostility, unexpected changes in the regulatory environment, trade protection measures, tax laws, our ability to market current or develop new products suitable for international markets, difficulties with deployments and acceptances of products, obtaining and maintaining successful distribution and resale channels, changes in tariffs and foreign currency exchange rates, and longer payment cycles. These specific risks, or an overall reduction in the demand for or the sales of our products in international markets, could adversely affect future results.

We face intense competition, which could result in our losing market share or experiencing a decline in our gross margins.

The markets for some of our products are very competitive. Some of our competitors have greater technological, financial, manufacturing, sales and marketing, and personnel resources than we have. As a result, these competitors may have an advantage in responding more rapidly or effectively to changes in industry standards or technologies. We are facing competition with our IP-based testing solutions, and many competitive technologies, encompassing both hardware and software, are available in these markets. Moreover, better financed competitors may be better able to withstand the pricing pressures that increased competition may bring. If our introduction of improved products or services is not timely or well received, or if our competitors reduce their prices for products that are comparable to ours, demand for our products and services could be adversely affected. Competition from certain network element providers offering chip-based testing functionality may also intensify the pricing pressure for our telecommunications products and adversely affect future revenues from such products. We also face increasing pressure from certain of our large domestic carrier customers on software maintenance agreements, as they continue to divert spending from legacy networks to next generation network elements.

We may also compete directly with our customers. Generally, we sell our products either directly or indirectly through OEM channels and other means to end-user telecommunications service providers. It is possible that our customers, as the result of bankruptcy or other rationales for dismantling network equipment, could attempt to resell our products. The successful development of such a secondary market for our products by a third party could negatively affect demand for our products, reducing our future revenues.

Our future results are dependent on our ability to establish, maintain and expand our distribution channels and our existing third-party distributors.

We market and sell certain of our products, including our DigiTest and LDU products, through domestic and international OEM relationships. Our future results are dependent on our ability to establish, maintain and expand third party relationships with OEM as well as other marketing and sales distribution channels. If, however, the third parties with whom we have entered into such OEM and other arrangements should fail to meet their contractual obligations, cease doing, or reduce the amount of their business with us or otherwise fail to meet their own performance objectives, customer demand for our products could be adversely affected, which would have an adverse effect on our revenues.

The sales cycle for our system products is long, and the delay or failure to complete one or more large transactions in a quarter could cause our operating results to fall below our expectations.

The sales cycle for our system products is highly customer specific and can vary from a few weeks to many months. The system requirements of customers is highly dependent on many factors, including but not limited to their projections of business growth, capital budgets and anticipated cost savings from implementation of the system. Our delay or failure to complete one or more large transactions in a quarter could harm our operating results. Our systems involve significant capital commitments by customers. Potential customers generally commit significant resources to an evaluation of available enterprise software and system testing solutions and require us to expend substantial time, effort and money educating them about the value of our solutions. System sales often require an extensive sales effort throughout a customer’s organization because decisions to acquire software licenses and associated system hardware involve the evaluation of the products by a significant number of customer personnel in various functional and geographic areas, each often having specific and conflicting requirements. A variety of factors, including actions by competitors and other factors over which we have little or no control, may cause potential customers to favor a particular supplier or to delay or forego a purchase.

Many of our products must comply with significant governmental and industry-based regulations, certifications, standards and protocols, some of which evolve as new technologies are deployed. Compliance with such regulations, certifications, standards and protocols may prove costly and time-consuming for us, and we cannot provide assurance that its products will continue to meet these standards in the future. In addition, regulatory compliance may present barriers to entry in particular markets or reduce the profitability of our product offerings. Such regulations, certifications, standards and protocols may also adversely affect the industries

in which we compete, limit the number of potential customers for our products and services or otherwise have a material adverse effect on its business, financial condition and results of operations. Failure to comply, or delays in compliance, with such regulations, standards and protocols or delays in receipt of such certifications could delay the introduction of new products or cause our existing products to become obsolete.

The continued adoption of industry-wide standards in the telecommunications market could have a material adverse effect on our profitability.

We are actively engaged in research to improve and expand our product offerings, including research and development to reduce product costs while providing enhancements; however, with the rise of industry-wide standards, among other factors, a number of our products have faced increased pricing pressure, driving lower margins. If sales of our network assurance and testing solutions do not increase, decrease rapidly, or are not accepted in the marketplace, or if our research and development activities do not produce marketable products that are both competitive and accepted by our customers, our overall revenues and profitability could be adversely affected.

The presence of available open source software could adversely affect our ability to maximize revenue from software products.

An emerging risk to our software development efforts is the presence of available open source software, which can allow our competitors and/or our customers to piece together a non-proprietary software solution relatively quickly. To the extent they are successful in developing software that meets their feature and benefit needs, revenue from our proprietary software could be adversely affected. Further, to the extent we incorporate open source into our software products, our ability to maximize revenue from our software products could be adversely impacted.

Our customers are subject to an evolving governmental regulatory environment that could significantly reduce the demand for our products or increase our costs of doing business.

Our domestic customers have historically been subject to a number of governmental regulations, many of which have been repealed or amended as a result of the passage of The Telecommunications Act of 1996. Deregulatory efforts have affected and likely will continue to affect our customers in several ways, including the introduction of competitive forces into the local telephone markets and the imposition (or removal) of controls on the pricing of services. These and other regulatory changes may limit the scope of our customers’ deployments of future services and budgets for capital expenditures, which could significantly reduce the demand for our products.

Moreover, as the FCC adopts new and amends existing regulations, and as the courts analyze the FCC’s authority to do so, our customers cannot accurately predict the rules which will regulate their conduct in their respective markets. Changes in the telecommunications regulatory environment could, among other results, increase our costs of doing business, require our customers to share assets with competitors or prevent the Company or our customers from engaging in business activities they may wish to conduct, which could adversely affect our future results.

Similarly, our international customers are subject to a number of governmental regulations. Regulatory changes affect our customers in several ways, including the introduction of competitive forces, controls (or removal of controls), and new rules and limits. These and other regulatory changes may limit our customers, their service offerings, of spending, which could significantly reduce the demand for our products.

Our limited ability to protect our proprietary information and technology may adversely affect our ability to compete, and our products could infringe upon the intellectual property rights of others, resulting in claims against us the results of which could be costly.

Many of our products consist entirely or partly of proprietary technology owned by us. Although we seek to protect our technology through a combination of copyrights, trade secret laws, contractual obligations and patents, these protections may not be sufficient to prevent the wrongful appropriation of our intellectual property, nor will they prevent our competitors from independently developing technologies that are substantially equivalent or superior to our proprietary technology. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the United States. In order to defend our proprietary rights in the technology utilized in our products from third party infringement, we may be required to institute legal proceedings. If we are unable to successfully assert and defend our proprietary rights in the technology utilized in our products, our future results could be adversely affected.

Although we attempt to avoid infringing known proprietary rights of third parties in our product development efforts, we may become subject to legal proceedings and claims for alleged infringement from time to time in the ordinary course of business. Any claims relating to the infringement of third-party proprietary rights, even if not meritorious, could result in costly litigation, divert management’s attention and resources, require us to reengineer or cease sales of our products or require us to enter into royalty or license agreements which are not advantageous to us. In addition, parties making claims may be able to obtain an injunction, which

could prevent us from selling our products in the United States or abroad. We also have contractual obligations with respect to claims of infringement that may be triggered by such claims, including the payment of third-parties’ legal costs, indemnification of third-parties or other contractual responsibilities relative to such claims which may be costly to us. Further, the loss of patent protection for any of our products might allow competition, which, if successful, could cause our revenues from affected products to be adversely affected. In particular, one of our patents for our MCU products expired in 2010 and the other two patents for our MCU products will expire between 2011 and 2014.

The success of some of our products is dependent on our ability to maintain licenses to technology from the manufacturers of systems with which our products must be compatible.

Some of our products require that we license technology from manufacturers of systems with which our products must be compatible. The success of our proprietary MCU products, in particular, rely upon our ability to acquire and maintain licensing arrangements with the various manufacturers of DLC systems for the Proprietary Design Integrated Circuits (“PDICs”) unique to each. Although most of our PDIC licensing agreements have perpetual renewal terms, all of them can be terminated by either party. If we are unable to obtain the PDICs necessary for our MCU products to be compatible with a particular DLC system, we may be unable to satisfy the needs of our customers. Furthermore, future PDIC license agreements may contain terms comparable to, or materially different than, the terms of existing agreements, as dictated by competitive or other conditions. The loss of these PDIC license agreements, or our inability to maintain an adequate supply of PDICs on acceptable terms, could have a material adverse effect on our business.

If we are unable to satisfy our customers’ specific product quality, certification or network requirements, our business could be disrupted and our financial condition could be harmed.

Our customers demand that our products meet stringent quality, performance and reliability standards. We have, from time to time, experienced problems in satisfying such standards. Defects or failures have in the past, and may in the future occur relating to our product quality, performance and reliability. From time to time, our customers also require us to implement specific changes to our products to allow these products to operate within their specific network configurations. If we are unable to remedy these failures or defects or if we cannot affect such required product modifications, we could experience lost revenues, increased costs, including inventory write-offs, warranty expense and costs associated with customer support, delays in or cancellations or rescheduling of orders or shipments and product returns or discounts, any of which would harm our business.

If our accounting controls and procedures are circumvented or otherwise fail to achieve their intended purposes, our business could be seriously harmed.

We evaluate our disclosure controls and procedures as of the end of each fiscal quarter, and are annually reviewing and evaluating our internal controls over financial reporting in order to comply with SEC rules relating to internal control over financial reporting adopted pursuant to the Sarbanes-Oxley Act of 2002. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

If we ship products that contain defects, the market acceptance of our products and our reputation will be harmed and our customers could seek to recover their damages from us.

Our products, are complex, and despite extensive testing, may contain defects or undetected errors or failures that may become apparent only after our products have been shipped to our customers and installed in their network or after product features or new versions are released. Any such defect, error or failure could result in failure of market acceptance of our products or damage to our reputation or relations with our customers, resulting in substantial costs for us and for our customers as well as the cancellation of orders, warranty costs and product returns. In addition, any defects, errors, misuse of our products or other potential problems within or out of our control that may arise from the use of our products could result in financial or other damages to our customers. Our customers could seek to have us pay for these losses. Although we maintain product liability insurance, it may not be adequate.

Compliance with environmental regulations could be costly, and noncompliance could have a material adverse effect on our results of operations, expenses and financial condition.

Failure to comply with environmental regulations in the jurisdictions in which we do business could result in penalties and damage to our reputation. In effect in the European Union are the directive on the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (the “RoHS Directive”) and the directive on Waste Electrical and Electronic Equipment (the “WEEE Directive”). Both the RoHS Directive and the WEEE Directive impact the form and manner in which electronic equipment is imported, sold and handled in the European Union. Other jurisdictions, such as China, have followed the European Union’s lead in enacting legislation with respect to hazardous substances and waste removal. Although we have concluded that our test and

measurement products fall outside the scope of the RoHS Directive, we have voluntarily undertaken to cause our next generation products to comply with its requirements. Ensuring compliance with the RoHS Directive, the WEEE Directive and similar legislation in other jurisdictions, and integrating compliance activities with our suppliers and customers could result in additional costs and disruption to operations and logistics and thus, could have a negative impact on our business, operations and financial condition. In addition, based on our conclusion that our test and measurement products do not fall within the scope of these Directives, we have determined not to take these compliance measures with respect to certain of our older, legacy products. Should our conclusions with respect to the applicability of the RoHS Directive to these products be challenged and fail to prevail, we may be subject to monetary and non-monetary penalties, and could suffer harm to our reputation or further decline in the sales of our legacy products.

We are subject to governmental export and import controls that could subject us to liability or impair our ability to compete in international markets.

Our products are subject to United States import and export controls. Changes in our products or changes in export and import regulations may create delays in the introduction of our products in international markets, prevent our customers with international operations from deploying our products throughout their networks or, in some cases, prevent the export or import of our products to certain countries altogether. Any change in export or import laws and regulations, shifts in approach to the enforcement or scope of existing laws and regulations, or change in the countries, persons or technologies targeted by such regulations, could result in decreased use of our products by, or in our decreased ability to import, export or sell our products to existing or potential customers with international operations. Any limitation on our ability to import, export or sell our products would likely adversely affect our business, operating results and financial condition.

Consolidations in, or a continued slowdown in, the telecommunications industry could harm our business.

We have derived a substantial amount of our revenues from sales of products and related services to the telecommunications industry. In recent quarters, capital spending in the telecommunications industry has decreased and may continue to decrease in the future as a result of the challenging general economic conditions prevailing in domestic and international markets. In particular, large carrier customers have been adversely affected by subscriber line losses as well as by competition from cable and wireless carriers and other carriers entering the local telephone service market. Certain emerging carriers also continue to be hampered by financial instability caused in large part by a lack of access to capital. In the event of continued or further significant decreases in capital spending of the telecommunications industry, our business would be adversely affected. Furthermore, as a result of industry consolidation, there may be fewer potential customers requiring our software in the future. Larger, consolidated telecommunications companies may also use their purchasing power to create pressure on the prices and the margins we could realize. We cannot be certain that consolidations in, or a slowdown in the growth of, the telecommunication industry will not harm our business.

Our expenses are relatively fixed in the short term, and we may be unable to adjust spending to compensate for unexpected revenue shortfalls.

We base our expense levels in part on forecasts of future orders and sales, which are extremely difficult to predict. A substantial portion of our operating expenses is related to personnel expense, facilities and public company costs. The level of spending for such expenses cannot be adjusted quickly and is, therefore, relatively fixed in the short term. Accordingly, our operating results will be harmed if revenues fall below our expectations in a particular quarter.

We rely on software that we license from third-party developers to perform key functions in our products.

We rely on software that we license from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. We could lose the right to use this software or it could be made available to us only on commercially unreasonable terms. Although we believe that, in most cases, alternative software is available from other third-party suppliers or internal developments, the loss of or inability to maintain any of these software licenses or the inability of the third parties to enhance in a timely and cost-effective manner their products in response to changing customer needs, industry standards or technological developments could delay or reduce our product shipments until equivalent software could be developed internally or identified, licensed and integrated, which would harm our business.

Our common stock price may be extremely volatile.

Our common stock price has been and is likely to continue to be highly volatile. The market price may vary in response to many factors, some of which are outside our control, including:

	•		General market and economic conditions;
	•		Changes in the telecommunications industry;

	•		Actual or anticipated variations in operating results;
	•		Announcements of technological innovations, new products or new services by us or by our competitors or customers;
	•		Lack of research coverage by sell-side market analysts;
	•		Announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures, capital commitments or other strategic announcements;
	•		Announcements by our customers regarding end market conditions and the status of existing and future infrastructure network deployments;
	•		Additions or departures of key personnel; and
	•		Future equity or debt offerings or our announcements of these offerings.

In addition, if the Merger is not completed, the price of our common stock may decline to the extent that the current market price of our common stock reflects an assumption that the Merger will be consummated, and such decline may be material. Further, in recent years, the stock market in general, and The NASDAQ Global Select Market and the securities of technology companies in particular, have experienced extreme price and volume fluctuations. These fluctuations have often been unrelated or disproportionate to the operating performance of individual companies. These broad market fluctuations have in the past and may in the future materially and adversely affect our stock price, regardless of our operating results. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been initiated against such company. Such litigation could result in substantial costs and a diversion of our management’s attention and resources that could harm our business regardless of the outcome of such litigation.

We may be subject from time to time to legal proceedings, and any adverse determinations in these proceedings could materially harm our business.

We may from time to time be involved in various lawsuits and legal proceedings, which arise in the ordinary course of business. Litigation matters are inherently unpredictable, and we cannot predict the outcome of any such matters. If we ultimately lose or settle a case, we may be liable for monetary damages and other costs of litigation. Even if we are entirely successful in a lawsuit, we may incur significant legal expenses and our management may expend significant time in the defense. An adverse resolution of a lawsuit or legal proceeding could negatively impact our financial position and results of operations.

In addition, we are currently named as a defendant in two actions related to the Merger Agreement and the transactions contemplated thereby, and may be named as a defendant in additional actions relating thereto. Plaintiffs in both of the pending cases are seeking to enjoin the Merger and other injunctive relief. We cannot at this time reasonably predict the outcome of these cases of whether the plaintiffs may additionally seek monetary relief. An adverse resolution of these proceedings could negatively impact our financial position and results of operations, and could delay or prevent the consummation of the Merger.

Item 1B. Unresolved Staff Comments.

None.

Item 2. Properties.

Effective February 28, 2011, our headquarters and principal administrative, engineering, manufacturing, warehouse and maintenance operations are located in a 24,402 square foot facility in Cranberry Township, Pennsylvania. A new seven year lease for this facility was signed in October 2010 and commenced on March 1, 2011. We previously occupied a 111,600 square foot facility in Cheswick, Pennsylvania, which is under lease through March 31, 2011.

We are also a party to a lease agreement for 11,429 square feet of space in Piscataway, New Jersey, which lease commenced on March 1, 2007 and expires April 30, 2012. The Piscataway facility provides workspace for the administrative, engineering and services personnel.

We lease office space in three locations in Europe, the largest of which is in Bracknell, United Kingdom. At that location, we lease 7,500 square feet of space, primarily for engineers who support our European customer base and customer support personnel. This lease expires on December 24, 2012. In addition, we lease 2,422 square feet of space in Wuppertal, Germany, under a lease which expires on January 31, 2012. This facility is used primarily by sales and customer support personnel. Lastly, we lease office space in Kontich, Belgium pursuant to a monthly lease commitment for sales and customer support personnel.

Item 3. Legal Proceedings.

On February 22, 2011, we announced that we had entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Talon Holdings, Inc., a Delaware corporation (“Parent”), and Talon Merger Sub, Inc., a Pennsylvania corporation and a direct wholly-owned subsidiary of Parent (“Merger Sub”), providing for the merger of Merger Sub with and into the Company (the “Merger”), with the Company surviving the Merger as a wholly-owned subsidiary of Parent. Parent is owned by investment funds managed by Golden Gate Capital, a San Francisco based private equity firm. At the effective time of the Merger, all of the shares of our outstanding common stock (other than shares held by us, Parent or Merger Sub) would be acquired by Parent for $10.10 per share in cash. We have subsequently been named as a defendant in two actions related to the Merger:

	•		Stephen Tencza v. the Company and each member of the board of directors of the Company (the “Directors”) filed on February 24, 2011 in the Court of Common Pleas of Allegheny County, Pennsylvania; and
	•		Vladimir Gusinsky Revocable Trust v. the Company and the Directors filed on March 1, 2011 in the Court of Common Pleas of Allegheny County, Pennsylvania

The named plaintiffs in the two cases allege breach of the Directors’ fiduciary duties to our stockholders. Specifically, the complaints allege that the Directors breached their fiduciary duties to the stockholders by agreeing to sell the Company without regard to the fairness of the transaction. We deny these allegations and plan to vigorously defend ourselves. Plaintiffs in both of the cases are seeking to enjoin the Merger and other injunctive relief. We cannot at this time reasonably predict the outcome of these cases of whether the plaintiffs may additionally seek monetary relief.

Item 4. Reserved.

PART II

Item 5. Market for the Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Our common stock is traded on The NASDAQ Global Select Market under the symbol “TLGD”. The following table sets forth, by quarter, the high and low sales prices for our common stock for the years ended December 31, 2010 and December 31, 2009.

		2010								2009
		High				Low				High				Low
First Quarter		$	6.88			$	6.00			$	7.14			$	4.73
Second Quarter		$	6.90			$	6.11			$	5.95			$	5.04
Third Quarter		$	8.30			$	6.16			$	6.93			$	4.98
Fourth Quarter		$	9.50			$	7.12			$	6.83			$	5.49

On February 28, 2011, there were 146 holders of record and 13,007,388 million shares outstanding of the Company’s common stock.

We have never paid any dividends on our common stock and do not expect to pay dividends in the foreseeable future. Our ability to pay dividends is currently restricted by the terms of the Agreement and Plan of Merger, dated February 21, 2011, among Talon Holdings, Inc. (“Parent”), Talon Merger Sub, Inc. and the Company, which restricts us from taking certain actions, including the payment of dividends from the date of the Merger Agreement until the effective time of the Merger, without the prior written consent of Parent.

STOCK PERFORMANCE GRAPH

Set forth below is a performance graph comparing the cumulative total returns (assuming reinvestment of dividends) for the five fiscal years ended December 31, 2010 of $100 invested on December 31, 2005 in Tollgrade’s common stock, the Standard & Poor’s 500 Composite Index and the NASDAQ Telecomm (IXTC).

The performance graph and related information shall not be deemed “soliciting material” or be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference to any future filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (the “Exchange Act”) or otherwise subject to the liabilities under that Section.

		December 31,				December 31,				December 31,				December 31,				December 31,				December 31,
		2005				2006				2007				2008				2009				2010
Tollgrade			100				97				73				44				56				85
NASDAQ Telecomm (IXTC)			100				128				139				80				118				123
S&P 500			100				114				118				72				89				101

Item 6. Selected Financial Data.

The following selected consolidated financial data of the Company has been derived from our audited consolidated financial statements. The following selected consolidated financial data may not be representative of our future financial performance and should be read in conjunction with the consolidated financial statements, the notes to the consolidated financial statements, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which are included elsewhere in this report.

(IN THOUSANDS, EXCEPT PER SHARE DATA AND NUMBER OF EMPLOYEES)

FOR THE YEARS ENDED DECEMBER 31:		2010				2009				2008				2007				2006
Revenues:
Products		$	19,067			$	19,936			$	26,997			$	36,143			$	35,270
Services			26,579				25,005				22,055				15,689				11,736
Total revenue			45,646				44,941				49,052				51,832				47,006
Cost of sales:
Products			8,259				11,812				14,181				15,874				14,653
Services			7,618				7,143				6,146				4,103				3,473
Amortization of intangible assets			1,570				2,576				3,085				2,199				2,597
Inventory write-down			—				3,070				759				—				4,101
Impairment of long-lived assets			—				27,151				201				1,090				—
Severance			319				778				—				—				—
Total cost of sales			17,766				52,530				24,372				23,266				24,824
Gross profit/(loss)			27,880				(7,589	)			24,680				28,566				22,182
Operating expenses:
Selling and marketing			5,967				6,809				6,835				7,807				7,794
General and administrative			8,561				12,141				9,455				9,702				7,702
Research and development			6,841				9,411				10,789				10,987				9,088
Restructuring/severance			1,826				1,180				827				922				566
Impairment of long-lived assets and goodwill			—				293				—				20,036				—
Total operating expenses			23,195				29,834				27,906				49,454				25,150
Income/(Loss) income from operations			4,685				(37,423	)			(3,226	)			(20,888	)			(2,968	)
Other income, net			9				567				1,337				2,770				2,741
Income/(Loss) income before income taxes			4,694				(36,856	)			(1,889	)			(18,118	)			(227	)
Provision/(Benefit) for income taxes			271				(874	)			1,137				1,220				(1,213	)
Income/(Loss) from continuing operations			4,423				(35,982	)			(3,026	)			(19,338	)			986
(Loss) from discontinued operations			—				(223	)			(4,089	)			(6,815	)			(2,820	)
Net Income/(Loss)		$	4,423			$	(36,205	)		$	(7,115	)		$	(26,153	)		$	(1,834	)
Weighted average shares of common stock equivalents:
Basic			12,736				12,683				13,102				13,219				13,239
Diluted			13,160				12,683				13,102				13,219				13,239
EARNINGS PER SHARE INFORMATION:
Net Income/(Loss) per common share:
Basic		$	0.35			$	(2.85	)		$	(0.54	)		$	(1.98	)		$	(0.14	)
Diluted		$	0.34			$	(2.85	)		$	(0.54	)		$	(1.98	)		$	(0.14	)
EARNINGS PER SHARE INFORMATION:
Net Income/(Loss) per common share from continuing operations:
Basic		$	0.35			$	(2.83	)		$	(0.23	)		$	(1.46	)		$	0.07
Diluted		$	0.34			$	(2.83	)		$	(0.23	)		$	(1.46	)		$	0.07
EARNINGS PER SHARE INFORMATION:
Net (Loss) per common share from discontinued operations:
Basic		$	—			$	(0.02	)		$	(0.31	)		$	(0.52	)		$	(0.21	)
Diluted		$	—			$	(0.02	)		$	(0.31	)		$	(0.52	)		$	(0.21	)

(IN THOUSANDS, EXCEPT PER SHARE DATA AND NUMBER OF EMPLOYEES)

FOR THE YEARS ENDED DECEMBER 31:		2010				2009				2008				2007				2006
BALANCE SHEET DATA:
Working capital		$	77,675			$	69,195			$	75,475			$	77,080			$	83,186
Total assets			91,337				87,687				124,347				140,143				162,352
Pension obligation			795				983				889				908				—
Shareholders’ equity			84,292				77,743				112,454				123,000				149,444

		2010				2009				2008				2007				2006
OTHER DATA: (unaudited)
Number of full-time employees at year-end			107				167				179				205				161

Item 7. Management’s Discussion and Analysis (“MD&A”) of Financial Condition and Results of Operations.

The following discussion should be read in conjunction with the other sections of this annual report on Form 10-K, including “Item 1: Business,” “Item 6: Selected Financial Data” and “Item 8: Financial Statements.” Unless otherwise specified, any reference to a “year” is to a year ended December 31. Additionally, when used in this Form 10-K, unless the context requires otherwise, the terms “we”, “our”, “us” and “the Company” refer to Tollgrade Communications, Inc. and its subsidiaries. Certain statements contained in this MD&A and elsewhere in this report are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended that involve risks and uncertainties. These statements relate to future events or our future financial performance. In some cases, forward-looking statements can be identified by terminology such as “believe,” “expect,” “intend,” “may,” “will,” “should,” “could,” “potential,” “continue,” “estimate,” “plan,” or “anticipate,” or the negatives thereof, other variations thereon or compatible terminology. These statements involve a number of risks and uncertainties. Actual events or results may differ materially from any forward-looking statement as a result of various factors, including those described in Item 1A above under “Risk Factors.”

Cable Product Line

On May 27, 2009, we completed the sale of our cable product line for consideration of approximately $3.4 million, subject to adjustment for certain items pursuant to the terms of the sale agreement. The cable product line no longer supported our refocused growth strategy and this divesture allows us to continue to focus on our core telecommunications markets and customers. Unless otherwise indicated, references to revenues and earnings throughout this MD&A and elsewhere in this Form 10-K refer to revenues and earnings from continuing operations and do not include revenue and earnings from the discontinued cable product line. Similarly, discussion of other matters in our Consolidated Financial Statements refers to continuing operations unless otherwise indicated. The results from this divested product line are reported in discontinued operations.

Overview

Tollgrade Communications, Inc. is a provider of centralized test and measurement systems and service offerings to the telecommunications market. We design, engineer, and support test systems and status monitoring hardware and software products for some of the largest telecommunication companies within the United States and Europe. Our products enable service providers to remotely diagnose and proactively address problems within their networks. By coupling our hardware and software offerings together, we provide proactive, centralized test solutions for our customers. Our service and managed service business includes software maintenance and support for our operating systems, along with hardware maintenance for our test probes, and our professional services, which are designed to ensure that all of the components of our customers test systems operate properly. In addition, since 2007, we have been developing a sensor and a software operating platform for the utility industry that leverages our core competences and years of experience in scaling test systems in large telecommunication networks and applying that similar business model to the utility marketplace.

In 2010 we increased our revenue, appointed a new President and Chief Executive Officer in June and returned the Company to annual profitability for the first time since 2005. We strived throughout the year to achieve our primary goals of strengthening our business and delivering improved operating results. In developing our business plan for 2010, we had three guiding principles:

	•		First and foremost, to ensure profitability;
	•		Second, to target resources and spending on legacy products to allow for focused investments; and
	•		Third, to align the business around growth initiatives and focus our resources on near-term opportunities.

Our efforts to return the Company to profitability began in late 2009 and continued aggressively over the first four months of 2010. By the end of 2009, we successfully outsourced almost 100% of our in-house manufacturing to Express Manufacturing. This action replaced our fixed overhead cost structure to support our previous in-house manufacturing process with a variable cost business model for our hardware product sales that also required less use of our working capital. In addition, in the fourth quarter of 2009, we eliminated 28 positions across all levels of the organization that produced approximately $2.4 million in annualized cost savings. In addition, early in the second quarter of 2010, we further accelerated our efforts to return to profitability by reducing our workforce by approximately 33% which contributed approximately $5.8 million in annualized salary and benefits savings. Our workforce reductions were carefully planned so as to ensure that we were able to achieve our cost reduction goals without sacrificing our ability to service our customers while also allowing us to focus research and development efforts on projects that could allow for near-term top line growth. In addition, throughout 2010, we also focused our attention on a number of non-headcount related costs and achieved substantial cost reductions in the areas of general and directors and officers insurance, audit costs and cash related board fees. Through a combination of all of these actions and initiatives, we posted final 2010 revenues of $45.6 million or a 1.6% growth over 2009 revenues, achieved three consecutive quarters of profitability from operations, posted annual net income of $4.4 million and basic net income per share of $0.35, while increasing our cash balance to $72.2 million, a $6.2 million increase over the $66.0 million cash balance at the end of 2009.

Although we have significantly reduced our operations and research and development departments from 68 and 66 employees at the beginning of 2009 to 36 and 34 employees, respectively, at the end of 2010, we have focused our product efforts on our best opportunities for revenue and profitability and reduced areas of investment that involved higher risk before any returns could be realized. For example, we discontinued two yet to be announced projects at the end of the first quarter of 2010 so that we could provide greater attention to a European customer that wanted to purchase our DigiTest ICE and LoopCare products and software to support their next generation broadband test capabilities. We ultimately received initial orders in excess of $1.0 million with this customer and expect additional revenues from this customer in the future. By again concentrating our resources towards a project with a high probability of future revenues, we also successfully completed a trial for our LDU telecommunications test products and new software with a major British customer in the fourth quarter of 2010. We expect to finalize the contract for this project in early 2011, and we expect to receive significant revenues related to this project over the next three to five years. Additionally, we will continue to support our broad product portfolio, including our DigiTest, LDU, and MCU hardware, and our LoopCare, 4TEL and Celerity software platforms, to ensure that our customers receive the high levels of customer support that they have grown accustomed to.

We also continue to promote and support our LightHouse product line for the utility industry. Our trial with a major US utility company concluded successfully last fall with only minor customer-driven product modifications requested. We have recently completed those product modifications and received our first commercial orders in early 2011. We are working with that utility on rolling out a full-scale deployment of the product over the first half of 2011. Furthermore, we have recently completed another successful trial with a major Canadian utility customer and have signed three more utility customers to test our product. We are also poised to launch our next LightHouse software release that we believe will widen the gap that we believe exists between our product offerings and those of our competitors. With our more than twenty years of testing large telecommunication networks, we believe that our in-house engineering expertise further strengthens our ability to service the utility marketplace. Although revenue in this area of our business has been slower to develop than we anticipated, we believe this market will provide us with long-term growth.

In 2009, we created a new area of opportunity through our managed services contract with Ericsson. We now have the expertise to provide a new suite of managed services not only to our service provider customers, but also to additional network equipment manufacturers, thus expanding our target market. We are deploying and focusing resources in this area as we believe this new platform will provide new growth opportunities and enable us to effectively respond to our customers’ trend in an area that builds upon our expertise and experience in test and measurement. We also continue to focus our sales and field service support personnel on our maintenance service contracts, and during 2010, we secured three long-term contract extensions with one major US and two major European telecommunication providers, thus providing us with predictable revenue streams through 2012.

On February 21, 2011, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Talon Holdings, Inc., a Delaware corporation (“Parent”), and Talon Merger Sub, Inc., a Pennsylvania corporation and a direct wholly-owned subsidiary of Parent (“Merger Sub”), providing for the merger of Merger Sub with and into the Company (the “Merger”), with the Company surviving the Merger as a wholly-owned subsidiary of Parent. Parent is owned by investment funds managed by Golden Gate Capital, a San Francisco based private equity firm. At the effective time of the Merger, all of the shares of our outstanding common stock (other than shares held by us, Parent or Merger Sub) would be acquired by Parent for $10.10 per share in cash. The Merger Agreement was unanimously approved by our board of directors. Consummation of the Merger is subject to customary conditions, including without limitation (i) the approval by the holders of at least a majority of the votes cast by the outstanding shares of our common stock entitled to vote on the Merger, (ii) the expiration or early termination of the waiting period applicable to the consummation of the Merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, (iii) the absence of any law or order restraining, enjoining or prohibiting the Merger, (iv) the absence of any pending litigation challenging the Merger, and (v) the absence of a material adverse effect on the Company. Moreover, each party’s obligation to consummate the Merger is subject to certain other conditions, including without limitation (x) the accuracy of the other party’s representations and warranties and

(y) the other party’s compliance with its covenants and agreements contained in the Merger Agreement. We expect the Merger to close during the second quarter of 2011.

Moving into 2011, we believe we will continue to see the benefits of our realigned cost structure, which has enhanced our ability to maintain profitability even when customers shift their project timelines. We also have more flexibility to reallocate resources and secure temporary labor to help us win new projects while maintaining our product and software platforms that are embedded in our tier one customer base. While some of our larger customers are in the process of upgrading their access networks and the related service assurance solutions for these networks, there is no guarantee that these activities will continue or that these customers will adopt our new technologies which would adversely affect future revenues related to these products and services. However, our goal is to continue to focus our efforts on near-term customer opportunities, especially in the managed services area, and with our LightHouse product for the utility market, while seeking new product and service offerings for our existing and potential new customers.

Results of Operations for the Year Ended December 31, 2010 Compared to the Year Ended December 31, 2009

Revenue

		2010				2009				Change				%
System Test Products		$	11,771			$	14,118			$	(2,347	)			-17	%
MCU			6,658				5,694				964				17	%
Other			638				124				514				415	%
Total Products			19,067				19,936				(869	)			-4	%
Managed Services			7,030				5,078				1,952				38	%
Other Services			19,549				19,927				(378	)			-2	%
Total Services			26,579				25,005				1,574				6	%
Total Revenue		$	45,646			$	44,941			$	705				2	%

Our total revenues for the year ended December 31, 2010 were $45.6 million, an increase of $0.7 million, or 2%, compared to our total revenues of $44.9 million for the year ended December 31, 2009. For the full year 2010, our total product revenues amounted to $19.1 million compared to $19.9 million for the same 2009 period, a decrease of $0.8 million or 4%. For the full year 2010, our total services revenues amounted to $26.6 million compared to $25.0 million for the same 2009 period, an increase of $1.6 million or 6%.

The overall decrease in our 2010 product line revenue is primarily due to a decline in some of our legacy system test product lines, including the product families of DigiTest, LDU and N(x)Test and their associated software applications and license fees. In particular under our System Test Products, our DigiTest products had lower sales of approximately $1.3 million, our LDU product sales had lower sales of approximately $0.2 million, and our N(x)Test product line, which was discontinued last year, experienced a decline in sales of approximately $0.8 million. These declines are primarily due to a combination of lower customer demand for these products along with a significant one time buy of our N(x)Test product in 2009. These declines were partially offset by increased revenues of our MCU product line of $0.9 million, primarily with AT&T, our largest domestic customer. Lastly, other product revenue increased primarily as a result of additional sales of our Protocol OEM product of $0.5 million as compared to the prior year when we first introduced this product. Our product revenues accounted for 42% of our total revenues for 2010 compared to 44% of our total revenues for 2009.

Our services revenue consists primarily of software maintenance for 4TEL and Celerity LTSC, and LoopCare, project management fees, repair work and managed services. The increase in our 2010 managed service revenue is due to a $2.0 million increase related to our having had a full year of revenue under our managed services contract with Ericsson during 2010, as opposed to the partial year of revenue in 2009, as that contract was signed in April of 2009. The increase in other services revenues, which consist primarily of our software maintenance and repair work, is the result of additional MCU repairs of approximately $0.5 million, additional DigiTest repairs of approximately $0.5 million, and additional service revenue of approximately $0.4 million related to our Protocol OEM product. These increases were partially offset by lower maintenance service revenues related to LoopCare of approximately $0.8 million and 4TEL of approximately $1.1 million. Services revenues accounted for approximately 58% of our total revenues for 2010 compared to 56% of 2009 total revenues.

Gross Profit /(Loss)

Our 2010 gross profit was $27.9 million compared to a gross loss of $(7.6) million for the same 2009 period, an increase of approximately $35.5 million. However, included in our 2009 gross margin was an impairment of long-lived assets of approximately $27.2 million and an inventory write-down of approximately $3.1 million. The total of these two charges approximated $30.3 million of our 2009 gross margin. In addition, our 2010 amortization of intangible asset expense decreased by approximately $1.0 million

over the same 2009 period due the overall reduction of the carrying balance of our intangible assets related to the 2009 LoopCare impairment previously discussed. The culmination of these 2009 charges and expenses that were present in 2009 and not in 2010 along with the reductions in headcount and cost saving from the outsourcing of our in-house manufacturing were the primary reasons for our increase in gross profit in 2010.

Selling and Marketing Expenses

		2010				2009				Change				%
Employee Costs		$	4,516			$	4,780			$	(264	)			-6	%
Travel Expenses			508				694				(186	)			-27	%
Consulting Expenses			323				419				(96	)			-23	%
Other			620				916				(296	)			-32	%
Total Selling and Marketing Expenses		$	5,967			$	6,809			$	(842	)			-12	%

Our 2010 total selling and marketing expenses were approximately $6.0 million compared to approximately $6.8 million in 2009, a decrease of $0.8 million, or 12%. Our total selling and marketing expenses consist primarily of employee costs, which include salaries and related payroll taxes, benefits and commission expenses as well as related travel expenses and certain consulting expenses and other expenses, which individually are not material. The decrease in employee costs in 2010 is primarily due to additional headcount reductions in 2010, which was the continuation of our overall cost reduction efforts that began in 2009. These headcount reductions also resulted in overall savings in travel, consulting, and various other overhead employee related expenses.

General and Administrative Expenses

		2010				2009				Change				%
Employee Costs		$	3,315			$	3,922			$	(607	)			-15	%
Legal and Professional Fees			1,786				3,880				(2,094	)			-54	%
Stock Compensation			914				855				59				7	%
General Insurance			348				656				(308	)			-47	%
Bad Debt			152				1,121				(969	)			-86	%
Other			2,046				1,707				339				20	%
Total General and Administrative Expenses		$	8,561			$	12,141			$	(3,580	)			-29	%

Our 2010 total general and administrative expenses were approximately $8.5 million compared to approximately $12.1 million in 2009, a decrease of $3.6 million, or 29%. Our general and administrative expenses consist primarily of employee costs, which include salaries and related payroll taxes, legal and professional fees, stock compensation expenses, general insurance expense, bad debt expenses, and other expenses. The decrease in employee costs in 2010 is primarily due to additional headcount reductions in 2010, which was the continuation of our overall cost reduction efforts that began in 2009. We also had a concerted effort to reduce costs for legal and other professional fees and achieved that in the areas of reduced audit fees, other audit related fees and board fees. In addition, we incurred professional fees in 2009 of approximately $0.7 million in connection with the contested election of directors and fees related to our evaluation of potential acquisition candidates, which were not incurred in 2010. General insurance declined by $0.3 million in 2010 due to a change in insurance providers, revised coverage, and other program changes. The $1.0 million decrease in bad debt expense is primarily attributable to a $1.1 million bad debt expense recorded in the third quarter of 2009 related to one of our large international contracts whose collectability was deemed to be uncertain. Other expense consists of various items which are individually immaterial.

Research and Development Expenses

		2010				2009				Change				%
Employee Costs		$	5,797			$	7,977			$	(2,180	)			-27	%
Professional Fees			618				722				(104	)			-14	%
Depreciation			567				622				(55	)			-9	%
Other			(141	)			90				(231	)			-257	%
Total Research and Development Expenses		$	6,841			$	9,411			$	(2,570	)			-27	%

Our 2010 total research and development expenses were approximately $6.8 million compared to approximately $9.4 million in 2009, a decrease of $2.6 million, or 27%. Our research and development expenses consist primarily of employee costs, which include salaries and related payroll taxes, professional fees, depreciation expenses and other expenses, which individually are not material. The decrease in our research and development expenses for 2010 is primarily related to reductions in the work force, reduced consulting and professional fees, lower depreciation and a larger portion of our engineering costs allocated to cost of sales due to some of our contractual agreements which require us to provide engineering development or repair services to our customers.

Severance Expenses

During the first quarter of 2010, we accelerated our efforts to reduce our operating expenses in order to help position ourselves to achieve stronger profitability levels in the future. As such, we eliminated 48 positions across all functional levels of the organization in an effort to reduce our overall cost structure. The total severance charge associated with these actions was approximately $1.7 million of which approximately $0.5 million was recorded as cost of sales expense and $1.2 million was recorded as an operating expense. During the second quarter of 2010, we incurred a severance charge of $0.9 million related to the departure of our former chief executive officer. This expense was recorded as an operating expense. In relation to these actions due to changes in certain circumstances related to our planned actions, we recorded certain positive adjustments to our severance accruals in both the second quarter and third quarters of 2010 in the amounts of $0.3 million and $0.2 million, respectively. We do not anticipate any further adjustment related to our workforce reduction or for the departure of our former chief executive officer and the majority of the cash payments related to these actions were made during the second quarter of 2010.

During 2009, we had several restructuring plans in order to reduce our headcount and achieve lower operating costs. During the third quarter of 2009, we developed an initial plan to reduce and restructure our workforce across all levels of the organization in an effort to reduce costs in order to better align our resources to our revenue streams. The total severance charge associated with this plan was approximately $1.4 million of which $0.5 million was recorded as cost of sales expense and $0.9 million was recorded as an operating expense. Additionally, we incurred $0.2 million of severance charges related to the departure of our former chief financial officer that was recorded as an operating cost. During the second quarter of 2009, we decided to outsource almost all of our in-house manufacturing to a third party vendor and, as such, we reduced our production staffing. The total severance expense associated with this action was approximately $0.1 million. During the first quarter of 2009, we implemented a restructuring program pursuant to which we realigned existing resources to new projects, reduced our field service and sales staffing and completed other reduction activities. The severance costs associated with this program amounted to approximately $0.3 million of which approximately $0.2 million was recorded in cost of sales and approximately $0.1 million was recorded as operating expenses. All cash payments related to these actions were paid in 2009 and no further expense is expected.

Other Income, (net)

Other income was less than $0.1 million for 2010 as compared to $0.6 million for 2009. This $0.5 million decrease in other income in 2010 is due primarily to a $0.2 million decline in interest income on our investment balances as a result of the overall decline in economic market conditions, foreign currency translation losses of $0.1 and an insurance loss reimbursement of $0.2 in 2009 not realized in 2010.

Income Taxes

For the year ended December 31, 2010, we recorded a total income tax expense of approximately $0.3 million, primarily related to foreign tax obligations generated by our profitable foreign jurisdictions, as well as adjustments to reserves for uncertain tax positions in all jurisdictions. For the year ended December 31, 2009, we incurred a total income tax benefit of $0.9 million, primarily related to the income tax benefit of $1.1 million associated with the impairment of our LoopCare intangible asset, whereby we reduced a deferred tax liability on our balance sheet. This benefit was offset by income tax expenses primarily related to foreign income tax obligations generated by profitable operations in certain foreign jurisdictions. Additionally, we continued to record a valuation allowance against U.S. federal, state and certain foreign net operating losses incurred in 2010, as we believe it is more likely than not that the tax benefit will not be realizable in future periods. The operating profits in 2010, as well as the tax benefit related to the intangible asset impairment in 2009, are the primary reasons for the increase of 8% in the effective tax rate year over year.

Results of Operations for the Year Ended December 31, 2009 Compared to the Year Ended December 31, 2008

		2009				2008				Change				%
System Test Products		$	14,118			$	18,061			$	(3,943	)			-22	%
MCU			5,694				8,936				(3,242	)			-36	%
Other			124				—				124				100	%
Total Products			19,936				26,997				(7,061	)			-26	%
Managed Services			5,078				—				5,078				100	%
Other Services			19,927				22,055				(2,128	)			-10	%
Total Services			25,005				22,055				2,950				13	%
Total Revenue		$	44,941			$	49,052			$	(4,111	)			-8	%

Our total revenues for the year ended December 31, 2009 were $44.9 million, a decrease of $4.1 million, or 8%, compared to our total revenues of $49.1 million for the year ended December 31, 2008. For the full year 2009, our total product revenues amounted to $19.9

million compared to $27.0 million for the same 2008 period, a decrease of $7.1 million or 26%. However, our full year 2009 service revenues increased to $25.0 million, a $3.0 million or a 13% increase over the same prior period.

The decline in our 2009 product line revenue of $7.1 million is primarily due to a decline in most of our legacy test product lines and our MCU products. Our Systems Test products include the product families of DigiTest, LDU and N(x)Test and associated software applications and license fees. Revenues for System Test products in 2009, were $14.1 million, a decrease of approximately $3.9 million, or 22% from the same prior year period. Our Systems Test product line revenues decreased in 2009 primarily as a result of the conclusion of certain international projects involving DigiTest products in 2008. The Systems Test product line revenue accounted for 31% of 2009 total revenues compared to 37% of 2008 total revenues. In addition, sales of our MCU product line in 2009 were $5.7 million, compared to $8.9 million in the previous year, which represents a decrease of approximately $3.2 million, or 36%. Although our MCU product line still provided a meaningful contribution to revenue in 2009, this is a very mature product line whose future sales are hard to predict due to the large domestic carriers’ limiting capital spending in their traditional POTS networks, and the evolution of the transmission network toward end-to-end fiber. Our MCU product line accounted for approximately 13% of our 2009 total revenues compared to 18% of our 2008 total revenues. Lastly, our other revenue for 2009 is comprised of approximately $0.1 million in revenue from OEM and LightHouse sales as we had no sales in either of these product lines in 2008. Our product revenues accounted for 44% of our total revenues for 2009 compared to 55% of our total revenues for 2008.

Our services revenue consists primarily of software maintenance for 4TEL and Celerity LTSC, and LoopCare, project management fees, repair work and managed services. Our 2009 managed service revenue of approximately $5.1 million is due entirely to our managed service contract with Ericsson that was signed in April of 2009. The decrease in other services revenues of approximately $2.1 million, which consist primarily of our software maintenance and repair work, is the result of lower repairs and the roll-off of certain maintenance contracts. Services revenues accounted for approximately 56% of our total revenues for 2009 compared to 45% of 2008 total revenues.

Gross (Loss)/profit

Our 2009 gross margin was a negative $(7.6) million compared to $24.7 million for the same 2008 period, a decrease of approximately $32.3 million. Our 2009 gross margin decrease of $32.3 million is primarily related to long-lived asset impairments of $27.2 million, which included the fourth quarter write-down of our LoopCare intangible asset that amount to approximately $27.0 million, a third quarter 2009 inventory write-down of approximately $3.1 million that primarily related to slow-moving and obsolete legacy product inventory, and severance costs that amounted to approximately $0.8 million.

Selling and Marketing Expenses

		2009				2008				Change				%
Employee Costs		$	4,780			$	4,583			$	197				4	%
Travel Expenses			694				799				(105	)			-13	%
Consulting Expenses			419				677				(258	)			-38	%
Other			916				776				140				18	%
Total Selling and Marketing Expenses		$	6,809			$	6,835			$	(26	)			0	%

Our selling and marketing expenses of $6.8 million for 2009 and 2008 were flat year over year. Our selling and marketing expenses consist primarily of employee costs, which include salaries and related payroll taxes, benefits and commission expenses as well as related travel expenses, and certain consulting fees and other miscellaneous expenses which individually are not material. The increase in employee costs in 2009 is primarily due to the addition of sales and business development employees in the fourth quarter of 2009 to bolster our sales efforts in certain markets. The 2009 decrease in travel costs and professional fees of approximately $0.1 million and $0.3 million is primarily related to our overall cost reduction efforts that occurred throughout 2009.

General and Administrative Expenses

		2009				2008				Change				%
Employee Costs		$	3,922			$	3,912			$	10				0	%
Legal and Professional Fees			3,880				3,132				748				24	%
Bad Debt			1,121				—				1,121				100	%
Stock Compensation			855				299				556				186	%
Other			2,363				2,112				251				12	%
Total General and Administrative Expenses		$	12,141			$	9,455			$	2,686				28	%

For the full year ended December 31, 2009, our general and administrative expenses were $12.1 million, or a $2.7 million increase over the same 2008 period. Our general and administrative expenses consist primarily of employee costs, which include salaries and related payroll taxes and benefit related costs, legal and profession professional fees, bad debt expenses, stock compensation expenses and other expenses which individually are not material. The $2.7 million increase is primarily attributable to a $1.1 million bad debt

expense recorded in the third quarter of 2009 related to one of our large international contracts whose collectability was deemed to be uncertain, additional legal expenses and professional service fees of approximately $0.7 million in connection with the contested election of directors and fees related to potential acquisition candidates that were not pursued beyond the due diligence stage, and $0.6 million in additional stock compensation expenses due primarily to restricted stock awards granted our non-employee directors in the fourth quarter of 2009 pursuant to the non-employee director compensation program adopted by the Board in October 2009. These non-employee director awards offset substantial reductions in director cash compensation and meeting fees .

Research and Development Expenses

		2009				2008				Change				%
Employee Costs		$	7,977			$	8,435			$	(458	)			-5	%
Professional Services			722				1,205				(483	)			-40	%
Depreciation			622				865				(243	)			-28	%
Other			90				284				(194	)			-68	%
Total Research and Development Expenses		$	9,411			$	10,789			$	(1,378	)			-13	%

Our research and development expenses for the full year ended December 31, 2009 were $9.4 million, or a $1.4 million decrease, over the same 2008 period. Our research and development expenses consist primarily of employee costs, which include salaries and related payroll taxes, professional fees, depreciation expenses and other expenses, which individually are not material. The decrease in our research and development expenses for 2009 is primarily related to reductions in the work force, reduced consulting and professional fees and lower depreciation expenses due to reduced capital spending.

Severance Expense

Severance expense primarily consists of wages, benefits and outplacement costs at a time when an employee is terminated. In 2009, we had three instances where we reduced and re-aligned our work force to reduce costs and to further streamline and improve our business. During the third quarter of 2009, we developed a plan to significantly reduce and restructure our workforce across all levels of the organization in an effort to reduce costs and to better align our human resources to match ongoing revenue streams. The total severance associated with this action was $1.4 million of which $0.5 million was recorded to cost of sales while $0.9 million was recorded as an operating expense. In addition, in the third quarter of 2009, we also incurred a $0.2 million charge related to the departure of our former chief financial officer. During the first and second quarters of 2009, we implemented certain initiatives aimed at increasing efficiency and decreasing costs, which included reductions in our professional services, operations and marketing staff. Severance expense associated with these actions was $0.3 million. Cash payments related to the aforementioned actions were $1.5 million in 2009. As of December 31, 2009, we had $0.4 million accrued on our balance sheet related to this action, which was paid in early 2010.

During the first quarter of 2008, we reduced our engineering and senior management staff, made changes to our field service and sales staffing, and realigned existing resources to new projects. The severance costs associated with this program amounted to approximately $0.4 million. In addition, we incurred severance costs in the fourth quarter related to the separation of two senior executives and one other executive that amounted to approximately $0.4 million. All cash payments related to this action have been paid in 2008 and no further expense is expected.

Long-Lived Asset Impairments

We perform impairment reviews on our long-lived assets upon a change in business conditions or upon the occurrence of a triggering event. In mid-December 2009, we learned that Verizon, a major customer of our LoopCare post-warranty software maintenance services, would not renew its direct contract with us for those services following the contract’s expiration date on December 31, 2009, but would instead consolidate its purchase of maintenance services (including LoopCare and 4TEL post-warranty services) through a single large supplier. However, based on this “triggering event” we evaluated the carrying value of the intangible asset related to our LoopCare post-warranty intangible asset using an undiscounted cash flow model, and determined the asset to be impaired. We then performed a valuation on this asset to determine its fair value. Through this valuation process, we determined that the fair value of this asset approximated $2.3 million compared to its current carrying value of $29.3 million and, as such, took an impairment charge of approximately $27.0 million in the fourth quarter of 2009. In addition, through this valuation process, we determined that a fifteen year life, instead of life of approximately forty-six years, on this asset is more indicative of current market and technological conditions, as well as the anticipated future ability to extend existing maintenance agreements. In 2009, we also recorded a $0.4 million charge for impairments in various other long-lived assets.

In 2008 we recorded an impairment charge on certain long-lived assets of $0.2 million.

Other Income, (net)

Other income, which consists primarily of interest income, was $0.6 million for 2009, compared to $1.3 million for 2008. The $0.7 million decrease in other income is due primarily to lower interest yields on our investment balances due to the overall decline in economic market conditions.

(Benefit)/Provisions for Income Taxes

For the year ended December 31, 2009, we recorded a total income tax benefit of approximately $0.9 million. The primary reason for this income tax benefit was the $1.1 million benefit associated with the impairment of our LoopCare intangible asset, whereby we reduced a deferred tax liability on our balance sheet. This benefit was offset by income tax expenses primarily related to foreign income tax obligations generated by profitable operations in certain foreign jurisdictions. This compares to the same 2008 period whereby we recorded $1.1 million of income tax expenses primarily related to foreign tax obligations generated by our profitable foreign jurisdictions, as well as adjustments to reserves for uncertain tax positions in all jurisdictions. Additionally, we continued to record a valuation allowance against U.S. federal, certain foreign and certain state net operating losses incurred in 2009 as the tax benefit was deemed more than likely not to be realizable in future periods.

Loss from Continuing Operations and Loss Per Share from Continuing Operations:

For the year ended December 31, 2009, our net loss from continuing operations was approximately $36.0 million compared to a net loss of $3.0 million from continuing operations for the year ended December 31, 2008 for the reasons stated above. Our basic and diluted loss from continuing operations per common share was $(2.83) for 2009 versus a loss of $(0.23) for 2008. Diluted weighted average shares of common stock and equivalents outstanding were 12.7 million and 13.1 million in 2009 and 2008, respectively.

Liquidity and Capital Resources

We have historically met our working capital and capital spending requirements, including the funding for expansion of operations, product developments and acquisitions, through net cash flows provided by operating activities. Our principle sources of liquidity are our operating cash flows and cash on our balance sheet. Our cash, cash equivalents and short-term investments are unrestricted and available for corporate purposes, including acquisitions, research and development and other general working capital requirements. In addition, there are no material restrictions on our ability to transfer and remit funds among our international affiliated companies. Our cash and cash equivalents and short-term investments increased to $72.2 million at December 31, 2010 from $66.0 million at December 31, 2009. The increase in cash and cash equivalents and short term investments from December 31, 2009 is largely attributable to positive cash flow from operations. We believe we have sufficient cash balances to meet our cash flow requirements and growth objectives over the next twelve months.

We had working capital of $77.7 million as of December 31, 2010, an increase of $8.5 million, or 12%, from the $69.2 million of working capital as of December 31, 2009. Overall, we generated cash from operating activities of $5.5 million in 2010 compared to $3.7 million in 2009. The $1.8 million increase in cash flow from operating activates is primarily attributable to operating profits and a decrease in inventory. In 2009, we generated cash from operating activities of $3.7 million compared to $4.6 million in 2008. The $0.9 million decrease in cash flow from operating activates is primarily attributable to the overall reduction in net working capital. In 2008, we generated cash from operating activities of $4.6 million compared to $10.4 million in 2007. The decrease in cash flow is attributable to payments in 2008 related to certain inventory components, warranty items and royalty obligations that had grown in 2007.

Cash used for investing activities in 2010 was approximately $0.3 million comprised of $0.4 million in capital expenditures, partially offset by $0.1 million in cash collected from a note receivable. This compares to the same 2009 period with cash provided by investing activities of approximately $4.5 million consisting of $3.2 million in proceeds and note repayments received from the divestiture of our cable product line, redemptions of short term investments in the amount of $2.4 million, partially offset by $0.3 million in acquired assets along with capital expenditures of approximately $0.8 million. During the same 2008 period we had cash used for investing activities of approximately $2.0 million, whereby we purchased net short-term investments of $1.8 million and incurred capital expenditures of approximately $0.5 million. Capital expenditures were $0.4 million, $0.8 million and $0.5 million in the years ended December 31, 2010, 2009 and 2008, respectively. Planned capital expenditures for 2011 are approximately $1.1 million and are primarily related to facility upgrades and new office furniture and fixtures at our new Cranberry location.

Cash provided by financing activities in 2010 was approximately $0.8 million for the year ended December 31, 2010 as a result of cash received from the exercise of stock grants in the amount of $0.9 million partially offset by our purchase of shares of our common stock under our stock re-purchase program. On October 28, 2008, our Board of Directors approved a share repurchase program, pursuant to which the Company could repurchase common stock with an aggregate share value of up to $15 million with no expiration date. Such purchases could be made through open market transactions and privately negotiated transactions at the discretion of executive management, subject to market conditions and other factors. The repurchase program does not obligate us to acquire any particular amount of common stock and, at the Board’s discretion, may be suspended, discontinued or modified at any time. During

the first quarter of the year ended December 31, 2010, we acquired 10,636 shares pursuant to this program at a total cost of $0.1 million. During the fourth quarter of the years ended December 31, 2009 and 2008, we acquired 79,043 and 496,918 shares pursuant to this program at a total cost of $0.5 million and $2.2 million, respectively.

Off-Balance Sheet Arrangements

As a matter of policy, we do not engage in transactions or arrangements with unconsolidated or other special purpose entities.

Commitments and Contractual Obligations

We lease office space and equipment under agreements which are accounted for as operating leases. The office lease for our former Cheswick, Pennsylvania headquarter’s expires on March 31, 2011. The lease for our Piscataway, New Jersey office expires on April 30, 2012. We also have office leases in Bracknell, United Kingdom; and Wuppertal, Germany, which expire on December 24, 2012, and January 31, 2012, respectively. We are also involved in various month-to-month leases for research and development and office equipment at all three European locations. In addition, all three of the European office leases include provisions for possible adjustments in annual future rental commitments relating to excess taxes, excess maintenance costs that may occur and increases in rent based on the consumer price index and based on increases in our annual lease commitments. None of these commitments are material.

In October 2010, we signed a seven year lease commitment for a new headquarters facility in Cranberry Twp., Pennsylvania as our Cheswick facility lease expires on March 31, 2011. The new lease for 24,402 square feet of office and lab space commenced on March 1, 2011 with annual payments of approximately $0.4 million. We also have a commitment for approximately $0.9 million of leasehold improvements and other costs related to this new facility that will be paid in the first quarter of 2011.

     Minimum annual future commitments as of December 31, 2010 are (in thousands):

Payments due by period

						Less than 1												More than 5
		total				year				1-3 years				3-5 years				years
Operating Lease Obligations		$	3,830			$	813			$	1,283			$	818			$	916
Purchase Obligations			922				922
Uncertain Tax Obligations			825								825
Pension Obligations			795																795
Total		$	6,372			$	1,735			$	2,108			$	818			$	1,711

     Our lease expense was $0.8 million in 2010, $1.0 million in 2009, and $1.2 million in 2008.

In addition, we are, from time to time, party to various legal claims and disputes, either asserted or unasserted, which arise in the ordinary course of business. While the final resolution of these matters cannot be predicted with certainty, we do not believe that the outcome of any of these claims will have a material adverse effect on the Company’s consolidated financial position, or annual results of operations or cash flow.

Critical Accounting Policies

Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. The application of certain of these accounting principles is more critical than others in gaining an understanding of the basis upon which our financial statements have been prepared. We consider the following accounting policies to involve critical accounting estimates.

Revenue Recognition

We market and sell test system hardware and related software to the telecommunications industry. We follow the revenue recognition accounting guidance for recognizing hardware and software sales. This guidance requires, among other things, that revenue should be recognized only when title has transferred and risk of loss has passed to a customer with the capability to pay, and that there are no significant remaining obligations related to the sale. The bulk of our hardware sales are made to our large domestic carriers and European telecommunication customers. Delivery terms of hardware sales are predominantly FOB origin. Revenue is recognized for these customers upon shipment against a valid purchase order. Where title and risk of loss do not pass to the customer until the product reaches the customer’s delivery site, revenue recognition is deferred until the customer assumes risk of loss and takes legal title. We reduce collection risk by requiring letters of credit or other payment guarantees for significant sales to new customers, certain international customers and customers in weak financial condition.

For perpetual software license fee and maintenance revenue, we follow the accounting guidance for software revenue recognition, which requires that software license fee revenue be recorded only when evidence of a sales arrangement exists, the software has been delivered, and a customer with the capacity to pay has accepted the software, leaving no significant obligations on our part to perform. We require a customer purchase order or other written agreement to document the terms of a software order. The Company determines the fair value of maintenance revenue (post-contract customer support or “PCS”) sold together with perpetual licenses based on the contractual renewal rate for PCS when sold on a standalone basis. Where possible we seek written customer acceptance prior to revenue recognition, however certain agreements provide for automatic customer acceptance after the passage of time from delivery and title transfer. In certain cases for orders of custom software, or orders that require significant software customization, we employ contract accounting using the percentage-of-completion method, whereby revenue is recognized based on costs incurred to date compared to total estimated contract cost in accordance with the accounting guidance for construction-type and certain production-type contracts.

The revenue for orders with multiple deliverables such as hardware, software and/or installation or other services may be separated into stand-alone fair values. The allocation of fair value for a multiple-element arrangements involving software is based on vendor specific objective evidence, or in the absence of VSOE for delivered elements, the residual method. Under the residual method, the Company allocates the residual amount of revenue from the arrangement to hardware and software licenses at the inception of the license term when VSOE for all undelivered elements, such as PCS, exists and all other revenue recognition criteria have been satisfied. Revenue will not be recognized for any single element until all elements considered essential to the functionality of the delivered elements under the contract are delivered and accepted.

The recognition of revenue requires certain judgment by management. If any undelivered elements, which can include hardware, software or services, are essential to the functionality of the system as defined in the contract, revenue will not be recorded until all of the items considered essential are delivered as one unit of accounting.

Our software customers usually enter into separate agreements for software maintenance upon expiration of the stated software warranty period. Maintenance agreements include software upgrades and bug fixes as they become available; however, newly developed features must be purchased separately. Post-warranty maintenance for new features is either included under the current maintenance agreement without additional charge, and is considered in the maintenance agreement fees, or is separately charged upon expiration of the warranty. Depending upon the timing of the new feature purchase and the length of the maintenance agreement, we must evaluate whether or not a portion of a perpetual right to use fee should be treated as post-contract support to be deferred and recognized over the remaining life of the maintenance agreement.

Software maintenance revenue is recognized on a straight-line basis over the period the respective arrangements are in effect. Revenue recognition, especially for software products, involves critical judgments and decisions that can result in material effects to reported net income.

Our managed service revenue is recognized in accordance with the terms of each specific contract. Our current contract is structured with declining revenues over a four year period in accordance with expected service delivery (primarily call volume) and costs. As such, we recognize revenue under the proportional performance method using service delivery output measures (call volume) over the term of the contract.

Intangible Assets

At December 31, 2010, we had net intangible assets of $5.4 million resulting from the acquisitions of the LoopCare product line in September 2001, the test business of Emerson in February 2006 and the Broadband Test Division of Teradyne, Inc. in August 2007. In connection with these acquisitions, we utilized the accounting guidance associated with business combinations, and goodwill and other intangible assets. This guidance requires that the purchase method of accounting be used for all business combinations and that goodwill, as well as any indefinite-lived intangible assets, not be amortized for financial reporting purposes. Finite-lived intangible assets are amortized on a straight-line basis or an accelerated method, whichever better reflects the pattern in which the economic benefits of the asset are consumed or otherwise used. Software-related intangible assets are amortized based on the greater of the amount computed using the ratio that current gross revenues bear to the total of current and anticipated future gross revenues for that product or the straight-line method over the remaining estimated economic life.

We review our finite-lived intangible assets or fixed assets and their related useful lives whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable, including: a change in the competitive landscape; any internal decisions to pursue new or different technology strategies; a loss of a significant customer; or a significant change in the market place including changes in the prices paid for our products or changes in the size of the market for our products. An impairment results if the carrying value of the asset exceeds the sum of the future undiscounted cash flows expected to result from the use and disposition of the asset or the period of economic benefit has changed. If impairment were indicated, the amount of the impairment would be determined by comparing the carrying value of the asset group to the fair value of the asset group. Fair value is generally determined by calculating the present value of the estimated future cash flows using an appropriate discount rate. The projection of the future cash flows and the selection of a discount rate require significant management judgment. The key assumptions that management must estimate include

sales volume, prices, inflation, product costs, capital expenditures and sales and marketing costs. For developed technology, we also must estimate the likelihood of both pursuing a particular strategy and the level of expected market adoption.

In 2010 we did not have impairments related to any of our intangible assets. During 2009, we had a significant impairment to one of our intangible assets related to the LoopCare product line that was acquired from Lucent in 2001. At the time of the acquisition, the intangible asset was valued at $32 million, with an indefinite life. In 2005, we determined that facts and circumstances which had supported the assignment of an indefinite life to this asset had changed, and we then determined the intangible asset to have a finite useful life of fifty years. In the fourth quarter 2009, facts and circumstances relating to the Company’s LoopCare post-warranty maintenance service agreements again led us to evaluate the life assigned to this intangible asset, as well as its valuation. Specifically, in mid-December of 2009, we learned that Verizon, a major customer of our LoopCare post warranty software maintenance services, was not going to renew its direct contract with Tollgrade that was due to expire on December 31, 2009. Verizon consolidated several vendor relationships through a single large global network equipment manufacturer, including both our LoopCare and 4TEL maintenance contracts. The loss of the direct contract with Verizon was a “triggering event” for us to evaluate the fair market value of the LoopCare intangible asset. Through our overall evaluation process, which included a valuation, we determined that not only the useful life estimate, but the value of the asset itself, was no longer supported. We ultimately determined that the LoopCare intangible asset had a fair value of $2.3 million coupled with a remaining life of fifteen years, versus its remaining carrying value of $29.3 million dollars and a forty-six year remaining life. We determined this current fair value and useful life is more indicative of current market and technological conditions and the life of the existing maintenance agreements.

In 2008 we determined that certain long-lived assets, primarily related to assets acquired as part of our Emerson acquisition, were impaired and an impairment loss of $0.2 million was recorded to reflect these assets at their fair market value.

Inventory Valuation

Our inventory cost in 2010 is primarily valued at the purchase price that we will pay the contractor to manufacture our products after we transitioned virtually 100% of our in-house manufacturing to a third party sub-contractor as of December 31, 2009. We evaluate our inventories quarterly for slow moving, excess and obsolete stock on hand. The carrying value of such inventory that is determined not to be realizable is reduced, in whole or in part, by a charge to cost of sales and reduction of the inventory value in the financial statements. The evaluation process relies on a review of expected customer orders and consumption expected to occur within a 12-18 month period. Management also reviews, where appropriate, inventory products that do not meet this threshold but which may be unrealizable due to discontinuance of products, evolving technologies, loss of certain customers or other known factors. As a result of this comprehensive review process, an adjustment to the reserve for slow moving and obsolete inventory is normally made quarterly if applicable. Inventory identified as obsolete is also discarded from time to time when circumstances warrant. As part of our review process in 2010 we had a positive adjustment to our inventory reserve of approximately $0.5 million, based on increases in projected consumption and sales of items previously reserved, as compared to a write-down of approximately $3.1 million in 2009, primarily related to slow moving and obsolete inventory.

Inventory valuation is considered a critical accounting estimate since it relies in large part on management judgments as to future events and differing judgments could materially affect reported net income.

Allowance for Doubtful Accounts — Accounts and Note receivables

Our allowance for doubtful accounts is based on our assessment of the collectability of customer accounts. We regularly review the allowance by considering factors such as historical experience, credit quality, age of the accounts receivable balances, and current economic conditions that may affect a customers’ ability to pay. We recorded a $0.1 million bad debt reserve in the fourth quarter of 2010 and a $1.1 million bad debt reserve in the third quarter of 2009. Both of these charges related to large international customer. balances whose collectability was deemed to be uncertain. We also recorded a $0.2 million bad debt reserve in the fourth quarter of 2010 related to the remaining balance due to us related to the sale of our cable division in 2009.

If a major customer’s creditworthiness deteriorates, or if actual defaults are higher than our historical experience, or if other circumstances arise, our estimates of the recoverability of amounts due to us could be overstated, and an additional allowance could be required, which could have a negative impact on our earnings and cash flow.

Income Taxes

We follow the accounting guidance for income taxes, in reporting the effects of income taxes in our consolidated financial statements. We are subject to income taxes in both the U.S. and numerous foreign jurisdictions. Significant judgments and estimates are required to determine the consolidated income tax expense.

Deferred tax assets and liabilities are determined based on temporary differences between the tax and financial statement recognition of revenue and expense using enacted tax rates in effect in the years in which the differences are expected to reverse. We evaluate our ability to recover our deferred tax assets, based on our current outlook, taking into consideration all positive and negative evidence. Based on this evaluation, as of December 31, 2010, all U.S. and certain foreign net operating losses and net deferred tax assets have been eliminated through the recording of a valuation allowance.

The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in multiple jurisdictions as well as transfer pricing exposures between jurisdictions. We record tax liabilities for these uncertain tax positions in our current tax expense. Additionally, we recognize interest and penalties related to uncertain tax positions in income tax expense.

Warranty

We record estimated warranty costs on the accrual basis of accounting. These warranty reserves are recorded by applying the five year historical returns percentage to the current level of product shipments within the agreed-upon warranty period. The costs associated with servicing these warranties are updated at least annually.

Pension Benefits

We sponsor defined benefit pension plans for one employee based in Germany, one employee based in Belgium and two employees based in Netherlands in addition to three former employees that were part of our Belgium plan and two employees that were part of our German plan. Accounting for the cost of these plans requires the estimation of the cost of the benefits to be provided well into the future and attributing that cost over the expected work life of employees participating in these plans. This estimation requires our judgment about the discount rate used to determine these obligations, rate of future compensation increases, withdrawal and mortality rates and participant retirement age. Differences between our estimates and actual results may significantly affect the cost of our obligations under these plans.

In the valuation of this pension benefit liability, management utilizes various assumptions. We determine our discount rate based on an investment grade bond yield curve with a duration that approximates the benefit payment timing of each plan. This rate can fluctuate based on changes in investment grade bond yields.

Future compensation rates, withdrawal rates and participant retirement age are determined based on historical information. These assumptions are not expected to significantly change. Mortality rates are determined based on a review of published mortality tables.

Stock-Based Compensation

We recognize stock-based compensation expense for all stock options and restricted stock awards over the period from the date of grant to the date when the award is no longer contingent on the employee providing additional service (substantive vesting period). We utilize the Black-Scholes valuation method to establish fair value of all awards. The Black-Scholes valuation method requires that we make certain assumptions regarding estimated forfeiture rates, expected holding period and stock price volatility.

These areas involving critical accounting estimates are periodically reviewed and discussed with the Audit Committee of our Board of Directors.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

Our current investment policy limits our investments in financial instruments to cash and cash equivalents, individual municipal bonds and corporate and government bonds. The use of financial derivatives and preferred and common stocks is strictly prohibited. We believe that our risk is minimized through proper diversification along with the requirements that the securities must be of investment grade with an average rating of “A” or better by Standard & Poor’s. We hold our investment securities to maturity and believe that earnings and cash flows are not materially affected by changes in interest rates, due to the nature and short-term investment horizon for which these securities are invested.

In addition, we are exposed to foreign currency translation fluctuations with our international operations. We do not have any foreign exchange derivative contracts to hedge against foreign currency exposures. Therefore, we are exposed to the related effects when the foreign currency exchange rates fluctuate. If the U.S. dollar strengthens against the Euro and/or the British pound sterling and or the Czech Republic’s Koruna, the translation rate for these foreign currencies will decrease, which will have a negative impact on our operating income. Foreign currency translation fluctuations have no impact on cash flows as long as we continue to reinvest any profits back into the respective foreign operations.

Item 8. Financial Statements and Supplementary Data.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Reports of Independent Registered Public Accounting Firms			37
Consolidated Balance Sheets			40
Consolidated Statements of Operations			41
Consolidated Statements of Changes in Shareholders’ Equity			42
Consolidated Statements of Cash Flows			43
Notes to Consolidated Financial Statements			44
Schedule II — Valuation and Qualifying Accounts			62

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Tollgrade Communications, Inc.
Cranberry Twp., PA

We have audited the accompanying consolidated balance sheet of Tollgrade Communications, Inc. and subsidiaries (the “Company”) as of December 31, 2010, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for the year then ended. Our audit also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audit. The consolidated financial statements and financial statement schedule of the Company for the years ended December 31, 2009 and 2008 were audited by other auditors whose report, dated March 10, 2010, expressed an unqualified opinion on those financial statements.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Tollgrade Communications, Inc. and subsidiaries as of December 31, 2010, and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2010, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 10, 2011 expressed an unqualified opinion on the Company’s internal control over financial reporting.

/s/ DELOITTE & TOUCHE LLP
Pittsburgh, Pennsylvania
March 10, 2011

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Tollgrade Communications, Inc.
Cranberry Twp., PA

We have audited the internal control over financial reporting of Tollgrade Communications, Inc. and subsidiaries (the “Company”) as of December 31, 2010, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting at Item 9A. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended December 31, 2010 of the Company and our report dated March, 10, 2011 expressed an unqualified opinion on those financial statements and financial statement schedule.

/s/ DELOITTE & TOUCHE LLP
Pittsburgh, Pennsylvania
March 10, 2011

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Tollgrade Communications, Inc.

In our opinion, the consolidated balance sheet as of December 31, 2009 and the related consolidated statements of operations, of changes in shareholders’ equity and of cash flows for each of the two years in the period ended December 31, 2009 presents fairly, in all material respects, the financial position of Tollgrade Communications, Inc. and subsidiaries (the “Company”) at December 31, 2009, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index for each of the two years in the period ended December 31, 2009 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express opinions on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP
Pittsburgh, Pennsylvania
March 10, 2010

Tollgrade Communications, Inc. and Subsidiaries

Consolidated Balance Sheets
In thousands (except par value)

		December 31, 2010				December 31, 2009
ASSETS
Current assets:
Cash and cash equivalents		$	72,194			$	66,046
Short-term investments			3				3
Accounts receivable:
Trade, net of allowance for doubtful accounts at $1,583 in 2010 and $1,496 in 2009			7,975				6,998
Other			650				1,007
Inventories			1,373				2,119
Prepaid expenses and deposits			798				759
Deferred and refundable income taxes			93				196
Total current assets			83,086				77,128
Property and equipment, net			2,246				3,101
Intangibles			5,391				7,110
Deferred tax assets			191				119
Other assets			423				229
Total assets		$	91,337			$	87,687
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	1,867			$	927
Accrued warranty			222				504
Accrued expenses			986				2,319
Accrued salaries and wages			1,044				1,190
Accrued royalties payable			218				137
Income taxes payable			481				393
Deferred revenue			593				2,463
Total current liabilities			5,411				7,933
Pension obligation			795				983
Deferred tax liabilities			14				290
Other tax liabilities			825				738
Total liabilities			7,045				9,944
Commitments and contingencies
Shareholders’ equity:
Common stock, $0.20 par value 50,000 authorized shares, issued shares, 14,073 in 2010 and 13,788 in 2009			2,815				2,746
Additional paid-in capital			77,326				75,244
Treasury stock, at cost, 1,162 shares in 2010 and 1,151 shares in 2009			(8,632	)			(8,563	)
Retained earnings			13,966				9,543
Accumulated other comprehensive loss			(1,183	)			(1,227	)
Total shareholders’ equity			84,292				77,743
Total liabilities and shareholders’ equity		$	91,337			$	87,687

The accompanying notes are an integral part of the consolidated financial statements.

Tollgrade Communications, Inc. and Subsidiaries

Consolidated Statements of Operations
In thousands (except per share data)

		Years Ended December 31,
		2010				2009				2008
Revenues:
Products		$	19,067			$	19,936			$	26,997
Services			26,579				25,005				22,055
Total revenues			45,646				44,941				49,052
Cost of sales:
Products			8,259				11,812				14,181
Services			7,618				7,143				6,146
Amortization of intangible assets			1,570				2,576				3,085
Inventory write-down			—				3,070				759
Impairment of long-lived assets			—				27,151				201
Severance			319				778				—
Total cost of sales			17,766				52,530				24,372
Gross Profit/(Loss)			27,880				(7,589	)			24,680
Operating expenses:
Selling and marketing			5,967				6,809				6,835
General and administrative			8,561				12,141				9,455
Research and development			6,841				9,411				10,789
Severance expense			1,826				1,180				827
Impairment of long-lived assets			—				293				—
Total operating expense			23,195				29,834				27,906
Income/(Loss) from operations			4,685				(37,423	)			(3,226	)
Other income, net			9				567				1,337
Income/(Loss) before income taxes			4,694				(36,856	)			(1,889	)
Provision/(Benefit) for income taxes			271				(874	)			1,137
Income/(Loss) from continuing operations			4,423				(35,982	)			(3,026	)
(Loss) from discontinued operations			—				(223	)			(4,089	)
Net Income/(Loss)		$	4,423			$	(36,205	)		$	(7,115	)
PER SHARE INFORMATION:
Weighted average shares of common stock and equivalents:
Basic			12,736				12,683				13,102
Diluted			13,160				12,683				13,102
Net Income/(Loss) per common share:
Basic		$	0.35			$	(2.85	)		$	(0.54	)
Diluted		$	0.34			$	(2.85	)		$	(0.54	)
Net Income/(Loss) per common share from continuing operations:
Basic		$	0.35			$	(2.83	)		$	(0.23	)
Diluted		$	0.34			$	(2.83	)		$	(0.23	)
Net loss per common share from discontinued operations:
Basic		$	—			$	(0.02	)		$	(0.31	)
Diluted		$	—			$	(0.02	)		$	(0.31	)

The accompanying notes are an integral part of the consolidated financial statements.

Tollgrade Communications, Inc. and Subsidiaries

Consolidated Statements of Changes in Shareholders’ Equity
In thousands

																										Accumulated
										Additional																Other								Other
		Common Stock								Paid-In				Treasury Stock								Retained				Comprehensive								Comprehensive
		Shares				Amount				Capital				Shares				Amount				Earnings				Loss				Total				Income/(Loss)
Balance at December 31, 2007			13,731			$	2,744			$	73,389				575			$	(5,900	)		$	52,863			$	(96	)		$	123,000
Purchase of Treasury Stock															497			$	(2,181	)										$	(2,181	)
Compensation expense for options and restricted stock, net			2							$	534																			$	534
Actuarial gain, net of tax																										$	87			$	87			$	87
Foreign currency translation																										$	(1,871	)		$	(1,871	)		$	(1,871	)
Net Loss																						$	(7,115	)						$	(7,115	)		$	(7,115	)
Comprehensive Loss																																		$	(8,899	)
Balance at December 31, 2008			13,733			$	2,744			$	73,923				1,072			$	(8,081	)		$	45,748			$	(1,880	)			112,454
Exercise of Common Stock Options			10			$	2			$	52																			$	54
Purchase of Treasury Stock															79			$	(482	)										$	(482	)
Compensation expense for options and restricted stock, net			45							$	1,269																			$	1,269
Actuarial loss, net of tax																										$	(13	)		$	(13	)		$	(13	)
Foreign currency translation																										$	666			$	666			$	666
Net Loss																						$	(36,205	)						$	(36,205	)		$	(36,205	)
Comprehensive Loss																																		$	(35,552	)
Balance at December 31, 2009			13,788			$	2,746			$	75,244				1,151			$	(8,563	)		$	9,543			$	(1,227	)			77,743
Exercise of Common Stock Options			165			$	33			$	848																			$	881
Purchase of Treasury Stock															11			$	(69	)										$	(69	)
Compensation expense for options and restricted stock, net			120			$	36			$	1,234																			$	1,270
Actuarial gain, net of tax																										$	179			$	179			$	179
Foreign currency translation																										$	(135	)		$	(135	)		$	(135	)
Net Income																						$	4,423							$	4,423			$	4,423
Comprehensive Income																																		$	4,467
Balance at December 31, 2010			14,073			$	2,815			$	77,326				1,162			$	(8,632	)		$	13,966			$	(1,183	)			84,292

The accompanying notes are an integral part of the consolidated financial statements.

Consolidated Statements of Cash Flows
(In thousands)

		Years Ended December 31,
		2010				2009				2008
Cash flows from operating activities:
Net income/(loss)		$	4,423			$	(36,205	)		$	(7,115	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Loss from discontinued operations			—				223				4,089
Depreciation and amortization			2,761				3,761				4,559
Impairment of long-lived assets			—				27,444				201
Valuation allowance			—				—				123
Compensation expense related to stock plans			1,270				1,236				468
Loss/(Gain) on disposed assets			12				(42	)			—
Deferred income taxes			(400	)			(1,030	)			182
Write-down of inventory			—				3,070				759
Provision for losses on inventories			(451	)			231				969
Provision for allowance for doubtful accounts			165				1,119				100
Changes in assets and liabilities, net of acquisitions:
Accounts receivable — trade & other			(809	)			3,148				4,997
Inventories			1,196				2,445				348
Prepaid expenses and deposits			(240	)			284				(375	)
Accounts payable			959				(1,276	)			(3,431	)
Accrued warranty			(267	)			(434	)			(218	)
Accrued expenses, deferred revenue and salaries and wages			(2,814	)			(310	)			(417	)
Accrued royalties payable			80				(152	)			(383	)
Income taxes payable			(355	)			114				(287	)
Net cash provided by discontinued operations:			—				57				38
Net cash provided by operating activities:			5,530				3,683				4,607
Cash flows from investing activities:
Proceeds from sale of assets			—				3,074				265
Proceeds from note receivable			124				112				—
Purchase of Ericsson test business			—				(300	)			—
Purchase of investments			—				—				(4,266	)
Redemption/maturity of investments			—				2,416				2,479
Capital expenditures			(416	)			(762	)			(469	)
Net cash used in investing activities of discontinued operations:			—				(57	)			(38	)
Net cash (used in)provided by investing activities:			(292	)			4,483				(2,029	)
Cash flows from financing activities:
Repurchase of treasury shares			(69	)			(482	)			(2,181	)
Proceeds from the exercise of stock options			881				54				—
Net cash provided by (used in) financing activities:			812				(428	)			(2,181	)
Net increase in cash and cash equivalents			6,050				7,738				397
Effect of exchange rate change on cash and cash equivalents			98				332				(643	)
Cash and cash equivalents at beginning of year			66,046				57,976				58,222
Cash and cash equivalents at end of year		$	72,194			$	66,046			$	57,976
Supplemental disclosure of cash flow information:
Cash paid during the year for income taxes		$	519			$	7			$	14