Exhibit 13.1 [PHOTO] DRIVING CONSUMER BROADBAND ASSURANCE TOLLGRADE COMMUNICATIONS, INC. 2001 ANNUAL REPORT ================================================================================ [PHOTO] DRIVING CONSUMER BROADBAND ASSURANCE Video on Demand...High-Speed Data Transmission... Digital Subscriber Line...Video Phones. These buzzwords all revolve around a single technology: Broadband. Broadband is the leading-edge technology of tomorrow that utilizes the maximum amount of bandwidth available to support numerous voice, video and data channels simultaneously. It's also a technology that we believe should be treated as a consumer service. And assuring consumer communications networks is what Tollgrade is all about. Curiously, the marketplace has been slow to respond to this emerging technology. Part of the reason for the slower-than-expected growth of broadband has been the struggle that service providers have had with wide-scale DSL deployment. The sudden slowdown of the Competitive Local Exchange Carrier (CLEC) industry, which had been a driving force behind DSL deployment, certainly has limited the competitive push. At the same time, broadband technology must also overcome the fact that it has proven too costly and manpower-intensive for Incumbent Local Exchange Carriers (ILECs) to efficiently deliver to the consumer marketplace. We believe that using tried-and-true consumer network assurance approaches will be the key to successful roll-out of these services. Additionally, over the long-term, there will likely be a move to converge private line (medium and large businesses) and consumer networks into a single IP/ATM architecture. There is an increased focus on providing the best maintenance processes for mature networks. Finally, the industry is seeing an increased emergence of passive optical networks, which has rejuvenated interest in "fiber-to-the-curb," or "broadband edge," applications. These market drivers, coupled with an intense demand for products that reduce deployment costs, indicate that the broadband world is ripe with opportunity. As a premier provider of leading-edge test and management solutions for consumer networks, Tollgrade has positioned itself to contribute significantly to this next phase of the communication evolution. ================================================================================ - -------------------------------------------------------------------------------- 2001 FINANCIAL HIGHLIGHTS (In thousands, except per share data and number of employees) December 31, 2000 DECEMBER 31, 2001 OPERATIONS Total Revenues $ 114,426 $ 82,239 - -------------------------------------------------------------------------------- Net Income $ 27,495 $ 13,675 - -------------------------------------------------------------------------------- Earnings Per Share -- Diluted $ 2.06 $ 1.02 - -------------------------------------------------------------------------------- Weighted Average Shares of Common Stock and Equivalents 13,359,270 13,412,037 - -------------------------------------------------------------------------------- Number of Employees 411 341 - -------------------------------------------------------------------------------- FINANCIAL POSITION Total Assets $ 131,275 $ 146,630 - -------------------------------------------------------------------------------- Working Capital $ 111,135 $ 67,628 - -------------------------------------------------------------------------------- Shareholders' Equity $ 122,760 $ 140,139 - -------------------------------------------------------------------------------- TABLE OF CONTENTS 2001 Financial Highlights...............1 Letter to Shareholders..................2 Driving Broadband Assurance to the Consumer Marketplace...........4 Selected Consolidated Financial Data....8 Management's Discussion and Analysis of Results of Operations and Financial Condition...............9 Statement of Management's Responsibility for Financial Reporting............................16 Report of Independent Accountants......17 Consolidated Financial Statements......18 Notes to the Consolidated Financial Statements.................22 Shareholder Information...............IBC Board of Directors, Executive Council and Officers......IBC REVENUES (DOLLARS IN THOUSANDS) 1997 $45,421* 1998 $46,277* 1999 $61,111 2000 $114,426 2001 $82,239 *Includes license fees of $250 and $150, respectively NET INCOME (DOLLARS IN THOUSANDS) 1997 $6,883 1998 $6,967 1999 $10,623 2000 $27,495 2001 $13,675 DILUTED EARNINGS PER SHARE 1997 $0.58 1998 $0.58 1999 $0.89 2000 $2.06 2001 $1.02 - -------------------------------------------------------------------------------- 1 ================================================================================ "WE EVOLVED FROM BEING A NICHE PLAYER TO A MAJOR SYSTEM PROVIDER BY ACQUIRING LOOPCARE." - -------------------------------------------------------------------------------- [PHOTO] DEAR SHAREHOLDER, 2001 was a tough year for everyone in the telecommunications equipment industry. Fortunately, we weathered the storm by continuing to focus on products and services that help our customers reduce costs and effectively deploy new services. Rather than contracting into our shell and deviating from our strategy, Tollgrade chose to use this time to build for the consumer broadband future. Specifically, we evolved from a niche player to a major system provider by acquiring the LoopCare(TM) OSS (Operations Support System) product from Lucent Technologies and positioning it with our MCU(R) products, DigiTest(R) system and Professional Services programs to provide a total solution strategy for assuring POTS (Plain Old Telephone Services) and consumer broadband networks. We also remained resolute on focusing on our core competency -- maintaining the quality of consumer communications networks. RATHER THAN CONTRACTING INTO OUR SHELL AND DEVIATING FROM OUR STRATEGY, TOLLGRADE CHOSE TO USE THIS TIME TO BUILD FOR THE CONSUMER BROADBAND FUTURE. To achieve our long-term goals, we've also retrenched our staff and made significant additions to our management team. In addition, we formed new, non-exclusive distribution agreements with Lucent and Acterna to grow our business internationally. Our organization also focused on a core group of product development initiatives tied to specific market segments and major industry trends related to the consumer broadband world. In 2001, our revenue was $82.2 million and our earnings per share was $1.02. Gross profit was 56 percent of revenue; operating expenses came in at 32 percent. We invested more in research and development as a result of adding more than 30 developers through the LoopCare acquisition. EBITDA was 27 percent of revenue, income from operations was approximately 24 percent of revenue and net income a healthy 17 percent of revenue. Last year we embarked upon a significant testability improvement initiative in the former Ameritech region of SBC. This led to a record year of MCU product sales in the region as well as significant Professional Services work. We also undertook a successful testability program in Verizon. In SBC, we shipped our first DigiTest systems to the region as part of a major MLT-1 replacement effort. This included the sale of our ATP (Advanced Test Package) feature for our LoopCare OSS. In addition, our balance sheet remains strong. Despite spending more than $62 million for LoopCare, we ended the year with $38.7 million in cash and investments. We have no debt. The purchase of LoopCare in 2001 was arguably the most significant event in our company's history. LoopCare controls the testing of approximately 143 million of the 180 million total POTS telephone lines in the United States. Globally, you can add another 8 million lines to the mix. By incorporating LoopCare into our product menu, we now offer a total test and management solution, which can be economically scalable for both the largest RBOCs (Regional Bell Operating Companies) and the smallest CLECs (Competitive Local Exchange Carriers). - -------------------------------------------------------------------------------- 2 ================================================================================ - -------------------------------------------------------------------------------- Teaming LoopCare with DigiTest creates a powerful end-to-end network assurance solution for POTS, as well as consumer broadband services, such as DSL (Digital Subscriber Line). In addition, we gained a highly experienced team of software developers and engineers and added a seasoned leader in Carol Franklin, our general manager of software products, who brings nearly 30 years of extensive industry experience. We also added several other key executives, including Greg Quiggle, who joined us from Acterna, as executive vice president of marketing; Wylie Etscheid, executive vice president of business development for software products, who brought more than 30 years of progressive RBOC experience; and Richard Skaare, executive vice president of organizational development and communication, who was formerly the head of global communications at AMP Incorporated. TEAMING LOOPCARE WITH DIGITEST CREATES A POWERFUL END-TO-END NETWORK ASSURANCE SOLUTION FOR POTS, AS WELL AS CONSUMER BROADBAND SERVICES, SUCH AS DSL. 2001 also marked the promotion of Matt Rosgone to executive vice president, operations and Mark Peterson to president. Matt is the grease that keeps the wheels of our production function turning. Mark continues to do a great job as he focuses his efforts on overseeing all of our sales channels. With these things in place, we seek to achieve the following goals in 2002: First, we want to maintain our franchise as the testability improvement leader through our Professional Services programs. These efforts, coupled with broadband edge device growth, sustain MCU sales. Second, we will focus on implementing our LTS POTS test head replacement program among key RBOC customers as a means of upgrading their networks for consumer broadband services. Third, we want to position DigiTest and LoopCare as the system of choice for DSL pre-qualification and wideband testing. Fourth, we intend to introduce a solution for DSL testing at remote DLC(Digital Loop Carrier) sites. This product will leverage embedded MCU products with state-of-the-art DigiTest wideband technology. Fifth, we want to continue to expand our opportunities in the international marketplace through our relationships with Acterna, Lucent and Nortel. Sixth, we will continue to develop embedded test elements for the broadband edge market. 2001 REVENUES BY PRODUCT (PERCENTAGE OF 2001 REVENUE) [PIE CHART] MCU Products 67.8% DigiTest 14.5% LoopCare 5.4%* TELACCORD(TM)/DAU 4.9% LIGHTHOUSE 3.7% Professional Services 3.5% Other 0.2% * Reflects sales during the 4th quarter 2001 only. We've outlined our strategy for accomplishing these goals on the following pages. As a premier provider of leading-edge test and management solutions, we are intent on managing the company for the long-term by providing network assurance products with a vision for the broadband future. On behalf of everyone at our company, please accept our thanks for your continued support. Very truly yours, /s/ CHRISTIAN L. ALLISON CHRIS ALLISON CHAIRMAN AND CHIEF EXECUTIVE OFFICER - -------------------------------------------------------------------------------- 3 DRIVING BROADBAND ASSURANCE TO THE CONSUMER MARKETPLACE - -------------------------------------------------------------------------------- In 2001, Tollgrade reorganized its internal structure and focused on the consumer broadband marketplace. As part of this initiative, the company added to its leadership team by blending key external additions with an already deep team of existing managers. The result is a diverse executive council (shown in the photographs on the following pages) that is responsible for establishing Tollgrade's strategic focus on consumer broadband assurance. A FOCUS ON CONSUMER BROADBAND ASSURANCE Tollgrade Communications develops network assurance products to better enable telephone and cable operators to efficiently manage their networks in an age of increased competition, continually evolving technology and ongoing pressure to control or reduce costs. [PHOTO] Tollgrade's leading-edge test and management solutions allow customers to: - - Competitively roll out digital broadband services; - - Fully leverage investments in existing network equipment; and - - Effectively utilize state-of-the-art technology for installing and remotely administering, testing and repairing traditional network infrastructure. While initial heavy demand for broadband services had slowed in recent years, there are signs that interest in these services is once again on the rise. DSL lines in service in North America rose to nearly 5.5 million at the end of 2001. In the United States, about 10 percent of the homes currently get broadband -- up from almost none in 1998. And, according to figures compiled by the Federal Communications Commission, the rate of adoption for broadband services compares favorably with the rollout of other consumer electronic products such as color televisions, cellular phones and compact disc players. Thus, as demand for broadband services increases, Tollgrade will provide a means for service providers to utilize traditional consumer network assurance approaches for the successful delivery of consumer broadband services. LEADING-EDGE PRODUCTS AND SERVICES With the recent acquisition of Lucent's LoopCare(TM) Test Operations Support System (OSS), Tollgrade has transformed itself from a hardware-based test and measurement company to a full-system provider of test and management solutions for network assurance. [PHOTO] Focused on telecommunications Local Exchange Carriers (LECs), including the Regional Bell Operating Companies (RBOCs), LoopCare works in concert with DigiTest(R) and MCU(R) measurement hardware to manage the test process for over 75 percent of the copper facilities in North America. In addition, Tollgrade's LIGHTHOUSE(R) cable monitoring system combines hardware and software to efficiently monitor the Broadband Hybrid-Fiber/Coax (HFC) system of major cable operators. Both systems are focused on efficiently managing the local access network. Tollgrade's solutions enable service providers to drive new service deployments while limiting operating expenses and capital investments. Tollgrade also complements its hardware and software products with Professional Services that help companies implement new technologies, migrate to new test access platforms and maintain current network operations. These services result in rapid deployment of new services, quicker integration with existing infrastructure and optimization of current network elements. ANTICIPATING NETWORK NEEDS While the basic premise of all communications networks is essentially the same, most service providers optimize their networks for a specific customer base. For example, the residential telephony marketplace, served by a CONSUMER ACCESS NETWORK, requires support for an extremely high volume of low-speed connections while the business subscriber marketplace, served by a - -------------------------------------------------------------------------------- 4 ================================================================================ - -------------------------------------------------------------------------------- "THE PURCHASE OF LOOPCARE IN 2001 WAS ARGUABLY THE MOST SIGNIFICANT EVENT IN OUR COMPANY'S HISTORY." - - CHRIS ALLISON, CHAIRMAN AND CEO "LONG-TERM, THE PRIVATE-LINE AND CONSUMER ACCESS NETWORKS WILL CONVERGE INTO A SINGLE, IP/ATM ARCHITECTURE." - - MARK PETERSON, PRESIDENT [PHOTO] (l to r): Chris Allison, Chairman & CEO; Mark Peterson, President; Matt Rosgone, EVP, Operations; Rocky Flaminio, Vice Chairman & CTO; Sam Knoch, CFO. PRIVATE-LINE ACCESS NETWORK, requires support for a lower volume of very high-speed connections. Furthermore, these same networks are then enhanced for the delivery of voice, data and/or video services. Recognizing these marketplace dynamics, the foundation of Tollgrade's 2002 marketing strategy is a detailed market segmentation model focusing on the unique needs of these individual network architectures. CONSUMER ACCESS NETWORK This network requires remote test solutions for service providers that deliver voice and data services to the residential and small business mass market. [CHART] As the illustration above indicates, the heart of the consumer access architecture is the Public Switched Telephone Network (PSTN). Often handling millions of subscribers on a single voice switch, the Consumer Access Network provides connections that range from basic "life-line" all the way up to complex, multi-line voice services. Low-speed data services have traditionally been offered to these subscribers via the same PSTN. However, the need for higher-speed connections, such as DSL, has driven the deployment of separate, Asynchronous Transfer Mode (ATM)-based overlay networks that are much more efficient for converged voice/data/video traffic. The price sensitivity of this market demands a test and management solution that minimizes dispatches. Doing so enables service providers to responsively meet the needs of a demanding consumer while minimizing costly operating expenses. With the recent acquisition of LoopCare, Tollgrade has emerged as a leader within the Consumer Access Test and Management marketplace. Currently managing the test process for the majority of Plain Old Telephone Service (POTS) lines in North America, Tollgrade is uniquely positioned to help service providers transition their existing subscriber base to a host of innovative digital voice and data services, such as DSL. By upgrading their existing Loop Test System (LTS) infrastructure, service providers can further optimize current POTS installation and maintenance processes while supporting new service deployments. Providing this upgrade path -- through both product development and industry partnerships -- is the focus of Tollgrade's DIGITAL LTS and PATCH THE POTS HOLES strategies. "Digital LTS" will enable service providers to competitively roll out DSL services by upgrading test and measurement infrastructure. "Patch the POTS Holes" will focus on utilizing Tollgrade technology to optimize remote testability and automated flow-through processes for the installation and maintenance of legacy POTS equipment. - -------------------------------------------------------------------------------- 5 ================================================================================ DRIVING BROADBAND ASSURANCE TO THE CONSUMER MARKETPLACE - -------------------------------------------------------------------------------- PRIVATE-LINE ACCESS NETWORK This network requires remote test solutions for service providers that deliver high-speed communications services -- including voice, data, and video -- to medium and large businesses. [CHART] Understanding that these business customers often require fixed connections between multiple locations, the private-line architecture has been traditionally based on a non-switched network of Time Division Multiplexers (TDM) and Digital Cross-Connect Systems (DCS). Offering more efficient use of highly valuable bandwidth and simplified provisioning, most Private-Line Networks have evolved in recent years to rely upon an ATM infrastructure -- replacing a fixed TDM path with Permanent Virtual Circuit (PVC). In this marketplace, the need for flawless service quality far exceeds any other. In fact, a vast majority of today's businesses simply can't function without vital communications services. As a result, Private-Line test and management solutions must focus on quickly diagnosing complex network problems - -- often involving multiple service providers and networks around the world -- regardless of the cost. Unlike the consumer marketplace, a trouble within the Private-Line Network can easily cost the business customer -- and service provider -- thousands of dollars every hour. Although Tollgrade is not currently a full system provider for the Private-Line test and management marketplace, it has focused heavily on enabling broadband deployments through key industry relationships. Specifically, Tollgrade develops broadband-focused test solutions that are integrated with industry leading network element and Private-Line test manufacturers. Leveraging its breakthrough copper test platform, the Integrated Measurement Unit (IMU), Tollgrade's IMU ANYWHERE initiative focuses on playing an integral role for test and management solutions developed in conjunction with industry leaders such as Lucent, Nortel, Alcatel, and Acterna. These solutions are aimed at providing the optimal price/performance product for the network edge. "THE MOST ECONOMICAL WAY TO MANAGE DSL DEPLOYMENT IS NOT AS A SPECIAL SERVICE, BUT RATHER AS A CONSUMER, MASS MARKET SERVICE." - - WYLIE ETSCHEID EVP, NEW BUSINESS DEVELOPMENT "WITH MORE THAN 20 YEARS OF PROGRESSIVE DEVELOPMENT BEHIND IT, LOOPCARE PROVIDES A COMPLETE LOOP SERVICE ASSURANCE SYSTEM FOR POTS AND BROADBAND SERVICES LIKE DSL." - - CAROL FRANKLIN, GM, SOFTWARE PRODUCTS [PHOTO] (l to r): Roger Smith, EVP, Technology; Jim Price, SVP, Systems Engineering; Rich Bair, EVP, Engineering & Testing; Wylie Etscheid, EVP, Business Development; Carol Franklin, GM, Software Products - -------------------------------------------------------------------------------- 6 ================================================================================ DRIVING BROADBAND ASSURANCE TO THE CONSUMER MARKETPLACE - -------------------------------------------------------------------------------- "WE'RE SEEING A SHIFT IN THE MARKETPLACE FROM BUILDING CAPACITY IN THE NETWORK CORE TO FILLING CAPACITY AT THE NETWORK EDGE." - - GREG QUIGGLE EVP, MARKETING "INVESTING IN TESTABILITY MAKES SENSE BECAUSE GOOD TESTING REDUCES COMMUNICATIONS COMPANIES' COSTS AND KEEPS CUSTOMERS SATISFIED." - - STEPHANIE WEDGE VP, PROFESSIONAL SERVICES [PHOTO] (l to r): Stephanie Wedge, VP, Professional Services; Joe O'Brien, SVP, Human Resources; Rich Skaare, EVP, Organizational Development & Communication; Sara Antol, General Counsel; Greg Quiggle, EVP, Marketing CABLE BROADBAND NETWORK This network requires remote test solutions for service providers that deliver video and data services to the residential marketplace. [CHART] The Cable Broadband Network is optimized for the delivery of high-quality video broadcasts. Recent transitions to a digital HFC architecture have enabled this same video network to provide extremely cost-effective data services, such as high-speed Internet access. Minimizing dispatches is the focus of a Cable Broad- band test solution. Doing so, however, requires the unique ability to isolate troubles without invoking intrusive tests. Through disciplined investments in the LIGHTHOUSE product family, Tollgrade has obtained a technology leadership position within the Cable Broadband marketplace. Continued digital network build-outs, combined with new cable monitoring interoperability standards, are creating numerous opportunities to leverage this leadership position. Tollgrade's strategy, known as ELEPHANT GUN, focuses on aiming an intensified sales and marketing campaign at premier cable service providers. THE IP/ATM INFRASTRUCTURE... A COMMON NETWORK ELEMENT Whether a Consumer Access, Private-Line, or Cable Broadband Network, the industry is transitioning to a unified IP/ATM soft network infrastructure. This transition will create a common set of challenges to service providers. Remote verification and trouble isolation in a "virtual" network will continue to require new and innovative test and management processes. The DIGITAL WITHOUT A DISPATCH initiative is focused on providing support for these new IP/ATM processes across Tollgrade's Telecommunications and Cable Broadband solutions. PROFESSIONAL SERVICES... BRINGING IT ALL TOGETHER Service providers face many obstacles in today's turbulent economic times. Network expertise has been challenged as a result of workforce reductions and increased pressure to reduce costs by automating test processes. Tollgrade's Professional Services can develop testability programs to meet these challenges by offering a variety of programs that support the planning, implementation, deployment and maintenance phases of a network's lifecycle. These programs have been successful because they are managed by some of the most highly skilled individuals in the industry. These Tollgrade employees have intimate first-hand network organization knowledge gained from years of experience in the RBOC testing environment. - -------------------------------------------------------------------------------- 7 ================================================================================ SELECTED CONSOLIDATED FINANCIAL DATA The selected consolidated financial data of the Company as of December 31, 1997, 1998, 1999, 2000, 2001 and for the years then ended is derived from audited consolidated financial statements of the Company. (In Thousands, Except Per Share Data and Number of Employees) Years Ended December 31, 1997 1998 1999 2000 2001 - --------------------------------------------------------------------------------------------------------------- STATEMENTS OF OPERATIONS DATA: Revenues: Products $ 45,421 $ 46,277 $ 60,031 $111,957 $77,612 Services -- -- 1,080 2,469 4,627 - --------------------------------------------------------------------------------------------------------------- 45,421 46,277 61,111 114,426 82,239 Cost of sales: Products 20,104 19,620 24,298 40,680 33,134 Services -- -- 716 1,958 2,555 Amortization -- -- -- -- 365 - --------------------------------------------------------------------------------------------------------------- 20,104 19,620 25,014 42,638 36,054 - --------------------------------------------------------------------------------------------------------------- Gross profit 25,317 26,657 36,097 71,788 46,185 - --------------------------------------------------------------------------------------------------------------- Operating expenses: Selling and marketing 5,446 5,704 7,006 12,289 9,160 General and administrative 3,768 4,128 4,723 6,216 4,827 Research and development 5,945 6,880 8,757 12,456 12,428 Severance and related expense -- -- -- -- 291 - --------------------------------------------------------------------------------------------------------------- Total operating expense 15,159 16,712 20,486 30,961 26,706 - --------------------------------------------------------------------------------------------------------------- Income from operations 10,158 9,945 15,611 40,827 19,479 Other income, net 899 1,062 949 2,525 2,796 - --------------------------------------------------------------------------------------------------------------- Income before taxes 11,057 11,007 16,560 43,352 22,275 Provision for income taxes 4,174 4,040 5,937 15,857 8,600 - --------------------------------------------------------------------------------------------------------------- Net income $ 6,883 $ 6,967 $ 10,623 $ 27,495 $ 13,675 - --------------------------------------------------------------------------------------------------------------- EARNINGS PER SHARE INFORMATION: Net income per common share: (1) Basic $ 0.61 $ 0.60 $ 0.92 $ 2.18 $ 1.05 - --------------------------------------------------------------------------------------------------------------- Diluted $ 0.58 $ 0.58 $ 0.89 $ 2.06 $ 1.02 - --------------------------------------------------------------------------------------------------------------- Weighted average shares of common stock and equivalents: Basic 11,372 11,683 11,574 12,636 13,038 - --------------------------------------------------------------------------------------------------------------- Diluted 11,923 11,933 11,959 13,359 13,412 - --------------------------------------------------------------------------------------------------------------- As of December 31, 1997 1998 1999 2000 2001 - --------------------------------------------------------------------------------------------------------------- BALANCE SHEET DATA: Working capital $ 34,570 $ 40,539 $ 49,958 $111,135 $ 67,628 Total assets 43,713 49,865 66,202 131,275 146,630 Shareholders' equity 38,101 45,696 57,504 122,760 140,139 1997 1998 1999 2000 2001 - --------------------------------------------------------------------------------------------------------------- OTHER DATA: (2) Number of employees at year end 205 230 282 411 341 Average revenue per employee $ 222 $ 201 $ 217 $ 278 $ 241 - --------------------------------------------------------------------------------------------------------------- (1) 1998 includes $.02 per share related to the after-tax effect of net key man life insurance proceeds associated with the death of the Company's former Chairman R. Craig Allison. (2) Data is unaudited and not derived from Company's audited financial statements. 8 ================================================================================ MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following discussion should be read in conjunction with the "Selected Consolidated Financial Statements" and notes thereto appearing elsewhere in this Annual Report to Shareholders. 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 to Shareholders, specifically those contained in the following Management's Discussion and Analysis of Results of Operations and Financial Condition which are not historical 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. These forward-looking statements represent Tollgrade Communications, Inc.'s (the "Company") present expectations or beliefs concerning future events. The Company cautions that such statements must be qualified by important factors that could cause actual earnings and other results to differ materially from those achieved in the past or those expected by the Company. These statements as to management's beliefs, strategies, plans, expectations or opinions in connection with Company performance, are based on a number of assumptions concerning future conditions that may ultimately prove to be inaccurate. Such statements must be qualified by important factors that could cause actual earnings and other results to differ materially from those achieved in the past or those expected by the Company. These include: - - General economic conditions and the economic conditions of the telecommunications industry; - - Customers' ability to meet established purchase forecasts and their own growth projections; - - The ability of certain customers to maintain financial strength and access to capital; - - The ability of sales and marketing partners to meet their own performance objectives (and, in certain cases, continue to provide vendor financing to certain local exchange carriers); - - Customers' seasonal buying patterns and the risk of order cancellations; - - Risk of shortage of key manufacturing components and possibility of limited source of supply; - - Manufacturing delays and availability of manufacturing capacity; - - Intense competition in all markets for the Company's products; - - Uncertain pace and scope of technological change along with the need to continually develop new products and gain customer acceptance and approval; - - The Company's dependence on a relatively narrow range of products and a small number of large customers; - - The Company's dependence on key employees and upon proprietary rights; - - Difficulties in managing the Company's growth; - - The Company's dependence upon certain suppliers; - - Risks of third party claims of infringement; - - Risk of product defects; and - - Changes in government regulation affecting the business of the Company and its customers. The Company does not undertake any obligation to publicly update any forward-looking statements. OVERVIEW The Company was organized in 1986 and began operations in 1988. The Company designs, engineers, markets and supports test system, test access and status monitoring products for the telecommunications and cable television industries. Effective September 30, 2001, the Company purchased certain assets of the LoopCare(TM) product business from Lucent Technologies, Inc. ("Lucent"). These assets consisted of LoopCare software base code and developed enhancements, as well as the rights to existing maintenance contracts for the LoopCare software. Effective September 30, 2001, revenues from the sales of either software base code or developed enhancements are reported as part of the Company's revenues attributable to test system products to which they synergistically relate, while the revenues from existing and any new maintenance contracts are reflected as part of the Company's Professional Services revenues. Refer to the Liquidity and Capital Resources section on page 14 for further discussion regarding this acquisition. The Company has determined that its business has one reportable segment in the test assurance industry. All product sales are considered components of the business of testing infrastructure and networks for the telecommunications and cable television industries. While the Company does internally develop sales results and other financial results associated with the various product categories, this information is not considered sufficient for segment reporting purposes nor does the chief operating decision maker make critical decisions based solely on this information. Its products and services have similar economic characteristics, the same or similar production processes and are sold to similar types or classes of customers in, or entering into, the telecommunications business through similar distribution means. The LoopCare software product line business was acquired by the Company to broaden its DigiTest(R) test platform into a system level offering. The Company's telecommunications proprietary test access products enable telephone companies to use their existing line test systems to remotely diagnose problems in Plain Old Telephone Service ("POTS") lines containing both copper and fiber-optics. The Company's MCU(R) product line, which includes POTS line testing as well as alarm-related products, represented approximately 68% of the Company's revenue for the year ended December 31, 2001 and will continue to account for a majority of the Company's revenues for the foreseeable future. The Company's DigiTest centralized network test system platform, which includes the LoopCare software base code and developed enhancements, focuses on helping local exchange carriers conduct the full range of fault diagnosis, along with the ability to qualify, deploy and maintain next generation services that include Digital Subscriber Line ("DSL") service and Integrated Services Digital Network ("ISDN") service. The Company's DigiTest system is designed to provide the complete solution for testing POTS and performing local loop prequalification for DSL services. The system currently consists of the comprehensive LoopCare diagnostic software, as well as three integrated pieces of hardware, the Digital Measurement Node ("DMN"), the Digital Measurement Unit ("DMU"), and the Digital Wideband Unit ("DWU"). 9 ================================================================================ MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION When used in an integrated fashion, the DigiTest system permits local exchange carriers to perform a complete array of central office testing including POTS, DSL line prequalification, bridged tap detection, data rate prediction, and in-service wideband testing. Sales of the DigiTest product line, including $2.8 million of LoopCare software license right-to-use fees since September 30, 2001, accounted for approximately 18% of the Company's revenue for the year ended December 31, 2001. The Company's LIGHTHOUSE(R) cable products consist of a complete cable status monitoring system that provides a broad testing solution for the Broadband Hybrid-Fiber/Coax distribution system. The status monitoring system includes a host for user interface, control and configuration; a headend controller for managing network communications; and transponders that are strategically located within the cable network to gather status reports from power supplies, line amplifiers and fiber-optic nodes. Sales of the LIGHTHOUSE product line accounted for approximately 4% of the Company's revenue for the year ended December 31, 2001. In 2001, sales of the Company's Digital Access Unit ("DAU") were approximately 5% of the Company's revenue. This access product was being sold primarily to Sprint in connection with its recently discontinued IONProject. Through 2001, the Company continued to build upon and extend its Professional Services offering to customers. The cornerstone of the Company's Professional Services business is the Testability Improvement Initiatives. These services may offer the customer the opportunity to make dramatic improvements in testability levels, while training their own staffs in targeted geographic regions over a defined period of time. In this way, the customers' internal repair technicians can make use of automated systems to diagnose and repair subscriber loop problems, thereby automatically eliminating the need for the involvement of several highly trained people to do so. The service offering was expanded upon the acquisition of software maintenance contracts related to the LoopCare software product line. Including these software maintenance revenues of $1.7 million since September 30, 2001, annual Professional Services revenue accounted for approximately 6.0% of the Company's revenue for the year ended December 31, 2001. The Company's telecommunications product and services sales are primarily to the four Regional Bell Operating Companies ("RBOCs"), as well as major independent telephone companies and to certain equipment manufacturers. For the year ended December 31, 2001, approximately 71% of the Company's total revenue was generated from sales to the RBOCs, the three largest of which individually comprised approximately 38%, 14% and 14%, or a combined 66%, of total revenue. In addition, one major independent telephone company contributed approximately 10.4% of the Company's total revenue. The Company markets and sells its products directly, as well as through various Original Equipment Manufacturer ("OEM") and reseller arrangements. The Company's operating results have fluctuated and may continue to fluctuate as a result of various factors, including the timing of orders from, shipments to, and acceptance of software by the RBOCs and significant independent telephone companies. This timing is particularly sensitive to various business factors within each of the company's significant customers including their relationships with their various organized labor groups. In addition, the markets for the Company's DigiTest and LIGHTHOUSE products are highly competitive. Due to the rapidly evolving market in which these products compete, additional competitors with significant market presence and financial resources could further intensify the competition for these products. The Company believes that recent changes within the telecommunication marketplace, including industry consolidation, as well as the Company's ability to successfully penetrate certain new markets, have resulted in some discounting and more favorable terms granted to certain customers of the Company. In addition, certain customers have consolidated product purchases that have translated into large bulk orders. Although the Company will continue to strive to meet the demands of its customers, which include delivery of quality products at an acceptable price and on acceptable terms, there are no assurances that the Company will be successful in negotiating acceptable terms and conditions in its purchase orders or its customer purchase agreements. Additionally, continuing consolidation efforts among the RBOCs, and their ability to consolidate their inventory and product procurement systems could cause fluctuations or delays in the Company's order patterns. Also, recent efforts in the cable industry to consolidate as well as to standardize transponders among status monitoring systems could cause pricing pressure as well as affect deployment within certain customers of the Company's cable products. These standards were adopted by the standards setting body in the year 2001 and may adversely affect the Company's revenues from such products in the year 2002 and in subsequent periods. In addition, markets for the Company's LIGHTHOUSE products have been, and may continue to be, difficult for the foreseeable future. The Company cannot predict such future events or business conditions and the Company's results could be adversely affected by these industry trends in the primary markets its serves. Although international sales to date have not been significant, the Company believes that certain international markets may offer opportunities. The addition of the LoopCare software product line may provide further opportunities to penetrate this market. However, the international telephony markets differ from those found domestically due to the different types and configurations of equipment used by those international communication companies to provide services. In addition, certain competitive elements are found internationally which do not exist in the Company's domestic markets. These factors, when combined, have made entrance into these international markets very difficult. From time to time, the Company has utilized the professional services of various marketing consultants to assist in defining the Company's international market opportunities. With the assistance of these consultants and through direct marketing efforts by the Company, it has been determined that its present MCU technology offers limited opportunities in certain international markets for competitive and other technological reasons. The Company continues to evaluate opportunities for its other products in international markets. However, there can be no assurance that any continued efforts by the Company will be successful or that the Company will achieve significant international sales. The Company believes that continued growth will depend, in part, on its ability to design and engineer new products and, therefore, spends a significant amount on research and development. Research and development expenses as a percent of revenues were approximately 15% for the year ended December 31, 2001. The Company believes that the economic climate will continue to be one of challenge and uncertainty. In response to such uncertainty, effective April 2001, the Company eliminated approximately 80 positions resulting in $4.3 million of annual savings for which the Company received the pro-rata benefit in 2001. In addition, the Company believes that future growth will be affected as a result of an overall continued economic slowdown whereby customers may become even more conservative in their ordering patterns and quantities, and certain emerging carriers will continue to be hampered by financial instability. Due to this uncertainty, the Company will continue to evaluate its investments 10 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION in production, marketing and research and development expenses and monitor, control or decrease expense levels, as appropriate. CRITICAL ACCOUNTING POLICIES The Company's financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. Certain of these accounting principles are more important than others in gaining an understanding of the basis upon which the Company's financial statements have been prepared. The Company considers the following accounting principles to be critical to the preparation of its consolidated financial statements: Revenue Recognition -- The Company markets and sells POTS and broadband test system hardware, and, since the September 30, 2001 acquisition of LoopCare, related software. For hardware sales, the Company follows Staff Accounting Bulletin 101, "Revenue Recognition in Financial Statements" ("SAB 101"). This bulletin requires, among other things, that revenue only be recognized when title has transferred and risk of loss has passed to a customer with the capability to pay, and that there be no significant remaining obligations related to the sale on the part of the Company. For software perpetual license fee and maintenance revenue, the Company follows the AICPA's Statement of Position "Software Revenue Recognition" SOP 97-2 and related modifications. This statement requires that software license fee revenue be recorded only when evidence of a sales arrangement exists, the software has been delivered, and a customer with the capacity to pay has accepted the software leaving no significant obligations on the part of the Company to perform. Software maintenance revenue is recognized on a straight-line basis over the period the respective arrangements are in effect. The Company also performs testability consulting work in its Professional Services group on a time and material basis. Revenue for this work is recognized on an accrual basis as the work is performed and costs are incurred. Segment Information -- The Company applies Statement of Financial Accounting Standards (SFAS) No. 131, "Disclosures about Segments of an Enterprise and Related Information." The Company markets and sells several products, but each have the same or similar economic characteristics, production processes, are subject to similar regulatory environments, and are sold to the same or similar types or classes of customers through the same distribution process. The chief decision maker allocates resources on the whole, rather than on the parts, of the Company's business. Therefore, the Company has determined that it has one operating segment and reports its business activities as such. Acquisition and Related Intangible Assets -- The Company made a significant acquisition of assets and assumed certain liabilities of the LoopCare product line from Lucent effective September 30, 2001. Consideration paid was $62.0 million including deal-related costs. This acquisition was recorded in accordance with the transitional guidance of SFAS No. 141 which required the transaction to be recorded under the purchase method of accounting. This method requires that the purchase price be allocated to identifiable tangible and intangible assets, with any excess allocated to goodwill. As this transaction involved primarily the acquisition of intellectual property and contractual rights, a substantial portion of the purchase price was allocated to intangible assets and goodwill. With regard to the establishment of fair value for the intangible assets under the transitional guidance of SFAS No. 141, and for guidance as to how these intangible assets should be viewed in light of the transitional rules of SFAS No. 142, the Company engaged a valuation consultant who is independent of the management and owners of the Company. This independent valuation consultant assisted the Company in determining that approximately $45.8 million of the $62.0 million purchase price was allocable to specific intangible assets at the date of acquisition. Due to the fact that the LoopCare software has been utilized for over 25 years by the Company's key customers, as well as being deeply integrated into their basic quality control systems, it was determined under the transitional guidance of SFASNo. 142 that $38.5 million of these intangible assets had indefinite lives at the date of acquisition and would not be subject to amortization. The Company will fully adopt the provisions of SFAS Nos. 141 and 142 effective January 1, 2002; non-amortizable intangibles and goodwill will be evaluated under SFAS No. 142 as required in 2002. Income Taxes -- The Company follows the provisions of SFAS No. 109, "Accounting for Income Taxes," in reporting the effects of income taxes in its consolidated financial statements. Temporary differences between book and taxable income result in deferred taxes in the Company's consolidated financial statements. The Company believes all of its deferred tax assets are realizable at their present recorded values, and, hence, believes there are no requirements to provide any allowances against such assets. Investments -- The Company follows SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," with regard to accounting for its short- and long-term investments. All of these investments are held in at least investment-grade municipal bonds and are accounted for as "held-to-maturity" securities and reflected in the consolidated balance sheet at amortized cost. YEAR ENDED DECEMBER 31, 2001 COMPARED TO YEAR ENDED DECEMBER 31, 2000 REVENUES Revenues for the year ended December 31, 2001 were $82.2 million, and were $32.2 million or 28.1% lower than the revenues of $114.4 million for the year ended December 31, 2000. The decrease in revenues is primarily associated with a decrease in the unit volume sales of traditional MCU products, the Company's DigiTest system, and the Company's LIGHTHOUSE Cable Status Monitoring System, offset slightly by an increase in billings related to the Company's Professional Services business. During 2001, the sales of the Company's MCU product line decreased by approximately $24.6 million, or 30.6%. This decrease in sales of the MCU product line resulted primarily from decreased sales to Qwest as that company's testability initiative matured. In addition, MCU sales decreased to SBC Communications, Inc. (including Ameritech, Pacific Bell and SNET) during 2001 primarily as a result of a slowdown in the rollout of Project Pronto, that company's broadband initiative. Also contributing to the decrease in MCU sales during 2001 were decreased sales of core MCU products to BellSouth and Verizon primarily associated with slowdowns in programs to upgrade select DLC systems within certain regions with MCU technology. The MCU product line accounted for approximately 67.8% of the current year revenues. During 2001, the sales of the Company's DigiTest product line, including $2.8 million of LoopCare software, decreased by approximately $6.4 million, or 30.4%. This decrease in DigiTest sales was primarily the result of decreased direct shipments during 2001 to Sprint USA and SBC Telecom, Inc., which is the Competitive Local Exchange Carrier ("CLEC") subsidiary of SBC. The decline in sales of DigiTest to Sprint occurred in connection with Sprint's decision to discontinue its IONProject, while SBC Telecom, Inc. substantially curtailed its plan for expansion. In addition, reduced sales of DigiTest to Nortel Networks and Lucent for deployment into the domestic CLEC markets, as well as reduced sales to Verizon for the replacement of certain 11 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Lucent Loop Testing System ("LTS") test head trunks for qualification of copper lines for Digital Subscriber Line ("DSL") service, contributed to the overall decrease in DigiTest sales during the current year. This was offset somewhat by direct sales of DigiTest to SBC Communications, Inc. for MLT-1 replacement, as well as sales to Nortel in anticipation of distribution in the international market. Overall, DigiTest sales accounted for approximately 17.8% of the current year revenues. Revenues from the Company's Professional Services group in 2001 increased by $2.2 million, or 87.4%. This includes $1.7 million of software maintenance fees associated with the LoopCare acquisition. The Company is continuing to expand its service offerings in order to provide its customer base with a full complement of expertise. Professional Services revenue accounted for 5.6% of current year revenues. During 2001, sales of the Company's Digital Access Unit increased by approximately $3.4 million, from $.6 million in the prior year. This product was developed to provide cost-effective test access in applications where it had not been provided for by the equipment manufacturer, and was primarily being sold to Sprint for use in its recently discontinued IONProject. Overall, sales of the Company's DAUwere approximately 4.9% of the Company's revenues. During 2001, sales of the Company's LIGHTHOUSE Cable Status Monitoring System decreased by approximately $6.8 million, or 69.2%. This decrease was primarily a result of decreased product sales to RCN Corporation and AT&T Broadband as a result of their decisions to delay purchases of cable related equipment. Overall, sales of the LIGHTHOUSE Cable Status Monitoring System accounted for approximately 3.7% of the current year revenues. Revenues from the LoopCare product line in the three-month period ended December 31, 2001 were $4.5 million, comprised of $2.8 million in license right-to-use fees and $1.7 million of maintenance fees. Gross margins on these revenues are substantially higher than other product lines of the Company, and the resulting impact on earnings was material for this period and the year. Offsetting these revenue increases were declines for the year and the fourth quarter in the Company's traditional MCU-related products as less purchasing incentives were offered by the Company as well as a continued general softening in the Company's test access markets. The Company expects the softness in its core equipment markets to continue for the foreseeable future as its key customers continue to restrict their capital budgets. The Company's strategy will be to supplement declining revenues from traditional MCU and related equipment product lines with LoopCare software license right-to-use fee revenue. As these software license products generally have long development and selling cycles, creating possibly significant revenue variations, there can be no assurance that the Company will be successful in the implementation of this strategy. Management continues to believe that there is a possibility that customer requirements for certain important MCU products which are utilized in legacy DLC systems may be satisfied at some point. In order to reduce associated risks, the Company is focusing on the development of new product lines to attempt to meet the other requirements of customers. GROSS PROFIT Gross profit for 2001 was $46.2 million compared to $71.8 million for 2000, representing a decrease of $25.6 million, or 35.7%. Gross profit as a percentage of revenues decreased to 56.2% for 2001 compared to 62.7% for 2000. The overall decrease in gross profit resulted primarily from the decreased sales levels, while the decline in gross margin as a percentage of sales was a result of decreased production volumes and associated decreases in cost absorption levels. To maintain the current gross margin levels, the Company will need to maintain pricing and gain further cost reductions. Gross margin levels will also depend on the actual mix of products sold. The LoopCare software product line carries higher gross margins and the Company's cable products carry lower gross margins than those earned historically on the Company's telecommunication products. In addition, if sales of the Company's DigiTest product line increases on an OEM or reseller basis, the overall margins would decline slightly as a result of a greater mix of lower-margin OEM sales versus direct sales. SELLING AND MARKETING EXPENSE Selling and marketing expenses consist primarily of personnel costs as well as commissions and travel expenses of direct sales and marketing personnel, and costs associated with various promotions and related marketing programs. Selling and marketing expense for 2001 was $9.2 million, or 11.1% of revenues, compared to $12.3 million, or 10.7% of revenues for 2000. This decrease of $3.1 million, or 25.5%, is primarily due to a decrease in the number of sales and marketing personnel due to a reduction in personnel in April 2001, a decrease in incentives and commissions associated with the lower sales levels, and cost reductions in the areas of advertising, promotion and related marketing activities. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expenses consist primarily of personnel costs for finance, administrative and general management personnel as well as accounting and legal expenses. General and administrative expense for 2001 was $4.8 million, or 5.9% of revenues, compared to $6.2 million, or 5.4% of revenues for 2000. This decrease of $1.4 million, or 22.3%, is primarily attributable to a decrease in employee recruiting-related expenditures, decreased incentive compensation, as well as a decrease in certain professional service and consulting fees. RESEARCH AND DEVELOPMENT EXPENSE Research and development expenses consist primarily of personnel costs and costs associated with the development of new products and technologies, including DigiTest and LIGHTHOUSE, and enhancing features of existing products. Research and development expense for 2001 was $12.4 million, or 15.1%, of revenues, compared to $12.5 million, or 10.9%, of revenues for 2000. This decrease of $.1 million was principally due to a reduction of engineering personnel in April 2001, offset by the additional personnel acquired as part of the LoopCare acquisition. The Company expenses all research and development costs as they are incurred. OTHER INCOME AND EXPENSE Other income, which consists primarily of interest income, was $2.8 million for 2001 compared to $2.5 million for 2000. The increase of $.3 million, or 10.7%, is primarily attributable to an increase in funds available for investment between periods. PROVISIONS FOR INCOME TAXES The Company's effective tax rate for 2001 was 38.6% of income before income taxes, compared to the 36.6% rate in 2000. The increase in the effective income tax rate was primarily due to higher relative levels of income taxes associated with expanding business activities. NET INCOME AND EARNINGS PER SHARE For the year ended December 31, 2001, net income was $13.7 million compared to $27.5 million for the year ended December 31, 2000, representing a decrease of $13.8 million, or 50.3%. Diluted earnings per common share of $1.02 for 2001 decreased by 50.5%, or 12 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION $1.04, from the $2.06 earned in 2000. Diluted weighted average shares of common stock and equivalents outstanding were 13,412,037 in 2001 compared to 13,359,270 in 2000. This increase in the diluted weighted average shares of common stock and equivalents outstanding is primarily the result of the effect on 2001 of exercised stock options. As a percentage of revenues, net income for 2001 decreased to 16.6% from 24.0% in 2000. YEAR ENDED DECEMBER 31, 2000 COMPARED TO YEAR ENDED DECEMBER 31, 1999 REVENUES Revenues for the year ended December 31, 2000 were $114.4 million, and were $53.3 million or 87.2% higher than the revenues of $61.1 million for the year ended December 31, 1999. The increase in revenues was primarily associated with an increase in the unit volume sales of core MCU products, increased sales associated with the Company's next generation DigiTest system, increased sales of the Company's LIGHTHOUSE Cable Status Monitoring System, as well as increased billings related to the Company's Professional Services business. During 2000, the Company increased the sales of its MCU product line by approximately $32.8 million, or 68.9%. This increase in sales of the MCU product line resulted primarily from increased sales to SBC Communications, Inc. (including Ameritech, Pacific Bell, and SNET) associated with Project Pronto, that company's broadband initiative. In addition, MCU sales increased to Verizon (formerly Bell Atlantic) during 2000 primarily as a result of certain ongoing remediation programs launched by the Company to improve Verizon's MLT testability and flow-through capabilities. Also contributing to the increase in MCU sales during 2000 were increased sales of core MCU products to BellSouth primarily associated with a program to upgrade select DLC systems within certain regions from remote terminal test devices to MCU technology. The MCU product line accounted for approximately 70.2% of revenues for the year. During 2000, the sales of the Company's DigiTest product line increased by approximately $14.4 million, or 218.4%. This increase in DigiTest sales was primarily the result of increased direct shipments during 2000 to Sprint USA and SBC Telecom, Inc., which is the Competitive Local Exchange Carrier ("CLEC") subsidiary of SBC. In addition, sales of DigiTest to Nortel Networks and Lucent for deployment into the CLEC markets, as well as sales to Verizon for the replacement of certain Lucent Loop Testing System ("LTS") test head trunks for qualification of copper lines for Digital Subscriber Line ("DSL") service, contributed to the overall increase in DigiTest sales during the current year. Overall, DigiTest sales accounted for approximately 18.4% of the current year revenues. During 2000, the sales of the Company's LIGHTHOUSE Cable Status Monitoring System increased by approximately $5.5 million, or 126.9%. This increase was primarily a result of increased product sales to RCN Corporation, offset slightly by a decrease in sales during the current year to AT&T Broadband as a result of their decision to delay purchases of cable related equipment. Overall, sales of the LIGHTHOUSE Cable Status Monitoring System accounted for approximately 8.6% of the current year revenues. GROSS PROFIT Gross profit for 2000 was $71.8 million compared to $36.1 million for 1999, representing an increase of $35.7 million, or 98.9%. Gross profit as a percentage of revenues increased to 62.7% for 2000 compared to 59.1% for 1999. The overall increase in gross profit resulted primarily from the increased sales levels, while improvements in gross margin as a percentage of sales were a result of a favorable sales mix in relation to higher-margined products, as well as increased sales volumes and associated manufacturing efficiencies. Maintaining the Company's current gross margin levels is contingent on its ability to negotiate price increases and gain further cost reductions. Furthermore, continuing gross margin levels will depend on the actual mix of products sold which will include the effect of the Company's cable products that carry lower gross margins than earned historically on the Company's telecommunication products. In addition, if the sales mix of the Company's DigiTest product line increases with partner companies, such as Nortel Networks or Lucent, the overall margins would decline slightly as a result of a greater mix of lower-margin OEM sales versus direct sales. SELLING AND MARKETING EXPENSE Selling and marketing expenses consist primarily of personnel costs as well as commissions and travel expenses of direct sales and marketing personnel, and costs associated with various promotions and related marketing programs. Selling and marketing expense for 2000 was $12.3 million, or 10.7% of revenues, compared to $7.0 million, or 11.5% of revenues for 1999. This increase of $5.3 million, or 75.4%, was primarily due to an increase in the number of sales and marketing personnel to support new product introductions and enhance customer support, as well as an increase in commissions associated with the increased sales level and increased expenditures on advertising, promotion and related marketing activities. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expenses consist primarily of personnel costs for finance, administrative and general management personnel as well as accounting and legal expenses. General and administrative expense for 2000 was $6.2 million, or 5.4% of revenues, compared to $4.7 million, or 7.7% of revenues for 1999. This increase of $1.5 million, or 31.6%, was primarily attributable to an increase in employee recruiting- related expenditures, increased legal expenses as well as an increase in certain professional service and consulting fees. RESEARCH AND DEVELOPMENT EXPENSE Research and development expenses consist primarily of personnel costs and costs associated with the development of new products and technologies, including DigiTest and LIGHTHOUSE, and enhancing features of existing products. Research and development expense for 2000 was $12.5 million, or 10.9%, of revenues, compared to $8.8 million, or 14.3%, of revenues for 1999. This increase of $3.7 million, or 42.3%, was principally due to the addition of personnel to support new product development activities and the project costs associated with product development. The Company expenses all research and development costs as they are incurred. OTHER INCOME AND EXPENSE Other income, which consists primarily of interest income, was $2.5 million for 2000 compared to $1.0 million for 1999. The increase of $1.5 million, or 166.2%, was primarily attributable to an increase in funds available for investment between periods. PROVISIONS FOR INCOME TAXES The Company's effective tax rate for 2000 was 36.6% of income before income taxes, compared to the 35.9% rate in 1999. The increase in the effective income tax rate was primarily due to higher relative levels of state income taxes associated with expanding business activities. 13 ================================================================================ MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION NET INCOME AND EARNINGS PER SHARE For the year ended December 31, 2000, net income was $27.5 million compared to $10.6 million for the year ended December 31, 1999, representing an increase of $16.9 million, or 158.8%. Diluted earnings per common share of $2.06 for 2000 increased by 131.5%, or $1.17, from the $.89 earned in 1999. Diluted weighted average shares of common stock and equivalents outstanding were 13,359,270 in 2000 compared to 11,958,976 in 1999. This increase in the diluted weighted average shares of common stock and equivalents outstanding was primarily the result of the effect of an increase in the average share price of common stock between periods. As a percentage of revenues, net income for 2000 increased to 24.0% from 17.4% in 1999. LIQUIDITY AND CAPITAL RESOURCES On September 30, 2001, the Company completed the acquisition of the software assets of LoopCare from Lucent for approximately $62,000,000 in cash. The transaction was consummated pursuant to an Asset Purchase Agreement, entered into on September 28, 2001. The assets consisted principally of software and related computer equipment. The equipment was used by Lucent in support of the software and the Company presently intends to continue to use the equipment for the same purpose. The Company used available cash and short-term investments to finance the acquisition. LoopCare is the Plain Old Telephone Services ("POTS") test system used by all of the Regional Bell Operating Companies. The test system measures loop parameters, gathers provisioning and operational information from the network elements, and analyzes data. The software products include the Mechanized Loop Testing (MLT) system that currently tests more than 151 million lines in telecommunication networks worldwide. LoopCare, which incorporates the expertise derived from the MLT system, supports xDSL, ISDN, POTS and coin service on local metallic wire and DLC loops. The LoopCare solution, which currently works with the Company's existing DigiTest test system platform, measures the metallic parameters of the loop to detect shorts, grounds, opens, or other metallic faults that could affect DSL service; measures the broadband spectral density of the noise on the loop; identifies the location and length of bridged taps that affect DSL service; predicts the downstream and upstream data rate that the loop can support; and recommends the most effective remedial action to improve the data rate on lines that cannot support the rate requested by the subscriber. The revenues from this product line include perpetual initial Right To Use ("RTU") fees, as well as fees associated with annual maintenance contracts. These maintenance fees are based upon various service levels selected by the customer. The Company recognizes revenue from the RTU fees in accordance with the American Institute of Certified Public Accountants Statement of Position ("SOP") 97-2, "Software Revenue Recognition," SOP 98-9 "Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions," and Emerging Issues Task Force Issue 01-03. When the arrangement with the customer includes future obligations for which fair value does not exist or when customer acceptance is required, revenue is recognized when those obligations have been met or customer acceptance has been received and collection is assured. The customer's network planning and purchase decisions for these software systems normally involve a significant commitment of its resources and a lengthy evaluation and qualification process. Revenue from maintenance support services will be deferred and then recognized on a straight-line basis over the period of the maintenance contract. The Company may experience fluctuations in its RTU fees in future periods. As the Company cannot predict such future events or business conditions the Company's results may be adversely affected by these trends. The LoopCare acquisition has been recorded in accordance with the transitional guidance of Statement of Financial Accounting Standards (SFAS) No. 141 under the purchase method of accounting and, accordingly, the results of operations of LoopCare for the period beginning September 30, 2001 forward, have been included in the consolidated financial statements of the Company. Independent valuation consultants assisted management in its determination of the fair values of certain intangible assets acquired. Intangible assets valued at September 30, 2001 include the LoopCare trade name ($1.3 million), base software ($5.2 million), capitalized software costs on developed software ($7.3 million), and post warranty maintenance service agreements ($32.0 million). Of the intangible assets identified, only capitalized software costs on developed software of $7.3 million have been determined to have a definite life, which has been estimated at five years, and will be amortized over that period. The remaining intangibles, which amount to $38.5 million, have been determined to have indefinite lives due to the degree of integration and resulting dependency on the related software and intellectual property by the Company's key customers who have utilized the software for over 25 years. If circumstances would change such that these intangible assets were, in fact, collectively determined to have a definite life, the accounting rules would require that these assets be amortized over such lives and, although such amortization would represent a non-cash charge, it would be material to the Company's consolidated statements of operations. The Company has followed the transitionary provisions of SFAS No. 142, and will evaluate all intangibles including goodwill periodically, in accordance with that accounting standard. The Company had working capital of $67.6 million as of December 31, 2001 compared to working capital of $111.1 million as of December 31, 2000. The decrease of $43.5 million, or 39.2%, can be attributed to operating cash flow (income from operations before depreciation and amortization) offset by the purchase of the LoopCare business product line for $62.0 million, including deal-related expenses, in cash. Significant changes during 2001 in the composite elements of working capital include a substantial decrease in accounts receivable-trade and inventories due to a substantial decline in sales activities due to current overall economic conditions, and corresponding adjustments made by the Company in forecasted production volumes to meet such lowered demands. In addition, as expected in 2001, the Company received $7.7 million of net tax refunds due largely to net operating loss carrybacks resulting from the exercise of certain of the Company's nonstatutory stock options and the associated tax deductions related thereto. As of December 31, 2001, the Company had $38.7 million of cash and cash equivalents, short-term investments and long-term investments, which are unrestricted and available for corporate purposes, including acquisitions and other general working capital requirements. In addition, effective December 20, 2001, the Company executed a five-year $25.0 million Unsecured Revolving Credit Facility (the "Facility") with a bank. In accordance with the terms of the Facility, the proceeds must be used for general corporate purposes, working capital needs, and in connection with certain acquisitions, as defined. The Facility contains certain standard covenants with which the Company must comply, including a minimum fixed charge ratio, a minimum defined level of tangible net worth and a restriction on the amount of capital expenditures that can be made on an annual basis, among others. 14 ================================================================================ MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Commitment fees are payable quarterly at 0.25% of the unused commitment. As of December 31, 2001, there were no outstanding borrowings under the Facility. No borrowings for working capital are currently anticipated, as the Company believes internally generated funds will be sufficient to sustain working capital requirements for the foreseeable future. The Company made capital expenditures of $3.5 million in 2001, primarily related to the acquisition of land adjacent to the Company's current manufacturing facility, as well as production test equipment and fixtures. Capital expenditures were $4.5 million and $2.3 million for 2000 and 1999, respectively, and were primarily related to upgrades to the IT infrastructure, office equipment, test fixtures and development systems, tooling and leasehold improvements. Planned capital expenditures for 2002 are anticipated to total approximately $4.1 million. These planned capital projects include test fixtures and development systems, and computer and office equipment. The Board of Directors has authorized the continuation of a share repurchase program it started in 1997. Under the current extension, the Company may repurchase a total of one million shares of its common stock before December 31, 2002. Since the initial repurchase program was instituted in April of 1997, and as of December 31, 2001, the Company has repurchased 382,400 shares of common stock. The repurchased shares are authorized to be utilized under certain employee benefit programs. The number of shares the Company intends to purchase and the time of such purchases will be determined by the Company at its discretion. The Company will use existing cash and short-term investments to finance the purchases. The impact of inflation on both the Company's financial position and the results of operations have been minimal and are not expected to adversely affect 2002 results. The Company's financial position enables it to meet cash requirements for operations and capital expansion programs. COMMITMENTS The Company has commitments under various non-cancelable leases; these leases relate primarily to real estate in Cheswick, Pennsylvania and Bridgewater, New Jersey which house the Company's operations. Rentals due beyond December 31, 2001 under these agreements amount to $1.1 million in 2002 and approximately $0.5 million annually through 2006. The Company also entered into a line of credit Facility discussed in the "Liquidity and Capital Resources" section of this MDA. Commitment fees associated with this Facility are as outlined in that discussion. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's current investment policy limits its investments in financial instruments to cash and cash equivalents, individual municipal bonds, and corporate and government bonds. The use of financial derivatives and preferred and common stocks is strictly prohibited. The Company believes it minimizes its risk through proper diversification along with the requirements that the securities must be of investment grade with an average rating of "A" or better by Standard &Poor's. The Company holds its investment securities to maturity and believes that earnings and cash flows are not materially affected by changes in interest rates, due to the nature and short-term investment horizon for which these securities are invested. KEY RATIOS The Company's days sales outstanding ("DSOs") in accounts receivable trade, based on twelve months rolling revenue, was 43 and 61 days as of December 31, 2001 and December 31, 2000, respectively. The Company's inventory turnover ratio was 1.3 and 1.8 turns for December 31, 2001 and December 31, 2000, respectively. Approximately $2,000,000 in inventory was returned to the Company's component vendors for credit during 2001 associated with a program addressed to decrease on hand inventory levels commensurate with current sales levels. BACKLOG As of December 31, 2001, the Company's backlog was $4.9 million compared to the backlog at December 31, 2000 of $8.2 million. The Company's backlog consists of firm customer purchase orders for the Company's various products. The Company believes that customers are returning to a more typical seasonal-based ordering pattern where the first quarter of the year is typically lower than the preceding quarter. The shippable backlog entering the first quarter of 2001 is lower than 2000 levels. Periodic fluctuations in customer orders and backlog result from a variety of factors, including but not limited to the timing of significant orders and shipments. While these fluctuations could impact short-term results, management believes these fluctuations are not necessarily indicative of long-term trends in sales of the Company's products. ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes standards for reporting information about various derivative financial instruments and accounting for their change in fair value. The Company does not hold or issue derivative instruments for hedging purposes and therefore the adoption of this standard in 2000 did not have a material effect on the consolidated financial position or results of operations of the Company. In December 1999, the Staff of the Securities and Exchange Commission issued Staff Accounting Bulletin 101, "Revenue Recognition in Financial Statements" ("SAB 101"), which provides guidance related to revenue recognition. The Company has adopted this standard in 2000 and doing so did not have a material effect on its business, results of operations and financial condition. In July 2001, the FASB issued SFAS No 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 established accounting and reporting standards for business combinations. SFAS No. 142 established accounting and reporting standards for acquired goodwill and other intangible assets, specifically, how they should be treated upon, and subsequent to, their acquisition. Both SFAS No. 141 and SFAS No. 142 are required to be applied in fiscal years beginning after December 15, 2001; however, early adoption is permitted. Both statements contain transitional provisions which require that these statements be applied to all business combinations initiated after June 30, 2001. The Company followed the transitional provisions of SFAS No. 141 and SFAS No. 142 during the fourth quarter of fiscal year 2001 as it related to its recent acquisition of the LoopCare product line. The Company will adopt the full provisions of these statements on January 1, 2002. The Company does not believe the adoption of these standards will have a material effect on its financial statements. On August 15, 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." On October 4, 2001, FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The Company will adopt these statements on January 1, 2003 and is presently evaluating the impact they may have on the Company. 15 ================================================================================ TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES STATEMENT OF MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL REPORTING The accompanying consolidated financial statements of Tollgrade Communications, Inc. and Subsidiaries have been prepared by management, who are responsible for their integrity and objectivity. The statements have been prepared in conformity with generally accepted accounting principles and include amounts based on management's best estimates and judgments. Financial information elsewhere in this Annual Report is consistent with that in the financial statements. Management has established and maintains a system of internal control designed to provide reasonable assurance that assets are safeguarded and that the financial records reflect the authorized transactions of the Company. The system of internal control includes widely communicated statements of policies and business practices that are designed to require all employees to maintain high ethical standards in the conduct of Company affairs. The internal controls are augmented by organizational arrangements that provide for appropriate delegation of authority and division of responsibility. The financial statements have been audited by PricewaterhouseCoopers LLP, Independent Accountants. As part of their audit of the Company's 2001 financial statements, PricewaterhouseCoopers LLP considered the Company's system of internal control to the extent they deemed necessary to determine the nature, timing and extent of their audit tests. The Report of Independent Accountants follows. The Board of Directors pursues its responsibility for the Company's financial reporting through its Audit Committee, which is composed entirely of outside directors. The Audit Committee has met periodically with the Independent Public Accountants and management. The Independent Public Accountants had direct access to the Audit Committee, with and without the presence of management representatives, to discuss the results of their audit work and their comments on the adequacy of internal accounting controls and the quality of financial reporting. /s/ CHRISTIAN L. ALLISON Christian L. Allison Chairman and Chief Executive Officer /s/ SAMUEL C. KNOCH Samuel C. Knoch Chief Financial Officer and Treasurer January 21, 2002 16 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Tollgrade Communications, Inc. and Subsidiaries: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, changes in shareholders' equity and cash flows present fairly, in all material respects, the financial position of Tollgrade Communications, Inc. and its subsidiaries at December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which 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, 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. PRICEWATERHOUSECOOPERS LLP /s/ PRICEWATERHOUSECOOPERS LLP Pittsburgh, Pennsylvania January 21, 2002 17 Tollgrade Communications, Inc. and Subsidiaries Consolidated Balance Sheets ASSETS December 31, 2000 DECEMBER 31, 2001 - ------------------------------------------------------------------------------------------------------------------------------ Current assets: Cash and cash equivalents $ 30,423,783 $ 32,105,845 Short-term investments 28,405,655 6,489,323 Accounts receivable: Trade 18,775,643 9,296,551 Other 813,809 320,501 Inventories 30,499,482 22,183,616 Prepaid expenses and deposits 787,098 916,723 Refundable income taxes 8,950,672 1,396,736 Deferred tax assets 983,246 1,116,756 - ------------------------------------------------------------------------------------------------------------------------------ Total current assets 119,639,388 73,826,051 Long-term investments 2,750,000 150,000 Property and equipment, net 6,503,923 8,012,546 Deferred tax assets 2,380,828 2,812,987 Intangibles -- 38,500,000 Goodwill -- 16,161,763 Capitalized software costs, net -- 6,935,000 Other assets 417 231,614 - ------------------------------------------------------------------------------------------------------------------------------ Total assets $ 131,274,556 $ 146,629,961 - ------------------------------------------------------------------------------------------------------------------------------ LIABILITIES AND SHAREHOLDERS' EQUITY - ------------------------------------------------------------------------------------------------------------------------------ Current liabilities: Accounts payable $ 1,874,328 $ 805,398 Accrued warranty 1,045,000 2,068,000 Accrued expenses 892,589 691,697 Accrued salaries and wages 2,813,433 329,126 Accrued royalties payable 1,142,478 397,451 Income taxes payable 636,938 1,433,554 Deferred income 100,000 472,674 - ------------------------------------------------------------------------------------------------------------------------------ Total current liabilities 8,504,766 6,197,900 Deferred tax liabilities 9,950 293,477 - ------------------------------------------------------------------------------------------------------------------------------ Total liabilities 8,514,716 6,491,377 Commitments and contingent liabilities -- -- Shareholders' equity: Preferred stock, $1.00 par value; authorized shares, 10,000,000; issued shares, -0- in 2000 and 2001 -- -- Common stock, $.20 par value--authorized shares, 50,000,000; issued shares, 13,329,264 in 2000 and 13,513,119 in 2001 2,665,853 2,702,624 Additional paid-in capital 66,343,728 70,010,254 Treasury stock, at cost, 386,800 shares in 2000 and 2001 (3,164,975) (3,164,975) Retained earnings 56,915,234 70,590,681 - ------------------------------------------------------------------------------------------------------------------------------ Total shareholders' equity 122,759,840 140,138,584 - ------------------------------------------------------------------------------------------------------------------------------ Total liabilities and shareholders' equity $ 131,274,556 $ 146,629,961 - ------------------------------------------------------------------------------------------------------------------------------ The accompanying notes are an integral part of the consolidated financial statements. 18 Tollgrade Communications, Inc. and Subsidiaries Consolidated Statements of Operations Years Ended December 31, 1999 2000 2001 - --------------------------------------------------------------------------------------------------------------------------------- Revenues: Products $ 60,031,005 $ 111,957,560 $ 77,611,861 Services 1,080,098 2,468,537 4,627,210 - --------------------------------------------------------------------------------------------------------------------------------- 61,111,103 114,426,097 82,239,071 Cost of sales: Products 24,298,741 40,680,034 33,134,366 Services 715,677 1,957,945 2,555,039 Amortization -- -- 365,000 - --------------------------------------------------------------------------------------------------------------------------------- 25,014,418 42,637,979 36,054,405 - --------------------------------------------------------------------------------------------------------------------------------- Gross profit 36,096,685 71,788,118 46,184,666 - --------------------------------------------------------------------------------------------------------------------------------- Operating expenses: Selling and marketing 7,006,118 12,288,646 9,159,227 General and administrative 4,722,970 6,216,427 4,827,120 Research and development 8,756,551 12,456,337 12,427,859 Severance and related expense -- -- 291,401 - --------------------------------------------------------------------------------------------------------------------------------- Total operating expense 20,485,639 30,961,410 26,705,607 - --------------------------------------------------------------------------------------------------------------------------------- Income from operations 15,611,046 40,826,708 19,479,059 Other (expense) income: Interest expense (1,549) -- -- Interest and other income 950,380 2,525,460 2,796,213 - --------------------------------------------------------------------------------------------------------------------------------- Total other income (expense) 948,831 2,525,460 2,796,213 - --------------------------------------------------------------------------------------------------------------------------------- Income before taxes 16,559,877 43,352,168 22,275,272 Provision for income taxes 5,937,000 15,857,000 8,599,825 - --------------------------------------------------------------------------------------------------------------------------------- Net income $ 10,622,877 $ 27,495,168 $ 13,675,447 - --------------------------------------------------------------------------------------------------------------------------------- EARNINGS PER SHARE INFORMATION: - --------------------------------------------------------------------------------------------------------------------------------- Weighted average shares of common stock and equivalents: Basic 11,573,580 12,636,284 13,037,906 Diluted 11,958,976 13,359,270 13,412,037 - --------------------------------------------------------------------------------------------------------------------------------- Net income per common share: Basic $ 0.92 $ 2.18 $ 1.05 Diluted $ 0.89 $ 2.06 $ 1.02 - --------------------------------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of the consolidated financial statements. 19 Tollgrade Communications, Inc. and Subsidiaries Consolidated Statements of Changes in Shareholders' Equity Additional Preferred Stock Common Stock Paid-in Shares Amount Shares Amount Capital - -------------------------------------------------------------------------------------------------------- Balance at December 31, 1998 -- $ -- 11,840,928 $2,368,186 $26,319,679 Exercise of common stock options -- -- 261,352 52,270 2,123,652 Tax benefit from exercise of stock options -- -- -- -- 385,237 Purchase of treasury stock -- -- -- -- -- Net income -- -- -- -- -- - -------------------------------------------------------------------------------------------------------- Balance at December 31, 1999 -- -- 12,102,280 2,420,456 28,828,568 Exercise of common stock options -- -- 1,226,984 245,397 11,580,460 Tax benefit from exercise of stock options -- -- -- -- 25,934,700 Net income -- -- -- -- -- - -------------------------------------------------------------------------------------------------------- Balance at December 31, 2000 -- -- 13,329,264 2,665,853 66,343,728 EXERCISE OF COMMON STOCK OPTIONS -- -- 183,855 36,771 1,626,764 TAX BENEFIT FROM EXERCISE OF STOCK OPTIONS -- -- -- -- 2,039,762 NET INCOME -- -- -- -- -- - -------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 2001 -- $ -- 13,513,119 $2,702,624 $70,010,254 - -------------------------------------------------------------------------------------------------------- Treasury Retained Stock Earnings Total - --------------------------------------------------------------------------------------- Balance at December 31, 1998 $(1,789,287) $18,797,189 $45,695,767 Exercise of common stock options -- -- 2,175,922 Tax benefit from exercise of stock options -- -- 385,237 Purchase of treasury stock (1,375,688) -- (1,375,688) Net income -- 10,622,877 10,622,877 - --------------------------------------------------------------------------------------- Balance at December 31, 1999 (3,164,975) 29,420,066 57,504,115 Exercise of common stock options -- -- 11,825,857 Tax benefit from exercise of stock options -- -- 25,934,700 Net income -- 27,495,168 27,495,168 - --------------------------------------------------------------------------------------- Balance at December 31, 2000 (3,164,975) 56,915,234 122,759,840 EXERCISE OF COMMON STOCK OPTIONS -- -- 1,663,535 TAX BENEFIT FROM EXERCISE OF STOCK OPTIONS -- -- 2,039,762 NET INCOME -- 13,675,447 13,675,447 - --------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 2001 $(3,164,975) $70,590,681 $140,138,584 - --------------------------------------------------------------------------------------- The accompanying notes are an integral part of the consolidated financial statements. 20 Tollgrade Communications, Inc. and Subsidiaries Consolidated Statements of Cash Flows Years Ended December 31, 1999 2000 2001 - ----------------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income $ 10,622,877 $ 27,495,168 $ 13,675,447 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,252,743 1,910,245 2,692,322 Tax benefit from exercise of stock options 385,237 15,044,372 2,039,762 Refundable income taxes paid -- -- 7,714,229 Deferred income taxes (253,512) (481,541) (442,435) Provision for losses on inventory 393,000 743,129 299,845 Provision for allowance for doubtful accounts 100,000 22,189 175,000 Changes in assets and liabilities: Decrease (increase) in accounts receivable -- trade (3,077,184) (7,932,588) 9,304,092 Decrease (increase) in accounts receivable -- other (34,475) (478,654) 1,390,808 Decrease (increase) in inventory (4,526,976) (13,906,864) 8,016,021 (Increase) decrease in prepaid expenses and deposits (109,521) (325,164) 7,875 (Decrease) increase in accounts payable 224,690 962,559 (1,068,929) Increase (decrease) in accrued expenses and deferred income 1,160,928 (291,760) (80,218) (Decrease) increase in accrued royalties payable 80,718 348,789 (745,027) (Decrease) increase in accrued salaries and wages 1,407,565 603,960 (2,484,307) Increase (decrease) in income taxes payable 1,655,130 (1,806,671) 796,616 - ----------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 9,281,220 21,907,169 41,291,101 - ----------------------------------------------------------------------------------------------------------------- Cash flows from investing activities: Purchase of investments (15,183,124) (38,637,741) (29,030,595) Redemption/maturity of investments 14,618,612 23,848,762 53,546,927 Capital expenditures (2,272,485) (4,076,074) (3,528,528) Investments in other assets -- -- (231,615) Purchase of treasury stock (1,375,688) -- -- Purchase of LoopCare business from Lucent -- -- (62,028,763) - ----------------------------------------------------------------------------------------------------------------- Net cash used in investing activities (4,212,685) (18,865,053) (41,272,574) - ----------------------------------------------------------------------------------------------------------------- Cash flows from financing activities: Proceeds from the exercise of stock options 2,175,922 11,825,857 1,663,535 - ----------------------------------------------------------------------------------------------------------------- Net cash provided by financing activities 2,175,922 11,825,857 1,663,535 - ----------------------------------------------------------------------------------------------------------------- Net increase in cash and cash equivalents 7,244,457 14,867,973 1,682,062 - ----------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at beginning of period 8,311,353 15,555,810 30,423,783 - ----------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $ 15,555,810 $ 30,423,783 $ 32,105,845 - ----------------------------------------------------------------------------------------------------------------- Supplemental disclosure of cash flow information: Cash paid during the year for interest $ 1,549 $ -- $ -- Cash paid during the year for income taxes $ 4,078,830 $ 3,145,422 $ 6,801,560 - ----------------------------------------------------------------------------------------------------------------- Supplemental disclosure of non-cash activity: Acquisition related receivable $ -- $ -- $ 897,000 Tax benefit from the exercise of stock options $ -- $ 10,890,328 $ -- - ----------------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of the consolidated financial statements. 21 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION, BUSINESS AND BASIS OF PRESENTATION Tollgrade Communications, Inc. (the Company) designs, engineers, markets and supports test system, test access and status monitoring products and test software for the telecommunications and cable television industries. The Company's telecommunications proprietary test access products enable telephone companies to use their existing line test systems to remotely diagnose problems in Plain Old Telephone Service (POTS) lines containing both copper and fiber optics. The Company's test system products, specifically the DigiTest test platform, focus on helping local exchange carriers conduct the full range of fault diagnosis along with the ability to prequalify, deploy and maintain next-generation services including Digital Subscriber Line service. The Company's cable products consist of a complete cable status monitoring system that provides a comprehensive testing solution for the Broadband Hybrid Fiber Coax distribution system. The status monitoring system consists of a host for user interface, control and configuration; a headend controller for managing network communications; and transponders that are strategically located within the cable network to gather status reports from power supplies, line amplifiers and fiber-optic nodes. The Company was organized in 1986 and began operations in 1988. The Company acquired, for cash, the LoopCare product line business, effective September 30, 2001. See Note 2. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the reporting period. Actual results could differ from those estimates. PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated. CASH AND CASH EQUIVALENTS The Company considers highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Substantially all of the Company's cash and cash equivalents are maintained at one financial institution. No collateral or security is provided on these deposits, other than $100,000 of deposits per financial institution insured by the Federal Deposit Insurance Corporation. INVESTMENTS Short-term investments at December 31, 2001 and December 31, 2000 consisted of individual municipal bonds stated at cost, which approximated market value. These securities have maturities of one year or less at date of purchase and/or contain a callable provision in which the bonds can be called within one year from date of purchase. Long-term investments are comprised of individual municipal bonds with a maturity of more than one year but less than eighteen months and are stated at amortized cost, which approximated market value. The primary investment purpose is to provide a reserve for future business purposes, including acquisitions and capital expenditures. Realized gains and losses are computed using the specific identification method. The Company classifies its investment in all debt securities as "held to maturity" as the Company has the positive intent and ability to hold the securities to maturity which is in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." INVENTORIES Inventories are stated at the lower of cost or market, with cost determined on the first-in, first-out method. The Company provides appropriate reserves for any inventory deemed slow moving or obsolete. PROPERTY AND EQUIPMENT Property and equipment is stated at cost and depreciated on a straight-line method over the estimated useful lives. Leasehold improvements are amortized over the related lease period or the estimated useful life, whichever is shorter. The cost of renewals and betterments that extend the lives or productive capacities of properties is capitalized. Expenditures for normal repairs and maintenance are charged to operations as incurred. The cost of property and equipment retired or otherwise disposed of and the related accumulated depreciation or amortization are removed from the accounts, and any resulting gain or loss is reflected in current operations. Major maintenance costs are expensed as incurred. 22 PRODUCT WARRANTY The Company records estimated warranty costs on the accrual basis of accounting. These reserves are based on applying historical returns to the current level of product shipments and the cost experience associated therewith. In the case of software, the reserves are based on the cost of performing specification updates. REVENUE RECOGNITION Revenue from product sales is recognized at the time of shipment when both risk of loss and title has transferred to the customer, which coincides with shipment of related products, and collection is reasonably assured. Software license revenue is recognized in accordance with the AICPA's Statement of Position ("SOP") 97-2, "Software Revenue Recognition," SOP 98-9 "Modification of SOP 97-2, Software Revenue Recognition With Respect to Certain Transactions," and Emerging Issues Task Force Issue 01-03. Revenue from software license, which is comprised of fees for perpetual licenses derived from contracts with corporate customers, is recognized when persuasive evidence of an arrangement exists, upon delivery of the product, acceptance by the customer and receipt of a signed notice indicating that no significant Company obligations exist, the fee is fixed or determinable, and collectibility is probable. Revenue from Professional Services (testability consulting) is recognized upon services being rendered. Reimbursement for out-of-pocket costs is recognized as revenue and simultaneously recognized as the cost of product sales. Revenue from Professional Services also includes revenue from maintenance agreements. Maintenance revenue is generally recognized on a straight-line basis over the life of the related agreement, which is typically one year. Customer advances and amounts due from customers in excess of revenue recognized are recorded as deferred income. Revenue for license and royalty fees is recognized when earned. In December 1999, the Staff of the Securities and Exchange Commission issued Staff Accounting Bulletin 101, "Revenue Recognition in Financial Statements" ("SAB 101"), which provides guidance related to revenue recognition. The Company has adopted this standard in 2000 and the impact did not have a material effect on its business, results of operations and financial condition. IMPAIRMENT OF LONG-LIVED ASSETS Long-lived assets and intangible assets to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Measurement of an impairment loss for long-lived assets and certain identifiable intangible assets that management expects to hold and use is based on the fair value of the asset. RESEARCH AND DEVELOPMENT COSTS Research and development costs are charged to operations as incurred. CAPITALIZED SOFTWARE DEVELOPMENT COSTS Any costs incurred to establish the technological feasibility of software to be sold or otherwise marketed are expensed as research and development costs. Costs incurred subsequent to the establishment of technological feasibility, and prior to the general availability of the product to the public are capitalized and subsequently amortized under the straight-line method. The Company defines technological feasibility as coding and testing in accordance with detailed program designs. INCOME TAXES The Company follows the provisions of SFAS No. 109, "Accounting for Income Taxes" (SFAS 109). Under SFAS 109, deferred tax liabilities and assets are determined based on the "temporary differences'' between the financial statement carrying amounts and the tax basis of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. SEGMENT INFORMATION The Company follows the provisions of SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information, Financial Reporting for Segments of a Business." This statement establishes standards for reporting information about operating segments, products and services, geographic areas and major customers in annual and interim financial statements. The Company manages and operates its business as one segment. 23 DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes standards for reporting information about various derivative financial instruments and accounting for their change in fair value. The Company does not hold or issue derivative instruments for hedging purposes and therefore this standard in 2001 did not have a material effect on the consolidated financial position or results of operations of the Company. 2. ACQUISITION On September 30, 2001, the Company acquired certain assets and assumed certain liabilities of the LoopCare(TM) Product line from Lucent Technologies, Inc. ("Lucent") for approximately $62,029,000 in cash which includes approximately $2,200,000 of acquisition-related costs. The LoopCare software product integrates with and enhances the value of the Company's core products, resulting in a significant competitive advantage in the marketplace. The assets consisted principally of rights to existing contracts, software and related computer equipment, while the liabilities were principally related to software warranties currently under contract and deferred income which results from customer contractual billings and advances in excess of revenue recognized in income. The finalization of the purchase price with the seller has not been completed and is subject to negotiation between the parties. The Company does not believe that the final adjusted price will vary materially from recorded amounts. The Company used available cash and short-term investments to finance the acquisition. LoopCare is the Plain Old Telephone Services ("POTS") test system used universally by the Regional Bell Operating Companies. The LoopCare acquisition has been recorded under the purchase method of accounting and, accordingly, the results of operations of the LoopCare business since October 1, 2001 have been included in the consolidated financial statements. The following summarizes the estimated fair values at the date of acquisition: Current assets $ 855,000 Property and equipment, net 307,000 Intangible assets: LoopCare trade name $ 1,300,000 Base software 5,200,000 Developed product software 7,300,000 Post warranty maintenance service agreements 32,000,000 45,800,000 ---------- Goodwill 16,161,763 -------------------------------------------------------------------------------------------------------------- Total assets acquired $ 63,123,763 -------------------------------------------------------------------------------------------------------------- Deferred income (1,076,000) Warranty reserve (19,000) -------------------------------------------------------------------------------------------------------------- Total liabilities assumed (1,095,000) -------------------------------------------------------------------------------------------------------------- NET ASSETS ACQUIRED $ 62,028,763 -------------------------------------------------------------------------------------------------------------- An independent valuation consultant assisted management in its determination of fair value assigned to certain intangible assets other than goodwill. Discounted future cash flow models were utilized where appropriate. The base software has a historically long life cycle and the Company intends to maintain the software and to continue to develop new LoopCare features. Consequently, it was assumed that the base software and the LoopCare trade name have an indefinitely long life. This software has been in use and embedded within the Company's key customers' operating systems for over 25 years. Similarly, the maintenance service agreements are expected to generate revenues into perpetuity and are assumed to have an indefinite life. The developed product software is estimated to have a useful life of approximately five years and the Company believes it can continue to market the product over that period. Rapid development of improved replacement products is not expected due to the relatively small customer base and the cost to develop new software. The Company has utilized the transitional guidance of Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets" which were issued in July 2001. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 and that goodwill, as well as any intangible assets believed to have an indefinite useful life, shall not be amortized for financial reporting purposes. Based on the aforementioned and the Company's belief that there are no legal, regulatory, contractual, competitive or economic limitations on the useful lives of the LoopCare trade name, the base software and the maintenance service agreements, these assets are deemed to have an indefinite useful life and, along with goodwill, are not being amortized. In addition, based on the foregoing analysis, the developed product software is being amortized over five years. For tax purposes, the Company is amortizing all intangible assets over 15 years. 24 SFAS No. 142 also provides that entities evaluate the remaining useful lives of intangible assets determined to have indefinite useful lives periodically to determine whether events and circumstances continue to support an indefinite useful life and that such assets be tested at least annually for impairment of value. Any determined impairment in value from the carrying amounts shall result in an impairment loss to the extent of that excess. The effective date and transition rules of SFAS No. 142 require that the Company develop a methodology to measure impairment of the intangible assets by June 30, 2002 and to begin to measure for impairment of value by December 31, 2002. The following condensed proforma results of operations reflect the proforma combination of the Company and the acquired LoopCare business as if the combination occurred on January 1, 2000: (In Thousands, Except Per Share Data) Proforma December 31, 2000 December 31, 2001 - ---------------------------------------------------------------------------------------------------- Revenues $ 127,916 $ 95,629 - ---------------------------------------------------------------------------------------------------- Income from operations $ 45,465 $ 23,728 - ---------------------------------------------------------------------------------------------------- Net income $ 26,774 $ 15,610 - ---------------------------------------------------------------------------------------------------- Net income per common share: Basic $ 2.12 $ 1.20 - ---------------------------------------------------------------------------------------------------- Diluted $ 2.00 $ 1.16 - ---------------------------------------------------------------------------------------------------- The results of operations for the LoopCare product line business included above include the twelve-month periods ending September 30, 2000 and 2001. Other proforma adjustments include an estimated allocation of selling, general and administrative expenses to the LoopCare operations based upon budgeted costs for 2002 and proforma amortization of the developed product software over five years. Proforma adjustments were also made to take into account the cost of money in connection with the acquisition costs. This was projected by reducing interest income at historical earning rates for working capital deemed to have been available to apply to the acquisition costs and projecting interest expense on borrowed funds for residual acquisition costs at the historical prime rates of interest plus 1.5%. Adjustments were also made to reflect the tax consequences of the foregoing proforma adjustments. 3. INVENTORIES Inventories consisted of the following: December 31, 2000 DECEMBER 31, 2001 - ----------------------------------------------------------------------------------------------------- Raw materials $ 14,885,196 $ 11,697,886 Work in process 12,981,052 6,443,549 Finished goods 3,718,234 5,153,181 - ----------------------------------------------------------------------------------------------------- $ 31,584,482 $ 23,294,616 - ----------------------------------------------------------------------------------------------------- Reserves for slow moving and obsolete inventory (1,085,000) (1,111,000) - ----------------------------------------------------------------------------------------------------- $ 30,499,482 $ 22,183,616 - ----------------------------------------------------------------------------------------------------- 4. PROPERTY AND EQUIPMENT Property and equipment consisted of the following: Years December 31, 2000 DECEMBER 31, 2001 - --------------------------------------------------------------------------------------------------------------------------- Test equipment and tooling 3-5 $ 5,900,085 $ 6,617,117 Office equipment and fixtures 5-7 4,735,551 5,853,773 Leasehold improvements 1-6 2,059,764 2,036,329 - --------------------------------------------------------------------------------------------------------------------------- 12,695,400 14,507,219 Less accumulated depreciation and amortization 6,191,477 8,117,330 - --------------------------------------------------------------------------------------------------------------------------- Subtotal $ 6,503,923 $ 6,389,889 - --------------------------------------------------------------------------------------------------------------------------- Land $ -- $ 1,622,657 - --------------------------------------------------------------------------------------------------------------------------- $ 6,503,923 $ 8,012,546 - --------------------------------------------------------------------------------------------------------------------------- 25 5. SHAREHOLDERS' EQUITY COMMON STOCK The Company has 50,000,000 authorized shares which have a par value of $.20 per share. As of December 31, 2000 and 2001, there were 13,329,264 and 13,513,119 issued shares, respectively. STOCK REPURCHASE PROGRAM On April 19, 2001, the Company announced its Board of Directors authorized the continuation of a share repurchase program that was originally initiated on April 22, 1997. Prior to this extension, the Company had repurchased 382,400 shares of common stock. The Company was authorized to repurchase a total of one million shares of its common stock before December 31, 2001. Through December 31, 2001, no additional shares were repurchased under this extended program. On January 24, 2002, the Board of Directors authorized the continuation of the share repurchase program under which the Company may repurchase a total of one million shares of its common stock before December 31, 2002. STOCK COMPENSATION PLANS Under the Company's stock compensation plans, directors, officers and other employees may be granted options to purchase shares of the Company's common stock. The option price on all outstanding options is equal to the fair market value of the stock at the date of the grant, as defined. The options generally vest ratably over a two-year period, with one-third vested upon grant. The Company's option programs cover all employees and are used to attract and retain qualified personnel in all positions. On February 19, 1999, the Board of Directors approved a proposal to increase the number of shares under the 1995 Long-Term Incentive Compensation Plan ("the 1995 Plan") by 230,000 shares, with a corresponding cancellation of a simlar number of shares under the 1998 Employee Incentive Compensation Plan ("the 1998 Plan"). The shareholders approved this action on May 6, 1999. On December 14, 2000, the Board of Directors of the Company approved a proposal to increase the number of shares available under the 1998 Plan by 200,000 shares, from 740,000 to 940,000 shares. On May 23, 2001, the shareholders approved an amendment to the Company's 1995 Plan, as adopted by the Board of Directors on January 25, 2001, to increase the number of shares available under the Plan by 275,000 shares, from 2,210,000 to 2,485,000. The aggregate number of shares of the Company's Common Stock which may be issued under the 1995 Plan and the 1998 Plan is 2,485,000 and 940,000 shares, respectively, subject to proportionate adjustment in the event of stock splits and similar events. On January 24, 2002, the Board of Directors approved a proposal to increase the number of shares available under the 1998 Plan by 50,000 shares, from 940,000 to 990,000 shares. That same date, the Board also approved a proposal to increase the number of shares available under the 1995 Plan by 200,000. Such increase is subject to shareholder approval at the Company's annual meeting, to be held May 7, 2002. The maximum number of shares which may be awarded under the 1995 Plan to any one Named Executive Officer during any calendar year of the life of the plan is 200,000 shares. All full-time active employees of the Company, excluding officers and directors, are eligible to participate in the 1998 Plan. The Company has 1,836,384 total shares reserved under the option plans. The shares authorized but not granted under these plans at December 31, 2000 and 2001 were as follows: Shares Authorized But Not Granted December 31, 2000 DECEMBER 31, 2001 - ------------------------------------------------------------------------------------------------------------------- 1995 Long-Term Incentive Compensation Plan 193,373 161,182 1998 Employee Incentive Compensation Plan 188,626 1,572 - ------------------------------------------------------------------------------------------------------------------- Total 381,999 162,754 - ------------------------------------------------------------------------------------------------------------------- The Company has adopted the disclosure-only provisions of SFAS No. 123 "Accounting for Stock-Based Compensation," but applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for its plans. If the Company had elected to recognize compensation cost for these stock options based on the fair value at the grant dates for awards granted under those plans in 1999, 2000 and 2001 consistent with the method prescribed by SFAS No. 123, net income and earnings per share would have been changed to the pro forma amounts indicated below: Years Ended December 31, 1999 2000 2001 - -------------------------------------------------------------------------------------------------------------------- Net income As reported $ 10,622,877 $ 27,495,168 $ 13,675,447 Pro forma $ 8,889,233 $ 19,734,070 $ 6,732,052 - -------------------------------------------------------------------------------------------------------------------- Diluted earnings per share As reported $ .89 $ 2.06 $ 1.02 Pro forma $ .74 $ 1.48 $ .50 - -------------------------------------------------------------------------------------------------------------------- 26 The fair value of the stock options used to compute pro forma net income and earnings per share disclosures is the estimated present value at grant date using the Black-Scholes option-pricing model with the following weighted average assumptions for 1999, 2000 and 2001: expected volatility of 51.9% in 1999, 77.0% in 2000 and 87.7% in 2001; a risk-free interest rate of 4.97% in 1999, 5.83% in 2000 and 3.65% in 2001; and an expected holding period of 4 years. Using the Black-Scholes option-pricing model, the weighted average fair value of stock options granted during 1999, 2000 and 2001, is $4.76, $58.36 and $17.84 per share, respectively. Transactions involving stock options under the Company's various stock option plans and otherwise are summarized below: Weighted Average Number of Shares Range of Option Price Exercise Price - ----------------------------------------------------------------------------------------------------------------------------------- Outstanding, December 31, 1998 2,122,439 $ 6.00000 - $ 13.56250 $ 9.08 Granted 432,000 7.50000 - 17.25000 10.41 Exercised (256,220) 6.00000 - 12.87500 8.30 Cancelled (103,196) 6.00000 - 13.56250 10.18 - ----------------------------------------------------------------------------------------------------------------------------------- Outstanding, December 31, 1999 2,195,023 6.00000 - 17.25000 9.38 Granted 416,625 51.62500 - 159.18750 95.84 Exercised (1,223,793) 6.00000 - 51.62500 9.59 Cancelled (24,615) 6.00000 - 159.18750 28.96 - ----------------------------------------------------------------------------------------------------------------------------------- Outstanding, December 31, 2000 1,363,240 6.00000 - 159.18750 35.25 Granted 560,650 20.53000 - 38.00000 27.60 Exercised (183,855) 6.00000 - 21.70000 9.05 Cancelled (66,405) 6.00000 - 159.18750 61.00 - ----------------------------------------------------------------------------------------------------------------------------------- OUTSTANDING, DECEMBER 31, 2001 1,673,630 $ 6.00000 - $159.18750 $ 34.55 - ----------------------------------------------------------------------------------------------------------------------------------- Weighted Average Options exercisable at: Number of Shares Exercise Price - ----------------------------------------------------------------------------------------------- December 31, 1999 1,660,425 $ 9.49 December 31, 2000 997,680 21.92 DECEMBER 31, 2001 1,219,648 $ 30.41 - ----------------------------------------------------------------------------------------------- The following table summarizes the status of the stock options, outstanding and exercisable, at December 31, 2001: Stock Options Outstanding Stock Options Exercisable - ----------------------------------------------------------------------------------------------------------------------- Number Weighted Average Weighted Weighted Range of Exercise Outstanding Remaining Average Average Prices as of 12/31/01 Contractual Life Exercise Price Shares Exercise Price - ----------------------------------------------------------------------------------------------------------------------- $ 6.00000 - $ 7.28130 250,433 5.78 $ 6.78 250,433 $ 6.78 - ----------------------------------------------------------------------------------------------------------------------- $ 7.50000 - $ 9.26570 215,788 6.69 8.22 215,788 8.22 - ----------------------------------------------------------------------------------------------------------------------- $ 9.81250 - $ 12.87500 238,366 5.67 11.30 238,366 11.30 - ----------------------------------------------------------------------------------------------------------------------- $ 13.56250 - $ 21.92500 201,333 8.98 19.60 106,671 18.22 - ----------------------------------------------------------------------------------------------------------------------- $ 28.39500 - $ 28.39500 216,508 9.78 28.40 80,353 28.40 - ----------------------------------------------------------------------------------------------------------------------- $ 28.70000 - $ 38.00000 177,150 9.71 32.45 69,073 32.51 - ----------------------------------------------------------------------------------------------------------------------- $ 55.89850 - $ 71.87500 145,918 8.95 56.12 106,240 56.10 - ----------------------------------------------------------------------------------------------------------------------- $ 103.59375 - $ 103.59375 21,500 8.80 103.59 14,338 103.59 - ----------------------------------------------------------------------------------------------------------------------- $ 117.34400 - $ 117.34400 179,167 8.62 117.34 120,015 117.34 - ----------------------------------------------------------------------------------------------------------------------- $ 159.18750 - $ 159.18750 27,467 8.53 159.19 18,371 159.19 - ----------------------------------------------------------------------------------------------------------------------- TOTAL 1,673,630 7.87 $ 34.55 1,219,648 $ 30.41 - ----------------------------------------------------------------------------------------------------------------------- 27 SERIES A JUNIOR PARTICIPATING PREFERRED STOCK PURCHASE RIGHTS In order to protect shareholder value in the event of an unsolicited offer to acquire the Company, on July 23, 1996, the Board of Directors of the Company declared a dividend of one preferred stock purchase right for each outstanding share of the Company's common stock. The dividend was payable on August 15, 1996 to shareholders of record as of that date. The aforementioned rights are exercisable only if a person or group acquires or announces an offer to acquire 20% or more of the Company's common stock. In such an event, each right will entitle shareholders to buy one-hundredth of a share of a new series of preferred stock at an exercise price of $115.00. Each one-hundredth of a share of the new preferred stock has terms designed to make it the economic and voting equivalent of one share of common stock. If a person or group acquires 20% or more of the Company's outstanding common stock, each right not owned by the person or group will entitle its holder to purchase at the right's exercise price a number of shares of the Company's common stock (or, at the option of the Company, the new preferred stock) having a market value of twice the exercise price. Further, at any time after a person or group acquires 20% or more (but less than 50%) of the outstanding common stock, the Board of Directors may at its option, exchange part or all of the rights (other than rights held by the acquiring person or group) for shares of the Company's common or preferred stock on a one-for-one basis. Each right further provides that if the Company is acquired in a merger or other business transaction, each right will entitle its holder to purchase, at the right's exercise price, a number of the acquiring company's common shares having a market value at that time of twice the exercise price. The Board of Directors is entitled to redeem the rights for one cent per right at any time before a 20% position has been acquired. The Board of Directors is also authorized to reduce the 20% thresholds referred to above to not less than 10%. 6. LICENSE AND ROYALTY FEES The Company has entered into several technology license agreements with certain major Digital Loop Carrier (DLC) vendors and major Operation Support System (OSS) equipment manufacturers under which the Company has been granted access to the licensor's patent technology and the right to manufacture and sell the patent technology in the Company's product line. The Company is obligated to pay royalty fees, as defined, through the terms of these license agreements. Under these agreements, license and royalty fees are due only upon purchase of the technology or shipment of units; there are no contingent payment provisions in any of these arrangements. Royalty fees of $2,011,930, $2,910,803 and $1,832,981 were incurred in 1999, 2000 and 2001, respectively, and are included in cost of product sales in the accompanying consolidated statements of operations. 7. INCOME TAXES The provision for income taxes consisted of the following: Years Ended December 31, 1999 2000 2001 - -------------------------------------------------------------------------------------- Current: Federal $ 5,478,412 $ 14,212,441 $ 8,192,841 - -------------------------------------------------------------------------------------- State 712,100 2,126,100 849,419 - -------------------------------------------------------------------------------------- 6,190,512 16,338,541 9,042,260 - -------------------------------------------------------------------------------------- Deferred: Federal (221,011) (434,521) (355,700) State (32,501) (47,020) (86,735) - -------------------------------------------------------------------------------------- (253,512) (481,541) (442,435) - -------------------------------------------------------------------------------------- $ 5,937,000 $ 15,857,000 $ 8,599,825 - -------------------------------------------------------------------------------------- Reconciliations of the federal statutory rate to the effective tax rates are as follows: Years Ended December 31, 1999 2000 2001 - -------------------------------------------------------------------------------------------------------------------- Federal statutory tax rate 34% 35% 35% State income taxes 3 5 3 Foreign sales corporation tax benefit (1) -- -- Other -- (3) 1 - -------------------------------------------------------------------------------------------------------------------- Effective tax rate 36% 37% 39% - -------------------------------------------------------------------------------------------------------------------- 28 The components of and changes in the deferred tax assets and liabilities recorded in the accompanying balance sheets at December 31, 2000 and 2001 were as follows: Deferred December 31, Expense December 31, 1999 (Credit) Other 2000 - ----------------------------------------------------------------------------------------------------------------- DEFERRED TAX ASSETS: Excess of tax basis over book basis for: Property and equipment $ 121,808 $ (63,082) $ -- $ 184,890 Inventory 247,182 (74,621) -- 321,803 Reserves recorded for: Warranty 234,000 (173,550) -- 407,550 Inventory 257,400 (165,750) -- 423,150 Allowance for doubtful accounts 70,670 (7,330) -- 78,000 Net operating loss carryforward 1,939,656 1,939,656 Other 11,817 2,792 -- 9,025 - ----------------------------------------------------------------------------------------------------------------- Total deferred tax assets $ 942,877 $ 3,364,074 - ----------------------------------------------------------------------------------------------------------------- Deferred Expense December 31, (Credit) Other 2001 - -------------------------------------------------------------------------------------------------- DEFERRED TAX ASSETS: Excess of tax basis over book basis for: Property and equipment $ (160,287) $ -- $ 345,177 Inventory (56,162) -- 377,965 Reserves recorded for: Warranty (398,970) -- 806,520 Inventory (10,140) -- 433,290 Allowance for doubtful accounts (68,250) -- 146,250 Net operating loss carryforward -- 160,293 1,779,363 Other (32,153) -- 41,178 - -------------------------------------------------------------------------------------------------- Total deferred tax assets $ 3,929,743 - -------------------------------------------------------------------------------------------------- DEFERRED TAX LIABILITIES: Excess of book basis over tax basis for: Goodwill & Intangibles Property and equipment Other (9,950) (9,950) - ------------------------------------------------------------------------------------------------------------- Total deferred tax liabilities $ (9,950) $ (9,950) - ------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------- Net deferred taxes $ 932,927 $ (481,541) $ 1,939,656 $ 3,354,124 Reconciliation to the balance sheet: Current portion of deferred tax assets 575,251 983,246 Long-term portion of deferred tax liabilities (9,950) (9,950) - ------------------------------------------------------------------------------------------------------------- Long-term deferred tax asset $ 367,626 $ 2,380,828 - ------------------------------------------------------------------------------------------------------------- DEFERRED TAX LIABILITIES: Excess of book basis over tax basis for: Goodwill & Intangibles 258,403 (258,403) Property and equipment 25,124 (25,124) Other (9,950) - ----------------------------------------------------------------------------------------------- Total deferred tax liabilities $ (293,477) - ----------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------- Net deferred taxes $ (442,435) $ 160,293 $ 3,636,266 Reconciliation to the balance sheet: Current portion of deferred tax assets 1,116,756 Long-term portion of deferred tax liabilities (293,477) - ----------------------------------------------------------------------------------------------- Long-term deferred tax asset $ 2,812,987 - ----------------------------------------------------------------------------------------------- The deferred tax asset from net operating loss carryforwards is applicable to Pennsylvania which allows a ten-year carryforward with a $2,000,000 cap on deductions each year. Unused carryforward losses will expire in 2010. 8. LINE OF CREDIT Effective December 20, 2001, the Company executed a five-year $25,000,000 Unsecured Revolving Credit Facility (the "Facility") with a bank. In accordance with the terms of the Facility, the proceeds must be used for general corporate purposes, working capital needs, and in connection with certain acquisitions, as defined. The Facility contains certain standard covenants with which the Company must comply, including a minimum fixed charge ratio, a minimum defined level of tangible net worth and a restriction on the amount of capital expenditures that can be made on an annual basis, among others. Interest is payable on any amounts utilized under the Facility at prime, or the prevailing Euro rate plus 1.0% to 1.5% depending on the fixed charge coverage ratio, at the option of the Company. Commitment fees are paid quarterly at the rate of 0.25% per annum on the average unused commitment. At December 31, 2001, there were no amounts outstanding under the Facility. 9. LEASE COMMITMENTS The Company leases office space and equipment under agreements which are accounted for as operating leases. The office lease for the Cheswick facility expires December 31, 2002 and may be extended for an additional 3 years. The equipment leases expire in August 2005 for the Cheswick facility and January 2007 for the Bridgewater facility. The Company is also involved in various month-to-month leases for research and development equipment. In addition, 29 the office lease includes provisions for possible adjustments in annual future rental commitments relating to excess taxes and excess maintenance costs that may occur. Minimum annual future rental commitments under noncancelable leases as of December 31 are: 2002........................................................ $1,137,146 2003........................................................ 533,302 2004........................................................ 533,302 2005........................................................ 507,879 2006........................................................ 457,032 The rent expense for all lease commitments was $599,615, $731,320 and $890,943 in 1999, 2000 and 2001, respectively. In October of 2001, the Company entered into a lease agreement for a facility in Bridgewater, New Jersey. The lease commenced on January 21, 2002 and will expire on January 21, 2007. 10. MAJOR CUSTOMERS, REVENUE CONCENTRATION AND DEPENDENCE ON CERTAIN SUPPLIERS The Company designs, engineers, markets and supports test system, test access and status monitoring products for the telecommunications and cable television industries. Sales are concentrated primarily with the four Regional Bell Operating Companies (RBOCs) as well as major independent telephone companies and to certain digital loop carrier equipment manufacturers. Sales are primarily from the Company's metallic channel unit (MCU) product line. The MCU product line accounted for approximately 68% of the Company's net product sales for 2001. The Company expects that revenues from MCU products will continue to account for a majority of the Company's revenues for the foreseeable future. The DigiTest product line accounted for approximately 18% of the Company's net product sales for 2001. Sales to the RBOCs accounted for approximately 61%, 64% and 71% of the Company's net product sales for fiscal years 1999, 2000 and 2001, respectively. During fiscal years 1999 and 2000, sales to four RBOCs individually exceeded 10% of consolidated revenues and on a combined basis, comprised 61% (individually, 18%, 17%, 16% and 10%) and 64% (individually, 29%, 14%, 11% and 10%), respectively, of the Company's net product sales. During 2001, sales to three RBOCs individually exceeded 10% of consolidated revenues and, on a combined basis, comprised 66% (individually, 38%, 14% and 14%) of the Company's net product sales. Sales to an Original Equipment Manufacturer accounted for approximately 11%, 4% and 5% of the Company's net product sales for fiscal years 1999, 2000 and 2001, respectively. In addition, sales to a large independent carrier accounted for approximately 10%, 12% and 11% of the Company's net product sales for fiscal years 1999, 2000 and 2001, respectively. Due to the Company's present dependency on the RBOCs, the loss of one or more of the RBOCs as a customer, or the reduction of orders for the Company's products by the RBOCs, could materially and adversely affect the Company. The Company utilizes two key independent subcontractors to perform a majority of the circuit board assembly and in-circuit testing work on its products. The Company also utilizes other subassembly contractors on a more limited basis. The loss of the subcontractors could cause delays in the Company's ability to meet production obligations and could have a material adverse effect on the Company's results of operations. In addition, shortages of raw material to, or production capacity constraints at, the Company's subcontractors could negatively affect the Company's ability to meet its production obligations and result in increased prices for affected parts. Any such reduction may result in delays in shipments of the Company's products or increases in the price of components, either of which could have a material adverse impact on the Company. 11. EMPLOYEE BENEFIT PLANS The Company has a 401(k) benefit plan. Eligible employees, as defined in the plan, may contribute up to 20% of eligible compensation, not to exceed the statutory limit. The Company does not make matching contributions to the plan. 12. DEFERRED AND REFUNDABLE TAX ASSETS The Company's current refundable tax assets as of December 31, 2000 and 2001 include tax benefits of $8,950,672 and $1,396,736, respectively, resulting from the exercising of certain nonqualified stock options by various directors, officers and other employees under the Company's various stock option programs during 2000 and 2001. The Company is entitled to a tax deduction equal to the difference between the fair market value of the shares received by the option holders upon exercise and the exercise price of the nonqualified stock options. The Company received $8,417,270 in 2001 in federal and state refunds in taxes paid in prior years. It is anticipated that the current deferred and refundable tax assets as of December 31, 2001 will be substantially utilized in 2002 either through refunds of prior year taxes paid or the elimination of income taxes due. 30 13. SEVERANCE AND RELATED EXPENSE On April 19, 2001, the Company announced a restructuring program to implement certain cost reduction initiatives that included the elimination of approximately 80 positions within the general and administrative, research and development and support areas. The restructuring program resulted in a pre-tax charge for severance, outplacement and other related costs of $291,000 in 2001. 14. RECENT ACCOUNTING PRONOUNCEMENTS In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 established accounting and reporting standards for business combinations. SFAS No. 142 established accounting and reporting standards for acquired goodwill and other intangible assets, specifically, how they should be treated upon, and subsequent to, their acquisition. Both SFAS No. 141 and SFAS No. 142 are required to be applied in fiscal years beginning after December 15, 2001; however, early adoption is permitted. SFAS No. 142 statements contain provisions which require that these statements be applied to all business combinations initiated after June 30, 2001. The Company utilized the transitional guidance of SFAS No. 141 and SFAS No. 142 in connection with the LoopCare acquisition on September 30, 2001. The Company will adopt the full provisions of these statements on January 1, 2002. The Company does not believe the adoption of these standards will have a material effect on its financial statements. On August 15, 2001, the FASB issued SFASNo. 143, "Accounting for Asset Retirement Obligation." On October 4, 2001, FASB issued SFASNo. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The Company will adopt these statements on January 1, 2003 and is presently evaluating the impact they may have on the Company. 15. SHORT- AND LONG-TERM INVESTMENTS The estimated fair values of the Company's financial instruments are as follows: December 31, 2000 DECEMBER 31, 2001 ---------------------------------------------------------------------------------------- Carrying Fair CARRYING FAIR Amount Value AMOUNT VALUE - ----------------------------------------------------------------------------------------------------------------------------------- Financial assets: Cash and cash equivalents $ 30,423,783 $ 30,423,783 $ 32,105,845 $ 32,105,845 Short-term and long-term investments 31,155,655 31,104,323 6,639,323 6,658,247 - ----------------------------------------------------------------------------------------------------------------------------------- $ 61,579,438 $ 61,528,106 $ 38,745,168 $ 38,764,092 - ----------------------------------------------------------------------------------------------------------------------------------- 16. PER SHARE INFORMATION Net income per share has been computed in accordance with the provisions of SFAS No. 128, "Earnings Per Share" for all periods presented. On February 10, 2000, the Company's Board of Directors authorized a two-for-one stock split of the Company's common stock, payable in the form of a 100 percent stock dividend. On March 20, 2000, shareholders of record received one additional share of common stock for each share of common stock held of record on February 28, 2000. All share and per share information reflects the two-for-one split of the Company's common stock. SFASNo. 128 requires companies with complex capital structures to report earnings per share on a basic and diluted basis, as defined. Basic earnings per share are calculated on the actual number of weighted average common shares outstanding for the period, while diluted earnings per share must include the effect of any dilutive securities. All prior periods have been restated in accordance with SFAS No. 128. A reconciliation of earnings per share is as follows: Years Ended December 31, 1999 2000 2001 - --------------------------------------------------------------------------------------------------------------------------------- Net Income $ 10,622,877 $ 27,495,168 $ 13,675,447 - --------------------------------------------------------------------------------------------------------------------------------- Weighted average common shares outstanding 11,573,580 12,636,284 13,037,906 - --------------------------------------------------------------------------------------------------------------------------------- Effect of dilutive securities - stock options 385,396 722,986 374,131 - --------------------------------------------------------------------------------------------------------------------------------- 11,958,976 13,359,270 13,412,037 - --------------------------------------------------------------------------------------------------------------------------------- Earnings per share: Basic $ .92 $ 2.18 $ 1.05 - --------------------------------------------------------------------------------------------------------------------------------- Diluted $ .89 $ 2.06 $ 1.02 - --------------------------------------------------------------------------------------------------------------------------------- 31 STATEMENTS OF OPERATIONS DATA BY QUARTER The following table presents unaudited quarterly operating results for each of the Company's last eight fiscal quarters. This information has been prepared by the Company on a basis consistent with the Company's audited financial statements and includes all adjustments (consisting only of normal recurring adjustments) that the Company considers necessary for a fair presentation of the data. Such quarterly results are not necessarily indicative of the future results of operations. (In Thousands, Except Net Income Per Common Share Data) Quarter Ended (Unaudited) March 31, June 30, Sept. 30, Dec. 31, 2000 2000 2000 2000 - ----------------------------------------------------------------------------------------- Revenues: Products $ 21,776 $ 29,074 $ 29,228 $ 31,882 Services 642 593 560 672 - ----------------------------------------------------------------------------------------- 22,418 29,667 29,788 32,554 Cost of Sales: Products 7,971 10,947 10,368 11,395 Services 401 467 473 617 Amortization of intangibles - ----------------------------------------------------------------------------------------- 8,372 11,414 10,841 12,012 - ----------------------------------------------------------------------------------------- Gross Profit 14,046 18,253 18,947 20,542 - ----------------------------------------------------------------------------------------- Operating Expenses: Selling and marketing 2,384 3,028 3,440 3,438 General and administrative 1,378 1,495 1,591 1,752 Research and development 2,590 3,098 3,178 3,589 Severance and related expense - ----------------------------------------------------------------------------------------- Total Operating Expense 6,352 7,621 8,209 8,779 - ----------------------------------------------------------------------------------------- Income from Operations 7,694 10,632 10,738 11,763 Other Income, Net 470 546 662 848 - ----------------------------------------------------------------------------------------- Income Before Taxes 8,164 11,178 11,400 12,611 Provision for Income Taxes 2,939 4,024 4,104 4,790 - ----------------------------------------------------------------------------------------- Net Income $ 5,225 $ 7,154 $ 7,296 $ 7,821 - ----------------------------------------------------------------------------------------- EARNINGS PER SHARE INFORMATION: Weighted average shares of common stock and equivalents: Basic 12,219 12,563 12,821 12,940 Diluted 13,546 13,318 13,460 13,434 Net income per common share: Basic $ 0.43 $ 0.57 $ 0.57 $ 0.60 Diluted $ 0.39 $ 0.54 $ 0.54 $ 0.58 - ----------------------------------------------------------------------------------------- MARCH 31, JUNE 30, SEPT. 30, DEC. 31, 2001 2001 2001 2001 - ------------------------------------------------------------------------------------------- Revenues: Products $ 27,464 $ 21,177 $ 15,077 $ 13,894 Services 526 599 961 2,541 - ------------------------------------------------------------------------------------------- 27,990 21,776 16,038 16,435 Cost of Sales: Products 11,851 9,047 7,158 5,076 Services 423 517 508 1,107 Amortization of intangibles 365 - ------------------------------------------------------------------------------------------- 12,274 9,564 7,666 6,548 - ------------------------------------------------------------------------------------------- Gross Profit 15,716 12,212 8,372 9,887 - ------------------------------------------------------------------------------------------- Operating Expenses: Selling and marketing 2,450 2,493 2,023 2,194 General and administrative 1,530 1,062 1,020 1,215 Research and development 3,360 2,749 2,639 3,681 Severance and related expense 400 (109) - ------------------------------------------------------------------------------------------- Total Operating Expense 7,340 6,704 5,682 6,981 - ------------------------------------------------------------------------------------------- Income from Operations 8,376 5,508 2,690 2,906 Other Income, Net 907 790 801 298 - ------------------------------------------------------------------------------------------- Income Before Taxes 9,283 6,298 3,491 3,204 Provision for Income Taxes 3,528 2,494 1,361 1,217 - ------------------------------------------------------------------------------------------- Net Income $ 5,755 $ 3,804 $ 2,130 $ 1,987 - ------------------------------------------------------------------------------------------- EARNINGS PER SHARE INFORMATION: Weighted average shares of common stock and equivalents: Basic 12,958 13,028 13,066 13,095 Diluted 13,377 13,404 13,378 13,472 Net income per common share: Basic $ 0.44 $ 0.29 $ 0.16 $ 0.15 Diluted $ 0.43 $ 0.28 $ 0.16 $ 0.15 - ------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- COMMON STOCK MARKET PRICES The Company's Common Stock has been included for quotation on The Nasdaq National Market System under the Nasdaq symbol "TLGD" since the Company's initial public offering in December 1995. The following table sets forth, for the periods indicated, the high and low sales prices for the Common Stock on such market: High Low - ----------------------------------------------------- 2000: First Quarter $ 84.00 $ 16.06 Second Quarter 147.19 31.50 Third Quarter 168.88 78.63 Fourth Quarter 148.00 25.75 2001: FIRST QUARTER $ 52.50 $ 15.25 SECOND QUARTER 40.35 18.75 THIRD QUARTER 29.35 18.00 FOURTH QUARTER 34.55 18.45 - ----------------------------------------------------- At January 31, 2002, the Company had 190 holders of record of its Common Stock and 13,521,836 shares outstanding. The Company has never paid any dividends on its Common Stock and does not expect to pay cash dividends in the foreseeable future. 32 SHAREHOLDER INFORMATION SHAREHOLDERS ANNUAL MEETING The Annual Meeting of Shareholders of Tollgrade Communications, Inc., will be held at The Syria Mosque, 1877 Shriners Way, Cheswick, PA 15024, on Tuesday, May 7, 2002, at 1:30 p.m. Notice of the meeting and proxy materials were included with this Annual Report. TRANSFER AGENT AND SHAREHOLDER INQUIRIES The Company's transfer agent is Mellon Investor Services, L.L.C. Inquiries concerning transfer requirements, lost certificates and change of address should be directed to: Mellon Investor Services, L.L.C. P.O. Box 3315 South Hackensack, NJ 07606 or: 85 Challenger Road Ridgefield Park, NJ 07660 1-800-756-3353 TDDfor Hearing Impaired: 1-800-231-5469 Foreign Shareholders: 201-329-8660 TDDForeign Shareholders: 201-329-8354 www.mellon-investor.com. All other inquiries should be directed to: Tollgrade Communications, Inc. Investor Relations Department 493 Nixon Road Cheswick, PA 15024 1-800-878-3399 www.tollgrade.com. FORM 10-K A copy of the Tollgrade Communications, Inc. Form 10-K for 2001, which will be filed with the Securities and Exchange Commission during the first quarter of 2002, is available without attachments at no charge upon written request. Inquiries should be directed to the Investor Relations Department, Tollgrade Communications, Inc., 493 Nixon Road, Cheswick, PA 15024. INDEPENDENT AUDITORS PricewaterhouseCoopers LLP, Pittsburgh, Pennsylvania. COUNSEL Reed Smith LLP, Pittsburgh, Pennsylvania. STOCK MARKET LISTING Tollgrade Communications, Inc. is listed on The Nasdaq Stock Market.(SM) Symbol: TLGD. BOARD OF DIRECTORS [PHOTO] CHRIS ALLISON Chairman and Chief Executive Officer [PHOTO] JAMES J. BARNES Attorney at Law, Reed Smith LLP [PHOTO] DANIEL P.BARRY Private Investor, Director of Respironics, Inc. [PHOTO] ROBERT W. KAMPMEINERT Chairman, President and Chief Executive Officer, Parker/Hunter Incorporated [PHOTO] ROCCO L. FLAMINIO Vice Chairman and Chief Technology Officer [PHOTO] RICHARD H. HEIBEL, M.D. Board Certified Cardiologist (retired) [PHOTO] DAVID S.EGAN Chief Marketing Officer, Reed Smith LLP EXECUTIVE COUNCIL AND OFFICERS CHRIS ALLISON Chairman and Chief Executive Officer SARA M. ANTOL General Counsel and Corporate Secretary RICHARD A. BAIR, JR. Executive Vice President, Engineering and Testing WYLIE E. ETSCHEID, JR. Executive Vice President of Business Development, Software Products ROCCO L. FLAMINIO Vice Chairman and Chief Technology Officer CAROL M. FRANKLIN General Manager, Software Products SAMUEL C. KNOCH Chief Financial Officer and Treasurer JOSEPH G. O'BRIEN Senior Vice President, Human Resources MARK B. PETERSON President GREGORY L. QUIGGLE Executive Vice President, Marketing JAMES N. PRICE Senior Vice President, Systems Engineering MATTHEW J. ROSGONE Executive Vice President, Operations CHARLES J. SHEARER Controller RICHARD A. SKAARE Executive Vice President, Organizational Development and Communication ROGER A. SMITH Executive Vice President, Technology STEPHANIE M. WEDGE Vice President, Professional Services (R) TOLLGRADE, MCU, DigiTest and LIGHTHOUSE are registered trademarks of Tollgrade Communications, Inc. TM LoopCare and TELACCORD are trademarks of Tollgrade Communications, Inc. All other trademarks are the property of their respective owners. (C) 2002 Tollgrade Communications, Inc. All rights reserved. [TOLLGRADE LOGO] CORPORATE HEADQUARTERS 493 Nixon Road, Cheswick, PA 15024 - 1-800-878-3399 - www.tollgrade.com