--------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC
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FORM 10-Q
(Mark One)
[X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended March 30, 2002
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ___________ to ____________
Commission file number 0-27312
TOLLGRADE COMMUNICATIONS, INC.
(Exact Name of Registrant as Specified in its Charter)
PENNSYLVANIA 25-1537134
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification Number)
493 NIXON RD.
CHESWICK, PA 15024
(Address of Principal Executive Offices, including zip code)
412-820-1400
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
--- ---
As of April 30, 2002, there were 13,547,736 shares of the Registrant's
Common Stock, $0.20 par value per share, and no shares of the Registrant's
Preferred Stock, $1.00 par value per share, outstanding.
- -------------------------------------------------------------------------------
This report consists of a total of 24 pages. The exhibit index is on page 23.
TOLLGRADE COMMUNICATIONS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED MARCH 30, 2002
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION PAGE NO.
ITEM 1 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS:
CONDENSED CONSOLIDATED BALANCE SHEETS AS OF MARCH 30,
2002 AND DECEMBER 31, 2001 ................................... 3
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE
THREE-MONTH PERIODS ENDED MARCH 30, 2002 AND MARCH 31, 2001... 4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE
THREE-MONTH PERIODS ENDED MARCH 30, 2002 AND MARCH 31, 2001 .. 5
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.......... 6
REVIEW REPORT OF INDEPENDENT ACCOUNTANTS...................... 12
ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION....................................... 12
PART II. OTHER INFORMATION
ITEM 1 LEGAL PROCEEDINGS............................................. 21
ITEM 2 CHANGES IN SECURITIES......................................... 21
ITEM 3 DEFAULTS UPON SENIOR SECURITIES............................... 21
ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........... 21
ITEM 5 OTHER INFORMATION............................................. 21
ITEM 6 EXHIBITS AND REPORTS FILED ON FORM 8-K........................ 21
SIGNATURE.............................................................. 22
EXHIBIT INDEX.......................................................... 23
2
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
DECEMBER 31,
MARCH 30, 2002 2001
- -------------------------------------------------------------------------------------------------------------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 34,225,969 $ 32,105,845
Short-term investments 4,682,176 6,489,323
Accounts receivable:
Trade 13,483,035 9,296,551
Other 605,354 320,501
Inventories 21,351,551 22,183,616
Prepaid expenses and deposits 974,263 916,723
Refundable income taxes 496,736 1,396,736
Deferred tax assets 1,339,016 1,116,756
- -------------------------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 77,158,100 73,826,051
Long-term investments -- 150,000
Property and equipment, net 8,423,017 8,012,546
Deferred tax assets 2,410,694 2,812,987
Intangibles 38,500,000 38,500,000
Goodwill 16,161,763 16,161,763
Capitalized software costs, net 6,572,350 6,935,000
Other assets 262,146 231,614
===================================================================================================================
TOTAL ASSETS $ 149,488,070 $ 146,629,961
===================================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $649,048 $ 805,398
Accrued warranty 2,318,000 2,068,000
Accrued expenses 1,131,406 691,697
Accrued salaries and wages 834,320 329,126
Accrued royalties payable 378,723 397,451
Income taxes payable 1,622,931 1,433,554
Deferred income 1,530,000 472,674
- -------------------------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 8,464,428 6,197,900
Deferred tax liabilities 577,004 293,477
- -------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 9,041,432 6,491,377
Commitments and contingent liabilities -- --
Shareholders' equity:
Common stock, $.20 par value; authorized shares,
50,000,000; issued shares, 13,547,336 and 13,513,119,
respectively
2,709,467 2,702,624
Additional paid-in capital 70,424,459 70,010,254
Treasury stock, at cost, 461,800 and 386,800 shares,
respectively (4,790,783) (3,164,975)
Retained earnings 72,103,495 70,590,681
- -------------------------------------------------------------------------------------------------------------------
TOTAL SHAREHOLDERS' EQUITY 140,446,638 140,138,584
===================================================================================================================
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 149,488,070 $ 146,629,961
===================================================================================================================
The accompanying notes are an integral part of the
condensed consolidated financial statements.
3
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
FOR THE
THREE MONTHS ENDED
MARCH 30, 2002 MARCH 31, 2001
===================================================================================================
REVENUES:
Products $14,929,379 $27,463,753
Services 2,592,895 526,249
- ---------------------------------------------------------------------------------------------------
$17,522,274 $27,990,002
COST OF PRODUCT SALES:
Products $ 6,062,344 $11,851,107
Services 954,874 423,176
Amortization 365,040 --
- ---------------------------------------------------------------------------------------------------
$ 7,382,258 $12,274,283
- ---------------------------------------------------------------------------------------------------
GROSS PROFIT 10,140,016 15,715,719
- ---------------------------------------------------------------------------------------------------
OPERATING EXPENSES:
Selling and marketing 2,417,309 2,449,824
General and administrative 1,526,251 1,530,152
Research and development 3,994,641 3,359,541
- ---------------------------------------------------------------------------------------------------
Total operating expenses 7,938,201 7,339,517
- ---------------------------------------------------------------------------------------------------
INCOME FROM OPERATIONS 2,201,815 8,376,202
Interest and other income, net 237,999 906,977
- ---------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 2,439,814 9,283,179
Provision for income taxes 927,000 3,528,010
===================================================================================================
NET INCOME $ 1,512,814 $ 5,755,169
===================================================================================================
EARNINGS PER SHARE INFORMATION:
Weighted average shares of common stock and equivalents:
Basic 13,099,210 12,957,833
Diluted 13,421,307 13,377,185
- ---------------------------------------------------------------------------------------------------
Net income per common and common equivalent shares:
Basic $ .12 $ .44
Diluted $ .11 $ .43
===================================================================================================
The accompanying notes are an integral part of the
condensed consolidated financial statements.
4
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended
March 30, 2002 March 31, 2001
- ---------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 1,512,814 $ 5,755,169
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 933,921 581,485
Tax benefit from exercise of stock options 176,579 --
Refund of income taxes paid 900,000 8,150,170
Deferred income taxes 463,560 (224,129)
Provision for losses on inventory 563,000 23,218
Provision for allowance for doubtful accounts -- 175,000
Changes in assets and liabilities:
Increase in accounts receivable-trade (4,186,484) (1,407,256)
(Increase) decrease in accounts receivable-other (152,353) 44,268
Decrease in inventories 269,065 240,018
(Increase) decrease in prepaid expenses and deposits (57,540) 238,279
Decrease in accounts payable (156,350) (1,501,390)
Increase in accrued warranty 250,000 176,000
Increase in accrued expenses and deferred income 1,364,535 46,613
Increase (decrease) in accrued salaries and wages 505,194 (2,156,672)
Decrease in royalties payable (18,728) (260,014)
Increase in income taxes payable 189,377 3,624,502
- ---------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 2,556,590 13,505,261
- ---------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Redemption/maturity of investments 2,317,930 7,002,881
Purchase of investments (360,783) (5,906,520)
Capital expenditures (979,352) (1,071,479)
Purchase of treasury stock (1,625,808) --
Investments in other assets (32,922) --
- ---------------------------------------------------------------------------------------------------------------------
Net cash (used in) provided by investing activities (680,935) 24,882
- ---------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options 244,469 332,731
- ---------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 244,469 332,731
- ---------------------------------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents 2,120,124 13,862,874
Cash and cash equivalents at beginning of period 32,105,845 30,423,783
- ---------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $34,225,969 $44,286,657
=====================================================================================================================
The accompanying notes are an integral part of the
condensed consolidated financial statements.
5
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements included
herein have been prepared by Tollgrade Communications, Inc. (the "Company") in
accordance with accounting principles generally accepted in the United States of
America for the interim financial information and Article 10 of Regulation S-X.
The condensed consolidated financial statements as of and for the three-month
period ended March 30, 2002 should be read in conjunction with the Company's
consolidated financial statements (and notes thereto) included in the Company's
Annual Report on Form 10-K for the year ended December 31, 2001. Accordingly,
the accompanying condensed consolidated financial statements do not include all
of the information and footnotes required by accounting principles generally
accepted in the United States of America for complete financial statements,
although the Company believes that the disclosures are adequate to make the
information presented not misleading. In the opinion of the Company's
management, all adjustments considered necessary for a fair presentation of the
accompanying condensed consolidated financial statements have been included, and
all adjustments are of a normal and recurring nature. Operating results for the
three-month period ended March 30, 2002 are not necessarily indicative of the
results that may be expected for the year ending December 31, 2002.
2. ACQUISITION AND INTANGIBLE ASSETS
On September 30, 2001, the Company acquired certain assets and assumed certain
liabilities of the LoopCareTM 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 acquisition has been recorded under
the purchase method of accounting and, accordingly, the results of operations of
the LoopCare product line since October 1, 2001 have been included in the
consolidated financial statements.
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. In connection with the acquisition,
$45,800,000 of intangible assets were identified, of which $7,300,000 were
related to capitalized software and determined to have a definite life, while
the remaining $38,500,000 of the identified intangible assets as well as
goodwill are not being amortized as they have been determined to have an
indefinite useful life.
As of January 1, 2002, the Company fully adopted the provisions of SFAS No. 142.
SFAS 142 requires that goodwill be analyzed for impairment under a two-step
process. The first step of the goodwill impairment test is to identify potential
impairment by comparing the fair value of the reporting unit with its carrying
amount, including the goodwill. The second step, used to measure
6
the potential impairment loss of the goodwill, is to compare the implied fair
value of the reporting unit goodwill with the carrying amount of that goodwill.
SFAS 142 requires that management complete the first step of the goodwill
impairment test by June 30, 2002. Step two of the goodwill impairment test is
required to be completed by December 31, 2002. In addition, intangible assets
that are not subject to amortization must be tested for impairment annually or
more frequently if events or changes in circumstances indicate that the asset
might be impaired. The impairment test for non-amortizable intangible assets
should consist of a comparison of the fair value of an intangible asset with its
carrying amount. The Company intends to meet the compliance requirements of SFAS
142.
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, 2001; compared with the actual results of
operations for the first quarter of 2002 which included the LoopCare operations:
(In thousands, Except per Share Data)
Three Months Ended
Historical Proforma
March 30, 2002 March 31, 2001
-------------- --------------
Revenues $17,522 $31,338
- ------------------------------------------------------------------------------
Income from operations 2,202 9,438
- ------------------------------------------------------------------------------
Net income 1,513 6,239
- ------------------------------------------------------------------------------
Net income per share
- ------------------------------------------------------------------------------
Diluted $ 0.11 $ 0.47
- ------------------------------------------------------------------------------
The proforma results of operations for the quarter ended March 31, 2001
reflected above include one-fourth of the annual audited results of the LoopCare
product line business for 2001. Proforma adjustments made 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.
The following information is provided regarding the Company's intangible assets:
As of March 30, 2002
--------------------
Gross Carrying Accumulated
Amount Amortization
-------------- ------------
Amortized intangible assets:
Developed product software $ 7,302,390 $ 730,040
=========== ===========
Unamortized intangible assets:
LoopCare trade name $ 1,300,000
Base software 5,200,000
Post warranty maintenance
service agreements 32,000,000
-----------
$38,500,000
===========
7
As of December 31, 2001
-----------------------
Gross Carrying Accumulated
Amount Amortization
-------------- ------------
Amortized intangible assets:
Developed product software $ 7,300,000 $ 365,000
=========== ==========
Unamortized intangible assets:
LoopCare trade name $ 1,300,000
Base software 5,200,000
Post warranty maintenance
service agreements 32,000,000
-----------
$38,500,000
Aggregate amortization expense:
For year ended December 31, 2001 $ 365,000
===========
Estimated amortization expense:
For year ended December 31, 2002 $ 1,460,398
For year ended December 31, 2003 $ 1,460,478
For year ended December 31, 2004 $ 1,460,478
For year ended December 31, 2005 $ 1,460,478
For year ended December 31, 2006 $ 1,095,478
3. INVENTORIES
At March 30, 2002 and December 31, 2001, inventories consisted of the following:
(Unaudited)
March 30, December 31,
2002 2001
----------- ------------
Raw materials . . . . . . . . . . . . . . . . . $11,308,503 $11,697,886
Work in progress. . . . . . . . . . . . . . . . 6,430,034 6,443,549
Finished goods. . . . . . . . . . . . . . . . . 5,043,864 5,153,181
----------- -----------
$22,782,401 $23,294,616
Reserves for slow moving and
obsolete inventory (1,430,850) (1,111,000)
----------- -----------
$21,351,551 $22,183,616
=========== ===========
8
4. SHORT-TERM AND LONG-TERM INVESTMENTS
Short-term investments at March 30, 2002 and December 31, 2001 consisted of
individual municipal bonds stated at cost, which approximated market value.
These securities have a maturity 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 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."
The estimated fair values of the Company's financial instruments are as follows:
(Unaudited)
March 30, December 31,
2002 2001
--------------------------- --------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
Financial assets:
Cash and cash equivalents . . . . . . . . $34,225,969 $34,225,969 $32,105,845 $32,105,845
Short-term and long-term investments. . . 4,682,176 4,645,076 6,639,323 6,658,247
----------- ----------- ----------- -----------
$38,908,145 $38,871,045 $38,745,168 $38,764,092
=========== =========== =========== ============
9
5. INCOME PER COMMON SHARE
Net income per share is calculated by dividing net income by the weighted
average number of common shares plus incremental common stock equivalent shares
(shares issuable upon exercise of stock options). Incremental common stock
equivalent shares are calculated for each measurement period based on the
treasury stock method, which uses the monthly average market price per share.
The calculation of net income per common and common equivalent shares follows
(unaudited):
--------------------------------------------------------------------------------
Three Months Three Months
Ended Ended
March 30, 2002 March 31, 2001
--------------------------------------------------------------------------------
Net income $ 1,512,814 $ 5,755,169
--------------------------------------------------------------------------------
Common and common equivalent shares:
Weighted average number of
common shares outstanding
during the period............................. 13,099,210 12,957,833
Common shares issuable upon exercise of
outstanding stock options:
Diluted.................................... 322,097 419,352
Common and common equivalent shares
outstanding during the period:
--------------------------------------------------------------------------------
Diluted.................................... 13,421,307 13,377,185
--------------------------------------------------------------------------------
Earnings per share data Net income per common
and common Equivalent shares:
Basic...................................... $ .12 $ .44
Diluted.................................... $ .11 $ .43
10
6. DEFERRED AND REFUNDABLE TAX ASSETS
The Company's current refundable tax assets as of December 31, 2001 included a
tax benefit of $1,396,736 resulting from the exercising of certain nonqualified
stock options by various directors, officers and other employees under the
Company's stock option programs during 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. During the first quarter of
2002, the Company received $900,000 in federal income tax refunds associated
with prior year taxes paid. It is anticipated that the remaining current
deferred and refundable tax assets will be substantially utilized in 2002 either
through refunds of prior year taxes paid or the elimination of income taxes due.
7. 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 the 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. 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. During the quarter
ended March 30, 2002, the Company purchased an additional 75,000 shares of the
Company's common stock under this program.
11
REVIEW REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of
Tollgrade Communications, Inc. and subsidiaries:
We have reviewed the accompanying condensed consolidated balance sheet of
Tollgrade Communications, Inc. and its subsidiaries as of March 30, 2002 and the
related condensed consolidated statement of operations for each of the
three-month periods ended March 30, 2002 and March 31, 2001 and the condensed
consolidated statement of cash flows for the three-month periods ended March 30,
2002 and March 31, 2001. These financial statements are the responsibility of
the Company's management.
We conducted our review in accordance with standards established by the American
Institute of Certified Public Accountants. A review of interim financial
information consists principally of applying analytical procedures to financial
data and making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in accordance
with generally accepted auditing standards, the objective of which is the
expression of an opinion regarding the financial statements taken as a whole.
Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to the accompanying condensed consolidated interim financial statements
for them to be in conformity with accounting principles generally accepted in
the United States of America.
We previously audited in accordance with auditing standards generally accepted
in the United States of America, the consolidated balance sheet as of December
31, 2001, and the related consolidated statements of operations, shareholders'
equity and of cash flows for the year then ended (not presented herein), and in
our report dated January 21, 2002 we expressed an unqualified opinion on those
consolidated financial statements. In our opinion, the information set forth in
the accompanying condensed consolidated balance sheet as of December 31, 2001,
is fairly stated in all material respects in relation to the consolidated
balance sheet from which it has been derived.
/s/ PricewaterhouseCoopers LLP
Pittsburgh, Pennsylvania
April 10, 2002
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF
OPERATIONS AND FINANCIAL CONDITION
The following discussion should be read in conjunction with the Condensed
Consolidated Financial Statements and Notes thereto appearing elsewhere in this
report.
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995.
The statements contained in 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:
o General economic conditions and the economic conditions of the
telecommunications industry;
o Customers' ability to meet established purchase forecasts and their own
growth projections;
o The ability of certain customers to maintain financial strength and access
to capital;
o 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);
o Customers' seasonal buying patterns and the risk of order cancellations;
o Risk of shortage of key manufacturing components and possibility of limited
source of supply;
o Manufacturing delays and availability of manufacturing capacity;
o Intense competition in all markets for the Company's products;
o Uncertain pace and scope of technological change along with the need to
continually develop new products and gain customer acceptance and approval;
o The Company's dependence on a relatively narrow range of products and a
small number of large customers;
o The Company's dependence on key employees and upon proprietary rights;
o Difficulties in managing the Company's growth;
o The Company's dependence upon certain suppliers;
o Risks of third party claims of infringement;
o Risk of product defects; and
o 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.
13
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
LoopCareTM 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 either reported separately or as part of the
Company's revenues attributable to test system products to which they
synergistically relate, while the revenues from existing and any new maintenance
contracts are reflected as part of the Company's Professional Services revenues.
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 associated with the various product categories, this information is not
considered sufficient for segment reporting purposes nor does the chief
operating decision maker make critical decisions or allocate assets based solely
on this information. 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 54% of the
Company's revenue for the first quarter ended March 30, 2002. The Company's MCU
product line 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
certain LoopCare software base code and developed enhancements, focuses on
helping local exchange carriers conduct the full range of fault diagnosis, along
with the ability to qualify, deploy and maintain next generation services that
include Digital Subscriber Line ("DSL") service and Integrated Services Digital
Network ("ISDN") service. The Company'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"). When used in an integrated
fashion, the DigiTest system permits local exchange carriers to perform a
complete array of central office testing including POTS, DSL line
prequalification, bridged tap detection, data rate prediction, and in-service
wideband testing. Sales of the DigiTest product line, accounted for
approximately 12% of the Company's revenue for the first quarter of 2002. Of
these DigiTest sales, approximately 5% included sales of related LoopCare
software.
14
The first quarter of 2002 included sales of the Company's Digital Access Unit
("DAU"). The DAU provides automated test access of locally non-switched, two
wire circuits and it helps facilitate the line sharing or the spectral
unbundling process for both incumbent (ILEC) and competitive local exchange
carriers (CLECs). Sales of this product line represented less than 1% of total
revenue for the current quarter.
The Company's LoopCare software products consist primarily of engineered
enhancements to the LoopCare base code software, which result in increased
connectivity and versatility of LoopCare within the customers' existing quality
assurance systems. Sales of stand-alone LoopCare software accounted for
approximately 15% of total first quarter 2002 revenue.
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 first quarter of 2002.
Through the first quarter of 2002, the Company continued to build upon and
extend its Services offering to customers. The cornerstone of the Company's
Professional Services offering is the Testability Improvement Initiatives. These
services may offer the customer the opportunity to make improvements in
testability levels, while training their own staffs in targeted geographic
regions over a defined period of time. In this way, the customers' internal
repair technicians can make use of automated systems to diagnose and repair
subscriber loop problems, thereby 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,
services revenue accounted for approximately 15% of the Company's revenue for
the first quarter ended March 30, 2002.
The Company's telecommunication product sales and services are primarily to the
four Regional Bell Operating Companies ("RBOCs") as well as major independent
telephone companies and to certain digital loop carrier ("DLC") equipment
manufacturers. For the first quarter ended March 30, 2002, approximately 74% of
the Company's total revenue was generated from sales to these four RBOCs. During
the first quarter of 2002, sales to three RBOCs (SBC, BellSouth and Verizon)
individually exceeded 10% of consolidated revenues and on a combined basis,
comprised approximately 71% (36.3%, 20.0% and 14.3%, respectively) of the
Company's net product sales. Due to the Company's present dependency on these
key customers, the loss of one or more of them as a customer or the reduction of
orders for the Company's products by them could materially and adversely affect
the Company.
The Company's operating results have fluctuated and may continue to fluctuate
as a result of various factors, including the timing of orders from, shipments
to, and acceptance of software by the RBOCs and significant independent
telephone companies. This timing is particularly sensitive
15
to various business factors within each of the RBOCs, including the RBOCs
relationships with their various organized labor groups. In addition, the
markets for the Company's products, specifically, LoopCare, DigiTest and
LIGHTHOUSE, 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 Company
believes the addition of the LoopCare software product line may provide further
opportunities to penetrate this market. The Company recorded its initial
LoopCare Software sale in the international market in the first quarter of 2002.
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 also 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 including its LoopCare Software 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.
16
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 in
production, marketing and research and development expenses and monitor, control
or decrease expense levels, as appropriate.
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 percentage
of revenues were 22.8% for the first quarter of 2002 compared to 12.0% for the
first quarter of 2001.
RESULTS OF OPERATIONS - FIRST QUARTER
REVENUES
Revenues for the first quarter of 2002 of $17,522,274 were $10,467,728, or
37.4%, lower than the revenues of $27,990,002 reported for the first quarter of
2001. The decrease in revenues for the first quarter of 2002 resulted from
slower deployments of the MCU product-line caused by the continuing budget
restrictions of the RBOCs. This decrease in sales of the MCU product line
resulted from decreased sales to all RBOCs, which is primarily associated with
slow-downs in capital spending programs to upgrade DLC systems within certain
regions with MCU technology. In addition, for similar reasons, Tollgrade OEM
resellers shipped fewer Digital Loop Carrier systems to their end customers,
which reduced MCU product sales to these customers. The first quarter of 2001
included shipments of $1,300,000 of Program Channel Units used to broadcast the
Winter Olympic Games from Salt Lake City, Utah; the first quarter of 2002 did
not contain any shipments of these special application products.
Sales of Tollgrade's DigiTest system products, which includes LoopCare software,
declined substantially between quarterly periods. Increases in sales of DigiTest
hardware and related LoopCare software to Sprint Canada and KPN Belgium were
more than offset by a substantial decline in sales of DigiTest hardware to
Nortel for international applications, and to Sprint USA as a result of the
discontinuation of their ION project. In addition, sales of the Company's DAU
product line declined between periods from the discontinuation of Sprint's ION
project.
The Company's first quarter 2002 Service revenues include $2,008,000 software
maintenance related to LoopCare. Professional Services revenue amounted to
$585,000 for the quarter, which related to installation oversight and project
management services. These services were provided to the Ameritech region of
SBC, with lesser amounts billed to Verizon and Bell South.
Periodic fluctuations in customer orders and backlog result from a variety of
factors, including but not limited to, the timing of significant orders from,
shipments to, and acceptance of software by the RBOCs, and are not necessarily
indicative of long-term trends in sales of the Company's products.
17
GROSS PROFIT
Gross profit for the first quarter of 2002 was $10,140,016 compared to
$15,715,719 for the first quarter of 2001, representing a decrease of
$5,575,703, or 35.5%. Gross profit as a percentage of revenues increased to
57.9% in the first quarter of 2002, compared to 56.1% in the same quarter last
year. The overall increase in gross profit as a percentage of sales resulted
primarily from higher margins associated with the sales of LoopCare software
products, offset by increased cost per unit sold due to substantially lower
hardware production, the product mix of hardware sales during the quarter
relative to last year and certain charges amounting to $563,000 for slow moving
inventory and inventory obsolescence and warranty items amounting to $250,000
during the first quarter of 2002. The Company's gross margin is and will
continue to be highly sensitive to the mix of products shipped.
SELLING AND MARKETING EXPENSE
Selling and marketing expense for the first quarter of 2002 was $2,417,309
compared to $2,449,824 for the first quarter of 2001. This decrease of $32,515,
or 1.3%, is primarily due to decreases in commissions and various promotions and
related marketing programs offset by increases caused by the addition of
LoopCare personnel. As a percentage of revenues, selling and marketing expenses
increased to 13.8% in the first quarter of 2002 from 8.8% in the first quarter
of 2001.
GENERAL AND ADMINISTRATIVE EXPENSE
General and administrative expense for the first quarter of 2002 was $1,526,251,
a decrease of $3,901, or 0.3%, from the $1,530,152 recorded in the first quarter
of 2001. Certain general reserves in the amount of $165,000 provided for by the
Company in 2001 were not required in 2002, however these decreases were offset
by an increase in salaries and wages in 2002 resulting from the addition of
administrative personnel and increased incentive compensation reserve
requirements. As a percentage of revenues, general and administrative expenses
increased to 8.7% in the first quarter of 2002 from 5.5% in the first quarter of
2001.
RESEARCH AND DEVELOPMENT EXPENSE
Research and development expense in the first quarter of 2002 was $3,994,641, an
increase of $635,100, or 18.9%, over the $3,359,541 recorded in the first
quarter of 2001. The increase is primarily associated with the addition of
approximately 29 engineering personnel added as a result of the LoopCare
acquisition along with other associated expenses. As a percentage of revenues,
research and development expense increased to 22.8% in the first quarter of 2002
from 12.0% in the first quarter of 2001.
INTEREST AND OTHER INCOME
Interest and other income consists of interest income in both quarterly periods.
For the first quarter of 2002, interest and other income was $237,999 compared
to $906,977 for the first quarter of 2001, representing a decrease of $668,978,
or 73.8%. This decrease is primarily a result of the decrease in funds available
for investments, as a direct result of the LoopCare acquisition for $62,029,000
in cash at the beginning of the fourth quarter of 2001.
PROVISION FOR INCOME TAXES
The provision for income taxes for the first quarter of 2002 was $927,000, a
decrease of $2,601,010 or 73.7%, from the $3,528,010 for the first quarter of
2001. The effective income tax rate for the
18
first quarter of 2002 was approximately 38.0% of pretax income, which is
consistent with the prior year.
NET INCOME AND EARNINGS PER SHARE
As a result of the above factors, net income for the first quarter of 2002 was
$1,512,814, a decrease of $4,242,355, or 73.7%, from the $5,755,169 recorded in
the first quarter of 2001. Basic and diluted earnings per common share of $.12
and $.11, respectively, for the first quarter of 2002 decreased by $.32 and
$.32, or 72.7% and 74.4%, from the $.44 and $.43, respectively, earned in the
first quarter of 2001. Basic and diluted weighted average common and common
equivalent shares outstanding were 13,099,210 and 13,421,307, respectively, in
the first quarter of 2002 compared to 12,957,833 and 13,377,185, respectively,
in the first quarter of 2001. As a percentage of revenues, net income for the
first quarter of 2002 decreased to 8.6% compared to the 20.6% for the first
quarter of 2001.
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. A
comprehensive review of these policies is contained in the Company's 2001 Annual
Report on Form 10-K filed on March 22, 2002. There have been no significant
changes in these policies or the application thereof during the first quarter of
2002.
LIQUIDITY AND CAPITAL RESOURCES
At March 31, 2002, the Company had working capital of $68,693,672, which
represented an increase of $1,065,521, or 1.6%, from the $67,628,151 of working
capital as of December 31, 2001. The increase in working capital is a result of
operating cash flows and proceeds from the exercise of stock options exceeding
requirements for purchase of property and equipment and approximately $1,625,000
of treasury stock.
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 March 30, 2002, the Company has repurchased 461,800 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 timing 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.
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
19
tangible net worth and a restriction on the amount of capital expenditures that
can be made on an annual basis, among others. Commitment fees are payable
quarterly at 0.25% of the unused commitment. As of March 30, 2002, there were no
outstanding borrowings under the Facility and the Company is in compliance with
all debt covenants. 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's days sales outstanding (DSO's) in accounts receivable trade, based
on the past twelve months rolling revenue, was 71 and 43 days as of March 30,
2002 and December 31, 2001, respectively. The increase is a direct result of the
timing of a substantial amount of revenue recognition including LoopCare
software product sales in the latter part of the first quarter of 2002. The
Company's inventory turnover ratio was 1.2 turns and 1.3 turns for March 30,
2002 and December 31, 2001, respectively. Management believes that operating
cash flow and cash reserves are adequate to finance currently planned capital
expenditures and to meet the overall liquidity needs of the Company.
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.
BACKLOG
The Company's backlog consists of firm customer purchase orders. As of March 31,
2002, the Company had an adjusted backlog of $8,119,432 compared to $4,936,448
at December 31, 2001 and $5,605,349 at March 31, 2001. The March 30, 2002
backlog includes approximately $6,434,356 related to software maintenance
contracts. This maintenance and support will be provided and billed for on a
straight-line basis throughout 2002. Including these scheduled maintenance
billings, approximately 47% of the current backlog is scheduled to be recognized
as revenue in the second quarter of 2002. Periodic fluctuations in customer
orders and backlog result from a variety of factors, including but not limited
to the timing of significant orders and shipments. While these fluctuations
could impact short-term results, they are not necessarily indicative of
long-term trends in sales of the Company's products.
20
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
The following exhibits are being filed with this report:
Exhibit
Number Description
------- -----------
15 Letter re unaudited interim financial information
21
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
TOLLGRADE COMMUNICATIONS, INC.
(REGISTRANT)
Dated: May 14, 2002 /S/ CHRISTIAN L. ALLISON
-------------------------------------
CHRISTIAN L. ALLISON
CHAIRMAN, PRESIDENT AND CHIEF EXECUTIVE OFFICER
Dated: May 14, 2002 /S/ SAMUEL C. KNOCH
-------------------------------------
SAMUEL C. KNOCH
CHIEF FINANCIAL OFFICER AND TREASURER
Dated: May 14, 2002 /S/ CHARLES J. SHEARER
-------------------------------------
CHARLES J. SHEARER
CONTROLLER
22
EXHIBIT INDEX
(Pursuant to Item 601 of Regulation S-K)
Exhibit
Number Description
------- -----------
15 Letter re unaudited interim financial information
23