------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC ------------------------------- FORM 10-Q (Mark One) [X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 28, 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 November 1, 2002, there were 13,552,736 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 61 pages. The exhibit index is on page 34. TOLLGRADE COMMUNICATIONS, INC. QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 28, 2002 TABLE OF CONTENTS PART I. FINANCIAL INFORMATION PAGE NO. - ------------------------------ -------- ITEM 1 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS: CONDENSED CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 28, 2002 AND DECEMBER 31, 2001 .........................................................................3 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE-MONTH AND NINE-MONTH PERIODS ENDED SEPTEMBER 28, 2002 AND SEPTEMBER 29, 2001 ...................................4 CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER'S EQUITY FOR THE THREE-MONTH AND NINE-MONTH PERIODS ENDED SEPTEMBER 28, 2002 AND SEPTEMBER 29, 2001 ........5 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE-MONTH PERIODS ENDED SEPTEMBER 28, 2002 AND SEPTEMBER 29, 2001..................................................6 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.......................................7 REPORT OF INDEPENDENT ACCOUNTANTS.........................................................14 ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION.......................................................................15 ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK................................27 ITEM 4 CONTROLS AND PROCEDURES...................................................................27 PART II. OTHER INFORMATION - --------------------------- ITEM 1 LEGAL PROCEEDINGS.........................................................................28 ITEM 2 CHANGES IN SECURITIES.....................................................................28 ITEM 3 DEFAULTS UPON SENIOR SECURITIES...........................................................28 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.......................................28 ITEM 5 OTHER INFORMATION.........................................................................28 ITEM 6 EXHIBITS AND REPORTS FILED ON FORM 8-K....................................................29 SIGNATURE...............................................................................................30 - --------- CERTIFICATIONS..........................................................................................31 - -------------- EXHIBIT INDEX...........................................................................................34 - ------------- 2 PART I. FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS SEPTEMBER 28, 2002 DECEMBER 31, 2001 * - -------------------------------------------------------------------------------------------------------------- ASSETS (UNAUDITED) CURRENT ASSETS: Cash and cash equivalents $ 33,056,359 $ 32,105,845 Short-term investments 13,945,043 6,489,323 Accounts receivable: Trade 10,893,693 9,296,551 Other 559,318 320,501 Inventories 16,169,767 22,183,616 Prepaid expenses and deposits 749,353 916,723 Refundable income taxes 873,9750 1,396,736 Deferred tax assets 1,393,580 1,116,756 - -------------------------------------------------------------------------------------------------------------- TOTAL CURRENT ASSETS 77,641,088 73,826,051 Long-term investments -- 150,000 Property and equipment, net 7,982,263 8,012,546 Deferred tax assets 2,867,715 2,812,987 Intangibles 38,500,000 38,500,000 Goodwill 16,161,763 16,161,763 Capitalized software costs, net 5,874,103 6,935,000 Other assets 262,146 231,614 ============================================================================================================== TOTAL ASSETS $ 149,289,078 $ 146,629,961 ============================================================================================================== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 171,939 $ 805,398 Accrued warranty 2,272,265 2,068,000 Accrued expenses 720,679 691,697 Accrued salaries and wages 725,582 329,126 Accrued royalties payable 107,174 397,451 Income taxes payable 1,355,936 1,433,554 Deferred income 939,731 472,674 - -------------------------------------------------------------------------------------------------------------- TOTAL CURRENT LIABILITIES 6,293,306 6,197,900 Deferred tax liabilities 1,194,033 293,477 - -------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES 7,487,339 6,491,377 Commitments and contingent liabilities -- -- Shareholders' equity: Common stock, $.20 par value; authorized shares, 50,000,000; issued shares, 13,552,736 and 13,513,119, respectively 2,710,547 2,702,624 Additional paid-in capital 70,394,275 70,010,254 Treasury stock, at cost, 461,800 and 386,800 shares, respectively (4,790,783) (3,164,975) Retained earnings 73,487,700 70,590,681 - -------------------------------------------------------------------------------------------------------------- TOTAL SHAREHOLDERS' EQUITY 141,801,739 140,138,584 ============================================================================================================== TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 149,289,078 $ 146,629,961 ------------------------------------------- * Amounts derived from audited financial statements The accompanying notes are an integral part of the condensed consolidated financial statements. 3 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) - ---------------------------------------------------------------------------------------------------------------------------- FOR THE FOR THE THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 28, SEPTEMBER 29, SEPTEMBER 28, SEPTEMBER 29, 2002 2001 2002 2001 - ---------------------------------------------------------------------------------------------------------------------------- REVENUES: Products $11,260,585 $15,077,227 $38,207,243 $63,718,147 Services 2,691,611 960,730 7,851,137 2,085,979 - ---------------------------------------------------------------------------------------------------------------------------- TOTAL REVENUES: 13,952,196 16,037,957 46,058,380 65,804,126 - ---------------------------------------------------------------------------------------------------------------------------- COST OF PRODUCT SALES: Products 5,645,694 7,158,355 16,577,424 28,057,498 Services 867,969 507,826 2,722,795 1,448,516 Amortization of intangibles 366,298 ----- 1,096,767 ----- - ---------------------------------------------------------------------------------------------------------------------------- 6,879,961 7,666,181 20,396,986 29,506,014 - ---------------------------------------------------------------------------------------------------------------------------- GROSS PROFIT: 7,072,235 8,371,776 25,661,394 36,298,112 - ---------------------------------------------------------------------------------------------------------------------------- Selling and marketing 2,162,734 2,022,930 6,804,876 6,965,250 General and administrative 1,216,570 1,019,748 4,011,415 3,612,046 Research and development 3,370,548 2,638,680 10,761,258 8,747,326 Severance and related expense ----- ----- ----- 400,000 - ---------------------------------------------------------------------------------------------------------------------------- TOTAL OPERATING EXPENSES 6,749,852 5,681,358 21,577,549 19,724,622 - ---------------------------------------------------------------------------------------------------------------------------- INCOME FROM OPERATIONS 322,383 2,690,418 4,083,845 16,573,490 Interest and other income, net 150,767 800,436 588,766 2,497,971 - ---------------------------------------------------------------------------------------------------------------------------- INCOME BEFORE INCOME TAXES 473,150 3,490,854 4,672,611 19,071,461 Provision for income taxes 179,798 1,361,000 1,775,592 7,383,012 - ---------------------------------------------------------------------------------------------------------------------------- NET INCOME $ 293,352 $ 2,129,854 $ 2,897,019 $11,688,449 ============================================================================================================================ EARNINGS PER SHARE INFORMATION: Weighted average shares of common stock and equivalents: Basic 13,090,936 13,065,809 13,096,496 13,017,819 Diluted 13,216,502 13,377,544 13,340,724 13,392,507 - ---------------------------------------------------------------------------------------------------------------------------- Net income per common and common equivalent shares: Basic $ .02 $ .16 $ .22 $ .90 Diluted $ .02 $ .16 $ .22 $ .87 ============================================================================================================================ The accompanying notes are an integral part of the condensed consolidated financial statements. 4 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 28, 2002 (Unaudited) ADDITIONAL PREFERRED COMMON STOCK PAID-IN TREASURY RETAINED SHARES AMOUNT SHARES AMOUNT CAPITAL STOCK EARNINGS TOTAL - ----------------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2001 ---- $ ---- 13,513,119 $ 2,702,624 $ 70,010,254 $ (3,164,975) $ 70,590,681 $ 140,138,584 Exercise Of common stock option ---- ---- 39,617 7,923 270,252 ---- ---- 278,175 Tax benefit from exercise of stock options ---- ---- ---- ---- 113,769 ---- ---- 113,769 Purchase of treasury stock ---- ---- ---- ---- ---- (1,625,808) ---- (1,625,808) Net Income ---- ---- ---- ---- ---- ---- 2,897,019 2,897,019 - ----------------------------------------------------------------------------------------------------------------------------------- Balance at September 28, 2002 ---- $ ---- 13,552,736 $ 2,710,547 $ 70,394,275 $ (4,790,783) $ 73,487,700 $ 141,801,739 - ----------------------------------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of the condensed consolidated financial statements. 5 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Nine Months Ended Sept. 28, 2002 Sept. 29, 2001 - ------------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 2,897,019 $ 11,688,449 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,820,998 1,738,537 Tax benefit from exercise of stock options 113,769 1,065,801 Refundable income taxes paid 522,761 8,417,270 Deferred income taxes 569,004 (268,523) Provision for losses on inventory 1,308,000 164,963 Provision for allowance for doubtful accounts 100,000 175,000 Changes in assets and liabilities: (Increase) decrease in accounts receivable-trade (1,697,142) 6,191,178 (Increase) decrease in accounts receivable-other (106,317) 438,392 Decrease in inventories 4,705,849 7,263,838 Decrease in prepaid expenses and deposits 167,370 391,314 Decrease in accounts payable (633,459) (1,645,462) Increase in accrued warranty 204,265 940,000 Increase (decrease) in accrued expenses and deferred income 363,539 (222,609) Increase (decrease) in accrued salaries and wages 396,456 (2,040,933) Decrease in accrued royalties payable (290,277) (803,240) Decrease in income taxes payable (77,618) (206,511) - ------------------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 11,364,217 33,287,464 - ------------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Redemption/maturity of investments 7,284,312 46,473,811 Purchase of investments (14,590,032) (27,822,448) Capital expenditures (1,729,818) (2,661,504) Purchase of treasury stock (1,625,808) -- Investments in other assets (30,532) (328,991) - ------------------------------------------------------------------------------------------------------------------------- Net cash used in investing activities (10,691,878) 15,660,868 - ------------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from exercise of stock options 278,175 1,058,210 - ------------------------------------------------------------------------------------------------------------------------- Net cash provided by financing activities 278,175 1,058,210 - ------------------------------------------------------------------------------------------------------------------------- Net increase in cash and cash equivalents 950,514 50,006,542 Cash and cash equivalents at beginning of period 32,105,845 30,423,783 - ------------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $ 33,056,359 $ 80,430,325 ========================================================================================================================= The accompanying notes are an integral part of the condensed consolidated financial statements 6 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements included herein have been prepared by Tollgrade Communications, Inc. (the "Company") in accordance with accounting principles generally accepted in the United States of America for interim financial information and Article 10 of Regulation S-X. The condensed consolidated financial statements as of and for the three-month and nine-month periods ended September 28, 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 Company management, all adjustments considered necessary for a fair presentation of the accompanying condensed consolidated financial statements have been included, and all adjustments are of a normal and recurring nature. Operating results for the three-month and nine-month periods ended September 28, 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 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 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 of approximately $16,162,000, 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 goodwill. The second step, used to measure 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. The 7 Company has determined that it has only one reporting segment and has completed the first step of the goodwill impairment test as of June 29, 2002 by comparing the aggregate market value of the Company's stock with its carrying value, including goodwill. This test indicated that there was no impairment of goodwill carrying value and, accordingly, step two of the test was not required. Future changes in circumstances, including a sustained decline in the aggregate market value of the Company's stock, could necessitate a reconsideration of whether an impairment of goodwill carrying value has occurred. Developed product software costs are being amortized over a five-year useful life. An annual review for impairment of these assets will be made following the guidance of SFAS 144. Specifically, the sum of the undiscounted future cash flows expected to be derived from the developed product software will be compared with the carrying value. If the carrying value is greater than the sum of the projected cash flows, an impairment loss will be recorded equal to the excess of the carrying value over the fair value of the assets. The fair value will be determined by a separate test utilizing the discounted present value of the expected cash flow stream from the software. In addition, other intangible assets that are not subject to amortization will 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 will consist of a comparison of the fair value of an intangible asset with its carrying amount. The Company intends to test the value of intangible assets other than goodwill as of December 31, 2002 using the same testing methodology employed by independent consultants in making the initial valuation in 2001. Specifically, the relief-from-royalty method will be used to test the value of the LoopCare trade name and discounted cash flow analyses will be used to value the base software and post warranty maintenance service agreements. The Company is currently in the process of negotiating the renewal of three of its four RBOC LoopCare software maintenance agreements, which expire on December 31, 2002. One of these customers has notified the Company of its desire to negotiate a need based, time and materials fee instead of the fixed maintenance fee arrangement. The Company has agreed to negotiate in good faith towards this type of arrangement but fully intends to maintain the value of this contract, as well as the other contracts renewing at the end of December. Therefore, at this point, the Company believes the value and non-amortizing characteristics of this intangible asset to be preserved. However, if through negotiations, new maintenance agreements with one or more RBOC customers cannot be reached, or if one or more new agreements are reached that are believed will result in less revenue to the Company than the current fixed fee agreements, the current fair value of the maintenance service agreements may be determined to be less than the $32,000,000 carrying value, perhaps materially so, resulting in a charge against operating income for 2002 and/or commencement of amortization of the remaining fair value over its determined useful life. 8 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 third quarter and first nine months of 2002, which included the LoopCare operations: (In thousands, Except per Share Data) Three Months Ended Nine Months Ended Historical Proforma Historical Proforma Sept. 28, 2002 Sept. 29, 2001 Sept. 28, 2002 Sept. 29, 2001 -------------- -------------- -------------- -------------- Revenues $13,952 $19,386 $46,058 $75,848 - -------------------------------------------------------------------------------------------------- Income from operations 322 3,752 4,084 19,759 - -------------------------------------------------------------------------------------------------- Net income 293 2,614 2,897 13,140 - -------------------------------------------------------------------------------------------------- Net income per share: - -------------------------------------------------------------------------------------------------- Diluted $ 0.02 $ 0.20 $ 0.22 $ 0.98 The proforma results of operations for the three months and nine-months ended September 29, 2001 reflected above include one-fourth and three-fourths, respectively, 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 estimated by reducing interest income at historical earning rates for working capital deemed to have been available to apply to the acquisition costs and estimating 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 September 28, 2002 ------------------------ Gross Carrying Accumulated Amount Amortization ---------------------------------- Amortized intangible assets: Developed product software $ 7,335,870 $1,461,767 =========== ========== 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 9 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 $1,463,082 For year ended December 31, 2003 $1,467,174 For year ended December 31, 2004 $1,467,174 For year ended December 31, 2005 $1,467,174 For year ended December 31, 2006 $1,102,174 Actual amortization expense: For the nine-month period ended September 29, 2001 $ -0- For the nine-month period ended September 28, 2002 $ 1,096,767 Actual net income: For the nine-month period ended September 29, 2001 $11,688,449 For the nine-month period ended September 28, 2002 $ 2,897,019 3. INVENTORIES At September 28, 2002 and December 31, 2001, inventories consisted of the following: (Unaudited) September 28, December 31, 2002 2001 ----------- ----------- Raw materials........................ $ 10,538,442 $ 11,697,886 Work in progress..................... 4,975,820 6,443,549 Finished goods....................... 3,074,505 5,153,181 ----------- ----------- $ 18,588,767 $ 23,294,616 Reserves for slow moving and obsolete inventory................ (2,419,000) (1,111,000) ----------- ----------- $ 16,169,767 $ 22,183,616 ===========- =========== 10 4. SHORT-TERM AND LONG-TERM INVESTMENTS Short-term investments at September 28, 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) September 28, December 31, 2002 2001 ----------------------------------- ---------------------------------- Fair Carrying Carrying Fair Amount Value Amount Value ------------ ------------ ----------- ------------ Financial assets: Cash and cash equivalents...................... $33,056,359 $33,056,359 $32,105,845 $32,105,845 Short-term and long-term investments........... 13,945,043 13,874,775 6,639,323 6,658,247 ------------ ------------ ----------- ------------ $47,001,402 $46,931,134 $38,745,168 $38,764,092 =========== =========== =========== =========== 11 5. INCOME PER COMMON SHARE Net income per share is calculated by dividing net income by the weighted average number of common shares plus incremental common stock equivalent shares (shares issuable upon exercise of stock options). Incremental common stock equivalent shares are calculated for each measurement period based on the treasury stock method, which uses the monthly average market price per share. The calculation of net income per common and common equivalent shares follows (unaudited): - ----------------------------------------------------------------------------------------------------------------------------------- Three Months Three Months Nine Months Nine Months Ended Ended Ended Ended September 28, 2002 September 29, 2001 September 28, 2002 September 29, 2001 - ----------------------------------------------------------------------------------------------------------------------------------- Net income $ 293,352 $ 2,129,854 $ 2,897,019 $11,688,449 - ----------------------------------------------------------------------------------------------------------------------------------- Common and common equivalent shares: Weighted average number of common shares outstanding during the period ........................ 13,090,936 13,065,809 13,096,496 13,017,819 Common shares issuable upon exercise Of outstanding stock options: Diluted ............................... 125,566 311,735 244,228 374,688 Common and common equivalent shares Outstanding during the period: - ----------------------------------------------------------------------------------------------------------------------------------- Diluted ............................... 13,216,502 13,377,544 13,340,724 13,392,507 =================================================================================================================================== Earnings per share data Net income per common and common Equivalent shares: Basic ................................. $ .02 $ .16 $ .22 $ .90 Diluted ............................... $ .02 $ .16 $ .22 $ .87 =================================================================================================================================== 12 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 nonqualified stock options 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 and third quarter of 2002, the Company received $900,000 and $331,000, respectively, in federal income tax refunds associated with prior year taxes paid. The remaining current federal refundable tax assets consist primarily of estimated tax payments for 2002 which will be substantially utilized in early 2003 either through refunds from taxing agencies or applied to estimated taxes for 2003. 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. No additional shares were repurchased through the third quarter of 2002. 8. ACCOUNTING PRONOUNCEMENTS In June 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 146, "Accounting For Costs Associated With Exit Or Disposal". SFAS No. 146 nullifies Emerging Tax Issues Task Forces (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)". The new Statement requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The Company does not believe that this statement will have an effect on the Company. 13 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Tollgrade Communications, Inc. and subsidiaries: We have reviewed the accompanying condensed consolidated balance sheet of Tollgrade Communications, Inc. and its subsidiaries as of September 28, 2002 and the related condensed consolidated statements of operations for each of the three-month and nine-month periods ended September 28, 2002 and September 29, 2001 and the condensed consolidated statement of cash flows for the nine-month periods ended September 28, 2002 and September 29, 2001 and the statements of changes in shareholders' equity for the nine-month period ended September 28, 2002. 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 October 14, 2002 14 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. This Quarterly Report on Form 10-Q contains statements relating to future events that are considered "forward-looking statements." These statements, which may be expressed in a variety of ways, including the use of future or present tense language, relate to, among other things, projected cash flows used in the valuation of intangible assets, the anticipated results of negotiations for new maintenance service agreements, as well as purchase orders and other customer purchase agreements, the ability to utilize current deferred and refundable tax assets, opportunities which the Company's professional services offer to customers, the potential loss of certain customers, the timing of orders from customers, the effect of consolidations in the markets to which the Company sells, the effects of the economic slowdown in the telecommunications industry, the possibility of future provisions for slow moving inventory, and the effect on earnings and cash flows of changes in interest rates. These forward-looking statements, and other forward-looking statements contained in other public disclosures of the Company which make reference to the cautionary factors contained in this Report, are based on assumptions that involve risks and uncertainties and are subject to change based on the considerations described below. The Company does not undertake any obligation to publicly update any forward-looking statements. General economic conditions and the economic conditions of the telecommunications industry, including the effect of subscriber line loss and competition for the Company's RBOC customers from wireless, cable providers and other carriers entering the local telephone service market can and have affected the capital budgets of the Company's customers. If such conditions result in a further reduction of such budgets, the Company's revenues can be adversely affected. If the Company's customers find themselves unable to meet their established purchase forecasts and their own growth projections, such customers may curtail their purchase of the Company's products, which would adversely affect the Company's revenues. If the financial strength of certain of the Company's major customers should deteriorate or such customers encounter difficulties in accessing capital, the ability of such customers to purchase and pay for the Company's products could be impaired, with a corresponding adverse effect on the Company's revenues. If third parties with whom the Company has entered into sales and marketing partnerships should fail to meet their own performance objectives or (in some cases) prove unable to continue to provide vendor financing to certain local exchange carriers, customer demand for the Company's products could be adversely affected, which would have an adverse effect on the Company's revenues. Seasonal fluctuations in customer demand for the Company's products can create corresponding fluctuations in period to period revenues, and any increases in the rate of order cancellation by customers could adversely affect future revenues. The carrying value of certain intangible assets, including goodwill, acquired by the Company from Lucent Technologies, Inc. ("Lucent") could be impaired if changing market conditions indicate that lower than anticipated cash flows will be produced by such intangible assets. If the Company were to encounter a shortage of key manufacturing components from limited sources of supply, or experience manufacturing delays caused by reduced manufacturing capacity, loss of key assembly 15 subcontractors or other factors, the Company's ability to produce and ship its manufactured products could be adversely affected, with an adverse effect upon revenues. The introduction of improved products or services or reduced prices by the Company's competitors could reduce the demand for the Company's products and services and adversely affect revenues. If the Company proves unable to respond effectively to technological change in its industry, such as an evolution of the telephone network from circuit to packet-based, by developing new products and services and obtaining customer approval and acceptance of its products and services, demand for the Company's products and services could be adversely affected, which would adversely affect revenues. The Company is dependent on a relatively narrow range of products and a small number of large customers. As a result, the failure of one or a small number of the Company's products to gain or maintain acceptance in the marketplace, or the decision by one or a few of the Company's customers to curtail their purchases of the Company's products could have an adverse effect on revenues. If one or more of a small number of key employees of the Company were to cease to be associated with the Company, the Company's future results could be adversely affected. If the Company is unable to successfully assert and defend its proprietary rights in the technology utilized in its products, its future results could be adversely affected. If third parties were able to successfully assert that the Company's use of technology infringed upon the proprietary rights of others, the future results of the Company could be adversely affected. If one or more of the Company's products were to prove defective, the Company's relationships with its customers could be jeopardized and the Company could be subject to potential liability, adversely affecting the Company's future results. If for any reason demand for the Company's products should continue to decrease, including the successful development of a secondary market for the Company's products by a third party, the Company could continue to find itself with excess inventory and obsolescent parts on hand, which could adversely affect future results. Changes in government regulation, such as modification or repeal of The Telecommunications Act of 1996, increasing the costs of doing business by the Company or its customers, or preventing the Company or its customers from engaging in business activities they may wish to conduct could adversely affect the Company's future results. 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. 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 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 and as a competitive defense to protect the Company's MCU(R) and DigiTest products market share. 16 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 product line, which includes POTS line testing as well as alarm-related products, represented approximately 32% of the Company's revenue for the third quarter ended September 28, 2002. The Company's MCU product line is expected to continue to account for a substantial portion of the Company's revenues. The Company's DigiTest centralized network test system platform, which includes certain LoopCare software base code and developed enhancements, focuses on helping local exchange carriers conduct the full range of fault diagnosis, along with the ability to qualify, deploy and maintain next generation services that include Digital Subscriber Line ("DSL") service and Integrated Services Digital Network ("ISDN") service. The Company'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 30% of the Company's revenue for the third quarter of 2002. The Company's Digital Access Unit ("DAU") provides automated test access of locally non-switched, two wire circuits and helps facilitate the line sharing or the spectral unbundling process for both incumbent (ILEC) and competitive local exchange carriers (CLEC). Although sales of the DAU have been significant in prior periods, 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 5% of total third quarter 2002 revenue. During the third quarter of 2002, the Company completed its first major central office test system upgrade package delivery, which included hardware resale and services. This project contributed approximately 7% of revenues for the quarter. 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 head-end 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 6% of the Company's revenue for the third quarter of 2002. 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. The services business was considerably expanded upon the acquisition of software maintenance contracts related to the LoopCare software product line. Effective October 11, 2002, however, an RBOC canceled a significant network testability services initiative which had accounted for revenue of approximately $980,000 17 for the nine months ended September 28, 2002. The cancellation could also adversely affect sales of MCU products that are driven by these testability programs. Including the software maintenance revenues, services revenue accounted for approximately 19% of the Company's revenue for the third quarter ended September 28, 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 third quarter ended September 28, 2002, approximately 79% of the Company's total revenue was generated from sales to these four RBOCs. During the third quarter of 2002, sales to two RBOCs (SBC and Verizon) individually exceeded 10% of consolidated revenues and on a combined basis, comprised approximately 67% (53.0% and 14%, respectively) of the Company's net sales. Although not 10% customers in the current quarter, in past periods Bell South and Qwest have been 10% customers. Due to the Company's present dependency on these key customers including Bell South and Qwest, the potential loss of one or more of them as a customer or the reduction of orders for the Company's products by them could materially and adversely affect the Company. The Company's operating results have fluctuated and may continue to fluctuate as a result of various factors, including the timing of orders from, shipments to, and acceptance of software by the RBOCs and significant independent telephone companies. This timing is particularly sensitive to various business factors within each of the RBOCs, including the RBOCs relationships with their various organized labor groups and an increasing tendency for the RBOCs to place large orders for shipment of hardware and software toward the end of a quarter. In addition, the markets for the Company's products, specifically, LoopCare, DigiTest and LIGHTHOUSE, are highly competitive. Although not yet completed, the acquisition of AT&T, one of the Company's primary LIGHTHOUSE customers, by Comcast may adversely affect sales of product to that customer. 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. As stated earlier, there is an increasing trend, in response to some of these discounting programs, for these customers to place large bulk orders toward the end of a quarter for shipment of large quantities of hardware and software in the last month of the quarter. Although the Company will continue to strive to meet the demands of its customers, which include delivery of quality products at an acceptable price and on acceptable terms, there 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. International sales in the third quarter ended September 28, 2002 were approximately 8% of total revenues and the Company believes that certain international markets may offer further opportunities. The addition of the LoopCare software product line has enhanced the Company's ability to penetrate this market. The Company 18 recorded its initial LoopCare software sale in the international market in the first quarter of 2002 with two additional sales in each of the second and third quarters of 2002. The Company also recorded a large international sale of LoopCare software bundled with DigiTest products during the third 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 are found internationally which do not exist in the Company's domestic markets. These factors, when combined, have made entrance into these international markets very difficult. From time to time, the Company has utilized the professional services of various marketing consultants to assist in defining the Company's international market opportunities. With the assistance of these consultants and through direct marketing efforts by the Company, it has been determined that its present MCU technology offers limited opportunities in certain international markets for competitive and other technological reasons. The Company continues to actively pursue opportunities for its other products including its LoopCare Software products in international markets. 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. In addition, Lucent Technologies announced recently that it is freezing its efforts relating to DSL services, which may have an adverse effect on the Company's deployment of LoopCare internationally through the Lucent OEM channel. Further, the international markets introduce the risk of loss from currency fluctuations. While the Company endeavors to price its products in U. S. dollars, this may not always be possible. Many International customers are also small and undercapitalized presenting possible exposure to credit losses to a greater degree than domestic customers. The Company believes that its future growth will be affected as a result of the economic slowdown in the telecommunications industry whereby established RBOC and large ILEC customers continue to reduce their capital and operating expense budgets with direct impact on ordering patterns and quantities. The Company believes that the RBOC and large ILEC customers are being adversely affected by deteriorating line growth and the after-effects of overspending in 1999 and 2000, as well as by competition from cable and wireless carriers and other carriers entering the local telephone service market. In addition, certain emerging carriers are continuing to be hampered by financial instability caused in large part by a lack of access to capital. 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 also 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 24% for the third quarter of 2002 compared to 17% for the third quarter of 2001. Future operating results may also be affected by anticipated higher renewal premiums for directors and officers liability insurance The Company is currently negotiating such premium renewals with several companies. The risk exists that the Company could be required to reduce its existing coverage to maintain affordability of this coverage. 19 RESULTS OF OPERATIONS - THIRD QUARTER REVENUES Revenues for the third quarter of 2002 of $13,952,196 were $2,085,761, or 13%, lower than the revenues of $16,037,957 reported for the third quarter of 2001, despite the inclusion of LoopCare revenues in the 2002 period which were not available in 2001. The revenue performance by product line for the third quarter of 2002 compared to the prior year period follows. The decrease in revenues for the third quarter of 2002 is due primarily to slower deployments of the MCU product-line caused by the continuing budget restrictions of the RBOCs, as well as to the effects of subscriber line loss and diminishing DLC deployment. Sales of the MCU product line decreased from three RBOCs as a result of slow-downs in capital spending programs to upgrade DLC systems within certain regions with MCU technology. Further, as the product life cycle for the MCU product continues to mature, there is a continuing possibility that customer requirements for certain legacy MCU products may be satisfied at some point. Sales of the Company's core MCU products were $4,551,000 for the third quarter of 2002, a decrease of $7,965,000 from the year earlier period. MCU sales comprised 32.6% of total third quarter 2002 revenues compared to 78.0% for the year earlier quarter. Sales of Tollgrade's DigiTest system products, which include LoopCare software, increased substantially between quarterly periods due to a major centralized test head replacement and augmentation program at an RBOC. Sales of DigiTest products of $4,132,000 included LoopCare revenues which were not available in the year earlier quarter and represented 29.6% of total revenue for the current quarter compared to 4% for the year earlier quarter. Sales of the Company's DAU product line, which accounted for 6.4% of revenue in the third quarter of 2001, were not significant during the third quarter 2002. Sales of LoopCare software products of $686,000 in the third quarter of 2002 were made to RBOC customers and certain international customers. This included the first sale to an RBOC of the Company's Interactive Voice Response system, developed for its LoopCare product. The Company acquired this product line from Lucent Technologies, Inc. on September 30, 2001 and thus had no comparable sales in the third quarter of 2001. These sales comprised 4.9% of total revenues during the third quarter of 2002. During the third quarter of 2002, the Company recognized sales of $977,000 or 7.0% of revenues from its first major central office test system upgrade package delivery, which included hardware resale and services. The Company's third quarter 2002 service revenues were $2,691,000, which represents 19.3% of total quarterly revenue and an increase of $1,730,000 over the third quarter of 2001. The increase is due to the inclusion of $1,934,000 from software maintenance and services related to the new LoopCare product line. The balance of professional services revenue relates to installation oversight and project management services. Service revenues were provided primarily to RBOC customers. LIGHTHOUSE cable product sales of $790,000 decreased $131,000 or 14.2% from the prior year's quarter, however, the Company benefited from higher sales to AT&T BIS. Sales of LIGHTHOUSE cable status monitoring system products amounted to 5.7% of total third quarter 2002 revenue. Periodic fluctuations in customer orders and backlog result from a variety of factors, including but not limited to, the timing of significant orders from, shipments to, and acceptance of software by the RBOCs, and are not necessarily indicative of long-term trends in sales of the Company's products. 20 GROSS PROFIT Gross profit for the third quarter of 2002 was $7,072,235 compared to $8,371,776 for the third quarter of 2001; a decrease of $1,299,541 or 15.5%. Gross profit as a percentage of revenues decreased to 50.7% in the third quarter of 2002 compared to 52.2% in the same quarter last year. The decrease in gross profit as a percentage of sales resulted primarily from 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 $751,000 provided for slow moving inventory, partially offset by higher margins associated with the sales of LoopCare software products. The provisions for inventory were due in part to LIGHTHOUSE cable products and the general slowdown in sales and production. The Company will continue to monitor and aggressively manage its inventory stock, but no assurances can be made that further provisions for slow moving inventory will not be required. The Company's gross margin is and will continue to be highly sensitive to the mix of products shipped, the level of operations and the level of reserves required for slow moving and obsolete inventory should current difficult economic conditions persist. SELLING AND MARKETING EXPENSE Selling and marketing expense for the third quarter of 2002 was $2,162,734 compared to $2,022,930 for the third quarter of 2001. The increase of $139,804 or 6.9% is primarily due to the addition of personnel and consulting expenses of the LoopCare operations. As a percentage of revenues, selling and marketing expenses increased to 15.5% in the third quarter of 2002 from 12.6% in the third quarter of 2001. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expense for the third quarter of 2002 was $1,216,570, an increase of $196,822, or 19.3% from the $1,019,748 recorded in the third quarter of 2001. The increase is attributable to the addition of LoopCare and other personnel and higher general and health insurance costs. As a percentage of revenues, general and administrative expenses increased to 8.7% in the third quarter of 2002 from 6.4% in the third quarter of 2001. RESEARCH AND DEVELOPMENT EXPENSE Research and development expense in the third quarter of 2002 was $3,370,548, an increase of $731,868 or 27.7% over the $2,638,680 recorded in the third quarter of 2001. The increase results from the addition of approximately 29 LoopCare engineering personnel and related expenses, partially offset by reductions in temporary labor and consulting expenses. As a percentage of revenues, research and development expense increased to 24.2% in the third quarter of 2002 from 16.5% in the third quarter of 2001. INTEREST AND OTHER INCOME Interest and other income consists of interest income in both quarterly periods. Interest income was $150,767 in the third quarter of 2002 compared to $800,436 for the third quarter of 2001, a decrease of $649,669, or 81.2%. This decrease results from the decrease in funds available for investment due to the LoopCare acquisition for $62,029,000 in cash at the beginning of the fourth quarter of 2001 and the general decline in interest rates. PROVISION FOR INCOME TAXES The provision for income taxes for the third quarter of 2002 was $179,798, a decrease of $1,181,202 or 76.8% from the $1,361,000 recorded for the third quarter of 2001. The effective income tax rate for both periods was approximately 38% of pretax income. NET INCOME AND EARNINGS PER SHARE As a result of the above factors, net income for the third quarter of 2002 was $293,352, a decrease of $1,836,502 or 86.2% from the $2,129,854 recorded in the third quarter of 2001. Basic and diluted earnings per common share of $.02 for the third quarter of 2002 decreased by $.14 or 87.5% from the $.16 earned in the third quarter of 2001. Basic and diluted weighted average common and common equivalent shares outstanding were 21 13,090,936 and 13,216,502, respectively, in the third quarter of 2002 compared to 13,065,809 and 13,377,544, respectively, in the third quarter of 2001. As a percentage of revenues, net income for the third quarter of 2002 decreased to 2.1% compared to 13.3% for the third quarter of 2001. RESULTS OF OPERATIONS YEAR-TO-DATE REVENUES For the first nine months of 2002, revenues were $46,058,380 compared to $65,804,126 for the first nine months of 2001, a decrease of $19,745,746, or 30.0%, despite the inclusion of LoopCare revenues in the 2002 period which were not available in 2001. The revenue performance by product line for the first nine months of 2002 compared to the prior year period follows. Revenues for the first nine months of 2002 decreased from the prior year period primarily due to reduced deployments of the MCU product line caused by the continuing budget restrictions of the RBOCs as well as from the effects of subscriber line loss and diminishing DLC deployment. The decrease in sales of the MCU product line resulted from decreased sales to all RBOCs, which is primarily associated with slowdowns in capital spending programs to upgrade DLC systems within certain regions with MCU technology. Further, as the product life cycle for the MCU product continues to mature, there is a continuing possibility that customer requirements for certain legacy MCU products may be satisfied at some point. For similar reasons, the Company's OEM resellers shipped fewer Digital Loop Carrier systems to their end customers, which reduced MCU product sales to these customers. Sales of the Company's core MCU products, which decreased by $25,518,000 to $21,610,000 between the nine month periods, comprised 46.9% of total revenue for the first nine months of 2002 compared to 71.6% for the year earlier period. Sales of Tollgrade's DigiTest system products in 2002, which include LoopCare software, declined by $3,105,000 to $6,650,000 between nine month periods despite the inclusion of LoopCare revenues in the 2002 period which were not available in 2001. This decrease is due to a lack of sales of DigiTest hardware to Nortel for international applications and a decline in sales to Sprint USA as a result of the discontinuation of its ION project. The declines from these customers were offset in part by sales in the third quarter of 2002 resulting from a major centralized test head replacement and augmentation program at an RBOC. Sales of DigiTest products represented 14.4% of total revenue for the first nine months of 2002. Sales of the Company's DAU product line, which accounted for 6.1% of revenues in the first nine months of 2001, were not significant during the first nine months of 2002 as a result of the discontinuation of Sprint's ION project. Sales of stand alone LoopCare software products of $6,148,000 for the first nine months of 2002 were made primarily to RBOC customers and certain international customers. The Company acquired this product line from Lucent Technologies, Inc. on September 30, 2001 and thus had no comparable sales in the first nine months of 2001. These sales comprised 13.3% of total revenues during the first nine months of 2002. During the first nine months of 2002, the Company recognized sales of $977,000 or 2.1% of revenues from its first major central office test system upgrade package delivery, which included hardware resale and services. The Company's service revenues for the first nine months of 2002 were $7,850,000 and 17.0% of total nine month revenue, which is an increase of $5,764,000 over the similar period in 2001. The increase is due to the inclusion of $5,832,000 from software maintenance related to the new LoopCare product line. The balance of professional services revenue relates to installation oversight and project management services. Service revenues were provided primarily to RBOC customers. 22 LIGHTHOUSE cable product sales were $2,456,000 during the first nine months of 2002, a decrease of 10.7% or $293,000 from the prior year period. Cable sales amounted to 5.3% of total revenue for the first nine months of 2002. GROSS PROFIT Gross profit for the first nine months of 2002 was $25,661,394 compared to $36,298,112 for the first nine months of 2001, resulting in a decrease of $10,636,718 or 29.3%. Gross profit as a percentage of revenues increased to 55.7% in the first nine months of 2002, compared to 55.2% in the same period last year. The 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 period relative to the previous period and $2,049,000 provided for slow moving and obsolete inventory and $254,000 for warranty items. The increase in slow moving and obsolete inventory were due in large part to LIGHTHOUSE cable inventory, products manufactured by Tollgrade for OEM partners who have seen substantial declines in business levels as a result of current difficult market conditions and due to the general decline in sales and production. The Company will continue to monitor and aggressively manage its inventory stock, but no assurances can be made that further provisions for slow moving inventory will not be required. The Company's gross margin is and will continue to be highly sensitive to the mix of products shipped, the level of operations and the level of reserves required for slow moving and obsolete inventory should current difficult economic conditions persist. SELLING AND MARKETING EXPENSE Selling and marketing expense for the first nine months of 2002 was $6,804,876 compared to $6,965,250 for the nine months of 2001. This decrease of $160,374 or 2.3% is primarily due to decreases in commissions, consulting fees 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 14.8% in the first nine months of 2002 from 10.6% in the same period last year. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expense for the first nine months of 2002 was $4,011,415, an increase of $399,369 or 11.1% from the $3,612,046 recorded in the first nine months of 2001. The increase is partially mitigated by a reduction in force undertaken by the Company in April 2001. The increase is attributable to the addition of LoopCare and other personnel, higher general insurance costs and higher professional services expenses. As a percentage of revenues, general and administrative expenses increased to 8.7% in the third quarter of 2002 from 5.5% in the same period of 2001. RESEARCH AND DEVELOPMENT EXPENSE Research and development expense for the first nine months of 2002 was $10,761,258, an increase of $2,013,932 or 23.0% over the $8,747,326 recorded in the first nine months of 2001. The increase results from the addition of approximately 29 LoopCare engineering personnel and related expenses, increased facilities expense associated with the Bridgewater office and increased software maintenance expense, partially offset by reduced materials and supplies expenditures. As a percentage of revenues, research and development expense increased to 23.4% in the first nine months of 2002 from 13.3% in the similar period of 2001. SEVERANCE AND RELATED EXPENSE On April 19, 2001, the Company announced a cost realignment initiative. The restructuring program resulted in workforce reduction charges of $400,000 which are separately stated in the Company's accompanying Condensed Consolidated Statements of Operations in the second quarter of 2001. These costs represent 23 estimates for severance and related benefits for the termination of approximately 80 employees, as well as exit costs consisting of consulting and legal fees. INTEREST AND OTHER INCOME Interest and other income consists of interest income in both nine month periods. For the first nine months of 2002, interest was $588,766 compared to $2,497,971 for the first nine months of 2001, a decrease of $1,909,205, or 76.4%. This decrease results from the decrease in funds available for investment due to the LoopCare acquisition for $62,029,000 in cash at the beginning of the fourth quarter of 2001 and the general decline in interest rates. PROVISION FOR INCOME TAXES The provision for income taxes for the first nine months of 2002 was $1,775,592, a decrease of $5,607,420 or 76.0% from the $7,382,012 recorded for the first nine months of 2001. The effective income tax rate for both periods was approximately 38% of pretax income. NET INCOME AND EARNINGS PER SHARE As a result of the above factors, net income for the first nine months of 2002 was $2,897,019, a decrease of $8,791,430, or 75.2%, from the $11,688,449 recorded in the first nine months of 2001. Basic and diluted earnings per common share of $.22 for the first nine months of 2002 decreased by $.68 and $.65, or 75.6% and 74.7%, from the $.90 and $.87, respectively, earned in the first nine months of 2001. Basic and diluted weighted average common and common equivalent shares outstanding were 13,096,496 and 13,340,724, respectively, for the first nine months of 2002 compared to 13,017,819 and 13,392,507 respectively, in the first nine months of 2001. As a percentage of revenues, net income for the first nine months of 2002 decreased to 6.3% compared to 17.8% for the first nine months of 2001. 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. CRITICAL ACCOUNTING POLICIES The Company's financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. Certain of these accounting principles are more critical than others in gaining an understanding of the basis upon which the Company's financial statements have been prepared. In addition to those policies discussed elsewhere in this report, 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 third quarter of 2002. LIQUIDITY AND CAPITAL RESOURCES The Company had working capital of $71,347,782 as of September 28, 2002, an increase of $3,719,631 or 5.5%, 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, the deferral of tax liabilities and proceeds from the exercise of stock options exceeding cash requirements for the 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 initiated 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 September 28, 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 24 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 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 September 28, 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) in accounts receivable trade, based on the past twelve months rolling revenue, was 66 and 43 days as of September 28, 2002 and December 31, 2001, respectively. The DSO increased as a result of a higher level of sales occurring later into the quarter ended September 28, 2002. The Company's inventory turnover ratio was 1.3 turns at both September 28, 2002 and December 31, 2001. 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. OTHER MATTERS On September 30, 2001, the Company acquired certain assets and assumed certain liabilities of the LoopCare 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 was 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 of approximately $16,162,000, 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 goodwill. The second step, used to measure 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. The Company has determined that it has only one reporting segment and has completed the first step of the goodwill impairment test as of June 29, 2002 by comparing the aggregate market value of the Company's stock with the Company's book carrying value, including goodwill. This test indicated that there was no impairment of goodwill carrying value and, accordingly, step two of the test was not required. Future changes in circumstances, including a sustained decline in the aggregate market value of the Company's stock, could necessitate a reconsideration of whether an impairment of goodwill carrying value has occurred. 25 Developed product software costs are being amortized over a five-year useful life. An annual review for impairment of these assets will be made following the guidance of SFAS 144. Specifically, the sum of the undiscounted future cash flows expected to be derived from the developed product software will be compared with the net book carrying value. If the carrying value is greater than the sum of the projected cash flows, impairment loss will be recorded equal to the excess of the carrying value over the fair value of the assets. The fair value will be determined by a separate test utilizing the discounted present value of the expected cash flow stream from the software. In addition, other intangible assets that are not subject to amortization will 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 will consist of a comparison of the fair value of an intangible asset with its carrying amount. The Company intends to test the value of intangible assets other than goodwill as of December 31, 2002 using the same testing methodology employed by independent consultants in making the initial valuation in 2001. Specifically, the relief-from-royalty method will be used to test the value of the LoopCare trade name and discounted cash flow analyses will be used to value the base software and post warranty maintenance service agreements. As previously discussed, at the date of the LoopCare acquisition, the Company established a non-amortizing intangible asset based primarily on the value of RBOC service maintenance agreements whose fees are fixed and which renewal is assumed to be for perpetuity. The Company is currently in the process of negotiating the renewal of three of its four RBOC LoopCare software maintenance agreements which expire on December 31, 2002. One of the Company's four RBOC customers has notified the Company of its intention to negotiate a need based, time and materials fee instead of the fixed maintenance fee when its current service agreement expires on December 31, 2002. The Company has agreed to negotiate in good faith towards this type of arrangement but fully intends to maintain the value of this contract. Therefore, at this point, the Company believes the value and non-amortizing characteristics of this intangible asset to be preserved. However, if through negotiations, new maintenance agreements with one or more RBOC customers cannot be reached, or if one or more new agreements are reached that are believed will result in less revenue to the Company than the current fixed fee agreements, the current fair value of the maintenance service agreements may be determined to be less than the $32,000,000 carrying value, perhaps materially so, resulting in a charge against operating income for 2002 and/or commencement of amortization of the remaining fair value over its determined useful life. A similar analysis of the fair value of the maintenance service agreements could be required if any of the Company's RBOC customers reduce or terminate their maintenance service agreements due to the RBOC customers' own financial difficulties. SUBSEQUENT EVENT On September 30, 2002, the Company announced its second reduction in force in two years to remain as competitive as possible amid spending pullbacks by telecom customers. The realignment reduced the Company's work force by approximately 47 positions, primarily in research and development, production and support areas. This year's initiative is expected to generate annual cost savings of approximately $3,600,000, adjusted by any cost increases the Company may incur as a result of increased premiums from the Company's health care insurance providers. The Company expects to record a charge of $200,000 or $ .01 per share for severance and related costs in the fourth quarter of 2002 in connection with this reduction in force. BACKLOG The Company's backlog consists of firm customer purchase orders and signed software maintenance agreements. As of September 28, 2002, the Company had a backlog of $4,451,078 compared to $4,936,448 at December 31, 2001 and $3,604,105 at September 29, 2001. The September 28, 2002 backlog includes approximately $2,570,599 related to software maintenance contracts. This maintenance and support will be provided for and billed on a straight-line basis through the remaining terms of the agreements. Including the 26 scheduled maintenance services, approximately 78.7% of the current backlog is expected to be recognized as revenue in the fourth 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. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's current investment policy limits its investments in financial instruments to cash and cash equivalents, individual municipal bonds, and corporate and government bonds. The use of financial derivatives and preferred and common stocks is strictly prohibited. The Company believes it minimizes its risk through proper diversification along with the requirements that the securities must be of investment grade with an average rating of "A" or better by Standard & Poor's. The Company holds its investment securities to maturity and believes that earnings and cash flows are not materially affected by changes in interest rates, due to the nature and short-term investment horizon for which these securities are invested. ITEM 4. CONTROLS AND PROCEDURES The Chief Executive Officer and the Chief Financial Officer of the Company (its principal executive officer and principal financial officer, respectively) have concluded, based on their evaluation as of a date within 90 days prior to the date of the filing of this Report, that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports filed or submitted by it under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and include controls and procedures designed to ensure that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company's management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. There were no significant changes in the Company's internal controls or in other factors that could significantly affect these controls subsequent to the date of such evaluation. 27 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. 28 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: The following exhibits are being filed with this report: Exhibit Number Description ------ ----------- 10.31 1995 Long-Term Incentive Compensation Plan, amended and restated as of January 24, 2002, filed herewith. 10.32 1998 Employee Incentive Compensation Plan, amended and restated as of January 24, 2002, filed herewith. 15 Letter re unaudited interim financial information (b) Reports on Form 8-K: The Company filed two current reports on Form 8-K during the quarter ended September 28, 2002. On August 7, 2002, the Company disclosed certain information in the Form 8-K pursuant to Regulation FD (17 CFR 243.100.243.103). On August 13, 2002, the Company filed a report on Form 8-K to provide the certification required by Section 302 of the Sarbanes-Oxley Act of 2002. 29 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: November 12, 2002 /s/ CHRISTIAN L. ALLISON -------------------------------------- CHRISTIAN L. ALLISON CHAIRMAN AND CHIEF EXECUTIVE OFFICER Dated: November 12, 2002 /s/ SAMUEL C. KNOCH -------------------------------------- SAMUEL C. KNOCH CHIEF FINANCIAL OFFICER AND TREASURER Dated: November 12, 2002 /s/ CHARLES J. SHEARER -------------------------------------- CHARLES J. SHEARER CONTROLLER 30 CERTIFICATION I, Christian L. Allison, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Tollgrade Communications, Inc. 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function); (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and(b) 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 12, 2002 /s/ Christian L. Allison - ------------------------ Name: Christian L. Allison Title: Chief Executive Officer 31 CERTIFICATION I, Samuel C. Knoch, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Tollgrade Communications, Inc. 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function); (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 12, 2002 /s/ Samuel C. Knoch - -------------------- Name: Samuel C. Knoch Title: Chief Financial Officer 32 Certification Pursuant to 18 U.S.C. Section 1350, the undersigned officer of Tollgrade Communications, Inc. (the "Corporation"), hereby certifies that the Corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 2002 (the "Report") fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Corporation. Dated: November 12, 2002 /s/ Christian L. Allison - ------------------------ Name: Christian L. Allison Title: Chief Executive Officer Certification Pursuant to 18 U.S.C. Section 1350, the undersigned officer of Tollgrade Communications, Inc. (the "Corporation"), hereby certifies that the Corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 2002 (the "Report") fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Corporation. Dated: November 12, 2002 /s/ Samuel C. Knoch - ------------------- Name: Samuel C. Knoch Title: Chief Financial Officer 33 EXHIBIT INDEX (Pursuant to Item 601 of Regulation S-K) Exhibit Number Description 10.31 1995 Long-Term Incentive Compensation Plan, amended and restated as of January 24, 2002, filed herewith. 10.32 1998 Employee Incentive Compensation Plan, amended and restated as of January 24, 2002, filed herewith. 15 Letter re unaudited interim financial information 34