EXHIBIT 13.1
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Tollgrade Communications, Inc.
2002 Annual Report to Shareholders
TABLE OF CONTENTS
2002 Financial Highlights ............................ 1 Statement of Management's
Letter to Shareholders ............................... 2 Responsibility for Financial Reporting ......... 18
Product Overview ..................................... 4 Report of Independent Accountants ................ 19
Selected Consolidated Financial Data ................. 6 Consolidated Financial Statements ................ 20
Management's Discussion and Notes to the Consolidated
Analysis of Results of Operations Financial Statements ........................... 24
and Financial Condition ............................ 7 Shareholder Information ......................... IBC
Board of Directors and Officers ................. IBC
2002 Financial Highlights
(In thousands, except per share data
and number of employees)
December 31, 2001 DECEMBER 31, 2002
OPERATIONS
Total Revenues $ 82,239 $ 58,574
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Net Income $ 13,675 $ 3,356
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Earnings Per Share-- Diluted $ 1.02 $ 0.25
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Weighted Average Shares of Common Stock and Equivalents 13,412 13,314
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Number of Employees 341 250
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FINANCIAL POSITION
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Total Assets $ 146,630 $ 149,542
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Working Capital $ 67,628 $ 73,189
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Shareholders' Equity $ 140,139 $ 142,356
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REVENUES NET INCOME DILUTED EARNINGS PER SHARE
(DOLLARS IN THOUSANDS) (DOLLARS IN THOUSANDS) (DOLLARS IN THOUSANDS)
1998 $ 46,277 $ 6,967 $0.58
1999 $ 61,111 $ 10,623 $0.89
2000 $114,426 $ 27,495 $2.06
2001 $ 82,239 $ 13,675 $1.02
2002 $ 58,574 $ 3,356 $0.25
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Letter to Our Shareholders
Dear Shareholders,
Sir Francis Bacon, the father of deductive reasoning, wrote, "Prosperity is not
without many fears and distastes; and adversity is not without comforts and
hopes."
While times have been tough for telecom equipment providers like
Tollgrade, we are hopeful about our future and comforted by what we accomplished
during 2002.
During this downdraft, we've worked extremely hard to maintain
profitability and generate operating cash; solidify our market positions; win
new business, both here and abroad; and set the stage for the future through
focused research and development.
Our Products
For the new Tollgrade investor, let me give you a quick primer on what we do.
Our company makes solutions for the centralized testing and monitoring of public
telecommunications and cable networks. In laymen's terms, if you're a Regional
Bell Operating Company (RBOC) customer with a malfunctioning telephone line,
more than likely your service provider uses our system to tell them what's wrong
with it. In the cable world, we help CATV companies head off trouble at the pass
by monitoring the power supplies that keep their systems running. This is
important because it helps our cable customers avoid network shut-downs due to
power failures. We also monitor fiber optic nodes and amplifiers, which deliver
service to customers.
Today, our telco systems test more than 150 million telephone access lines
worldwide. We concentrate on the RBOCs, as well as major independent carriers.
And Tollgrade products are reaching beyond the voice world to automate and test
broadband services such as Digital Subscriber Line service, more commonly
referred to as DSL. Recently, we've been helping our customers determine if your
voice line can handle DSL service.
We hope to establish a similar market position among CATV multiple system
operators with our recent acquisition of Acterna, LLC's Cheetah(TM) status and
performance monitoring product line, which will bolster our LIGHTHOUSE(R)
status monitoring business. By combining Cheetah with our LIGHTHOUSE system, we
have established a solid position in cable status and performance monitoring
across North America.
A Tough 2002
2002 was challenging for everyone serving telephone and cable companies. Our
customers experienced severe line loss, cut expenses and reduced capital
expenditures. No one knows for sure when this will improve. But by sticking to
our knitting, Tollgrade stayed profitable, made cash and won new business.
Sales were $58.6 million and we earned $.25 per share. In 2001, our sales
were $82.2 million and we earned $1.02 per share. Almost everyone in our
industry was affected negatively like this. But we responded to this downturn by
making sure that we kept making money while building for the future. In 2002, we
maintained a gross profit of 56.3% and put 5.7% of revenue to the bottom line.
We also right-sized our business and reduced our quarterly breakeven point,
eliminating approximately $3.6 million in annual expenses from the business at
the end of 2002. As a result, we generated $17.6 million in cash from
operations.
The line loss experienced by our customers slowed the deployment of
digital loop carrier (DLC) systems. Because our MCU(R) Metallic Channel Units
enable DLC lines to be tested, this slowdown in deployment hurt MCU sales. We
mitigated those losses somewhat by mounting DLC testability improvement
initiatives among our customers through our Services group. Essentially, these
initiatives involve ensuring that our customers' test systems are working
properly. In some cases, this involves making sure that MCU products are
installed in legacy DLC systems.
Despite the difficulties in the telecom sector, Tollgrade has always
worked hard to try to create value for our shareholders. The market has had its
ups and downs, certainly, but comparing our market capitalization of $65.3
million on the day of our initial public offering to our market capitalization
of $159.0 million at the end of 2002 still reflects significant growth.
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New DSL Business
Despite reduced capital expenditures, we won new product business. We landed a
DSL prequalification software feature sale during the fourth quarter. So now,
two of the four RBOCs are using LoopCare(TM) to improve the rollout of DSL
service. We also sold our Benchmark Database (BMDB), a sister feature to our
prequalification software, to those same two customers. The BMDB is a store
house for DSL prequalification data.
2
We also booked sales of our LoopCare CORBA API and Advanced Test Package
features to Baby Bell customers. And, we completed a server port project, which
is essentially the re-sale and installation of new servers.
In terms of DigiTest(R), we generated Loop Test System (LTS) replacement
sales to a major RBOC, and expect a similar project in 2003 for another
customer. Because some LTSs are 10-20 years old, our customers replaced them
with DigiTest Systems so they would not lose their ability to test their lines
if an LTS broke down. Those same DigiTest Systems can also be upgraded with
wideband testing to help our customers roll out new services, such as DSL. Many
of our non-RBOC customers also chose to take this route.
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Good International and
Independent Sales
We also saw activity with independent carriers both here and abroad. Our list of
new LoopCare and DigiTest customers has grown with the addition of Century
Telephone, PBT, Wesbell, Frontier, nTelos, Florida Digital Networks and the City
of Portland. Our new international customers include Albacom (Italy), Easynet
(United Kingdom), Batelco (Bahamas) and STC (Kingdom of Saudi Arabia).
Many of these sales, specifically to North American independent carriers,
were made by bundling LoopCare software and DigiTest hardware sales together to
create more attractive value propositions. Our international LoopCare sales were
made primarily through our relationship with Lucent Technologies.
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Cheetah Deal
a Lot Like LoopCare
In terms of our cable status monitoring business, we added Time Warner as a
customer, and maintained business with RCN and Comcast (formerly AT&T BIS), both
of which rolled out our new industry-standard HMS software. By acquiring new
status and performance monitoring products and customers, and flying under the
Cheetah banner, we believe that we will have a solid cable franchise for the
future.
Our engineers stayed pretty busy in 2002. Despite the fact that we reduced
the size of our R&D workforce to control costs, we neared completion of a
low-cost method of conducting DSL tests at DLC systems, which are the home of
our flagship MCU products. We're combining the wideband capabilities of DigiTest
with MCU products already deployed in the field for a truly economical solution
for DLC broadband testing.
We also worked on new DSL/broadband/IP testing hardware for the edge of
the broadband network.
At our Bridgewater, New Jersey facility, our corps of former Bell Labs
software developers created new LoopCare features that expand the capabilities
of our Operation Support System (OSS) product.
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Into 2003
So what's our plan for 2003?
- - We will stay focused on centralized consumer broadband testing, whether it is
among telecommunications service providers or cable companies;
- - We will seek to help our customers keep their DLC systems and central offices
testable;
- - We will continue our efforts to harvest DigiTest sales by replacing aging LTS
test heads;
- - We will work hard to add to our list of independent and international LoopCare
and DigiTest customers;
- - We will continue to position our systems for automated DSL rollout and begin
to ready our customers for testing challenges as networks evolve from circuit-
to packet-based;
- - We will consolidate our Cheetah and LIGHTHOUSE product lines, making cable
status and performance monitoring an even bigger part of our business; and
- - We will strive to continue to manage our business conservatively from a
financial standpoint, while looking to make further acquisitions like the
LoopCare and Cheetah product lines.
Make no mistake, times are tough for anyone in the telecom equipment
sector. But companies like Tollgrade can not only withstand this Winter of our
industry, we can look forward to the warmth of a coming Spring. In 2002, we
sought to help customers reduce labor costs and roll out new services by
delivering products with solid return-on-investment business cases.
Believing this did not just give us comfort, it gave us a lot of hope.
Very truly yours,
/s/ CHRIS ALLISON
Chris Allison
Chairman and Chief Executive Officer
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CONSUMER ACCESS
TEST AND MANAGEMENT SOLUTIONS
Tollgrade's centralized and remote test systems help telephone companies
diagnose problems on their voice-grade lines by measuring their electrical
characteristics and analyzing the data. The data is presented to maintenance
attendants in an easy-to-understand format so they can explain service problems
to troubled customers. We also help telephone companies determine if their lines
are suitable for broadband services, such as DSL. These solutions include:
- - MCU(R) Test Extension products that access the lines served;
- - DigiTest(R) hardware that measures the electrical characteristics of telephone
lines; and
- - LoopCare(TM), the world's dominant test Operations Support System (OSS), that
analyzes the electrical characteristics and converts it to an
easy-to-understand diagnosis.
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BROADBAND EDGE
TEST AND MANAGEMENT SOLUTIONS
Tollgrade's innovative Broadband Edge solutions are optimized to help service
providers quickly and accurately deploy and maintain IP/ATM-based broadband
networks. These solutions include:
- - A scalable version of our LoopCare Test OSS, which is evolving beyond testing
voice lines to testing new broadband services;
- - DigiTest EDGE, our new, leading-edge test head platform being developed to
qualify and troubleshoot multi-layered broadband services, such as high-speed
Internet and Voice-over-IP (VoIP); and
- - TELACCORD(R), a simple and cost-effective device use to access the lines to
be tested.
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Our
Lines
Help Keep
Your
Lines
Open.
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Virtually every day, you rely on efficient, clear lines of communications.
Whether you're exploring the Internet, banking on-line, calling your folks back
home, or even checking the latest school closings on TV, chances are good that a
Tollgrade product is behind the scenes helping your service provider keep the
lines open.
However, the average consumer takes for granted the challenges service providers
face every day just to keep the communications flowing, much less what it takes
to prepare their networks to offer and maintain expanded services. When service
is down, consumers simply want to know two things: what's wrong with the line
and when it will be fixed. Tollgrade helps providers answer those questions
today, while helping them meet tomorrow's challenges. And, we do it with
solutions on several fronts:
- - While telecom service providers look to expand their networks to offer
broadband services, they rely heavily
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on Tollgrade's incumbent test solutions to tell them if their lines can
deliver them. Our telco product lines help them test and manage their existing
networks while transparently transitioning to a packet/cell-based
architecture. Doing so limits the up-front barriers and costs of aggressively
deploying new voice, data and video services.
- - When Cable Broadband Multiple System Operators (MSOs) expand their existing
video delivery infrastructures to offer digital voice and data services, their
need for proactive network management increases. Our cable product lines help
them keep a watchful eye on their networks, ensuring the highest possible
operational efficiencies and customer responsiveness while minimizing their
incremental test and management investments.
- - As both telco and cable service providers simultaneously try to accomplish
more with fewer resources, keep pace with the latest technologies and meet
higher expectations while remaining competitive, they turn to Tollgrade's
Professional Services operation to provide single-point-of-contact support for
their network's lifecycle.
Whether it's software, hardware, services, or the entire suite, Tollgrade Test
and Management Solutions help our customers keep their lines open by bringing
efficiencies to their everyday network operations. And, as consumer demand
drives service providers beyond today's offerings, Tollgrade will be there to
help them take the next big leap without missing a step.
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CABLE BROADBAND
TEST AND MONITORING SOLUTIONS
Tollgrade's Cheetah(TM) and LIGHTHOUSE(R) Cable Broadband solutions help MSOs
ensure that their network power supplies and fiber-optic nodes are working
properly. This proactive monitoring allows them to avoid network shut-downs
caused by power supply failures. These solutions include:
- - Intelligent transponders to detect problems within network power supplies,
amplifiers and nodes;
- - Modular, multi-port headend controllers (HECs) for aggregating data collected
from the transponders; and
- - Powerful, scalable system software that uses the data from the HECs to
efficiently monitor the status of the power supplies, amplifiers and nodes.
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PROFESSIONAL SERVICES
SPECIALIZED TESTING AND MONITORING
EXPERTISE ON CALL ANY TIME
Tollgrade complements its hardware and software products with service programs
that help our customers maintain their network operations. Our highly
experienced Professional Services team is mainly comprised of:
- - Former Bell Operating Company technicians and engineers who know how to keep
telephone network test systems running: and
- - Former CATV technicians and engineers who know how to keep cable networks
monitored.
Working office-by-office or video-headend-by-video-headend, our
professionals serve as "extra sets of arms and legs" by providing highly
specialized knowledge of testing and monitoring to help our customers keep their
customers happy.
Tollgrade's Professional Services programs offer a variety of options that
support the planning, implementation, deployment and maintenance phases of a
network's lifecycle. These programs have historically resulted in significantly
improved overall testability percentages.
5
Selected Consolidated Financial Data
The selected consolidated financial data of the Company as of December 31, 1998,
1999, 2000, 2001, 2002 and for the years then ended is derived from audited
consolidated financial statements of the Company.
(IN THOUSANDS, EXCEPT PER SHARE DATA AND NUMBER OF EMPLOYEES)
YEARS ENDED DECEMBER 31,
1998 1999 2000 2001 2002
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STATEMENTS OF OPERATIONS DATA:
Revenues:
Products $ 46,277 $ 60,031 $ 111,957 $ 77,612 $ 48,146
Services -- 1,080 2,469 4,627 10,428
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46,277 61,111 114,426 82,239 58,574
Cost of sales:
Products 19,620 24,298 40,680 33,134 20,800
Services -- 716 1,958 2,555 3,319
Amortization -- -- -- 365 1,464
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19,620 25,014 42,638 36,054 25,583
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Gross profit 26,657 36,097 71,788 46,185 32,991
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Operating expenses:
Selling and marketing 5,704 7,006 12,289 9,160 8,766
General and administrative 4,128 4,723 6,216 4,827 5,489
Research and development 6,880 8,757 12,456 12,428 13,839
Severance and related expense -- -- -- 291 176
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Total operating expense 16,712 20,486 30,961 26,706 28,270
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Income from operations 9,945 15,611 40,827 19,479 4,721
Other income, net 1,062 949 2,525 2,796 693
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Income before taxes 11,007 16,560 43,352 22,275 5,414
Provision for income taxes 4,040 5,937 15,857 8,600 2,057
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Net income $ 6,967 $ 10,623 $ 27,495 $ 13,675 $ 3,357
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EARNINGS PER SHARE INFORMATION:
Net income per common share: (1)
Basic $ 0.60 $ 0.92 $ 2.18 $ 1.05 $ 0.26
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Diluted $ 0.58 $ 0.89 $ 2.06 $ 1.02 $ 0.25
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Weighted average shares
of common stock and equivalents:
Basic 11,683 11,574 12,636 13,038 13,095
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Diluted 11,933 11,959 13,359 13,412 13,314
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AS OF DECEMBER 31,
1998 1999 2000 2001 2002
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BALANCE SHEET DATA:
Working capital $ 40,539 $ 49,958 $ 111,135 $ 67,628 $ 73,189
Total assets 49,865 66,202 131,275 146,630 149,542
Shareholders' equity 45,696 57,504 122,760 140,139 142,356
1998 1999 2000 2001 2002
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OTHER DATA: (2)
Number of employees at year end 230 282 411 341 250
Average revenue per employee $ 201 $ 217 $ 278 $ 241 $ 234
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(1) 1998 includes $.02 per share related to the after-tax effect of net key man
life insurance proceeds associated with the death of the Company's former
Chairman R. Craig Allison.
(2) Data is unaudited and not derived from Company's audited financial
statements.
6
Management's Discussion and Analysis
of Results of Operations and Financial Condition
The following discussion should be read in conjunction with the Selected
Consolidated Financial Data and the audited Consolidated Financial Statements
and Notes thereto appearing elsewhere in this Annual Report to Shareholders.
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995.
The statements contained in this Annual Report to Shareholders, including, but
not limited to, those contained in the following Management's Discussion and
Analysis of Results of Operations and Financial Condition, which are not
historical facts are considered "forward-looking statements" within the meaning
of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. These statements, which may be
expressed in a variety of ways, including the use of future or present tense
forward-looking terminology such as "believes," "expects," "may," "will,"
"should," "estimate," "plan" or "anticipates" or the negative thereof, other
variations thereon, or compatible terminology, 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 Services
group offers to customers, the potential loss of certain customers, the timing
of orders from customers, the effect of consolidations in the markets to which
Tollgrade Communications, Inc. (the "Company") sells, the effects of the
economic slowdown in the telecommunications and cable industries, the
possibility of future provisions for slow moving inventory, and the effect on
earnings and cash flows of changes in interest rates. The Company does not
undertake any obligation to publicly update any forward-looking statements.
These forward-looking statements, and other forward-looking statements
contained in other public disclosures of the Company which make reference to the
cautionary factors contained in this Annual Report, are based on assumptions
that involve risks and uncertainties and are subject to change based on the
considerations described below. These risks, uncertainties and other factors may
cause actual results, performance or achievements to differ materially from
anticipated future results, performance or achievements expressed or implied by
such forward-looking statements. Therefore, the Company wishes to caution each
reader of this Annual Report to consider the following factors and certain other
factors discussed herein and in other past reports including, but not limited
to, prior year Annual Reports and Form 10-K reports filed with the Securities
and Exchange Commission ("SEC"). The factors discussed herein may not be
exhaustive. Therefore, the factors contained herein should be read together with
other reports and documents that are filed by the Company with the SEC from time
to time, which may supplement, modify, supersede or update the factors listed in
this document.
General economic conditions and the economic conditions of the
telecommunications and cable industries, including the effect of subscriber line
loss and competition for the Company's RBOC customers from wireless, cable
providers and other carriers entering the local telephone service market, can
and have affected the capital budgets of the Company's customers. If such
conditions result in a further reduction of such budgets, the Company's revenues
could be adversely affected.
If the Company's customers find themselves unable to meet their
established purchase forecasts and their own growth projections, such customers
may further curtail their purchase of the Company's products, which would
adversely affect the Company's revenues.
If the Company would be unable to establish customer or sales distribution
or original equipment manufacturer ("OEM") relationships relating to the new
Cheetah(TM) business, it could affect the rate of incoming orders, which would
adversely affect sales and 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,
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 encountered a shortage of key manufacturing components from
limited sources of supply, or experience manufacturing delays caused by reduced
manufacturing capacity or integration issues related to the acquisition of the
Cheetah product line, loss of key assembly subcontractors or other factors, the
Company's ability to produce and ship its manufactured products could be
adversely affected, with an adverse effect upon revenues.
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
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Management's Discussion and Analysis
of Results of Operations and Financial Condition
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 obsolete parts on hand, which could adversely affect
future results.
Changes in government regulation, such as modification or repeal of The
Telecommunications Act of 1996, increasing the costs of doing business by the
Company or its customers, or preventing the Company or its customers from
engaging in business activities they may wish to conduct could adversely affect
the Company's future results.
The Company has recently completed several acquisitions and expects to
pursue additional acquisitions and new business opportunities in the future as
part of its business strategy. If the Company fails to integrate successfully
the operations and products of acquired businesses, or if such acquisitions
subject the Company to unexpected liabilities and claims, the Company's future
results could be adversely affected.
The Company's future sales in international markets are subject to
numerous risks and uncertainties, including local economic and labor conditions,
political instability including terrorism and other acts of war or hostility,
unexpected changes in the regulatory environment, trade protection measures, tax
laws, the ability of the Company to market current or develop new products
suitable for international markets, obtaining and maintaining successful
distribution and resale channels and foreign currency exchange rates. Reductions
in the demand for or the sales of the Company's products in international
markets could adversely affect future results.
Overview
The Company was organized in 1986, began operations in 1988 and completed its
initial public offering in 1995. The Company designs, engineers, markets and
supports test system, test access and status and performance monitoring products
for the telecommunications and cable television industries. 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 software base code and 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 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. Although 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 base his critical decisions or allocate assets solely
on this information. The Company's products and services have similar economic
characteristics, the same or similar production processes and are sold to
similar types or classes of customers in, or entering into, the
telecommunications and cable businesses through similar distribution means. The
LoopCare software product line 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.
The Company's proprietary telecommunications test access products enable
telephone companies to use their existing line test systems to remotely diagnose
problems in "Plain Old Telephone Service" ("POTS") lines containing both copper
and fiber optics. The Company's MCU product line, which includes POTS line
testing as well as alarm-related products, represented approximately 48% of the
Company's revenue for the year ended December 31, 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
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Management's Discussion and Analysis
of Results of Operations and Financial Condition
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. The Company expects to introduce soon its new DigiTest EDGE
test head for the evolving broadband network in which integrated digital
services are offered. Sales of the DigiTest product line accounted for
approximately 14% of the Company's revenue for the year ended December 31, 2002.
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 13% of total revenue for the year ended December 31, 2002.
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 5% of the Company's revenue for the
year ended December 31, 2002.
During 2002, the Company completed its first major central office test
system upgrade package delivery, which included hardware resale and services.
This project contributed approximately 2% of revenues for the year ended
December 31, 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 years, this product line represented less than 1% of total
revenue for 2002.
The cornerstones of the Company's Services offerings are the Testability
Improvement Initiatives. These services may offer the customer the opportunity
to make improvements in testability levels, while training their own staffs in
targeted geographic regions over a defined period of time. In this way, the
customers' internal repair technicians can make use of automated systems to
diagnose and repair subscriber loop problems, thereby 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 that had accounted for revenue of approximately $980,000 for the nine
months ended September 28, 2002. The cancellation is believed to have
considerably reduced ongoing sales of MCU products, that are driven by these
testability programs, to this RBOC. Including software maintenance, Services
revenue accounted for approximately 14% of the Company's revenue for the year
ended December 31, 2002.
The Company's primary customers for its telecommunication products and
services are the four Regional Bell Operating Companies ("RBOC") as well as
major independent telephone companies and certain digital loop carrier ("DLC")
equipment manufacturers. For the year ended December 31, 2002, approximately 77%
of the Company's total revenue was from sales to these four RBOC customers, the
three largest of which individually accounted for approximately 38%, 18% and 14%
of the Company's revenue, or a combined 70% of its total revenue. Due to the
Company's present dependency on all four of these key customers, the potential
loss of one or more of them as a customer or the reduction of orders for the
Company's products by any one of 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 RBOC customers and significant
independent telephone companies. This timing is particularly sensitive to
various business factors within each of the RBOC customers, including the RBOC
customers' relationships with their various organized labor groups and an
increasing tendency for the RBOC customers 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, LIGHTHOUSE and
Cheetah, are highly competitive. The acquisition of AT&T Broadband, one of the
Company's primary LIGHTHOUSE and Cheetah customers, by Comcast Corporation may
adversely affect sales of product to that customer which contributed almost 4%
to revenues for the year ended December 31, 2002. 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 required it to grant more
favorable terms to some of its customers. In addition, certain customers have
consolidated product purchases that have resulted in large bulk orders. As
stated earlier, there is an increasing trend, in part 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 on acceptable terms, there can be 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 RBOC customers,
providing the RBOCs the ability to consolidate their inventory and product
procurement systems, could cause fluctuations or delays in the Company's order
patterns. Consolidation in the cable
9
Management's Discussion and Analysis
of Results of Operations and Financial Condition
industry as well as the adoption of industry standards for transponders to
function among various status monitoring systems could cause pricing pressure as
well as adversely affect certain customers' deployment of the Company's cable
products. In addition, markets for the Company's cable 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 were approximately 6.3% of total revenues for the year
ended December 31, 2002. The Company believes that certain international markets
may offer further opportunities. The addition of the LoopCare software product
line, including the Lucent OEM resale arrangement for the LoopCare product, has
enhanced the Company's ability to penetrate this market. The Company sold
LoopCare software to over a half dozen international customers in 2002 including
a large sale bundled with DigiTest products. The Company also enjoys a stream of
software maintenance revenue from international sources, primarily from renewal
of contracts acquired through the business acquired from Lucent. However, the
international telephony markets differ from those found domestically due to the
different types and configurations of equipment used by 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 has reduced its efforts relating to DSL services,
which could have an adverse effect on the Company's deployment of LoopCare
internationally through the Lucent OEM channel. Furthermore, the international
markets introduce the risk of loss from currency fluctuations. While the Company
endeavors to price its products in U.S. dollars, this is not always possible.
Many international customers are also small and undercapitalized, presenting
possible exposure to credit losses to a greater degree than has historically
been seen from domestic customers. The exposure was minimal at December 31,
2002.
The Company believes that its growth will continue to be affected by the
economic slowdown in the telecommunications industry as established RBOC and
large ILEC customers strive to further reduce their capital and operating
expense budgets which will directly impact RBOC and ILEC ordering patterns and
quantities. The Company believes that its RBOC and large ILEC customers are
being adversely affected by subscriber line losses 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 continue 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. On September 30, 2002, the Company
implemented its second work force reduction in two years by eliminating 47
positions, a decision which was intended to generate annual cost savings of
approximately $3,600,000. Increases in insurance premiums, including for
healthcare and directors and officers' liability insurance, of approximately
$600,000 will partially offset these savings.
The Company also believes that future growth will depend, in part, on its
ability to design and engineer new products and, therefore, the Company spends a
significant amount on research and development. Research and development
expenses as a percentage of revenues were approximately 24% for the year ended
December 31, 2002.
Application of Critical Accounting Policies
The Company's financial statements are prepared in conformity with accounting
principles generally accepted in the United States of America. The application
of 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. The Company deems the following accounting
policies to involve critical accounting estimates.
Revenue Recognition -- The Company markets and sells POTS and broadband
test system hardware, and, since the September 30, 2001 acquisition of LoopCare,
related software. The Company follows Staff Accounting Bulletin 101, "Revenue
Recognition in Financial Statements" for hardware sales. This bulletin requires,
among other things, that revenue should be recognized only when title has
transferred and risk of loss has passed to a customer with the capability to
pay, and that there are no significant remaining obligations of the Company
related to the sale. The bulk of the Company's hardware sales are made to RBOC
and other large customers. Terms of these hardware sales are predominantly FOB
shipping point. Revenue is recognized for these customers upon shipment against
a valid purchase order. The timing of revenue recognition may require the
judgment of management. The Company reduces collection risk by requiring letters
of credit or other payment guarantees for significant sales to new customers
and/or those in weak financial condition.
The Company follows the AICPA's Statement of Position "Software Revenue
Recognition" SOP 97-2 and related modifications for software perpetual license
fee and maintenance revenue. This statement requires that software license fee
revenue be recorded only when evidence of a sales arrangement exists, the
software has been delivered, and a customer with the capacity to pay has
accepted the software leaving no significant obligations on the part of the
Company to perform. The Company requires a customer purchase order or
10
Management's Discussion and Analysis
of Results of Operations and Financial Condition
other written agreement to document the terms of a software order and written,
unqualified acceptance from the customer prior to revenue recognition. In
certain limited cases, however, agreements provide for automatic customer
acceptance after the passage of time from a pre-determined event and the Company
has relied on these provisions for an indication of the timing of revenue
recognition. In cases for orders of custom software, or orders that require
significant software customization, the Company will employ contract accounting
using the percentage-of-completion method, whereby revenue is recognized based
on costs incurred to date compared to total estimated contract cost. The revenue
for orders with multiple deliverables such as hardware, software and/or
installation or other services may be separated into stand-alone fair values if
not already documented in the purchase order or agreement and where list prices
or other objective evidence of fair value exists to support such allocation, in
accordance with the provisions of EITF 00-21, "Accounting for Revenue
Arrangements with Multiple Deliverables." Revenue will not be recognized for any
single element until all essential elements are delivered and accepted.
LoopCare software customers usually enter into separate agreements for
software maintenance upon expiration of the stated software warranty period.
Maintenance agreements include software upgrades and bug fixes as they become
available; however, newly developed features must be purchased separately.
Post-warranty maintenance for new features is either included under the current
maintenance agreement without additional charge, and is considered in the
maintenance agreement fees, or is separately charged upon expiration of the
warranty. Depending on the timing of the enhancement purchase and the length of
the maintenance agreement, the Company must evaluate whether a portion of the
enhancement right to use fee should be treated as post contract support to be
deferred and recognized over the remaining life of the maintenance agreement.
Software maintenance revenue is recognized on a straight-line basis over
the period the respective arrangements are in effect.
Revenue recognition, especially for software products, involves critical
judgments and decisions that can result in material effects to reported net
income.
Intangible Assets and Goodwill -- The Company had net intangible assets of
$60.2 million at December 31, 2002 primarily resulting from the acquisition of
the LoopCare product line in September 2001. In connection with the acquisition,
the Company 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 assets
acquired, intangible assets of $45.8 million were identified, of which
capitalized software valued at $7.3 million was determined to have a definite
useful life of five years and is being amortized over that period.
The remaining identified intangible assets of $38.5 million have been determined
to have an indefinite useful life and, along with goodwill of approximately
$16.2 million, are not being amortized. An independent valuation consultant
assisted the Company in identifying and valuing the acquired intangible assets.
As of January 1, 2002, the Company fully adopted the provisions of SFAS
No. 142. The Company has determined that it has only one reporting segment and
has completed a test for goodwill impairment as of June 29, 2002 and December
31, 2002 by comparing the aggregate market value of the Company's stock with the
Company's book carrying value, including goodwill. These tests indicated that
there was no impairment of the goodwill carrying value. From time to time after
the initial impairment test of goodwill at June 29, 2002 was completed, the
market value of the Company's stock temporarily declined to an amount below the
Company's book carrying value. Management believes that these cases are
reflective of current conditions in the telecommunications and general markets.
However, 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, requiring an alternate testing of the fair value of the Company under
guidance of SFAS No. 142. In that event, impairment in value up to the full
amount of the goodwill could be determined, resulting in an impairment loss to
be recorded in the Company's financial statements.
All other intangible assets were tested for impairment of carrying value
as of December 31, 2002 using assumptions and techniques employed in the
original valuation and following the guidance of SFAS No. 144, "Accounting for
the Impairment or Disposal of Long-Lived Assets." Specifically, the sum of the
projected future cash flows to be derived from the developed product software
was compared with the net book carrying value. The impairment test for
non-amortizable intangible assets other than goodwill consisted of a comparison
of the estimated fair value with carrying amounts. The value of the LoopCare
trade name was measured using the relief-from-royalty method and discounted cash
flow analyses were employed to test the value of the base software and post
warranty maintenance service agreements. These tests indicated that none of the
intangible assets had impairment in carrying value. The Company plans to retest
these assets annually as of December 31 or more frequently if events or changes
in circumstances indicate that assets might be impaired.
This testing relative to impairments involved critical accounting
estimates. The Company relied upon its financial plan for 2003 and best
estimates of revenues and cash flows for later years in measuring current
values; however, these expectations may not be realized and future events and
market conditions might indicate material impairment of value that could result
in material charges to net income. Such a future situation would not, however,
in and of itself affect the cash flow or liquidity of the Company.
The identified intangible assets include LoopCare RBOC service maintenance
agreements valued at $32.0 million. It is believed that these annual agreements
11
Management's Discussion and Analysis
of Results of Operations and Financial Condition
will be renewed into perpetuity due to their critical importance in the
operations of the customers. The Company has entered into new contracts for 2003
with two RBOC customers and is in negotiations with the remaining two RBOC
customers whose agreements will expire March 31, 2003. The Company intends to
maintain fixed fee arrangements for all contracts. Therefore, the Company
believes that the non-amortizing characteristics of these intangible assets will
be preserved. However, if new maintenance agreements with the two remaining RBOC
customers cannot ultimately be reached, or if an agreement is reached with
either customer that results in substantially 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 $32.0 million carrying
value, perhaps materially so, resulting in a non-cash charge against operating
income in 2003 or beyond 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 would be required if any of the Company's
RBOC customers reduce or terminate their maintenance service agreements for any
reason.
Inventory Valuation -- The Company utilizes a standard cost system that
approximates first-in, first-out costing of the products. Standards are
monitored monthly and changes are made on individual parts if warranted;
otherwise standard costs are updated on all parts annually, normally in November
of each year. The Company evaluates its inventories on a monthly basis for slow
moving, excess and obsolete stock on hand. The carrying value of such inventory
that is determined not to be realizable is reduced, in whole or in part, by a
charge to cost of sales and reduction of the inventory value in the financial
statements. The evaluation process, which has been consistently followed, relies
in large part on a review of inventory items that have not been sold, purchased
or used in production within a one-year period. Management also reviews, where
appropriate, inventory products that do not appear on the slow moving report but
which may be unrealizable due to discontinuance of products, evolving
technologies, loss of certain customers or other known factors. As a result of
this comprehensive review process, an adjustment to the reserve for slow moving
and obsolete inventory is normally made monthly. Inventory identified as
obsolete is also discarded from time to time when circumstances warrant.
Inventory realization is considered a critical accounting estimate since
it relies in large part on management judgments as to future events and
differing judgments could materially affect reported net income.
Due to the decline in sales in 2001 and 2002, slow moving inventory
increased in volume but included many items believed to be active inventory for
active products. This trend resulted not only from slower sales but also from
the strong effort to reduce inventory levels in 2001 and 2002 that resulted in
reduced manufacturing activity and parts usage. The expense for slow moving and
obsolete inventory was $543,129, $299,846 and $2,547,072 for 2000, 2001 and
2002, respectively, while the valuation reserves increased $225,000, $26,000 and
$1,231,833, respectively in those years, to a balance at December 31, 2002 of
$2,043,833.
Income Taxes -- The Company follows the provisions of SFAS No. 109,
"Accounting for Income Taxes," in reporting the effects of income taxes in the
Company's consolidated financial statements. Deferred tax assets and liabilities
are determined based on the "temporary differences" between the financial
statement carrying amounts and the tax basis of assets and liabilities using
enacted tax rates in effect in the years in which the differences are expected
to reverse. As of December 31, 2002, the Company has recorded net deferred tax
assets of $2,689,448, comprised of $1,641,862 resulting from carry forward of
state net operating losses, other tax assets of $2,531,833 and deferred tax
liabilities of $1,484,247. Total net deferred tax assets decreased by $946,818
in 2002 due to the amortization of intangible assets for tax purposes and are
expected to continue to decrease in future years. The timing of the reversal of
the deferred tax liabilities and to a large extent the deferred tax assets is
dependent upon uncertain future events and can't be assumed to occur in the same
tax years.
The state net operating loss carryforward relates primarily to stock
option deductions in 2000. The majority of this carryforward is subject to state
laws that allow a 20-year carry forward period with a $2.0 million limit on
deductions in each year. Future realization of the recorded tax assets resulting
from both timing differences and carryforward losses is dependent upon the
existence of sufficient taxable income in future years.
SFAS No. 109 requires that a valuation allowance be recorded against
deferred tax assets when it is more likely than not that some or all of the
deferred tax assets will not be realized. Management believes that the current
business climate in the telecommunications industry is not permanent and that
the recorded tax assets will more likely than not be realized in future years,
especially for federal tax assets that comprise 90% of the non-carryforward
amounts. The Company had federal taxable income in 2002 and expects that will
continue.
Warranty -- The Company provides warranty coverage on its various
products. Terms of coverage range from up to one year on software to two to five
years for hardware products. The Company reviews products returned for repair
under warranty on a quarterly basis and adjusts the accrual for future warranty
costs based upon cumulative returns experience. The Company also evaluates
special warranty problems for products with a high return rate to correct the
underlying causes and, where deemed necessary, to provide additional warranty
expense for expected higher returns of these products. Warranty costs associated
with software sales are also accrued based on the projected hours to be incurred
during the warranty period (normally three months). The accounting for warranty
costs involves critical estimates and judgments that can have a material effect
on net income. The warranty accrual increased by $445,000 in 2000, $1,023,000 in
2001 and decreased by $87,480 in 2002 to a balance of $1,980,520 at December 31,
2002. Management expects, unless unforeseen circumstances arise, that this
accrual will continue to decrease in 2003 since the moving twenty-four month
period of shipments includes fewer shipped units on which the accrual is based
due to decreasing sales levels in late 2001 and 2002.
12
Management's Discussion and Analysis
of Results of Operations and Financial Condition
These areas involving critical accounting estimates are periodically
reviewed with the audit committee and, in the case of revenue recognition and
valuation of intangible assets, the audit committee has assisted in the
development of the corporate policies and procedures followed.
Results of Operations Year Ended
December 31, 2002 Compared
to Year Ended December 31, 2001
Revenues
Revenues for the year ended December 31, 2002 were $58.6 million, and were $23.6
million or 28.8% lower than the revenues of $82.2 million for the year ended
December 31, 2001. The decrease in revenues primarily resulted from further
erosion in unit volume sales of traditional MCU and DigiTest system products,
partially offset by an increase in LoopCare software sales and maintenance
services. LoopCare products, however, were only available for sale during the
final three months of 2001. Sales of the MCU product line in 2002 decreased by
approximately $27.7 million, or 49.8%, from the results of the previous year.
This decrease in sales was across the board among the RBOC customers and is
primarily associated with slowdowns in RBOC capital spending programs to upgrade
DLC systems. Further, as the life cycle for the MCU product continues to mature,
there is an increasing possibility that customers requirements for certain
legacy MCU products may be satisfied. The MCU product line accounted for
approximately 47.8% of 2002 revenues.
Sales of the Company's DigiTest product line in 2002, including $0.6
million of LoopCare software, decreased by approximately $3.9 million, or 33.0%,
from the results of the year ended December 31, 2001. This decrease in DigiTest
sales was primarily the result of decreased direct shipments during 2002 to
Sprint USA as a result of the discontinuation of its ION project and to Nortel
Networks and Choice One Communications. The declines from these customers were
offset in part by a major centralized test head replacement and augmentation
program at an RBOC. DigiTest sales accounted for approximately 13.6% of 2002
revenues.
Sales of stand-alone LoopCare software products in 2002 were approximately
$7.5 million, representing 12.8% of total revenues for the year, and were made
primarily to two RBOC and various international customers. Gross margins on the
LoopCare product line business are substantially higher than other product lines
of the Company, and the resulting impact on earnings was material. The Company
acquired the LoopCare product line on September 30, 2001; therefore, 2002
included twelve months of LoopCare operations while 2001 included only three
months.
Services revenues, which includes installation oversight and project
management services provided to RBOC customers and fees for LoopCare software
maintenance, were approximately $10.3 million in 2002, or 17.7% of total
revenues. Services revenues increased $5.7 million in 2002 over the results of
the previous year due to the inclusion of LoopCare maintenance fees in 2002 for
twelve months compared to three months in 2001.
Sales of the Company's LIGHTHOUSE Cable Status Monitoring System increased
slightly in 2002 to approximately $3.1 million and 5.3% of total revenue. Strong
sales to AT&T Broadband were mostly offset by reduced sales to other cable
service providers. During the first quarter of 2003, AT&T Broadband completed a
business combination with Comcast Corporation. The effect of the combination on
the Company's cable business is uncertain and will be highly dependent upon the
strategic direction taken by the combined entity. The magnitude of this effect
is likely to be amplified due to the Company's recent acquisition of the Cheetah
product line.
The Company expects the weakness in its core equipment markets to continue
for the foreseeable future as its key customers continue to restrict their
capital budgets. The Company expects in the near future to introduce its new
DigiTest EDGE test head for the evolving broadband network and continues to
invest in research to develop new and improved products to stimulate demand for
its hardware products. The Company also continues its strategy to offset
declining revenues from traditional MCU and related equipment product lines with
LoopCare software license right-to-use fee revenue. These software license
products generally have long development and selling cycles, creating possibly
significant revenue variations; there, however, can be no assurance that the
Company will be successful in the implementation of this strategy.
Gross Profit
Gross profit for 2002 was $33.0 million compared to $46.2 million for 2001, a
decrease of $13.2 million, or 28.6%, from the previous year. Gross profit as a
percentage of revenues increased to 56.3% for 2002 compared to 56.2% for 2001.
The overall decrease in gross profit resulted primarily from the decreased sales
levels. Despite the decline in revenue from 2001, gross margin in 2002 as a
percentage of sales remained level due to several offsetting factors including
increased costs per unit sold due to substantially lower hardware production,
the product mix of hardware sales during 2002 compared to 2001 and a net
increase in slow moving and obsolete inventory and warranty costs of
approximately $1,191,000 in 2002. These higher costs were offset, however, by
changes in the product mix brought about by the acquisition of the LoopCare
product line on September 30, 2001. LoopCare products, which enjoy higher gross
margins than those earned historically on the Company's other products,
contributed 26.3% of sales revenue in 2002 compared to 5.4% in 2001. While the
Company will continue to reduce its manufacturing costs and to improve
efficiencies, the level of LoopCare revenues will continue to be a determinant
factor in gross profit margins in 2003.
Selling and Marketing Expense
Selling and marketing expenses consist primarily of personnel costs as well as
commissions and travel expenses of direct sales and marketing personnel, and
costs associated with various promotions and related marketing programs. Selling
and marketing expense for 2002 was $8.8 million, or 15.0% of revenues, compared
13
Management's Discussion and Analysis
of Results of Operations and Financial Condition
to $9.2 million, or 11.1% of revenues for 2001. This decrease of $0.4 million,
or 4.3%, is primarily due to lower commissions associated with lower sales
levels, and cost reductions in the areas of test and evaluation units,
advertising, meetings and seminars and related marketing activities, partially
offset by higher salaries and consulting expenses.
General and Administrative Expense
General and administrative expenses consist primarily of personnel costs for
finance, administrative and general management personnel as well as accounting,
legal and insurance expenses. General and administrative expense for 2002 was
$5.5 million, or 9.4% of revenues, compared to $4.8 million, or 5.9% of revenues
for 2001. This increase of $0.7 million, or 13.7%, is primarily attributable to
increases in outside professional fees, general insurance and salaries and
wages, with the increase in salaries and wages largely related to the LoopCare
acquisition.
Research and Development Expense
Research and development expenses consist primarily of personnel costs and costs
associated with the development of new products and technologies, including
DigiTest, LIGHTHOUSE and LoopCare software, as well as enhancing features of
existing products. Research and development expense for 2002 was $13.8 million,
or 23.6% of revenues, compared to $12.4 million, or 15.1% of revenues for 2001.
This increase of $1.4 million was due to an increase of $3.3 million, primarily
salaries, wages and rent expense, attributable to the LoopCare product line in
Bridgewater, New Jersey, which was in operation for only three months in 2001.
These increases were offset in part by reductions in other salaries, wages and
benefits, travel and materials and supplies; brought about in large part by a
reduction in work force at the beginning of the fourth quarter of 2002 for which
the Company recorded a pre-tax charge of $175,723. The Company expenses research
and development costs as they are incurred.
Other Income and Expense
Other income, which consists primarily of interest income, was $0.7 million for
2002 compared to $2.8 million for 2001. The decrease of $2.1 million, or 75.2%,
is primarily attributable to a decrease in funds available for investment
resulting from the $62 million LoopCare acquisition in the fourth quarter of
2001 and to the current low market yields on short term interest bearing
investments.
Provisions for Income Taxes
The Company's effective tax rate for 2002 was 38.0% of income before income
taxes, compared to the 38.6% rate in 2001.
Net Income and Earnings Per Share
For the year ended December 31, 2002, net income was $3.4 million compared to
$13.7 million for the year ended December 31, 2001, a decrease of $10.3 million,
or 75.5%. Diluted earnings per common share of $.25 for 2002 decreased by 75.5%,
or $.77, from the $1.02 earned in 2001. Diluted weighted average shares of
common stock and equivalents outstanding were 13,313,676 in 2002 compared to
13,412,037 in 2001. The decrease in the diluted weighted average shares of
common stock and equivalents outstanding is primarily the result of a reduction
in the dilutive effect of outstanding stock options related to the decrease in
weighted average share price of the Company's common stock. As a percentage of
revenues, net income for 2002 decreased to 5.7% from 16.6% in 2001.
Results of Operations Year Ended
December 31, 2001 Compared to
Year Ended December 31, 2000
Revenues
Revenues for the year ended December 31, 2001 were $82.2 million, and were $32.2
million or 28.1% lower than the revenues of $114.4 million for the year ended
December 31, 2000. The decrease in revenues is primarily associated with a
decrease in the unit volume sales of traditional MCU products, the Company's
DigiTest system, and the Company's LIGHTHOUSE Cable Status Monitoring System,
offset slightly by an increase in billings related to the Company's Professional
Services business. During 2001, the sales of the Company's MCU product line
decreased by approximately $24.6 million, or 30.6%. This decrease in sales of
the MCU product line resulted primarily from decreased sales to Qwest as that
company's testability initiative matured. In addition, MCU sales decreased to
SBC Communications, Inc. (including Ameritech, Pacific Bell and SNET) during
2001 primarily as a result of a slowdown in the rollout of Project Pronto, that
company's broadband initiative. Also contributing to the decrease in MCU sales
during 2001 were decreased sales of core MCU products to BellSouth and Verizon
primarily associated with slowdowns in programs to upgrade select DLC systems
within certain regions with MCU technology. The MCU product line accounted for
approximately 67.8% of the 2001 revenues. During 2001, the sales of the
Company's DigiTest product line, including $2.8 million of LoopCare software,
decreased by approximately $6.4 million, or 30.4%. This decrease in DigiTest
sales was primarily the result of decreased direct shipments during 2001 to
Sprint USA and SBC Telecom, Inc., which is the CLEC subsidiary of SBC. The
decline in sales of DigiTest to Sprint occurred in connection with Sprint's
decision to discontinue its ION Project, while SBC Telecom, Inc. substantially
curtailed its plan for expansion. In addition, reduced sales of DigiTest to
Nortel Networks and Lucent for deployment into the domestic CLEC markets, as
well as reduced sales to Verizon for the replacement of certain Lucent LTS test
head trunks for qualification of copper lines for DSL service, contributed to
the overall decrease in DigiTest sales during the current year. This was offset
somewhat by direct sales of DigiTest to SBC Communications, Inc. for MLT-1
replacement, as well as sales to Nortel in anticipation of distribution in the
international market. Overall, DigiTest sales accounted for approximately 17.8%
of 2001 revenues. Revenues from the Company's Services group in 2001 increased
by $2.2 million, or 87.4%. This includes $1.7 million of software maintenance
14
Management's Discussion and Analysis
of Results of Operations and Financial Condition
fees associated with the LoopCare acquisition. Services revenue accounted for
5.6% of 2001 revenues. During 2001, sales of the Company's Digital Access Unit
increased by approximately $3.4 million, from $0.6 million in the prior year.
This product was developed to provide cost-effective test access in applications
where it had not been provided for by the equipment manufacturer, and was
primarily being sold to Sprint for use in its recently discontinued ION Project.
Overall, sales of the Company's DAU were approximately 4.9% of the Company's
revenues for 2001. During 2001, sales of the Company's LIGHTHOUSE Cable Status
Monitoring System decreased by approximately $6.8 million, or 69.2%. This
decrease was primarily a result of decreased product sales to RCN Corporation
and AT&T Broadband as a result of their decisions to delay purchases of cable
related equipment. Overall, sales of the LIGHTHOUSE Cable Status Monitoring
System accounted for approximately 3.7% of 2001 revenues.
Revenues from the LoopCare product line in the three-month period ended
December 31, 2001 were $4.5 million, comprised of $2.8 million in license
right-to-use fees and $1.7 million of maintenance fees. Gross margins on these
revenues are substantially higher than other product lines of the Company, and
the resulting impact on earnings was material for this period and for 2001.
Offsetting these revenue increases were declines for the year and the fourth
quarter in the Company's traditional MCU-related products as less purchasing
incentives were offered by the Company as well as a continued general softening
in the Company's test access markets.
Gross Profit
Gross profit for 2001 was $46.2 million compared to $71.8 million for 2000,
representing a decrease of $25.6 million, or 35.7%. Gross profit as a percentage
of revenues decreased to 56.2% for 2001 compared to 62.7% for 2000. The overall
decrease in gross profit resulted primarily from the decreased sales levels,
while the decline in gross margin as a percentage of sales was a result of
decreased production volumes and associated decreases in cost absorption levels.
Selling and Marketing Expense
Selling and marketing expense for 2001 was $9.2 million, or 11.1% of revenues,
compared to $12.3 million, or 10.7% of revenues for 2000. This decrease of $3.1
million, or 25.5%, is primarily due to a decrease in the number of sales and
marketing personnel resulting from a reduction in personnel in April 2001, a
decrease in incentives and commissions associated with the lower sales levels,
and cost reductions in the areas of advertising, promotion and related marketing
activities.
General and Administrative Expense
General and administrative expense for 2001 was $4.8 million, or 5.9% of
revenues, compared to $6.2 million, or 5.4% of revenues for 2000. This decrease
of $1.4 million, or 22.3%, is primarily attributable to a decrease in employee
recruiting-related expenditures, decreased incentive compensation, as well as a
decrease in certain professional service and consulting fees.
Research and Development Expense
Research and development expense for 2001 was $12.4 million, or 15.1%, of
revenues, compared to $12.5 million, or 10.9%, of revenues for 2000. This
decrease of $0.1 million was principally due to a reduction of engineering
personnel in April 2001, offset by the additional personnel acquired as part of
the LoopCare acquisition. The Company expenses all research and development
costs as they are incurred.
Other Income and Expense
Other income, which consists primarily of interest income, was $2.8 million for
2001 compared to $2.5 million for 2000. The increase of $.3 million, or 10.7%,
is primarily attributable to an increase in funds available for investment
between periods.
Provisions for Income Taxes
The Company's effective tax rate for 2001 was 38.6% of income before income
taxes, compared to the 36.6% rate in 2000. The increase in the effective income
tax rate was primarily due to higher relative levels of income taxes associated
with expanding business activities.
Net Income and Earnings Per Share
For the year ended December 31, 2001, net income was $13.7 million compared to
$27.5 million for the year ended December 31, 2000, representing a decrease of
$13.8 million, or 50.3%. Diluted earnings per common share of $1.02 for 2001
decreased by 50.5%, or $1.04, from the $2.06 earned in 2000. Diluted weighted
average shares of common stock and equivalents outstanding were 13,412,037 in
2001 compared to 13,359,270 in 2000. This increase in the diluted weighted
average shares of common stock and equivalents outstanding is primarily the
result of the effect of stock options exercised in 2001. As a percentage of
revenues, net income for 2001 decreased to 16.6% from 24.0% in 2000.
Liquidity and Capital Resources
The Company had working capital of $73.2 million as of December 31, 2002, an
increase of $5.6 million or 8.2% from the $67.6 million of working capital as of
December 31, 2001. The increase in working capital is largely a result of income
before depreciation and amortization of $7.2 million and the deferral of tax
liabilities of $1.2 million, primarily related to the amortization of intangible
assets for tax purposes, exceeding capital expenditures of $1.8 million and the
purchase of treasury stock of $1.6 million. Significant changes during 2002 in
the composite elements of working capital include an $8.1 million decrease in
accounts receivable-trade and inventories, excluding changes in reserve
accounts, due to the continuing decline in sales activities caused by the severe
budget restrictions of telecommunications providers, and corresponding
adjustments made by the Company in forecasted production volumes to meet such
lowered demands. Further reductions in these assets will be increasingly
difficult. Overall, the Company generated cash from operating activities of
$17.6 million in 2002, which was primarily invested in short term investments.
As of December 31, 2002, the Company had $53.1 million of cash, cash equivalents
and short-term investments that are unrestricted and available
15
Management's Discussion and Analysis
of Results of Operations and Financial Condition
for corporate purposes, including acquisitions and other general working capital
requirements.
On September 30, 2002, the Company implemented its second work force
reduction in two years by targeting 47 positions for elimination, which was
intended to generate annual cost savings of approximately $3.6 million. A
reserve for severance and related costs of $175,723 was recorded in connection
with this reduction. Increases in health insurance and other general insurance
of the Company of approximately $600,000 will partially offset these savings in
2003.
Effective December 20, 2001, the Company executed a five-year $25.0
million Unsecured Revolving Credit Facility (the "Facility") with a bank. Under
the terms of the Facility, the proceeds must be used for general corporate
purposes, working capital needs, and in connection with certain acquisitions.
The Facility contains certain standard covenants with which the Company must
comply, including a minimum fixed charge ratio, a minimum defined level of
tangible net worth and a restriction on the amount of capital expenditures that
can be made on an annual basis, among others. Commitment fees are payable
quarterly at a rate of 0.25% of the unused commitment. The Facility was amended
in February 2003 in connection with an acquisition of a new cable product line.
See "Subsequent Event" below. As of December 31, 2002 and currently, there are
no outstanding borrowings under the Facility, and the Company is in compliance
with all debt covenants. Borrowings for working capital are not currently
anticipated, as the Company believes its cash reserves and internally generated
funds will be sufficient to sustain working capital requirements for the
foreseeable future.
The Company made capital expenditures of $1.8 million, $3.5 million and
$4.1 million in the three years ended December 31, 2002, 2001 and 2000,
respectively. The expenditures were primarily related to upgrades to the IT
infrastructure, office equipment, test fixtures and development systems, tooling
and leasehold improvements and, in 2001, for the acquisition of land adjacent to
the Company's current manufacturing facility. Planned capital expenditures for
2003 are approximately $3.0 million. These planned capital projects include test
fixtures and development systems, and computer and office equipment.
The Board of Directors has authorized the continuation of a share
repurchase program first initiated in 1997. Under the current extension, the
Company may repurchase a total of one million shares of its common stock before
December 31, 2003. Since the initial repurchase program was instituted in April
of 1997, and as of December 31, 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 Company at its discretion will determine
the number of shares and the timing of such purchases, which will be made using
existing cash and short-term investments.
The impact of inflation on both the Company's financial position and the
results of operations have been minimal and are not expected to adversely affect
2003 results. The Company's financial position enables it to meet cash
requirements for operations and capital expansion programs.
Subsequent Event
On February 13, 2003, the Company closed on a Purchase and Sale Agreement with
Acterna, LLC to acquire certain assets and assume certain liabilities related to
Acterna's Cheetah status and performance monitoring product line for $14.3
million in cash. As part of the agreement, contingent purchase consideration of
up to $2.4 million in the form of an earn-out, may be payable based on certain
2003 performance targets for the acquired business. The assets consist
principally of existing contracts, product inventory, intellectual property,
software and related computer equipment, while the liabilities principally
relate to warranty obligations. The $14.3 million due at closing was paid from
available cash and short-term investments. The Company believes the acquired
business will complement and augment its current cable operations and
strategically position the Company to be the leading supplier of testing
equipment and software for the cable industry. The acquisition will be recorded
under the purchase method of accounting and accordingly, the results of
operations of the acquired business from February 14, 2003 forward will be
included in the consolidated financial statements of the Company. In connection
with the acquisition, the Company entered into an amendment to its $25.0 million
Unsecured Revolving Credit Facility to maintain compliance with certain base net
worth covenants. The purchase price allocation is currently under evaluation and
is expected to be finalized by the end of the first quarter.
Off-Balance Sheet Arrangements
The Company does not engage in transactions or arrangements with unconsolidated
or other special purpose entities.
Commitments
The Company has commitments under various non-cancelable leases; these leases
relate primarily to real estate in Cheswick, Pennsylvania, Bridgewater, New
Jersey and Sarasota, Florida, which house the Company's operations. Annual
rentals due beyond December 31, 2002 under these agreements are $1.4 million in
2003, $1.6 million in both 2004 and 2005, $0.8 million in 2006, $0.4 million in
2007 and $0.1 million in 2008. The Company is also obligated to pay commitment
fees under a credit Facility as discussed in the "Liquidity and Capital
Resources" section above. The Company also has commitments to provide software
maintenance services under agreements generally one year in length and has
warranty obligations on products sold in prior periods.
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
16
Management's Discussion and Analysis
of Results of Operations and Financial Condition
nature and short-term investment horizon for which these securities are
invested.
Key Ratios
The Company's days sales outstanding ("DSOs") in accounts receivable trade,
based on twelve months rolling revenue, was 53 and 43 days as of December 31,
2002 and December 31, 2001, respectively. The December 31, 2001 DSOs were
unusually low from an historical perspective. The Company's inventory turnover
ratio was 1.4 and 1.3 turns for December 31, 2002 and December 31, 2001,
respectively.
Backlog
The Company's backlog consists of firm customer purchase orders and signed
software maintenance agreements. As of December 31, 2002, the Company had a
backlog of $7.2 million compared to $4.9 million at December 31, 2001. The
increase between years is due partially to the timing of signing renewal annual
software maintenance contracts with two existing RBOC customers. The backlog at
December 31, 2002 includes approximately $3.8 million related to LoopCare
software maintenance contracts. Income under these maintenance agreements will
be earned and recognized on a straight-line basis over the remaining terms of
the underlying agreements, which are usually one year or less. Periodic
fluctuations in customer orders and backlog result from a variety of factors,
including but not limited to the timing of significant orders and shipments.
While these fluctuations could impact short-term results, they are not
necessarily indicative of long-term trends in sales of the Company's products.
Accounting Pronouncements
In July 2001, the FASB issued SFAS No 141, "Business Combinations" and SFAS No.
142, "Goodwill and Other Intangible Assets." SFAS No. 141 established accounting
and reporting standards for business combinations. SFAS No. 142 established
accounting and reporting standards for acquired goodwill and other intangible
assets, specifically, how they should be treated upon, and subsequent to, their
acquisition. Both SFAS No. 141 and SFAS No. 142 are required to be applied in
fiscal years beginning after December 15, 2001; however, early adoption is
permitted. Both statements contain transitional provisions that require that
these statements be applied to all business combinations initiated after June
30, 2001. The Company followed the transitional provisions of SFAS No. 141 and
SFAS No. 142 during the fourth quarter of 2001 as it related to its acquisition
of the LoopCare product line. The Company adopted the full provisions of these
statements on January 1, 2002. The adoption of these standards did not have a
material effect on the Company's financial statements.
On August 15, 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations." On October 4, 2001, FASB issued SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets." The Company
adopted these statements on January 1, 2003 and such adoption is not expected to
have a material effect on the Company's financial statements.
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 a
material effect on the Company's financial position or results of operations.
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires that upon
issuance of a guarantee, a guarantor must recognize a liability for the fair
value of an obligation assumed under a guarantee. FIN 45 also requires
additional disclosures by a guarantor in its interim and annual financial
statements about the obligations associated with guarantees issued. The
recognition provisions of FIN 45 will be effective for any guarantees that are
issued or modified after December 31, 2002. The provisions of FIN 45 are not
expected to have a material impact on the Company's results of operations or
financial position.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure." This Statement amends
SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative
methods of transition to SFAS No. 123's fair value method of accounting for
stock-based employee compensation. This Statement also amends the disclosure
provision of SFAS No. 123 and APB No. 28, Interim Financial Reporting, to
require disclosure in the summary of significant accounting policies footnote in
the financial statements of the effects of an entity's accounting policy with
respect to stock-based employee compensation on reported net income and earnings
per share in annual and interim financial statements. The Company has elected to
continue to follow the disclosure-only provisions of SFAS No. 123 and adopted
the disclosure provisions of SFAS No. 148.
On January 17, 2003 the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities - an interpretation of ARB No. 51"
("FIN 46"). FIN 46 clarifies the application of Accounting Research Bulletin No.
51, "Consolidated Financial Statements", to certain entities in which equity
investors do not have the characteristics of a controlling financial interest or
do not have sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support from other parties. FIN 46 is
effective for the Company after January 31, 2003 and is not expected to have a
material impact on the Company's results of operations or financial condition.
The Company has early adopted Emerging Issues Task Force (EITF) Issue
00-21, "Accounting for Revenue Arrangements with Multiple Deliverables," which
applies to all deliverables within contractually binding arrangements that
include multiple revenue-generating activities. This issue is expected to be
finalized in March of 2003.
17
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
Statement of Management's Responsibility
for Financial Reporting
The accompanying consolidated financial statements of Tollgrade Communications,
Inc. and Subsidiaries have been prepared by management, who are responsible for
their integrity and objectivity. The statements have been prepared in conformity
with generally accepted accounting principles and include amounts based on
management's best estimates and judgments. Financial information elsewhere in
this Annual Report is consistent with that in the financial statements.
Management has established and maintains a system of internal controls
designed to provide reasonable assurance that assets are safeguarded and that
the financial records reflect the authorized transactions of the Company. The
system of internal controls includes widely communicated statements of policies
and business practices that are designed to require all employees to maintain
high ethical standards in the conduct of Company affairs. The internal controls
are augmented by organizational arrangements that provide for appropriate
delegation of authority and division of responsibility.
The financial statements have been audited by PricewaterhouseCoopers LLP,
Independent Accountants. As part of their audit of the Company's 2002 financial
statements, PricewaterhouseCoopers LLP considered the Company's system of
internal controls to the extent they deemed necessary to determine the nature,
timing and extent of their audit tests. The Report of Independent Accountants
follows.
The Board of Directors pursues its responsibility for the Company's
financial reporting through its Audit Committee, which is composed entirely of
outside directors. The Audit Committee has met periodically with the Independent
Public Accountants and management. The Independent Public Accountants had direct
access to the Audit Committee, with and without the presence of management
representatives, to discuss the results of their audit work and their comments
on the adequacy of internal accounting controls and the quality of financial
reporting.
/s/ CHRISTIAN L. ALLISON
Christian L. Allison
Chairman and Chief Executive Officer
/s/ SAMUEL C. KNOCH
Samuel C. Knoch
Chief Financial Officer and Treasurer
January 22, 2003
18
Report of Independent Accountants
To the Board of Directors and Shareholders of Tollgrade Communications, Inc. and
Subsidiaries:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, changes in shareholders' equity and cash
flows present fairly, in all material respects, the financial position of
Tollgrade Communications, Inc. and its subsidiaries at December 31, 2002 and
2001, and the results of their operations and their cash flows for each of the
three years in the period ended December 31, 2002 in conformity with accounting
principles generally accepted in the United States of America. These financial
statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States of America, which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
As discussed in Note 2 to the consolidated financial statements, the
Company changed its method of accounting for long-lived asset impairments,
goodwill and other intangible assets in 2002.
PRICEWATERHOUSECOOPERS LLP
/s/ PRICEWATERHOUSECOOPERS LLP
Pittsburgh, Pennsylvania
January 22, 2003, except for Note 8, as to which the date is February 7, 2003
and Note 13, as to which the date is February 13, 2003.
19
Tollgrade Communications, Inc. and Subsidiaries
Consolidated Balance Sheets
ASSETS December 31, 2001 DECEMBER 31, 2002
- ------------------------------------------------------------------------------------------------------
Current assets:
Cash and cash equivalents $ 32,105,845 $ 33,799,284
Short-term investments 6,489,323 19,328,883
Accounts receivable:
Trade 9,296,551 7,946,276
Other 320,501 152,290
Inventories 22,183,616 14,092,596
Prepaid expenses and deposits 916,723 1,529,968
Refundable income taxes 1,396,736 637,156
Deferred tax assets 1,116,756 1,404,122
- ------------------------------------------------------------------------------------------------------
Total current assets 73,826,051 78,890,575
Long-term investments 150,000 ----
Property and equipment, net 8,012,546 7,438,870
Deferred tax assets 2,812,987 2,769,573
Intangibles 38,500,000 38,500,000
Goodwill 16,161,763 16,161,763
Capitalized software costs, net 6,935,000 5,539,002
Other assets 231,614 242,115
- ------------------------------------------------------------------------------------------------------
Total assets $ 146,629,961 $ 149,541,898
- ------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
- ------------------------------------------------------------------------------------------------------
Current liabilities:
Accounts payable $ 805,398 $ 499,642
Accrued warranty 2,068,000 1,980,520
Accrued expenses 691,697 748,576
Accrued salaries and wages 329,126 543,339
Accrued royalties payable 397,451 322,380
Income taxes payable 1,433,554 1,141,293
Deferred income 472,674 465,887
- ------------------------------------------------------------------------------------------------------
Total current liabilities 6,197,900 5,701,637
Deferred tax liabilities 293,477 1,484,247
- ------------------------------------------------------------------------------------------------------
Total liabilities 6,491,377 7,185,884
Commitments and contingent liabilities -- ----
Shareholders' equity:
Preferred stock, $1.00 par value; authorized shares,
10,000,000; issued shares, -0- in 2001 and 2002 -- ----
Common stock, $.20 par value--authorized shares,
50,000,000; issued shares, 13,513,119 in 2001
and 13,552,736 in 2002 2,702,624 2,710,547
Additional paid-in capital 70,010,254 70,489,025
Treasury stock, at cost, 386,800 shares
in 2001 and 461,800 shares in 2002 (3,164,975) (4,790,783)
Retained earnings 70,590,681 73,947,225
- ------------------------------------------------------------------------------------------------------
Total shareholders' equity 140,138,584 142,356,014
- ------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 146,629,961 $ 149,541,898
- ------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
20
Tollgrade Communications, Inc. and Subsidiaries
Consolidated Statements of Operations
Years Ended December 31,
2000 2001 2002
- ------------------------------------------------------------------------------------------------------------------
Revenues:
Products $ 111,957,560 $ 77,611,861 $ 48,146,350
Services 2,468,537 4,627,210 10,428,165
- ------------------------------------------------------------------------------------------------------------------
114,426,097 82,239,071 58,574,515
Cost of sales:
Products 40,680,034 33,134,366 20,799,976
Services 1,957,945 2,555,039 3,319,441
Amortization -- 365,000 1,464,098
- ------------------------------------------------------------------------------------------------------------------
42,637,979 36,054,405 25,583,515
- ------------------------------------------------------------------------------------------------------------------
Gross profit 71,788,118 46,184,666 32,991,000
- ------------------------------------------------------------------------------------------------------------------
Operating expenses:
Selling and marketing 12,288,646 9,159,227 8,766,207
General and administrative 6,216,427 4,827,120 5,489,163
Research and development 12,456,337 12,427,859 13,838,719
Severance and related expense -- 291,401 175,723
- ------------------------------------------------------------------------------------------------------------------
Total operating expense 30,961,410 26,705,607 28,269,812
- ------------------------------------------------------------------------------------------------------------------
Income from operations 40,826,708 19,479,059 4,721,188
Other income:
Interest and other income 2,525,460 2,796,213 692,592
- ------------------------------------------------------------------------------------------------------------------
Total other income 2,525,460 2,796,213 692,592
- ------------------------------------------------------------------------------------------------------------------
Income before taxes 43,352,168 22,275,272 5,413,780
Provision for income taxes 15,857,000 8,599,825 2,057,236
- ------------------------------------------------------------------------------------------------------------------
Net income $ 27,495,168 $ 13,675,447 $ 3,356,544
- ------------------------------------------------------------------------------------------------------------------
EARNINGS PER SHARE INFORMATION:
- ------------------------------------------------------------------------------------------------------------------
Weighted average shares of common stock and equivalents:
Basic 12,636,284 13,037,906 13,095,068
Diluted 13,359,270 13,412,037 13,313,676
- ------------------------------------------------------------------------------------------------------------------
Net income per common share:
Basic $ 2.18 $ 1.05 $ 0.26
Diluted $ 2.06 $ 1.02 $ 0.25
- ------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
21
Tollgrade Communications, Inc. and Subsidiaries
Consolidated Statements of Changes in Shareholders' Equity
Additional
Preferred Stock Common Stock Paid-in Treasury Retained
Shares Amount Shares Amount Capital Stock Earnings Total
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at
December 31, 1999 -- $ -- 12,102,280 $2,420,456 $28,828,568 $(3,164,975) $29,420,066 $57,504,115
Exercise of common
stock options -- -- 1,226,984 245,397 11,580,460 -- -- 11,825,857
Tax benefit from exercise
of stock options -- -- -- -- 25,934,700 -- -- 25,934,700
Net income -- -- -- -- -- -- 27,495,168 27,495,168
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at
December 31, 2000 -- -- 13,329,264 2,665,853 66,343,728 (3,164,975) 56,915,234 122,759,840
Exercise of common
stock options -- -- 183,855 36,771 1,626,764 -- -- 1,663,535
Tax benefit from exercise
of stock options -- -- -- -- 2,039,762 -- -- 2,039,762
Net income -- -- -- -- -- -- 13,675,447 13,675,447
- ------------------------------------------------------------------------------------------------------------------------------------
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 OPTIONS -- -- 39,617 7,923 270,252 -- -- 278,175
TAX BENEFIT FROM EXERCISE
OF STOCK OPTIONS -- -- -- -- 208,519 -- -- 208,519
PURCHASE OF TREASURY STOCK -- -- -- -- -- (1,625,808) -- (1,625,808)
NET INCOME -- -- -- -- -- -- 3,356,544 3,356,544
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE AT
DECEMBER 31, 2002 -- $ -- 13,552,736 $2,710,547 $70,489,025 $(4,790,783) $73,947,225 $142,356,014
- ------------------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
22
Tollgrade Communications, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
Years Ended December 31,
2000 2001 2002
- ------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income $ 27,495,168 $ 13,675,447 $ 3,356,544
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization 1,910,245 2,692,322 3,799,353
Tax benefit from exercise of stock options 15,044,372 2,039,762 208,519
Refund and utilization of income taxes paid -- 8,369,552 1,742,597
Deferred income taxes (481,541) (442,435) 540,391
Provision for losses on inventories 43,129 299,845 1,231,833
Provision for allowance for doubtful accounts 22,189 175,000 100,000
Changes in assets and liabilities:
Decrease (increase) in accounts receivable-- trade (7,932,588) 9,304,092 1,250,275
Decrease (increase) in accounts receivable-- other (478,654) 1,390,808 300,711
Decrease (increase) in inventories (13,906,864) 8,016,021 6,859,187
(Increase) decrease in prepaid expenses
and deposits (325,164) 7,875 (613,245)
Increase in deferred and refundable tax assets -- (655,323) (576,590)
(Decrease) increase in accounts payable 962,559 (1,068,929) (305,756)
(Decrease) increase in accrued warranty 445,000 1,023,000 (87,480)
Decrease in accrued expenses
and deferred income (736,760) (1,103,218) (82,408)
(Decrease) increase in accrued royalties payable 348,789 (745,027) (75,071)
Increase (decrease) in accrued salaries and wages 603,960 (2,484,307) 214,213
(Decrease) increase in income taxes payable (1,806,671) 796,616 (292,261)
- ------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 21,907,169 41,291,101 17,570,812
- ------------------------------------------------------------------------------------------------------------------
Cash flows from investing activities:
Purchase of investments (38,637,741) (29,030,595) (23,057,447)
Redemption/maturity of investments 23,848,762 53,546,927 10,367,887
Capital expenditures (4,076,074) (3,528,528) (1,829,679)
Investments in other assets -- (231,615) (10,501)
Purchase of LoopCare business from Lucent -- (62,028,763) --
- ------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (18,865,053) (41,272,574) (14,529,740)
- ------------------------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Purchase of treasury stock -- -- (1,625,808)
Proceeds from the exercise of stock options 11,825,857 1,663,535 278,175
- ------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 11,825,857 1,663,535 (1,347,633)
- ------------------------------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents 14,867,973 1,682,062 1,693,439
- ------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at beginning of period 15,555,810 30,423,783 32,105,845
- ------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 30,423,783 $ 32,105,845 $ 33,799,284
- ------------------------------------------------------------------------------------------------------------------
Supplemental disclosure of cash flow information:
Cash paid during the year for income taxes $ 3,145,422 $ 6,801,560 $ 1,898,379
Supplemental disclosure of non-cash financing activity:
Acquisition related receivable $ -- $ 897,000 $ --
Tax benefit from the exercise of stock options $ 10,890,328 $ -- $ --
- ------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
23
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION, BUSINESS AND BASIS OF PRESENTATION
Tollgrade Communications, Inc. (the Company) designs, engineers, markets and
supports test system, test access and status monitoring products and test
software for the telecommunications and cable television industries. The
Company's telecommunications proprietary test access products enable telephone
companies to use their existing line test systems to remotely diagnose problems
in Plain Old Telephone Service (POTS) lines containing both copper and fiber
optics. The Company's test system products, specifically the DigiTest test
platform, focus on helping local exchange carriers conduct the full range of
fault diagnosis along with the ability to prequalify, deploy and maintain
next-generation services including Digital Subscriber Line service. The
Company's cable products consist of a complete cable status monitoring system
that provides a comprehensive testing solution for the Broadband Hybrid Fiber
Coax distribution system. The status monitoring system consists of a host for
user interface, control and configuration; a headend controller for managing
network communications; and transponders that are strategically located within
the cable network to gather status reports from power supplies, line amplifiers
and fiber-optic nodes. The Company was organized in 1986 and began operations in
1988. The Company acquired, for cash, the LoopCare product line business,
effective September 30, 2001. See Note 2.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles in the United States of America requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of income and expense during
the reporting period. Actual results could differ from those estimates.
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries. All significant intercompany
transactions have been eliminated.
CASH AND CASH EQUIVALENTS
The Company considers highly liquid investments with a maturity of three months
or less when purchased to be cash equivalents. Substantially all of the
Company's cash and cash equivalents are maintained at one financial institution.
No collateral or security is provided on these deposits, other than $100,000 of
deposits per financial institution which is insured by the Federal Deposit
Insurance Corporation.
INVESTMENTS
Short-term investments at December 31, 2002 and December 31, 2001 consisted of
individual municipal bonds stated at cost, which approximated market value.
These securities have maturities of one year or less at date of purchase and/or
contain a callable provision in which the bonds can be called within one year
from date of purchase. Long-term investments are comprised of individual
municipal bonds with a maturity of more than one year but less than eighteen
months and are stated at amortized cost, which approximated market value. The
primary investment purpose is to provide a reserve for future business purposes,
including acquisitions and capital expenditures. Realized gains and losses are
computed using the specific identification method. The Company classifies its
investment in all debt securities as "held to maturity" as the Company has the
positive intent and ability to hold the securities to maturity.
INVENTORIES
Inventories are stated at the lower of cost or market, with cost determined on
the first-in, first-out method. The Company provides appropriate reserves for
any inventory deemed slow moving or obsolete.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost and depreciated on a straight-line
method over the estimated useful lives. Leasehold improvements are amortized
over the related lease period or the estimated useful life, whichever is
shorter. The cost of renewals and betterments that extend the lives or
productive capacities of properties is capitalized. Expenditures for normal
repairs and maintenance are charged to operations as incurred. The cost of
property and equipment retired or otherwise disposed of and the related
accumulated depreciation or amortization are removed from the accounts, and any
resulting gain or loss is reflected in current operations.
PRODUCT WARRANTY
The Company records estimated warranty costs on the accrual basis of accounting.
These reserves are based on applying historical returns to the current level of
product shipments and the cost experience associated therewith. In the case of
software, the reserves are based on the expected cost of providing services
within the agreed-upon warranty period. Activity in the warranty accrual is as
follows:
2001 2002
- -----------------------------------------------------------------------------------------
Balance at the beginning of the period $1,045,000 $ 2,068,000
Accruals for warranties issued during the period 2,099,000 972,000
Accruals related to pre-existing warranties (923,000) (161,000)
Settlements during the period (153,000) (898,000)
- -----------------------------------------------------------------------------------------
Balance at the end of the period $2,068,000 $ 1,981,000
- -----------------------------------------------------------------------------------------
24
REVENUE RECOGNITION
Revenue from product sales is recognized at the time of shipment when both risk
of loss and title has transferred to the customer, which coincides with shipment
of related products, and collection is reasonably assured. Software license
revenue is recognized in accordance with the AICPA's Statement of Position
("SOP") 97-2, "Software Revenue Recognition," SOP 98-9 "Modification of SOP
97-2, Software Revenue Recognition With Respect to Certain Transactions," and
Emerging Issues Task Force Issue 00-21, "Accounting for Revenue Arrangements
with Multiple Deliverables." Revenue from software license, which is comprised
of fees for perpetual licenses derived from contracts with corporate customers,
is recognized when persuasive evidence of an arrangement exists, the product is
delivered, acceptance by the customer and receipt of a signed notice indicating
that no significant Company obligations exist, the fee is fixed or determinable,
and collectibility is probable. In cases for orders of custom software, or
orders that require significant software customization, the Company will employ
contract accounting using the percentage-of-completion method whereby revenue is
recognized based on costs incurred to date compared to total estimated contract
cost. Revenue from Services (testability consulting) is recognized upon services
being rendered. Reimbursement for out-of-pocket costs is recognized as revenue
and simultaneously recognized as the cost of product sales. Revenue from
Services also includes revenue from maintenance agreements. Maintenance revenue
is generally recognized on a straight-line basis over the life of the related
agreement, which is typically one year. Customer advances and amounts due from
customers in excess of revenue recognized are recorded as deferred income.
Revenue for license and royalty fees is recognized when earned.
In December 1999, the Staff of the Securities and Exchange Commission
issued Staff Accounting Bulletin 101, "Revenue Recognition in Financial
Statements" ("SAB 101"), which provides guidance related to revenue recognition.
The Company adopted this standard in 2000 and the effect was not material to its
business, results of operations and financial condition.
IMPAIRMENT OF LONG-LIVED ASSETS
Long-lived and intangible assets to be held and used are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of
such assets may not be recoverable. Intangible assets are reviewed at least
annually. Determination of recoverability is based on an estimate of discounted
or undiscounted future cash flows resulting from the use of the asset and its
eventual disposition. Measurement of an impairment loss for long-lived assets
and certain identifiable intangible assets that management expects to hold and
use is based on the fair value of the assets.
RESEARCH AND DEVELOPMENT COSTS
Research and development costs to develop or improve hardware-related products
are charged to operations as incurred.
CAPITALIZED SOFTWARE DEVELOPMENT COSTS
Any costs incurred to establish the technological feasibility of software to be
sold or otherwise marketed are expensed as research and development costs. Costs
incurred subsequent to the establishment of technological feasibility, and prior
to the general availability of the product to the public are capitalized and
subsequently amortized under the straight-line method. The Company defines
technological feasibility as coding and testing in accordance with detailed
program designs. There were no software development costs capitalized in 2000 or
2001 and $68,100 was capitalized in 2002. Such costs are being amortized over
five years.
INCOME TAXES
The Company follows the provisions of SFAS No. 109, "Accounting for Income
Taxes" (SFAS 109). Under SFAS 109, deferred tax liabilities and assets are
determined based on the "temporary differences" between the financial statement
carrying amounts and the tax basis of assets and liabilities using enacted tax
rates in effect in the years in which the differences are expected to reverse.
Valuation allowances are established when necessary to reduce deferred tax
assets to the amount expected to be realized.
SEGMENT INFORMATION
The Company follows the provisions of SFAS No. 131, "Disclosures about Segments
of an Enterprise and Related Information, Financial Reporting for Segments of a
Business." This statement establishes standards for reporting information about
operating segments, products and services, geographic areas and major customers
in annual and interim financial statements. The Company manages and operates its
business as one segment. International sales were 6.3% of revenues in 2002, 5.3%
in 2001 and 2.0% in 2000.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative
Instruments and Hedging Activities," as amended by SFAS No. 138, "Accounting for
Certain Instruments and Certain Hedging Activities." This statement establishes
standards for reporting information about various derivative financial
instruments and accounting for their change in fair value. The Company does not
hold or issue derivative instruments for hedging purposes and, therefore, this
standard does not have a material effect on the consolidated financial position
or results of operations of the Company.
ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company has two stock-based employee compensation plans which are described
more fully in Note 5. The Company accounts for these plans under the recognition
and measurement provisions of APB Opinion No. 25, "Accounting for Stock Issued
to Employees." Under these provisions, stock-based employee compensation cost is
not reflected in net income for any year, as all options granted under the plans
had an exercise price equal to the market value of the underlying common stock
on the date of grant. If the Company had elected to recognize compensation
25
cost for these stock options based on the fair value method set forth in SFAS
No. 123, "Accounting for Stock-Based Compensation," net income and earnings per
share would have reflected the pro forma amounts indicated below:
Years Ended December 31,
2000 2001 2002
- -------------------------------------------------------------------------------------------------
Net income, as reported $ 27,495,168 $ 13,675,447 $ 3,356,544
Deduct: Total stock-based employee
compensation expense based on
the fair value method for all awards,
net of related tax effects 7,761,098 6,943,395 4,626,927
- -------------------------------------------------------------------------------------------------
Pro forma net income $ 19,734,070 $ 6,732,052 $ (1,270,383)
Earnings per share:
Basic-- as reported $ 2.18 $ 1.05 $ 0.26
Basic-- pro forma $ 1.56 $ 0.52 $ (0.10)
- -------------------------------------------------------------------------------------------------
Diluted-- as reported $ 2.06 $ 1.02 $ 0.25
Diluted-- pro forma $ 1.48 $ .50 $ (0.10)
- -------------------------------------------------------------------------------------------------
2. ACQUISITION
On September 30, 2001, the Company acquired certain assets and assumed certain
liabilities of the LoopCare(TM) Product line from Lucent Technologies, Inc.
("Lucent") for approximately $62,029,000 in cash, which includes approximately
$2,200,000 of acquisition-related costs. The LoopCare software product
integrates with and enhances the value of the Company's core products, resulting
in a significant competitive advantage in the marketplace. The assets consisted
principally of rights to existing contracts, software and related computer
equipment, while the liabilities were principally related to software warranties
currently under contract and deferred income which results from customer
contractual billings and advances in excess of revenue recognized in income. The
Company used available cash and short-term investments to finance the
acquisition. LoopCare is the Plain Old Telephone Services ("POTS") test system
used universally by the Regional Bell Operating Companies. The LoopCare
acquisition was recorded under the purchase method of accounting and,
accordingly, the results of operations of the LoopCare business since October 1,
2001 have been included in the consolidated financial statements.
The following summarizes the estimated fair values at the date of
acquisition:
Current assets $ 855,000
Property and equipment, net 307,000
Intangible assets:
LoopCare trade name $ 1,300,000
Base software 5,200,000
Developed product software 7,300,000
Post warranty maintenance service agreements 32,000,000 45,800,000
----------
Goodwill 16,161,763
- -----------------------------------------------------------------------------------
Total assets acquired $ 63,123,763
- -----------------------------------------------------------------------------------
Deferred income (1,076,000)
Warranty reserve (19,000)
- -----------------------------------------------------------------------------------
Total liabilities assumed (1,095,000)
- -----------------------------------------------------------------------------------
NET ASSETS ACQUIRED $ 62,028,763
- -----------------------------------------------------------------------------------
An independent valuation consultant assisted management in its
determination of fair value assigned to certain intangible assets other than
goodwill. Discounted future cash flow models were utilized where appropriate.
The base software has a historically long life cycle and the Company
intends to maintain the software and to continue to develop new LoopCare
features. Consequently, it was assumed that the base software and the LoopCare
trade name have an indefinitely long life. This software has been in use and
embedded within the Company's key customers' operating systems for over 25
years. Similarly, the maintenance service agreements are expected to generate
revenues into perpetuity and are assumed to have an indefinite life. The
developed product software was estimated to have a useful life at acquisition
date of approximately five years and the Company believes it can continue to
market the product over that period. Rapid development of improved replacement
products is not expected due to the relatively small customer base and the cost
to develop new software. The Company has utilized the transitional guidance of
Statement of Financial Accounting Standards (SFAS) No. 141, "Business
Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets" which
were issued in July 2001. SFAS No. 141 requires that the purchase method of
accounting be used for all business combinations initiated after June 30, 2001
and that goodwill, as well as any intangible assets believed to have an
indefinite useful life, shall not be amortized for financial reporting purposes.
Based on the aforementioned and the Company's belief that there are no
legal, regulatory, contractual, competitive or economic limitations on the
useful lives of the LoopCare trade name, the base software and the maintenance
service agreements, these assets are deemed to have an indefinite useful life
and, along with goodwill, are not being amortized. In addition, based on the
foregoing analysis, the developed product software is being amortized over five
years. For tax purposes, the Company is amortizing all intangible assets over 15
years.
SFAS No. 142 also provides that entities evaluate the remaining useful
lives of intangible assets determined to have indefinite useful lives
periodically to determine whether events and circumstances continue to support
an indefinite useful life and that such assets be tested at least annually for
impairment of value. Any determined impairment in
26
value from the carrying amounts shall result in an impairment loss to the extent
of that excess. As of January 1, 2002, the Company fully adopted the provisions
of SFAS No. 142.
Goodwill was tested for impairment as of June 29, 2002 and December 31,
2002 by comparing the aggregate market value of the Company's stock with the
Company's book carrying value, including goodwill. These tests indicated that
there was no impairment of goodwill carrying value. All other intangible assets
were tested for impairment of carrying value as of December 31, 2002 using
assumptions and techniques employed in the original valuation and following the
guidance of SFAS No. 144. Specifically, the sum of the projected future cash
flows to be derived from the developed product software was compared with the
net book carrying value. The impairment test for non-amortizable intangible
assets other than goodwill consisted of a comparison of the estimated fair value
with carrying amounts. The value of the LoopCare trade name was measured using
the relief-from-royalty method and discounted cash flow analyses were employed
to test the value of the base software and post-warranty maintenance service
agreements. These tests indicated that none of the intangible assets had
impairment in carrying value as of December 31, 2002. The Company plans to
retest these assets annually as of December 31 or more frequently if events or
changes in circumstances indicate that assets might be impaired.
The following condensed proforma results of operations reflect the
proforma combination of the Company and the acquired LoopCare business as if the
combination occurred on January 1, 2001:
(In Thousands, Except Per Share Data)
Proforma Historical
December 31, 2001 December 31, 2002
- --------------------------------------------------------------------------------------------
Revenues $ 95,629 $ 58,575
- --------------------------------------------------------------------------------------------
Income from operations $ 23,728 $ 4,721
- --------------------------------------------------------------------------------------------
Net income $ 15,610 $ 3,357
- --------------------------------------------------------------------------------------------
Net income per common share:
Basic $ 1.20 $ 0.26
- --------------------------------------------------------------------------------------------
Diluted $ 1.16 $ 0.25
- --------------------------------------------------------------------------------------------
The results of operations for the LoopCare product line business included above
include the twelve-month periods ending September 30, 2001. Other proforma
adjustments include an estimated allocation of selling, general and
administrative expenses to the LoopCare operations based upon budgeted costs for
2002 and proforma amortization of the developed product software over five
years. Proforma adjustments were also made to take into account the cost of
money in connection with the acquisition costs. This was projected by reducing
interest income at historical earning rates for working capital deemed to have
been available to apply to the acquisition costs and projecting interest expense
on borrowed funds for residual acquisition costs at the historical prime rates
of interest plus 1.5%. Adjustments were also made to reflect the tax
consequences of the foregoing proforma adjustments.
The following information is provided regarding the Company's intangible
assets:
As of December 31, 2002
Gross Carrying Amount Accumulated Amortization
- ---------------------------------------------------------------------------------------------------------
Amortized intangible assets:
Developed product software $ 7,368,100 $ 1,829,098
- ---------------------------------------------------------------------------------------------------------
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
- ---------------------------------------------------------------------------------------------------------
As of December 31, 2001
Gross Carrying Amount Accumulated 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
- ---------------------------------------------------------------------------------------------------------
Estimated amortization expense:
For year ended December 31, 2003 $ 1,473,620
For year ended December 31, 2004 $ 1,473,620
For year ended December 31, 2005 $ 1,473,620
For year ended December 31, 2006 $ 1,108,620
For year ended December 31, 2007 $ 9,522
Actual amortization expense:
For year ended December 31, 2001 $ 365,000
For year ended December 31, 2002 $ 1,464,098
Actual net income:
For year ended December 31, 2001 $ 13,675,447
For year ended December 31, 2002 $ 3,356,544
27
3. INVENTORIES
Inventories consisted of the following:
December 31, 2001 DECEMBER 31, 2002
- -----------------------------------------------------------------------------------------------
Raw materials $ 11,697,886 $ 9,726,789
Work in process 6,443,549 4,518,164
Finished goods 5,153,181 2,190,476
- -----------------------------------------------------------------------------------------------
$ 23,294,616 16,435,429
- -----------------------------------------------------------------------------------------------
Reserves for slow moving and obsolete inventory (1,111,000) (2,342,833)
- -----------------------------------------------------------------------------------------------
$ 22,183,616 $ 14,092,596
- -----------------------------------------------------------------------------------------------
4. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following:
Years December 31, 2001 DECEMBER 31, 2002
- -----------------------------------------------------------------------------------------------
Test equipment and tooling 3-5 $ 6,617,117 $ 7,414,502
Office equipment and fixtures 5-7 5,853,773 6,716,510
Leasehold improvements 1-6 2,036,329 2,137,786
- -----------------------------------------------------------------------------------------------
$ 14,507,219 $ 16,268,798
Less accumulated depreciation and amortization 8,117,330 10,452,585
- -----------------------------------------------------------------------------------------------
Subtotal $ 6,389,889 $ 5,816,213
- -----------------------------------------------------------------------------------------------
Land $ 1,622,657 $ 1,622,657
- -----------------------------------------------------------------------------------------------
$ 8,012,546 $ 7,438,870
- -----------------------------------------------------------------------------------------------
5. SHAREHOLDERS' EQUITY
COMMON STOCK
The Company has 50,000,000 authorized shares which have a par value of $.20 per
share. As of December 31, 2001 and 2002, there were 13,513,119 and 13,552,736
issued shares, respectively.
STOCK REPURCHASE PROGRAM
On January 24, 2002, the Company's Board of Directors authorized the
continuation of a share repurchase program that was originally initiated on
April 22, 1997. Prior to this extension, the Company had repurchased 382,400
shares of common stock. This continuation authorized the Company to repurchase a
total of one million shares of its common stock before December 31, 2002. During
2002, the Company bought an additional 75,000 shares for a total of 457,400
shares repurchased under the program and all extensions.
On January 22, 2003, 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, 2003.
STOCK COMPENSATION PLANS
Under the Company's stock compensation plans, directors, officers and other
employees may be granted options to purchase shares of the Company's common
stock. The option price on all outstanding options is equal to the fair market
value of the stock at the date of the grant, as defined. The options generally
vest ratably over a two-year period, with one-third vested upon grant. The
Company's option programs cover all employees and are used to attract and retain
qualified personnel in all positions.
On February 19, 1999, the Board of Directors approved a proposal to
increase the number of shares under the 1995 Long-Term Incentive Compensation
Plan ("the 1995 Plan") by 230,000 shares, with a corresponding cancellation of a
similar number of shares under the 1998 Employee Incentive Compensation Plan
("the 1998 Plan"). The shareholders approved this action on May 6, 1999. On
December 14, 2000, the Board of Directors of the Company approved a proposal to
increase the number of shares available under the 1998 Plan by 200,000 shares,
from 740,000 to 940,000 shares. On May 23, 2001, the shareholders approved an
amendment to the Company's 1995 Plan, as adopted by the Board of Directors on
January 25, 2001, to increase the number of shares available under the Plan by
275,000 shares, from 2,210,000 to 2,485,000. The aggregate number of shares of
the Company's Common Stock which may be issued under the 1995 Plan and the 1998
Plan is 2,485,000 and 940,000 shares, respectively, subject to proportionate
adjustment in the event of stock splits and similar events. On January 24, 2002,
the Board of Directors approved a proposal to increase the number of shares
available under the 1998 Plan by 50,000 shares, from 940,000 to 990,000 shares.
That same date, the Board also approved a proposal to increase the number of
shares available under the 1995 Plan by 200,000. On May 7, 2002, the
shareholders approved an amendment to the 1995 Plan, as adopted by the Board of
Directors on January 24, 2002, to increase the number of shares available by
200,000 from 2,485,000 to 2,685,000. The maximum number of shares which may be
awarded under the 1995 Plan to any one Named Executive Officer during any
calendar year of the life of the plan is 200,000 shares. All full-time active
employees of the Company, excluding officers and directors, are eligible to
participate in the 1998 Plan. Amendments to the 1998 Plan do not require the
approval of the shareholders, but are approved by the Board of Directors. The
Company has
28
2,061,767 total shares reserved under the option plans. The shares authorized
but not granted under these plans at December 31, 2001 and 2002 were as follows:
Shares Authorized But Not Granted
December 31, 2001 DECEMBER 31, 2002
- -----------------------------------------------------------------------------------------------------
1995 Long-Term Incentive Compensation Plan 161,182 317,211
1998 Employee Incentive Compensation Plan 1,572 26,850
- -----------------------------------------------------------------------------------------------------
Total 162,754 344,061
- -----------------------------------------------------------------------------------------------------
The fair value of the stock options used to compute pro forma net income
and earnings per share disclosures is the estimated present value at grant date
using the Black-Scholes option-pricing model with the following weighted average
assumptions for 2000, 2001 and 2002: expected volatility of 77.0% in 2000, 87.7%
in 2001 and 92.3% in 2002; a risk-free interest rate of 5.83% in 2000, 3.65% in
2001 and 2.67% in 2002; and an expected holding period of four years. Using the
Black-Scholes option-pricing model, the weighted average fair value of stock
options granted during 2000, 2001 and 2002, is $58.36, $17.84 and $9.52 per
share, respectively.
Transactions involving stock options under the Company's various stock
option plans and otherwise are summarized below:
Weighted Average
Number of Shares Range of Option Price Exercise Price
- -----------------------------------------------------------------------------------------------------------------
Outstanding, December 31, 1999 2,195,023 6.00000 - 17.25000 $ 9.38
Granted 416,625 51.62500 - 159.18750 95.84
Exercised (1,223,793) 6.00000 - 51.62500 9.59
Cancelled (24,615) 6.00000 - 159.18750 28.96
- -----------------------------------------------------------------------------------------------------------------
Outstanding, December 31, 2000 1,363,240 6.00000 - 159.18750 35.25
Granted 560,650 20.53000 - 38.00000 27.60
Exercised (183,855) 6.00000 - 21.70000 9.05
Cancelled (66,405) 6.00000 - 159.18750 61.00
- -----------------------------------------------------------------------------------------------------------------
Outstanding, December 31, 2001 1,673,630 6.00000 - 159.18750 34.55
Granted 152,000 9.48500 - 24.21000 14.39
Exercised (39,617) 6.00000 - 28.39500 7.02
Cancelled (83,307) 6.00000 - 159.18750 41.29
- -----------------------------------------------------------------------------------------------------------------
OUTSTANDING, DECEMBER 31, 2002 1,702,706 $ 6.00000 - $ 159.18750 $ 33.06
- -----------------------------------------------------------------------------------------------------------------
Weighted Average
Options exercisable at: Number of Shares Exercise Price
- -----------------------------------------------------------------------------------------------------------------
December 31, 2000 997,680 $ 21.92
December 31, 2001 1,219,648 $ 30.41
DECEMBER 31, 2002 1,454,464 $ 34.90
- -----------------------------------------------------------------------------------------------------------------
The following table summarizes the status of the stock options,
outstanding and exercisable, at December 31, 2002:
Stock Options Outstanding Stock Options Exercisable
- -----------------------------------------------------------------------------------------------------------------
Number Weighted Average Weighted Weighted
Range of Exercise Outstanding Remaining Average Average
Prices as of 12/31/02 Contractual Life Exercise Price Shares Exercise Price
- -----------------------------------------------------------------------------------------------------------------
$ 6.00000 - $ 7.28130 224,433 5.00 $ 6.87 224,433 $ 6.87
- -----------------------------------------------------------------------------------------------------------------
$ 7.50000 - $ 9.26570 194,955 5.69 8.17 194,955 8.17
- -----------------------------------------------------------------------------------------------------------------
$ 9.48500 - $ 10.31250 178,466 6.31 9.98 146,486 10.08
- -----------------------------------------------------------------------------------------------------------------
$ 11.03130 - $ 13.63000 173,900 5.86 13.04 144,570 12.92
- -----------------------------------------------------------------------------------------------------------------
$ 15.83500 - $ 21.92500 200,334 8.51 19.57 135,011 19.71
- -----------------------------------------------------------------------------------------------------------------
$ 21.51500 - $ 24.21000 24,000 9.14 22.80 8,005 22.80
- -----------------------------------------------------------------------------------------------------------------
$ 28.39500 - $ 28.39500 188,388 8.78 28.40 133,135 28.40
- -----------------------------------------------------------------------------------------------------------------
$ 28.70000 - $ 55.89850 297,670 8.38 42.52 247,309 44.58
- -----------------------------------------------------------------------------------------------------------------
$ 71.87500 - $103.59375 19,000 7.75 100.25 19,000 100.25
- -----------------------------------------------------------------------------------------------------------------
$ 117.34400 - $159.18750 201,560 7.61 122.68 201,560 122.68
- -----------------------------------------------------------------------------------------------------------------
TOTAL 1,702,706 7.12 $ 33.06 1,454,464 $ 34.90
- -----------------------------------------------------------------------------------------------------------------
29
SERIES A JUNIOR PARTICIPATING PREFERRED STOCK PURCHASE RIGHTS
In order to protect shareholder value in the event of an unsolicited offer to
acquire the Company, on July 23, 1996, the Board of Directors of the Company
declared a dividend of one preferred stock purchase right for each outstanding
share of the Company's common stock. The dividend was payable on August 15, 1996
to shareholders of record as of that date. The aforementioned rights are
exercisable only if a person or group acquires or announces an offer to acquire
20% or more of the Company's common stock. In such an event, each right will
entitle shareholders to buy one-hundredth of a share of a new series of
preferred stock at an exercise price of $115.00. Each one-hundredth of a share
of the new preferred stock has terms designed to make it the economic and voting
equivalent of one share of common stock.
If a person or group acquires 20% or more of the Company's outstanding
common stock, each right not owned by the person or group will entitle its
holder to purchase at the right's exercise price a number of shares of the
Company's common stock (or, at the option of the Company, the new preferred
stock) having a market value of twice the exercise price. Further, at any time
after a person or group acquires 20% or more (but less than 50%) of the
outstanding common stock, the Board of Directors may at its option, exchange
part or all of the rights (other than rights held by the acquiring person or
group) for shares of the Company's common or preferred stock on a one-for-one
basis. Each right further provides that if the Company is acquired in a merger
or other business transaction, each right will entitle its holder to purchase,
at the right's exercise price, a number of the acquiring company's common shares
having a market value at that time of twice the exercise price.
The Board of Directors is entitled to redeem the rights for one cent per
right at any time before a 20% position has been acquired. The Board of
Directors is also authorized to reduce the 20% thresholds referred to above to
not less than 10%.
6. LICENSE AND ROYALTY FEES
The Company has entered into several technology license agreements with certain
major Digital Loop Carrier (DLC) vendors and major Operation Support System
(OSS) equipment manufacturers under which the Company has been granted access to
the licensor's patent technology and the right to manufacture and sell the
patent technology in the Company's product line. The Company is obligated to pay
royalty fees, as defined, through the terms of these license agreements. Under
these agreements, license and royalty fees are due only upon purchase of the
technology or shipment of units; there are no contingent payment provisions in
any of these arrangements. Royalty fees of $2,910,803, $1,832,981 and $889,024
were incurred in 2000, 2001 and 2002, respectively, and are included in cost of
product sales in the accompanying consolidated statements of operations.
7. INCOME TAXES
The provision for income taxes consisted of the following:
Years Ended December 31,
2000 2001 2002
- -----------------------------------------------------------------------------------------
Current:
Federal $ 14,212,441 $ 8,192,841 $ 1,491,245
State 2,126,100 849,419 25,600
- -----------------------------------------------------------------------------------------
16,338,541 9,042,260 1,516,845
- -----------------------------------------------------------------------------------------
Deferred:
Federal (434,521) (355,700) 675,547
State (47,020) (86,735) (135,155)
- -----------------------------------------------------------------------------------------
(481,541) (442,435) 540,392
- -----------------------------------------------------------------------------------------
$ 15,857,000 $ 8,599,825 $ 2,057,237
- -----------------------------------------------------------------------------------------
Reconciliations of the federal statutory rate to the effective tax rates
are as follows:
Years Ended December 31,
2000 2001 2002
- -----------------------------------------------------------------------------------------
Federal statutory tax rate 35% 35% 34%
State income taxes 5 3 (1)
Other (3) 1 5
Effective tax rate 37% 39% 38%
- -----------------------------------------------------------------------------------------
30
The components of and changes in the deferred tax assets and liabilities
recorded in the accompanying balance sheets at December 31, 2001 and 2002 were
as follows:
Deferred Deferred
December 31, Expense December 31, Expense December 31,
2000 (Credit) Other 2001 (Credit) Other 2002
- ------------------------------------------------------------------------------------------------------------------------------------
DEFERRED TAX ASSETS:
Excess of tax basis over book basis for:
Property and equipment $ 184,890 $ (160,287) $ -- $ 345,177 $ (4,375) $ -- $ 349,552
Inventory 321,803 (56,162) -- 377,965 72,798 -- 305,167
Reserves recorded for:
Warranty 407,550 (398,970) -- 806,520 34,117 -- 772,403
Inventory 423,150 (10,140) -- 433,290 (480,415) -- 913,705
Allowance for
doubtful accounts 78,000 (68,250) -- 146,250 (39,000) -- 185,250
Net operating loss carryforward 1,939,656 -- 160,293 1,779,363 (234,500) 372,001 1,641,862
Other 9,025 (32,153) -- 41,178 997 34,425 5,756
- ------------------------------------------------------------------------------------------------------------------------------------
Total deferred tax assets $3,364,074 $3,929,743 $ 4,173,695
- ------------------------------------------------------------------------------------------------------------------------------------
DEFERRED TAX LIABILITIES:
Excess of book basis over tax basis for:
Goodwill & Intangibles 258,403 (258,403) 1,042,539 (1,300,942)
Property and equipment 25,124 (25,124) 148,231 (173,355)
Other (9,950) (9,950) (9,950)
- ------------------------------------------------------------------------------------------------------------------------------------
Total deferred tax liabilities $ (9,950) $ (293,477) $(1,484,247)
- ------------------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------------
Net deferred taxes $3,354,124 $ (442,435) $ 160,293 $3,636,266 $ 540,392 $ 406,426 $ 2,689,448
Reconciliation to the balance sheet:
Current portion
of deferred tax assets 983,246 1,116,756 1,404,122
Long-term portion
of deferred tax liabilities (9,950) (293,477) (1,484,247)
- ------------------------------------------------------------------------------------------------------------------------------------
Long-term deferred
tax asset $2,380,828 $2,812,987 $ 2,769,573
- ------------------------------------------------------------------------------------------------------------------------------------
The deferred tax asset from net operating loss carryforwards is applicable to
Pennsylvania which presently allows a 20-year carryforward with a $2,000,000
limit on deductions each year. Unused carryforward losses will expire in 2020.
8. LINE OF CREDIT
Effective December 20, 2001, and amended effective February 7, 2003, the Company
executed a five-year $25,000,000 Unsecured Revolving Credit Facility (the
"Facility") with a bank. In accordance with the terms of the Facility, the
proceeds must be used for general corporate purposes, working capital needs, and
in connection with certain acquisitions, as defined. The Facility contains
certain standard covenants with which the Company must comply, including a
minimum fixed charge ratio, a minimum defined level of tangible net worth and a
restriction on the amount of capital expenditures that can be made on an annual
basis, among others. Interest is payable on any amounts utilized under the
Facility at prime, or the prevailing Euro rate plus 1.0% to 1.5% depending on
the fixed charge coverage ratio, at the option of the Company. Commitment fees
are paid quarterly at the rate of 0.25% per annum on the average unused
commitment. At December 31, 2002, there were no amounts outstanding under the
Facility.
9. LEASE COMMITMENTS
The Company leases office space and equipment under agreements which are
accounted for as operating leases. The office lease for the Cheswick facility
expires December 31, 2003 and is extended to December 31, 2005. The equipment
leases expire in August 2005 for the Cheswick facility and January 2007 for the
Bridgewater facility. The Company is also involved in various month-to-month
leases for research and development equipment. In addition, the office lease
includes provisions for possible adjustments in annual future rental commitments
relating to excess taxes and excess maintenance costs that may occur.
Minimum annual future rental commitments under noncancelable leases
as of December 31 are:
2003 .........................................................$ 1,177,234
2004 ......................................................... 1,196,206
2005 ......................................................... 1,190,871
2006 ......................................................... 457,032
2007 ......................................................... 25,965
The rent expense for all lease commitments was $731,320, $890,943 and
$1,170,101 in 2000, 2001 and 2002, respectively.
31
10. MAJOR CUSTOMERS, REVENUE CONCENTRATION AND DEPENDENCE ON CERTAIN SUPPLIERS
The company designs, engineers, markets and supports test system, test access
and status monitoring products for the telecommunications and cable television
industries. Sales are concentrated primarily with the four Regional Bell
Operating Companies (RBOCs) as well as major independent telephone companies and
to certain digital loop carrier equipment manufacturers. Sales are primarily
from the Company's metallic channel unit (MCU) product line. The MCU product
line accounted for approximately 48% of the Company's net product sales for
2002. The DigiTest product line accounted for approximately 14% of the Company's
net product sales for 2002. LoopCare RTU sales accounted for approximately 13%
of the Company's net products sales for 2002. Revenue from Services, which
includes installation oversight and project management services provided to
RBOCs and fees for LoopCare software maintenance, accounted for approximately
18% of the Company's net product sales for 2002.
Sales to RBOC customers accounted for approximately 64%, 71% and 77% of
the Company's net product sales for fiscal years 2000, 2001 and 2002,
respectively. During fiscal year 2000, sales to four RBOC customers individually
exceeded 10% of consolidated revenues and on a combined basis, comprised 64%
(individually, 29%, 14%, 11% and 10%) of the Company's net product sales. During
fiscal years 2001 and 2002, sales to three RBOC customers individually exceeded
10% of consolidated revenues and, on a combined basis, comprised 66%
(individually, 38%, 14% and 14%) and 70% (individually, 38%, 18% and 14%) of the
Company's net product sales. Sales to a large independent carrier accounted for
approximately 12%, 11% and 2% of the Company's net product sales for fiscal
years 2000, 2001 and 2002, respectively. Due to the Company's present dependency
on RBOC customers, the loss of one or more of the RBOCs as a customer, or the
reduction of orders for the Company's products by the RBOCs, could materially
and adversely affect the Company.
The Company utilizes two key independent subcontractors to perform a
majority of the circuit board assembly and in-circuit testing work on its
products. The Company also utilizes other subassembly contractors on a more
limited basis. The loss of the subcontractors could cause delays in the
Company's ability to meet production obligations and could have a material
adverse effect on the Company's results of operations. In addition, shortages of
raw material to, or production capacity constraints at, the Company's
subcontractors could negatively affect the Company's ability to meet its
production obligations and result in increased prices for affected parts. Any
such reduction may result in delays in shipments of the Company's products or
increases in the price of components, either of which could have a material
adverse impact on the Company.
11. EMPLOYEE BENEFIT PLANS
The Company has a 401(k) benefit plan. Eligible employees, as defined in the
plan, may contribute up to 20% of eligible compensation, not to exceed the
statutory limit. The Company does not make matching contributions to the plan.
12. SEVERANCE AND RELATED EXPENSE
On September 30, 2002, the Company announced its second restructuring program in
two years to implement certain cost reduction initiatives which included the
elimination of 47 positions, primarily in research and development. The
restructuring program resulted in a pre-tax charge for severance, outplacement
and other related costs of $175,723 in 2002. The initial restructuring program
in April 2001 resulted in a pre-tax charge of $291,000 in 2001 and eliminated
approximately 80 positions.
13. SUBSEQUENT EVENT
On February 13, 2003, the Company closed on a Purchase and Sale Agreement with
Acterna, LLC (Acterna) to acquire certain assets and assume certain liabilities
related to Acterna's Cheetah status and performance monitoring product line for
$14,300,000 in cash. As part of the agreement, contingent purchase consideration
of up to $2,400,000 in the form of an earn-out, may be payable based on certain
2003 performance targets for the acquired business. The assets consist
principally of existing contracts, product inventory, intellectual property,
software and related computer equipment, while the liabilities principally
relate to warranty obligations. The $14,300,000 due at closing was paid from
available cash and short-term investments. The Company believes the acquired
business will complement and augment its current cable operations and
strategically position the Company to be the leading supplier of testing
equipment and software for the cable industry. The acquisition will be recorded
under the purchase method of accounting and, accordingly, the results of
operations of the acquired business from February 14, 2003 forward will be
included in the consolidated financial statements of the Company. In connection
with the acquisition, the Company entered into an amendment to its $25.0 million
Unsecured Revolving Credit Facility to maintain compliance with certain base net
worth covenants. The purchase price allocation is currently under evaluation and
is expected to be finalized by the end of the first quarter.
In connection with the acquisition, the Company entered into a lease for
office space to house the acquired business. Minimum payments due under this
lease are approximately $200,000 in 2003, $370,500 in each of the years 2004
through 2007 and $123,500 in 2008.
14. RECENT ACCOUNTING PRONOUNCEMENTS
In July 2001, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 141, "Business Combinations" and
SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 established
accounting and reporting standards for business combinations. SFAS No. 142
established accounting and reporting standards for acquired goodwill and other
intangible assets, specifically, how they should be treated upon, and subsequent
to, their acquisition. Both SFAS No. 141 and SFAS No. 142 are required to be
applied in fiscal years beginning after December 15, 2001; however, early
adoption is permitted. SFAS No. 142 statements contain provisions which require
that these statements be applied to all business combinations initiated after
June 30, 2001. The Company utilized the transitional guidance of SFAS No. 141
and SFAS No. 142 in connection with the LoopCare acquisition on September 30,
2001. The Company adopted the full provisions of these statements on January 1,
2002. The Company
32
does not believe the adoption of these standards will have a material effect on
its financial statements.
On August 15, 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligation." On October 4, 2001, FASB issued SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets." The Company
will adopt these statements on January 1, 2003 and such adoption is not expected
to have a material effect on the Company's financial statements.
In June 2002, the 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 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 material effect on the Company.
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires that upon
issuance of a guarantee, a guarantor must recognize a liability for the fair
value of an obligation assumed under a guarantee. FIN 45 also requires
additional disclosures by a guarantor in its interim and annual financial
statements about the obligations associated with guarantees issued. The
recognition provisions of FIN 45 will be effective for any guarantees that are
issued or modified after December 31, 2002. The provisions of FIN 45 are not
expected to have a material impact on the Company's results of operations or
financial position.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure." This Statement amends
SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative
methods of transition to SFAS No. 123's fair value method of accounting for
stock-based employee compensation. This Statement also amends the disclosure
provision of SFAS No. 123 and APB No. 28, "Interim Financial Reporting," to
require disclosure in the summary of significant accounting policies of the
effects of an entity's accounting policy with respect to stock-based employee
compensation on reported net income and earnings per share in annual and interim
financial statements. The Company adopted the disclosure provision of SFAS No.
148.
On January 17, 2003 the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities - an interpretation of ARB No. 51"
("FIN 46"). FIN 46 clarifies the application of Accounting Research Bulletin No.
51, "Consolidated Financial Statements", to certain entities in which equity
investors do no have the characteristics of a controlling financial interest or
do not have sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support from other parties. FIN 46 is
effective for the Company after January 31, 2003 and is not expected to have a
material impact on the Company's results of operations or financial condition.
The Company has early adopted Emerging Issues Task Force (EITF) Issue
00-21, "Accounting for Revenue Arrangements with Multiple Deliverables," which
applies to all deliverables within contractually binding arrangements that
include multiple revenue-generating activities. This issue is expected to be
finalized in March of 2003.
15. SHORT- AND LONG-TERM INVESTMENTS
The estimated fair values of the Company's financial instruments are as follows:
December 31, 2001 DECEMBER 31, 2002
------------------------------------------------------------
Carrying Fair CARRYING FAIR
Amount Value AMOUNT VALUE
- -------------------------------------------------------------------------------------------------------------
Financial assets:
Cash and cash equivalents $ 32,105,845 $ 32,105,845 $ 33,799,284 $ 33,799,284
Short-term and long-term investments 6,639,323 6,658,247 19,328,883 19,257,039
- -------------------------------------------------------------------------------------------------------------
$ 38,745,168 $ 38,764,092 $ 53,128,167 $ 53,056,323
- -------------------------------------------------------------------------------------------------------------
16. PER SHARE INFORMATION
Net income per share has been computed in accordance with the provisions of SFAS
No. 128, "Earnings Per Share" for all periods presented. On February 10, 2000,
the Company's Board of Directors authorized a two-for-one stock split of the
Company's common stock, payable in the form of a 100 percent stock dividend. On
March 20, 2000, shareholders of record received one additional share of common
stock for each share of common stock held of record on February 28, 2000. All
share and per share information reflects the two-for-one split of the Company's
common stock. SFAS No. 128 requires companies with complex capital structures to
report earnings per share on a basic and diluted basis, as defined. Basic
earnings per share are calculated on the actual number of weighted average
common shares outstanding for the period, while diluted earnings per share must
include the effect of any dilutive securities. All prior periods have been
restated in accordance with SFAS No. 128. A reconciliation of earnings per share
is as follows:
Years Ended December 31,
2000 2001 2002
- --------------------------------------------------------------------------------------------------
Net Income $ 27,495,168 $ 13,675,447 $ 3,356,544
- --------------------------------------------------------------------------------------------------
Weighted average common shares outstanding 12,636,284 13,037,906 13,095,068
- --------------------------------------------------------------------------------------------------
Effect of dilutive securities - stock options 722,986 374,131 218,608
- --------------------------------------------------------------------------------------------------
13,359,270 13,412,037 13,313,676
- --------------------------------------------------------------------------------------------------
Earnings per share:
Basic $ 2.18 $ 1.05 $ 0.26
- --------------------------------------------------------------------------------------------------
Diluted $ 2.06 $ 1.02 $ 0.25
- --------------------------------------------------------------------------------------------------
33
STATEMENTS OF OPERATIONS DATA BY QUARTER
The following table presents unaudited quarterly operating results for each of
the Company's last eight fiscal quarters. This information has been prepared by
the Company on a basis consistent with the Company's audited financial
statements and includes all adjustments (consisting only of normal recurring
adjustments) that the Company considers necessary for a fair presentation of the
data. Such quarterly results are not necessarily indicative of the future
results of operations.
(In Thousands, Except Net Income Per Common Share Data)
Quarter Ended (Unaudited)
March 31, June 30, Sept. 30, Dec. 31, March 31, June 30, Sept. 30, Dec. 31,
2001 2001 2001 2001 2002 2002 2002 2002
- ----------------------------------------------------------------------------------------------------------------------------
Revenues:
Products $ 27,464 $ 21,177 $ 15,077 $ 13,894 $ 14,929 $ 12,018 $ 11,260 $ 9,939
Services 526 599 961 2,541 2,593 2,566 2,692 2,577
- ----------------------------------------------------------------------------------------------------------------------------
27,990 21,776 16,038 16,435 17,522 14,584 13,952 12,516
Cost of Sales:
Products 11,851 9,047 7,158 5,076 6,062 4,880 5,646 4,212
Services 423 517 508 1,107 955 890 868 607
Amortization of intangibles -- -- -- 365 365 365 366 368
- ----------------------------------------------------------------------------------------------------------------------------
12,274 9,564 7,666 6,548 7,382 6,135 6,880 5,187
- ----------------------------------------------------------------------------------------------------------------------------
Gross Profit 15,716 12,212 8,372 9,887 10,140 8,449 7,072 7,329
- ----------------------------------------------------------------------------------------------------------------------------
Operating Expenses:
Selling and marketing 2,450 2,493 2,023 2,194 2,417 2,225 2,163 1,961
General and administrative 1,530 1,062 1,020 1,215 1,526 1,268 1,217 1,478
Research and development 3,360 2,749 2,639 3,681 3,995 3,396 3,370 3,078
Severance and related expense -- 400 -- (109) -- -- -- 176
- ----------------------------------------------------------------------------------------------------------------------------
Total Operating Expense 7,340 6,704 5,682 6,981 7,938 6,889 6,750 6,693
- ----------------------------------------------------------------------------------------------------------------------------
Income from Operations 8,376 5,508 2,690 2,906 2,202 1,560 322 636
Other Income, Net 907 790 801 298 238 200 151 104
- ----------------------------------------------------------------------------------------------------------------------------
Income Before Taxes 9,283 6,298 3,491 3,204 2,440 1,760 473 740
Provision for Income Taxes 3,528 2,494 1,361 1,217 927 669 180 281
- ----------------------------------------------------------------------------------------------------------------------------
Net Income $ 5,755 $ 3,804 $ 2,130 $ 1,987 $ 1,513 $ 1,091 $ 293 $ 459
- ----------------------------------------------------------------------------------------------------------------------------
EARNINGS PER SHARE INFORMATION:
Weighted average shares of common stock and equivalents:
Basic 12,958 13,028 13,066 13,095 13,099 13,089 13,091 13,091
Diluted 13,377 13,404 13,378 13,472 13,421 13,339 13,217 13,199
Net income per common share:
Basic $ 0.44 $ 0.29 $ 0.16 $ 0.15 $ 0.12 $ 0.08 $ 0.02 $ 0.04
Diluted $ 0.43 $ 0.28 $ 0.16 $ 0.15 $ 0.11 $ 0.08 $ 0.02 $ 0.03
- ----------------------------------------------------------------------------------------------------------------------------
o o o o o o o o o o o o o o o o o o o o o o o o o o o o o o o o o o o o o o o o
COMMON STOCK MARKET PRICES
The Company's Common Stock has been included for quotation on The Nasdaq
National Market System under the Nasdaq symbol "TLGD" since the initial public
offering of the Company's Common Stock in December 1995. The following table
sets forth, for the periods indicated, the high and low sales prices for the
Common Stock on such market:
High Low
- -----------------------------------------------------------------------------
2001:
First Quarter $ 52.50 $ 15.25
Second Quarter 40.35 18.75
Third Quarter 29.35 18.00
Fourth Quarter 34.55 18.45
2002:
First Quarter $ 37.80 $ 20.38
Second Quarter 26.20 14.25
Third Quarter 17.31 7.48
Fourth Quarter 14.90 6.77
- -----------------------------------------------------------------------------
At January 31, 2003, the Company had 198 holders of record of its Common
Stock and 13,552,736 shares outstanding.
The Company has never paid any dividends on its Common Stock and does not
expect to pay cash dividends in the foreseeable future.
34
Shareholder Information
SHAREHOLDERS ANNUAL MEETING
Tollgrade's Annual Meeting of Shareholders will be held at 3:00 p.m. on Tuesday,
May 13, 2003 at The Holiday Inn R.I.D.C., 180 Gamma Drive, Pittsburgh, PA 15238.
Notice of the meeting and proxy materials were included with this Annual Report.
TRANSFER AGENT AND
SHAREHOLDER INQUIRIES
The Company's transfer agent is Mellon Investor Services, L.L.C. Inquiries
concerning transfer requirements, lost certificates and change of address should
be directed to:
Mellon Investor Services, L.L.C.
P.O. Box 3315
South Hackensack, NJ 07606
or:
85 Challenger Road
Ridgefield Park, NJ 07660
1-800-756-3353
TDD for Hearing Impaired: 1-800-231-5469
Foreign Shareholders: 201-329-8660
TDD Foreign Shareholders: 201-329-8354
www.melloninvestor.com.
All other inquiries should be directed to:
Tollgrade Communications, Inc.
Investor Relations Department
493 Nixon Road
Cheswick, PA 15024
1-800-878-3399
www.tollgrade.com.
FORM 10-K
A copy of the Tollgrade Communications, Inc. Form 10-K for 2002, which will be
filed with the Securities and Exchange Commission during the first quarter of
2003, is available without attachments at no charge upon written request. It is
also available at www.tollgrade.com. Inquiries should be directed to the
Investor Relations Department, Tollgrade Communications, Inc., 493 Nixon Road,
Cheswick, PA 15024.
INDEPENDENT AUDITORS
PricewaterhouseCoopers LLP, Pittsburgh, Pennsylvania.
STOCK MARKET LISTING
Tollgrade Communications, Inc. is listed on The Nasdaq Stock Market.(SM) Symbol:
TLGD.
Board of Directors
CHRIS ALLISON
Chairman and Chief Executive Officer
JAMES J. BARNES
Attorney at Law, Reed Smith LLP
DANIEL P. BARRY
Private Investor
DAVID S. EGAN
Chief Marketing Officer, Reed Smith LLP
RICHARD H. HEIBEL, M.D.
Board Certified Cardiologist (retired)
ROBERT W. KAMPMEINERT
Chairman, President and Chief Executive Officer, Parker/Hunter Incorporated
BRIAN C. MULLINS
Former Senior Vice President, Chief Financial Officer and Treasurer of Tuscarora
Incorporated (retired)
ROCCO L. FLAMINIO
Non-voting Director Emeritus
Executive Council and Officers
CHRIS ALLISON
Chairman and Chief Executive Officer
SARA M. ANTOL
General Counsel and Corporate Secretary
RICHARD A. BAIR, JR.
Executive Vice President, Engineering and Testing
DAVID J. BREITER
General Manager, Cable Products
WYLIE E. ETSCHEID, JR.
Executive Vice President of Business Development, Software Products
ROCCO L. FLAMINIO
Vice Chairman and Chief Technology Officer
CAROL M. FRANKLIN
Executive Vice President, Software Products
SAMUEL C. KNOCH
Chief Financial Officer and Treasurer
JOSEPH G. O'BRIEN
Senior Vice President, Human Resources
MARK B. PETERSON
President
GREGORY L. QUIGGLE
Executive Vice President, Marketing
MATTHEW J. ROSGONE
Executive Vice President, Operations
CHARLES J. SHEARER
Controller
ROGER A. SMITH
Executive Vice President, Technology
STEPHANIE M.WEDGE
Vice President, Professional Services
(R) TOLLGRADE, MCU, DigiTest, TELACCORD and LIGHTHOUSE are registered trademarks
of Tollgrade Communications, Inc.
TM LoopCare and Cheetah are trademarks of Tollgrade Communications, Inc.
All other trademarks are the property of their respective owners.
(C) 2003 Tollgrade Communications, Inc.
All rights reserved.
TOLLGRADE(R)
CORPORATE HEADQUARTERS
493 Nixon Road, Cheswick, PA 15024 - 1-800-878-3399 - www.tollgrade.com