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Exhibit 13.1
SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data of the Company as of December 31, 1994,
1995, 1996, 1997, 1998 and for the years then ended is derived from audited
consolidated financial statements of the Company.
(In thousands, except per share data)
Years Ended December 31,
1994 1995 1996 1997 1998
- ---------------------------------------------------------------------------------------------------------------
STATEMENTS OF OPERATIONS DATA:
Revenues(1) $ 14,722 $ 22,310 $ 37,490 $ 45,421 $ 46,277
Cost of product sales 8,168 11,329 18,322 20,104 19,620
...............................................................................................................
Gross profit 6,554 10,981 19,168 25,317 26,657
Operating expenses:
Selling and marketing 1,903 2,953 4,767 5,446 5,704
General and administrative 1,268 1,471 2,552 3,768 4,128
Research and development 1,585 2,637 3,921 5,945 6,880
...............................................................................................................
Total operating expenses 4,756 7,061 11,240 15,159 16,712
Income from operations 1,798 3,920 7,928 10,158 9,945
Other income (expense), net (270) 20 845 899 1,062
...............................................................................................................
Income before income taxes 1,528 3,940 8,773 11,057 11,007
Provision (benefit) for income taxes (617) 1,418 3,176 4,174 4,040
- ---------------------------------------------------------------------------------------------------------------
Net income $ 2,145 $ 2,522 $ 5,597 $ 6,883 $ 6,967
Net income applicable
to common stock (2) $ 1,311 $ 2,522 $ 5,597 $ 6,883 $ 6,967
- ---------------------------------------------------------------------------------------------------------------
Earnings per share: (3)
Basic $ .49 $ .60 $ 1.02 $ 1.21 $ 1.19
Diluted .32 .56 .94 1.15 1.17
- ---------------------------------------------------------------------------------------------------------------
Weighted average shares of common stock
and equivalents:
Basic 2,674 4,228 5,501 5,686 5,841
Diluted 4,159 4,504 5,940 5,962 5,967
- ---------------------------------------------------------------------------------------------------------------
As of December 31,
1994 1995 1996 1997 1998
- ---------------------------------------------------------------------------------------------------------------
BALANCE SHEET DATA:
Working capital $ 3,195 $ 21,159 $ 27,232 $ 34,570 $ 40,539
Total assets 7,151 25,728 34,626 43,713 49,865
Long-term debt, less current portion 1,400 -- -- -- --
Shareholders' equity 1,387 22,609 30,006 38,101 45,696
- ---------------------------------------------------------------------------------------------------------------
1994 1995 1996 1997 1998
- ---------------------------------------------------------------------------------------------------------------
OTHER DATA: (4)
Number of employees at year end 96 126 184 205 230
Average revenue per employee $ 153 $ 177 $ 204 $ 222 $ 201
- ---------------------------------------------------------------------------------------------------------------
(1) Includes license fees of $250 and $150 for 1997 and 1998, respectively.
(2) Net of accretion for redeemable warrants, all of which were redeemed in
February 1995.
(3) 1998 includes $.04 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.
(4) Data not derived from Company's audited financial statements.
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Management's Discussion and Analysis of Results of Operations and Financial
Condition
The following discussion should be read in conjunction with the "Selected
Consolidated Financial Statements" and notes thereto appearing elsewhere in this
Annual Report to Shareholders.
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995.
The statements contained in this Annual Report to Shareholders, specifically
those contained in the following Management's Discussion and Analysis of Results
of Operations and Financial Condition which are not historical, are
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. These forward-looking statements represent Tollgrade Communications,
Inc.'s (the "Company") present expectations or beliefs concerning future events.
The Company cautions that such statements must be qualified by important factors
that could cause actual earnings and other results to differ materially from
those achieved in the past or those expected by the Company. These include rapid
technological change, along with the need to continually develop new products;
the Company's dependence on a single product line; competition; the Company's
dependence on key employees; difficulties in managing the Company's growth; the
Company's dependence upon a small number of large customers and certain
suppliers; the Company's dependence upon proprietary rights; risks of
third-party claims of infringement; and government regulation.
OVERVIEW
The Company was organized in 1986 and began operations in 1988. The Company
designs, engineers, markets and supports test access and test extension products
for the telecommunications and cable television industries. The Company's
telecommunication proprietary 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 90% of the Company's revenue for the year
ended December 31, 1998 and will continue to account for a majority of the
Company's revenues for the foreseeable future. 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's telecommunication product sales are primarily to the five
Regional Bell Operating Companies (RBOCs) as well as major independent telephone
companies such as Sprint and to certain digital loop carrier (DLC) equipment
manufacturers. For the year ended December 31, 1998, approximately 79% of the
Company's total revenue was generated from sales to these five RBOCs, the two
largest of which comprised approximately 54% of revenues. The Company intends to
market and sell its cable products directly, as well as through various Original
Equipment Manufacturer (OEM) arrangements with cable network equipment
manufacturers. The Company presently has one OEM arrangement under contract and
works on less formal arrangements with several other OEM partners. Sales for the
Company's cable products for the year ended December 31, 1998 were not material.
The Company's operating results have fluctuated and may continue to
fluctuate as a result of various factors, including the timing of orders from
and shipments to the RBOCs.
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This timing is particularly sensitive to various business factors within each of
the RBOCs, including the RBOCs relationships with their various organized labor
groups. During the third quarter of 1998, the Company's financial results were
impacted by the effect of certain labor disputes at Bell Atlantic, USWest and
Southern New England Telephone. These work stoppages, along with other factors,
disrupted ongoing and established network expansion and maintenance programs and
exacerbated seasonally lower sales. Certain contracts concerning the RBOCs
organized employees were renegotiated during the third quarter of 1998. Refer to
discussions on 1998 revenues for further comments.
The Company believes that recent changes within the telecommunication
marketplace, including industry consolidation, as well as the Company's ability
to successfully penetrate certain new markets, have resulted in some discounting
and more favorable terms granted to certain customers of the Company. In
addition, the Company has recently experienced certain customer demands to
consolidate product purchases which have translated into large bulk orders.
Although the Company will continue to strive to meet the demands of its
customers, which include delivery of quality products at an acceptable price and
on acceptable terms, there are no assurances that the Company will be successful
in negotiating acceptable terms and conditions pertaining to these large orders.
Additionally, recent consolidations and potential future consolidations among
the RBOCs, and their ability to consolidate their inventory and product
procurement systems could cause fluctuations or delays in the Company's order
patterns. The Company cannot predict such future events or business conditions,
and the Company's results may be adversely affected by these industry trends in
the primary markets its serves.
Although international sales to date have not been significant, the Company
believes the international markets offer opportunities. The international
telephony markets differ from those found domestically due to the different
types and configurations of equipment used by those international communication
companies to provide services. Certain competitive elements also are found
internationally which do not exist in the Company's domestic markets. The
Company has, up to the present time, utilized the professional services of
various marketing consultants to define the Company's international market
opportunities. Markets that are the subject of continuing review are those
markets in China, Europe and several countries in the Pacific Rim area. During
the fourth quarter of 1998, the Company streamlined the structure responsible
for its international efforts. The changes resulted in a more cost-effective
structure that is now focused at the customer level. There continues to be a
high level of interest expressed by certain potential customers in the
international markets; however, there can be no assurance that these efforts
will be successful or that the Company will achieve significant international
sales.
The Company believes that continued growth will depend on its ability to
design and engineer new products and, therefore, spends a significant amount on
research and development. Research and development expenses as a percent of
revenues were approximately 14.9% for the year ended December 31, 1998. The
Company expects its research and development expenses to continue at significant
levels.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
REVENUES
Revenues for the year ended December 31, 1998 were $46.3 million and were $0.9
million, or 1.9%, higher than the revenues of $45.4 million for the year ended
December 31, 1997. Revenues for both periods consisted almost entirely of
product sales. Revenues for 1998 and 1997 include approximately $0.5 million and
$0.9 million, respectively, for non-recurring engineering fees, royalty and
license fees. The increase in revenues is primarily associated with new product
revenues. During 1998, the Company generated revenues of approximately $2.2
million associated with new product introductions, including the Company's
LIGHTHOUSE cable products, while same product sales between periods decreased
$1.3 million, or 3.0%. This decrease occurred primarily in the second half of
1998, and the Company believes it was caused by several factors, including
certain labor disputes at Bell Atlantic, USWest and Southern New England
Telephone during the third quarter of 1998, higher than expected inventories at
Ameritech, as well as slower than expected deployment of MCU products within
certain regions of Bell Atlantic. Bell Atlantic's testability improvement
initiatives migrated to more complex embedded DLC
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architectures that require the provisioning of additional equipment and
increased installation time. The Company is working to implement strategies
designed to return product usage to historical levels for certain customers
through comprehensive technical training and other testability improvement
initiatives. The effectiveness of these programs from a timing point of view are
highly dependent upon a number of factors outside of the Company's control,
including the Company's customers' willingness to dedicate the appropriate
levels of resources to see such initiatives through to their successful
conclusion. Therefore, there can be no assurances as to the ultimate
effectiveness of these programs in returning product deployment to historical
levels. Periodic fluctuations in customer orders and backlog result from a
variety of factors, including but not limited to the timing of significant
orders and shipments, and are not necessarily indicative of long-term trends in
sales of the Company's products. Management believes that there is a continuing
possibility that the requirements for certain important MCU products which are
utilized in legacy DLC systems may be satisfied in the near future, especially
within one major customer. In order to reduce associated risks, the Company is
focusing on the development of new product lines to attempt to meet the other
requirements of this and other customers.
GROSS PROFIT
Gross profit for 1998 was $26.7 million compared to $25.3 million for 1997,
representing an increase of $1.4 million, or 5.3%. Gross profit as a percentage
of revenues increased to 57.6% for 1998 compared to 55.7% for 1997. The overall
increase in gross profit resulted primarily from the increased sales levels,
while improvements in gross margin as a percentage of sales were a result of
increased sales volumes and increased manufacturing efficiencies. The Company's
continuing gross margin levels will depend on its success in holding pricing,
gaining further cost reductions, as well as the mix of products sold including
the effect of the Company's cable products which carry lower gross margins than
earned historically on the Company's telecommunication products.
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 marketing programs. Selling and marketing expense for 1998
was $5.7 million, or 12.3% of revenues, compared to $5.4 million, or 12.0% of
revenues for 1997. This increase of $0.3 million, or 4.7%, is primarily
associated with additional personnel to support expanding product lines and
increased consulting and travel expenses associated with international market
development. The Company expects selling and marketing expenses to rise
commensurate with increased revenues and selling efforts. The Company is
continuing its efforts to expand its business by marketing new products and the
development of comprehensive technical training and other testability
improvement initiatives.
GENERAL AND ADMINISTRATIVE EXPENSE
General and administrative expenses consist primarily of personnel costs for
finance, administrative and general management personnel as well as accounting
and legal expenses. General and administrative expense for 1998 was $4.1
million, or 8.9% of revenues, compared to $3.8 million, or 8.3% of revenues for
1997. This increase of $0.3 million, or 9.5%, is primarily attributable to
increased expenditures for legal and professional fees associated with business
development activities as well as personnel recruiting costs.
RESEARCH AND DEVELOPMENT EXPENSE
Research and development expenses consist primarily of personnel costs and costs
associated with the development of new products and technologies. Research and
development expense for 1998 was $6.9 million, or 14.9% of revenues, compared to
$5.9 million, or 13.1% of revenues for 1997. This increase of $1.0 million, or
15.7%, was principally due to costs associated with new product development and
the addition of personnel to support these new product development activities.
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 $1.1 million for
1998 compared to $0.9 million for 1997. The increase of $0.2 million, or 18.2%,
includes approximately $0.2 million of net key man life insurance proceeds
associated with the death of the Company's former Chairman R. Craig Allison.
Additionally, 1998 other income and expense included
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interest expense of approximately $0.1 million related to settlements of issues
with certain prior years' tax returns.
PROVISION FOR INCOME TAXES
The Company's effective tax rate for 1998 was 36.7% of income before income
taxes, compared to the 37.7% rate in 1997. The decrease in the effective income
tax rate primarily reflects the permanent effect of an increase in non-taxable
interest income on the Company's short- and long-term investments related to
individual municipal bonds.
NET INCOME AND EARNINGS PER SHARE
For the year ended December 31, 1998, net income was $7.0 million compared to
$6.9 million for the year ended December 31, 1997, representing an increase of
$0.1 million, or 1.2%. Diluted earnings per common share of $1.17 for 1998
increased by 1.7%, or $.02, from the $1.15 earned in 1997. Fiscal year 1998
includes approximately $0.2 million, or $.04 per share, related to the after-tax
effect of net key man life insurance as previously discussed above. Excluding
the effect of net key man life insurance proceeds, net income decreased $0.1
million, or 2.1% while diluted earnings per share for 1998 decreased 1.7% to
$1.13 per share. Diluted weighted average shares of common stock and equivalents
outstanding were 5,966,551 in 1998 compared to 5,961,540 in 1997. As a
percentage of revenues, net income for 1998 decreased to 15.1% from 15.2% in
1997.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
REVENUES
Revenues for the year ended December 31, 1997 were $45.4 million and were $7.9
million, or 21.2% higher than revenues of $37.5 million for the year ended
December 31, 1996. Revenues for both periods consisted almost entirely of
product sales. 1997 revenues included $250,000 of royalty and license fees,
while similar fees for 1996 were immaterial. The increase in revenues was
primarily associated with the increase in unit volume sales of the MCU product
line as a result of increased market penetration and customer acceptance. The
increase included revenues of $0.7 million from six new products introduced in
1997. Overall, increased product demand was at least partly attributable to
technology licensing agreements and/or joint venture relationships with certain
major DLC vendors, as well as continued expansion of a marketing program to
train customers in advanced line test system trouble-shooting. 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, and
are not necessarily indicative of long-term trends in sales of the Company's
products. Management believed that during fiscal year 1998, there was a
possibility that one of the Company's major customers would satisfy a
substantial portion of its requirements for certain of the Company's important
product lines. Management focused on the development of new product lines to
attempt to meet the other requirements of this and other customers. Refer to
discussions on 1998 revenues for further comments
GROSS PROFIT
Gross profit for 1997 was $25.3 million compared to $19.2 million for 1996,
representing an increase of $6.1 million, or 32.1%. Gross profit as a percentage
of revenues increased to 55.7% for 1997 compared to 51.1% for 1996. The overall
increase in gross profit margin resulted primarily from the increased sales
levels, while improvements in gross margin as a percentage of sales were a
result of increased sales volumes and increased manufacturing efficiencies. The
Company's ability to sustain current gross margin levels has depended on its
success in gaining further cost reductions, as well as experiencing a similar
mix of products sold and maintaining current pricing levels.
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 marketing programs. Selling and marketing expense for 1997
was $5.4 million, or 12.0% of revenues, compared to $4.8 million, or 12.7% of
revenues for 1996. This increase of $0.6 million, or 14.2%, reflected additional
salaries and benefits associated with increased staffing levels to support
expanding product lines and increased consulting and travel expenses associated
with the planned expansion into international markets. The Company's selling and
marketing expenses have risen commensurate with increased revenues and selling
efforts. The Company is continuing its efforts to expand its business
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by marketing new products, developing additional customer training programs and
expanding its international presence.
GENERAL AND ADMINISTRATIVE EXPENSE
General and administrative expenses consist primarily of personnel costs for
finance, administrative and general management personnel, as well as accounting
and legal expenses. General and administrative expense for 1997 was $3.8
million, or 8.3% of revenues, compared to $2.6 million, or 6.8% of revenues for
1996. This increase of $1.2 million, or 47.6%, was primarily attributable to
additional salaries and benefits associated with increased staffing levels to
support the expanded business operations and increased travel and business
development activities.
RESEARCH AND DEVELOPMENT EXPENSE
Research and development expenses consist primarily of personnel costs and costs
associated with the development of new products. Research and development
expense for 1997 was $5.9 million, an increase of $2.0 million, or 51.6%,
compared to $3.9 million for 1996. The increase was principally due to costs
associated with additional personnel to support new product introductions. As a
percentage of revenues, research and development expense was 13.1% for 1997
compared to 10.5% for 1996. 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 $0.9 million for
1997 compared to $0.8 million for 1996. The increase in other income was
primarily attributable to increased interest income, which resulted from the
increased levels of investable funds.
PROVISION FOR INCOME TAXES
The Company's effective tax rate for 1997 was 37.7% of income before income
taxes, compared to the 36.2% rate in 1996. The slight increase reflected
increases in state taxes offset by benefits from higher levels of tax-exempt
interest and increased credits for research and development.
LIQUIDITY AND CAPITAL RESOURCES
The Company had working capital of $40.5 million as of December 31, 1998
compared to the working capital of $34.6 million as of December 31, 1997. The
increase of $5.9 million, or 17.3%, can be attributed to operating cash flow
(income from operations before depreciation and amortization) and proceeds from
the exercise of stock options exceeding requirements for purchases of property
and equipment and funding of the Company's stock buyback program. Significant
components of the Company's change in working capital include an increase in
cash and cash equivalents, which include the effect of cash received as a result
of stock option exercises and net collections, an increase in inventories due to
the investment required to introduce new products and to maintain sufficient
inventory stocking levels. Most significantly offsetting these increases was a
decrease in short-term investments of $1.4 million; the majority of such funds
were invested in long-term investments and, as such, are still available for
general corporate use upon maturity. These investments reflect the Company's
strategy to migrate to individual municipal bonds with a maturity of more than
one year and less than eighteen months and was undertaken to maximize investment
income levels. As of December 31, 1998, the Company had $24.1 million of cash
and cash equivalents, short-term and long-term investments which are available
for acquisitions and other corporate requirements.
The Company made capital expenditures of $1.7 million in 1998 and were
primarily related to an upgrade of the MIS infrastructure, production test
equipment and fixtures, as well as leasehold improvements made to the Company's
facilities. Capital expenditures were $1.2 million and $2.0 million for 1997 and
1996, respectively, and were primarily related to office equipment, test
fixtures and development systems, tooling and leasehold improvements. The
Company presently has no material capital expenditure commitments. Planned
capital expenditures for 1999 are anticipated to total approximately $2.4
million. These planned capital projects include test fixtures and development
systems, computer and office equipment and leasehold improvements to the
Company's facilities.
As of May 31, 1998, the Company terminated its $2,500,000 bank line of
credit. The Company believes that, based upon its current financial position,
the line of credit is not necessary to be continued at the present time.
On April 22, 1997, the Company's Board of Directors authorized a program to
purchase up to 200,000 shares of its common stock over the
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next two years. The shares will be utilized to provide stock under certain
employee benefit programs. The number of shares that the Company intends to
purchase and the time of such purchases will be determined by the Company, at
its discretion. The Company plans to use existing cash and short-term
investments to finance the purchases. As of December 31, 1998, the Company had
purchased 106,900 shares of common stock under this program. Subsequent to
December 31, 1998 and through March 1, 1999, the Company purchased an additional
27,900 shares of common stock under this program.
The impact of inflation on both the Company's financial position and the
results of operations has been minimal and is not expected to adversely affect
1998 results. The Company's financial position enables it to meet cash
requirements for operations and capital expansion programs.
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 rights will be exercisable only if a person or group
acquires or announces a tender or exchange offer for 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.
If after a person or group acquires 20% or more of the outstanding common
stock, 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%.
The rights were not distributed in response to any specific effort to
acquire control of the Company, nor is the Company presently aware of any such
effort. The distribution of the rights will not affect the Company's reported
earnings and is not taxable to shareholders or to the Company. Shareholders will
not receive any documents evidencing their rights unless and until the rights
become exercisable. Until that time, the rights will not trade separately from
the common stock. The rights will expire on August 15, 2006.
IMPACT OF THE YEAR 2000 ISSUE
The Year 2000 issue exists because many computer systems and applications use
two-digit rather than four-digit date fields to designate an applicable year. As
a result, the systems and applications may not properly recognize the year 2000
or process data which include it, potentially causing data miscalculations or
inaccuracies or operational malfunctions or failures.
The Company has established a Year 2000 committee to transition the
Company's business applications, computing infrastructure and communication
systems into the next millennium. The objectives of the Year 2000 committee are
to ensure all internal computer systems function correctly in the Year 2000,
ensure data exchanged with external organizations conforms to Year 2000
standards and ensure all products sold by the Company conform to Year 2000
standards. The Company has developed an inventory of all Company business
systems and corresponding software applications and is currently in the process
of assessing the business priority of each system. Each system will be
classified by mission criticality and a determination will be made to either
replace or remediate the system, depending upon its importance. In addition, the
Year 2000 project will include a review of the Year 2000 compliance efforts of
the Company's key suppliers and other principal business partners and, as
appropriate, the development of joint business support and continuity plans
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for Year 2000 issues. While this initiative is broad in scope, it has been
structured to identify and prioritize efforts for mission-critical systems,
products and key business partners.
The inventory and assessment phases have been substantially completed as of
December 31, 1998. The Company has established a Year 2000 test center to
certify all business applications and processes utilized throughout the Company.
To date, more than 300 internal software applications or systems have been
identified for testing. Initial results indicate less than 20% of these
applications do not meet Year 2000 standards and, more importantly, less than 5%
are business-critical. During the remainder of 1999, the Year 2000 committee
will focus attention to remediation and testing of internal business systems and
contingency planning.
The Company's products with time-of-day (TOD) clocks in their design have
been tested for successful Year 2000 operation. Products that do not have TOD
clocks have no potential Year 2000 operational issues and, therefore, have not
been tested. The Company believes that it will have no material exposure to
contingencies related to the Year 2000 issue for the products it has sold.
In order to ensure Year 2000 compliance among the Company's key suppliers
and business partners, the Year 2000 committee developed surveys that were
provided to the suppliers in addition to verifying compliance efforts via the
suppliers' and business partners' Web sites for Year 2000 compliance-related
information. The Company is currently examining where and how outside suppliers
and business partners impact the business and apply the same mission-critical
standard to suppliers and business partners that applies to the Company's own
internal systems.
Under the Company's current Year 2000 plan, the target date of June 30,
1999 has been established for completion of remediation, testing and
implementation. The Company's ability to meet that target date is dependent upon
the timely provision of necessary upgrades and modifications by the Company's
suppliers and customers. There can be no guarantee that the systems of other
companies on which the Company's systems rely will be timely converted, or that
a failure to convert by another company, or a conversion that is incompatible
with the Company's systems, would not have a material adverse effect on the
Company.
The Company currently estimates the expenses associated with the
anticipated Year 2000 efforts to be approximately $0.1 million through 1999,
with an additional $0.3 million for capital improvement costs to support this
project. The costs expensed to date have been immaterial. The timing of the
Company's expenses may vary and is not necessarily indicative of readiness
efforts or progress to date. The Company anticipates that a portion of the Year
2000 expenses will not be incremental costs, but rather will represent the
redeployment of existing Information Technology (IT) resources.
As part of the Year 2000 initiative, the Company is evaluating scenarios
that may occur as a result of the century change and is in the process of
developing contingency and business plans that address potential Year
2000-related occurrences. These plans are expected to assess the potential for
business disruption and to provide operational back-up, recovery and restoration
alternatives.
The above information is based on the Company's current best estimates.
Given the complexity of the Year 2000 issues and risks, actual results may vary
materially from those anticipated and discussed above. Specific factors that
might cause such differences include, among others, the availability and cost of
personnel trained in this area, the ability to locate and correct all affected
computer systems, applications and products and the timing and success of
remedial efforts of the Company's third party suppliers and business partners.
BACKLOG
The Company's backlog consists of firm customer purchase orders for the
Company's various products. As of December 31, 1998, the Company had a backlog
of $0.6 million, a $1.0 million decrease from the December 31, 1997 backlog of
$1.6 million. At December 31, 1998, the composition of the backlog related
primarily to one customer order, while backlog at December 31, 1997 consisted of
several customer orders. 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, and are not necessarily indicative of
long-term trends in sales of the Company's products.
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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 judgements. Financial information elsewhere in
this Annual Report is consistent with that in the financial statements.
Management has established and maintains a system of internal control
designed to provide reasonable assurance that assets are safeguarded and that
the financial records reflect the authorized transactions of the Company. The
system of internal control includes widely communicated statements of policies
and business practices that are designed to require all employees to maintain
high ethical standards in the conduct of Company affairs. The internal controls
are augmented by organizational arrangements that provide for appropriate
delegation of authority and division of responsibility.
The financial statements have been audited by PricewaterhouseCoopers LLP,
Independent Accountants. As part of their audit of the Company's 1998 financial
statements, PricewaterhouseCoopers LLP considered the Company's system of
internal control to the extent they deemed necessary to determine the nature,
timing and extent of their audit tests. The Independent Accountants' Report
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, President and
Chief Executive Officer
/s/ Samuel C. Knoch
--------------------------
Samuel C. Knoch
Chief Financial Officer and Treasurer
January 25, 1999
14
10
REPORT OF INDEPENDENT ACCOUNTANTS
January 25, 1999
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, of changes in shareholders' equity and of
cash flows present fairly, in all material respects, the consolidated financial
position of Tollgrade Communications, Inc. and subsidiaries at December 31, 1998
and 1997, and the consolidated results of their operations and their cash flows
for each of the three years in the period ended December 31, 1998, in conformity
with generally accepted accounting principles. 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 generally accepted auditing
standards 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 the opinion expressed above.
/s/ PRICEWATERHOUSECOOPERS LLP
-------------------------------
PricewaterhouseCoopers LLP
Pittsburgh, Pennsylvania
January 25, 1999
15
11
TOLLGRADE COMMUNICATIONS, INC., AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS December 31, 1997 DECEMBER 31, 1998
- -----------------------------------------------------------------------------------------------------------------
Current assets:
Cash and cash equivalents $ 3,183,944 $ 8,311,353
Short-term investments 15,666,626 14,249,164
Accounts receivable:
Trade 7,884,683 7,888,060
Other 517,090 300,680
Inventories 12,101,114 13,201,771
Prepaid expenses and deposits 409,252 352,413
Deferred tax assets 213,216 354,891
.................................................................................................................
Total current assets 39,975,925 44,658,332
Long-term investments 600,000 1,553,000
Property and equipment, net 3,001,824 3,314,522
Deferred tax assets 126,895 334,474
Patents and other assets 8,568 4,247
.................................................................................................................
Total assets $ 43,713,212 $ 49,864,575
- -----------------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
- -----------------------------------------------------------------------------------------------------------------
Current liabilities:
Accounts payable $ 959,185 $ 687,079
Accrued expenses 1,091,990 1,128,421
Accrued salaries and wages 1,529,525 801,908
Royalties payable 878,780 712,971
Income taxes payable 946,233 788,479
.................................................................................................................
Total current liabilities 5,405,713 4,118,858
Deferred income -- 40,000
Deferred tax liabilities 206,116 9,950
.................................................................................................................
Total liabilities 5,611,829 4,168,808
Commitments
Shareholders' equity:
Preferred stock, $1.00 par value; authorized shares,
10,000,000; issued shares, -0- in 1997 and 1998, respectively -- --
Common stock, $.20 par value; authorized shares, 25,000,000;
issued shares, 5,727,350 in 1997 and 5,920,464 in 1998 1,145,470 1,184,093
Additional paid-in capital 25,232,315 27,503,772
Treasury stock, at cost, 3,200 shares in 1997
and 109,100 shares in 1998 (70,355) (1,789,287)
Unearned compensation (35,934) --
Retained earnings 11,829,887 18,797,189
.................................................................................................................
Total shareholders' equity 38,101,383 45,695,767
.................................................................................................................
Total liabilities and shareholders' equity $ 43,713,212 $ 49,864,575
- -----------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
16
12
TOLLGRADE COMMUNICATIONS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31,
1996 1997 1998
- ---------------------------------------------------------------------------------------------------------------
Revenues $ 37,489,949 $ 45,421,135 $ 46,277,409
Cost of product sales 18,321,677 20,104,202 19,620,226
...............................................................................................................
Gross profit 19,168,272 25,316,933 26,657,183
Operating expenses:
Selling and marketing 4,767,339 5,446,102 5,704,323
General and administrative 2,551,959 3,767,925 4,127,580
Research and development 3,921,091 5,944,819 6,880,015
...............................................................................................................
Total operating expenses 11,240,389 15,158,846 16,711,918
...............................................................................................................
Income from operations 7,927,883 10,158,087 9,945,265
Other income (expense):
Interest expense (3,076) (3,271) (107,694)
Interest and other income 848,569 901,981 1,169,531
...............................................................................................................
Total other income (expense) 845,493 898,710 1,061,837
Income before income taxes 8,773,376 11,056,797 11,007,102
Provision for income taxes 3,176,753 4,173,649 4,039,800
...............................................................................................................
Net income $ 5,596,623 $ 6,883,148 $ 6,967,302
- ---------------------------------------------------------------------------------------------------------------
EARNINGS PER SHARE INFORMATION:
- ---------------------------------------------------------------------------------------------------------------
Weighted average shares of common stock and equivalents:
Basic 5,500,884 5,686,182 5,841,347
Diluted 5,939,662 5,961,540 5,966,551
...............................................................................................................
Net income per common share: (1)
Basic $ 1.02 $ 1.21 $ 1.19
Diluted .94 1.15 1.17
- ---------------------------------------------------------------------------------------------------------------
(1) 1998 includes $.04 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.
The accompanying notes are an integral part of the consolidated financial
statements.
17
13
TOLLGRADE COMMUNICATIONS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Additional
Preferred Stock Common Stock Paid-in Treasury
Shares Amount Shares Amount Capital Stock
- ---------------------------------------------------------------------------------------------
Balance at
December 31, 1995 -- $ -- 5,443,830 $ 1,088,766 $ 22,339,022 $ --
- ---------------------------------------------------------------------------------------------
Issuance costs for
initial public
offering in 1995 -- -- -- -- (55,889) --
Exercise of common
stock options -- -- 179,027 35,805 439,005 (49,775)
Restricted stock -
compensation
charged to
expense, net -- -- -- -- -- --
Shares forfeited -- -- (2,440) (488) (8,999) --
Tax benefit from
exercise of
stock options -- -- -- -- 1,378,071 --
Net income -- -- -- -- -- --
.............................................................................................
Balance at
December 31, 1996 -- -- 5,620,417 1,124,083 24,091,210 (49,775)
Exercise of common
stock options -- -- 107,283 21,457 456,759 --
Restricted stock -
compensation
charged to
expense, net -- -- -- -- -- --
Shares forfeited -- -- (350) (70) (18,338) --
Tax benefit from
exercise of
stock options -- -- -- -- 702,684 --
Purchase of
treasury stock -- -- -- -- -- (20,580)
Net income -- -- -- -- -- --
.............................................................................................
Balance at
December 31, 1997 -- -- 5,727,350 1,145,470 25,232,315 (70,355)
EXERCISE OF COMMON
STOCK OPTIONS -- -- 193,814 38,763 1,114,876 --
RESTRICTED STOCK -
COMPENSATION
CHARGED TO
EXPENSE, NET -- -- -- -- -- --
SHARES FORFEITED -- -- (700) (140) (6,860) --
TAX BENEFIT FROM
EXERCISE OF
STOCK OPTIONS -- -- -- -- 1,163,441 --
PURCHASE OF
TREASURY STOCK -- -- -- -- -- (1,718,932)
NET INCOME -- -- -- -- -- --
.............................................................................................
BALANCE AT
DECEMBER 31, 1998 -- $ -- 5,920,464 $1,184,093 $27,503,772 $(1,789,287)
- ---------------------------------------------------------------------------------------------
Retained
Earnings
Unearned (Accumulated
Compensation Deficit) Total
- -----------------------------------------------------------------------
Balance at
December 31, 1995 $ (168,529) $ (649,884) $ 22,609,375
- -----------------------------------------------------------------------
Issuance costs for
initial public
offering in 1995 -- -- (55,889)
Exercise of common
stock options -- -- 425,035
Restricted stock -
compensation
charged to
expense, net 52,356 -- 52,356
Shares forfeited 9,487 -- --
Tax benefit from
exercise of
stock options -- -- 1,378,071
Net income -- 5,596,623 5,596,623
.......................................................................
Balance at
December 31, 1996 (106,686) 4,946,739 30,005,571
Exercise of common
stock options -- -- 478,216
Restricted stock -
compensation
charged to
expense, net 52,344 -- 52,344
Shares forfeited 18,408 -- --
Tax benefit from
exercise of
stock options -- -- 702,684
Purchase of
treasury stock -- -- (20,580)
Net income -- 6,883,148 6,883,148
.......................................................................
Balance at
December 31, 1997 (35,934) 11,829,887 38,101,383
EXERCISE OF COMMON
STOCK OPTIONS -- -- 1,153,639
RESTRICTED STOCK -
COMPENSATION
CHARGED TO EXPENSE,
NET 28,934 -- 28,934
SHARES FORFEITED 7,000 -- --
TAX BENEFIT FROM
EXERCISE OF
STOCK OPTIONS -- -- 1,163,441
PURCHASE OF
TREASURY STOCK -- -- (1,718,932)
NET INCOME -- 6,967,302 6,967,302
.......................................................................
BALANCE AT
DECEMBER 31, 1998 $ -- $18,797,189 $45,695,767
- -----------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
18
14
TOLLGRADE COMMUNICATIONS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
1996 1997 1998
- --------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income $ 5,596,623 $ 6,883,148 $ 6,967,302
Adjustments to reconcile net income
to net cash provided by operating activities:
Depreciation and amortization 688,323 1,005,744 1,387,598
Deferred income taxes (77,990) 26,495 (545,420)
Provision for losses on inventory 95,000 -- 88,000
Provision for allowance for doubtful accounts -- 50,000 50,000
Compensation expense for restricted stock 52,356 52,344 28,934
Changes in assets and liabilities:
Increase in accounts receivable-trade (2,582,356) (2,781,094) (53,377)
(Increase) decrease in accounts receivable-other (192,716) (212,656) 216,410
Increase in inventories (2,643,352) (3,531,296) (1,188,657)
(Increase) decrease in prepaid expenses and deposits (398,302) 140,501 56,839
Decrease in accounts payable (275,517) (732,743) (272,106)
Increase (decrease) in accrued expenses, salaries
and wages, royalty payable and deferred income 1,679,404 911,508 (816,995)
Increase (decrease) in income taxes payable 86,089 775,344 (157,754)
..............................................................................................................
Net cash provided by operating activities 2,027,562 2,587,295 5,760,774
..............................................................................................................
Cash flows from investing activities:
Purchase of investments (20,690,542) (19,567,255) (17,380,104)
Redemption/maturity of investments 8,347,950 15,643,221 17,844,566
Capital expenditures (1,993,541) (1,230,910) (1,695,975)
Patent expenditures (4,760) -- --
Purchase of treasury stock -- (20,580) (1,718,932)
..............................................................................................................
Net cash used in investing activities (14,340,893) (5,175,524) (2,950,445)
..............................................................................................................
Cash flows from financing activities:
Proceeds from the exercise of stock options
including related tax benefits 1,803,106 1,180,900 2,317,080
Issuance costs related to the initial public offering (55,889) -- --
..............................................................................................................
Net cash provided by financing activities 1,747,217 1,180,900 2,317,080
..............................................................................................................
Net increase (decrease) in cash and cash equivalents (10,566,114) (1,407,329) 5,127,409
Cash and cash equivalents at beginning of year 15,157,387 4,591,273 3,183,944
..............................................................................................................
Cash and cash equivalents at end of year $ 4,591,273 $ 3,183,944 $ 8,311,353
- --------------------------------------------------------------------------------------------------------------
Supplemental disclosure of cash flow information:
Cash paid during the year for interest $ 3,076 $ 3,271 $ 107,694
Cash paid during the year for income taxes 2,013,981 2,420,460 3,596,079
- --------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
19
15
TOLLGRADE COMMUNICATIONS, INC., AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION AND BASIS OF PRESENTATION
Tollgrade Communications, Inc. (the Company) designs, engineers, markets and
supports test access and test extension products for the telecommunications and
cable television industries. The Company's telecommunications proprietary
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 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.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of income and expense during the reporting period. Actual
results could differ from those estimates.
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts of the
Company and its wholly owned subsidiaries. All significant intercompany
transactions have been eliminated.
CASH AND CASH EQUIVALENTS
The Company considers highly liquid investments with a maturity of three months
or less when purchased to be cash equivalents. Substantially all of the
Company's cash and cash equivalents are maintained at one financial institution.
No collateral or security is provided on these deposits, other than $100,000 of
deposits per financial institution insured by the Federal Deposit Insurance
Corporation.
INVESTMENTS
Short-term investments at December 31, 1997 and 1998 consist of a treasury note
and/or individual municipal bonds stated at cost, which approximated market
value. These securities have a maturity of one year or less at date of purchase
and/or contain a callable provision in which the bonds can be called within one
year from date of purchase. Long-term investments are individual municipal bonds
with a maturity of more than one year but less than eighteen months. The primary
investment purposes are to provide a reserve for future business purposes,
including possible acquisitions, capital expenditures and to meet working
capital requirements.
The Company classifies its investment in all debt securities as "held to
maturity" in accordance with Statement of Financial Accounting Standards (SFAS)
No. 115, "Accounting for Certain Investments in Debt and Equity Securities."
INVENTORIES
Inventories are stated at the lower of cost or market, with cost determined on
the first-in, first-out method. The Company provides appropriate reserves for
any inventory deemed slow moving or obsolete.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost. Property and equipment is depreciated
on a straight-line method over their estimated useful lives ranging from 3 to 7
years. 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.
PATENTS
The costs of patents are being amortized on a straight-line method over a period
of five years.
PRODUCT WARRANTY
The Company records estimated warranty costs on the accrual basis of accounting.
These reserves are based on applying historical returns and cost experience to
the current level of product shipments.
20
16
REVENUE RECOGNITION
Revenue from product sales is recognized at the time of shipment. Revenue for
license and royalty fees is recognized when earned.
RESEARCH AND DEVELOPMENT COSTS
Research and development costs are charged to operations in the year incurred.
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.
RECLASSIFICATIONS
Certain reclassifications have been made to the Company's 1997 financial
statements to agree with current year classifications.
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. The statement 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,
1996 1997 1998
- ---------------------------------------------------------------------------------------------------------------
Net Income $ 5,596,623 $ 6,883,148 $ 6,967,302
- ---------------------------------------------------------------------------------------------------------------
Weighted average common shares outstanding 5,500,884 5,686,182 5,841,347
...............................................................................................................
Effect of dilutive securities - stock options 438,778 275,358 125,204
...............................................................................................................
5,939,662 5,961,540 5,966,551
- ---------------------------------------------------------------------------------------------------------------
Earnings per share:
Basic $ 1.02 $ 1.21 $ 1.19
- ---------------------------------------------------------------------------------------------------------------
Diluted $ .94 $ 1.15 $ 1.17
- ---------------------------------------------------------------------------------------------------------------
2. INVENTORIES
Inventories consisted of the following:
December 31, 1997 DECEMBER 31, 1998
- -----------------------------------------------------------------------------------------------------------------
Raw materials $ 5,738,576 $ 6,135,743
Work in process 5,070,113 4,725,776
Finished goods 1,292,425 2,340,252
.................................................................................................................
$ 12,101,114 $ 13,201,771
- -----------------------------------------------------------------------------------------------------------------
3. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following:
December 31, 1997 DECEMBER 31, 1998
- -----------------------------------------------------------------------------------------------------------------
Test equipment and tooling $ 2,409,088 $ 3,289,767
Office equipment and fixtures 2,143,567 2,728,443
Leasehold improvements 921,049 1,127,904
.................................................................................................................
5,473,704 7,146,114
Less accumulated depreciation and amortization 2,471,880 3,831,592
.................................................................................................................
$ 3,001,824 $ 3,314,522
- -----------------------------------------------------------------------------------------------------------------
21
17
4. SHAREHOLDERS' EQUITY
COMMON STOCK
The Company has 25,000,000 authorized shares which have a par value of $.20 per
share. As of December 31, 1997 and 1998, there are 5,727,350 and 5,920,464
issued shares, respectively.
STOCK REPURCHASE PROGRAM
On April 22, 1997, the Company's Board of Directors authorized a program to
repurchase up to 200,000 shares of its common stock over the next two years. The
shares will be utilized to provide stock under certain employee benefit
programs. The number of shares that the Company intends to purchase and the time
of such purchases will be determined by the Company, at its discretion. The
Company plans to use existing cash and short-term investments to finance the
purchases. As of December 31, 1998, the Company had purchased 106,900 shares of
the Company's common stock under this program.
RESTRICTED STOCK
In May 1989, the Company adopted the Tollgrade Communications, Inc., Restricted
Stock Employee Incentive Plan (the Plan), which provides for the granting of
restricted common stock to key employees. A maximum of 140,000 shares were
issuable under the Plan. During 1995, 18,960 shares of restricted stock under
the Plan were issued. Effective upon approval by the Company's Board of
Directors of the 1995 Long-Term Incentive Compensation Plan, the Plan was
terminated. No shares of restricted stock were granted under the 1995 Long-Term
Incentive Compensation Plan in 1997 and 1998.
All shares of restricted stock were issued at no cost. Generally, the
recipients of the restricted stock are required to continue in the employment of
the Company for three to five years after the date of issuance for ownership to
vest. The unearned compensation related to the restricted stock is being charged
to expense over the vesting period, using the market value at the issuance date
of $10.00, as determined by the Board of Directors.
Compensation expense was $52,356, $52,344 and $28,934 in 1996, 1997 and
1998, respectively. In 1996, 1997 and 1998, 2,440, 350 and 700 shares of
restricted stock, respectively, were forfeited due to the termination of certain
employees. Accordingly, the compensation expense recorded for these shares in
prior periods amounting to $9,487, $18,408 and $7,000 was reversed in 1996, 1997
and 1998, respectively. At December 31, 1998, all shares of restricted common
stock granted had vested.
STOCK COMPENSATION PLANS
Under the Company's stock compensation plans, 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 April 22, 1997, the shareholders of the Company approved an amendment of
the 1995 Long-Term Incentive Compensation Plan to increase the number of shares
authorized for issuance under the plan by 375,000 and to allow for inclusion of
non-employee directors under the plan.
The Company's Board of Directors adopted the 1998 Employee Incentive
Compensation Plan on January 29, 1998 and further amended such plan on April 10,
1998. All full-time active employees of the Company, excluding officers and
directors, are eligible to participate in the plan. The aggregate number of
shares of the Company's common stock which may be issued under the plan is
600,000 shares, subject to proportionate adjustment in the event of stock splits
and similar events. The shares authorized but not granted under these plans at
December 31, 1997 and 1998 were as follows:
Shares Authorized But Not Granted
December 31, 1997 DECEMBER 31, 1998
- ------------------------------------------------------------------------------------------------------
1995 Long-Term Incentive Compensation Plan 357,973 64,073
1998 Employee Incentive Compensation Plan -- 389,333
......................................................................................................
Total 357,973 453,406
- ------------------------------------------------------------------------------------------------------
22
18
Certain employees and directors of the Company were granted stock options
under the 1995 Long-Term Incentive Compensation Plan and the 1998 Employee
Incentive Compensation Plan and various other agreements. The Company has
adopted the disclosure-only provisions of SFAS No. 123 "Accounting for
Stock-Based Compensation," but applies Accounting Principles Board Opinion No.
25 and related interpretations in accounting for its plans. If the Company had
elected to recognize compensation cost for these stock options based on the fair
value at the grant dates for awards granted under those plans in 1996, 1997 and
1998 consistent with the method prescribed by SFAS No. 123, net income and
earnings per share would have been changed to the pro forma amounts indicated
below:
Years Ended December 31,
1996 1997 1998
- ------------------------------------------------------------------------------------------------------------
Net income As reported $ 5,596,623 $ 6,883,148 $ 6,967,302
Pro forma $ 4,687,153 $ 5,805,709 $ 5,159,610
............................................................................................................
Diluted earnings per share As reported $ .94 $ 1.15 $ 1.17
Pro forma $ .79 $ .97 $ .86
- ------------------------------------------------------------------------------------------------------------
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 1996, 1997 and 1998: expected volatility of 46.5% in 1996, 40.4%
in 1997 and 50.8% in 1998; a risk-free interest rate of 5.64% in 1996, 6.10% in
1997 and 4.82% in 1998; and an expected holding period of 4 years. The weighted
average fair value of stock options, calculated using the Black-Scholes
option-pricing model, granted during the year ended 1996, 1997 and 1998, is
$10.71, $8.54 and $7.68, 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, 1995 710,582 $ .957 - $15.00 $ 7.00
Granted 201,500 21.75 - 25.75 25.33
Exercised (179,027) 1.43 - 15.00 2.67
Cancelled (3,000) 12.00 12.00
- -----------------------------------------------------------------------------------------------------------
Outstanding, December 31, 1996 730,055 .957 - 25.75 13.10
Granted 135,750 17.50 - 25.13 21.50
Exercised (107,283) .957 - 17.50 4.42
Cancelled (5,055) 12.00 - 15.00 13.81
- -----------------------------------------------------------------------------------------------------------
Outstanding, December 31, 1997 753,467 .957 - 25.75 15.84
Granted 540,000 14.5625 - 27.125 17.19
Exercised (193,714) 17.00 - 27.125 5.95
Cancelled (40,533) 12.00 - 27.125 20.66
- -----------------------------------------------------------------------------------------------------------
OUTSTANDING, DECEMBER 31, 1998 1,059,220 $ 12.00 - $27.125 $ 18.16
- -----------------------------------------------------------------------------------------------------------
Weighted Average
Options exercisable at: Number of Shares Exercise Price
- -----------------------------------------------------------------------------------------------------------
December 31, 1996 542,369 $ 10.33
December 31, 1997 615,289 14.17
DECEMBER 31, 1998 711,015 18.40
- -----------------------------------------------------------------------------------------------------------
23
19
The following table summarizes the status of the stock options, outstanding
and exercisable, at December 31, 1998:
Stock Options
Stock Options Outstanding Exercisable
- -----------------------------------------------------------------------------------------------------------------
Weighted Average Weighted Weighted
Range of Exercise Remaining Average Average
Prices Shares Contractual Life Exercise Price Shares Exercise Price
- -----------------------------------------------------------------------------------------------------------------
$12.0000 - $15.0000 312,597 7.78 $13.19 279,264 $13.03
.................................................................................................................
$15.1250 - $19.6250 390,704 9.62 16.84 128,229 16.77
.................................................................................................................
$20.6250 - $25.7500 333,252 8.34 23.76 296,519 23.96
.................................................................................................................
$27.1250 - $27.1250 22,667 9.54 27.13 7,003 27.13
.................................................................................................................
Total 1,059,220 8.67 $18.16 711,015 $18.40
- -----------------------------------------------------------------------------------------------------------------
Subsequent to December 31, 1998, the Board of Directors granted an
additional 157,000 options to employees of the Company pursuant to the 1998
Employee Incentive Compensation Plan.
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%.
5. LICENSE AND ROYALTY FEES
The Company has entered into several technology license agreements with certain
major Digital Loop Carrier (DLC) vendors 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. Royalty fees of $1,893,000, $2,014,000 and $1,903,701 were incurred
in 1996, 1997 and 1998, respectively, and are included in cost of product sales
in the accompanying consolidated statements of operations.
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6. INCOME TAXES
The provision for income taxes consisted of the following:
Years Ended December 31,
1996 1997 1998
- ---------------------------------------------------------------------------------------------------------------
Current:
Federal $ 2,938,491 $ 3,726,200 $ 4,030,841
State 316,252 421,000 554,379
...............................................................................................................
3,254,743 4,147,200 4,585,220
- ---------------------------------------------------------------------------------------------------------------
Deferred:
Federal (111,056) (28,160) (475,494)
State 33,066 54,609 (69,926)
...............................................................................................................
(77,990) 26,449 (545,420)
...............................................................................................................
$ 3,176,753 $ 4,173,649 $ 4,039,800
- ---------------------------------------------------------------------------------------------------------------
Reconciliations of the federal statutory rate to the effective tax rates
are as follows:
Years Ended December 31,
1996 1997 1998
- ---------------------------------------------------------------------------------------------------------------
Federal statutory tax rate 34% 34% 34%
Research and development tax credit (1) (2) (1)
State income taxes 2 3 3
Other 1 3 1
...............................................................................................................
Effective tax rate 36% 38% 37%
- ---------------------------------------------------------------------------------------------------------------
The components of and changes in the deferred tax assets and liabilities
recorded in the accompanying balance sheets at December 31, 1997 and 1998 were
as follows:
Deferred Deferred
December 31, Expense December 31, Expense DECEMBER 31,
1996 (Credit) 1997 (Credit) 1998
- -----------------------------------------------------------------------------------------------------------------
DEFERRED TAX ASSETS:
Excess of tax basis over book basis for:
Property and equipment $ -- $ -- $ -- $ (149,797) $149,797
Inventory 57,470 (16,328) 73,798 (130,980) 204,778
Reserves recorded for:
Warranty 78,000 (39,000) 117,000 (52,650) 169,650
Obsolescence 83,850 14,040 69,810 (34,320) 104,130
Allowance for doubtful accounts -- (19,500) 19,500 (19,500) 39,000
Net operating loss carryforward - State 58,750 58,750 -- -- --
Other 50,829 (9,174) 60,003 37,993 22,010
...................................................... ......... ........
Total deferred tax assets 328,899 340,111 689,365
- ------------------------------------------------------ --------- --------
DEFERRED TAX LIABILITIES:
Excess of book basis over tax basis for:
Property and equipment (111,777) 84,389 (196,166) (196,166) --
Other (56,678) (46,728) (9,950) -- (9,950)
...................................................... ......... ........
Total deferred tax liabilities (168,455) (206,116) (9,950)
- ------------------------------------------------------ --------- --------
- -----------------------------------------------------------------------------------------------------------------
Net deferred taxes $ 160,444 $ 26,449 $ 133,995 $ (545,420) $679,415
Reconciliation to the consolidated balance
sheets:
Current portion of deferred tax assets 171,776 213,216 354,891
Current portion of deferred
tax liabilities (168,455) (206,116) (9,950)
.................................................................................................................
Long-term deferred taxes, net $ 157,123 $ 126,895 $334,474
- -----------------------------------------------------------------------------------------------------------------
The Company had a state tax operating loss carryforward at December 31, 1996 of
approximately $500,000 which was utilized in 1997.
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7. LEASE COMMITMENTS
The Company leases office space and equipment under agreements which are
accounted for as operating leases. The office lease expires December 31, 2001
and may be extended up to an additional 3 years. The equipment lease expires in
September 2003. 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. The Company made
additional rental payments of $4,827, $4,727 and $1,619 in 1998, 1997 and 1996,
respectively.
Minimum annual future rental commitments under noncancelable leases
as of December 31 are:
1999................................................................ $ 579,917
2000................................................................ 595,577
2001................................................................ 616,457
2002................................................................ 31,817
2003................................................................ 23,863
The rent expense for all lease commitments was approximately $335,000,
$354,000 and $425,714 in 1996, 1997 and 1998, respectively.
8. MAJOR CUSTOMERS, REVENUE CONCENTRATION AND DEPENDENCE ON CERTAIN SUPPLIERS
The Company sells primarily precision electronic equipment to companies in the
telecommunications industry primarily in the United States. Sales are
concentrated primarily with the five Regional Bell Operating Companies (RBOCs)
as well as major independent telephone companies such as Sprint. Sales are
primarily from the Company's metallic channel unit (MCU) product line. The MCU
product line accounted for more than 90% of the Company's net product sales for
1998. The Company expects that revenues from MCU products will continue to
account for a majority of the Company's revenues for the foreseeable future.
Sales to the RBOCs accounted for approximately 86%, 86% and 79% of the Company's
net product sales for fiscal years 1996, 1997 and 1998, respectively. During
fiscal years 1996, 1997 and 1998, sales to two RBOCs individually exceeded 10%
of consolidated revenues and, on a combined basis, comprised 60%, 54% and 54%,
respectively, of the Company's net product sales. At December 31, 1997 and 1998,
accounts receivable-trade included in the consolidated balance sheets related to
these two RBOCs was approximately $3,819,000 and $3,639,000, respectively. Due
to the Company's present dependency on the RBOCs, the loss of one or more of the
RBOCs as a customer, or the reduction of orders for the Company's products by
the RBOCs, could materially and adversely affect the Company.
The Company utilizes two key independent subcontractors to perform a
majority of the circuit board assembly and in-circuit testing work on its
products. The Company also utilizes other subassembly contractors on a more
limited basis. The loss of the subcontractors could cause delays in the
Company's ability to meet production obligations and could have 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.
9. EMPLOYEE BENEFIT PLANS
The Company adopted a 401(k) benefit plan effective March 1, 1996. Eligible
employees, as defined in the plan, may contribute up to 20% of eligible
compensation or not to exceed the regulatory imposed limit, as defined. The
Company does not make any matching contributions to the plan.
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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 per share data)
Quarter Ended (Unaudited)
March 31, June 30, Sept. 30, Dec. 31, MARCH 31, JUNE 30, SEPT. 30, DEC. 31,
1997 1997 1997 1997 1998 1998 1998 1998
- ------------------------------------------------------------------------------------------------------------------
Revenues $ 8,619 $ 12,115 $ 11,363 $ 13,324 $ 10,764 $ 14,025 $ 10,120 $ 11,368
Cost of product sales 3,789 5,454 5,226 5,635 4,355 5,920 4,511 4,834
..................................................................................................................
Gross profit 4,830 6,661 6,137 7,689 6,409 8,105 5,609 6,534
Operating expenses:
Selling and marketing 1,046 1,334 1,287 1,779 1,622 1,499 1,227 1,356
General and administrative 831 914 948 1,075 1,090 1,263 1,133 642
Research and development 1,241 1,425 1,517 1,762 1,628 1,542 1,587 2,123
..................................................................................................................
Total operating expenses 3,118 3,673 3,752 4,616 4,340 4,304 3,947 4,121
..................................................................................................................
Income from operations 1,712 2,988 2,385 3,073 2,069 3,801 1,662 2,413
Other income, net 177 239 221 261 189 417 103 353
..................................................................................................................
Income before income taxes 1,889 3,227 2,606 3,334 2,258 4,218 1,765 2,766
Provision for income taxes 710 1,194 999 1,270 813 1,575 655 997
..................................................................................................................
Net income $ 1,179 $ 2,033 $ 1,607 $ 2,064 $ 1,445 $ 2,643 $ 1,110 $ 1,769
- ------------------------------------------------------------------------------------------------------------------
Net income per common share (1)
Basic $ .21 $ .36 $ .28 $ .36 $ .25 $ .45 $ .19 $ .30
Diluted $ .20 $ .34 $ .27 $ .35 $ .24 $ .44 $ .18 $ .30
Weighted average shares of
common stock and equivalents:
Basic 5,632 5,677 5,709 5,725 5,778 5,855 5,893 5,839
Diluted 5,976 5,942 5,955 5,975 5,956 6,008 6,048 5,890
- ------------------------------------------------------------------------------------------------------------------
(1) Second quarter 1998 includes $.04 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.
COMMON STOCK MARKET PRICES
The Company's Common Stock has been included for quotation on the Nasdaq
National Market System under the Nasdaq symbol "TLGD" since the Company's
initial public offering in December 1995. The following table sets forth, for
the periods indicated, the high and low sales prices for the Common Stock on
such market:
High Low
- ------------------------------------------------------------------------------------------------------------------
1997:
First Quarter $ 31-3/4 $ 17
Second Quarter 24-1/4 16-3/4
Third Quarter 24 20
Fourth Quarter 26-1/2 20-1/2
1998:
FIRST QUARTER $ 23-3/4 $ 18-1/4
SECOND QUARTER 26-1/2 20-1/2
THIRD QUARTER 27-3/4 19-3/4
FOURTH QUARTER 21 11
- ------------------------------------------------------------------------------------------------------------------
At March 1, 1999, the Company had 352 holders of record of its Common Stock
and 5,922,543 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.
27