TOLLGRADE COMMUNICATIONS INC \PA\, 10-Q, 1997-11-10

TOLLGRADE COMMUNICATIONS INC \PA\
10-Q, 1997-11-10
TELEPHONE INTERCONNECT SYSTEMS

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<PAGE> 1

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC

-------------------------------
FORM 10-Q

(Mark One)

[ X ] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934

For the quarterly period ended September 27, 1997

[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934

For the transition period from _____________ to ____________

Commission file number 0-27312

TOLLGRADE COMMUNICATIONS, INC.
(Exact Name of Registrant as Specified in its Charter)

PENNSYLVANIA 25-1537134
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification Number)

493 NIXON RD.
CHESWICK, PA 15024
(Address of Principal Executive Offices, including zip code)

412-274-2156
(Registrant's telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

Yes ___X___ No _______

As of November 1, 1997, there were 5,726,467 shares of the Registrant's
Common Stock, $0.20 par value per share, and no shares of the Registrant's
Preferred Stock, $1.00 par value per share, outstanding.

- --------------------------------------------------------------------------------

This report consists of a total of 38 pages. The exhibit index is on page 17.

<PAGE> 2

TOLLGRADE COMMUNICATIONS, INC.

QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 27, 1997

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION PAGE NO.
<S> <C>
ITEM 1 -- CONDENSED CONSOLIDATED FINANCIAL STATEMENTS:

CONDENSED CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 27, 1997
AND DECEMBER 31,1996 ......................................................................3

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE-MONTH AND NINE-MONTH
PERIODS ENDED SEPTEMBER 27, 1997 AND SEPTEMBER 28, 1996 ...................................4

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE-MONTH
PERIODS ENDED SEPTEMBER 27, 1997 AND SEPTEMBER 28, 1996 ...................................5

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.......................................6

REPORT OF INDEPENDENT ACCOUNTANTS .........................................................8

ITEM 2 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION......................................................9

PART II. OTHER INFORMATION

ITEM 1 -- LEGAL PROCEEDINGS.........................................................................15
ITEM 2 -- CHANGES IN SECURITIES.....................................................................15
ITEM 3 -- DEFAULTS UPON SENIOR SECURITIES...........................................................15
ITEM 4 -- SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.......................................15
ITEM 5 -- OTHER INFORMATION.........................................................................15
ITEM 6 -- EXHIBITS AND REPORTS ON FORM 8-K..........................................................15

SIGNATURE...........................................................................................16
EXHIBIT INDEX.......................................................................................17
</TABLE>

<PAGE> 3

PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
(UNAUDITED)
SEPTEMBER 27, 1997 DECEMBER 31, 1996
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 2,147,053 $ 4,591,273
Short term investments 16,592,411 12,342,592
Accounts receivable:
Trade 7,202,714 5,153,589
Other 689,486 304,434
Inventories 9,419,883 8,569,818
Prepaid expenses and deposits 245,075 549,753
Deferred tax asset 171,730 171,776
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 36,468,382 31,683,235

Property and equipment, net 2,942,601 2,769,657
Deferred tax asset 157,169 157,169
Patents and other assets 10,783 15,569
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $39,578,935 $34,625,630
- -----------------------------------------------------------------------------------------------------------------------------------

LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 1,033,032 $ 1,691,928
Accrued expenses 721,156 1,077,151
Accrued salaries and wages 727,198 769,855
Royalties payable 531,660 741,781
Income taxes payable 445,649 170,889
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 3,458,694 4,451,604

Deferred tax liability 168,455 168,455
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 3,627,149 4,620,059

SHAREHOLDERS' EQUITY:
Common stock, $.20 par value; authorized shares, 7,000,000;
issued 5,725,667 and 5,620,417, respectively 1,145,133 1,124,083
Additional paid-in capital 25,155,359 24,091,210
Treasury stock, at cost, 2,200 shares (49,775) (49,775)
Unearned compensation (65,386) (106,686)
Retained earnings 9,766,455 4,946,739
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL SHAREHOLDERS' EQUITY 35,951,786 30,005,571
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $39,578,935 $34,625,630
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>

The accompanying notes are an integral part of the condensed consolidated
financial statements.

<PAGE> 4

TOLLGRADE COMMUNICATIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------
FOR THE FOR THE
THREE MONTHS ENDED NINE MONTHS ENDED
SEPT.27, 1997 SEPT.28, 1996 SEPT.27, 1997 SEPT.28, 1996
- ------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
REVENUES $11,362,609 $10,080,385 $32,097,040 $27,112,057
COST OF PRODUCT SALES 5,225,317 4,999,944 14,469,083 13,435,042
- ------------------------------------------------------------------------------------------------------------------
GROSS PROFIT 6,137,292 5,080,441 17,627,957 13,677,015
- ------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSES:
Selling and marketing 1,286,864 1,234,448 3,666,999 3,385,308
General and administrative 947,799 671,673 2,691,834 1,746,702
Research and development 1,517,571 1,044,087 4,183,425 2,635,778
- ------------------------------------------------------------------------------------------------------------------
TOTAL OPERATING EXPENSES 3,752,234 2,950,208 10,542,258 7,767,788
- ------------------------------------------------------------------------------------------------------------------
INCOME FROM OPERATIONS 2,385,058 2,130,233 7,085,699 5,909,227
Interest and other income, net 220,887 90,138 637,252 478,810
- ------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 2,605,945 2,220,371 7,722,951 6,388,037
Provision for income taxes 999,022 824,695 2,903,274 2,422,695
- ------------------------------------------------------------------------------------------------------------------
NET INCOME $ 1,606,923 $ 1,395,676 $ 4,819,677 $ 3,965,342
- ------------------------------------------------------------------------------------------------------------------
EARNINGS PER SHARE INFORMATION:
Fully diluted weighted average shares of
common stock and equivalents 5,955,104 5,943,265 5,956,921 5,919,579
Net income per common and common equivalent shares:
Primary $ .27 $ .23 $ .81 $ .67
- ------------------------------------------------------------------------------------------------------------------
Fully Diluted $ .27 $ .23 $ .81 $ .67
- ------------------------------------------------------------------------------------------------------------------
</TABLE>

The accompanying notes are an integral part of the condensed consolidated
financial statements.

<PAGE> 5

TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------
NINE MONTHS ENDED
SEPT. 27, 1997 SEPT. 28, 1996
- ------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 4,819,677 $ 3,965,342
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 733,411 416,801
Deferred income taxes 46 (65,951)
Compensation expense for restricted stock 41,300 47,399
Changes in assets and liabilities:
Increase in accounts receivable-trade (2,049,125) (1,304,070)
(Increase) decrease in accounts receivable-other (385,052) 22,576
Increase in inventories (850,065) (2,684,372)
Decrease (increase) in prepaid expenses and deposits 304,678 (144,745)
Increase in other assets ----- (9,336)
(Decrease) increase in accounts payable (658,858) 103,879
(Decrease) increase in accrued expense and royalties payable (608,773) 734,100
Increase in income taxes payable 274,760 743,181
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Net cash provided by operating activities 1,621,999 1,824,804
- -------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Redemption/maturity of short-term investments 13,425,893 3,056,986
Purchase of short-term investments (17,675,742) (15,471,874)
Capital expenditures (901,569) (1,527,508)
Patent expenditures ----- (4,760)
- -------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities (5,151,418) (13,947,156)
- -------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from the exercise of stock options including related
tax benefits 1, 085,199 205,643
IPO issuance cost ---- (49,290)
- -------------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities 1,085,199 156,353
- -------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 2,444,220 (11,965,999)
Cash and cash equivalents at beginning of period 4,591,273 15,157,387
- -------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 2,147,053 $3,191,388
- ------------------------------------------------------------------------------------------------------------------
</TABLE>

The accompanying notes are an integral part of the condensed consolidated
financial statements.

<PAGE> 6

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements included
herein have been prepared by Tollgrade Communications, Inc. (the "Company") in
accordance with generally accepted accounting principles for the interim
financial information and Article 10 of Regulation S-X. The condensed
consolidated financial statements as of and for the three and nine-month
periods ended September 27, 1997 should be read in conjunction with the
Company's consolidated financial statements (and notes thereto) included in the
Company's Annual Report on Form 10-K for the year ended December 31, 1996.
Accordingly, the accompanying condensed consolidated financial statements do
not include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements, although the Company
believes that the disclosures are adequate to make the information presented
not misleading. In the opinion of the Company's management, all adjustments
considered necessary for a fair presentation of the accompanying condensed
consolidated financial statements have been included, and all adjustments are
of a normal and recurring nature. Operating results for the three and
nine-month periods ended September 27, 1997 are not necessarily indicative of
the results that may be expected for the year ending December 31, 1997.

2. INVENTORY

At September 27, 1997 and December 31, 1996 inventory consisted of the
following:

<TABLE>
<CAPTION>
(Unaudited)
September 27, December 31,
1997 1996
------------- ------------
<S> <C> <C>
Raw materials . . . . . . . . . . . . . . . . . . . . .$4,622,792 $3,816,242
Work in progress. . . . . . . . . . . . . . . . . . . . 3,143,117 3,808,842
Finished goods. . . . . . . . . . . . . . . . . . . . . 1,653,974 944,734
---------- ----------
$9,419,883 $8,569,818
========== ==========
</TABLE>

3. SHORT-TERM INVESTMENTS

Short-term investments at September 27, 1997 consisted of individual U.S.
Government and municipal bonds stated at cost, which approximated market value.
The primary investment purpose is to provide a reserve for future business
purposes, including possible acquisitions, capital expenditures and to meet
working capital requirements.

<PAGE> 7

4. NEW ACCOUNTING PRONOUNCEMENTS:

In February 1997 the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 128, "Earnings Per Share". SFAS 128
specifies the computation, presentation, and disclosure requirements for
earnings per share. SFAS 128 is effective for financial statements issued for
periods ending after December 15, 1997, including interim periods. The Company
plans to adopt the new standard at year-end 1997 and believes that the impact
of this standard will not have a material impact on the Company's consolidated
earnings per share calculations.

<PAGE> 8

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors of
Tollgrade Communications, Inc.:

We have reviewed the accompanying condensed consolidated balance sheet of
Tollgrade Communications, Inc. and subsidiaries as of September 27, 1997, and
the related condensed consolidated statements of operations for the three
months and nine months then ended and the condensed consolidated statements of
cash flows for the nine months then ended. These financial statements are the
responsibility of the Company's management.

We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data and making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted
in accordance with generally accepted auditing standards, the objective of
which is the expression of an opinion regarding the financial statements taken
as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should
be made to the accompanying financial statements for them to be in conformity
with generally accepted accounting principles.

We have previously audited, in accordance with generally accepted auditing
standards, the consolidated balance sheet of Tollgrade Communications, Inc. and
subsidiaries as of December 31, 1996 and the related consolidated statements of
operations, shareholders' equity and cash flows for the year then ended (not
presented herein); and in our report dated January 29, 1997, we expressed an
unqualified opinion on those consolidated financial statements. In our opinion,
the information set forth in the accompanying condensed consolidated balance
sheet as of December 31, 1996, is fairly stated in all material respects in
relation to the consolidated balance sheet from which it has been derived.

/s/ Coopers & Lybrand L.L.P.

Pittsburgh, Pennsylvania
October 10, 1997

<PAGE> 9

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION

The following discussion should be read in conjunction with the Condensed
Consolidated Financial Statements and Notes thereto appearing elsewhere in this
report.

CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.

The statements contained in the following Management's Discussion and Analysis
of Results of Operations and Financial Condition which are not historical are
"forward looking statements" within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended. These forward-looking statements represent the
Company's present expectations or beliefs concerning future events. The Company
cautions that such statements are qualified by important factors that could
cause actual results to differ materially from those in the forward-looking
statements. Results actually achieved thus may differ materially from expected
results included in these statements. Those factors which specifically relate
to the Company's business include the following: rapid technological change
along with the need to continually develop new products; dependence on a single
product line; competition; dependence on key employees; management of Company's
growth; dependence on certain customers; dependence on certain suppliers;
fluctuations in operating results; proprietary rights and 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 proprietary products which enable
telephone companies to use their existing line test systems to remotely
diagnose problems in Plain Old Telephone Service ("POTS") lines containing both
copper and fiber optics. The Company's MCU(R) product line, which includes POTS
line testing as well as alarm-related products, represented approximately 91%
of the Company's revenue for the third quarter ended September 27, 1997 and
will continue to account for a majority of the Company's revenues for the
foreseeable future.

The Company's 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 third quarter ended September 27, 1997, approximately 85% of the Company's
total revenue was generated from sales to these five RBOCs, the two largest of
which comprised approximately 44% of revenues. 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.

Management believes that during fiscal year 1998 there is a possibility that
one of the Company's major customers will have satisfied a substantial portion
of its requirements for certain of the Company's product lines. Management is
focusing on the development of new product lines to meet the requirements of
this and other customers.

<PAGE> 10

Although international sales to date have not been significant, the Company
believes the international markets offer opportunities. The Company intends to
focus additional sales, marketing and development resources on increasing its
international presence; 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 13.4% for the third quarter ended September 27,
1997. The Company expects its research and development expenses to continue at
significant levels.

On July 18, 1997, the United States Court of Appeals for the Eighth Circuit
issued an opinion vacating, in part, the Federal Communication Commission's
Interconnection Order promulgated under the Telecommunications Act of 1996 (the
"Act") in Iowa Utilities Board, et. al. v. FCC, et al (consolidated cases
beginning at no. 96-3321). In the opinion, the court vacated the FCC's pricing
rules on the basis that the FCC exceeded its jurisdiction in promulgating
pricing rules regarding local telephone service, and asserting that the Act
grants state commissions, not the FCC, authority to determine the rates
involved in the implementation of the local competition provisions of the Act.
In addition, the court vacated the FCC's "pick and choose" rule implemented
under subsection 252(I) of the Act which allowed a local exchange carrier to
select among individual provisions of other interconnection agreements
previously negotiated between an incumbent local exchange carrier and other
requesting carriers, without being required to accept the terms and conditions
of the agreements in their entirety. Among other actions taken by the court, it
also upheld most of the unbundling regulations promulgated by the FCC in the
Interconnection Order. To date, it remains uncertain how this decision and the
actions of state commissions required as a result will affect the Company's
future results of operations.

Historically, the Company has utilized one key independent subcontractor to
perform a majority of the circuit board assembly and in-circuit testing work on
its products. The Company has also utilized other subassembly subcontractors on
a more limited basis. During the third quarter, 1997, the key subassembly
subcontractor notified the Company that due to a change in its business
strategy only customers that provide certain volume levels of business would be
sought or retained. As a result of this evaluation, the key subassembly
subcontractor notified the Company that its services would no longer be
available effective January 1, 1998. The Company is in the process of phasing
out the use of that subcontractor, and is beginning to utilize on a more
extensive basis, two of the other subassembly subcontractors that had been
utilized by the Company on a more limited basis in the past. By the end of
1997, the Company expects to have its subassembly requirements met by these two
subcontractors. Although the Company is striving to complete a seamless
transition, there is a risk that transitional issues could cause delays in the
Company's production requirements which could have an adverse effect on the
Company's results of operations.

<PAGE> 11

RESULTS OF OPERATIONS - THIRD QUARTER

REVENUES

Revenue for the third quarter of 1997 were $11,362,609 and were $1,282,224, or
12.7% higher than the revenues of $10,080,385 reported for the third quarter of
1996. The increase in revenues for the third quarter was primarily attributable
to an increase in unit volume sales of the MCU line testing products as a
result of increased market penetration and customer acceptance. This increased
product demand is at least partly attributable to technology licensing
agreements and/or joint venture relationships with certain major DLC equipment
manufacturers, as well as continued expansion of a marketing program to train
customers in advanced line test system trouble-shooting.

GROSS PROFIT

Gross profit for the third quarter of 1997 was $6,137,292 compared to
$5,080,441 for the third quarter of 1996, representing an increase of
$1,056,851, or 20.8%. Gross profit as a percentage of revenues increased to
54.0% in the third quarter of 1997, compared to 50.4% in the same quarter last
year. The overall increase in gross profit margin resulted primarily from
increased sales levels, while improvements in gross margin as a percentage of
revenues were a result of increased sales of certain higher-margined products
within the MCU product line.

SELLING AND MARKETING EXPENSE

Selling and marketing expense for the third quarter of 1997 was $1,286,864
compared to $1,234,448 for the third quarter of 1996. This increase of $52,416,
or 4.2%, is due to the addition of personnel associated with the expansion of
marketing and communications functions and the development of domestic and
international markets. As a percentage of revenues, selling and marketing
expenses decreased to 11.3% in the third quarter of 1997 from 12.2% in the
third quarter of 1996, primarily due to the increased revenue base discussed
above.

GENERAL AND ADMINISTRATIVE EXPENSE

General and administrative expense for the third quarter of 1997 was $947,799,
an increase of $276,126, or 41.1%, over the $671,673 recorded in the third
quarter of 1996. The increase in general and administrative expense primarily
reflects additional salaries and benefits associated with increased staffing
levels to support expanded business operations, increased international travel
costs, as well as increased costs associated with recruiting-type activities.
As a percentage of revenues, general and administrative expenses increased to
8.3% in the third quarter of 1997 from 6.7% in the third quarter of 1996.

RESEARCH AND DEVELOPMENT EXPENSE

Research and development expense in the third quarter of 1997 was $1,517,571,
an increase of $473,484, or 45.3%, over the $1,044,087 recorded in the third
quarter of 1996. The increase is primarily associated with additional personnel
and related development costs to support new product introductions. The new
personnel were hired for positions in design engineering, hardware and software
development, engineering support, and test engineering. Their efforts are
associated with the development of future products, support for newer products,
and feature enhancements for existing products. As a percentage of revenues,
research and development expense increased to 13.4% in the third quarter of
1997 from

<PAGE> 12

10.4% in the third quarter of 1996.

INTEREST AND OTHER INCOME

Interest and other income consists primarily of interest income. For the third
quarter of 1997, interest and other income was $220,887 compared to $90,138 for
the third quarter of 1996, representing an increase of $130,749, or 145.1%. The
increase was primarily attributable to increased interest income, which
resulted from an overall increase in funds available for investment between
comparable periods.

PROVISION FOR INCOME TAXES

The provision for income taxes for the third quarter of 1997 was $999,022, an
increase of $174,327, or 21.1%, from $824,695 for the third quarter of 1996.
The effective income tax rate increased to approximately 38.3% in the third
quarter of 1997, compared to approximately 37.1% in the third quarter of 1996.
The increased provision for income taxes was primarily due to increased
earnings levels of the Company between comparable periods. The increase in the
effective tax rate between periods reflects certain refinements for the
estimated effective tax rate for fiscal year 1997.

NET INCOME

As a result of the above factors, net income for the third quarter of 1997 was
$1,606,923, an increase of $211,247, or 15.1%, over the $1,395,676 recorded in
the third quarter of 1996. Primary and fully diluted earnings per common share
of $.27 for the third quarter of 1997 increased by $.04, or 17.4%, from the
$.23 per share earned in the third quarter of 1996. Fully diluted weighted
average common and common equivalent shares outstanding were 5,955,104 in the
third quarter of 1997 compared to 5,943,265 in the third quarter of 1996. As a
percentage of revenues, net income for the third quarter of 1997 increased to
14.1% compared to the 13.8% for the third quarter of 1996.

RESULTS OF OPERATIONS - YEAR TO DATE

REVENUES

For the first nine months of 1997, revenues were $32,097,040 compared to
$27,112,057 for the first nine months of 1996, representing an increase of
$4,984,983 or 18.4%. The increase in revenues for the nine month period was
primarily attributable to an increase in unit sales volume of the MCU line
testing products as a result of increased market penetration and customer
acceptance. In addition, increased product demand is at least partly
attributable to technology and licensing agreements and/or joint venture
relationships with certain major DLC equipment manufacturers, as well as
continued expansion of a marketing program to train customers in advanced line
test system trouble-shooting. MCU line testing and synchronization product
revenue increased $5,486,000, or 22.4%, in the nine month period ended
September 27, 1997 compared to first nine months of 1996.

GROSS PROFIT

For the nine months of 1997, gross profit increased to $17,627,957 compared to
$13,677,015 for the first nine months of 1996, representing an increase of
$3,950,942, or 28.9%. As a percentage of revenues, gross profit increased to
54.9% in the first nine months of 1997 compared to 50.4% in the same period for
1996. The overall increase in gross profit margin resulted primarily from
increased sales levels, while

<PAGE> 13

improvements in gross margin as a percentage of revenues were a result of
increased sales of certain higher-margined products within the MCU product
line.

SELLING AND MARKETING EXPENSE

For the first nine months of 1997, selling and marketing expense totaled
$3,666,999 compared to $3,385,308 for the first nine months of 1996,
representing an increase of $281,691, or 8.3%. The increase is due to the
addition of new personnel associated with the expansion of customer technical
support, expansion of marketing and communication functions and the development
of domestic and international markets. As a percentage of revenues, selling and
marketing expense decreased to 11.4% in the first nine months of 1997 from
12.5% for the same period of 1996. The decrease was due primarily to the
increased revenue base discussed above.

GENERAL AND ADMINISTRATIVE EXPENSE

For the first nine months of 1997, general and administrative expense totaled
$2,691,834 compared to $1,746,702 for the first nine months of 1996,
representing an increase of $945,132, or 54.1%. The increase in general and
administrative expense primarily reflects the addition of personnel to support
expanded business requirements for accounting, legal, operations, investor
relations and administrative support, as well as increased international travel
costs. As a percentage of revenues, general and administrative expense
increased to 8.4% for the first nine months of 1997 from 6.4% for the same
period of 1996.

RESEARCH AND DEVELOPMENT EXPENSE

For the first nine months of 1997, research and development expense totaled
$4,183,425 compared to $2,635,778 for the first nine months of 1996,
representing an increase of $1,547,647, or 58.7%. The increase was due to
engineering and development costs associated with the addition of new
personnel, as well as other costs associated with new product development. As a
percentage of revenues, research and development expense increased to 13.0% in
the first nine months of 1997 from 9.7% for the first nine months of 1996.

INTEREST AND OTHER INCOME

Interest and other income consists primarily of interest income. For the first
nine months of 1997, interest and other income was $637,252 compared to
$478,810 for the first nine months of 1996, representing an increase of
$158,442, or 33.1%. This was primarily attributable to increased interest
income, which resulted from an overall increase in funds available for
investment between comparable periods.

PROVISIONS FOR INCOME TAXES

The provision for income taxes for the first nine months of 1997 was $2,903,274
which was an increase of $480,579, or 19.8%, from $2,422,695 for the first nine
months of 1996. The effective tax rate was 37.6% for the first nine months of
1997 versus 37.9% for the comparable period in the prior year. The increased
provision for income taxes was primarily due to increased earnings levels of
the Company between comparable periods, while the decrease in effective tax
rate reflects the estimated benefit related to R&D tax credits which are
available during the entire year of 1997 but were not available during the
first half of 1996.

<PAGE> 14

NET INCOME

For the first nine months of 1997, net income was $4,819,677 compared to
$3,965,342 for the first nine months of 1996, representing an increase of
$854,335, or 21.5%. Fully diluted earnings per common share of $.81 for the
first nine months of 1997 increased by $.14, or 20.9%, from the $.67 per share
earned in the first nine months of 1996. Fully diluted weighted average common
and common equivalent shares outstanding were 5,956,921 in the first nine
months of 1997 compared to 5,919,579 in the first nine months of 1996. As a
percentage of revenues, net income for the first nine months of 1997 increased
to 15.0% from 14.6% in the comparable period in the prior year.

LIQUIDITY AND CAPITAL RESOURCES

At September 27, 1997, the Company had working capital of $33,009,688, which
represented an increase of $5,778,057, or 21.2%, from the $27,231,631 of
working capital as of December 31, 1996. The increase in working capital can be
attributed primarily to operating cash flow (income from operations before
depreciation and amortization) exceeding requirements for purchases of property
and equipment. Management believes that operating cash flow and cash reserves
are adequate to finance currently planned capital expenditures and to meet the
overall liquidity needs of the Company.

The Company made capital expenditures of $901,569 in the first nine months of
1997 and were primarily related to test fixtures and development systems,
computer and office equipment for increased staff, as well as leasehold
improvements made to the Company's facilities. The Company presently has no
material capital expenditure commitments.

As of and through September 27, 1997, the Company had not borrowed any amounts
against its $2,500,000 available bank line of credit. The credit agreement has
been extended to June 30, 1998 on terms similar to those previously in effect.

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 repurchases. To date, the Company has not purchased any stock under this
program.

BACKLOG

The Company's backlog consists of firm customer purchase orders for the
Company's various products. As of September 27, 1997 the Company had a backlog
of $1,823,785 compared to $912,507 at December 31, 1996 and $1,385,102 at June
28, 1997. The increase in backlog for the quarter occurred due to customer
orders exceeding product shipments during the period, resulting in part from
increased order levels compared to the previous quarter. 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.

<PAGE> 15

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS
None.

ITEM 2. CHANGES IN SECURITIES
None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.

ITEM 5. OTHER INFORMATION
None.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits:

The following exhibits are being filed with this report:

<TABLE>
<CAPTION>
Exhibit
Number Description
------ -----------
<S> <C>
10.1 Change in Control Agreement, entered
into July 17, 1997 between the Company and
Timothy O'Brien, together with a schedule
listing substantially a similar agreement
with Joe O'Brien.

10.2 Stock Option Agreement entered into October
15, 1997 between the Company and Mark
Peterson, together with a schedule listing
substantially similar agreements with John
Benedict, Bradley N. Dinger, Joe O'Brien and
Timothy O'Brien.

10.3 Amendment , dated February 21, 1997, to
Technical Information Agreement relating to
Metallic Channel Units Types A and B, dated
February 1, 1993, between American Telephone
and Telegraph Company ("AT&T") (licensor)
and the Company (licensee).

11.1 Statement re Computation of Per Share Earnings

15 Letter re unaudited interim financial information

27 Financial Data Schedule
</TABLE>

(b) Reports on Form 8-K:

The Company did not file any Current Report on Form 8-K during the
quarter ended September 27, 1997.

<PAGE> 16

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.

TOLLGRADE COMMUNICATIONS, INC.
(REGISTRANT)

Dated: November 10, 1997 /S/ CHRISTIAN L. ALLISON
----------------------------------
CHRISTIAN L. ALLISON
CHIEF EXECUTIVE OFFICER & DIRECTOR

Dated: November 10, 1997 /S/ SAMUEL C. KNOCH
----------------------------------
SAMUEL C. KNOCH
CHIEF FINANCIAL OFFICER

Dated: November 10, 1997 /S/ BRADLEY N. DINGER
----------------------------------
BRADLEY N. DINGER
CONTROLLER

<PAGE> 17

EXHIBIT INDEX
(Pursuant to Item 601 of Regulation S-K)

11.1 Statement re Computation of Per Share Earnings

15 Letter re unaudited interim financial information

27 Financial Data Schedule
</TABLE>

<PAGE> 1

EXHIBIT 10.1

AGREEMENT

This Agreement, made as of the 17th day of July, 1997 by and between
TOLLGRADE COMMUNICATIONS, INC., a Pennsylvania corporation (the "Corporation")
and TIMOTHY O'BRIEN, an individual residing in the Commonwealth of Pennsylvania
and an employee of the Corporation (the "Executive").

WITNESSETH:

WHEREAS, the Board of Directors of the Corporation has determined that
it is in the best interests of the Corporation to enter into this Agreement
with the Executive to provide for compensation of the Executive upon
termination of employment under certain circumstances relating to a change in
control of the Corporation; and

WHEREAS, the Executive desires to obtain such benefits in the event
the Executive's employment is terminated under the circumstances provided
herein.

NOW, THEREFORE, in consideration of the covenants and premises
contained herein, and intending to be legally bound hereby, the parties hereto
agree as follows:

1. DEFINITION OF TERMS. The following terms when used in this
Agreement shall have the meaning hereafter set forth:

"ANNUAL SALARY ADJUSTMENT PERCENTAGE" shall mean the mean average
percentage increase in base salary for all elected officers of the
Corporation during the two full calendar years immediately preceding
the time to which such percentage is being applied; provided however,
that if after a Change-in-Control, as hereinafter defined, there
should be a significant change in the number of elected officers of
the Corporation or in the manner in which they are compensated, then
the foregoing definition shall be changed by substituting for the
phrase "elected officers of the Corporation" the phrase "persons then
performing the functions formerly performed by the elected officers of
the Corporation."

"CAUSE FOR TERMINATION" shall mean:

(a) the deliberate and intentional failure by the Executive to
devote substantially his entire business time and best
efforts to the performance of his duties (other than any such
failure resulting from the Executive's incapacity due to
physical or mental illness or disability) after a demand for
substantial performance is delivered to the Executive by the
Board of Directors which specifically identifies the manner
in which the Board of Directors believes that the Executive
has not substantially performed his duties,

(b) wilfully engaging by the Executive in conduct which constitutes a
fraud against the Corporation or a material breach of this
Agreement,

18
<PAGE> 2

For purposes of this definition, no act, or failure to act, on the
Executive's part shall be considered "deliberate and intentional" or
"willfully" unless done, or omitted to be done, by the Executive not
in good faith and without reasonable belief that his action or
omission was in the best interests of the Corporation.

"CHANGE-IN-CONTROL" shall mean the determination (which may be made
effective as of a particular date specified by the Board of Directors
of the Corporation) by the Board of Directors of the Corporation, made
by a majority vote that a change in control has occurred, or is about
to occur. Such a change shall not include, however, a restructuring,
reorganization, merger, or other change in capitalization in which the
Persons who own an interest in the Corporation on the date hereof (the
"Current Owners")(or any individual or entity which receives from a
Current Owner an interest in the Corporation through will or the laws
of descent and distribution) maintain more than a sixty-five percent
(65%) interest in the resultant entity. Regardless of the Board's vote
or whether or not the Board votes, a Change-in-Control will be deemed
to have occurred as of the first day any one (1) or more of the
following subparagraphs shall have been satisfied:

(a) Any Person (other than the Person in control of the Corporation as
of the date of this Agreement, or other than a trustee or other
fiduciary holding securities under an employee benefit plan of the
Corporation, or a corporation owned directly or indirectly by the
stockholders of the Corporation in substantially the same
proportions as their ownership of stock of the Corporation),
becomes the beneficial owner, directly or indirectly, of
securities of the Corporation representing more than thirty five
percent (35%) of the combined voting power of the Corporation's
then outstanding securities; or

(b) The stockholders of the Corporation approve:

(i) A plan of complete liquidation of the Corporation;

(ii) An agreement for the sale or disposition of all or
substantially all of the Corporation's assets; or

(iii) A merger, consolidation, or reorganization of the Corporation
with or involving any other corporation, other than a merger,
consolidation, or reorganization that would result in the
voting securities of the Corporation outstanding immediately
prior thereto continuing to represent (either by remaining
outstanding or by being converted into voting securities of
the surviving entity) at least sixty-five percent (65%) of
the combined voting power of the voting securities of the
Corporation (or such surviving entity) outstanding
immediately after such merger, consolidation, or
reorganization.

However, in no event shall a Change in Control be deemed to have
occurred, with respect to the Executive, if the Executive is part of a
purchasing group which consummates the Change-in-Control transaction.
The Executive shall be deemed "part of the purchasing group" for
purposes

19
<PAGE> 3

of the preceding sentence if the Executive is an equity participant or
has agreed to become an equity participant in the purchasing company
or group (except for (i) passive ownership of less than five percent
(5%) of the voting securities of the purchasing company; or (ii)
ownership of equity participation in the purchasing company or group
which is otherwise deemed not to be significant, as determined prior
to the Change-in-Control by a majority of the non-employee continuing
Directors of the Board of Directors of the Corporation).

"DATE OF TERMINATION" shall mean:

(a) if the Executive's employment is terminated for Disability, the
date that a Notice of Termination is given to the Executive;

(b) if the Executive terminates due to his death or Retirement, the
date of death or Retirement, respectively;

(c) if the Executive decides to terminate employment upon Good Reason
for Termination, the date following such decision specified by the
Corporation after it has been notified of the Executive's decision
to terminate employment; or

(d) if the Executive's employment is terminated for any other reason,
the date on which such termination becomes effective pursuant to a
Notice of Termination.

"DISABILITY" shall mean such incapacity due to physical or mental
illness or injury as causes the Executive to be unable to perform his
duties with the Corporation during 180 consecutive days.

"GOOD REASON FOR TERMINATION" shall mean the occurrence of:

(a) without the Executive's express written consent, the assignment to
the Executive of any duties materially and substantially
inconsistent with his positions, duties, responsibilities and
status with the Corporation immediately prior to a
Change-in-Control, or a material change in his reporting
responsibilities, titles or offices as in effect immediately prior
to a Change-in-Control, or any removal of the Executive from or
any failure to re-elect the Executive to any of such positions,
except in connection with the termination of the Executive's
employment due to Cause for Termination, Disability or Retirement
(as hereinafter defined) or as a result of the Executive's death;

(b) (i) a reduction by the Corporation prior to a Change-in-Control in
the Executive's base salary unless such reduction is the result of
the Board of Directors of the Corporation determining that the
Executive has not adequately discharged his duties;

(ii) a reduction by the Corporation after a Change-in-Control in
the Executive's base salary as in effect immediately prior to any
Change-in-Control or a failure by the Corporation after a
Change-in-Control to increase the Executive's base salary by the
Annual Salary Adjustment Percentage;

20
<PAGE> 4

to that provided by the Corporation immediately prior to any
Change-in-Control;

(d) a failure by the Corporation after a Change-in-Control to continue
in effect any benefit or compensation plan, stock option plan,
pension plan, life insurance plan, health and accident plan or
disability plan in which the Executive is participating
immediately prior thereto (provided, however, that there shall not
be deemed to be any such failure if the Corporation substitutes
for the discontinued plan, a plan providing the Executive with
substantially similar benefits) or the taking of any action by the
Corporation which would adversely affect the Executive's
participation in or materially reduce the Executive's benefits
under any of such plans or deprive the Executive of any material
fringe benefit enjoyed by the Executive immediately prior to a
Change-in-Control (provided, however, that any act or failure to
act by the Corporation that is on a plan- wide basis, i.e., it
similarly affects all employees of the Corporation or all
employees eligible to participate in any such plan, as the case
may be, shall not constitute Good Reason for Termination);

(e) the failure of the Corporation to obtain the assumption of this
Agreement by any successor as contemplated in SECTION 10(C)
hereof;

(f) any purported termination of the employment of the Executive by
the Corporation which is not (i) due to the Executive's
Disability, Retirement (as hereinafter defined) or Cause for
Termination, or (ii) effected as a Notice of Termination, as
defined herein; or

(g) the Corporation's requiring the Executive to be based anywhere
other than the Corporation's executive offices at which the
Executive has his principal office immediately prior to a
Change-in-Control or executive offices located within 50 miles of
the location of the Corporation's executive offices immediately
prior to a Change-in-Control, except for required travel on the
Corporation's business to an extent substantially consistent with
the Executive's present business travel obligations.

"NOTICE OF TERMINATION" shall mean a written statement which sets
forth the specific reason for termination and, if such is claimed to
be a Cause for Termination or Good Reason for Termination, in
reasonable detail the facts and circumstances which indicate that such
is Cause for Termination or Good Reason for Termination.

"OPTIONS" shall mean any stock options issued pursuant to any present
or future stock option plan of the Corporation.

"PERSON" shall have the meaning ascribed to such term in Section
3(a)(9) of the Securities Exchange Act of 1934, as in effect on the
date hereof and used in Sections 13(d) and 14(d) thereof, including a
"group" as defined in Section 13(d) thereof.

"RETIREMENT" shall mean the termination of the Executive's employment
after age 65 or in accordance with any mandatory retirement
arrangement with respect to an earlier age agreed to by the Executive.

"STOCK APPRECIATION RIGHT" shall mean any stock appreciation rights
issued pursuant to any

21
<PAGE> 5

stock option plan of the Corporation or any future stock appreciation
rights plan.

2. TERMS OF EMPLOYMENT. The Executive acknowledges that this Agreement
does not constitute an employment contract and that the Executive's employment
relationship with the Corporation is at-will and not for any particular period.
Rather, this Agreement is only intended to set forth certain liquidated damages
to be paid in the event of termination of the Executive upon the terms and
conditions specified herein.

3. TERM OF AGREEMENT. The initial term of this Agreement shall be for
a period of four (4) years. Upon expiration of the initial term, the Company
shall, in its sole discretion, determine whether this Agreement shall be
renewed upon such terms it deems advisable.

4. PAYMENTS FOLLOWING TERMINATION OF EMPLOYMENT UPON A CHANGE-IN-
CONTROL.

(a) If the Executive's employment with the Corporation shall be
terminated:

(i) due to the Executive's death,

(ii) by the Executive other than the Executive's having terminated
for Good Reason for Termination following a
Change-in-Control, or

(iii) by the Corporation due to Cause for Termination or for
Disability or Retirement,

then the Corporation shall have no obligations to the Executive
other than to pay the Executive any unpaid portion of base salary
due until the Date of Termination and any other sums due in
accordance with the then various policies, practices and benefit
plans of the Corporation.

(b) If the Executive's employment with the Corporation shall have
terminated during the period commencing six months prior to the
date of a Change-in-Control and ending on the third anniversary of
a Change-in-Control other than in the circumstances described in
subsection (a) above, then the Corporation shall pay on or before
the fifth day following the Date of Termination (or if the Date of
Termination preceded the date of the Change-in-Control, on or
before the fifth day following the date of the Change-in-Control),
to the Executive the following sums:

(i) in cash any unpaid portion of the Executive's full base
salary for the period from the last period for which the
Executive was paid to the Date of Termination, or the date of
the Change-in-Control, as the case may be; and

(ii) an amount in cash as liquidated damages for lost future
renumeration equal to the product obtained by multiplying

(A) the lesser of

(1) two, or

<PAGE> 6

(2) a number equal to the number of calendar
months remaining from the Date of
Termination to the date on which the
Executive is 65 years of age (or, if
earlier, the age agreed to by the Executive
pursuant to any prior arrangement) divided
by twelve, or

(3) a number equal to the greater of (i) one
(1.0) and (ii) thirty six (36) less the
number of completed months commencing after
the date of the Change-in-Control during
which the Executive was employed by the
Corporation and did not have Good Reason
for Termination times (iii) one-twelfth
(1/12)

times

(B) the sum of

(1) the greater of

(i) the Executive's annual base salary
for the year in effect on the Date
of Termination (provided that in
the case of Termination for Good
Reason by the Executive the date
immediately preceding the date of
the earliest event which gave rise
to the Termination for Good Reason
by the Executive shall be used
instead of the Date of Termination)

(ii) the Executive's annual base salary
for the year in effect on the date
of the Change-in-Control;

plus

(2) the greater of

(i) the average annual cash award
received by the Executive as
incentive compensation or bonus for
one calendar year immediately
preceding the Date of Termination
(provided that in the case of
Termination for Good Reason by the
Executive the date immediately
preceding the date of the event
which gave rise to the Termination
for Good Reason by the Executive
shall be used instead of the Date
of Termination)

(ii) the average annual cash award
received by the Executive as
incentive compensation or bonus for
one calendar year immediately
preceding the date of the
Change-in-Control.

5. OUTPLACEMENT SERVICES. If the Executive's employment with the
Corporation

23
<PAGE> 7

should terminate under circumstances as to entitle the Executive to receive
payment hereunder, the Corporation shall reimburse the Executive for any
reasonable fees or other costs incurred by the Executive during the two (2)
years following the Date of Termination in retaining executive placement
agencies, up to a maximum dollar amount not to exceed fifteen percent (15%) of
the Executive's base salary at the time of such termination. Such reimbursement
shall be made within five (5) days following the Executive's presentment of
bills or other evidence of the costs incurred with executive placement
agencies.

6. TAX IMPLICATIONS. If any payment due to the Executive pursuant to
this Agreement result in a tax being imposed on the Executive pursuant to
Section 4999 of the Internal Revenue Code of 1954, as amended, or any successor
provision ("Section 4999"), then the Corporation shall, at the Executive's
option, either (i) reduce the total payments payable to the Executive to the
maximum amount payable without incurring the Section 4999 tax, or (ii) pay to
the Executive the total amount payable, with the understanding that Section
4999 tax will be due on that total amount.

7. BENEFITS. If the Executive's employment with the Corporation should
terminate under circumstances as to entitle the Executive to receive payment
hereunder, the Executive shall also be deemed, for purposes of medical
insurance, pension and other benefits of the Corporation, to have remained in
the continuous employment of the Corporation for the two (2) year period
following the Date of Termination and shall be entitled to all of the medical
insurance, pension or other benefits provided by the Corporation as if the
Executive had so remained in the employment of the Corporation. If, for any
reason, whether by law or provisions of the Corporation's employee medical
insurance, pension or other benefit plans, or otherwise any benefits which the
Executive would be entitled to under this SECTION 6 cannot be paid pursuant to
such employee benefit plans, then the Corporation contractually agrees to pay
the Executive the difference between the benefits which the Executive would
have received in accordance with this Section if the relevant employee medical
insurance, pension or other benefit plan could have paid such benefit and the
amount of benefits, if any, actually paid by such employee medical insurance,
pension or other benefit plan. The Corporation shall not be required to fund
its obligation to pay the foregoing difference.

8. OTHER EMPLOYMENT. In the event of termination under the
circumstances contemplated in SECTION 4(B) hereunder, the Executive shall have
no duty to seek any other employment after termination of his employment with
the Corporation and the Corporation hereby waives and agrees not to raise or
use any defense based upon the position that the Executive had a duty to
mitigate or reduce the amounts due him hereunder by seeking other employment
whether suitable or unsuitable and should the Executive obtain other
employment, then the only effect of such on the obligations of the Corporation
shall be that the Corporation shall be entitled to credit against any payments
that would otherwise be made pursuant to SECTION 7 hereof, any comparable
payments to which the executive is entitled under the employee benefit plans
maintained by the Executive's other employer or employers in connection with
services to such employer or employers after termination of this employment
with the Corporation.

9. STOCK APPRECIATION RIGHTS AND OPTIONS. If the Executive's
employment should terminate under circumstances as to entitle the Executive to
receive payment hereunder, then with respect to any standing Stock Appreciation
Rights and/or Options which did not immediately become exercisable upon the
occurrence of a Change-in-Control, such Stock Appreciation Right or Option
shall be automatically vested and remain outstanding in accordance with its
terms and be exercisable

24
<PAGE> 8

thereafter until the stated expiration date of such Stock Appreciation Right or
Option.

10. MISCELLANEOUS.

(a) This Agreement shall be construed under the laws of the
Commonwealth of Pennsylvania.

(b) This Agreement constitutes the entire understanding of the parties
hereto with respect to the subject matter hereof and may only be
amended or modified by written agreement signed by the parties
hereto.

(c) The Corporation will require any successor (whether direct or
indirect, by purchase, merger, consolidation or otherwise) to all
or substantially all of the business and/or assets of the
Corporation, by agreement in form and substance satisfactory to
the Executive, to expressly assume and agree to perform this
Agreement in the same manner required of the Corporation and to
perform it as if no such succession had taken place. As used in
this Agreement, "Corporation" shall mean the Corporation as
hereinbefore defined and any successor to its business and/or
assets as aforesaid which executes and delivers the agreement
provided for in this subsection (c) or which otherwise becomes
bound by all of the terms and provisions of this Agreement by
operation of law.

(d) This Agreement shall inure to the benefit of and be enforceable by
the Executive and the Corporation and their respective legal
representatives, executors, administrators, successors, heirs,
distributees, devisees and legatees. If the Executive should die
while any amounts would still be payable to him hereunder if he
had continued to live, all such amounts, unless otherwise provided
herein, shall be paid in accordance with the terms of this
Agreement to his devisee, legatee or other designee or, if there
be no such designee, to his estate.

(e) Any notice or other communication provided for in this Agreement
shall be in writing and, unless otherwise expressly stated herein,
shall be deemed to have been duly given if mailed by United States
registered mail, return receipt requested, postage prepaid,
addressed in the case of the Executive to his office at the
Corporation with a copy to his residence and in the case of the
Corporation to its principal executive offices, attention to the
Chief Executive Officer.

(f) No provision of this Agreement may be modified, waived or
discharged unless such waiver, modification or discharge is agreed
to in writing signed by the Executive and approved by resolution
of the Board of Directors of the Corporation. No waiver by either
party hereto at any time of any breach by the other party hereto
of, or compliance with, any condition or provision of this
Agreement to be performed by such other party shall be deemed a
waiver of similar or dissimilar provisions or conditions at the
same or at any prior or subsequent time. No agreements or
representations, oral or otherwise, express or implied, with
respect to the subject matter hereof have been made by either
party which are not set forth expressly in this Agreement.

(g) The invalidity or unenforceability of any provisions of this
Agreement shall not affect the validity or unenforceability of any
other provision of this Agreement, which shall

25
<PAGE> 9

remain in full force and effect. If any provision hereof shall be
deemed invalid or unenforceable, either in whole or in part, this
Agreement shall be deemed amended to delete or modify, as
necessary, the offending provision and to alter the bounds thereof
in order to render it valid and enforceable.

(h) This Agreement may be executed in one or more counterparts, each
of which shall be deemed to be an original but all of which taken
together will constitute one and the same instrument.

(i) If litigation should be brought to enforce, interpret or challenge
any provision contained herein, the prevailing party shall be
entitled to its reasonable attorney's fees and disbursements and
other costs incurred in such litigation and, if a money judgment
be rendered in favor of the Executive, to interest on any such
money judgment obtained calculated at the prime rate of interest
in effect from time to time at Mellon Bank, N.A., from the date
that the payment should have been made or damages incurred under
this Agreement.

IN WITNESS WHEREOF, this Agreement has been executed on the date first
above written.

ATTEST: TOLLGRADE COMMUNICATIONS, INC.

/s/ Sara M. Antol By: /s/ Christian L. Allison
- --------------------- ---------------------------
WITNESS:

/s/ Sara M. Antol /s/ Timothy O'Brien
- --------------------- ------------------------------
TIMOTHY O'BRIEN

26
<PAGE> 10

SCHEDULE TO EXHIBIT 10.1

Change in Control Agreement entered into between the Company and Joe O'Brien
dated July 17, 1997 which was substantially identical to that filed as Exhibit
10.1.

<PAGE> 1

EXHIBIT 10.2

TOLLGRADE COMMUNICATIONS, INC.
1995 LONG-TERM INCENTIVE COMPENSATION PLAN

EMPLOYEE NONSTATUTORY STOCK OPTION AGREEMENT

THIS AGREEMENT is made and entered into this 23rd day of October,
1997, by and between TOLLGRADE COMMUNICATIONS, INC., a Pennsylvania corporation
(the "Company") and MARK PETERSON, an employee of the Company (the "Holder").

WHEREAS, the Company desires to issue, and the Holder desires to
receive, an option to purchase shares of the common stock of the Company,
pursuant to the terms described herein.

NOW, THEREFORE, in consideration of the terms and conditions contained
herein and intending to be legally bound hereby, the parties agree as follows:

1. Grant of Option. The Company hereby confirms the grant to the
Holder on October 15, 1997 (the "Date of Grant") of an option (the "Option") to
purchase, from time to time in accordance with the terms hereof Ten Thousand
(10,000) shares of common stock of the Company, par value $.20 per share (the
"Common Stock") at an option price of $23.50 per share, under and subject to
the terms and conditions of the Company's 1995 Long-Term Incentive Compensation
Plan, as amended (the "Plan") and this Agreement. The Plan is incorporated
herein by reference and made a part hereof as though set forth in full herein.
Terms which are capitalized herein but which are not defined herein have the
same meaning as in the Plan unless the context otherwise requires.

The Option confirmed hereby is a nonstatutory stock option as that
term is defined in Section 2.20 of the Plan. Subject to the terms of Section
6.8 of the Plan regarding the periods during which stock options may be
exercised upon termination of employment, and Section 14.1 of the Plan
regarding the periods during which the Option may be exercised during a
Change-in-Control (as defined in the Plan), the Option shall be exercisable as
follows:

(a) From and after April 15, 1998, the Option shall be exercisable
for 3,333 shares covered hereby.

(b) From and after October 15, 1998, the Option shall be exercisable
for an additional 3,333 shares covered hereby.

The Option will expire at the close of business on October 15, 2007.

2. Acceptance of Grant of Option. The Holder accepts the grant of the
Option confirmed hereby, acknowledges having received a copy of the Plan and
agrees to be bound by the terms and provisions

28
<PAGE> 2

of the Plan, as the Plan may be amended from time to time; provided, however,
that no alteration, amendment, revocation or termination of the Plan shall,
without the written consent of the Holder, adversely affect the rights of the
Holder with respect to the Option.

3. Non-Transferability. This Option shall not be transferrable
otherwise than by Will or the laws of descent or distribution, and the Option
shall be exercisable during the lifetime of the Holder only by the Holder.

4. Procedure for Exercise of Option. The Option may be exercised only
by (a) execution and delivery by the Holder to the Company of an exercise form
or forms prescribed by the Committee; and (b) surrender of this Agreement at
the principal office of the Company. Each exercise form must set forth the
number of shares of Common Stock for which the Option is exercised and must be
dated and signed by the person exercising the Option.

Subject to the last paragraph of this Section 4, the exercise is not
effective until the Company receives payment of the full option price for the
number of shares of Common Stock for which the Option is exercised. The Option
Price shall be paid to the Company in full in the manner specified in Section
6.6 of the Plan. To the extent the Holder pays the Option Price in whole or in
part by shares of already-owned Common Stock, as permitted by the Plan, the
Company shall advise any person exercising the Option in such manner as to the
amount of any cash required to be paid to the Company for any shares
representing a fraction of a share, and such person will be required to pay any
such cash directly to the Company before any distribution of certificates
representing shares of Common Stock will be made. The person exercising the
Option should execute the form of assignment on the back of the certificate or
should deliver an executed Assignment Separate from Certificate with respect to
each stock certificate delivered in payment of the Option Price.

If any person other than the Holder exercises the Option, the exercise
material must include proof satisfactory to the Company of the right of such
person to exercise the Option, and the signature on all certificates or stock
powers must be guaranteed by a commercial bank or trust company or by a firm
having membership in the New York Stock Exchange, Inc., the American Stock
Exchange, Inc., or the National Association of Securities Dealers, Inc.

The date of exercise of the Option is the date on which the exercise
form or forms, proof of right to exercise (if required) and payment of the
Option Price are received by the Company. For purposes of determining the date
of exercise where payment of the Option Price is made in shares of
already-owned Common Stock, any cash required to be paid to the Company with
respect to a fraction of a share shall not be taken into account when
determining whether payment of the Option Price has been made.

5. Issuance of Certificates. Subject to Section 4 above and this
Section 5, the Company will issue a certificate or certificates representing
the number of shares of Common Stock for which the Option is exercised as soon
as practicable after the date of exercise. Unless otherwise directed, the
certificate(s) will be registered in the name of the person exercising the
Option and delivered to such person. If the Option Price is paid in whole or in
part with shares of already-owned Common Stock, the Company will issue at the
same time and return to the person exercising the Option a certificate
representing the number of any excess shares included in any certificate or
certificates delivered to the Company at the time of exercise.

The obligation of the Company to issue shares on exercise of an option
is subject to the effectiveness

29
<PAGE> 3

of a Registration Statement under the Securities Act of 1933, as amended, with
respect to such shares, if deemed necessary or appropriate by counsel to the
Company. The Company is not obligated to file such a Registration Statement. If
at the time of exercise of the Option, no such Registration Statement is in
effect, the issuance of shares on exercise of the Option may also be made
subject to restrictions on the transfer of the shares, including the placing of
an appropriate legend on the certificates restricting the transfer thereof, and
to such other restrictions as the Committee, on the advice of counsel, may deem
necessary or appropriate to prevent a violation of applicable securities laws.

6. Withholding of Taxes. The Holder will be advised by the Company as
the amount of any Federal income, employment or excise taxes required to be
withheld by the Company on any compensation income resulting from the exercise
of the Option, and the Holder will pay such taxes directly to the Company upon
request. State, local or foreign income or employment taxes may also be
required to be withheld by the Company and the Holder will also be required to
pay such taxes directly to the Company upon request. If the Holder does not pay
any taxes required to be withheld directly to the Company within ten (10) days
after any such request, the Company may withhold such taxes from any other
compensation to which the Holder is entitled from the Company. The Holder will
hold the Company harmless in acting to satisfy its withholding obligations in
this manner if it becomes necessary to do so.

7. Interpretation of Plan and Agreement. This Agreement is an award
agreement referred to in Section 6.2 of the Plan. If there is any conflict
between the Plan and this Agreement, the provisions of the Plan shall control.
However, there may be provisions in this Agreement not contained in the Plan,
which provisions shall nonetheless be effective. In addition, to the extent
that provisions of the Plan are expressly modified for purposes of this
Agreement pursuant to authorization in the Plan, the provisions of this
Agreement shall control. Any dispute or disagreement which shall arise under or
in any way relate to the construction or interpretation of the Plan or this
Agreement shall be resolved by the Committee, and the decision of the Committee
shall be final, binding and conclusive for all purposes.

8. Effect of Agreement on Rights of Company and Holder. This Agreement
does not confer any rights on the Holder to continue in the employ of the
Company or interfere in any way with the rights of the Company to terminate the
employment of the Holder or to otherwise reassign or change the current
position of the Holder.

9. Indemnification. The Holder indemnifies and holds harmless the
Company from and against any and all loss, damages, liability or expense,
including costs and reasonable attorneys' fees, to which the Company may be put
or may incur by reason of or in connection with any misrepresentation made by
the Holder, any breach of the Holder's warranties, or the Holder's failure to
fulfill any of his or her covenants or agreements set forth herein.

10. Binding Effect. This Agreement shall be binding upon the
successors and assigns of the Company and upon the legal representatives, heirs
and legatees of the Holder.

11. Entire Agreement. This Agreement constitutes the entire agreement
between the parties and supersedes all prior agreements and understandings,
oral or written, between the parties with respect to the subject matter of this
Agreement.

12. Amendment. This Agreement may be amended only a written instrument
signed by the Company and the Holder.

30
<PAGE> 4

13. Governing Law. This Agreement shall be governed by and construed
and enforced in accordance with the laws of the Commonwealth of Pennsylvania.

IN WITNESS WHEREOF, the Company and the Holder have executed this
Agreement as of the date first written above.

TOLLGRADE COMMUNICATIONS, INC.

By: /s/ Sara M. Antol
-----------------------------
Title: Chief Counsel & Secretary
--------------------------
WITNESS: HOLDER:

/s/ Sara M. Antol /s/ Mark Peterson
- -------------------------------- --------------------
MARK PETERSON

31
<PAGE> 5

SCHEDULE 10.2

Stock Option Agreements were entered into between the Company and John Benedict
dated October 15, 1997; Bradley N. Dinger, dated October 15, 1997; Joe O'Brien,
dated October 15, 1997; and Tim O'Brien, dated July 17, 1997, which were
substanitally identical to that filed as Exhibit 10.2, differing only in the
number of shares underlying the option granted, the exercise price and vesting
schedule.

<PAGE> 1

EXHIBIT 10.3

February 2l, 1997

2180 William Pitt Way
Pittsburgh, Pennsylvania

Re: February 1, 1993 Technical Information Agreement, as amended, relating to
Metallic Channel Units, Types A and B and Program Channel Units

Based upon the patent licensing negotiations between our companies concerning
the Agreement, the following is proposed:

1. The February 1, 1993 Agreement, as amended on April 18, 1994 and February 9,
1996 shall remain in full force and effect except as specifically modified
herein and any term in capital letters which is defined in the Definitions
Appendix of the Agreement or its subsequent amendments shall retain the meaning
specified therein.

2. LICENSEE is aware that AT&T Corp., the licensor in the Agreement, has
restructured itself into three separate legal entities. These three entities
are AT&T Corp., Lucent Technologies Inc ("LUCENT") and NCR Corp. By a letter
from Francine Berry, V.P. to you dated March 29, 1996, the Agreement has been
assigned to LUCENT. LICENSEE acknowledges that LUCENT has full benefit of the
licenses granted to AT&T under Section 1.06. Such licenses extend to all
improvements made to the TECHNICAL INFORMATION as such term is defined in the
Agreement and all amendments thereto. LICENSEE's obligation to supply LUCENT
with such improvements shall extend for 5 years from the date LICENSEE receives
the particular TECHNICAL INFORMATION upon which LICENSEE makes an improvement.
Lucent acknowledges that Tollgrade has full benefits of the Licenses granted by
AT&T under Section 1.04.

33
<PAGE> 2

3. The table in Article II, Section 2.02 is amended to include the following:

<TABLE>
<CAPTION>
Articles Rates
(in %)
<S> <C>
QUAD P-PHONE
CHANNEL UNIT 5
</TABLE>

The royalty rate applicable to each Quad P Phone Channel Unit applies after the
sale of the first 2000 such units to customers other than LUCENT or its
SUBSIDIARIES. No royalty is applicable to any unit sold to LUCENT or its
SUBSIDIARIES.

4. The following definition is added to the DEFINITIONS APPENDIX:

QUAD P-PHONE CHANNEL UNIT means any plug-in channel unit designed to
interconnect a NORTEL digital switch with an enhanced business service (EBS)
telephone and compatible for use in LUCENT's SLC-2000 Access System. Two such
channel units are presently identified. The SPQ-328 channel unit is adapted for
use in the Central Office Terminal (COT) of the SLC-2000 Access System and the
SPQ-429 channel unit is adapted for use in the Remote Terminal (RT) of such
system.

5. The following information is appended to the definition of TECHNICAL
INFORMATION:

SLC-2000 system software upgrades
Unit ID cards for QUAD P-PHONE CHANNEL UNITS

6. LUCENT hereby grants LICENSEE a nonexclusive, royalty-free, license to use
the mark SPQ in the United States on its QUAD P-PHONE CHANNEL UNITS sold on a
private label basis and identified as SPQ(R) 328 and SPQ(R) 429. This license
shall be coterminus with the Agreement. LICENSEE understands that LUCENT must
ensure that products bearing its trademark are of comparable quality to
LUCENT's own products or risk the loss of the trademark. LICENSEE agrees
therefore to maintain the quality of its products at a level at least equal to
that of LUCENT's own products. LICENSEE further agrees to provide LUCENT with a
sample of its products marked with the trademarks SPQ 328 and SPQ 429 upon
request. Such samples to be provided within two days of such request. LUCENT
agrees that it will limit its requests so that they will not be unduly
burdensome.

In the event that the products bearing the licensed mark do not meet the
quality standards, LUCENT shall notify LICENSEE in writing. LICENSEE shall have
30 days from the date of that writing to return the products to the requisite
quality standard. In the event that LICENSEE

34
<PAGE> 3

fails to correct the product quality, LUCENT may terminate the license granted
in paragraph 6 hereof.

If, in the judgment of LUCENT, LICENSEE's use of the licensed mark is likely to
cause LUCENT harm either in the form of the destruction of the ability of the
mark to identify LUCENT's products or expose LUCENT to claims by third parties
for personal injury or other loss or any other harm, LICENSEE will immediately
cease use of the mark upon notice, in writing, from LUCENT.

LICENSEE agrees that LUCENT's mark is valid and agrees not to challenge the
mark and further agrees to take whatever reasonable steps are necessary to
secure protection for the mark. LUCENT agrees to pay the reasonable expenses of
LICENSEE in the event LUCENT requests LICENSEE's aid in protecting the mark.
LICENSEE agrees that its use of the mark inures to the benefit of LUCENT.

LICENSEE may not sublicense the use of the mark nor may it assign its rights
under this trademark license to a third party without the prior written consent
of LUCENT.

LICENSEE agrees to display the mark only in accordance LUCENT's guidelines for
using its marks, which guidelines may amended from time to time.

7. After Section 4.10, add the following Section 4.11 entitled "Dispute
Resolution":

(a) If a dispute arises out of or relates to this agreement, or the
breach, termination or validity thereto the parties agree to submit the dispute
to a sole mediator selected by the parties or, at any time at the option of a
party, to mediation by the American Arbitration Association ("AAA"). If not
thus resolved, it shall be referred to a sole arbitrator selected by the
parties within thirty (30) days of the mediation, or in the absence of such
selection, to AAA arbitration which shall be governed by the United States
Arbitration Act.

(b) Any award made (i) shall be a bare award limited to a holding for
or against a party and affording such remedy as is deemed equitable, just and
within the scope of the agreement; (ii) shall be without findings as to issues
(including but not limited to patent validity and/or infringement) or a
statement of the reasoning on which the award rests; (iii) may in appropriate
circumstances (other than patent disputes) include injunctive relief; (iv)
shall be made within four (4) months of the appointment of the arbitrator; and
(v) may be entered in any court.

(c) The requirement for mediation and arbitration shall not be deemed a
waiver of any right of termination under this agreement and the arbitrator is
not empowered to act or make any award other than based solely on the rights
and obligations of the parties prior to any such termination.

(d) The arbitrator shall determine issues of arbitrability but may not
limit, expand or otherwise modify the terms of the agreement.

(e) The agreement shall be interpreted in accordance with the laws of
the State of New York exclusive of its conflict of laws provisions and the
place of mediation and arbitration shall be New York City.

35
<PAGE> 4

(f) Each party shall bear its own expenses but those related to the
compensation and expenses of the mediator and arbitrator shall be borne
equally.

(g) A request by a party to a court for interim measures shall not be
deemed a waiver of the obligation to mediate and arbitrate.

(h) The arbitrator shall only have authority to award compensatory
damages. There is no authority granted to award punitive or other damages and
each party irrevocably waives any claim thereto.

(i) The parties, their representatives, other participants mediator and
arbitrator shall hold the existence, content and result of mediation and
arbitration in confidence.

If you agree with the foregoing, please so indicate by signing and dating this
Letter Agreement in the spaces provided below, and returning it to us.

Very truly yours,

LUCENT TECHNOLOGIES INC.

By /s/ M.R. Greene
----------------------
M.R. Greene

Date 3-4-97
----------------------------

ACCEPTED AND AGREED TO:
TOLLGRADE COMMUNICATIONS, INC.

By /s/ Sara M. Antol
------------------------------
Title Chief Counsel & Secretary
---------------------------
Date 3/17/97
----------------------------

<PAGE> 1

EXHIBIT 11.1

CALCULATION OF EARNINGS PER SHARE
FOR THE THREE MONTHS AND NINE MONTHS ENDED
SEPTEMBER 27, 1997 AND SEPTEMBER 28, 1996

<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------
THREE MONTHS THREE MONTHS NINE MONTHS NINE MONTHS
ENDED ENDED ENDED ENDED
SEPT. 27, 1997 SEPT. 28, 1996 SEPT. 27, 1997 SEPT. 28, 1996
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Net income . . . . . . . . . . . . . . . . . . . . . . $1,606,923 $1,395,676 $4,819,677 $3,965,342
========== ========== ========== ==========
Common and common equivalent shares:
Weighted average number of
common shares outstanding
during the period. . . . . . . . . . . . . . . . 5,708,583 5,504,280 5,672,689 5,463,983

Common shares issuable upon exercise
of outstanding stock options
Primary . . . . . . . . . . . . . . . . 246,521 435,786 284,232 437,592
Fully diluted . . . . . . . . . . . . . 246,521 438,985 284,232 455,596

Common and common equivalent shares
outstanding during the period
Primary . . . . . . . . . . . . . . . . 5,955,104 5,940,066 5,956,921 5,901,575
========= ========= ========= =========
Fully diluted . . . . . . . . . . . . . 5,955,104 5,943,265 5,956,921 5,919,579
========= ========= ========= =========
Earnings per share data
Net income per common and common
equivalent shares
Primary . . . . . . . . . . . . . . . . $ 0.27 $ 0.23 $ 0.81 $ 0.67
Fully diluted . . . . . . . . . . . . . $ 0.27 $ 0.23 $ 0.81 $ 0.67
</TABLE>

<PAGE> 1

EXHIBIT 15

October 10, 1997

Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

RE: Tollgrade Communications, Inc. and subsidiaries

1). Form S-8 (Registration No. 333-4290) 1995 Long-Term Incentive
Compensation Plan and Individual Stock Options Granted to Certain Directors and
Employees Prior to the Adoption of the Plan

Ladies and gentlemen:

We are aware that our report dated October 10, 1997 on our review of interim
financial information of Tollgrade Communications, Inc. and subsidiaries for
the three months and nine months ended September 27, 1997 and included within
the Company's quarterly report on Form 10-Q for the quarter then ended is
incorporated by reference in the registration statement referred to above.
Pursuant to Rule 436(c)under the Securities Act of 1933, this report should not
be considered a part of the registration statement prepared or certified by us
within the meaning of Sections 7 and 11 of that Act.

Very truly yours,

/s/ Coopers & Lybrand L.L.P.

<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 27, 1997 AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<CIK> 0001002531
<NAME> TOLLGRADE COMMUNICATIONS, INC.

<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> SEP-27-1997
<CASH> 2,147,053
<SECURITIES> 16,592,411
<RECEIVABLES> 7,892,200
<ALLOWANCES> 48,270
<INVENTORY> 9,419,883
<CURRENT-ASSETS> 36,468,382
<PP&E> 5,144,363
<DEPRECIATION> 2,201,762
<TOTAL-ASSETS> 39,578,935
<CURRENT-LIABILITIES> 3,458,694
<BONDS> 0
0
0
<COMMON> 1,145,133
<OTHER-SE> 34,806,653
<TOTAL-LIABILITY-AND-EQUITY> 39,578,935
<SALES> 31,572,040
<TOTAL-REVENUES> 32,097,040
<CGS> 14,469,083
<TOTAL-COSTS> 14,469,083
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 50,000
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 7,722,951
<INCOME-TAX> 2,903,274
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,819,677
<EPS-PRIMARY> 0.81
<EPS-DILUTED> 0.81

</TABLE>