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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 25, 1999
[ ] 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)
724-274-2156
(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 October 28, 1999, there were 5,980,327 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 22 pages. The exhibit index is on page 21.
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TOLLGRADE COMMUNICATIONS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 25, 1999
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION PAGE NO.
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<S> <C>
ITEM 1 Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets as of September 25, 1999 and December 31,1998 .......3
Condensed Consolidated Statements of Operations for the three-month and nine-month periods
ended September 25, 1999 and September 26, 1998............................................4
Condensed Consolidated Statements of Cash Flows for the nine-month periods ended
September 25, 1999 and September 26, 1998 .................................................5
Notes to Condensed Consolidated Financial Statements.......................................6
Report of Independent Accountants..........................................................9
ITEM 2 Management's Discussion and Analysis of Results of Operations and Financial
Condition................................................................................ 10
PART II. OTHER INFORMATION
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ITEM 1 Legal Proceedings.........................................................................19
ITEM 2 Changes in Securities.....................................................................19
ITEM 3 Defaults Upon Senior Securities...........................................................19
ITEM 4 Submission of Matters to a Vote of Security Holders.......................................19
ITEM 5 Other Information.........................................................................19
ITEM 6 Exhibits and Reports on Form 8-K..........................................................19
SIGNATURE...............................................................................................20
EXHIBIT INDEX...........................................................................................21
</TABLE>
2
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PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
(UNAUDITED DECEMBER 31,
SEPTEMBER 25, 1999 1998
===========================================================================================================
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 8,305,683 $ 8,311,353
Short term investments 12,858,506 14,249,164
Accounts receivable:
Trade 9,409,482 7,888,060
Other 313,073 300,680
Inventories 17,942,072 13,201,771
Prepaid expenses and deposits 228,191 352,413
Deferred tax asset 583,781 354,891
- ----------------------------------------------------------------- --------------------- ------------------
Total current assets 49,640,788 44,658,332
Long term investments 2,890,000 1,553,000
Property and equipment, net 3,656,275 3,314,522
Deferred tax asset 359,129 334,474
Patents and other assets 2,109 4,247
==========================================================================================================
Total assets $56,548,301 $49,864,575
==========================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,405,519 $ 687,079
Accrued expenses 984,196 1,128,421
Accrued salaries and wages 934,277 801,908
Royalties payable 493,066 712,971
Income taxes payable 940,342 788,479
- ----------------------------------------------------------------------------------------------------------
Total current liabilities 4,757,400 4,118,858
Deferred income 985,443 40,000
Deferred tax liability 9,950 9,950
- ----------------------------------------------------------------------------------------------------------
Total liabilities 5,752,793 4,168,808
Shareholders' equity:
Common stock, $.20 par value; authorized shares,
25,000,000; issued 5,970,481 and 5,920,464,
respectively 1,194,097 1,184,093
Additional paid-in capital 28,171,625 27,503,772
Treasury stock, at cost, 193,400 and 109,100 shares,
respectively (3,164,975) (1,789,287)
Retained earnings 24,594,761 18,797,189
- ----------------------------------------------------------------------------------------------------------
Total shareholders' equity 50,795,508 45,695,767
==========================================================================================================
Total liabilities & shareholders' equity $56,548,301 $49,864,575
==========================================================================================================
The accompanying notes are an integral part of the condensed consolidated financial statements.
==========================================================================================================
</TABLE>
3
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TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
<TABLE>
<CAPTION>
For the For the
Three Months Ended Nine Months Ended
Sept. 25, 1999 Sept. 26, 1998 Sept. 25, 1999 Sept. 26, 1998
===========================================================================================================================
<S> <C> <C> <C> <C>
Revenues $13,402,653 $10,120,469 $38,792,717 $34,909,333
Cost of product sales 6,039,595 4,511,004 16,694,313 14,785,953
- ---------------------------------------------------------------------------------------------------------------------------
Gross profit 7,363,058 5,609,465 22,098,404 20,123,380
- ---------------------------------------------------------------------------------------------------------------------------
Operating expenses:
Selling and marketing 1,560,692 1,227,629 4,726,680 4,348,831
General and administrative 980,508 1,132,867 2,993,877 3,485,424
Research and development 2,125,826 1,586,704 6,159,484 4,757,156
- ---------------------------------------------------------------------------------------------------------------------------
Total operating expenses 4,667,026 3,947,200 13,880,041 12,591,411
- ---------------------------------------------------------------------------------------------------------------------------
Income from operations 2,696,032 1,662,265 8,218,363 7,531,969
Interest and other income, net 334,301 103,131 842,064 709,122
- ---------------------------------------------------------------------------------------------------------------------------
Income before income taxes 3,030,333 1,765,396 9,060,427 8,241,091
Provision for income taxes 1,092,000 654,803 3,262,855 3,042,803
===========================================================================================================================
Net income $1,938,333 $1,110,593 $5,797,572 $5,198,288
===========================================================================================================================
Earnings per share information:
Weighted average shares of common stock and
common stock equivalents
Basic 5,773,805 5,892,894 5,776,746 5,842,308
Diluted 6,008,302 6,048,223 5,893,040 6,004,436
- ---------------------------------------------------------------------------------------------------------------------------
Net income per common and common equivalent shares:
Basic $.34 $.19 $1.00 $.89
Diluted $.32 $.18 $.98 $.87
===========================================================================================================================
</TABLE>
The accompanying notes are an integral part of the condensed
consolidated financial statements.
4
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TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
<TABLE>
<CAPTION>
Nine Months Ended
Sept. 25, 1999 Sept. 26, 1998
=====================================================================================================================
<S> <C> <C>
Cash flows from operating activities:
Net income $5,797,572 $5,198,288
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 920,097 864,992
Deferred income taxes (253,545) (476,351)
Compensation expense for restricted stock ----- 35,934
Changes in assets and liabilities:
Increase in accounts receivable-trade (1,521,422) (1,454,283)
Increase in accounts receivable-other (12,393) (562,872)
Increase in inventories (4,740,301) (872,698)
Decrease in prepaid expenses and deposits 124,222 203,201
Increase (decrease) in accounts payable 718,440 (413,730)
Increase (decrease)in accrued expenses and deferred income 801,218 (3,064)
Decrease in royalties payable (219,905) (298,154)
Increase (decrease) in accrued salaries and wages 132,369 (755,452)
Increase (decrease) in income taxes payable 151,863 (292,849)
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Net cash provided by operating activities 1,898,215 1,172,962
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Cash flows from investing activities:
Redemption/maturity of short-term investments 9,353,489 5,643,578
Purchase of short-term/long-term investments (9,299,831) (5,569,749)
Capital expenditures (1,259,712) (1,286,060)
Purchase of treasury stock (1,375,688) (287,623)
- ---------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (2,581,742) (1,499,854)
- ---------------------------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Proceeds from exercise of stock options including related tax 677,857 2,293,513
benefits
- ---------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 677,857 2,293,513
- ---------------------------------------------------------------------------------------------------------------------
Net (decrease) increase in cash and cash equivalents (5,670) 1,966,621
Cash and cash equivalents at beginning of period 8,311,353 3,183,944
- ---------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $8,305,683 $5,150,565
=====================================================================================================================
</TABLE>
The accompanying notes are an integral part of the condensed
consolidated financial statements.
5
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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 25, 1999 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, 1998. 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
25, 1999 are not necessarily indicative of the results that may be expected for
the year ending December 31, 1999.
2. INVENTORIES
At September 25, 1999 and December 31, 1998, inventory consisted of the
following:
<TABLE>
<CAPTION>
(Unaudited)
September 25, December 31 ,
1999 1998
------------- -------------
<S> <C> <C>
Raw materials . . . . . . . . . . . . . . . . $9,080,124 $6,135,743
Work in progress. . . . . . . . . . . . . . . 6,446,753 4,725,776
Finished goods. . . . . . . . . . . . . . . . 2,415,195 2,340,252
---------- -----------
$17,942,072 $13,201,771
=========== ===========
</TABLE>
3. SHORT-TERM AND LONG-TERM INVESTMENTS
Short-term investments at September 25, 1999 and December 31, 1998 consisted of
individual municipal bonds stated at cost, which approximated market value.
These securities have a maturity of one year or less at date of purchase and/or
contain a callable provision in which the bonds can be called within one year
from date of purchase. Long-term investments are comprised of individual
municipal bonds with a maturity of more than one year but less than eighteen
months. The primary investment purpose is to provide a reserve for future
business purposes, including possible acquisitions and capital expenditures and
to meet working capital requirements.
6
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4. INCOME PER COMMON SHARE
Net income per share is calculated by dividing net income by the weighted
average number of common shares plus incremental common stock equivalent shares
(shares issuable upon exercise of stock options). Incremental common stock
equivalent shares are calculated for each measurement period based on the
treasury stock method, which uses the monthly average market price per share.
The calculation of net income per common and common equivalent shares follows
(unaudited):
<TABLE>
<CAPTION>
======================================================================================================================
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
Sept. 25, 1999 Sept. 26, 1998 Sept. 25, 1999 Sept. 26, 1998
======================================================================================================================
<S> <C> <C> <C> <C>
Net income $1,938,333 $1,110,593 $5,797,572 $5,198,288
======================================================================================================================
Common and common equivalent shares:
Weighted average number of
common shares outstanding
during the period............................. 5,773,805 5,892,894 5,776,746 5,842,308
Common shares issuable upon exercise
of outstanding stock options:
Diluted.................................... 234,497 155,329 116,294 162,128
Common and common equivalent shares
outstanding during the period:
- ----------------------------------------------------------------------------------------------------------------------
Diluted.................................... 6,008,302 6,048,223 5,893,040 6,004,436
======================================================================================================================
Earnings per share data
Net income per common and common equivalent
shares:
Basic...................................... $ .34 $ .19 $ 1.00 $ .89
Diluted.................................... $ .32 $ .18 $ .98 $ .87
</TABLE>
7
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5. DEFERRED INCOME
Deferred income as of September 25, 1999 of $985,443 represents product
shipments to one of the Company's customers for various cable-related products
during the third quarter of 1999. Revenues and corresponding income related to
this deferral were not recognized in the Company's third quarter, 1999
consolidated statement of operations because of substantial contingencies
surrounding such recognition, including customer right of return as well as
other contractual matters under negotiation. Such revenues and income will be
recognized when contractual discussions between the Company and the customer
have been completed and all contingencies have been satisfactorily resolved.
8
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REVIEW 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 25, 1999, and
the related condensed consolidated statements of operations for each of the
three month and nine month periods ended September 25, 1999 and September 26,
1998 and the condensed consolidated statement of cash flows for the nine month
periods ended September 25, 1999 and September 26, 1998. These financial
statements are the responsibility of the Company's management.
We conducted our review in accordance with standards established by the American
Institute of Certified Public Accountants. A review of interim financial
information consists principally of applying analytical procedures to financial
data and making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in accordance
with generally accepted auditing standards, the objective of which is the
expression of an opinion regarding the financial statements taken as a whole.
Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to the accompanying condensed consolidated interim financial statements
for them to be in conformity with 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, 1998 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 25, 1999, 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, 1998, is fairly stated in all material respects in
relation to the consolidated balance sheet from which it has been derived.
/s/ PricewaterhouseCoopers LLP
Pittsburgh, Pennsylvania
October 8, 1999
9
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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 statements as to management's beliefs, strategies, plans,
expectations or opinions in connection with Company performance, which are based
on a number of assumptions concerning future conditions that may ultimately
prove to be inaccurate. Such statements must be qualified by important factors
that could cause actual earnings and other results to differ materially from
those achieved in the past or those expected by the Company. These include:
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(R) product line, which includes POTS line testing as well as alarm-related
products, represented approximately 69% of the Company's revenue for the third
quarter ended September 25, 1999 and will continue to account for a majority of
the Company's revenues for the foreseeable future. In addition, the Company has
begun shipments of the DigiTest (TM) centralized network test platform. The
DigiTest system provides complete hardware testing for POTS and local loop
prequalification for Digital Subscriber Line ("DSL") services. DigiTest's
compact digital measurement unit ("DMU") which resides in the central office,
qualifies local loops through load coil detection, identification, and location.
The DMU is designed to act as the test head in the system, with the ability to
determine subscriber-line characteristics for POTS and xDSL. The DigiTest system
also includes the digital measurement node, which consists of a metal-chassis,
backplane and an alarm/fuse card. The Company's cable products consist of a
complete cable status monitoring system that provides a broad testing solution
for the Broadband Hybrid Fiber Coax distribution system. The status monitoring
system includes a host for user interface, control and configuration; a headend
controller for managing network communications; and transponders that are
strategically located within the cable network to gather status reports from
power supplies, line amplifiers and fiber-optic nodes.
The Company's telecommunication product sales are primarily to the four Regional
Bell Operating Companies ("RBOCs") as well as major independent telephone
companies such as Sprint and to certain
10
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digital loop carrier ("DLC") equipment manufacturers. For the quarter ended
September 25, 1999, approximately 50% of the Company's total revenue was
generated from sales to these four RBOCs, the two largest of which comprised
approximately 41% of revenues. The Company markets and sells its cable products
directly, as well as through various Original Equipment Manufacturer ("OEM")
arrangements with cable network equipment manufacturers. The Company presently
has one such OEM arrangement under contract and works under less formal
arrangements with several other OEM partners.
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. This timing is particularly sensitive to various business factors
within each of the RBOCs including the RBOCs relationships with their various
organized labor groups.
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 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 among the RBOCs, and their ability to
consolidate their inventory and product procurement systems could cause
fluctuations or delays in the Company's order patterns. Also, recent efforts in
the cable status monitoring industry to standardize transponders among status
monitoring systems could cause pricing pressure as well as affect deployment
within certain customers of the Company's cable products. These standards, if
adopted by the standards setting body, are expected to become final in the year
2000 and may affect the Company's revenues from such products in subsequent
periods. 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 that certain international markets may offer opportunities. However,
the international telephony markets differ from those found domestically due to
the different types and configurations of equipment used by those international
communication companies to provide services. In addition, certain competitive
elements also are found internationally which do not exist in the Company's
domestic markets. These factors, when combined, have made entrance into these
international markets extremely difficult. From time to time, the Company has
utilized the professional services of various marketing consultants to assist in
defining the Company's international market opportunities. With the assistance
of these consultants and through direct marketing efforts by the Company, it has
been determined that its present MCU technology offers limited opportunities in
certain international markets for competitive and other technological reasons.
These markets include China other than through an existing OEM relationship,
Europe and the Pac Rim countries. There can be no assurance that any continued
efforts by the Company will be successful or that the Company will achieve
significant international sales.
11
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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 16% for the third quarter ended September 25, 1999.
The Company expects its research and development expenses to continue at
significant levels.
RESULTS OF OPERATIONS - THIRD QUARTER
Revenues
Revenues for the third quarter of 1999 of $13,402,653 were $3,282,184, or 32.4%,
higher than the revenues of $10,120,469 reported for the third quarter of 1998.
The increase in revenues for the third quarter of 1999 was primarily
attributable to an increase in unit volume sales of core MCU(R) line testing
products to US West, as well as increased shipments of MCU technology sold on an
Original Equipment Manufacturer ("OEM") basis related to a non-cancellable
purchase order received in the second quarter of 1999 in the amount of
$4,170,000. During the third quarter, shipments in the total amount of
$2,488,000 were shipped under this order. Delivery of the balance of the order
is expected to occur in the fourth quarter, 1999. In addition, the current
quarter included increased shipments of the Company's new DigiTest next
generation testing products to Lucent Canada and to other customers, as well as
increased billings related to the Company's newly established professional
services business. The current quarter sales increase was offset somewhat by
decreased shipment levels to BellSouth when compared to the third quarter of
1998; however the prior year's third quarter sales to BellSouth were
significantly larger than normal. In addition, the current quarter sales results
included decreased shipment levels to Bell Atlantic, which the Company believes
can be attributed to lingering product deployment issues. The Company is
continuing to implement strategies designed to bring this customer back to its
historical product usage levels, including product installation training and
support. 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.
Gross Profit
Gross profit for the third quarter of 1999 was $7,363,058 compared to $5,609,465
for the third quarter of 1998, representing an increase of $1,753,593, or 31.3%.
Gross profit as a percentage of revenues decreased to 54.9% in the third quarter
of 1999, compared to 55.4% in the same quarter last year. The overall increase
in the gross profit from the prior year period resulted primarily from the
increased sales levels, while the decrease in gross profit as a percentage of
revenues was primarily a result of increased manufacturing costs associated with
the initial production of certain of the Company's new products.
Selling and Marketing Expense
Selling and marketing expense for the third quarter of 1999 was $1,560,692
compared to $1,227,629 for the third quarter of 1998. This increase of $333,063,
or 27.1%, is primarily attributable to an increase in commission expenses
associated with the increased sales levels during the current quarter, as well
as increased spending on advertising, promotion and related marketing
activities. As a percentage of revenues, selling and marketing expenses
decreased to 11.6% in the third quarter of 1999 from 12.1% in the third quarter
of 1998.
12
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General and Administrative Expense
General and administrative expense for the third quarter of 1999 was $980,508, a
decrease of $152,359, or 13.4%, from the $1,132,867 recorded in the third
quarter of 1998. The decrease in general and administrative expense primarily
reflects a reduction in certain professional service fees between periods. As a
percentage of revenues, general and administrative expenses decreased to 7.3% in
the third quarter of 1999 from 11.2% in the third quarter of 1998.
Research and Development Expense
Research and development expense in the third quarter of 1999 was $2,125,826, an
increase of $539,122, or 34.0%, over the $1,586,704 recorded in the third
quarter of 1998. The increase is primarily associated with additional personnel
and related development costs to support new product introductions (primarily
DigiTest and various cable-related products). The new personnel were hired for
positions in design engineering, hardware and software development, engineering
support, and test engineering. Their efforts are associated with new product
development, as well as support, and feature enhancement of existing products.
As a percentage of revenues, research and development expense increased to 15.9%
in the third quarter of 1999 from 15.7% in the third quarter of 1998.
Interest and Other Income
Interest and other income consists primarily of interest income. For the third
quarter of 1999, interest and other income was $334,301 compared to $103,131 for
the third quarter of 1998, representing a increase of $231,170, or 224.2%. This
increase over the prior year period was primarily the result of $95,545 of
interest expense related to settlements of certain prior years' tax returns
being recorded in the third quarter of 1998. Excluding this prior year interest
expense, interest and other income increased $135,625, or 68.3%, primarily as a
result of additional funds available for investment purposes during the current
period.
Provision for Income Taxes
The provision for income taxes for the third quarter of 1999 was $1,092,000, an
increase of $437,197, or 66.8%, from the $654,803 for the third quarter of 1998.
The effective income tax rate decreased to approximately 36.0% in the third
quarter of 1999, compared to approximately 37.1% in the third quarter of 1998.
The decrease in the effective tax rate between periods reflects certain
refinements for the estimated effective tax rate for fiscal year 1999.
Net Income and Earnings Per Share
As a result of the above factors, net income for the third quarter of 1999 was
$1,938,333, an increase of $827,740, or 74.5%, from the $1,110,593 recorded in
the third quarter of 1998. Basic and diluted earnings per common share of $.34
and $.32, respectively, for the third quarter of 1999 increased by $.15 and
$.14, or 78.9% and 77.8%, from the $.19 and $.18, respectively, earned in the
third quarter of 1998. Basic and diluted weighted average common and common
equivalent shares outstanding were 5,773,805 and 6,008,302, respectively, in the
third quarter of 1999 compared to 5,892,894 and 6,048,223, respectively, in the
third quarter of 1998. As a percentage of revenues, net income for the third
quarter of 1999 increased to 14.5% compared to the 11.0% for the third quarter
of 1998.
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RESULTS OF OPERATIONS - YEAR TO DATE
Revenues
For the first nine months of 1999, revenues were $38,792,717 compared to
$34,909,333 for the first nine months of 1998, representing an increase of
$3,883,384 or 11.1%. The increase in revenues for the first nine months of 1999
was primarily attributable to an increase in unit volume sales of core MCU(R)
line testing products to US West and SBC Communications and to certain
Competitive Local Exchange Carriers ("CLEC's") such as Allegiance Telecom, as
well as increased shipments of MCU technology sold on an Original Equipment
Manufacturer ("OEM") basis related to a non-cancellable purchase order received
in the second quarter of 1999 in the amount of $4,170,000. During the third
quarter of 1999, shipments in the total amount of $2,488,000 were shipped under
this order. Delivery of the balance of the order is expected to occur in the
fourth quarter, 1999. In addition, the first nine months of 1999 included
increased shipments of the Company's new DigiTest next generation testing
products to Lucent Canada and to other customers, as well as increased billings
related to the Company's newly established professional services business. The
first nine months of 1999 sales increase was offset somewhat by decreased
shipment levels to BellSouth when compared to the first nine months of 1998;
however the prior year period included sales in the third quarter to BellSouth
that were significantly larger than normal. In addition, the first nine months
of 1999 sales results included decreased shipment levels to Bell Atlantic, which
the Company believes can be attributed to lingering product deployment issues.
The Company is continuing to implement strategies designed to bring this
customer back to its historical product usage levels, including product
installation training and support. 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.
Gross Profit
For the nine months of 1999, gross profit increased to $22,098,404 compared to
$20,123,380 for the first nine months of 1998, representing an increase of
$1,975,024, or 9.8%. As a percentage of revenues, gross profit decreased to
57.0% in the first nine months of 1999 compared to 57.6% in the same period for
1998. The overall increase in gross profit margin resulted primarily from
increased sales levels, while the decrease in gross margin as a percentage of
revenues was primarily a result of increased manufacturing costs associated with
the initial production of certain of the Company's new products.
Selling and Marketing Expense
For the first six months of 1999, selling and marketing expense totaled
$4,726,680 compared to $4,348,831 for the first nine months of 1998,
representing an increase of $377,849 ,or 8.7%. This increase is primarily
attributable to an increase in commission expenses associated with the increased
sales levels during the current period, as well as increased spending on
advertising, promotion and related marketing activities. As a percentage of
revenue, selling and marketing expense decreased to 12.2% in the first nine
months of 1999 from 12.5% for the same period of 1998.
General and Administrative Expense
For the first nine months of 1999, general and administrative expense totaled
$2,993,877 compared to $3,485,454 for the first nine months of 1998,
representing a decrease of $491,547 or 14.1%. The decrease in general and
administrative expense primarily reflects a reduction in salary and related
expense
14
<PAGE> 15
associated with the death of the former Chairman, R. Craig Allison, as well as a
reduction in certain professional service fees between periods. As a percentage
of revenue, general and administrative expense decreased to 7.7% in the first
nine months of 1999 from 10.0% for the same period of 1998.
Research and Development Expense
For the first nine months of 1999, research and development expense totaled
$6,159,484 compared to $4,757,156 for the first nine months of 1998,
representing an increase of $1,402,328, or 29.5%. This increase is primarily
associated with additional personnel and related development costs to support
new product introductions (primarily DigiTest and cable-related products). The
new personnel were hired for positions in design engineering, hardware and
software development, engineering support, and test engineering. Their efforts
are associated with new product development as well as support, and feature
enhancements for existing products. As a percentage of revenues, research and
development expense increased to 15.9% in the first nine months of 1999 from
13.6% for the first nine months of 1998.
Interest and Other Income
For the first nine months of 1999, interest and other income was $842,064
compared to $709,122 for the first nine months of 1998, representing an increase
of $132,942, or 18.7%. This increase over the prior year period was primarily
the result of additional funds available for investment purposes during the
current period.
Provision for Income Taxes
The provision for income taxes for the first nine months of 1999 was $3,262,855
which was an increase of $220,052, or 7.2%, from $3,042,803 for the first nine
months of 1998. The effective income tax rate decreased to approximately 36.0%
in the first nine months of 1999, compared to approximately 36.9% in the first
nine months of 1998. The decrease in the effective tax rate between periods
reflects certain refinements for the estimated effective tax rate for fiscal
year 1999.
Net Income and Earnings Per Share
As a result of the above factors, net income for the first nine months of 1999
was $5,797,572, an increase of $599,284, or 11.5%, from the $5,198,288 recorded
in the first nine months of 1998. Basic and diluted earnings per common share of
$1.00 and $.98, respectively, for the first nine months of 1999 increased by
$.11, or 12.4%, from the $.89 and $.87, respectively, earned in the first nine
months of 1998. The prior year period includes approximately $226,000, or $.04
per share, related to the after-tax effect of the key man life insurance
proceeds. Excluding the effect of these net insurance proceeds, net income
increased $825,284, or 16.6%, between periods and diluted earnings per common
share increased $.15, or 18.1%. Basic and diluted weighted average common and
common equivalent shares outstanding were 5,776,746 and 5,893,040, respectively,
in the first nine months of 1999 compared to 5,842,308 and 6,004,436,
respectively, in the first nine months of 1998. As a percentage of revenues, net
income for the first nine months of 1999 remained unchanged between periods at
14.9%.
15
<PAGE> 16
LIQUIDITY AND CAPITAL RESOURCES
At September 25, 1999, the Company had working capital of $44,883,388 which
represented an increase of $4,343,914, or 10.7%, from the $40,539,474 of working
capital as of December 31, 1998. The increase in working capital can be
attributed primarily 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 inventories of $4,740,301
associated primarily with increases in raw materials and work-in-process to
support the new product introductions of the Company's DigiTest and cable status
monitoring system. In addition, the increase in working capital was also
associated with a $1,521,422 increase in accounts receivable-trade which
reflects the shipment of certain large purchases during the latter portion of
the current quarter. 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.
16
<PAGE> 17
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 has assessed the business priority of each system.
Each system was classified by mission criticality and a determination was made
to either replace or remediate the system depending upon its importance. In
addition, the Year 2000 project included 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 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.
As of September 25, 1999, the vast majority of the Company's critical
applications are currently prepared to process Year 2000 information. In
addition, we have conducted integration testing of our critical systems. During
the remainder of 1999, the Year 2000 committee will focus attention to continue
remediation and testing on a few remaining 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 supplier
and business partners Web site for Year 2000 compliance-related information. The
Company continues to examine 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. 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 approximated the Company's initial estimates.
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
17
<PAGE> 18
incremental costs, but rather will represent the redeployment of existing
information technology 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 and services. As of September 25, 1999, the Company
had a backlog of $7,765,957 compared to $570,155 at December 31, 1998 and
$2,147,707 at September 26, 1998. During the latter part of June 1999, the
Company received a non-cancelable order from an Original Equipment Manufacturing
(OEM) customer of $4,170,000 for one of the Company's MCU products. Shipments of
approximately $2,488,000 of this product has occurred during the third quarter
of 1999. It is expected that the remaining portion of products subject to the
order will be delivered during the fourth quarter of 1999 as under the terms of
the order, delivery may be deferred until November 30, 1999. The Company has not
been given reason to expect that this order will be repeated by this customer in
comparable volume in the foreseeable future. As with any OEM purchases, there is
a possibility that this order may reduce the Company's direct sales of other MCU
products to its customer base in some future period. In addition, the backlog as
of September 25, 1999 reflects $1,572,000 related to certain cable-related
product purchase orders for products shipped prior to September 25, 1999, but
for which revenue recognition has been delayed. Refer to Note 5 to the
accompanying condensed consolidated financial statements for further details
regarding this matter. For these reasons, this order is not necessarily
indicative of a corresponding increase in sales during the fourth quarter of
1999. 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.
18
<PAGE> 19
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
The following exhibits are being filed with this report:
Exhibit
Number Description
------- -----------
10.3 1995 Long-Term Incentive Compensation Plan, filed as
Exhibit A to the Company's 1999 Proxy Statement and
incorporated herein by reference thereto.
15 Letter re unaudited interim financial information
27 Financial Data Schedule
(b) Reports on Form 8-K:
The Company did not file any Current Report on Form 8-K during the
quarter ended September 25, 1999.
19
<PAGE> 20
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 9, 1999 /s/ CHRISTIAN L. ALLISON
-----------------------------------------------
Christian L. Allison
Chairman, President and Chief Executive Officer
Dated: November 9, 1999 /s/ SAMUEL C. KNOCH
-----------------------------------------------
Samuel C. Knoch
Chief Financial Officer and Treasurer
Dated: November 9, 1999 /s/ BRADLEY N. DINGER
Bradley N. Dinger
Controller
20
<PAGE> 21
EXHIBIT INDEX
(Pursuant to Item 601 of Regulation S-K)
Exhibit
Number Description
------- -----------
10.3 1995 Long-Term Incentive Compensation Plan, filed as
Exhibit A to the Company's 1999 Proxy Statement and
incorporated herein by reference thereto.
15 Letter re unaudited interim financial information
27 Financial Data Schedule
21
<PAGE> 1
EXHIBIT 15
November 9, 1999
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
2). Form S-8 (Registration No. 333-52907) 1998 Employee Incentive
Compensation Plan
Ladies and gentlemen:
We are aware that our report dated October 8, 1999 on our review of interim
financial information of Tollgrade Communications, Inc. and subsidiaries as of
and for the three months and nine months ended September 25, 1999 and in 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.
Very truly yours,
/s/ PricewaterhouseCoopers LLP
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 25, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<CIK> 0001002531
<NAME> TOLLGRADE COMMUNICATIONS, INC.
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JUN-27-1999
<PERIOD-END> SEP-25-1999
<CASH> 8,305,683
<SECURITIES> 15,748,506
<RECEIVABLES> 9,608,283
<ALLOWANCES> 198,801
<INVENTORY> 17,942,072
<CURRENT-ASSETS> 49,640,788
<PP&E> 8,068,136
<DEPRECIATION> 4,411,861
<TOTAL-ASSETS> 56,548,301
<CURRENT-LIABILITIES> 4,757,400
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<COMMON> 1,194,097
<OTHER-SE> 49,601,411
<TOTAL-LIABILITY-AND-EQUITY> 56,548,301
<SALES> 13,402,653
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<CGS> 6,039,595
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