ITEM 1. BUSINESS.
The Company was incorporated in Pennsylvania in 1986 and began operations in 1988. Its principal offices are located at 493 Nixon Road, Cheswick, Pennsylvania 15024 and its telephone number is (412) 274-2156.
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. POTS lines comprise the vast majority of lines in service today throughout the world. In addition to traditional voice service, POTS includes lines for popular devices such as computer modems and fax machines. POTS excludes the more complex lines, such as data communications service lines, commonly referred to as "special services."
POTS line test systems, located at telephone companies' central offices, diagnose problems in the "local loop", which is the portion of the telephone network which connects end users to a telephone company's central office, and is comprised primarily of copper wireline. The ability to remotely test reduces the time needed to identify and resolve problems and eliminates or reduces the cost of dispatching a technician to the problem site. Most POTS line test systems were designed for use over copper wireline only, so that the introduction of fiber-optic technology into the local loop renders it inaccessible to these test systems. The Company's metallic channel unit ("MCU") products solve this problem by extending test-system access through the fiber-optic portion into the copper portion of the local loop.
Products. The Company's MCU products plug into the digital loop carrier ("DLC") systems that are large systems manufactured by equipment vendors such as AT&T, that are used by telephone companies to link the copper and fiber-optic portions of the local loop. DLC systems are located at the telephone company central offices and at remote sites within a local user area, and effectively multiplex the services of the copper lines into a single fiber-optic line. In many instances, several DLC systems are located at a single remote site to serve several thousand different end-user homes and offices. Generally, for every DLC remote site, two MCU line testing products are deployed. To ensure compatibility with these DLC systems, the Company pays royalties pursuant to license agreements for the use of
proprietary design integrated circuits ("PIDCs"). The PIDCs are the design and property of the DLC system manufacturer from which they are purchased. The Company maintains license agreements with Advanced Fibre Communications, Lucent Technologies, DSC Technologies Corporation, Fujitsu Network Transmission Systems, Inc., NEC American, Inc., Northern Telecom Inc. and Reliance Comm/Tec Corporation. In general, the current terms of these agreements expire at various times between July 1997 and November 2004, with renewal provisions (unless either party desires to terminate) for periods of between one and five years. The Company paid $254,300, $1,075,800 and $1,779,700, respectively in 1994, 1995 and 1996 as royalties under the license agreements, which royalties are calculated based on a percentage of the list price of MCU products which incorporate the technology licensed under each such agreement. Certain of the license agreements require the Company to maintain the confidentiality of the licensor's proprietary information and/or the terms and conditions of the agreement itself. Future license agreements entered into by the Company may contain terms comparable to, or materially different than, the terms of existing agreements as competitive and other conditions warrant. The loss of PDICs license agreements or the inability of the Company to maintain an adequate supply of PDICs could have a material adverse effect on the Company's business. Other MCU technology is also used with home and business alarm systems. As with home service line testing, home alarm systems must be monitored from the alarm company's headquarters along a hybrid copper and fiber-optic line. The Company's alarm-related MCU products are used to facilitate the transport of analog alarm signals from subscriber homes to alarm company monitoring stations across the hybrid telephone network. These units plug into equipment at both central office and remote locations. MCU products accounted for more than 90%, 93% and 93% of the Company's sales in 1994, 1995 and 1996, respectively.
Product and Technology Development. The Company's product development personnel are organized into teams, each of which is effectively dedicated to a specific product line or lines. Each product team also implements the Company's ongoing "value engineering" programs which are designed to replace the Company's products with successive generations having additional features and/or lower costs. The Company continuously monitors developing technologies and introduces products as defined standards and markets emerge. In addition, the Company continues to investigate the development of new applications for its MCU technology and other technologies to service the telecommunications industry. During 1994, 1995 and 1996, research and development expenses were approximately $1,585,000, $2,637,000 and $3,921,000, respectively.
Proprietary Rights. The names "Tollgrade(R)", "MCU(R)" and "Micro-Bank(R)", and the Company's corporate logo are registered trademarks of the Company. "Team Tollgrade(SM)" is a service mark of the Company. The Company has obtained three patents on the MCU products with expiration dates ranging from 2010 to the year 2014 and has two provisional patent applications pending. The Company will seek additional patents from time to time related to its research and development activities. The Company protects its trademarks, patents, inventions, trade secrets, and other proprietary rights by contract, trademark, copyright and patent registration, and internal security.
Customers. The Company's primary customers are the seven regional Bell operating companies ("RBOCs"), which are Ameritech Corporation, Bell Atlantic Corporation, BellSouth Corporation, NYNEX Corporation, Pacific Telesis Group, SBC Communications Inc., and US WEST Inc., as well as major independent telephone companies such as GTE Corporation, Sprint and The Southern New England Telephone Company. Historically, almost all of the Company's sales have been made to the RBOCs (86% in 1996). BellSouth Corporation, NYNEX Corporation, Bell Atlantic Corporation and US WEST Inc. accounted for 30%, 27%, 8% and 8%, respectively, of the Company's total sales in 1996. The Company's relationships with its customers are material to the Company's business, and the loss of any such relationship could have a material adverse effect on the Company's business.
Manufacturing. The Company's manufacturing operations consist primarily of quality control, functional testing, final assembly, burn-in and shipping. The Company uses independent third-party contract assembly and test companies on primarily a consignment basis for circuit board
assembly and in-circuit testing for all of its products. In particular, one third-party contract assembler is utilized by the Company for a significant portion of its circuit board assembly and in-circuit testing requirements. The loss of this particular subcontractor could cause delays in the Company's ability to meet production obligations and could have a material adverse effect on the Company's results of operations. In addition, shortages of raw material to, or production capacity constraints at, the Company's subcontractors could negatively affect the Company's ability to meet its production obligations and result in increased prices for affected parts. Any such reduction may result in delays in shipments of the Company's products or increases in the price of components, either of which could have a material adverse impact on the Company.
The Company currently procures all of its components from outside suppliers. Generally, the Company uses industry standard components for its products. Application specific integrated circuits ("ASICs") are a key component to the manufacturing process and are custom made to the Company's specifications. Currently the Company obtains all of its ASICs from National Semiconductor Corp. Although the Company has generally been able to obtain ASICs on a timely basis, a delay in the delivery of these components could have a material adverse impact on the Company.
Backlog. The Company's backlog at December 31, 1996 was approximately $0.9 million, as compared to approximately $2.1 million at December 31, 1995. The decrease was due largely to a $1.3 million order relating to a one-time project for a major customer that was included in the December 31, 1995 backlog and was subsequently shipped in the first quarter of 1996. The Company includes in backlog all firm purchase orders for products regardless of their ship date. Because of the quick turnaround that the customers expect on their orders, which is sometimes one to two weeks, and because of the possibility of customer changes in delivery schedules or cancellation of orders, the Company's backlog as of any particular date may not be indicative of actual revenues expected for any future period.
Competitive Conditions. The deciding competitive factors in the Company's market include price, product features, performance, reliability, service and support, breadth of product line, technical documentation and prompt delivery. The Company believes that it competes favorably on all of these factors, and certain of its products have proprietary or patented features. The Company also attempts to enter into development agreements for its MCU products with the manufacturers of DLC and other complex systems, which serves to ensure compatibility for its products. Competition would increase if new companies enter the Company's product markets or existing competitors expand their product lines. For instance, the recently enacted telecommunications reform legislation has lifted the restrictions which previously prevented the RBOCs from manufacturing telecommunications equipment. Pursuant to this legislative reform, the RBOCs, which are the Company's largest customers, may become competitors of the Company in the markets served by the Company.
For the Company's line-testing MCU devices, the primary competitive products are the remote monitoring units made by Teradyne, Inc. and the Harris Dracon division of Harris Corporation. The Company's MCU is simpler and less costly to install and permits the full complement of centralized testing to be performed as quickly and accurately as with copper by-pass wiring. The Company believes that Wiltron Company, Inc. and the Tau-Tron division of General Signal Corporation, providers of special services test systems, could expand into POTS line testing. The alarm-related MCU product's primary competitor is the Turbo 2000 unit made by Antec Corporation.
Employees. At December 31, 1996 the Company had 184 full-time employees, all in the United States. None of the Company's employees is represented by a collective bargaining agreement.
Government Regulation. The telecommunications industry is subject to regulation in the United States and other countries. Federal and state regulatory agencies, including the FCC and various state public utility commissions and public service commissions, regulate most of the Company's domestic customers. While such regulation does not typically affect the Company directly, the effects of such regulations on the Company's customers may, in turn,
adversely impact the Company's business and operating results. Governmental authorities also have promulgated regulations which, among other things, set installation and equipment standards for private telecommunications systems and require that all newly installed hardware be registered and meet certain government standards.
ITEM 2.
ITEM 2. PROPERTIES.
The Company's headquarters and principal administrative, engineering and assembly facilities are located in Cheswick, Pennsylvania and occupy approximately 58,000 square feet. The Company occupies its current facilities under a lease that expires in December, 1998 with successive options to renew through 2010. The Company believes that its current facilities are adequate to support its present level of operations and there is ample room to support continued sales growth for the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
There are currently no outstanding or pending material legal proceedings with respect to the Company or its business.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
During the fourth quarter of 1996, there were no matters submitted to a vote of security holders through solicitation of proxies or otherwise.
EXECUTIVE OFFICERS OF THE COMPANY ---------------------------------
Information relating to the executive officers of the Company as of January 31, 1997 is set forth below:
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS.
Information relating to the market for the Company's Common Stock and other matters related to the holders thereof is set forth under the caption "Common Stock Market Prices" on page 29 of the Company's 1996 Annual Report to Shareholders and is incorporated herein by reference.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
A summary of selected financial data for the Company, including each of the last five fiscal years in the period ended December 31, 1996, is set forth under the caption "Selected Consolidated Financial Data" on page 8 of the Company's 1996 Annual Report to Shareholders and is incorporated herein by reference.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
A discussion of the Company's financial condition and results of operations is set forth under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 9 through 13 of the Company's 1996 Annual Report to Shareholders and is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The Company's consolidated financial statements, together with the report thereon of Coopers & Lybrand L.L.P., are set forth on pages 15 through 28 of the Company's 1996 Annual Report to Shareholders and are incorporated herein by reference. Such financial statements and supplementary data are listed in Item 14(a) (1), "Exhibits, Financial Statement Schedules, and Reports on Form 8-K."
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
In addition to the information reported in Part I of this Form 10-K, under the caption "Executive Officers of the Company", the information required by this item appears beneath the captions "Election of Directors" and "Executive Compensation -- Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive proxy statement for its 1997 Annual Meeting of Shareholders and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
Information relating to executive compensation is set forth beneath the caption "Executive Compensation" in the Company's definitive proxy statement for its 1997 Annual Meeting of Shareholders and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information relating to the security ownership of beneficial owners of 5% or more of the Common Stock and of the executive officers and directors of the Company is set forth under the caption "Stock Ownership of Management and Certain Beneficial Owners" in the Company's definitive proxy statement for its 1997 Annual Meeting of Shareholders and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information relating to certain relationships and related transactions is set forth beneath the caption "Certain Relationships and Related Transactions" in the Company's definitive proxy statement for its 1997 Annual Meeting of Shareholders and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a)(1) The following financial statements and supplementary data are incorporated in Item 8 of Part II of this Form 10-K by reference to pages 14 through 29 of the Company's 1996 Annual Report to Shareholders, which are incorporated herein by reference:
Statement of Management's Responsibility for Financial Reporting, dated January 29, 1997 Report of Independent Accountants, dated January 29, 1997 Consolidated Balance Sheets at December 31, 1995 and 1996 Consolidated Statements of Operations for the three years ended December 31, 1996 Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1996 Consolidated Statements of Cash Flows for the three years ended December 31, 1996 Notes to Consolidated Financial Statements Statements of Operations Data by Quarter
(a)(2) The following financial statement schedule is included herewith on page 14 and made a part hereof:
Schedule II (Valuation and Qualifying Accounts)
(a)(3) The following exhibits are included herewith and made a part hereof:
* Management contract or compensatory plan, contract or arrangement required to be filed by item 601(b)(10)(iii) of Regulation S-K.
The Company agrees to furnish to the Commission upon request copies of all instruments not listed above which define the rights of holders of long-term debt of the Company.
Copies of the exhibits filed as part of this Form 10-K are available at a cost of $.20 per page to any shareholder of record upon written request to the Secretary, Tollgrade Communications, Inc., 493 Nixon Road, Cheswick, Pennsylvania 15024.
(b) Reports on Form 8-K filed during the quarter ended December 31, 1996.
None
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized as of March 19, 1997.
TOLLGRADE COMMUNICATIONS, INC.
By /s/ Christian L. Allison ---------------------------- Christian L. Allison Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated as of March 19, 1997.
Report of Independent Accountants
To the Board of Directors Tollgrade Communications, Inc.:
Our report on the consolidated financial statements of Tollgrade Communications, Inc. and subsidiaries has been incorporated by reference in this Form 10-K from page 15 of the 1996 Annual Report to Shareholders of Tollgrade Communications, Inc. and subsidiaries. In connection with our audits of such financial statements, we have also audited the related financial statement schedule listed in the index on page 9 of this Form 10-K.
In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presently fairly, in all material respects, the information required to be included therein.
/s/ COOPERS & LYBRAND L.L.P.
Pittsburgh, Pennsylvania January 29, 1997
SCHEDULE II
TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1994, 1995 and 1996 (In thousands)
EXHIBIT INDEX (Pursuant to Item 601 of Regulation S-K)
- -------------- * Incorporated by reference.