Tollgrade Communications, Inc.

views updated

Tollgrade Communications, Inc.

492 Nixon Road
Cheswick, Pennsylvania 15024
U.S.A.
Telephone: (412) 820-1400
Toll Free: (800) 878-3399
Fax: (412) 820-1530
Web site: http://www.tollgrade.com

Public Company
Incorporated: 1986
Employees: 296
Sales: $114.4 million (2000)
Stock Exchanges: NASDAQ
Ticker Symbol: TLGD
NAIC: 513390 Other Telecommunications; 334210 Telephone Apparatus Manufacturing

Tollgrade Communications, Inc. is devoted to line testing for the telecommunications and cable television industries. Located in the Pittsburgh, Pennsylvania, suburb of Cheswick, the company was originally limited to the manufacture of equipment, but has since grown into a systems developer, providing customers with a total solutions capability. Tollgrade’s testing products allow customers to use their existing line tests to monitor systems and diagnose problems from a central office, rather than incurring the expense of dispatching repairmen to test lines on location. Independent telephone companies and the cable television industry have become increasingly more important customers, but Tollgrade’s primary customers remain the four regional Bell operating companies: Verizon, BellSouth, SBC, and Qwest. Although more complex lines that are designed to carry high-speed internet service and other data communications are gaining in importance, most of Tollgrade’s products are dedicated to plain old telephone service, so-called POTS.

Break up of AT&T in the Mid-1980s Leads to Tollgrade

Richard Craig Allison founded Tollgrade, incorporating it in Pennsylvania in 1986, although the company did not begin operating until 1988. He was born in Ashtabula, Ohio, raised in Erie, Pennsylvania, and graduated from Gannon University in 1965 with a degree in accounting. He worked as an auditor in the accounting department of U.S. Steel Corporation, then worked in pharmaceutical sales, and established the West Coast division of a radio frequency electronics firm before striking out on his own. Returning to Erie, he founded UTEK, Inc., a construction business that dug ditches and laid pipeline for natural gas utilities. Although the business was successful, it did not fulfil Allison’s ambitious nature. He became attracted to the telecommunications business when UTEK began to install high tech gas meters that automatically transmitted data to the utility company.

In the mid-1980s AT&T was broken up into four regional companies, the so-called Baby Bells. Allison sensed that the changing landscape in the telephone industry presented great opportunities for new companies. Because he lacked technical expertise, Allison sought out help. A friend from Erie introduced him to a former Bell of Pennsylvania engineer named Rocco L. Faminio, who had spent 38 years at Bell, managed its Transmission Lab in Pittsburgh, and, despite having retired in 1985, continued to serve as a consultant to the company. The men met for lunch outside of Pittsburgh and agreed to go into business together. The goal was to develop a product that would supply a need in the revised telecommunications landscape. “We took the Microsoft approach,” Allison recalled years later. “We wanted everybody to use it.”

Allison recruited investors, one of the most important being Dr. Richard H. Heibel, a cardiologist. He also began to establish a management team, which included his son, Chris, whose degree in English and background in public relations appeared on the surface to be ill suited to the business, but he also had served as a marketing consultant for high-tech companies during his days as an account executive at Ketchum Public Relations Worldwide. All the new company needed was a name and a product. Flaminio, who was given a free hand on all technology issues, supplied the answer in both instances. The company name was drawn from telephone industry terminology: Only lines that met the highest standard were designated as “toll grade.” Thus, Tollgrade was incorporated in 1986. The product that Flaminio knew he wanted to develop was a device that permitted telephone companies to test lines that combined copper and fiber optics, fast becoming the industry standard, with equipment originally designed to test the quality of all-copper telephone lines. What would become the metallic channel unit (MCU) had a ready market in telephone companies, which would now be able to extend the life of their testing equipment and avoid an expensive upgrade. Flaminio had previously attempted to convince Bell Labs to develop his idea, but it proved too complicated and the company elected instead to focus on the manufacture of switches.

Between the time Tollgrade was incorporated and began actual operations in 1988, Flaminio searched for engineers to help in the development of the MCU. Because the man he wanted was under contract, Flaminio interviewed a number of candidates but settled on Fred Kiko, who contacted him in late 1987. Kiko was working in San Diego, but when his contract was up, he didn’t want to move back to Chicago. Instead, he agreed to work with Tollgrade when he became available. Work on the MCU would then take place in both San Diego and Pittsburgh, as Flaminio and his team would alternate sites during the development phase. For the first year or so, nobody in the company was paid.

Tollgrade Goes Operational in 1988

As a five-person company during the early years, Tollgrade operated out of the University of Pittsburgh Research Center (U-PARC), which was originally built in the 1930s as the Gulf Oil Corp. Research Center. Following a merger between Gulf and Chevron in the 1980s, the park was donated to the University of Pittsburgh and it served as the incubator for a number of area high tech companies. Tollgrade had a large space at U-PARC that was partitioned into two rooms. Chris Allison had a desk on one side and Flaminio had a lab on the other. They stayed at U-PARC for a year before moving to space across the street when, in order to generate cash, the company developed some less complicated products to sell. Tollgrade produced an upgrade to the high-tech gas meter that UTEK had been installing. The meters were connected to a home’s phone line and would dial in daily to the gas company. Unfortunately, the residents were unable to use the phone during these times. Any malfunction, or if the unit’s battery went dead, would result in the complete loss of phone service. The Tollgrade device allowed customers to override the meter and obtain a dial tone. The company sold a few units, but made little money because the utility decided to go to a radio frequency system, abandoning phone lines completely. Tollgrade was a bit more successful with its second telecommunications product, the OIU-2E, an enhanced synchronization device. The company then produced a device that would be a precursor to the MCU. It allowed alarms to be relayed from the customer to a central office, despite the mix of fiber optic and copper lines. In effect, it simulated a copper line.

By the end of 1990 Tollgrade was generating some $2 million in revenues, but it was also running out of cash and because Allison wanted to maintain the company’s freedom he was reluctant to turn to venture capitalists for funding. The company already had bank financing. Flaminio and Kiko had originally worked as consultants, but it was the bank that insisted they become full-time employees. As a result, Flaminio came out of official retirement, as Allison named him president of the small start-up. When they went back to the bank in the early 1990s in need of funds to put the final touches on the MCU, they met with little enthusiasm. The company was simply too small. Tollgrade had been testing the MCU with Bell Labs, and although it was not quite up to the necessary specifications, Flaminio was confident that his team would have a suitable product in a matter of weeks. In the end, Tollgrade received its bank loan, but it had to be personally backed by Allison, who put up his house, as well as Dr. Heibel. In February 1992, Flaminio’s group had produced an MCU that exceeded the Bell Lab’s requirements. By May of that year it had made its first sale to New Jersey Bell and began to quickly make the MCU compatible with all major digital loop carrier systems. With the company’s flagship product launched, revenues jumped to $5.3 million by the end of 1992.

By now, however, Allison was experiencing serious heart problems. He had had a heart bypass operation at the age of 37, and just before undergoing a second heart bypass operation he turned over the day-to-day responsibilities of the company to his son, who had been serving as Tollgrade’s chief operating officer since 1990. With the MCU gaining industry acceptance, Tollgrade saw its revenues increase steadily. In 1994, revenues more than doubled over the previous year, reaching $14.7 million, then grew to $22.3 million in 1995. Net income stood at $2.3 million, a significant improvement over the $114,000 the company earned in 1992. With its business growing, the company was able to move to its present location at Cheswick in September 1994.

In 1995 Chris Allison was named chief executive officer. A short time later, in December 1995, Tollgrade went public, selling 1,485,585 shares of common stock at $12 per share. After underwriting discounts and associated costs of the offering, the company netted approximately $15.8 million, which was earmarked for general corporate purposes. Shares began trading on the Nasdaq. In general the market was cautious about telecommunications stocks, given the move in Congress to deregulate the industry. As much as 97 percent of Tollgrade’s business came from the four major Bell companies, and they were reluctant to buy new products until the details of the telecommunications bills in Congress were settled. The Bells were looking to get involved in the long distance business, while long distance carriers were eager to enter the local phone business. Although Tollgrade’s immediate prospects were somewhat clouded by the uncertainty in the industry, there was no doubt that once Congress acted, suppliers like Tollgrade would be in a position to experience exceptional growth. Moreover, the rising importance of fiber optics and the need for greater speed because of the emergence of the Internet bode well for the company’s prospects. Rather than just rely on the MCU, however, Tollgrade invested generously in a research and development program.

Company Perspectives:

Tollgrade Communications, Inc. provides the highest quality centralized and remote test systems for communications service providers, while generating a positive return for investors and a fulfilling work/life balance for its employees.

Tollgrade introduced a switching MCU with the ability to communicate with 15 remote terminals instead of just one. It also developed a fiber loop test product for shorter circuits where MCU was not suitable. Tollgrade also teamed with Encompass software of Buford, Georgia, to develop capabilities of testing the test systems themselves. Although false alarms caused by faulty test equipment only accounted for 2 percent of total alarms, the cost of needlessly dispatching repairmen justified an investment in the product. Because Tollgrade was expanding its product lines, and deregulation was taking effect, the company saw its potential market growing steadily. Cable television companies looking to offer telecommunications services appeared to be a promising target. Typically, cable dispatched repairmen more often than the telephone companies, making them prime customers for less expensive remote testing. In 1997, Tollgrade introduced its LIGHTHOUSE Cable Status Monitoring System, the company’s first product specifically designed for the Broadband Hybrid Fiber Coax distribution system used by the cable television industry. Moreover, Tollgrade saw long-term growth possibilities overseas, where the telecommunications testing niche was virtually unfilled. It established a beachhead in Latin America and the United Kingdom.

Stock Surge in 1996 Anticipates Greater Heights

Revenues in 1996 grew by 68 percent over the previous year to $37.5 million, while net income rose by 122 percent to $5.6 million. A year later, revenues reached $45.4 million and Tollgrade was listed by Forbes magazine as one of “The 200 Best Small Companies in America.” In turn, investors were becoming enthusiastic about Tollgrade. If anything, they worried about the company growing too fast too soon, but were comforted by the fact that Tollgrade’s new markets were opening at a manageable pace. The company’s stock surged to $31.75 before settling to the $25 range. That movement, however, was only a harbinger of what was to come a few years later.

In 1998 the elder Allison died of a heart attack at the age of 57, leaving his 37-year-old son as chief executive and chairman of the company. Not only was the younger Allison a seasoned executive by now, Tollgrade enjoyed stable management and continued its steady growth. It gained an entry into a new and potentially lucrative market, signing a product development agreement with UT Starcom, an international telecommunications systems developer, which would deploy Tollgrade’s MCU technology in the Peoples Republic of China. Also in 1998 Tollgrade announced the development of a new product called DigiTest, its most advance centralized testing solution. It then signed a multi-year, product development, license, and authorized reseller agreement with Lucent Technologies. Tollgrade would adapt DigiTest to work with Lucent’s Mechanized Loop Testing operations support system used by the Bell operating companies. The integrated system would work with Integrated Services Digital Network (ISDN) service, Asymmetrical Digital Subscriber Line (ADSL) service, as well as POTS.

For 1998, Tollgrade showed only a modest improvement in revenues, reaching $46.3 million. Nevertheless, it made the Forbes Top 200 list for a second consecutive year. In 1999 Tollgrade would renew its impressive gains in revenues, exceeding $61 million. The following year, however, would prove to be an exceptional year for the company. Not only did it enjoy tremendous results, posting net earning of $27.5 million on revenues of $114.4 million, Tollgrade experienced an extraordinary run-up on the price of its stock. After three years of little movement, shares began to rise in value late in 1999 and continued to move on expectations of robust first quarter results. Then a competitor, Turnstone Systems, went public in February 2000, establishing a benchmark against which to judge Toll-grade. Following its offering, Turnstone had a market capitalization of $2.8 billion, while Tollgrade was valued at just $405 million. Going back the previous four quarters, however Turnstone had earned $4.5 million on $49.4 million in revenues compared to Tollgrade’s $14.4 million in net profits on $72.4 million in revenues. Turnstone was experiencing rapid growth, but so was Tollgrade, which had proven that it had the ability to rollout new products suitable to the changing needs of the telecommunications industry. Essentially, the market was rectifying the imbalance between the worth of Tollgrade and Turnstone. In March, a two-for-one split slowed Tollgrade’s rising price, but only momentarily. In the autumn of 2000, shares would top out at $168.88, giving Tollgrade a market capitalization of over $2 billion.

The price of Tollgrade stock declined somewhat, but a correction in late 2000 would quickly result in a complete reversal. Despite reporting impressive year-end results, Tollgrade was caught up in the effects of a sour national economy that hindered the growth of the telecommunications industry. Competitive Local Exchange Carriers either went out of business or curtailed investments, cable television slowed the build-outs of hybrid-fiber-coax systems, and the regional Bells were also reluctant to deploy new networks. As a result, Tollgrade’s revenues dropped, and investors reacted to the bad news by bidding down the company’s stock. In mid-March 2001, it reached a low of $15.25. Tollgrade lost 80 percent of its value in a matter of six months.

Key Dates:

1986:: The company is incorporated in Pennsylvania.
1988:: The company begins operating.
1992:: Flagship MCU product is introduced.
1995:: The company goes public.
1998:: Founder Richard Craig Allison dies.

At the end of 2000, Tollgrade had record employment of 411, but poor conditions soon forced management to institute cost cutting measures, including the laying off of more than 100 employees. Allison also asked the company’s board to cut his salary by 20 percent and to rescind any potential bonus for him for the year. Despite these measures and the gloomy state of telecommunications, Allison considered the downturn to be a temporary setback. In fact, the company began to buy back its stock, which stabilized above $20. As soon as telephone and cable companies began to invest in their infrastructures in order to gain a competitive edge, Tollgrade could be expected to regain its balance. With the rising use of the Internet and the greater demand for high-speed access and the wiring needed to support it, Tollgrade continued to be positioned for substantial long-term growth.