Test of will Featured

8:00pm EDT May 23, 2004
Chris Allison remembers clearly the calls from unnerved shareholders in the wake of the telecom industry meltdown.

"I got calls from people who wanted to know if their kids' college education was secure," says Allison, CEO of Tollgrade Communications.

Those were among the more restrained inquiries Allison took. Some, he says, were outright obscene.

Coming out of an era when manic growth was the mantra of a new economy, Allison was engineering his company to keep the bottom line from bottoming out. Shareholders - seeing valuations plummet as an overbuilt market began to shake out the weak and debt-laden performers, and scandals scarred the industry - got nervous as Tollgrade began its shrinking act.

Tollgrade founded by Allison's father, R. Craig Allison, in 1988, and taken public in 1995, manufactures hardware and software network assurance solutions for the telecommunications and cable broadband industries.

In a sense, Allison's response to the telecom industry's sag is hardly surprising. He prefers McDonald's coffee to the pricey brew served at more trendy shops and, unlike a lot of CEOs, doesn't hold a country club membership. No slave to fashion, the 43-year-old executive of the 300-employee company says he buys his clothes online from JCPenney and admits that he harbors a bit of mistrust for people he terms "flashy."

Read Allison's letters to shareholders in the company's annual reports, and you'll notice that it isn't full of the florid language employed to puff up accomplishments or the euphemisms so often used in such documents to describe or excuse poor performance.

Even Tollgrade's unpretentious Cheswick headquarters is well-removed from the trendy office parks that serve as home to some tech companies.

Allison's philosophy for survival in tough times and growth in good ones is fairly simple: "You've got to keep making money, you've got to keep making cash," he says.

That strategy, Allison says, has resulted in a company that can see light at the end of the tunnel, and not an oncoming train.

As Tollgrade's sales slid to $82 million in 2001 and to $58 million in 2002, Allison resisted trying to grow the top line. Instead, Tollgrade embarked on a strategy to preserve cash, continue to earn money and lay the groundwork for future growth by making strategic acquisitions that would complement its existing capabilities. In 2003, Tollgrade's revenue bounced back, with $65 million in sales. First-quarter 2004 sales were $17.6 million.

While Tollgrade's revenue has tailed off since 2000, when it posted $114 million in sales, the company has managed to maintain a strong cash position. That, as well as strategic acquisitions it has made since 2001, have caught the attention of at least one analyst.

"In the longer term, we continue to believe that TLGD's expanded solutions portfolio should meet the needs of (telephone companies) to reduce operating expense and improve service quality," writes Parker/Hunter analyst Tim Slevin in an April research comment.

Telecom tanks

The telecom industry made massive investments in infrastructure during the 1990s in anticipation of a boom in e-commerce and communications on the Internet.

"The expectation was that there was going to be all of these dot-coms that were going to need all of this bandwidth, so they're going to need a lot of T-1 lines, so they built up all the optical backbone to serve all of these companies," Allison says.

In 2000, carriers spent $51.9 billion on telecommunications equipment, according to a study by the Telecommunications Industry Association (TIA). But as Internet ventures continued to topple, it became obvious that the telecom system was overbuilt. Venture capitalists poured $18 billion into telecom investments in 2000, according to PricewaterhouseCoopers' MoneyTree Survey; by 2003, venture investment in telecom ventures had dropped to $2 billion. At one point, 600,000 manufacturing jobs had been lost in the industry, and corporate debt reached $1 trillion, according to the TIA.

Clearly, the industry was going into a steep spiral as telecom companies found themselves heavily in debt and without the customers they had expected to come during the overheated market of the Internet gold rush. Throw in scandals at giants like those at WorldCom and Qwest, and confidence in the industry reached an all-time low.

As a provider to telecom companies, Tollgrade was being drawn into the undertow.

Detour from Disney World

Tollgrade adopted an aggressive cost-cutting strategy to ensure the company's profitability, if not its short-term growth. In what Allison calls a "step back to step forward" approach, Tollgrade acknowledged that while its revenue might shrink or stagnate, maintaining a strong cash position was critical to survival and remaining competitive.

Tollgrade cut 62 jobs in 2001, and another 47 the following year. The annual company sales meeting at Disney World was eliminated, replaced by an event at company headquarters. Salaries were frozen, bonuses eliminated for two years and Allison took a 30 percent cut in pay, lopping $100,000 off his annual salary. Employees held onto a generous health plan but were required to share in its costs, car leases were ended and all travel had to be approved by the CFO.

Some long-term research and development was cut short. Conference participation was discontinued, trade show activity was pared back and inventories were reduced.

Acquisitions

While the telecom crash put plenty of companies out of business and dealt serious blows to others, it provided opportunities as well. Tollgrade decided to seek out acquisitions not simply to buy revenue, but to gain market share and acquire technology and technologists.

In the average month, a telephone company finds trouble reported on 3 percent of its lines, with the problem often as simple as a phone left off the hook. Dispatching a service technician is an expensive proposition, so a testing solution like the one that Tollgrade offers can keep costs down for telephone companies.

"That's getting a lot of visibility right now," Allison says. "They're making sure their lines are getting tested. Because of that 3 percent phenomenon, they're looking at every way they can to save money, so it's really playing in to us."

While the telecom industry had shrunk, demand for broadband began to increase and migrate into the consumer arena. Overall, broadband grew by 1.31 percent in December 2003, with nearly 43 percent of Internet-connected U.S. households enjoying a high-speed connection, according to www.websiteoptimization.com.

And business demands for faster data transfer could be the strongest driver for broadband services, a study by Deloitte contends: "While overall broadband adoption will continue to grow in popularity within the United States, small businesses will be motivated to migrate toward broadband as the demand for faster e-mail and Internet access increases, while pricing falls and connection speeds rise. New broadband appliances such as game consoles, video phones, home security systems, set top boxes, VoIP phones, digital hi-fi and home media systems will also drive robust broadband adoption this year, expanding broadband's functionality beyond PC-oriented technology."

Allison says that most of Tollgrade's competitors are small divisions of large conglomerates and not the core business of an enterprise. When the telecom industry crashed, companies were looking to unload noncore or poorly performing units. Valuations fell and bargains emerged, some of them scooped up by the survivors.

To bolster its position in line testing, Tollgrade spent $60 million to acquire the software assets of the LoopCare test system, used universally by the Regional Bell Operating Companies, from Lucent Technologies, a company created as a result of the breakup of AT&T. The LoopCare product complements Tollgrade's line testing equipment. Together, the two technologies create an integrated testing solution for traditional wire-based telephone networks, as well as for DSL lines in those companies' networks. The buy added $15 million in annual revenue, but just as important, Tollgrade acquired intellectual capital that will help it to develop additional testing technologies.

"What we bought was a Bell Labs research team," says Allison.

The acquisition was critical, says Allison, from a competitive standpoint.

"If one of our competitors would have got it, they could have frozen us out," Allison says.

Last year, Tollgrade bought the status and performance monitoring product line used to monitor cable networks from Acterna LLC, a Germantown, Md., firm, for $14 million, paying for its purchase out of 2003 cash flow.

While Acterna struggled to make the product successful, Tollgrade made it profitable in 30 days, Allison says.

With the acquisition, Tollgrade secured a complementary business that allows it to offer testing products and services to the cable, telephone and broadband platforms.

"We can shrink wrap these all these products and go to one of these competitive carriers and say, for $500,000, we can put a complete test system in to test your whole network," Allison says.

Going forward

While Allison concedes that the dynamics of the telecom industry could bring abrupt changes and shifts in the future, he's confident that Tollgrade is on the right track. Investments in research and development have been increased, and the company's cash position has remained strong. The growth of DSL lines bodes well for Tollgrade's new testing systems, and its cable testing products are doing well.

Now, Allison says, Tollgrade has to persuade its existing and prospective clients that it can deliver a wider range of testing services than it has offered in the past.

Says Allison: "The big challenge is convincing our customers that we're a broadband company." How to reach: Tollgrade Communications Inc., www.tollgrade.com; Telecommunications Industry Association, www.tiaonline.org; Parker/Hunter Inc., www.parkerhunter.com; Deloitte, www.deloitte.com