Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements. For
this purpose, any statements contained herein that are not statements of
historical fact may be deemed to be forward-looking statements. Without limiting
the foregoing, the words "believes," "anticipates," "plans," "expects" and
similar expressions are intended to identify forward-looking statements. There
are a number of important factors that could cause the Company's actual results
to differ materially from those indicated by such forward-looking statements.
These factors include, without limitation, those set forth in the risk factors
section included in the Company's Form 10-K for the year ended December 31,
2019, as filed with the SEC.
General
We offer technologically advanced, software-based security solutions that
empower and protect the world's most security-conscious organizations against
rapidly evolving, sophisticated and pervasive threats. Our portfolio of security
products, services and expertise empower our customers with capabilities to
reach new markets, serve their stakeholders more effectively, and successfully
defend the nation or their enterprise. We protect our customers' people,
information, and digital assets so they can pursue their corporate goals and
conduct their global missions with confidence in their security and privacy.
Our mission is to protect our customers' people, systems, and vital information
assets with offerings for cybersecurity, cloud security, and enterprise
security. In the current global environment, our mission is more critical than
ever. The emergence of each new information and communications technology
("ICT") introduces new vulnerabilities, as security is still too often
overlooked in solution development. Networks and applications meant to enhance
productivity and profitability often jeopardize an organization due to poor
planning, misconfiguration, or an unknown gap in security. Ransomware, insider
threats, cybercrime, and advanced persistent threats continue to menace public
and private enterprises across all industries.
Cybersecurity, cloud security, and enterprise security of the modern
organization share much in common, yet also call for a diverse range of skills,
capabilities, and experience in order to meet the requirements of
security-conscious customers. Decades of experience in developing,
orchestrating, and delivering solutions across these three domains gives us the
vision and the confidence to provide solutions that empower and protect the
enterprise at an integrated, holistic level. Our experience in addressing
challenges in one area of an enterprise helps us meet requirements in others. We
understand that a range of complementary capabilities may be needed to solve a
single challenge, and we also recognize when a single solution might address
multiple challenges.
Our security solutions span across the following domains:
• Cybersecurity - We help our customers ensure the ongoing security, integrity,
and compliance of their on-premises and related cloud-based systems, reducing
threats and vulnerabilities to foil cyber adversaries before they can attack.
Our consultants assess our customers' security environments and design,
engineer, and operate the systems they need to strengthen their cybersecurity
posture.
• Cloud Security - The cloud as an organizational resource is more than two
decades old, yet the needs of cloud users are constantly changing. Telos offers
the specialized skills and experience needed to help our customers plan,
engineer, and execute secure cloud migration strategies and then assure ongoing
management and security in keeping with the leading standards for cloud-based
systems and workloads.
• Enterprise Security - Securing the enterprise means protecting the essential
and timeless elements common to every organization: its people and processes,
its supply chain and inventories, its finances and facilities, and its
information and communications. As ICT and operational technology ("OT") have
become part of the organizational make-up, we have offered solutions that
ensure personnel can work securely and productively across and beyond the
enterprise.
We refer to our cyber and cloud applications as Security Solutions, which
includes Information Assurance / Xacta® (previously referred to as Cyber & Cloud
Solutions), Secure Communications (previously referred to as Secure
Communications Cyber and Enterprise Solutions), and Telos ID (previously
referred to as Telos ID Enterprise Solutions). We refer to our offerings for
enterprise security as Secure Networks (previously referred to as Secure
Mobility and Network Management/Defense Enterprise Solutions).
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Security Solutions
• Information Assurance / Xacta: a premier platform for enterprise cyber risk
management and security compliance automation, delivering security awareness
for systems in the cloud, on-premises, and in hybrid and multi-cloud
environments. Xacta delivers automated cyber risk and compliance management
solutions to large commercial and government enterprises. Across the U.S.
federal government, Xacta is the de facto commercial cyber risk and compliance
management solution.
• Secure Communications:
? Telos Ghost: a virtual obfuscation network-as-a-service with encryption and
managed attribution capabilities to ensure the safety and privacy of
people, information, and resources on the network. Telos Ghost seeks to
eliminate cyber-attack surfaces by obfuscating and encrypting data, masking
user identity and location, and hiding network resources. It provides the
additional layers of security and privacy needed for intelligence
gathering, cyber threat protection, securing critical infrastructure, and
protecting communications and applications when operations, property, and
even lives can be jeopardized by a single error in security.
? Telos Automated Message Handling System ("AMHS"): web-based organizational
message distribution and management for mission-critical communications;
the recognized gold standard for organizational messaging in the U.S.
government. Telos AMHS is used by military field operatives for critical
communications on the battlefield and is the only web-based solution for
assured messaging and directory services using the Defense Information
System Agency's ("DISA") Organizational Messaging Service and its
specialized communications protocols.
• Telos ID: offering Identity Trust and Digital Services through IDTrust360® -
an enterprise-class digital identity risk platform for extending
software-as-a-service ("SaaS") and custom digital identity services that
mitigate threats through the integration of advanced technologies that fuse
biometrics, credentials, and other identity-centric data used to continuously
monitor trust. We maintain government certifications and designations that
distinguish Telos ID, including TSA PreCheck™ enrollment provider, Designated
Aviation Channeling provider, FBI-approved Channeler, and the Financial
Industry Regulatory Authority ("FINRA") Electronic Fingerprint Submission
provider. We are the only commercial entity in our industry designated as a
Secure Flight Services provider for terrorist watchlist checks.
Secure Networks
• Secure Mobility: solutions for business and government that enable remote
work and minimize concern across and beyond the enterprise. Our secure
mobility team brings credentials to every engagement, supplying deep
expertise and experience as well as highly desirable clearances and
industry recognized certifications for network engineering, mobility, and
security.
• Network Management and Defense: services for operating, administrating, and
defending complex enterprise networks and defensive cyber operations. Our
diverse portfolio of capabilities addresses common and uncommon
requirements in many industries and disciplines, ranging from the military
and government agencies to Fortune 500 companies.
Backlog
Many of our contracts with the U.S. Government are funded year to year by the
procuring U.S. Government agency as determined by the fiscal requirements of the
U.S. Government and the respective procuring agency.
Total backlog, a component of recurring revenue, consists of the aggregate
contract revenues remaining to be earned by us at a given time over the life of
our contracts, whether funded or unfunded. Funded backlog consists of the
aggregate contract revenues remaining to be earned at a given time, which, in
the case of U.S. government contracts, means that they have been funded by the
procuring agency. Unfunded backlog is the difference between total backlog and
funded backlog and includes potential revenues that may be earned if customers
exercise delivery orders and/or renewal options to continue these contracts.
Based on historical experience, we generally assume option year renewals to be
exercised. Most of our customers fund contracts on a basis of one year or less
and, as a result, funded backlog is generally expected to be earned within one
year from any point in time, whereas unfunded backlog is expected to be earned
over a longer period.
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A number of contracts that we undertake extend beyond one year and, accordingly,
portions of contracts are carried forward from one year to the next as part of
the backlog. Because many factors affect the scheduling and continuation of
projects, no assurance can be given as to when revenue will be realized on
projects included in our backlog.
At September 30, 2020 and 2019, we had total backlog from existing contracts of
approximately $374.6 million and $307.5 million, respectively. Such backlog was
$354.5 million at December 31, 2019. Such amounts are the maximum possible value
of additional future orders for systems, products, maintenance and other support
services presently allowable under those contracts, including renewal options
available on the contracts if fully exercised by the customers.
Funded backlog as of September 30, 2020 and 2019 was $147.0 million and $104.0
million, respectively. Funded backlog was $112.4 million at December 31, 2019.
While backlog remains a measurement consideration, in recent years we, as well
as other U.S. Government contractors, experienced a material change in the
manner in which the U.S. Government procures equipment and services. These
procurement changes include the growth in the use of General Services
Administration ("GSA") schedules which authorize agencies of the U.S. Government
to purchase significant amounts of equipment and services. The use of the GSA
schedules results in a significantly shorter and much more flexible procurement
cycle, as well as increased competition with many companies holding such
schedules. Along with the GSA schedules, the U.S. Government is awarding a large
number of omnibus contracts with multiple awardees. Such contracts generally
require extensive marketing efforts by the multiple awardees to procure business
under the omnibus contract through separate task or delivery orders. The use of
GSA schedules and omnibus contracts, while generally not providing immediate
backlog, provide areas of growth that we continue to aggressively pursue.
Consolidated Results of Operations (Unaudited)
The accompanying condensed consolidated financial statements include the
accounts of Telos Corporation and its subsidiaries including Ubiquity.com, Inc.,
Xacta Corporation, Teloworks, Inc., and Telos APAC Pte. Ltd., all of whose
issued and outstanding share capital is owned by Telos Corporation
(collectively, the "Company" or "Telos" or "We"). We have also consolidated the
results of operations of Telos ID (see Note 2 - Non-controlling Interests). All
intercompany transactions have been eliminated in consolidation.
Our operating cycle involves many types of solutions, product and service
contracts with varying delivery schedules. Accordingly, results of a particular
quarter, or quarter-to-quarter comparisons of recorded sales and operating
profits may not be indicative of future operating results and the following
comparative analysis should therefore be viewed in such context.
Our revenues are generated from a number of contract vehicles and task orders.
Over the past several years we have sought to diversify and improve our
operating margins through an evolution of our business from an emphasis on
product reselling to that of an advanced solutions technologies provider. To
that end, although we continue to offer resold products through our contract
vehicles, we have focused on selling solutions and outsourcing product sales, as
well as designing and delivering Telos manufactured and branded technologies.
We believe our contract portfolio is characterized as having low to moderate
financial risk due to the limited number of long-term fixed price development
contracts. Our firm fixed-price activities consist principally of contracts for
the products and services at established contract prices. Our time-and-material
contracts generally allow the pass-through of allowable costs plus a profit
margin.
We provide different solutions and are party to contracts of varying revenue
types under the NETCENTS (Network-Centric Solutions) and NETCENTS-2 contracts to
the U.S. Air Force. NETCENTS and NETCENTS-2 are IDIQ and GWAC, therefore any
government customer may utilize the NETCENTS and NETCENTS-2 vehicles to meet its
purchasing needs. Consequently, revenue earned on the underlying NETCENTS and
NETCENTS-2 delivery orders varies from period to period according to the
customer and solution mix for the products and services delivered during a
particular period, unlike a standalone contract with one separately identified
customer. The contracts themselves do not fund any orders and they state that
the contracts are for an indefinite delivery and indefinite quantity. The
majority of our task/delivery orders have periods of performance of less than 12
months, which contributes to the variances between interim and annual reporting
periods. We have also been awarded other IDIQ/GWACs, including the Department of
Homeland Security's EAGLE II, GSA Alliant 2, and blanket purchase agreements
under our GSA schedule.
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U.S. Government appropriations have been and continue to be affected by larger
U.S. Government budgetary issues and related legislation. In 2011, Congress
enacted the Budget Control Act of 2011 (the "BCA"), which established specific
limits on annual appropriations for fiscal years 2012-2021. The BCA has been
amended a number of times, most recently by the Bipartisan Budget Act of 2019
(the "BBA"), which was enacted on August 2, 2019. As a result, DoD funding
levels have fluctuated over this period and have been difficult to predict. Most
recently, while the two-year BBA allowed for modestly increased defense spending
in FY 2020, unless and until it is again modified, the BBA also essentially will
maintain defense spending in FY 2021 with only a minor increase (less than one
percent) permitted above the current FY 2020 appropriated funding level.
According to the Office of Management and Budget, federal outlays devoted to
defense programs have fallen from 4.5 percent to 3.2 percent as a share of Gross
Domestic Product (GDP) since enactment of the BCA. Moreover, as a result of the
spending caps imposed by the BCA, annual DoD budget authority in FY 2020 is only
3.7 percent higher (in unadjusted dollars) than it was a decade ago in FY 2010.
Since final enactment in December 2019 of appropriations legislation for FY
2020, and the February 10, 2020 submission of the President's proposed FY 2021
budget, the Coronavirus pandemic and associated economic dislocation in the
United States has resulted in the need for an overwhelming federal response.
This has led to the enactment of several comprehensive appropriations and
economic stimulus measures, as well as negotiations between Congress and the
White House for additional massive initiatives for the current year and into the
next fiscal year, the details of which are not yet finalized. These substantial
alterations to FY 2020 spending baselines are also likely to further impact FY
2021 spending in ways that cannot be predicted. The impact of the health and
economic crisis, and the resulting large increase in federal spending, on the
government contracts that we hold and the federal procurements that we would
otherwise compete for cannot be known.
In addition to the ongoing need to respond to the crisis in the current fiscal
year, Congress and the President must agree on FY 2021 appropriations
legislation prior to December 11, 2020; failing to do so by then would likely
mean DoD and other departments will again be funded for an unknown period of
time under another Continuing Resolution, which would again restrict new
spending initiatives. This is consistent with the practice for a number of
years where the U.S. Government has been unable to complete its appropriations
process prior to the beginning of the next fiscal year, resulting in actual or
threatened governmental shut-downs and repeated use for extended time periods
each year of Continuing Resolutions to fund part or all of the government. The
impact of the substantial additional spending on the Coronavirus pandemic on the
appropriations for FY 2021, and the appropriations process itself, is not known.
The current health and economic crisis is highly fluid, and it is likely to
continue to affect multiple federal departments and agencies for an unknown
period of time and in ways that are difficult to predict. Nonetheless, we
believe that the federal government will very likely endeavor to maintain
continuity of services and, with much of the business of government now being
conducted through use of information technology systems and in many cases during
the crisis remotely, we believe there will still be a need on the part of the
government for the types of solutions and services provided by Telos.
We anticipate there will continue to be a significant amount of debate and
negotiations within the U.S. Government over federal and defense spending, and
these deliberations may be impacted by the health and economic impacts of the
COVID-19 pandemic in ways that are at this time difficult to foresee. In the
context of these negotiations, it is possible that the U.S. Government, or
portions of the U.S. Government, could be shut down or disrupted for periods of
time, and that government programs could be modified, cut or replaced as part of
broader reforms to reduce the federal deficit or efforts to redirect federal
spending, whether related or unrelated to the COVID-19 crisis. For more
information on the risks and uncertainties related to U.S. Government contracts,
see Part I - Item 1A Risk Factors as disclosed in our Annual Report on Form 10-K
for the year ended December 31, 2019.
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The principal elements of the Company's operating expenses as a percentage of
sales for the three and nine months ended September 30, 2020 and 2019 are as
follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2020 2019 2020 2019
(unaudited)
Revenue 100.0% 100.0% 100.0% 100.0%
Cost of sales 65.1 64.2 65.7 68.7
Selling, general, and administrative 25.4 23.4 26.9 27.9
expenses
Operating income 9.5 12.4 7.4 3.4
Other income ---- ---- ---- 0.2
Interest expense (4.2) (4.3) (4.5) (4.9)
Income (loss) before income taxes 5.3 8.1 2.9 (1.3)
Benefit from income taxes ---- ---- 0.1 0.2
Net income (loss) 5.3 8.1 3.0 (1.1)
Less: Net income attributable to (5.7) (3.2) (4.6) (1.5)
non-controlling interest
Net (loss) income attributable to Telos
Corporation (0.4)% 4.9% (1.6)% (2.6)%
Three Months Ended September 30, 2020 Compared with Three Months Ended September
30, 2019
Revenue increased by 4.2% to $47.4 million for the third quarter of 2020, from
$45.5 million for the same period in 2019. Services revenue increased to $44.2
million for the third quarter of 2020 from $39.2 million for the same period in
2019, primarily attributable to increases in sales of $2.5 million by Telos ID,
$2.1 million by Assurance / Xacta, and $1.7 million by Secure Communications,
offset by a decrease in sales of $1.3 million by Secure Networks. The change in
product and services revenue varies from period to period depending on the mix
of solutions sold and the nature of such solutions, as well as the timing of
deliverables. Product revenue decreased to $3.3 million for the third quarter of
2020 from $6.3 million for the same period in 2019, primarily attributable to
decreases in sales of $2.5 million by Assurance / Xacta and $0.6 million by
Telos ID, offset by an increase in sales of $0.1 million by Secure
Communications.
Cost of sales increased to $30.9 million for the third quarter of 2020, from
$29.2 million for the same period in 2019, primarily due to an increase in
revenue of $1.9 million, coupled with an increased cost of sales as a percentage
of revenue of 0.9%. Cost of sales for services increased by $2.0 million, and as
a percentage of services revenue decreased by 3.0%, due to a change in the mix
of the programs and timing of certain deliverables. Cost of sales for products
decreased by $0.4 million, and as a percentage of product revenue increased by
27.4% due primarily to a decrease in proprietary software sales which carry
lower cost of sales. The increase in cost of sales as a percentage of revenue is
not necessarily indicative of a trend as the mix of solutions sold and the
nature of such solutions can vary from period to period, and further can be
affected by the timing of deliverables.
Gross profit increased by 1.5% to $16.6 million for the third quarter of 2020
from $16.3 million for the same period in 2019. Gross margin decreased to 34.9%
in the third quarter of 2020, from 35.8% for the same period in 2019. Services
gross margin increased to 35.2% in 2020 from 32.2% in 2019 due to the change in
program mix during the period as noted above, and product gross margin decreased
to 31.0% in 2020 from 58.4% in 2019, due primarily to a decrease in proprietary
software sales.
Selling, general, and administrative expense (SG&A) increased by 13.3% to $12.0
million for the third quarter of 2020, from $10.6 million for the same period in
2019, primarily attributable to increases in labor costs of $1.6 million,
outside services of $1.6 million, legal costs of $0.4 million, and trade shows
of $0.1 million, offset by a increase in capitalized software development costs
of $1.4 million, and decreases in accrued bonuses of $0.7 million and travel
costs of $0.2 million.
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Operating income decreased by 20.5% to $4.5 million for the third quarter of
2020, from $5.7 million for the same period in 2019, due primarily to an
increase in SG&A as noted above.
Interest expense increased by 2.2% to $2.0 million for the third quarter of
2020, from $2.0 million for the same period in 2019, primarily due to an
increase in interest on the EnCap senior term loan.
Income tax provision was $8,000 for the third quarter of 2020, compared to
income tax benefit of $10,000 for the same period in 2019, which is based on the
estimated annual effective tax rate applied to the pretax income incurred for
the quarter plus discreet tax items, based on our expectation of pretax loss for
the fiscal year.
Net loss attributable to Telos Corporation was $0.2 million for the third
quarter of 2020, compared to a net income of $2.2 million for the same period in
2019, primarily attributable to the decrease in operating income for the quarter
as discussed above.
Nine Months Ended September 30, 2020 Compared with Nine Months Ended September
30, 2019
Revenue increased by 19.8% to $135.0 million for the nine months ended September
30, 2020, from $112.7 million in the same period in 2019. Services revenue
increased to $124.2 million for the nine months ended September 30, 2020, from
$101.6 million for the same period in 2019, primarily attributable to increases
in sales of $15.7 million by Telos ID, $6.8 million by Secure Communications,
and $1.5 million by Assurance / Xacta, offset by a decrease in sales of $1.4
million by Secure Networks. The change in product and services revenue varies
from period to period depending on the mix of solutions sold and the nature of
such solutions, as well as the timing of deliverables. Product revenue decreased
to $10.8 million for the nine months ended September 30, 2020, from $11.1
million for the same period in 2019, primarily attributable to decreases in
sales of $0.7 million by Assurance / Xacta and $0.3 million by Secure
Communications, offset by an increase in sales of $0.7 million by Telos ID.
Cost of sales increased by 14.5% to $88.7 million for the nine months ended
September 30, 2020, from $77.4 million for the same period in 2019, primarily
due to an increase in revenue of $22.3 million, however cost of sales as a
percentage of revenue decreased by 3.0%. Cost of sales for services increased by
$10.9 million, and as a percentage of services revenue decreased by 4.1%, due
primarily to a change in the mix of the programs and timing of certain Telos ID
deliverables. Cost of sales for products increased by $0.3 million, and as a
percentage of product revenue increased by 4.4% due primarily to a decrease in
proprietary software sales which carry lower cost of sales. The decrease in cost
of sales as a percentage of revenue is not necessarily indicative of a trend as
the mix of solutions sold and the nature of such solutions can vary from period
to period, and further can be affected by the timing of deliverables.
Gross profit increased by 31.4% to $46.4 million for the nine months ended
September 30, 2020, from $35.3 million compared to the same period in 2019, due
primarily to the change in the mix of the solutions sold as discussed above,
primarily in Telos ID. Gross margin increased to 34.3% for the nine months ended
September 30, 2020, from 31.3% in the same period in 2019.
SG&A expense increased by 15.8% to $36.4 million for the nine months ended
September 30, 2020, from $31.4 million for the same period in 2019, primarily
attributable to increases in outside services of $4.2 million, labor costs of
$3.6 million, software maintenance costs of $0.2 million, accrued bonuses of
$0.2 million, recruiting fees of $0.2 million, and legal costs of $0.1 million,
offset by an increase in capitalized software development costs of $3.3 million,
and a decrease in travel costs of $0.4 million.
Operating income increased by 157.8% to $10.0 million for the nine months ended
September 30, 2020, from $3.9 million for the same period in 2019, due primarily
to an increase in gross profit as noted above.
Interest expense increased by 10.2% to $6.0 million for the nine months ended
September 30, 2020, from $5.5 million for the same period in 2019, primarily due
to an increase in interest on the EnCap senior term loan.
Income tax benefit was $136,000 for the nine months ended September 30, 2019,
compared to $187,000 for the same period in 2019, which is based on the
estimated annual effective tax rate applied to the pretax loss incurred for the
nine month period plus discreet tax items, adjusted for the income tax benefit
previously provided, based on our expectation of pretax loss for the fiscal
year.
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Net loss attributable to Telos Corporation was $2.2 million for the nine months
ended September 30, 2020, compared to $2.9 million for the same period in 2019,
primarily attributable to the increase in operating income as discussed above,
offset by an increase to income attributable to noncontrolling interest.
Liquidity and Capital Resources
As described in Note 5 - Current Liabilities and Debt Obligations, we maintain a
Credit Agreement with EnCap and a Purchase Agreement with RCA. The willingness
of RCA to purchase our accounts receivable under the Purchase Agreement, and our
ability to obtain additional financing, may be limited due to various factors,
including the eligibility of our receivables, the status of our business, global
credit market conditions, and perceptions of our business or industry by EnCap,
RCA, or other potential sources of financing. If we are unable to maintain the
Purchase Agreement, we would need to obtain additional credit to fund our future
operations. If credit is available in that event, lenders may impose more
restrictive terms and higher interest rates that may reduce our borrowing
capacity, increase our costs, or reduce our operating flexibility. The failure
to maintain, extend, renew or replace the Purchase Agreement with a comparable
arrangement or arrangements that provide similar amounts of liquidity for the
Company would have a material negative impact on our overall liquidity,
financial and operating results.
While a variety of factors related to sources and uses of cash, such as
timeliness of accounts receivable collections, vendor credit terms, or
significant collateral requirements, ultimately impact our liquidity, such
factors may or may not have a direct impact on our liquidity based on how the
transactions associated with such circumstances impact the availability under
our credit arrangements. For example, a contractual requirement to post
collateral for a duration of several months, depending on the materiality of the
amount, could have an immediate negative effect on our liquidity, as such a
circumstance would utilize cash resources without a near-term cash inflow back
to us. Likewise, the release of such collateral could have a corresponding
positive effect on our liquidity, as it would represent an addition to our cash
resources without any corresponding near-term cash outflow. Similarly, a
slow-down of payments from a customer, group of customers or government payment
office would not have an immediate and direct effect on our availability unless
the slowdown was material in amount and over an extended period of time. Any of
these examples would have an impact on our cash resources, our financing
arrangements, and therefore our liquidity: The Credit Agreement currently
matures in January 2021, but we may extend the maturity to January 2022 at our
election in accordance with the Fifth Amendment. Our ability to renew or
refinance the Credit Agreement after January 2022 or to enter into a new credit
facility to replace or supplement the Credit Agreement may be limited due to
various factors, including the status of our business, global credit market
conditions, and perceptions of our business or industry by sources of financing.
In addition, if credit is available, lenders may seek more restrictive covenants
and higher interest rates that may reduce our borrowing capacity, increase our
costs, or reduce our operating flexibility. The failure to extend, renew or
replace the Credit Agreement beyond the current or ultimate maturity date of
January 2022 (assuming we exercise all options to extend as provided by the
Fifth Amendment) with a comparable credit facility that provides similar amounts
of liquidity for the Company would have a material negative impact on our
overall liquidity, financial and operating results.
Management may determine that, in order to reduce capital and liquidity
requirements, planned spending on capital projects and indirect expense growth
may be curtailed, subject to growth in operating results. Additionally,
management may seek to put in place a credit facility with a commercial bank,
although no assurance can be given that such a facility could be put in place
under terms acceptable to the Company. Should management determine that
additional capital is required, management would likely look first to the
sources of funding discussed above to meet any requirements or may seek to raise
additional capital by selling equity, although no assurances can be given that
these investors would be able to invest or that the Company and the investors
would agree upon terms for such investments.
Our working capital was $(11.3) million and $2.9 million as of September 30,
2020 and December 31, 2019, respectively. Our current working capital deficit is
due to the classification of the EnCap Credit Agreement as a current liability
as discussed in Note 5 to the financial statements, although the Fifth Amendment
to the Credit Agreement provides us the option to extend the maturity of the
agreement. We intend to consider exercising the option at the appropriate time.
Although no assurances can be given, we expect that our financing arrangements
with EnCap and RCA, collectively, and funds generated from operations are
sufficient to maintain the liquidity we require to meet our operating, investing
and financing needs for the next 12 months.
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Cash provided by operating activities was $12.0 million for the nine months
ended September 30, 2020, compared to $4.4 million for the same period in 2019.
Cash provided by or used in operating activities is primarily driven by the
Company's operating income, the timing of receipt of customer payments, the
timing of its payments to vendors and employees, and the timing of inventory
turnover, adjusted for certain non-cash items that do not impact cash flows from
operating activities. Additionally, net income was $4.1 million for the nine
months ended September 30, 2020, compared to a net loss of $1.2 million for the
nine months ended September 30, 2019.
Cash used in investing activities was approximately $6.1 million and $5.3
million for the nine months ended September 30, 2020 and 2019, respectively, due
primarily to the capitalization of software development costs of $5.5 million
and $2.2 million for the nine months ended September 30, 2020 and 2019,
respectively, and the purchase of property and equipment $0.6 million and $3.1
million for the nine months ended September 30, 2020 and 2019, respectively.
Cash used in financing activities for the nine months ended September 30, 2020
was $2.3 million, compared to cash provided by financing activities of $2.7
million for the same period in 2019, primarily attributable to proceeds from the
EnCap senior term loan for the nine months ended September 30, 2019, and
payments under finance leases and distribution to the Telos ID Class B member
for both periods.
Additionally, our capital structure consists of redeemable preferred stock and
common stock. The capital structure is complex and requires an understanding of
the terms of the instruments, certain restrictions on scheduled payments and
redemptions of the various instruments, and the interrelationship of the
instruments especially as it relates to the subordination hierarchy. Therefore,
a thorough understanding of how our capital structure impacts our liquidity is
necessary and, accordingly, we have disclosed the relevant information about
each instrument as follows:
Enlightenment Capital Credit Agreement
On January 25, 2017, we entered into a Credit Agreement (the "Credit Agreement")
with Enlightenment Capital Solutions Fund II, L.P., as agent (the "Agent") and
the lenders party thereto (the "Lenders") (together referenced as "EnCap"). The
Credit Agreement provided for an $11 million senior term loan (the "Loan") with
a maturity date of January 25, 2022, subject to acceleration in the event of
customary events of default.
All borrowings under the Credit Agreement accrue interest at the rate of 13.0%
per annum (the "Accrual Rate"). If, at the request of the Company, the Agent
executes an intercreditor agreement with another senior lender under which the
Agent and the Lenders subordinate their liens (an "Alternative Interest Rate
Event"), the interest rate will increase to 14.5% per annum. After the
occurrence and during the continuance of any event of default, the interest rate
will increase 2.0%. The Company is obligated to pay accrued interest in cash on
a monthly basis at a rate of not less than 10.0% per annum or, during the
continuance of an Alternate Interest Rate Event, 11.5% per annum. The Company
may elect to pay the remaining interest in cash, by payment-in-kind (by addition
to the principal amount of the Loan) or by combination of cash and
payment-in-kind. Upon thirty days prior written notice, the Company may prepay
any portion or the entire amount of the Loan.
The Credit Agreement contains representations, warranties, covenants, terms and
conditions customary for transactions of this type. In connection with the
Credit Agreement, the Agent has been granted, for the benefit of the Lenders, a
security interest in and general lien upon various property of the Company,
subject to certain permitted liens and any intercreditor agreement. The
occurrence of an event of default under the Credit Agreement could result in the
Loan and other obligations becoming immediately due and payable and allow the
Lenders to exercise all rights and remedies available to them under the Credit
Agreement or as a secured party under the UCC, in addition to all other rights
and remedies available to them.
In connection with the Credit Agreement, on January 25, 2017, the Company issued
warrants (each, a "Warrant") to the Agent and certain of the Lenders
representing in the aggregate the right to purchase in accordance with their
terms 1,135,284.333 shares of the Class A Common Stock of the Company, no par
value per share, which is equivalent to approximately 2.5% of the common equity
interests of the Company on a fully diluted basis. The exercise price is $1.321
per share and each Warrant expires on January 25, 2027. The value of the
warrants was determined to be de minimis and no value was allocated to them on a
relative fair value basis in accounting for the debt instrument.
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The Credit Agreement also included an $825,000 exit fee, which was payable upon
any repayment or prepayment of the loan. This amount had been included in the
total principal due and treated as an unamortized discount on the debt, which
would be amortized over the term of the loan, using the effective interest
method at a rate of 15.0%. We incurred fees and transaction costs of
approximately $374,000 related to the issuance of the Credit Agreement, which
are being amortized over the life of the Credit Agreement.
Effective February 23, 2017, the Credit Agreement was amended to change the
required timing of certain post-closing items, to allow for more time to
complete the legal and administrative requirements around such items. On April
18, 2017, the Credit Agreement was further amended (the "Second Amendment") to
incorporate the parties' agreement to subordinate certain debt owed by the
Company to the affiliated entities of Mr. John R. C. Porter (the "Subordinated
Debt") and to redeem all outstanding shares of the Series A-1 Redeemable
Preferred Stock and the Series A-2 Redeemable Preferred Stock, including those
owned by Mr. John R.C. Porter and his affiliates, for an aggregate redemption
price of $2.1 million.
In connection with the Second Amendment and that subordination of debt, on April
18, 2017, we also entered into Subordination and Intercreditor Agreements (the
"Intercreditor Agreements") with affiliated entities of Mr. John R. C. Porter
(together referenced as "Porter"), in which Porter agreed that the Subordinated
Debt is fully subordinated to the amended Credit Agreement and related
documents, and that required payments, if any, under the Subordinated Debt are
permitted only if certain conditions are met.
On March 30, 2018, the Credit Agreement was further amended (the "Third
Amendment") to waive certain covenant defaults and to reset the covenants for
2018 measurement periods to more accurately reflect the Company's projected
performance for the year. The measurement against the covenants for consolidated
leverage ratio and consolidated fixed charge coverage ratio were agreed to not
be measured as of December 31, 2017 and were reset for 2018 measurement periods.
Additionally, a minimum revenue covenant and a net working capital covenant were
added. In consideration of these amendments, the interest rate on the loan was
increased by 1%, which will revert back to the original rate upon achievement of
two consecutive quarters of a specified fixed charge coverage ratio as defined
in the agreement. The Company may elect to pay the increase in interest expense
in cash or by payment-in-kind (by addition to the principal amount of the
Loan). The increase in interest expense has been paid in cash.
Contemporaneously with the Third Amendment, Mr. John B. Wood agreed to transfer
50,000 shares of the Company's Class A Common Stock owned by him to EnCap.
On July 19, 2019, we entered into the Fourth Amendment to Credit Agreement and
Waiver; First Amendment to Fee Letter ("Fourth Amendment") to amend the Credit
Agreement. As a result of the Fourth Amendment, several terms of the Credit
Agreement were amended, including the following:
• The Company borrowed an additional $5 million from the Lenders, increasing the
total amount of the principal to $16 million.
• The maturity date of the Credit Agreement was amended from January 25, 2022 to
January 15, 2021.
• The prepayment price was amended as follows: (a) from January 26, 2019 through
January 25, 2020, the prepayment price is 102% of the principal amount, (b)
from January 26, 2020 through October 14, 2020, the prepayment price is 101% of
the principal amount, and (c) from October 15, 2020 to the maturity date, the
prepayment price will be at par. However, the prepayment price for the
additional $5 million loan attributable to the Fourth Amendment will be at par.
• The following financial covenants, as defined in the Credit Agreement, were
amended and updated: Consolidated Leverage Ratio, Consolidated Senior Leverage
Ratio, Consolidated Capital Expenditures, Minimum Fixed Charge Coverage Ratio,
and Minimum Consolidated Net Working Capital.
• Any actual or potential non-compliance with the applicable provisions of the
Credit Agreement were waived.
• The borrowing under the Credit Agreement continues to be collateralized by
substantially all of the Company's assets including inventory, equipment and
accounts receivable.
• The Company paid the Agent a fee of $110,000 in connection with the Fourth
Amendment. We incurred immaterial third party transaction costs which were
expensed in the current period.
• The exit fee was increased from $825,000 to $1,200,000.
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The exit fee has been included in the total principal due and treated as an
unamortized discount on the debt, which is being amortized over the term of the
loan using the effective interest method at a rate of 17.3% over the remaining
term of the loan. For the measurement period ended September 30, 2020, we were
in compliance with the Credit Agreement's financial covenants, based on an
agreement between the Company and EnCap on the definition of certain input
factors that determine the measurement against the covenants.
On March 26, 2020, the Credit Agreement was amended (the "Fifth Amendment") to
modify the financial covenants for 2020 through the maturity of the Credit
Agreement to establish that the covenants will remain at the December 31, 2019
levels and to update the previously agreed-upon definition of certain financial
covenants, specifically the amount of Capital Expenditures to be included in the
measurement of the covenants. The Fifth Amendment also provides for the right
for the Company to elect to extend the maturity date of the Credit Agreement
which is currently scheduled to mature on January 15, 2021. The Fifth Amendment
provides for four quarterly maturity date extensions, which would increase the
Exit Fee payable under the Credit Agreement by $250,000 for each quarterly
maturity date extension elected, for a total of $1 million increase to the Exit
Fee were all four of the maturity date extensions to be elected. The Company
paid EnCap an amendment fee of $100,000 and out-of-pocket costs and expenses in
consideration for the Fifth Amendment.
As the Company has not exercised the option(s) to extend the maturity of the
Credit Agreement, the current maturity date remains January 15, 2021, which is
within one year from the balance sheet date. Accordingly, the balance of the
EnCap loan has been classified as a current liability. However, the options to
extend the maturity provide the Company with the ability by contractual right to
extend the maturity of the loan, which the Company intends to consider
exercising at the appropriate time.
We incurred interest expense in the amount of $0.8 million and $2.3 million for
the three and nine months ended September 30, 2020, respectively, and $0.7
million and $1.5 million for the three and nine months ended September 30, 2019,
respectively, under the Credit Agreement.
Accounts Receivable Purchase Agreement
On July 15, 2016, we entered into an Accounts Receivable Purchase Agreement (the
"Purchase Agreement") with Republic Capital Access, LLC ("RCA" or "Buyer"),
pursuant to which we may offer for sale, and RCA, in its sole discretion, may
purchase, eligible accounts receivable relating to U.S. Government prime
contracts or subcontracts of the Company (collectively, the "Purchased
Receivables"). Upon purchase, RCA becomes the absolute owner of any such
Purchased Receivables, which are payable directly to RCA, subject to certain
repurchase obligations of the Company. The total amount of Purchased Receivables
is subject to a maximum limit of $10 million of outstanding Purchased
Receivables (the "Maximum Amount") at any given time. On November 15, 2019, the
term of the Purchase Agreement was extended to June 30, 2022.
The initial purchase price of a Purchased Receivable is equal to 90% of the face
value of the receivable if the account debtor is an agency of the U.S.
Government, and 85% if the account debtor is not an agency of the U.S.
Government; provided, however, that RCA has the right to adjust these initial
purchase price rates in its sole discretion. After collection by RCA of the
portion of a Purchased Receivable in excess of the initial purchase price, RCA
shall pay the Company the residual 10% or 15% of such Purchased Receivable, as
appropriate, less (i) a discount factor equal to 0.30%, for federal government
prime contracts (or 0.56% for non-federal government investment grade account
obligors or 0.62% for non-federal government non-investment grade account
obligors) of the face amounts of Purchased Receivables; (ii) a program access
fee equal to 0.008% of the daily ending account balance for each day that
Purchased Receivables are outstanding; (iii) a commitment fee equal to 1% per
annum of the Maximum Amount minus the amount of Purchased Receivables
outstanding; and (iv) fees, costs and expenses relating to the preparation,
administration and enforcement of the Purchase Agreement and any other related
agreements.
The Purchase Agreement provides that in the event, but only to the extent, that
the conveyance of Purchased Receivables by the Company is characterized by a
court or other governmental authority as a loan rather than a sale, the Company
shall be deemed to have granted RCA, effective as of the date of the first
purchase under the Purchase Agreement, a security interest in all of the
Company's right, title and interest in, to and under all of the Purchased
Receivables, whether now or hereafter owned, existing or arising.
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The Company provides a power of attorney to RCA to take certain actions in the
Company's stead, including (a) to sell, assign or transfer in whole or in part
any of the Purchased Receivables; (b) to demand, receive and give releases to
any account debtor with respect to amounts due under any Purchased Receivables;
(c) to notify all account debtors with respect to the Purchased Receivables; and
(d) to take any actions necessary to perfect RCA's interests in the Purchased
Receivables.
The Company is liable to the Buyer for any fraudulent statements and all
representations, warranties, covenants, and indemnities made by the Company
pursuant to the terms of the Purchase Agreement. It is considered an event of
default if (a) the Company fails to pay any amounts it owes to RCA when due
(subject to a cure period); (b) the Company has voluntary or involuntary
bankruptcy proceedings commenced by or against it; (c) the Company is no longer
solvent or is generally not paying its debts as they become due; (d) any
voluntary liens, garnishments, attachments, or the like are issued against or
attach to the Purchased Receivables; (e) the Company breaches any warranty,
representation, or covenant (subject to a cure period); (f) the Company is not
in compliance or has otherwise defaulted under any document or obligation in
favor of RCA or an RCA affiliate; or (g) the Purchase Agreement or any material
provision terminates (other than in accordance with the terms of the Purchase
Agreement) or ceases to be effective or to be a binding obligation of the
Company. If any such event of default occurs, then RCA may take certain actions,
including ceasing to buy any eligible receivables, declaring any indebtedness or
other obligations immediately due and payable, or terminating the Purchase
Agreement.
Subordinated Debt
On March 31, 2015, the Company entered into Subordinated Loan Agreements and
Subordinated Promissory Notes ("Porter Notes") with affiliated entities of Mr.
John R. C. Porter (together referenced as "Porter"). Mr. Porter and Toxford
Corporation, of which Mr. Porter is the sole shareholder, own 35.0% of our Class
A Common Stock. Under the terms of the Porter Notes, Porter lent the Company
$2.5 million on or about March 31, 2015. Telos also entered into Subordination
and Intercreditor Agreements (the "Subordination Agreements") with Porter and a
prior senior lender, in which the Porter Notes were fully subordinated to the
financing provided by that senior lender, and payments under the Porter Notes
were permitted only if certain conditions are met. According to the original
terms of the Porter Notes, the outstanding principal sum bears interest at the
fixed rate of twelve percent (12%) per annum which would be payable in arrears
in cash on the 20th day of each May, August, November and February, with the
first interest payment date due on August 20, 2015. The Porter Notes do not call
for amortization payments and are unsecured. The Porter Notes, in whole or in
part, may be repaid at any time without premium or penalty. The unpaid
principal, together with interest, was originally due and payable in full on
July 1, 2017.
On April 18, 2017, we amended and restated the Porter Notes to reduce the
interest rate from twelve percent (12%) to six percent (6%) per annum, to be
accrued, and extended the maturity date from July 1, 2017 to July 25, 2022.
Telos also entered into Intercreditor Agreements with Porter and EnCap, in which
the Porter Notes are fully subordinated to the Credit Agreement and any
subsequent senior lenders, and payments under the Porter Notes are permitted
only if certain conditions are met. All other terms remain in full force and
effect. We incurred interest expense in the amount of $90,000 and $265,000 for
the three and nine months ended September 30, 2020, respectively, and $83,000
and $245,000 for the three and nine months ended September 30, 2019,
respectively, on the Porter Notes. As of September 30, 2020, approximately $1.2
million of accrued interest was payable according to the stated interest rate of
the Porter Notes.
Public Preferred Stock
A maximum of 6,000,000 shares of the Public Preferred Stock, par value $.01 per
share, has been authorized for issuance. We initially issued 2,858,723 shares of
the Public Preferred Stock pursuant to the acquisition of the Company during
fiscal year 1990. The Public Preferred Stock was recorded at fair value on the
date of original issue, November 21, 1989, and we made periodic accretions under
the interest method of the excess of the redemption value over the recorded
value. We adjusted our estimate of accrued accretion in the amount of $1.5
million in the second quarter of 2006. The Public Preferred Stock was fully
accreted as of December 2008. We declared stock dividends totaling 736,863
shares in 1990 and 1991. Since 1991, no other dividends, in stock or cash, have
been declared. In November 1998, we retired 410,000 shares of the Public
Preferred Stock. The total number of shares issued and outstanding at September
30, 2020 and December 31, 2019 was 3,185,586. The Public Preferred Stock is
quoted as "TLSRP" on the OTCQB marketplace and the OTC Bulletin Board.
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Since 1991, no dividends were declared or paid on our Public Preferred Stock,
based upon our interpretation of restrictions in our Articles of Amendment and
Restatement, limitations in the terms of the Public Preferred Stock instrument,
specific dividend payment restrictions in the various financing documents to
which the Public Preferred Stock is subject, other senior obligations currently
or previously in existence, and Maryland law limitations in existence prior to
October 1, 2009. Subsequent to the 2009 Maryland law change, dividend payments
have continued to be prohibited except under certain specific circumstances as
set forth in Maryland Code Section 2-311. Pursuant to the terms of the Articles
of Amendment and Restatement, we were scheduled, but not required, to redeem the
Public Preferred Stock in five annual tranches during the years 2005 through
2009. However, due to our substantial senior obligations currently or previously
in existence, limitations set forth in the covenants in the various financing
documents to which the Public Preferred Stock is subject, foreseeable capital
and operational requirements, and restrictions and prohibitions of our Articles
of Amendment and Restatement, we were and remain unable to meet the redemption
schedule set forth in the terms of the Public Preferred Stock as of the
measurement dates. Moreover, the Public Preferred Stock is not payable on
demand, nor callable, for failure to redeem the Public Preferred Stock in
accordance with the redemption schedule set forth in the instrument. Therefore,
we classify these securities as noncurrent liabilities in the condensed
consolidated balance sheets as of September 30, 2020 and December 31, 2019.
On January 25, 2017, we became parties with certain of our subsidiaries to the
Credit Agreement with EnCap. Under the Credit Agreement, we agreed that, until
full and final payment of the obligations under the Credit Agreement, we would
not make any distribution or declare or pay any dividends (other than common
stock) on our stock, or purchase, acquire, or redeem any stock, or exchange any
stock for indebtedness, or retire any stock. Additionally, the Porter Notes
contain similar prohibitions on dividend payments or stock redemptions.
Accordingly, as stated above, we will continue to classify the entirety of our
obligation to redeem the Public Preferred Stock as a long-term obligation.
Various financing documents to which the Public Preferred Stock is subject
prohibit, among other things, the redemption of any stock, common or preferred,
other than as described above. The Public Preferred Stock by its terms also
cannot be redeemed if doing so would violate the terms of an agreement regarding
the borrowing of funds or the extension of credit which is binding upon us or
any of our subsidiaries, and it does not include any other provisions that would
otherwise require any acceleration of the redemption of or amortization of
payments with respect to the Public Preferred Stock. Thus, the Public Preferred
Stock is not and will not be due on demand, nor callable, within 12 months from
September 30, 2020. This classification is consistent with ASC 210, "Balance
Sheet" and 470, "Debt" and the FASB ASC Master Glossary definition of "Current
Liabilities."
ASC 210 and the FASB ASC Master Glossary define current liabilities as follows:
The term current liabilities is used principally to designate obligations whose
liquidation is reasonably expected to require the use of existing resources
properly classifiable as current assets, or the creation of other current
liabilities. As a balance sheet category, the classification is intended to
include obligations for items which have entered into the operating cycle, such
as payables incurred in the acquisition of materials and supplies to be used in
the production of goods or in providing services to be offered for sale;
collections received in advance of the delivery of goods or performance of
services; and debts that arise from operations directly related to the operating
cycle, such as accruals for wages, salaries, commissions, rentals, royalties,
and income and other taxes. Other liabilities whose regular and ordinary
liquidation is expected to occur within a relatively short period of time,
usually twelve months, are also intended for inclusion, such as short-term debts
arising from the acquisition of capital assets, serial maturities of long-term
obligations, amounts required to be expended within one year under sinking fund
provisions, and agency obligations arising from the collection or acceptance of
cash or other assets for the account of third persons.
ASC 470 provides the following: The current liability classification is also
intended to include obligations that, by their terms, are due on demand or will
be due on demand within one year (or operating cycle, if longer) from the
balance sheet date, even though liquidation may not be expected within that
period. It is also intended to include long-term obligations that are or will be
callable by the creditor either because the debtor's violation of a provision of
the debt agreement at the balance sheet date makes the obligation callable or
because the violation, if not cured within a specified grace period, will make
the obligation callable.
If, pursuant to the terms of the Public Preferred Stock, we do not redeem the
Public Preferred Stock in accordance with the scheduled redemptions described
above, the terms of the Public Preferred Stock require us to discharge our
obligation to redeem the Public Preferred Stock as soon as we are financially
capable and legally permitted to do so. Therefore, by its very terms, the Public
Preferred Stock is not due on demand or callable for failure to make a scheduled
payment pursuant to its redemption provisions and is properly classified as a
noncurrent liability.
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We pay dividends on the Public Preferred Stock when and if declared by the Board
of Directors. The Public Preferred Stock accrues a semi-annual dividend at the
annual rate of 12% ($1.20) per share, based on the liquidation preference of $10
per share, and is fully cumulative. Dividends in additional shares of the Public
Preferred Stock for 1990 and 1991 were paid at the rate of 6% per share for each
$.60 of such dividends not paid in cash. For the cash dividends payable since
December 1, 1995, we have accrued $110.2 million and $107.4 million as of
September 30, 2020 and December 31, 2019, respectively. We accrued dividends on
the Public Preferred Stock of $1.0 million and $2.9 million for each of the
three and nine months ended September 30, 2020 and 2019, respectively, which was
recorded as interest expense. Prior to the effective date of ASC 480 on July 1,
2003, such dividends were charged to stockholders' accumulated deficit.
Recent Accounting Pronouncements
See Note 1 of the Condensed Consolidated Financial Statements for a discussion
of recently issued accounting pronouncements.
Critical Accounting Policies
During the three months ended September 30, 2020, there were no material changes
to our critical accounting policies as reported in our Annual Report on
Form 10-K for the year ended December 31, 2019 as filed with the SEC on April
13, 2020.
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