TELOS CORP 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 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, 2020, 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 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). 29 Table of Contents 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: o 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. o 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 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 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 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 We develop our annual budgeted revenue by estimating for the upcoming year our continuing business from existing customers and active contracts. We consider backlog, both funded and unfunded (as explained below), other expected annual renewals, and expansion planned by our current customers. In the context of our current customer portfolio, we view “recurring revenue” as revenue that occurs often and repeatedly. In each of the last three years, recurring revenue has exceeded 85% of our annual revenue. Our total budgeted revenue is the combination of recurring revenue and a forecast of new business. 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. 30 Table of Contents 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, Telos Identity Management Solutions, LLC, 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”). All intercompany transactions have been eliminated in consolidation. 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. 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). 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. These limits were subsequently amended several times. With the expiration of the BCA at the end of FY 2021, there are no statutory limits in place for FY 2022 to guide federal spending negotiations and decisions. According to the non-partisan Congressional Budget Office (CBO), since enactment of the BCA, federal outlays devoted to defense programs fell from 4.5 percent as a share of Gross Domestic Product (GDP) to as low as 3.1 percent of GDP in each of FYs 2016-18, before rising slightly the past two years to a level of 3.4 percent in FY 2020. Moreover, CBO reports that, as a result of the spending caps imposed by the BCA, non-adjusted defense outlays subsequently shrank from $699.4 billion in FY 2011 to as low as $583.4 billion in FY 2016, and did not again exceed their FY 2011 level until FY 2020, when outlays were $713.8 billion, two percent above the FY 2011 level. In fiscal years 2020 and 2021, the COVID-19 pandemic and associated economic dislocation in the United States has resulted in an overwhelming federal response, including enactment of multiple massive and comprehensive emergency appropriations and economic stimulus measures. These were in addition to annual appropriations legislation for FY 2021, which was not enacted into law until late December 2020, nearly three months after the beginning of the fiscal year, during which time the government once again operated under a series of Continuing Resolutions which strictly limited new spending initiatives. These enormous emergency spending packages and their resulting increases in the budget deficit will necessarily factor into future federal budget planning and spending decisions, which will affect to an unknown degree the government contracts that we hold and the federal procurements that we would otherwise compete for. While a detailed FY 2022 budget proposal has not been released, on April 9, 2021, the White House released an outline of President Biden’s discretionary budget request, with topline numbers to help Congress begin the annual appropriations process. The President’s budget proposes $715 billion in base spending for the Department of Defense (“DoD”) in FY 2022, which the Office of Management and Budget described as an $11.3 billion (1.6 percent) increase above the FY 2021 enacted level of $703.7 billion. However, this requested base defense budget also now includes wartime spending which was formerly provided in a separate account for Overseas Contingency Operations. Moreover, congressional support for the President’s proposed level of defense spending is uncertain, as there are some in Congress who are advocating large cuts to the defense budget, as well as others who are calling for much greater increases in military spending. 31 Table of Contents Should Congress and the White House be unable to make sufficient progress on the FY 2022 budget and enact appropriations legislation prior to the beginning of the new fiscal year on October 1, 2021, the DoD and other federal departments and agencies will likely again be funded for an unknown period of time under a Continuing Resolution, which would restrict new spending initiatives. Despite the pandemic’s resultant massive shift to teleworking by federal employees and contractors, the government has successfully maintained continuity of services as has Telos. With much of the business of government continuing to be conducted remotely through use of information technology systems, now and in the future, we believe there will continue to be a need on the part of the government for the types of solutions and services provided by Telos. The principal elements of the Company’s operating expenses as a percentage of sales for the three months ended March 31, 2021 and 2020 are as follows: Three Months Ended March 31, 2021 2020 (unaudited) Revenue 100.0% 100.0% Cost of sales 74.3 68.6 Selling, general and administrative expenses 49.9 30.4 Operating (loss) income (24.2) 1.0 Other expense (1.9) ---- Interest expense (0.4) (5.1) Loss before income taxes (26.5) (4.1) Benefit from income taxes ---- 0.4 Net loss (26.5) (3.7) Less: Net income attributable to non-controlling interest ---- (2.0) Net loss attributable to Telos Corporation (26.5)% (5.7)% Revenue increased by 43.0% to $55.8 million for the first quarter of 2021, from $39.0 million for the same period in 2020. Security Solutions revenue was $22.9 million and $27.3 million for the first quarter of 2021 and 2020, respectively. This decrease of approximately 16.1% was driven primarily by a decrease of $5.3 million in sales of offerings in Telos ID on the contract with the U.S. Census Bureau as the contract ramps down, offset by various increases in Information Assurance and Secure Communications offerings. Secure Networks revenue was $32.9 million and $11.7 million for the first quarter of 2021 and 2020, respectively. This increase of approximately 181.2% resulted from various contracts with the DoD, primarily in our Secure Mobility Solutions offerings. Due to the various solutions offerings within the business groups, sales may vary from period to period according to the solution mix and timing of deliverables for a particular period. 32 Table of Contents Cost of sales increased by 54.8% to $41.4 million for the first quarter of 2021, from $26.7 million for the same period in 2020 as a result of increases in revenue. Cost of sales for Security Solutions decreased to $13.6 million (inclusive of $660,000 of stock-based compensation) for the first quarter of 2021 from $17.2 million for the same period in 2020 (which had no stock-based compensation), which translates as a decrease in the cost of sales as a percentage of revenue to 59.4% from 63.0%, due to a change in the mix and nature of the programs. Cost of sales for Secure Networks increased to $27.8 million (inclusive of $77,000 of stock-based compensation) for the first quarter of 2021 from $9.5 million for the same period in 2020 (which had no stock-based compensation), which translates as an increase in the cost of sales as a percentage of revenue to 84.5% from 81.2%. Gross profit increased by 17.3% to $14.4 million for the first quarter of 2021 from $12.3 million for the same period in 2020. Gross profit for Security Solutions decreased to $9.3 million for the first quarter of 2021 from $10.1 million for the same period in 2020. Gross profit for Secure Networks increased to $5.1 million for the first quarter of 2021 from $2.2 million for the same period in 2020. Gross margin decreased to 25.7% for the first quarter of 2021 from 31.4% for the same period in 2020, due to stock-based compensation and various changes in the mix of contracts in all business lines as discussed above. Gross margin for Security Solutions increased to 40.6% for the first quarter of 2021 from 37.0% for the same period in 2020. Gross margin for Secure Networks decreased to 15.5% for the first quarter of 2021 from 18.8% for the same period in 2020. Selling, general, and administrative (“SG&A”) expense increased by 135.2% to $27.9 million for the first quarter of 2021, from $11.8 million for the same period in 2020, primarily attributable to increases in stock-based compensation of $12.9 million, labor costs of $2.2 million, outside services of $0.8 million, insurance costs of $0.3 million, legal costs of $0.2 million, and trade shows costs of $0.2 million, offset by the capitalization of software development costs of $0.7 million. Operating loss was $13.5 million for the first quarter of 2021, compared to $0.4 million operating income for the same period in 2020, due primarily to the stock-based compensation related to the RSUs granted in the first quarter of 2021. Other expense of $1.1 million for the first quarter of 2021 was attributable to an accrual for a litigation settlement agreement. Interest expense decreased by 90.3% to $0.2 million for the first quarter of 2021, from $2.0 million for the same period in 2020, primarily due to the payoff of the EnCap senior term loan, subordinated debt, and redemption of public preferred stock upon the closing of our initial public offering (“IPO”) in November 2020. Income tax provision was $34,000 for the first quarter of 2021, compared to $146,000 income tax benefit for the same period in 2020, 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 income for the fiscal year. Net loss attributable to Telos Corporation was $14.8 million for the first quarter of 2021, compared to $2.2 million for the same period in 2020, primarily attributable to the stock-based compensation recorded in the first quarter of 2021 as mentioned above. 33 Table of Contents Non-GAAP Financial Measures In addition to our results determined in accordance with GAAP, we believe the non-GAAP financial measures of Enterprise EBITDA, Adjusted EBITDA, Adjusted Net Income (Loss) and Adjusted EPS are useful in evaluating our operating performance. We believe that this non-GAAP financial information, when taken collectively with our GAAP results, may be helpful to readers of our financial statements because it provides consistency and comparability with past financial performance and assists in comparisons with other companies, some of which use similar non-GAAP financial information to supplement their GAAP results. The non-GAAP financial information is presented for supplemental informational purposes only, should not be considered a substitute for financial information presented in accordance with GAAP, and may be different from similarly-titled non-GAAP measures used by other companies. A reconciliation is provided below for each of these non-GAAP financial measures to the most directly comparable financial measure stated in accordance with GAAP. We use the following non-GAAP financial measures to understand and evaluate our core operating performance and trends, to prepare and approve our annual budget, to develop short-term and long-term operating plans, and to evaluate the performance of certain management personnel when determining incentive compensation. We believe these non-GAAP financial measures facilitate comparison of our operating performance on a consistent basis between periods by excluding certain items that may, or could, have a disproportionate positive or negative impact on our results of operations in any particular period. When viewed in combination with our results prepared in accordance with GAAP, these non-GAAP financial measures help provide a broader picture of factors and trends affecting our results of operations. Enterprise EBITDA and Adjusted EBITDA Both Enterprise EBITDA and Adjusted EBITDA are supplemental measures of operating performance that are not made under GAAP and that does not represent, and should not be considered as, an alternative to net income (loss) as determined by GAAP. We define Enterprise EBITDA as net income (loss) attributable to Telos Corporation, adjusted for net income attributable to non-controlling interest, non-operating expense (income), interest expense, provision for (benefit from) income taxes, and depreciation and amortization. We define Adjusted EBITDA as Enterprise EBITDA, adjusted for transaction gains/losses/expenses related to our IPO and stock-based compensation expense. A reconciliation of Enterprise EBITDA and Adjusted EBITDA to net income (loss) attributable to Telos Corporation, the most directly comparable GAAP measure, is as follows: Three Months Ended March 31, 2021 2020 Net loss attributable to Telos Corporation $ (14,778 ) $ (2,244 ) Adjustments: Net income attributable to non-controlling interest ---- 784 Non-operating expense (income) 1,054 (8 ) Interest expense 196 2,017 Provision for (benefit from) income taxes 34 (146 ) Depreciation and amortization 1,360 1,389 Enterprise EBITDA (12,134 ) 1,792 Stock-based compensation expense 13,670 ---- Adjusted EBITDA $ 1,536 $ 1,792 34 Table of Contents Adjusted Net Income (Loss) and Adjusted EPS The adjusted measures of Net Income (Loss) and Diluted EPS, (defined as “Adjusted Net Income (Loss)” and “Adjusted EPS”, respectively) are supplemental measures of operating performance that are not made under GAAP and that does not represent, and should not be considered as, an alternative to net income (loss) as determined by GAAP. We define Adjusted Net Income (Loss) as net income (loss) attributable to Telos Corporation, adjusted for non-operating expense (income) and stock-based compensation expense. We define Adjusted EPS as Adjusted Net Income (Loss) divided by the weighted-average number of common shares outstanding for the period. A reconciliation of Adjusted Net Loss and Adjusted EPS to net loss attributable to Telos Corporation, the most directly comparable GAAP measure, is as follows: Three Months Ended March 31, 2021 Three Months Ended March 31, 2020 Net Loss Attributable to Telos Corporation Diluted Earnings Per Share Net Loss Attributable to Telos Corporation Diluted Earnings Per Share (in thousands) (in thousands) Reported GAAP measure $ (14,778 ) $ (0.23 ) $ (2,244 ) $ (0.06 ) Adjustments: Non-operating expense (income) 1,054 0.02 (8 ) ---- Stock-based compensation expense 13,670 0.21 ---- ---- Adjusted non-GAAP measure $ (54 ) $ 0.00 $ (2,252 ) $ (0.06 ) Weighted-average shares of common stock outstanding 64,625 38,073 Each of Enterprise EBITDA, Adjusted EBITDA, Adjusted Net Income (Loss) and Adjusted EPS has limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. Among other limitations, each of Enterprise EBITDA, Adjusted EBITDA, Adjusted Net Income (Loss) and Adjusted EPS does not reflect our cash expenditures, or future requirements, for capital expenditures or contractual commitments, does not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of our ongoing operations, and does not reflect income tax expense or benefit. Other companies in our industry may calculate Adjusted EBITDA, Adjusted Net Income (Loss) and Adjusted EPS differently than we do, which limits its usefulness as a comparative measure. Because of these limitations, neither Enterprise EBITDA, Adjusted EBITDA, Adjusted Net Income (Loss) nor Adjusted EPS should be considered as a replacement for net income (loss) or earnings per share, as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes. 35 Table of Contents Liquidity and Capital Resources Upon the closing of our IPO, we issued 17.2 million shares of our common stock at a price of $17.00 per share, generating net proceeds of approximately $272.8 million. We used approximately $108.9 million of the net proceeds in connection with the ERPS Conversion (see Note 6 – Exchangeable Redeemable Preferred Stock Conversion), $30.0 million to fund our acquisition of the outstanding Class B Units of Telos ID (see Note 2 – Purchase of Telos ID/Non-controlling Interests), $21.0 million to repay our outstanding senior term loan and subordinated debt (see Note 5 – Current Liabilities and Debt Obligations). We intend to use the remaining net proceeds for general corporate purposes. We also may use a portion of the net proceeds to acquire complementary businesses, products, services, or technologies. The amounts and timing of our actual use of the net proceeds will vary depending on numerous factors. Proceeds held by us are invested in short-term investments until needed for the uses described above. We currently anticipate that we will retain all available funds for use in the operation and expansion of our business, and we do not anticipate paying any cash dividends on our common stock in the foreseeable future. On April 6, 2021, we completed our follow-on offering of 9.1 million shares of our common stock at a price of $33.00 per share, including a secondary public offering of 7.0 million shares of common stock by certain existing stockholders of Telos. The offering generated approximately $64.5 million of net proceeds to Telos. We did not receive any proceeds from the shares of common stock sold by the selling stockholders. On April 19, 2021, we used approximately $28.1 million of the net proceeds to repurchase all the shares and warrants owned by EnCap. Our working capital was $102.2 million and $105.2 million as of March 31, 2021 and December 31, 2020, respectively. Although no assurances can be given, we expect that 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. Cash used in operating activities was $9.3 million for the three months ended March 31, 2021, compared to cash provided by operating activities of $1.7 million for the same period in 2020. 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 loss was $14.8 million for the three months ended March 31, 2021, compared to $1.5 million for the three months ended March 31, 2020. Cash used in investing activities was approximately $2.6 million and $1.7 million for the three months ended March 31, 2021 and 2020, respectively, due primarily to the capitalization of software development costs of $2.2 million and $1.5 million for the three months ended March 31, 2021 and 2020, respectively, and the purchase of property and equipment. Cash used in financing activities was $0.3 million and $0.4 million for the three months ended March 31, 2021 and 2020, respectively, primarily attributable to payments under finance leases for both periods and an amendment fee paid to lender for the three months ended March 31, 2020. 36 Table of Contents 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 March 31, 2021, 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, 2020 as filed with the SEC on March 25, 2021. Item 3. Quantitative and Qualitative Disclosures about Market Risk None.