What changed in this filing

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Item 2. Management’s Discussion and Analysis

2021-11-15 compared with 2021-08-16 · 147 added, 124 removed, 126 unchanged (68% of the section changed)

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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 and Business Overview

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.

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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.

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.

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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

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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.

Business Environment

Our business performance continues to be heavily affected by the overall level of U.S.

Government spending and the alignment of our solutions with the priorities of the U.S.

Government spending and contracts continue to be affected by the federal budget and appropriations process and related legislation.

Due to delays in the passage of FY 2022 appropriations legislation, the federal government is operating under the terms of a Continuing Resolution ("CR"), which limits spending to the prior year’s funding levels and generally prohibits new spending initiatives and contract starts.

The current CR will expire December 3, and unless the individual appropriations bills are enacted by then, another CR will be needed to avert a government shutdown.

Cybersecurity Landscape

Despite the massive shift to teleworking by federal employees and contractors as a result of the pandemic, the government has successfully maintained continuity of services.

More recently, as the government has proceeded to develop and implement its reopening process, officials have said they will seek to continue to maximize use of teleworking by federal employees.

As such, with much of the business of government still being conducted by federal employees working remotely using information technology systems, 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.

Over the past year, continued and increasingly damaging ransomware and other cyberattacks against federal, state and local government and K-12 education (SLED), and higher education, and private sector enterprises have resulted in intensified efforts to better defend against such attacks.

The growing demand for these solutions continues to provide Telos with the privilege of offering our expertise to protect these vitally important organizations.

Ransomware remains arguably the most severe cyber threat to enterprises in the commercial and SLED sectors.

Our Xacta offering empowers these organizations and institutions to maintain a strong cyber risk posture to minimize the risk of ransomware gaining a foothold in their IT environment.

Should ransomware get loose in the enterprise network, Telos Ghost, our virtual obfuscation network offering, can hide vital resources from view to prevent the payload from reaching them.

Critical infrastructure and industrial Internet of things are among the categories at greatest risk of cyberattacks.

Energy, utilities, transportation, and food supply were among the critical infrastructure sectors that experienced high-profile breaches or ransomware attacks over the past year.

Telos Ghost can hide critical OT and industrial control systems (ICS) from the public internet to keep them from being compromised.

It can also cordon off financial data, medical records, intellectual property, and other crown-jewel assets from visibility or accessibility by adversaries.

Government mandates and initiatives to assure stronger security in highly regulated industries also lead to opportunities for Xacta.

A pending update to the research study Telos conducted last year reveals that audit fatigue continues to burden these organizations, with automation solutions being recognized as the most effective remedy for the many repetitive and redundant tasks that security compliance requires.

Xacta streamlines, harmonizes, and automates the security controls and processes that comprise the leading cybersecurity standards and frameworks, in on-premises, cloud, hybrid, and multi-cloud environments.

President Biden’s May 12 Executive Order on “Improving the Nation’s Cybersecurity” acknowledged the severity and scope of the cybersecurity challenges facing the public and private sectors, the American people and our economy.

It gave direction for federal departments and agencies to modernize government cybersecurity by:

moving more rapidly to adopt secure cloud services;

adopting multifactor authentication;

pushing for increased use in government of such practices as zero trust architecture;

and improving the security and integrity of the software supply chain, with a priority on addressing critical software.

The executive order also called for improving communications with cloud service providers through automation and standardization of messages at each stage of the Federal Risk and Authorization Management Program ("FedRAMP") process, and for other changes in an effort to accelerate and improve the process.

Subsequently, federal agencies, including the Cybersecurity & Infrastructure Security Agency and the Transportation Security Administration, which have specific responsibilities for various aspects of government and private sector cybersecurity, have taken steps to enhance public sector and critical infrastructure cybersecurity.

Congress has given final approval to a $1.2 trillion infrastructure package which contains a number of provisions dealing with cybersecurity and would provide considerable funding for infrastructure-related cybersecurity.

We believe many of these actions could ultimately result in increased need for solutions and services provided by Telos.

Congress is also considering a potentially $2 trillion budget reconciliation measure that could, among other things, also boost federal support for cybersecurity and provide additional opportunities for Telos.

For example, Telos Ghost is a perfect complement to zero trust security, creating an additional layer of defense against intruders by hiding critical resources and users in an anonymous undiscoverable network.

As noted earlier, it is also ideal for protecting the crown-jewel assets of critical infrastructure from unauthorized access.

Xacta streamlines and automates the critical processes of the leading cybersecurity standards and frameworks, in particular FedRAMP, allowing all process participants to collaborate within the same Xacta application to attain a FedRAMP Authority to Operate.

Xacta is also a trailblazer in adopting the Open Security Controls Assessment Language, a multi-format framework adopted by FedRAMP to allow security professionals to automate security assessment, auditing, and continuous monitoring processes.

Finally, as a whole, the COVID-19 pandemic has resulted in acceleration of digital transformation and cloud adoption within the government and beyond, which will likely increase demand for Xacta and Telos Ghost.

Xacta is engineered to manage risk and compliance of complex cloud and multi-cloud environments, a key capability for federal agencies and regulated industries that need to gain and maintain compliance with cloud-specific security regulations.

Telos Ghost is a cloud-native, as-as-service offering that delivers network obfuscation and managed attribution capabilities on a global scale to support the cloud-enabled enterprise.

COVID-19 Pandemic

The coronavirus disease 2019 ("COVID-19") pandemic has caused a disruption of the normal operations of many businesses, including the temporary closure or scale-back of business operations and/or the imposition of either quarantine or remote work or meeting requirements for employees, either by government order or on a voluntary basis.

The ongoing pandemic may adversely affect our customers’ ability to perform their missions and is in many cases disrupting their operations.

It may also impact the ability of our subcontractors, partners, and suppliers to operate and fulfill their contractual obligations, and result in an increase in their costs and cause delays in performance.

These supply chain effects, and the direct effect of the virus and the disruption on our operations, may negatively impact both our ability to meet customer demand and our revenue and profit margins.

Our employees, in some cases, are working remotely due either to safety concerns or to customer imposed limitations and using various technologies to perform their functions.

On September 24, 2021, Executive Order 14042 on Ensuring Adequate COVID Safety Protocols for Federal Contractors was issued requiring, amongst other things, all employees, sub-contractors and vendors working on certain federal contracts or who do work related to these federal contracts be fully vaccinated by December 8, 2021.

While that deadline to be fully vaccinated has been pushed back to January 18, 2022, this new requirement may negatively impact our ability to hire and retain talent, and to utilize certain sub-contractors and/or vendors to meet our customer demands and/or contractual requirements.

Additionally, the disruption and volatility in the global and domestic capital markets may increase the cost of capital and limit our ability to access capital.

Both the health and economic aspects of COVID-19 are highly fluid and the future course of each is uncertain.

We develop our annual budgeted revenue by estimating for the upcoming year our continuing business from existing customers and active contracts.

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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.

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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.

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).

Government appropriations have been and continue to be affected by larger U.S.

Government budgetary issues and related legislation.

According to the Office of Management and Budget, since enactment of the Budget Control Act of 2011 (the “BCA”), which imposed statutory annual spending caps on federal discretionary spending for ten years, federal outlays devoted to all national defense programs (which includes Energy Department and other non-DoD defense programs) fell from 4.6 percent as a share of Gross Domestic Product (“GDP”) in FY 2011 to as low as 3.1 percent of GDP in each of FYs 2017-18, before rising slightly the past two years to a level of 3.5 percent in FY 2020.

Moreover, OMB reports that total national defense program outlays (in current, non-adjusted dollars) shrank from $705.6 billion in FY 2011 to as low as $589.7 billion in FY 2015, and did not again exceed their FY 2011 level until FY 2020, when outlays were $724.6 billion, approximately 2.7 percent above their level a decade previously.

(By comparison, inflation, as measured by the Consumer Price Index, rose by approximately 15 percent over the same period.)

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, possibly coupled with new massive infrastructure and other economic recovery and stimulus proposals being actively considered by Congress, and their resulting increases in the budget deficit will necessarily factor into future federal budget planning and spending decisions, affecting to an unknown degree the government contracts that we hold and the federal procurements that we would otherwise compete for.

President Biden’s budget request for FY 2022, submitted to Congress in late May, called for $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.

This requested base defense budget for FY 2022 also now includes wartime spending, which in previous fiscal years was provided for in a separate account for Overseas Contingency Operations.

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, while others are calling for greater increases in military spending.

Additionally, Congress must take action shortly to raise or suspend the debt ceiling, and there are some in Congress who have said they want to block such action unless it is coupled with statutory requirements to limit future federal discretionary and/or entitlement spending.

With the expiration of the BCA at the end of FY 2021, there are currently no statutory limits in place to guide federal discretionary spending negotiations and decisions, and action on the annual defense authorization and appropriations bills has been significantly delayed this year.

As a result, and assuming Congress is able to reach agreement on such a measure and avoid a government shutdown, FY 2022 is expected to begin on October 1, 2021 with DoD and other federal departments and agencies again 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.

More recently, as the government has proceeded to develop and implement its reopening process, officials have said they will seek to continue to maximize use of teleworking by federal employees.

As such, with much of the business of government still being conducted by federal employees working remotely through use of information technology systems, 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.

Over the past year, continued and increasingly impactful ransomware and other cyberattacks against government entities at the federal, state and local levels, and against private sector organizations in the critical infrastructure and other sectors, have resulted in intensified efforts to better defend against such attacks.

It gave direction for federal departments and agencies to modernize government cybersecurity by:

moving more rapidly to adopt secure cloud services;

adopt multifactor authentication;

push for increased use in government of such practices as zero trust architecture;

and improve the security and integrity of the software supply chain, with a priority on addressing critical software.

The executive order also called for improving communications with Cloud Service Providers through automation and standardization of messages at each stage of the Federal Risk and Authorization Management Program (FedRAMP) process, and for other changes in an effort to accelerate and improve the process.

Subsequently, federal agencies, including the Cybersecurity & Infrastructure Security Agency (CISA) and the Transportation Security Administration (TSA), which have specific responsibilities for various aspects of government and private sector cybersecurity, have taken steps to enhance public sector and critical infrastructure cybersecurity.

Finally, Congress is working on a massive infrastructure package which contains a number of provisions dealing with cybersecurity and would provide considerable funding for infrastructure-related cybersecurity.

We believe many of these actions could ultimately result in increased need for solutions and services provided by Telos.

Finally, as a whole the COVID-19 pandemic has resulted in acceleration of digital transformation and cloud adoption within the government and beyond, which will likely increase demand for Telos solutions Xacta and Ghost.

The principal elements of the Company’s operating expenses as a percentage of sales for the three and six months ended June 30, 2021 and 2020 are as follows:

Three Months Ended June 30,

Six Months Ended June 30,

The following table sets forth selected data as a percentage of sales for the three and nine months ended September 30, 2021 and 2020 are as follows:

Three Months Ended September 30,

Nine Months Ended September 30,

2021 2020 2021 2020

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(Loss) income before income taxes (7.7) 5.3 (21.8) 2.9

Benefit from income taxes — — — 0.2

Benefit from (provision for) income taxes — — — 0.1

Net (loss) income (7.7) 5.3 (21.8) 3.0

Net income attributable to non-controlling interest — (5.7) — (4.6)

Net (loss) income attributable to Telos Corporation (35.6) % 0.5 % (30.9) % (2.3) %

Three Months Ended June 30, 2021 Compared with Three Months Ended June 30, 2020

Revenue increased by 8.1% to $52.6 million for the second quarter of 2021, from $48.6 million for the same period in 2020.

Security Solutions revenue was $31.2 million and $34.2 million for the second quarter of 2021 and 2020, respectively.

This decrease of approximately 8.8% was driven primarily by a decrease of $4.6 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 $21.4 million and $14.4 million for the second quarter of 2021 and 2020, respectively.

Net loss attributable to Telos Corporation (7.7) % (0.4) % (21.8) % (1.6) %

Three Months Ended September 30, 2021 Compared with Three Months Ended September 30, 2020

Revenue increased by 47.7% to $70.1 million for the third quarter of 2021, from $47.4 million for the same period in 2020.

Revenue for the third quarter, excluding the contract with the U.S.

Census Bureau of $1.6 million in 2021 and $9.4 million in 2020, would have grown by 79.9% in the current quarter compared with prior year same period.

Security Solutions revenue was $35.7 million and $31.2 million for the third quarter of 2021 and 2020, respectively.

This increase of approximately 14.4% was driven primarily by the increases in sales of Telos ID and Information Assurance offerings, offset by the decrease in Secure Communications offerings.

Secure Networks revenue was $34.4 million and $16.2 million for the third quarter of 2021 and 2020, respectively.

This increase of approximately 112.3% 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.

Cost of sales increased by 3.1% to $32.0 million for the second quarter of 2021, from $31.0 million for the same period in 2020 as a result of increases in revenue.

Cost of sales for Security Solutions decreased to $15.7 million (inclusive of $0.7 million of stock-based compensation) for the second quarter of 2021 from $19.5 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 50.3% from 57.0%, due to a change in the mix and nature of the programs.

Cost of sales for Secure Networks increased to $16.3 million (inclusive of $0.1 million of stock-based compensation) for the second quarter of 2021 from $11.5 million for the same period in 2020 (which had no stock-based compensation).

Cost of sales increased by 42.5% to $44.0 million for the third quarter of 2021, from $30.9 million for the same period in 2020 as a result of increases in revenue.

Cost of sales for Security Solutions decreased to $15.3 million (inclusive of $0.4 million of stock-based compensation) for the third 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 42.9% from 55.1%, due to a change in the mix and nature of the programs.

Cost of sales for Secure Networks increased to $28.7 million (inclusive of $0.1 million stock-based compensation) for the third quarter of 2021 from $13.7 million for the same period in 2020 (which had no stock-based compensation).

While the cost of sales increased between periods, the sales mix improved, which translates to a decrease in the cost of sales as a percentage of revenue to 83.4% from 84.6%.

Gross profit increased by 17.0% to $20.6 million for the second quarter of 2021 from $17.6 million for the same period in 2020.

Gross profit for Security Solutions increased to $15.5 million for the second quarter of 2021 from $14.7 million for the same period in 2020.

Gross profit for Secure Networks increased to $5.1 million for the second quarter of 2021 from $2.9 million for the same period in 2020.

Gross margin increased to 39.1% for the second quarter of 2021 from 36.2% for the same period in 2020, due to various changes in the mix of higher profit margin contracts in all business lines as discussed above.

Gross margin for Security Solutions increased to 49.7% for the second quarter of 2021 from 43.0% for the same period in 2020.

Gross margin for Secure Networks increased to 23.8% for the second quarter of 2021 from 20.1% for the same period in 2020.

Selling, general, and administrative (“SG&A”) expense increased by 212.7% to $39.1 million for the second quarter of 2021, from $12.5 million for the same period in 2020, primarily attributable to increases in stock-based compensation of $20.5 million, labor costs of $4.1 million, outside services of $1.1 million, and trade shows costs of $0.5 million, offset by a decrease in bonus costs of $1.1 million.

Operating loss was $18.6 million for the second quarter of 2021, compared to $5.1 million operating income for the same period in 2020, primarily due to the stock-based compensation expense related to the RSUs granted in the first quarter of 2021.

Interest expense decreased by 90.4% to $0.2 million for the second quarter of 2021, from $2.0 million for the same period in 2020, primarily due to the repayment of the EnCap loan, subordinated debt, and redemption of public preferred stock upon the closing of our IPO in November 2020.

Income tax provision was $13,000 for the second quarter of 2021, compared to $2,000 for the same period in 2020, which is based on the estimated annual effective tax rate applied to the pretax loss 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 $18.7 million for the second quarter of 2021, compared to $0.3 million of net income attributable to Telos Corporation for the same period in 2020, primarily due to the stock-based compensation recorded in the second quarter of 2021 as mentioned above.

Six Months Ended June 30, 2021 Compared with Six Months Ended June 30, 2020

Revenue increased by 23.7% to $108.3 million for the six months ended June 30, 2021, from $87.6 million for the same period in 2020.

Security Solutions revenue was $54.0 million and $61.5 million for the six months ended June 30, 2021 and 2020, respectively.

This decrease of approximately 12.2% was driven primarily by a decrease of $9.5 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 $54.3 million and $26.1 million for the six months ended June 30, 2021 and 2020, respectively.

Gross profit increased by 57.4% to $26.1 million for the third quarter of 2021 from $16.6 million for the same period in 2020.

Gross profit for Security Solutions increased to $20.4 million for the third quarter of 2021 from $14.0 million for the same period in 2020.

Gross profit for Secure Networks increased to $5.7 million for the third quarter of 2021 from $2.6 million for the same period in 2020.

Gross margin increased to 37.2% for the third quarter of 2021 from 34.9% for the same period in 2020, due to various changes in the mix of higher profit margin contracts in all business lines as discussed above.

Gross margin for Security Solutions increased to 57.1% for the third quarter of 2021 from 44.9% for the same period in 2020.

Gross margin for Secure Networks increased to 16.6% for the third quarter of 2021 from 15.8% for the same period in 2020.

Selling, general, and administrative (“SG&A”) expense increased by 160.0% to $31.3 million for the third quarter of 2021, from $12.0 million for the same period in 2020, primarily attributable to increases in stock-based compensation of $11.8 million, labor costs of $5.5 million, and outside services of $1.2 million.

Operating loss was $5.3 million for the third quarter of 2021, compared to $4.5 million operating income for the same period in 2020, primarily due to the stock-based compensation expense related to the RSUs granted in fiscal year 2021.

Interest expense decreased by 90.3% to $0.2 million for the third quarter of 2021, from $2.0 million for the same period in 2020, primarily due to the repayment of the EnCap loan, subordinated debt, and redemption of public preferred stock upon the closing of our IPO in November 2020.

Income tax benefit was $41,000 for the third quarter of 2021, compared to $8,000 income tax provision for the same period in 2020, which is based on the estimated annual effective tax rate applied to the pretax loss 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 $5.4 million for the third quarter of 2021, compared to $0.2 million for the same period in 2020, primarily due to the stock-based compensation recorded in the third quarter of 2021 as mentioned above.

Nine Months Ended September 30, 2021 Compared with Nine Months Ended September 30, 2020

Revenue increased by 32.1% to $178.4 million for the nine months ended September 30, 2021, from $135.0 million for the same period in 2020.

Revenue, excluding the contract with the U.S.

Census Bureau of $4.2 million in 2021 and $29.9 million in 2020, would have grown by 65.8% year-over-year.

Security Solutions revenue was $89.7 million and $92.5 million for the nine months ended September 30, 2021 and 2020, respectively.

This decrease of approximately 3.0% was driven primarily by decreases in sales of offerings in Telos ID, as the Census contract ramps down, and Secure Communication offerings, offset by an increase in Information Assurance offerings.

Secure Networks revenue was $88.7 million and $42.5 million for the nine months ended September 30, 2021 and 2020, respectively.

This increase of approximately 108.7% 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.

Cost of sales increased by 27.1% to $73.4 million for the six months ended June 30, 2021, from $57.8 million for the same period in 2020 as a result of increases in revenue.

Cost of sales for Security Solutions decreased to $29.3 million (inclusive of $1.3 million of stock-based compensation) for the six months ended June 30, 2021 from $36.8 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 54.3% from 59.8%, due to a change in the mix and nature of the programs.

Cost of sales for Secure Networks increased to $44.1 million (inclusive of $0.2 million of stock-based compensation) for the six months ended June 30, 2021 from $21.0 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 81.2% from 80.5%.

Gross profit increased by 17.1% to $34.9 million for the six months ended June 30, 2021 from $29.8 million for the same period in 2020.

Gross profit for Security Solutions was $24.7 million for the six months ended June 30, 2021 and for the same period 2020.

Gross profit for Secure Networks increased to $10.2 million for the six months ended June 30, 2021 from $5.1 million for the six months ended June 30, 2020.

Gross margin decreased to 32.2% for the second quarter of 2021 from 34.0% 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 45.7% for the second quarter of 2021 from 40.2% for the same period in 2020.

Gross margin for Secure Networks decreased to 18.8% for the second quarter of 2021 from 19.5% for the same period in 2020.

SG&A expense increased by 175.1% to $67.0 million for the six months ended June 30, 2021, from $24.3 million for the same period in 2020, primarily attributable to increases in stock-based compensation of $33.5 million, labor costs of $6.3 million, outside services of $2.0 million, insurance costs of $0.7 million, and trade shows costs of $0.7 million, offset by the capitalization of software development costs of $0.5 million and a decrease in bonus costs of $1.5 million.

Operating loss was $32.1 million for the six months ended June 30, 2021, compared to $5.5 million of operating income for the same period in 2020, primarily due to the stock-based compensation recorded as of the second quarter of 2021 as mentioned above.

Other expense of $1.0 million for the six months ended June 30, 2021 was as a result of the settlement of outstanding litigation.

Interest expense decreased by 90.3% to $0.4 million for the six months ended June 30, 2021, from $4.0 million for the same period in 2020, primarily due to the repayment of the EnCap loan, subordinated debt, and redemption of public preferred stock upon the closing of our IPO in November 2020.

Income tax provision was $47,000 for the six months ended June 30, 2021, compared to $144,000 income tax benefit for the same period in 2020, which is based on the estimated annual effective tax rate applied to the pretax loss incurred for the six months period plus discreet tax items, based on our expectation of pretax loss for the fiscal year.

Net loss attributable to Telos Corporation was $33.5 million for the six months ended June 30, 2021, compared to $2.0 million for the same period in 2020, primarily attributable to the stock-based compensation recorded in 2021 as mentioned above.

Cost of sales increased by 32.4% to $117.4 million for the nine months ended September 30, 2021, from $88.7 million for the same period in 2020 as a result of increases in revenue.

Cost of sales for Security Solutions decreased to $44.5 million (inclusive of $1.7 million of stock-based compensation) for the nine months ended September 30, 2021 from $53.8 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 49.6% from 58.2%, due to a change in the mix and nature of the programs.

Cost of sales for Secure Networks increased to $72.9 million (inclusive of $0.3 million of stock-based compensation) for the nine months ended September 30, 2021 from $34.9 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 82.2% from 82.1%.

Gross profit increased by 31.5% to $61.0 million for the nine months ended September 30, 2021 from $46.4 million for the same period in 2020.

Gross profit for Security Solutions increased to $45.2 million for the nine months ended September 30, 2021 from $38.7 million for the nine months ended September 30, 2020.

Gross profit for Secure Networks increased to $15.8 million for the nine months ended September 30, 2021 from $7.6 million for the nine months ended September 30, 2020.

Gross margin decreased to 34.2% as of the third quarter of 2021 from 34.3% for the same period in 2020, due to various changes in the mix of contracts in all business lines as discussed above.

Gross margin for Security Solutions increased to 50.4% as of the third quarter of 2021 from 41.8% for the same period in 2020.

Gross margin for Secure Networks decreased to 17.8% as of the third quarter of 2021 from 17.9% for the same period in 2020.

SG&A expense increased by 170.1% to $98.3 million for the nine months ended September 30, 2021, from $36.4 million for the same period in 2020, primarily attributable to increases in stock-based compensation of $45.2 million, labor costs of $11.9 million, outside services of $3.2 million, insurance costs of $1.0 million, and trade show costs of $1.1 million, offset by the decrease in bonus costs of $1.6 million.

Operating loss was $37.3 million for the nine months ended September 30, 2021, compared to $10.0 million of operating income for the same period in 2020, primarily due to the stock-based compensation recorded as of the third quarter of 2021 as mentioned above.

Other expense for the nine months ended September 30, 2021 was $1.0 million compared to $14,000 of other income for the nine months ended September 30, 2020 was as a result of the settlement of outstanding litigation.

Interest expense decreased by 90.3% to $0.6 million for the nine months ended September 30, 2021, from $6.0 million for the same period in 2020, primarily due to the repayment of the EnCap loan, subordinated debt, and redemption of public preferred stock upon the closing of our IPO in November 2020.

Income tax provision was $6,000 for the nine months ended September 30, 2021, compared to $136,000 income tax benefit for the same period in 2020, which is based on the estimated annual effective tax rate applied to the pretax loss incurred for the nine months period plus discreet tax items, based on our expectation of pretax loss for the fiscal year.

Net loss attributable to Telos Corporation was $38.9 million for the nine months ended September 30, 2021, compared to $2.2 million for the same period in 2020, primarily attributable to the stock-based compensation recorded in 2021 as mentioned above.

Balance Sheet Review

The Company's total assets as of June 30, 2021 were $220.1 million compared to $183.8 million as of December 31, 2020.

The increase in total assets was primarily attributable to an increase in cash and cash equivalents provided by the follow-on offering and an increase in accounts receivables due to higher revenue generation during the three months ended June 30, 2021.

The Company's total liabilities as of June 30, 2021 were $55.4 million compared to $56.7 million as of December 31, 2020.

The decrease in total liabilities was primarily attributable to payments made under our finance lease obligations.

As of June 30, 2021, the Company had a total equity of $164.7 million compared to $127.1 million as of December 31, 2020.

The Company's total assets as of September 30, 2021 were $242.7 million compared to $183.8 million as of December 31, 2020.

The increase in total assets was primarily attributable to an increase in cash and cash equivalents provided by the follow-on offering, an increase in accounts receivables due to higher revenue generation and increase in intangible assets and goodwill as a result of the acquisition during the nine months ended September 30, 2021.

The Company's total liabilities as of September 30, 2021 were $71.2 million compared to $56.7 million as of December 31, 2020.

The increase in total liabilities was primarily attributable to the increase in accounts payable and other accrued liabilities as a result of the increase in cost of sales as of September 30, 2021.

As of September 30, 2021, the Company had a total equity of $171.5 million compared to $127.1 million as of December 31, 2020.

The increase in equity is primarily driven by the follow-on offering that raised $64.3 million and stock-based compensation of $47.2 million;

offset by the repurchase of the common stock and outstanding warrants held by the EnCap fund holders for $1.3 million and $26.9 million, respectively.

The Company reported a net loss of $33.5 million for the six months ended June 30, 2021.

offset by the repurchase of the common stock and outstanding warrants held by EnCap for $1.3 million and $26.9 million, respectively.

The Company reported a net loss of $38.9 million for the nine months ended September 30, 2021.

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.

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), Adjusted EPS and Free Cash Flow 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.

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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 (loss) income as determined by GAAP.

We define Enterprise EBITDA as net (loss) income 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.

Both Enterprise EBITDA and Adjusted EBITDA are supplemental measures of operating performance that are not made under GAAP and do not represent, and should not be considered as, an alternative to net loss as determined by GAAP.

We define Enterprise EBITDA as net loss attributable to Telos Corporation, adjusted for net income attributable to non-controlling interest, non-operating (income) expense, 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 (loss) income attributable to Telos Corporation, the most directly comparable GAAP measure, is as follows (in thousands):

Three Months Ended June 30, Six Months Ended June 30,

A reconciliation of net loss attributable to Telos Corporation to Enterprise EBITDA and Adjusted EBITDA, the most directly comparable GAAP measure, is as follows (in thousands):

Three Months Ended September 30, Nine Months Ended September 30,

2021 2020 2021 2020

Net (loss) income attributable to Telos Corporation $ (18,729) $ 266 $ (33,507) $ (1,978)

Net loss attributable to Telos Corporation $ (5,387) $ (200) $ (38,894) $ (2,178)

Net income attributable to non-controlling interest — 2,694 — 6,284

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Interest expense 195 2,013 583 6,026

Provision for (benefit from) income taxes 13 2 47 (144)

(Benefit from) provision for income taxes (41) 8 6 (136)

Depreciation and amortization 1,459 1,284 4,223 4,018

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Adjusted Net Income (Loss) and Adjusted EPS

The adjusted measures of Net Income (Loss) and Adjusted 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, alternatives to net income (loss) as determined by GAAP.

Adjusted Net Income (Loss) and Adjusted EPS are supplemental measures of operating performance that are not made under GAAP and do not represent, and should not be considered as, alternatives 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) income attributable to Telos Corporation, the most directly comparable GAAP measure, is as follows:

Three Months Ended June 30, 2021 2020

A reconciliation of net loss attributable to Telos Corporation to Adjusted Net Income (Loss) and Adjusted EPS, the most directly comparable GAAP measure, is as follows:

Three Months Ended September 30, 2021 2020

Adjusted Net Income (Loss) Adjusted Earnings Per Share Adjusted Net Income (Loss) Adjusted Earnings Per Share

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Weighted-average shares of common stock outstanding 66,755 39,002

Six Months Ended June 30, 2021 2020

Nine Months Ended September 30, 2021 2020

Adjusted Net Income (Loss) Adjusted Earnings Per Share Adjusted Net Income (Loss) Adjusted Earnings Per Share

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Weighted-average shares of common stock outstanding 65,999 38,554

Each of Enterprise EBITDA, Adjusted EBITDA, Adjusted Net Income (Loss) and Adjusted EPS has limitations as an analytical tool, and you should not consider any of them 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.

Free Cash Flow

Free cash flow, as reconciled in the table below, is a non-GAAP financial measure defined as net cash provided by or used in operating activities, less capital expenditure and adjusted for the final distribution to Telos ID Class B members included in cash from operating activities.

This non-GAAP financial measure may be a useful measure for investors and other users of our financial statements as a supplemental measure of our cash performance and assess the quality of our earnings as a key performance measure in evaluating management.

Nine Months Ended September 30, 2021 2020

(in thousands) (in thousands)

Net cash flows provided by operating activities $ 6,668 $ 11,957

Capital expenditure (7,784) (6,083)

Final distribution to Telos ID Class B member - included in cash from operating activities 2,436 —

Free cash flow $ 1,320 $ 5,874

Each of Enterprise EBITDA, Adjusted EBITDA, Adjusted Net Income (Loss), Adjusted EPS and Free Cash Flow has limitations as an analytical tool, and you should not consider any of them 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), Adjusted EPS and Free Cash Flow does not reflect our 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), Adjusted EPS and Free Cash Flow 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), Adjusted EPS nor Free Cash Flow should be considered as a replacement for net income (loss), earnings per share or net cash flows provided by operating activities, 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.

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 – Non-controlling Interest / Purchase of Telos ID), $21.0 million to repay our outstanding senior term loan and subordinated debt (see Note 5 – Current Liabilities and Debt Obligations).

Upon the closing of the IPO in November 2020, 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 9 – Exchangeable Redeemable Preferred Stock Conversion), $30.0 million to fund our acquisition of the outstanding Class B Units of Telos ID (see Note 3 – Non-controlling Interests / Purchase of Telos ID), and $21.0 million to repay our outstanding senior term loan and subordinated debt (see Note 8 – Debt Obligations).

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 7.0 million shares of common stock by certain existing stockholders of Telos.

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We did not receive any proceeds from the shares of common stock sold by the selling stockholders.

On April 19, 2021, we used approximately $1.3 million of the net proceeds to repurchase 39,682 shares of our common stock and $26.9 million to repurchase 900,970 outstanding warrants for our common stock held by EnCap fund holders (see Note 5 - Current Liabilities and Debt Obligations).

We intend to use the remaining net proceeds from the IPO and the follow-on offering for general corporate purposes.

On April 19, 2021, we used approximately $1.3 million of the net proceeds to repurchase 39,682 shares of our common stock and $26.9 million to repurchase warrants to purchase 900,970 shares our common stock owned by EnCap (see Note 8 - Debt Obligations).

Further, on July 30, 2021, we used approximately $5.9 million of the net proceeds to acquire the assets of DFT (see Note 4 - Acquisition).

We intend to use the remaining net proceeds of the IPO and the follow-on offering 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.

Our working capital was $139.7 million and $105.2 million as of June 30, 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 $5.8 million for the six months ended June 30, 2021, compared to cash provided by operating activities of $0.8 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.

Cash used in investing activities was approximately $4.7 million and $3.5 million for the six months ended June 30, 2021 and 2020, respectively, primarily due to software development costs of $3.7 million and $3.2 million for the six months ended June 30, 2021 and 2020, respectively.

Cash provided by financing activities was $35.5 million for the six months ended June 30, 2021 compared to cash used in financing activities of $1.7 million for the same period in 2020, primarily attributable to the proceeds from the follow-on offering that generated $64.3 million of net proceeds, reduced by $26.9 million used to repurchase the outstanding warrants and $1.3 million to repurchase the common stock held by EnCap fund holders.

Proceeds held by us is invested in short-term investments until needed for the uses described above.

Our working capital was $137.9 million and $105.2 million as of September 30, 2021 and December 31, 2020, respectively.

Although no assurances can be given, we expect our current sources of liquidity are sufficient to support our operating, investing and financing needs for the next 12 months.

We ended the third quarter of 2021 with a cash and cash equivalent balance of $134.1 million compared to $106.0 million at the end of 2020.

We believe we have adequate funds on hand to execute our financial and operating strategy.

The following is a discussion of our major operating, investing and financing activities in the first nine months of 2021 and 2020, as classified on the Condensed Statements of Cash Flows in Part I, Item 1.

Cash provided by operating activities was $6.7 million for the nine months ended September 30, 2021, compared to cash provided by operating activities of $12.0 million for the same period in 2020.

Cash provided by or used in operating activities is primarily driven by the timing of receipt of customer payments, the timing of payments to vendors and employees, and the timing of inventory turnover.

Cash used in investing activities was approximately $13.7 million and $6.1 million for the nine months ended September 30, 2021 and 2020, respectively, primarily driven by the $5.9 million of cash paid for the acquisition completed in July 2021 (see Note 4 - Acquisition).

Cash provided by financing activities was $35.1 million for the nine months ended September 30, 2021 compared to cash used in financing activities of $2.3 million for the same period in 2020, primarily attributable to the proceeds from the follow-on offering that generated $64.3 million of net proceeds, reduced by $26.9 million used to repurchase the outstanding warrants and $1.3 million to repurchase the common stock held by EnCap.

Recent Accounting Pronouncements

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Critical Accounting Policies

During the three months ended June 30, 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.

During the three months ended September 30, 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.

Quantitative and Qualitative Disclosures about Market Risk

Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-Q

Item 2. Management’s Discussion and Analysis