What changed in this filing

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Item 2. Management’s Discussion and Analysis

2022-05-10 compared with 2021-11-15 · 158 added, 169 removed, 104 unchanged (76% of the section changed)

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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.

The emergence of each new information and communications technology 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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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.

Decades of experience in developing, orchestrating, and delivering solutions across these three domains give 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.

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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).

cybersecurity, cloud security and enterprise security.

We refer to our cyber and cloud applications as Security Solutions, which includes Information Assurance / Xacta®, Secure Communications, and Telos ID.

We refer to our offerings for enterprise security as Secure Networks.

Security Solutions

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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.

Telos Ghost seeks to eliminate cyberattack 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.

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the recognized gold standard for organizational messaging in the U.S.

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.

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.

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 Organizational Messaging Service and its specialized communications protocols.

offering identity trust and digital services through IDTrust360 ® – an enterprise-class digital identity risk platform for extending flexible hybrid cloud identity services enabled for mobile and enterprise environments 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.

In April 2021, we announced the acquisition of the assets of DFT, whose ONYX ® touchless mobile fingerprint software is being integrated with the IDTrust 360 platform.

Secure Networks

• Secure Mobility:

solutions for business and government that enable remote work and minimize concern across and beyond the enterprise.

solutions for business and government that enable remote work and minimize operational and security concerns 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.

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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.

Congress reached an agreement in March 2022 on fiscal year ("FY") 2022 appropriations legislation, which allows our federal customers to finally operate under more normal conditions and with updated funding levels through the remainder of FY 2022.

Of note, the final FY 2022 appropriations bill provided $728.5 billion for the DoD and related activities.

This amount is $32.5 billion more than the FY 2021 enacted level, and is an increase above the level proposed last spring by President Biden for FY 2022.

This delay in enacting final FY 2022 appropriations legislation postponed submission to Congress of the President’s FY 2023 budget request, and could ultimately delay the congressional budget and appropriations process for the next fiscal year.

These delays could, in turn, impact future planning by Telos and its government customers.

The President’s FY 2023 budget request, which was released on March 25, 2022, calls for approximately 4% more in defense spending than was ultimately provided for FY 2022.

However, this FY 2023 budget was developed prior to Russia’s invasion of Ukraine and did not include expenditures related to that ongoing event.

The proposed FY 2023 budget also assumes an inflation rate for DoD of 2.2%, which Pentagon officials have subsequently admitted will need to be adjusted higher.

As such, there will be significant pressure in Congress to boost defense spending further to account for these factors and other needs.

The proposed FY 2023 budget also calls for an increase in federal civilian agency (non-defense) cybersecurity funding of nearly 10.7%.

The Biden Administration says it is seeking to increase investments across the various civilian federal agencies to help align them to the cybersecurity practices and priorities outlined in the President’s Executive Order 14028, “Improving the Nation’s Cybersecurity.” The proposed budget says this specifically includes providing funding to facilitate the ongoing transition to a “zero trust” approach to cybersecurity, per the direction of President Biden's May 12, 2021 Executive Order on "Improving the Nation's Cybersecurity." Also in accordance with that order, various federal departments and agencies have been taking steps to enhance public sector and critical infrastructure cybersecurity and to accelerate adoption of zero trust architecture throughout government, and the proposed budget would further support those efforts.

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.

Over the past few years, continued and increasingly damaging ransomware and other cyberattacks against federal, state and local governments, the K-12 and higher education sectors, 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.

Ransomware remains arguably the most severe cyber threat to enterprises in the commercial and state, local government and education 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.

Critical infrastructure and industrial internet of things ("IoT") 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.

Telos Ghost can hide critical IoT and industrial control systems from the public internet to keep them from being compromised.

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

Telos Ghost complements zero trust security, creating an additional layer of defense against intruders by hiding critical resources and users in an anonymous undiscoverable network.

As noted above, it protects the crown-jewel assets of critical infrastructure from unauthorized access.

Xacta streamlines and automates the critical processes of the leading cybersecurity standards and frameworks, particularly Federal Risk and Authorization Management Program ("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.

The Cyber Incident Reporting for Critical Infrastructure Act of 2022, which was signed into law on March 15, 2022 will require critical infrastructure owners and operators as well as federal agencies to report to Cybersecurity & Infrastructure Security Agency significant cyber incidents within 72 hours and any ransomware payments made within 24 hours.

Telos believes that having to make such disclosures will make organizations even more sensitive to boosting their cybersecurity posture, and that our Xacta solution will help illuminate their risk profile so that they can better understand the issues and address those issues proactively.

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

An 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.

The Securities and Exchange Commission has also recently proposed new, mandatory cyber risk management and cybersecurity incident reporting requirements for publicly traded companies.

Telos believes this will ensure companies have a sound cyber risk management strategy based on recognized best practices, such as the National Institute of Standards and Technology Cybersecurity Framework, and Telos solutions will support this.

Finally, as a whole, the COVID-19 pandemic has resulted in the acceleration of digital transformation and cloud adoption within the government and beyond, which could 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.

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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.

Despite the pandemic’s resultant massive shift to teleworking by federal employees and contractors, the government successfully maintained the continuity of services, as did Telos.

As the government has developed and implemented its reopening process, and made adjustments based on changing circumstances, officials have said they will seek to continue to maximize the use of teleworking by federal employees.

This stance continued during the most recent, renewed surge of COVID-19 variant transmission.

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

Reportable Segment

During the fourth quarter of 2021, we revised our reportable segments to reflect changes to our organization and leadership structure.

As a result, we established and operate in two reportable segments - Security Solutions and Secure Networks.

Prior to the fourth quarter of 2021, the Company had one operating and reportable segment.

We updated the results for the prior period to conform to the current period presentation.

• Security Solutions focuses on cybersecurity, cloud and identity solutions.

Cybersecurity solutions help our customers ensure the ongoing security, integrity, and compliance of their on-premises and related cloud-based systems by reducing threats and vulnerabilities to foil cyber adversaries before they can attack.

Our security engineers and subject matter experts assess our customers’ cybersecurity environments and design, engineer, and operate systems needed to strengthen their cybersecurity posture.

Our cloud solutions leverage the specialized skills and experience needed to help our customers plan, engineer, execute and accelerate secure cloud migrations while assuring ongoing management and security of enterprise cloud technology environments.

Our identity solutions deliver digital identity, biometric, and nationwide enrollment services and address Know Your Customer ("KYC") and identity management challenges for enterprises working within regulated and critical infrastructure environments.

• Secure Networks provides secure networking architectures and solutions to the DoD, IC and other federal government agencies.

Our net-centric solutions enable collaboration and connectivity in order to increase efficiency, reduce costs, and improve mission outcomes.

We provide an extensive range of wired and wireless, fixed and deployable, classified and unclassified voice, data, and video secure network solutions and services to support defense and civilian missions.

Capabilities include network design, operations and sustainment;

system integration and engineering;

network security and compliance;

deployable comms;

innovation and digital transformation;

service desk;

defensive cyber operations;

and program management.

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.

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.

Total backlog 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.

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Consolidated Results of Operations (Unaudited)

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

(unaudited) (unaudited)

The following table summarizes our result of operations as a percentage of revenue for the periods presented:

Three Months Ended March 31,

Revenue 100.0 % 100.0 %

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Selling, general and administrative expenses 67.0 % 50.2 %

Operating (loss) income (7.5) 9.5 (20.9) 7.4

Other income (expense) — — (0.6) —

Operating loss (29.4) % (24.2) %

Other expense — % (1.9) %

Interest expense (0.4) % (0.4) %

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

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 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 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 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.

Loss before income taxes (29.8) % (26.5) %

Provision for income taxes (0.1) % — %

Net loss (29.9) % (26.5) %

We generate revenue from the delivery of products and services to our customers.

Revenue decreased by 10.0% to $50.2 million for the quarter ended March 31, 2022, from $55.8 million for the same period in 2021.

The decrease in revenue was attributable to the impact of certain projects winding down near its completion within Secure Networks.

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 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 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 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.

Cost of sales consists of materials, labor, subcontracting costs and an allocation of indirect costs.

Cost of sales decreased by 24.2% to $31.3 million for the quarter ended March 31, 2022, from $41.3 million for the same period in 2021.

The change in the cost of sales is directly driven by the change in mix and nature of the programs.

For the quarter ended March 31, 2022, there was a decrease in cost of sales resulting from the winding down of low-margin projects.

Gross profit increased by 30.4% to $18.9 million for the quarter ended March 31, 2022, from $14.5 million for the same period in 2021.

Gross margin increased to 37.6% for the first quarter of 2022 from 26.0% for the same period in 2021.

The change in gross margin is due to a change in the mix of contracts within each of Security Solutions and Secure Networks, as well as the relative weighting of revenue between Security Solutions and Secure Networks.

Selling, general, and administrative expense increased by 20.2% to $33.6 million for the first quarter of 2022, from $28.0 million for the same period in 2021, primarily attributable to increases in labor costs by $5.0 million, outside services by $0.7 million, offset by the capitalization of software development costs of $0.5 million.

Operating loss was $14.7 million for the quarter ended March 31, 2022, compared with $13.5 million for the same period in 2021, due primarily to the increase in operating cost for the first quarter of 2022 compared with same period in prior year.

Other expense of $1.1 million for the first quarter of 2021 was attributable to an accrual for a litigation settlement agreement, with no similar cost in 2022.

There was no significant change in interest expense year over year.

Income tax provision was $71,000 for the first quarter of 2022, compared to $34,000 for the same period in 2021, 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 was $15.0 million for the quarter ended March 31, 2022, compared to $14.8 million for the same period in 2021, primarily attributable to the changes in the gross profit and increase in certain selling, general and administrative expenses as mentioned above.

Segment Results

The accounting policies of each business segment are the same as those followed by the Company as a whole.

Management evaluates business segment performance based on gross profit.

Security Solutions Segment:

Three Months Ended March 31,

Revenue $ 26,919 $ 22,829

Gross profit $ 15,051 $ 9,326

Gross margin 55.9 % 40.9 %

Security Solutions' revenue increased by $4.1 million year over year, or approximately 17.9%.

This is primarily due to an increase in sales offerings.

Gross profit for Security Solutions increased by $5.7 million primarily due to the significant increase in revenue coupled by the various changes in the sales mix on various programs.

Gross margin for Security Solutions increased to 55.9% for the first quarter of 2022 from 40.9% for the same period in 2021.

The increase in profitability in the first quarter of 2022 was due to growth in high margin projects.

Secure Networks Segment:

Three Months Ended March 31,

Revenue $ 23,241 $ 32,928

Gross profit $ 3,820 $ 5,143

Gross margin 16.4 % 15.6 %

Secure Networks' revenue decreased by $9.7 million year over year, or approximately 29.4%.

This is primarily due to the ramping down of certain projects under Secure Networks offerings.

Gross profit for Secure Networks decreased by $1.3 million as a result of lower revenue volume.

Gross margin for Secure Networks increased to 16.4% for the first quarter of 2022 from 15.6% for the same period in 2021.

The increase in gross margin is due to lower margin projects winding down in the first quarter of 2022.

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), Adjusted EPS and Free Cash Flow are useful in evaluating our operating performance.

In addition to our results determined in accordance with U.S.

GAAP, we believe the non-GAAP financial measures of Enterprise EBITDA, Adjusted EBITDA, Adjusted Net Income (Loss), Adjusted Earnings Per Share ("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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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.

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 disproportionately 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.

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

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

We define Enterprise EBITDA as net (loss) income, adjusted for 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 stock-based compensation expense.

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

Three Months Ended March 31,

Net loss $ (14,983) $ (14,778)

Non-operating (income) expense (12) 1,054

Interest expense 190 196

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

Provision for income taxes 71 34

Depreciation and amortization 1,405 1,360

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Stock-based compensation expense (1)

$ 14,298 $ 13,670

Adjusted EBITDA $ 969 $ 1,536

(1) The Stock-based Compensation adjustment to EBITDA as of March 31, 2022 is made up of $12.6 million stock-based compensation expense for the awarded RSUs and PSUs, and $1.7 million of other sources of stock-based compensation expense.

The other sources of stock-based compensation consists of accrued compensation, which the Company intends to settle in shares of the Company's common stock.

However, it is the Company’s discretion as to whether this compensation will ultimately be paid in stock or cash.

The Company has the right to dictate the form of these payments up until the date at which they are paid.

Any change to the expected payment form would result in out of quarter adjustments to this add back to Adjusted EBITDA.

Adjusted Net Income (Loss) and Adjusted EPS

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 Net Income (Loss) as net income (loss), adjusted for non-operating expense (income), 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 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

(in thousands) (in thousands)

Reported GAAP measure $ (5,387) $ (0.08) $ (200) $ (0.01)

Non-operating income (20) — (2) —

Stock-based compensation expense 12,191 0.18 4 —

Adjusted non-GAAP measure $ 6,784 $ 0.10 $ (198) $ (0.01)

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

Nine Months Ended September 30, 2021 2020

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

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

Three Months Ended March 31, 2022

Three Months Ended March 31, 2021

Net Loss Diluted Earnings Per Share Net Loss Diluted Earnings Per Share

(in thousands) (in thousands)

Reported GAAP measure $ (14,983) $ (0.22) $ (14,778) $ (0.23)

Non-operating expense (income) 1,001 0.01 (14) —

Non-operating (income) expense (12) — 1,054 0.02

Stock-based compensation expense (2)

14,298 0.21 13,670 0.21

Adjusted non-GAAP measure $ (697) $ (0.01) $ (54) $ —

Weighted-average shares of common stock outstanding 67,559 64,625

(2) The Stock-based Compensation adjustment to Net Loss as of March 31, 2022 is made up of $12.6 million stock-based compensation expense for the awarded RSUs and PSUs, and $1.7 million of other sources of stock-based compensation expense.

The other sources of stock-based compensation consist of accrued compensation, which the Company intends to settle in shares of the Company’s common stock.

However, it is the Company's discretion as to whether this compensation will ultimately be paid in stock or cash.

The Company has the right to dictate the form of these payments up until the date at which they are paid.

Any change to the expected form of payment would result in out of quarter adjustments to this add back to Adjusted Net Loss.

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, as reconciled in the table below, is a non-GAAP financial measure defined as net cash provided by or used in operating activities, less purchases of property and equipment and capitalized software development costs.

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 to assess the quality of our earnings as a key performance measure in evaluating management.

Three Months Ended March 31,

(in thousands)

Net cash flows provided by (used in) operating activities $ 249 $ (6,882)

Purchases of property and equipment (546) (480)

Capitalized software development costs (2,795) (2,165)

Free cash flow $ (3,092) $ (9,527)

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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).

We used approximately $108.9 million of the net proceeds in connection with the exchangeable redeemable preferred stock conversion, $30.0 million to fund our acquisition of the outstanding Class B Units of Telos ID (see Note 7 – Purchase of Telos ID Non - cont rolling Interest ), and $21.0 million to repay our outstanding senior term loan and subordinated debt.

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 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 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 used the remaining net proceeds of the IPO and the follow-on offering for general corporate purposes.

Our overall financial position and liquidity are strong.

Our working capital was $132.7 million and $140.8 million as of March 31, 2022 and December 31, 2021, 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.

As of March 31, 2022, we had a cash and cash equivalent balance of $120.2 million, compared to $126.6 million at the end of 2021.

This balance gives us the flexibility for capital deployment while maintaining our focus on preserving a strong balance sheet to position us for future opportunities.

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.

The following is a discussion of our major operating, investing and financing activities for the quarter ended March 31, 2022 and 2021.

Cash provided by operating activities was $0.2 million for the three months ended March 31, 2022, compared to cash used in operating activities of $6.9 million for the same period in 2021.

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 $3.3 million and $2.6 million for the three months ended March 31, 2022 and 2021, respectively, due primarily to the investment in software development costs of $2.8 million and $2.2 million for the three months ended March 31, 2022 and 2021, respectively, and the purchase of property and equipment.

Cash used in financing activities was $3.2 million and $2.8 million for the three months ended March 31, 2022 and 2021, respectively, primarily attributable to payments under finance leases for both periods, payment of tax withholding related to net share settlement of equity awards of $2.9 million in the first quarter of 2022, and a final distribution of $2.4 million of the Class B Member of Telos ID in the first quarter of 2021.

Recent Accounting Pronouncements

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Critical Accounting Policies

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.

During the three months ended March 31, 2022, 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, 2021 as filed with the SEC on March 28, 2022.

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