TELOS CORP 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words "believes," "anticipates," "plans," "expects," and similar expressions are intended to identify forward-looking statements. Several important factors could cause the Company's actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth in the risk factors section included in the Company's Form 10-K for the year ended December 31, 2022, as filed with the Securities and Exchange Commission on March 16, 2023. 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. Our portfolio of security products, services and expertise empowers our customers with capabilities to reach new markets, serve their stakeholders more effectively, and successfully defend the nation or their enterprise. We protect our customers' people, information, and digital assets so they can pursue their corporate goals and conduct their global missions with confidence in their security and privacy. Our primary customers include the U.S. federal government, large commercial businesses, state and local governments, and international customers. Our consolidated revenue is largely attributable to prime contracts or to subcontracts with our contractors engaged in work for the U.S. government, with the remaining attributable to state, local and commercial markets. Information regarding our two reportable segments – Security Solutions and Secure Networks – is presented in Note 17 - Segment Information to the unaudited consolidated financial statements at Item 1 of this Form 10-Q. Fiscal year 2023 will be a transition year for Telos focusing on streamlining our operations and rebuilding and growing the revenue base by generating new business wins. Our 2023 business development priorities are to: • Reorganize internally to consolidate and centralize business development resources; • Add new talent to drive execution of solution development and new business generation; • Maximize existing strategic partnerships for market expansion; and • Increase our opportunity portfolio and quality of contract vehicles. Business Environment U.S. Budget The final fiscal year ("FY") 2023 omnibus appropriations legislation approved in December 2022 provided an increase in total defense spending of $44 billion above the budget proposed last spring by the White House, and represented a $76 billion increase above the previous year's funding level. It also included significant increases in federal civilian agency (non-defense) cybersecurity funding, including a 15% increase from last year for the Cybersecurity and Infrastructure Security Agency ("CISA") for various program enhancements and new initiatives. In March 2023, the White House released its proposed FY2024 budget, which calls for a further $26 billion increase for the DoD next year, roughly 3% above the FY2023 enacted level. Congress may seek to boost this increase to offset current and expected inflationary trends and the threats posed by foreign adversaries. The President's budget also proposes increased investments for cybersecurity within numerous federal civilian departments and agencies, including $3.1 billion in funding for CISA, a 5% increase, of which $98 million is intended to implement the Cyber Incident Reporting for Critical Infrastructure Act. In general, the President's budget also reflects the prioritization of accelerated cloud adoption, IT modernization, further private sector collaboration for sector risk management responsibilities, ensuring adequate cyber threat information sharing, and supply chain risk management. These priorities align with the solutions Telos has been developing and bringing to market for the past several years. However, for both defense and non-defense spending, it remains to be seen how a divided Congress and the White House can reconcile their differences over fiscal policy before the start of FY2024 on October 1, 2023. Failing to do so could mean the federal government will begin another fiscal year under the constraints of a continuing resolution, with funding frozen at FY2023 levels and restrictions likely on new contracts and acceleration of current programs. 19 Table of Contents Cybersecurity Landscape In recent years, we saw cybersecurity threats become more complex, leveraging a wide variety of tactics to exploit their victims. The continuing and increasingly damaging ransomware and other cyberattacks against federal, state and local governments, education, and private sector enterprises have resulted in intensified efforts to better defend against such attacks. With this growing threat, below are trends to consider when looking at the cybersecurity landscape: Rising Threats, Rising Liability : Ransomware remains arguably the most severe cyber threat to enterprises in the commercial, state, and local government and education sectors. The Nation's Critical Systems Are Still at Risk : Critical infrastructure and industrial IoT are among the categories at greatest risk of cyberattacks. The Challenging Complexity of Regulatory Compliance : Government mandates stronger security in highly regulated industries. These government initiatives and audit fatigue continue 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. Identity Assurance and Privacy Protection are Essential for Today's Enterprises : Identity and access management continues to be a major cybersecurity concern for organizations and individuals that need to ensure their security and protect their privacy. Trusted identities are essential to confidence in IT and physical security strategies and to the success of Zero Trust security models and architectures. Global Networks and Worldwide Communications Need Baked-in Security : Enterprises also need resilient cyber and information security capabilities to protect and defend critical infrastructure to ensure mission success. Telos has several available solutions (Xacta, Telos Ghost, Telos ACA and IDTrust 360 ® ) to help our customers protect and secure their on-premise, cyber, and cloud-based networks, and mitigate risk to critical infrastructure. Further, Secure Networks offers secure mobility solutions and management expertise to defend against cyber threats and vulnerabilities. Backlog Backlog is a useful measure in developing 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. 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. government contracts, means that they have been funded by the procuring agency. Unfunded backlog is the difference between total backlog and funded backlog and includes potential revenues that may be earned if customers exercise delivery orders and/or renewal options to continue these contracts. Based on historical experience, we generally assume option year renewals to be exercised. Most of our customers fund contracts on the basis of one year or less, and, as a result, funded backlog is generally expected to be earned within one year from any point in time, whereas unfunded backlog is expected to be earned over a longer period. Financial Overview A number of factors have contributed to our first quarter results of operations, the most significant of which are described below. More details on these changes are presented below within our "Results of Operations" section. • The winding down of certain projects, completion of several large programs, and new business wins below expectations in 2022, resulted in a decline in current year revenue. • Gross margin expansion due to a shift in mix across the portfolio driven by the wind-down of lower margin programs. • The restructuring plan committed in the fourth quarter of 2022 is continuously being implemented in fiscal year 2023, with the majority of the affected employees separating from the business in early 2023. The restructuring expenses include severance-related benefit costs (including outplacement services and continuing health insurance coverage), and external consulting and advisory fees related to implementing the restructuring plan. • Reported a $1.4 million gain on early extinguishment of other financing obligations. 20 Table of Contents Results of Operations Table MD&A 1: Consolidated Results of Operations For the Three Months Ended March 31, 2023 March 31, 2022 (dollars in thousands) Revenue $ 35,222 $ 50,160 Cost of sales 21,740 31,289 Gross profit 13,482 18,871 Gross margin 38.3 % 37.6 % Selling, general and administrative expenses 26,452 35,238 Selling, general and administrative expenses as percentage of revenue 75.1 % 70.3 % Operating loss (12,970) (16,367) Other income 2,496 12 Interest expense (249) (190) Loss before income taxes (10,723) (16,545) Provision for income taxes (23) (71) Net loss $ (10,746) $ (16,616) Consolidated Results Our business segments have different factors driving revenue fluctuations and profitability. The discussion of the changes in our revenue and profitability are covered in greater detail under the section that follows "Segment Results." We generate revenue from the delivery of products and services to our customers. Cost of sales, for both products and services, consists of labor, materials, subcontracting costs and an allocation of indirect costs. Selling, general, and administrative expenses decreased by $8.8 million, or 24.9% , in the first quarter of 2023 compared to the same period in 2022. This is primarily due to reduced stock-based compensation costs of $5.8 million, and decreased labor costs of $3.8 million, partially offset by $1.2 million in restructuring charges. Other income increased by $2.5 million due to increases in dividend income from money market placements of $1.1 million, and gain on early extinguishment of other financing obligations of $1.4 million in the first quarter of 2023 without similar gain in the same period in 2022. There was no significant change in interest expense between comparable periods. The change in the income tax provision for the first quarter of 2023 compared to the same period in 2022 is based on the estimated annual effective tax rate applied to the pretax loss incurred for the quarter plus discrete tax items, based on our expectation of pretax loss for the fiscal year. 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. Table MD&A 2: Security Solutions Segment - Financial Results For the Three Months Ended March 31, 2023 March 31, 2022 (dollars in thousands) Revenue $ 19,773 $ 26,919 Gross profit 10,274 15,051 Gross margin 52.0 % 55.9 % For the three months ended March 31, 2023, Security Solutions segment revenue decreased by $7.1 million, or 26.5%, compared to the same period in 2022, primarily due to the loss of a program and lower volume on two other programs. Gross profit for Security Solutions decreased by $4.8 million, or 31.7%, for the first quarter of 2023 compared with the same period in 2022, primarily due to the decrease in revenue. Further, the segment gross margin decreased to 52.0% for the first quarter of 2023 from 55.9% for the same period in 2022. The gross margin contraction in the first quarter of 2023 was the result of changes in the mix of programs within the portfolio and lower margin on certain projects within the segment. 21 Table of Contents Table MD&A 3: Secure Networks Segment - Financial Results For the Three Months Ended March 31, 2023 March 31, 2022 (dollars in thousands) Revenue $ 15,449 $ 23,241 Gross profit 3,208 3,820 Gross margin 20.8 % 16.4 % Secure Networks segment revenue for the three months ended March 31, 2023 decreased by $7.8 million, or 33.5%, compared to the same period in 2022, due to the successful wind-down of large programs in the second half of 2022 and 2023 as expected. Gross profit for Secure Networks decreased by $0.6 million, or 16.0%, for the first quarter of 2023 compared with the same period in 2022 due to the lower revenue, offset by improved margin across the portfolio. Segment gross margin increased to 20.8% for the first quarter of 2023 from 16.4% for the same period in 2022 due to improved margin performance on several programs and a shift in mix across the portfolio driven by the wind-down of lower margin programs. Non-GAAP Financial Measures In addition to our results determined in accordance with U.S. GAAP, we believe the non-GAAP financial measures of EBITDA, Adjusted EBITDA, Adjusted EBITDA Margin, 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. The non-GAAP financial information is presented for supplemental informational purposes only, should not be considered a substitute for financial information presented in accordance with GAAP, and may be different from similarly-titled non-GAAP measures used by other companies. A reconciliation is provided below for each of these non-GAAP financial measures to the most directly comparable financial measure stated in accordance with GAAP. We use these 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 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. EBITDA, Adjusted EBITDA and Adjusted EBITDA Margin EBITDA, Adjusted EBITDA and Adjusted EBITDA Margin 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 EBITDA as net (loss)/income, adjusted for non-operating (income)/expense, interest expense, (benefit from)/provision for income taxes, and depreciation and amortization. We define Adjusted EBITDA as EBITDA, adjusted for stock-based compensation expense and restructuring expenses/(adjustments). We define Adjusted EBITDA Margin as Adjusted EBITDA as a percentage of total revenue. Table MD&A 4: Reconciliation of Net Loss to EBITDA, Adjusted EBITDA and Adjusted EBITDA Margin For the Three Months Ended March 31, 2023 March 31, 2022 Amount Margin Amount Margin (dollars in thousands) Net loss $ (10,746) (30.5 %) $ (16,616) (33.1 %) Other income (2,496) (7.1 %) (12) — % Interest expense 249 0.7 % 190 0.4 % Provision for income taxes 23 0.1 % 71 0.1 % Depreciation and amortization 1,425 4.0 % 1,405 2.8 % EBITDA (11,545) (32.8 %) (14,962) (29.8 %) Stock-based compensation expense (1) 9,499 27.0 % 15,931 31.7 % Restructuring expenses/(adjustments) (2) 1,200 3.4 % — — % Adjusted EBITDA $ (846) (2.4 %) $ 969 1.9 % 22 Table of Contents (1) The Stock-based Compensation adjustment to EBITDA as of March 31, 2023 and 2022 is made up of $7.9 million and $14.3 million, respectively, of stock-based compensation expense for the awarded RSUs and PSUs, and $1.6 million and $1.7 million, respectively, 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 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. (2) The restructuring expenses/(adjustments) to EBITDA include severance and other related benefit costs (including outplacement services and continuing health insurance coverage), external consulting and advisory fees related to implementing the restructuring plan. Adjusted Net Loss and Adjusted EPS Adjusted Net 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 Loss as net loss, adjusted for non-operating (income)/expense, stock-based compensation expense and restructuring expense/(adjustments). We define Adjusted EPS as Adjusted Net Loss divided by the weighted-average number of common shares outstanding for the period. Table MD&A 5: Reconciliation of Net Loss to Non-GAAP Adjusted Net Loss and Adjusted EPS For the Three Months Ended March 31, 2023 March 31, 2022 Adjusted Net Loss Adjusted Earnings Per Share Adjusted Net Loss Adjusted Earnings Per Share (in thousands, except per share data) Net loss - GAAP measure $ (10,746) $ (0.16) $ (16,616) $ (0.25) Adjustments: Other income (2,496) (0.04) (12) — Stock-based compensation expense (1) 9,499 0.14 15,931 0.24 Restructuring expenses/(adjustments) (2) 1,200 0.02 — — Adjusted net loss - non-GAAP measure $ (2,543) $ (0.04) $ (697) $ (0.01) Weighted-average shares of common stock outstanding, basic 68,176 67,559 (1) The Stock-based Compensation adjustment to Net Loss as of March 31, 2023 and 2022 is made up of $7.9 million and $14.3 million, respectively, of stock-based compensation expense for the awarded RSUs and PSUs, and $1.6 million and $1.7 million, respectively, 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 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 Net Loss. (2) The restructuring expenses/(adjustments) to net loss include severance and other related benefit costs (including outplacement services and continuing health insurance coverage), external consulting and advisory fees related to implementing the restructuring plan. Free Cash Flow Free cash flow, as reconciled in the table below, is a non-GAAP financial measure defined as net cash provided by/(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. Table MD&A 6: Free Cash Flow For the Three Months Ended March 31, 2023 March 31, 2022 (in thousands) Net cash (used in)/provided by operating activities $ (100) $ 249 Adjustments: Purchases of property and equipment (223) (546) Capitalized software development costs (3,800) (2,795) Free cash flow $ (4,123) $ (3,092) 23 Table of Contents Each of EBITDA, Adjusted EBITDA, Adjusted EBITDA Margin, 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 EBITDA, Adjusted EBITDA, Adjusted EBITDA Margin, Adjusted Net Income/(Loss), Adjusted EPS and Free Cash Flow 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 EBITDA Margin, Adjusted Net Income/(Loss), Adjusted EPS and Free Cash Flow differently than we do, which limits their usefulness as comparative measures. Because of these limitations, neither EBITDA, Adjusted EBITDA, Adjusted EBITDA Margin, Adjusted Net Income/(Loss), Adjusted EPS nor Free Cash Flow should be considered as a replacement for net (loss)/income, earnings per share or net cash flows provided by/(used in) 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 Our primary sources of liquidity are cash on hand, future operating cash flows, and, if needed, borrowings under our $30.0 million revolving credit facility, with an available expansion feature of up to $30.0 million of additional revolver facility. While a variety of factors related to sources and uses of cash, such as timeliness of accounts receivable collections, vendor credit terms, or significant collateral requirements, ultimately impact our liquidity, such factors may or may not have a direct impact on our liquidity. As of March 31, 2023, we had cash and cash equivalents of $112.5 million and our working capital was $116.5 million. We place a strong emphasis on liquidity management. This focus gives us the flexibility for capital deployment while 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. Our overall financial position and liquidity are strong. Although no assurances can be given, we believe the available cash balances and access to our revolving credit facility are sufficient to maintain the liquidity we require to meet our operating, investing and financing needs for the next 12 months. Cash Flow Table MD&A 7: Net Change in Cash, Cash Equivalents, and Restricted Cash For the Three Months Ended March 31, 2023 March 31, 2022 (in thousands) Net cash (used in)/provided by operating activities $ (100) $ 249 Net cash used in investing activities (4,587) (3,341) Net cash used in financing activities (2,156) (3,237) Net change in cash, cash equivalents, and restricted cash $ (6,843) $ (6,329) Net cash used in operating activities for the three months ended March 31, 2023, was $0.1 million, a decrease of $0.35 million compared to the same period in 2022. The change is primarily driven by the Company's operating losses, the timing of receipts of customer payments, the timing of 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. Net cash used in investing activities for the three months ended March 31, 2023 increased by $1.2 million compared to the same period of the prior year primarily, due to the investment in software development costs of $3.8 million and $2.8 million for the three months ended March 31, 2023 and 2022, respectively, and payment of the DFT holdback amount of $0.6 million in February 2023. This is partially offset by the slight decrease in purchases of property and equipment. Net cash used in financing activities for the three months ended March 31, 2023, decreased by $1.1 million compared to the same period in 2022. This is primarily attributable to the decrease in payment of tax withholding related to net share settlement of equity awards of $1.5 million in the first quarter of 2023 compared with $2.9 million in the same period of 2022. Critical Accounting Policies and Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires us to make estimates, judgments, and assumptions that affect the amounts reported. Actual results could differ from those estimates. The 2022 Form 10-K, as filed with the SEC on March 16, 2023, includes a summary of critical accounting policies we believe are the most important to aid in understanding our financial results. There have been no changes to those critical accounting policies that have had a material impact on our reported amounts of assets, liabilities, revenues, or expenses during the three months ended March 31, 2023. 24 Table of Contents Item 3. Quantitative and Qualitative Disclosures about Market Risk None.