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, 2024, as filed with the Securities and Exchange Commission on March 10, 2025. 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 1 5 - Segment Information to the unaudited consolidated financial statements at Item 1 of this Form 10-Q. Economic Opportunities, Challenges and Risks We generated approximately 89% of our total revenues from contracts with U.S. government agencies in the first quarter of fiscal year ("FY") 2025. Our business performance is affected by the overall level of U.S. government spending and the alignment of our offerings and capabilities with the budget priorities of the U.S. government. The new Presidential Administration is currently evaluating federal agencies and existing government contracts, grants, and programs for affordability, efficiency, and alignment with U.S. government objectives. The Administration’s efforts to reduce federal spending create uncertainty and risk for government contractors, including potentially resulting in change in budgetary priorities and timing on issuing awards. Decreases in, or delays in contract awards and in government spending on the types of programs that we support, and terminations or stop-work-orders on government contracts on which we are currently performing could adversely affect our future revenues and profitability. The ongoing and potential future reforms to the U.S. government acquisition process, including changes to procurement rules and regulations, could transform how contracts are awarded, negotiated, and managed, which could lead to delays in contract awards and/or modifications to the scope or terms of contracts we hold. At the same time, given the nature of our business, the Administration’s focus on efficiency, along with the potential for certain traditionally government functions to be transferred to private entities, may present business opportunities for us. In light of ongoing conflicts and heightened global instability as well as political tensions and related legal challenges, we expect continued uncertainty in the U.S. political, budget and regulatory environment. Initiatives to reduce governmental spending, federal budget and debt ceiling action, and U.S. government policy positions, including trade policy, potential tax reform and U.S. government policies or priorities, could materially impact federal spending broadly and the company’s programs in particular. Financial Overview A number of factors have contributed to our first quarter of fiscal year 2025 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 year-over-year increase in our Security Solutions revenue was primarily driven by the successful transition and ramping towards the full operational capacity of a significant program. • Our TSA PreCheck enrollment revenue grew as a result of the expansion of TSA PreCheck enrollment sites. • Our overall gross margin increased as the result of a more favorable program mix. 18 Table of Contents Results of Operations Table MD&A 1: Consolidated Results of Operations For the Three Months Ended March 31, 2025 March 31, 2024 Dollar Change (dollars in thousands) Revenue $ 30,616 $ 29,619 $ 997 Cost of sales 18,434 18,658 (224) Gross profit 12,182 10,961 1,221 Gross margin 39.8 % 37.0 % Operating expenses 21,204 19,399 1,805 Operating expenses as percentage of revenue 69.3 % 65.5 % Operating loss (9,022) (8,438) (584) Other income 561 1,252 (691) Interest expense (147) (175) 28 Loss before income taxes (8,608) (7,361) (1,247) Provision for income taxes 4 (17) 21 Net loss $ (8,604) $ (7,378) $ (1,226) 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 in the following section, "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. Operating expenses increased by $1.8 million, or 9.3%, in the first quarter of 2025, compared to the same period in 2024. Selling, general and administrative expenses increased by $3.4 million, or 21.0%, in the first quarter of 2025, compared to the same period in 2024, due to higher stock-based compensation costs. Research and development expenses declined by $1.6 million, or 50.4%, in the first quarter of 2025, compared to the same period in 2024, due to lower amortization costs and stock-based compensation expenses, coupled with the discontinued development of selected solutions. Other income decreased by 55.2% in the first quarter of 2025, compared to the same period in 2024, primarily due to a decrease in dividend income from money market placements. 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, 2025 March 31, 2024 Dollar Change (dollars in thousands) Revenue $ 25,818 $ 18,640 $ 7,178 Cost of sales (excluding depreciation and amortization) 13,257 8,739 4,518 Depreciation and amortization 1,501 1,275 226 Total cost of sales 14,758 10,014 4,744 Gross profit $ 11,060 $ 8,626 $ 2,434 Gross margin 42.8 % 46.3 % For the quarter ended March 31, 2025, Security Solutions segment revenue increased by 38.5%, compared to the same period in 2024, primarily due to the successful ramp towards the full operational capacity of a significant program and increased volume of product sales. For the quarter ended March 31, 2025, Security Solutions segment gross profit increased by 28.2%, compared with the same period in 2024, due to higher segment revenues. Segment gross margin decreased from 46.3% in 2024 to 42.8% in 2025, primarily due to the result of the unfavorable program mix within the segment and increased costs on a specific program. 19 Table of Contents Table MD&A 3: Secure Networks Segment - Financial Results For the Three Months Ended March 31, 2025 March 31, 2024 Dollar Change (dollars in thousands) Revenue $ 4,798 $ 10,979 $ (6,181) Cost of sales (excluding depreciation and amortization) 3,674 8,641 (4,967) Depreciation and amortization 2 3 (1) Cost of sales 3,676 8,644 (4,968) Gross profit $ 1,122 $ 2,335 $ (1,213) Gross margin 23.4 % 21.3 % For the quarter ended March 31, 2025, Secure Networks segment revenue decreased by 56.3%, compared to the same period in 2024, primarily due to the ramp down of several programs within the portfolio. For the quarter ended March 31, 2025, Secure Networks segment gross profit decreased by 51.9%, compared with the same period in 2024, due to lower revenue. Segment gross margin expanded to 23.4% for the first quarter of 2025, from 21.3% for the same period in 2024, primarily due to the impact of indirect costs allocation on revenue. 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, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net (Loss) Income, Adjusted Earnings Per Share ("EPS"), Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin, Cash Gross Margin 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 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, EBITDA Margin and Adjusted EBITDA Margin EBITDA, Adjusted EBITDA, EBITDA Margin 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, provision for (benefit from) income taxes, and depreciation and amortization. We define Adjusted EBITDA as EBITDA, adjusted for stock-based compensation expense and restructuring expenses. We define EBITDA Margin as EBITDA as a percentage of total revenue. We define Adjusted EBITDA Margin as Adjusted EBITDA as a percentage of total revenue. We believe that EBITDA, EBITDA Margin, Adjusted EBITDA and Adjusted EBITDA Margin provide the Board, management and investors with clear representation of our core operating performance and trends, provide greater visibility into the long-term financial performance of the Company, and eliminate the impact of items that do not relate to the ongoing operating performance of the business. Further, Adjusted EBITDA is used by the Board and management to prepare and approve our annual budget, and to evaluate the performance of certain management personnel when determining incentive compensation. 20 Table of Contents Table MD&A 4: Reconciliation of Net Loss to EBITDA and Adjusted EBITDA; Net Loss Margin to EBITDA Margin and Adjusted EBITDA Margin For the Three Months Ended March 31, 2025 March 31, 2024 Amount Margin Amount Margin (dollars in thousands) Net loss $ (8,604) (28.1 %) $ (7,378) (24.9 %) Other income (561) (1.8 %) (1,252) (4.2 %) Interest expense 147 0.5 % 175 0.5 % (Benefit from) provision for income taxes (4) — % 17 0.1 % Depreciation and amortization 2,336 7.6 % 3,129 10.6 % EBITDA (Non-GAAP) (6,686) (21.8 %) (5,309) (17.9 %) Stock-based compensation expense (1) 7,048 23.0 % 2,984 10.0 % Restructuring adjustments (2) — — % (10) — % Adjusted EBITDA (Non-GAAP) $ 362 1.2 % $ (2,335) (7.9) % (1) The stock-based compensation expense to EBITDA as of March 31, 2025, and 2024 is made up of $5.5 million and $1.6 million, respectively, of stock-based compensation expense for the awarded RSUs, PSUs, and stock options, and $1.5 million and $1.3 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, the Company has the discretion to determine whether this compensation will ultimately be paid in stock or cash 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 (adjustments) expenses 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) Income 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 (loss) income as determined by GAAP. We define Adjusted Net (Loss) Income as net loss, adjusted for non-operating (income) expense, stock-based compensation expense and restructuring expense. We define Adjusted EPS as Adjusted Net (Loss) Income divided by the weighted-average number of common shares outstanding for the period. Adjusted Net (Loss) Income and Adjusted EPS provide the Board, management and investors with clear representation of our core operating performance and trends, provide greater visibility into the long-term financial performance of the Company, and eliminate the impact of items that do not relate to the ongoing operating performance of the business. Table MD&A 5: Reconciliation of Net Loss to Adjusted Net Loss; EPS to Adjusted EPS For the Three Months Ended March 31, 2025 March 31, 2024 Adjusted Net Loss Adjusted Earnings Per Share Adjusted Net Loss Adjusted Earnings Per Share (in thousands, except per share data) Net loss $ (8,604) $ (0.12) $ (7,378) $ (0.10) Adjustments: Other income (561) (0.01) (1,252) (0.02) Stock-based compensation expense (1) 7,048 0.10 2,984 0.04 Restructuring adjustments (2) — — (10) — Adjusted net loss (Non-GAAP measure) $ (2,117) $ (0.03) $ (5,656) $ (0.08) Weighted-average shares of common stock outstanding, basic 72,715 70,628 (1) The stock-based compensation expense to net loss as of March 31, 2025, and 2024 is made up of $5.5 million and $1.6 million, respectively, of stock-based compensation expense for the awarded RSUs, PSUs and stock options, and $1.5 million and $1.3 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, the Company has the discretion to determine whether this compensation will ultimately be paid in stock or cash 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 (adjustments) expenses 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. 21 Table of Contents Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin and Cash Gross Margin Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin and Cash Gross Margin are supplemental measures of operating performance that are not made under GAAP and do not represent, and should not be considered as, alternatives to gross profit and gross margin as determined by GAAP. We define Adjusted Gross Profit as gross profit, plus stock-based compensation expense, impairment loss on intangible assets, and restructuring expenses charged under cost of sales. We define Adjusted Gross Margin as Adjusted Gross Profit as a percentage of total revenue. We define Cash Gross Profit as Adjusted Gross Profit, plus depreciation and amortization charged under cost of sales. We define Cash Gross Margin as Cash Gross Profit as a percentage of total revenue. Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin and Cash Gross Margin provide management and investors a clear representation of the core economics of gross profit and gross margin without the impact of non-cash expenses and sunk costs expended. Table MD&A 6: Reconciliation of Gross Profit to Adjusted Gross Profit and Cash Gross Profit; Gross Margin to Adjusted Gross Margin and Cash Gross Margin For the Three Months Ended March 31, 2025 March 31, 2024 Amount Margin Amount Margin (dollars in thousands) Gross profit $ 12,182 39.8% $ 10,961 37.0% Adjustments: Stock-based compensation expense — cost of sales 190 0.6% 257 0.9% Adjusted gross profit (Non-GAAP) 12,372 40.4% 11,218 37.9% Depreciation and amortization — cost of sales 1,503 4.9% 1,278 4.3% Cash gross profit (Non-GAAP) $ 13,875 45.3% $ 12,496 42.2% Free Cash Flow Free cash flow is a supplemental measure of operating and cash flow performance that is not made under GAAP and does not represent, and should not be considered as an alternative to, net cash flow provided by (used in) operating activities, as determined by GAAP. We define Free Cash Flow as net cash provided by (used in) operating activities, less purchases of property and equipment, and capitalized software development costs. We use Free Cash Flow to understand the cash flows that directly correspond with our operations and the investments we must make in those operations, using a methodology that combines operating cash flows and capital expenditures. Further, Free Cash Flow may be useful to management and investors in evaluating the Company's operating performance and liquidity, and to evaluate the performance of certain management personnel when determining incentive compensation. Table MD&A 7: Reconciliation of Net Cash Provided by (Used in) Operating Activities to Free Cash Flow For the Three Months Ended March 31, 2025 March 31, 2024 (in thousands) Net cash provided by (used in) operating activities $ 6,106 $ (350) Adjustments: Capitalized software development costs (2,214) (3,202) Purchases of property and equipment (123) (97) Free cash flow (Non-GAAP) $ 3,769 $ (3,649) 22 Table of Contents Each of EBITDA, Adjusted EBITDA, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net Loss, Adjusted EPS, Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin, Cash Gross Margin 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, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net Loss, Adjusted EPS, Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin, Cash Gross Margin 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 and non-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 (Loss) Income, Adjusted EPS, Cash Gross Profit, Cash Gross Margin and Free Cash Flow differently than we do, which limits their usefulness as comparative measures. Because of these limitations, neither EBITDA, Adjusted EBITDA, EBITDA Margin, Adjusted EBITDA Margin, Adjusted Net Loss, Adjusted EPS, Adjusted Gross Profit, Cash Gross Profit, Adjusted Gross Margin, Cash Gross Margin nor Free Cash Flow should be considered as a replacement for gross profit, gross margin, net (loss) income, earnings per share or net cash flows (used in) 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 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 a maturity date of December 30, 2025, and 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, 2025, we had cash and cash equivalents of $57.8 million and our working capital was $70.6 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 8: Net Change in Cash, Cash Equivalents, and Restricted Cash For the Three Months Ended March 31, 2025 March 31, 2024 (in thousands) Net cash provided by (used in) operating activities $ 6,106 $ (350) Net cash used in investing activities (2,337) (4,149) Net cash used in financing activities (556) (846) Net change in cash, cash equivalents, and restricted cash $ 3,213 $ (5,345) Net cash provided by operating activities for the three months ended March 31, 2025, was $6.1 million, an increase of $6.5 million compared to the same period in 2024. The change is primarily driven by the Company's operating losses, the timing of receipts of customer payments, and the timing of payments to vendors and employees, 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, 2025, decreased by $1.8 million, compared to the same period of the prior year, primarily due to the decreases in capital expenditures in 2024 and purchase of an investment of $0.9 million in 2024, with no similar transaction in 2025. Net cash used in financing activities for the three months ended March 31, 2025, slightly decreased by $0.3 million, compared to the same period in 2024. This is primarily attributable to the decreases in payment of tax withholding related to net share settlement of equity awards of $0.1 million in the first quarter of 2025, compared with $0.4 million in the same period of 2024. 23 Table of Contents Critical Accounting Policies and Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates, judgments, and assumptions that affect the amounts reported. Actual results could differ from those estimates. The 2024 Form 10-K, as filed with the SEC on March 10, 2025, 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, 2025.