Item 7. Management’s Discussion and Analysis
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations
General
We offer technologically advanced, software-based security solutions that empower and protect the
world’s most security-conscious organizations against rapidly evolving, sophisticated and pervasive threats. Our portfolio of security products, services and expertise empower our customers with capabilities to reach new markets, serve their
stakeholders more effectively, and successfully defend the nation or their enterprise. We protect our customers’ people, information, and digital assets so they can pursue their corporate goals and conduct their global missions with confidence in
their security and privacy.
Our mission is to protect our customers’ people, systems, and vital information assets with offerings
for cybersecurity, cloud security, and enterprise security. In the current global environment, our mission is more critical than ever. The emergence of each new ICT introduces new vulnerabilities, as security is still too often overlooked in solution
development. Networks and applications meant to enhance productivity and profitability often jeopardize an organization due to poor planning, misconfiguration, or an unknown gap in security. Ransomware, insider threats, cybercrime, and advanced
persistent threats continue to menace public and private enterprises across all industries.
Cybersecurity, cloud security, and enterprise security of the modern organization share much in common,
yet also call for a diverse range of skills, capabilities, and experience in order to meet the requirements of security-conscious customers. Decades of experience in developing, orchestrating, and delivering solutions across these three domains gives
us the vision and the confidence to provide solutions that empower and protect the enterprise at an integrated, holistic level. Our experience in addressing challenges in one area of an enterprise helps us meet requirements in others. We understand
that a range of complementary capabilities may be needed to solve a single challenge, and we also recognize when a single solution might address multiple challenges.
Our security solutions span across the following domains:
•
Cybersecurity – We help our
customers ensure the ongoing security, integrity, and compliance of their on-premises and related cloud-based systems, reducing threats and vulnerabilities in order to foil cyber adversaries before they can attack. Our consultants assess our
customers’ security environments and then 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. We offer the specialized skills and experience needed to help our customers plan, engineer, and execute secure cloud migration
strategies and then ensure 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 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).
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Security Solutions
•
Information
Assurance / Xacta: a premier platform for enterprise cyber risk management and security compliance automation, delivering security awareness for systems in the cloud, on-premises, and in hybrid and multi-cloud environments. Xacta
delivers automated cyber risk and compliance management solutions to large commercial and government enterprises. Across the U.S. federal government, Xacta is the de facto commercial cyber risk and compliance management solution.
•
Secure Communications:
○
Telos Ghost:
a virtual obfuscation network-as-a-service with encryption and managed attribution capabilities to ensure the safety and privacy of people, information, and resources on the network. Telos Ghost seeks to eliminate cyber-attack surfaces by
obfuscating and encrypting data, masking user identity and location, and hiding network resources. It provides the additional layers of security and privacy needed for intelligence gathering, cyber threat protection, securing critical
infrastructure, and protecting communications and applications when operations, property, and even lives can be jeopardized by a single error in security.
○
Telos Automated
Message Handling System (“AMHS”): web-based organizational message distribution and management for mission-critical communications; the recognized gold standard for organizational messaging in the U.S. government. Telos AMHS is used
by military field operatives for critical communications on the battlefield and is the only web-based solution for assured messaging and directory services using the DISA Organizational Messaging Service and its specialized communications
protocols.
•
Telos ID: offering
Identity Trust and Digital Services through IDTrust360 ® – an enterprise-class digital identity risk platform for extending SaaS and custom digital identity services that mitigate threats through the integration of advanced
technologies that fuse biometrics, credentials, and other identity-centric data used to continuously monitor trust. We maintain government certifications and designations that distinguish Telos ID, including TSA PreCheck ®
enrollment provider, Designated Aviation Channeling provider, FBI-approved Channeler, and FINRA Electronic Fingerprint Submission provider. We are the only commercial entity in our industry designated as a Secure Flight Services provider for
terrorist watchlist checks.
Secure Networks
•
Secure Mobility:
solutions for business and government that enable remote work and minimize concern across and beyond the enterprise. Our secure mobility team brings credentials to every engagement, supplying deep expertise and experience as well as highly
desirable clearances and industry recognized certifications for network engineering, mobility, and security.
•
Network
Management and Defense: services for operating, administrating, and defending complex enterprise networks and defensive cyber operations. Our diverse portfolio of capabilities addresses common and uncommon requirements in many
industries and disciplines, ranging from the military and government agencies to Fortune 500 companies.
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements in conformity with GAAP requires management to make
estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during
the reporting period. Significant estimates and assumptions used in the preparation of our consolidated financial statements include revenue recognition, allowance for doubtful accounts receivable, allowance for inventory obsolescence, the valuation
allowance for deferred tax assets, income taxes, contingencies and litigation, potential impairments of goodwill and intangible assets, estimated pension-related costs for our foreign subsidiaries and accretion of public preferred stock. Actual
results could differ from those estimates.
The following is a summary of the most critical accounting policies used in the preparation of our consolidated
financial statements.
Revenue Recognition
We account for revenue in accordance with Accounting Standards Codification (“ASC”) Topic 606, “Revenue
from Contracts with Customers.” The unit of account in ASC 606 is a performance obligation, which is a promise in a contract with a customer to transfer a good or service to the customer. ASC 606 prescribes a five-step model for recognizing revenue
that includes identifying the contract with the customer, determining the performance obligation(s), determining the transaction price, allocating the transaction price to the performance obligation(s), and recognizing revenue as the performance
obligations are satisfied. Timing of the satisfaction of performance obligations varies across our businesses due to our diverse product and service mix, customer base, and contractual terms. Significant judgment can be required in determining
certain performance obligations, and these determinations could change the amount of revenue and profit recorded in a given period. Our contracts may have a single performance obligation or multiple performance obligations. When there are multiple
performance obligations within a contract, we allocate the transaction price to each performance obligation based on our best estimate of standalone selling price.
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The majority of our revenue is recognized over time, as control is transferred continuously to our
customers who receive and consume benefits as we perform, and is classified as services revenue. All of our business groups earn services revenue under a variety of contract types, including time and materials, firm-fixed price, firm-fixed price
level of effort, and cost plus fixed fee contract types, which may include variable consideration as discussed further below. Revenue is recognized over time using costs incurred to date relative to total estimated costs at completion to measure
progress toward satisfying our performance obligations. Incurred cost represents work performed, which corresponds with, and thereby best depicts, the transfer of control to the customer. Contract costs include labor, material, subcontractor costs
and indirect expenses. This continuous transfer of control to the customer is supported by clauses in our contracts with U.S. Government customers whereby the customer may terminate a contract for convenience and then pay for costs incurred plus a
profit, at which time the customer would take control of any work in process. For non-U.S. Government contracts where we perform as a subcontractor and our order includes similar Federal Acquisition Regulation (FAR) provisions as the prime
contractor’s order from the U.S. Government, continuous transfer of control is likewise supported by such provisions. For other non-U.S. Government customers, continuous transfer of control to such customers is also supported due to general terms in
our contracts and rights to recover damages which would include, among other potential damages, the right to payment for our work performed to date plus a reasonable profit.
Due to the transfer of control over time, revenue is recognized based on progress towards completion of
the performance obligation. The selection of the method to measure progress towards completion requires judgment and is based on the nature of the performance obligations. We generally use the cost-to-cost measure of progress on a proportional
performance basis for our contracts because it best depicts the transfer of control to the customer which occurs as we incur costs on our contracts. Under the cost-to-cost measure of progress, the extent of progress towards completion is measured
based on the ratio of costs incurred to date to the total estimated costs at completion of the performance obligation. Revenues are recorded proportionally as costs are incurred. Due to the nature of the work required to be performed on certain of
our performance obligations, the estimation of total revenue and cost at completion is complex, subject to many variables and requires significant judgment. Contract estimates are based on various assumptions including labor and subcontractor costs,
materials and other direct costs and the complexity of the work to be performed. A significant change in one or more of these estimates could affect the profitability of our contracts. We review and update our contract-related estimates regularly and
recognize adjustments in estimated profit on contracts on a cumulative catch-up basis, which may result in an adjustment increasing or decreasing revenue to date on a contract in a particular period that the adjustment is identified. Revenue and
profit in future periods of contract performance are recognized using the adjusted estimate.
Revenue that is recognized at a point in time is for the sale of software licenses in our Information
Assurance / Xacta ® and Secure Communications business groups and for the sale of resold products in Telos ID and Secure Networks, and is classified as product revenue. Revenue on these contracts is recognized when the customer obtains
control of the transferred product or service, which is generally upon delivery of the product to the customer for their use, due to us maintaining control of the product until that point. Orders for the sale of software licenses may contain multiple
performance obligations, such as maintenance, training, or consulting services, which are typically delivered over time, consistent with the transfer of control disclosed above for the provision of services. When an order contains multiple
performance obligations, we allocate the transaction price to the performance obligations using our best estimate of standalone selling price.
Contracts are routinely and often modified to account for changes in contract requirements,
specifications, quantities, or price. Depending on the nature of the modification, we determine whether to account for the modification as an adjustment to the existing contract or as a new contract. Generally, modifications are not distinct from
the existing contract due to the significant interrelatedness of the performance obligations and are therefore accounted for as an adjustment to the existing contract, and recognized as a cumulative adjustment to revenue (as either an increase or
reduction of revenue) based on the modification’s effect on progress toward completion of a performance obligation.
Our contracts may include various types of variable consideration, such as claims (for instance,
indirect rate or other equitable adjustments) or incentive fees. We include estimated amounts in the transaction price based on all of the information available to us, including historical information and future estimations, and to the extent it is
probable that a significant reversal of cumulative revenue recognized will not occur when any uncertainty associated with the variable consideration is resolved. We have revised and re-submitted several years of incurred cost submissions reflecting
certain indirect rate structure changes as a result of regular Defense Contract Audit Agency (“DCAA”) audits of incurred cost submissions. This resulted in signed final rate agreement letters for fiscal years 2011 to 2013 and conformed incurred cost
submissions for 2014 to 2015. We evaluated the resulting changes to revenue under the applicable cost plus fixed fee contracts for the years 2011 to 2015 as variable consideration, and determined the most likely amount to which we expect to be
entitled, to the extent that no constraint exists that would preclude recognizing this revenue or result in a significant reversal of cumulative revenue recognized. We included these estimated amounts of variable consideration in the transaction
price and as performance on these contracts is complete, we have recognized revenue of $6.0 million during the year ended December 31, 2018.
Historically, most of our contracts do not include award or incentive fees. For incentive fees, we would
include such fees in the transaction price to the extent we could reasonably estimate the amount of the fee. With limited historical experience, we have not included any revenue related to incentive fees in our estimated transaction prices. We may
include in our contract estimates additional revenue for submitted contract modifications or claims against the customer when we believe we have an enforceable right to the modification or claim, the amount can be estimated reliably and its
realization is probable. We consider the contractual/legal basis for the claim (in particular FAR provisions), the facts and circumstances around any additional costs incurred, the reasonableness of those costs and the objective evidence available to
support such claims.
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For our contracts that have an original duration of one year or less, we use the practical expedient
applicable to such contracts and do not consider the time value of money. We capitalize sales commissions related to proprietary software and related services that are directly tied to sales. We do not elect the practical expedient to expense as
incurred the incremental costs of obtaining a contract if the amortization period would have been one year or less. For the sales commissions that are capitalized, we amortize the asset over the expected customer life, which is based on recent and
historical data.
Contract assets are amounts that are invoiced as work progresses in accordance with agreed-upon
contractual terms, either at periodic intervals or upon achievement of contractual milestones. Generally, revenue recognition occurs before billing, resulting in contract assets. These contract assets are referred to as unbilled receivables and are
reported within accounts receivable, net of reserve on our consolidated balance sheets.
Billed receivables are amounts billed and due from our customers and are reported within accounts
receivable, net of reserve on the consolidated balance sheets. The portion of the payments retained by the customer until final contract settlement is not considered a significant financing component due to the intent of the retainage being the
customer’s protection with respect to full and final performance under the contract.
Contract liabilities are payments received in advance and milestone payments from our customers on
selected contracts that exceed revenue earned to date, resulting in contract liabilities. Contract liabilities typically are not considered a significant financing component because they are generally satisfied within one year and are used to meet
working capital demands that can be higher in the early stages of a contract. Contract liabilities are reported on our consolidated balance sheets on a net contract basis at the end of each reporting period.
We have one reportable segment. We treat sales to U.S. customers as sales within the U.S. regardless of
where the services are performed. Substantially all of our revenues are from U.S. customers as revenue derived from international customers is de minimus. The following tables disclose revenue (in thousands) by customer type and contract type for the
periods presented. Prior period amounts have not been adjusted under the modified retrospective method.
2020
2019
2018
Federal
$
171,677
$
149,257
$
129,279
State & Local, and Commercial
8,240
9,961
8,737
Total
$
179,917
$
159,218
$
138,016
2019
2019
2018
Firm fixed-price
$
151,703
$
131,629
$
103,454
Time-and-materials
13,455
14,569
16,795
Cost plus fixed fee
14,759
13,020
17,767
Total
$
179,917
$
159,218
$
138,016
The following table discloses accounts receivable and contract assets (in thousands):
December 31,
2020
2019
Billed accounts receivable
$
12,060
$
11,917
Unbilled receivables
19,161
16,745
Allowance for doubtful accounts
(308
)
(720
)
Receivables – net
$
30,913
$
27,942
As of December 31, 2020 and 2019, we had $127.7 million and $112.4 million of remaining performance
obligations, respectively, which we also refer to as funded backlog. We expect to recognize approximately 92.4% of our remaining performance obligations as revenue in 2021, an additional 2.5% by 2022 and the balance thereafter. For the years ended
December 31, 2020, 2019, and 2018, the amount of revenue recognized during the year that was included in the opening contract liabilities balance was $5.3 million, $4.2 million, and $5.5 million, respectively. Contract liabilities were $5.7 million
and $6.3 million as of December 31, 2020 and 2019, respectively.
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We develop our annual budgeted revenue by estimating for the upcoming year our continuing business from
existing customers and active contracts. We consider backlog, both funded and unfunded (as explained below), other expected annual renewals, and expansion planned by our current customers. In the context of our current customer portfolio, we view
“recurring revenue” as revenue that occurs often and repeatedly. In each of the last three years, recurring revenue has exceeded 85% of our annual revenue. Our total budgeted revenue is the combination of recurring revenue and a forecast of new
business.
Total backlog, a component of recurring revenue, consists of the aggregate contract revenues remaining
to be earned by us at a given time over the life of our contracts, whether funded or unfunded. Funded backlog consists of the aggregate contract revenues remaining to be earned at a given time, which, in the case of U.S. government contracts, means
that they have been funded by the procuring agency. Unfunded backlog is the difference between total backlog and funded backlog and includes potential revenues that may be earned if customers exercise delivery orders and/or renewal options to
continue these contracts. Based on historical experience, we generally assume option year renewals to be exercised. Most of our customers fund contracts on a basis of one year or less and, as a result, funded backlog is generally expected to be
earned within one year from any point in time, whereas unfunded backlog is expected to be earned over a longer period.
Inventories
Inventories are stated at the lower of cost or net realizable value, where cost is determined primarily
using the weighted average cost method. Inventories consist primarily of purchased off-the-shelf hardware and software, and component computer parts used in connection with system integration services that we perform. Inventories also include spare
parts utilized to support certain maintenance contracts. Spare parts inventory is amortized on a straight-line basis over two to five years, which represents the shorter of the warranty period or estimated useful life of the asset. An allowance for
obsolete, slow-moving or non-salable inventory is provided for all other inventory. This allowance is based on our overall obsolescence experience and our assessment of future inventory requirements.
Goodwill
We evaluate the impairment of goodwill in accordance with ASC 350, “Intangibles – Goodwill and Other,”
which requires goodwill and indefinite-lived intangible assets to be assessed on at least an annual basis for impairment using a fair value basis. Between annual evaluations, if events occur or circumstances change that would more likely than not
reduce the fair value of the reporting unit below its carrying amount, then impairment must be evaluated. Such circumstances could include, but are not limited to: (1) a significant adverse change in legal factors or business climate, or (2) a loss
of key contracts or customers.
As the result of an acquisition, we record any excess purchase price over the net tangible and
identifiable intangible assets acquired as goodwill. An allocation of the purchase price to tangible and intangible net assets acquired is based upon our valuation of the acquired assets. Goodwill is not amortized, but is subject to annual impairment
tests. We complete our goodwill impairment tests as of December 31st each year. Additionally, we make evaluations between annual tests if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit
below its carrying amount. The evaluation is based on the estimation of the fair values of our three reporting units, CO&D (comprised of Information Assurance / Xacta and Secure Networks), Telos ID, and Secure Communications, of which goodwill is
housed in the CO&D reporting unit, in comparison to the reporting unit’s net asset carrying values. Our discounted cash flows required management’s judgment with respect to forecasted revenue streams and operating margins, capital expenditures
and the selection and use of an appropriate discount rate. We utilized the weighted average cost of capital as derived by certain assumptions specific to our facts and circumstances as the discount rate. The net assets attributable to the reporting
units are determined based upon the estimated assets and liabilities attributable to the reporting units in deriving its free cash flows. In addition, the estimate of the total fair value of our reporting units is compared to the market
capitalization of the Company. The Company’s assessment resulted in a fair value that was greater than the Company’s carrying value, therefore the second step of the impairment test, as prescribed by the authoritative literature, was not required to
be performed and no impairment of goodwill was recorded as of December 31, 2020. Subsequent reviews may result in future periodic impairments that could have a material adverse effect on the results of operations in the period recognized. Recent
operating results have reduced the projection of future cash flow growth potential, which indicates that certain negative potential events, such as a material loss or losses on contracts, or failure to achieve projected growth could result in
impairment in the future. We estimate the fair value of our reporting unit and compare the valuation with the respective carrying value for the reporting unit to determine whether any goodwill impairment exists. If we determine through the impairment
review process that goodwill is impaired, we will record an impairment charge in our consolidated statements of operations. Goodwill is amortized and deducted over a 15-year period for tax purposes.
Income Taxes
We account for income taxes in accordance with ASC 740, “Income Taxes.” Under ASC 740, deferred tax
assets and liabilities are recognized for the estimated future tax consequences of temporary differences and income tax credits. Deferred tax assets and liabilities are measured by applying enacted statutory tax rates that are applicable to the
future years in which deferred tax assets or liabilities are expected to be settled or realized for differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Any change in tax rates on deferred
tax assets and liabilities is recognized in net income in the period in which the tax rate change is enacted. We record a valuation allowance that reduces deferred tax assets when it is "more likely than not" that deferred tax assets will not be
realized. We are required to establish a valuation allowance for deferred tax assets if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based on
available evidence, realization of deferred tax assets is dependent upon the generation of future taxable income. We considered projected future taxable income, tax planning strategies, and reversal of taxable temporary differences in making this
assessment. As such, we have determined that a full valuation allowance is required as of December 31, 2020 and 2019. As a result of a full valuation allowance against our deferred tax assets, a deferred tax liability related to goodwill remained on
our consolidated balance sheet at December 31, 2020 and 2019. Due to the tax reform enacted on December 22, 2017, net operating losses generated in taxable years beginning after December 31, 2017 will have an indefinite carryforward period, which
will be available to offset future taxable income created by the reversal of temporary taxable differences related to goodwill. As a result, we have adjusted the valuation allowance on our deferred tax assets and liabilities at December 31, 2020 and
2019. See additional information on tax reform and its impact on our income taxes in Note 9 – Income Taxes.
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Results of Operations
We derive a substantial portion of our revenues from contracts and subcontracts with the U.S.
Government. Our revenues are generated from a number of contract vehicles and task orders. Over the past several years we have sought to diversify and improve our operating margins through an evolution of our business from an emphasis on product
reselling to that of an advanced solutions technologies provider. To that end, although we continue to offer resold products through our contract vehicles, we have focused on selling solutions and outsourcing product sales, as well as designing and
delivering Telos manufactured and branded technologies. We believe our contract portfolio is characterized as having low to moderate financial risk due to the limited number of long-term fixed price development contracts. Our firm fixed-price
activities consist principally of contracts for the products and services at established contract prices. Our time-and-material contracts generally allow the pass-through of allowable costs plus a profit margin. For 2020, 2019, and 2018, the
Company’s revenue derived from firm fixed-price contracts was 84.3%, 82.7%, and 74.9%, respectively, cost-plus contracts was 8.2%, 8.2%, and 12.9%, respectively, and time-and-material contracts was 7.5%, 9.1%, and 12.2%, respectively.
We provide different solutions and are party to contracts of varying revenue types under the NETCENTS
(Network-Centric Solutions) and NETCENTS-2 contracts to the U.S. Air Force. NETCENTS and NETCENTS-2 are IDIQ and GWAC, therefore any government customer may utilize the NETCENTS and NETCENTS-2 vehicles to meet its purchasing needs. Consequently,
revenue earned on the underlying NETCENTS and NETCENTS-2 delivery orders varies from period to period according to the customer and solution mix for the products and services delivered during a particular period, unlike a standalone contract with one
separately identified customer. The contracts themselves do not fund any orders and they state that the contracts are for an indefinite delivery and indefinite quantity. The majority of our task/delivery orders have periods of performance of less
than 12 months, which contributes to the variances between interim and annual reporting periods. We have also been awarded other IDIQ/GWACs, including the Department of Homeland Security’s EAGLE II, GSA Alliant 2, and blanket purchase agreements
under our GSA schedule.
We refer to our cyber and cloud applications as Security Solutions, which includes Information Assurance
/Xacta® (previously referred to as Cyber & Cloud Solutions), Secure Communications (previously referred to as Secure Communications Cyber and Enterprise Solutions), and Telos ID (previously referred to as Telos ID Enterprise Solutions). We refer
to our offerings for enterprise security as Secure Networks (previously referred to as Secure Mobility and Network Management/Defense Enterprise Solutions).
U.S. Government appropriations have been and continue to be affected by larger U.S. Government budgetary
issues and related legislation. In 2011, Congress enacted the Budget Control Act of 2011 (the “BCA”), which established specific limits on annual appropriations for fiscal years 2012-2021. These limits were subsequently amended several times. With
the expiration of the BCA at the end of FY 2021, there are no statutory limits in place for FY 2022.
According to the non-partisan Congressional Budget Office (CBO), since enactment of the BCA, federal
outlays devoted to defense programs fell from 4.5 percent as a share of Gross Domestic Product (GDP) to as low as 3.1 percent of GDP in each of FYs 2016-18, before rising slightly the past two years to a level of 3.4 percent in FY 2020. Moreover, CBO
reports that, as a result of the spending caps imposed by the BCA, non-adjusted defense outlays subsequently shrank from $699.4 billion in FY 2011 to as low as $583.4 billion in FY 2016, and did not again exceed their FY 2011 level until FY 2020,
when outlays were $713.8 billion, two percent above the FY 2011 level.
In Fiscal Years 2020 and 2021, the COVID-19 pandemic and associated economic dislocation in the United
States has resulted in an overwhelming federal response, including enactment of several massive and comprehensive emergency appropriations and economic stimulus measures. These were in addition to annual appropriations legislation for FY 2021, which
was not enacted into law until late December, 2020, nearly three months after the beginning of the fiscal year, during which time the government once again operated under a series of Continuing Resolutions which strictly limited new spending
initiatives. These enormous emergency spending packages and their resulting increases in the budget deficit will necessarily factor into future spending decisions to an unknown degree. Further, as the outgoing Trump Administration did not complete
its work on a proposed FY 2022 budget prior to leaving office on January 20, 2021, and the incoming Biden Administration has been delayed in submitting a proposed budget to Congress, the proposed spending levels for FY 2022 cannot be predicted.
Finally, the near- and long-term impacts of the COVID-19 health and associated economic crisis on federal budget planning and the government contracts that we hold, and on the federal procurements that we would otherwise compete for, cannot be known.
Should Congress and the White House be unable to make sufficient progress on the FY 2022 budget and
enact appropriations legislation prior to the beginning of the new fiscal year on October 1, 2021, the Department of Defense and other federal departments and agencies will likely again be funded for an unknown period of time under a Continuing
Resolution, which would restrict new spending initiatives.
Despite the pandemic’s resultant shift to teleworking by federal employees and contractors, the
government has successfully maintained continuity of services as has Telos Corporation. With much of the business of government continuing to be conducted remotely through use of information technology systems, we believe there will continue to be a
need on the part of the government for the types of solutions and services provided by Telos.
For more information on the risks and uncertainties related to U.S. Government contracts, see Part I –
Item 1A Risk Factors in this Annual Report on the Form 10-K.
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Statement of Operations Data
The following table sets forth certain consolidated financial data and related percentages for the
periods indicated:
Years Ended December 31,
2020
2019
2018
(dollar amounts in thousands)
Revenue
$
179,917
100.0
%
$
159,218
100.0
%
$
138,016
100.0
%
Cost of sales
117,497
65.3
106,874
67.1
84,954
61.6
Selling, general and administrative expenses
62,123
34.5
47,319
29.7
44,048
31.9
Operating income
297
0.2
5,025
3.2
9,014
6.5
Other income (expenses):
Gain on redemption of public preferred stock
14,012
7.8
----
----
----
----
Non-operating (expense) income
(255
)
(0.2
)
201
0.1
12
----
Interest expense
(7,259
)
(4.0
)
(7,467
)
(4.7
)
(7,258
)
(5.2
)
Income (loss) income before income taxes
6,795
3.8
(2,241
)
(1.4
)
1,768
1.3
Benefit from (provision for) income taxes
46
----
104
0.1
(31
)
----
Net income (loss)
6,841
3.8
(2,137
)
(1.3
)
1,737
1.3
Less: Net income attributable to non-controlling interest
(5,154
)
(2.9
)
(4,264
)
(2.7
)
(3,377
)
(2.4
)
Net income (loss) attributable to Telos Corporation
$
1,687
0.9
%
$
(6,401
)
(4.0
)%
$
(1,640
)
(1.1
)%
Years ended December 31, 2020, 2019, and 2018
Revenue. Revenue
increased by 13.0% to $179.9 million for 2020 from $159.2 million for 2019. Security Solutions revenue was $117.3 million and $101.9 million for 2020 and 2019, respectively. This increase in 2020 of approximately 15% was driven primarily by an
increase of $8.1 million in sales of offerings in Telos ID on the contract with the U.S. Census Bureau and $7.3 million in sales of offerings related to the contract with a U.S. government agency for our Telos Ghost managed intelligence support
solution in Secure Communications. Secure Networks revenue was $62.6 million and $57.3 million for 2020 and 2019, respectively. This increase in 2020 of approximately 9% resulted from various DoD contracts, in both our Secure Mobility and Network
Management/Defense Enterprise Solutions offerings. Due to the various solutions offerings and within the business groups, sales may vary from period to period according to the solution mix and timing of deliverables for a particular period.
Revenue increased by 15.4% to $159.2 million for 2019 from $138.0 million for 2018. Such increase primarily consists of an
increase in sales from the U.S. Air Force NETCENTS-2 contract. As discussed above, NETCENTS-2 is an IDIQ contract utilized by multiple government customers and sales under NETCENTS-2 vary from period to period according to the solution mix and timing
of deliverables for a particular period. Security Solutions revenue was $101.9 million and $86.6 million in 2019 and 2018, respectively. This increase in 2019 of approximately 18% is primarily attributable to a $10.1 million increase in sales of
offerings in Telos ID on a contract with the U.S. Census Bureau and a $6.3 million increase in sales of offerings related to a contract with a U.S. government agency for our Telos Ghost managed intelligence support solution in Secure Communications.
Secure Networks revenue was $57.3 million in 2019 and $51.4 million in 2018. The sales increase in 2019 is the result of various DoD contracts around our Secure Mobility as well as our Network Management and Defense offerings.
Cost of sales. Cost
of sales increased by 9.9% to $117.5 million for 2020 from $106.9 million for 2019 as a result of increases in revenue. Cost of sales for Security Solutions increased to $66.9 million in 2020 from $59.9 million in 2019 which translates as a decrease
in the cost of sales as a percentage of revenue to 57.0% from 58.7%. due to a change in the mix and nature of the programs. Cost of sales for Secure Networks increased to $50.6 million in 2020 from $47.0 million in 2019 which translates as a decrease
in the cost of sales as a percentage of revenue to 80.9% from 82.0%.
Cost of sales increased by 25.8% to $106.9 million for 2019 from $85.0 million for 2018 as a result of
increases in revenue. Cost of sales for Security Solutions increased to $59.9 million in 2019 from $48.2 million in 2018 which translates as a increase in the cost of sales as a percentage of revenue to 58.7% from 55.7%. due to a change in the mix
and nature of the programs. Cost of sales for Secure Networks increased to $47.0 million in 2019 from $36.7 million in 2018 which translates as an increase in the cost of sales as a percentage of revenue to 82.0% from 71.5% due primarily to the
effect of revenue accruals in 2018 for multiple contracts as a result of several years of cumulative indirect rate adjustments, which did not include direct costs.
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Gross
profit . Gross profit increased by 19.2% to $62.4 million for 2020 from $52.3 million for 2019. Gross profit for Security Solutions increased to $50.5 million in 2020 from $42.1 million in 2019. Gross profit for Secure Networks increased to
$12.0 million in 2020 from $10.3 million in 2019. Gross margin increased to 34.7% for 2020 from 32.9% for 2019, due to various changes in the mix of contracts in all business lines as discussed above. Gross margin for Security Solutions increased to
43.0% in 2020 from 41.3% in 2019. Gross margin for Secure Networks increased to 19.1% in 2020 from 18% in 2019.
Gross profit decreased by 1.4% to $52.3 million for 2019 from $53.1 million for 2018. Gross profit for
Security Solutions increased to $42.1 million in 2019 from $38.4 million in 2018. Gross profit for Secure Networks decreased to $10.3 million in 2019 from $14.6 million in 2018, due primarily to the effect of revenue accruals in 2018 for multiple
contracts as a result of several years of cumulative indirect rate adjustments, which did not include direct costs. Gross margin decreased to 32.9% for 2019 from 38.4% for 2018, due to various changes in the mix of contracts in all business lines,
primarily decreases in proprietary software sales. Gross margin for Security Solutions decreased to 41.3% in 2019 from 44.3% in 2018. Gross margin for Secure Networks decreased to 18% in 2019 from 28.5% in 2018.
Selling,
general, and administrative expenses . Selling, general, and administrative expenses increased by 31.3% to $62.1 million for 2020 from $47.3 million for 2019. Such increase is primarily attributable to increases in bonuses of $6.3 million,
outside services of $5.9 million, labor costs of $5.9 million, and $0.6 million in legal fees, offset by capitalization of research and development costs of $4.2 million.
Selling, general, and administrative expenses increased by 7.4% to $47.3 million for 2019 from $44.0
million for 2018. Such increase is primarily attributable to increases in labor costs of $1.9 million, bonuses of $0.5 million, bad debt expenses of $0.5 million, and outside services of $0.4 million.
Interest
expense. Interest expense decreased by 2.8% to $7.3 million for 2020 from $7.5 million for 2019, primarily due to decreases in public preferred stock interest as a result of such stock redemption, and interest on an equipment purchase
arrangement, offset by an increase in interest on the senior term loan with EnCap (as defined below).
Interest expense increased by 2.9% to $7.5 million for 2019 from $7.3 million for 2018, primarily due to
an increase in interest on the EnCap senior term loan, offset by a decrease in interest on an equipment purchase arrangement.
Components of interest expense are as follows:
December 31,
2020
2019
2018
(amounts in thousands)
Commercial and subordinated note interest incurred
$
3,875
$
3,644
$
3,436
Preferred stock interest accrued
3,384
3,823
3,822
Total
$
7,259
$
7,467
$
7,258
Provision
for income taxes . Income tax benefit was $46,000 for 2020, compared to an income tax provision of $104,000 for 2019, primarily attributable to administrative practice release of certain FIN48 liability.
Income tax benefit was $104,000 for 2019, compared to an income tax provision of $31,000 for 2018,
primarily attributable to the decrease in deferred tax liability due to the timing of the state conformity to the indefinite-lived net operating loss provision of the Tax Act (as described below).
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Table of Contents
Non-GAAP Financial Measures
In addition to our results determined in accordance with GAAP, we believe the non-GAAP financial
measures of Non-GAAP Operating Income, Enterprise EBITDA and Adjusted EBITDA are useful in evaluating our operating performance. We believe that this non-GAAP financial information, when taken collectively with our GAAP results, may be helpful to
readers of our financial statements because it provides consistency and comparability with past financial performance and assists in comparisons with other companies, some of which use similar non-GAAP financial information to supplement their GAAP
results. The non-GAAP financial information is presented for supplemental informational purposes only, should not be considered a substitute for financial information presented in accordance with GAAP, and may be different from similarly-titled
non-GAAP measures used by other companies. A reconciliation is provided below for each of these non-GAAP financial measures to the most directly comparable financial measure stated in accordance with GAAP.
We use the following non-GAAP financial measures to understand and evaluate our core operating
performance and trends, to prepare and approve our annual budget, to develop short-term and long-term operating plans, and to evaluate the performance of certain management personnel when determining incentive compensation. We believe these non-GAAP
financial measures facilitate comparison of our operating performance on a consistent basis between periods by excluding certain items that may, or could, have a disproportionate positive or negative impact on our results of operations in any
particular period. When viewed in combination with our results prepared in accordance with GAAP, these non-GAAP financial measures help provide a broader picture of factors and trends affecting our results of operations.
Enterprise EBITDA and Adjusted EBITDA
Both Enterprise EBITDA and Adjusted EBITDA are supplemental measures of operating performance that are
not made under GAAP and that does not represent, and should not be considered as, an alternative to net income (loss) as determined by GAAP. We define Enterprise EBITDA as net income (loss) attributable to Telos Corporation, adjusted for net income
attributable to non-controlling interest, non-operating income, interest expense, (benefit) provision for income taxes, and depreciation and amortization. We define Adjusted EBITDA as Enterprise EBITDA, adjusted for stock-based compensation expense,
the gain realized on redemption of the public preferred stock upon the closing of our initial public offering, the losses realized on the extinguishment of senior term loan and subordinated debt upon the closing of our initial public offering,
bonuses paid as a result of the closing of our initial public offering, and other expenses related to our initial public offering.
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A reconciliation of Enterprise EBITDA and Adjusted EBITDA to net income (loss) attributable to Telos
Corporation, the most directly comparable GAAP measure, is as follows:
Years Ended December 31,
2020
2019
2018
(amount in thousands)
Net income (loss) attributable to Telos Corporation
$
1,687
$
(6,401
)
$
(1,640
)
Net income attributable to non-controlling interest
5,154
4,264
3,377
Non-operating income
(20
)
(201
)
(12
)
Interest expense
7,259
7,467
7,258
(Benefit) provision for income taxes
(46
)
(104
)
31
Depreciation and amortization
5,353
4,972
3,028
Enterprise EBITDA
19,387
9,997
12,042
Transaction related gains/losses/expenses:
Transaction related legal and accounting
1,914
----
----
Transaction related bonus
3,816
----
----
Gain on redemption of public preferred stock
(14,012
)
----
----
Transaction related non-operating income
(274
)
----
----
Loss on extinguishment of senior term loan
138
----
----
Loss on extinguishment of subordinated debt
411
----
----
Stock-based compensation expense
----
----
----
Total transaction related gains/losses/expenses
(8,007
)
----
----
Stock-based compensation expense
4
----
----
Adjusted EBITDA
$
11,384
$
9,997
$
12,042
Each of Enterprise EBITDA and Adjusted EBITDA has limitations as an analytical tool, and you should not
consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. Among other limitations, each of Enterprise EBITDA and Adjusted EBITDA 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 differently than we do, which limits its usefulness as a comparative measure. Because of these limitations, neither Enterprise EBITDA nor Adjusted EBITDA should be considered as a replacement for net income
(loss), 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.
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Table of Contents
Liquidity and Capital Resources
Upon the closing of our initial public offering, 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 7 – Exchangeable Redeemable Preferred Stock Conversion),
$30.0 million to fund our acquisition of the outstanding Class B Units of Telos ID (see Note 2 – Purchase of Telos ID/Non-controlling Interests), $21.0 million to repay our outstanding senior term loan and subordinated debt (see Note 6 – Debt
Obligations). We intend to use the remaining net proceeds for general corporate purposes. We also may use a portion of the net proceeds to acquire complementary businesses, products, services, or technologies. However, we do not have agreements,
commitments, or plans for any specific acquisitions at this time. The amounts and timing of our actual use of the net proceeds will vary depending on numerous factors. Proceeds held by us are invested in short-term investments until needed for the
uses described above. We currently anticipate that we will retain all available funds for use in the operation and expansion of our business, and we do not anticipate paying any cash dividends on our common stock in the foreseeable future.
Our working capital was $105.2 million and $2.9 million as of December 31, 2020 and 2019, respectively.
Although no assurances can be given, we expect that funds generated from operations are sufficient to maintain the liquidity we require to meet our operating, investing and financing needs for the next 12 months.
Cash used in operating activities was $2.1 million for the year ended December 31, 2020, compared to
cash provided by operating activities of $11.8 million and $6.3 million, for the years ended December 31, 2019 and 2018, respectively. Cash provided by operating activities is primarily driven by our operating income, the timing of receipt 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. Additionally, cash used in operating activities
also includes dividends from preferred stock recorded as interest expense of $3.4 million, $3.8 million, and $3.8 million for 2020, 2019, and 2018, respectively. In 2020, net income was $6.8 million, $14.0 million of gain related to the redemption of
public preferred stock, and $5.4 million of depreciation and amortization, $1.7 million of which was amortization of capitalized software development costs. In 2019, net loss was $2.1 million, which included $5.0 million of depreciation and
amortization, $1.8 million of which was amortization of capitalized software development costs. In 2018, net income was $1.7 million, which included $3.0 million of depreciation and amortization, $1.1 million of which was amortization of capitalized
software development costs.
Cash used in investing activities for the years ended December 31, 2020, 2019, and
2018 was $7.5 million, $6.5 million, and $4.1 million, respectively, which, for the year ended December 31, 2020, 2019 and 2018, consisted of the capitalization of software development costs of $6.7 million, $2.4 million and $1.6 million,
respectively, and the purchases of property and equipment of $0.8 million, $4.1 million and $2.5 million, respectively.
Cash provided by financing activities for the years ended December 31, 2020 and 2019
was $108.9 million and $1.4 million, respectively, compared to cash used in financing activities $2.7 million for 2018. The financing activities in 2020 consisted of net proceeds of $272.8 million from the initial public offering, offset by $108.9
million redemption of the public preferred stock, $17.4 million payoff of senior term loan, $30.0 million purchase of Telos ID membership interest, distributions of $2.7 million to the Class B Member of Telos ID, $3.7 million payoff of subordinated
debt, and repayments of $1.2 million under finance leases. The financing activities in 2019 consisted of net proceeds of $4.9 million from the EnCap senior term loan, distributions of $2.4 million to the Class B Member of Telos ID, and repayments of
$1.1 million under finance leases. The financing activities in 2018 consisted of distributions of $1.7 million to the Class B Member of Telos ID and repayments of $1.0 million under finance leases.
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Table of Contents
Contractual Obligations
The following summarizes our contractual obligations and our redeemable preferred stock at December
31, 2020 (in thousands):
Payments due by Period
Total
2021
2022 - 2024
2025 - 2027
2028 and later
Finance lease obligations (1)
$
19,364
$
2,097
$
6,609
$
7,117
$
3,541
Operating lease obligations (2)
1,744
752
992
----
----
$
21,108
$
2,849
$
7,601
$
7,117
$
3,541
(1) Includes interest expense:
$
3,724
$
758
$
1 ,826
$
1,009
$
131
(2) Includes operating lease right-of-use obligations and short-term leases with terms of 12 months or less.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements (as defined in Item 303, paragraph (a)(4)(ii) of Regulation S-K) that have or are
reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, sales or expenses, results of operations, liquidity, capital expenditures or capital resources.
Capital Expenditures
Capital expenditures for property and equipment were $0.8 million, $4.1 million, and $2.5 million for
2020, 2019, and 2018, respectively. We presently anticipate capital expenditures of approximately $5.2 million in 2021; however, there can be no assurance that this level of capital expenditures will occur. We believe that available cash and
borrowings under the Purchase Agreement will be sufficient to generate adequate amounts of cash to fund our projected capital expenditures for 2021.
Leases and Related Obligations
We have various lease agreements for property and equipment that, pursuant to ASC 840, “Leases,”
require us to record the present value of the minimum lease payments for such equipment and property as an asset in our consolidated financial statements. Such assets are amortized on a straight-line basis over the term of the related lease or their
useful life, whichever is shorter.
We adopted ASU 2016-02
effective January 1, 2019 and recorded right-of-use assets and liabilities in our consolidated balance sheets and expanded disclosures about leasing arrangements, among other items, for most lease arrangements.
Inflation
The rate of inflation has been moderate over the past five years and, accordingly, has not had a
significant impact on the Company. We have generally been able to pass through any increased costs to customers through higher prices to the extent permitted by competitive pressures.
Recent Accounting Pronouncements
See Note 1 – Summary of Significant Accounting Policies of the Consolidated Financial Statements for
a discussion of recently issued accounting pronouncements.