Telos Corporation — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012. Telos provides IT solutions and services, principally to U.S. government customers, across Cyber Operations and Defense, Secure Communications, and Identity Management. The company reported one segment. Amounts below are in U.S. dollars; financial statement amounts are generally in millions.
Financial performance and position
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Revenue | $66.9 | $53.0 | $177.7 | $142.1 |
| Gross profit / margin | $14.9 / 22.3% | $11.7 / 22.1% | $43.6 / 24.5% | $34.9 / 24.6% |
| Operating income | $3.8 | $2.7 | $15.1 | $10.1 |
| Net income | $1.3 | $1.2 | $5.9 | $3.7 |
| Net income attributable to Telos | $0.5 | $0.1 | $4.3 | $2.0 |
Q3 services revenue rose to $47.4 million from $28.6 million, while product revenue fell to $19.5 million from $24.3 million. For the nine-month period, services revenue increased to $142.1 million from $94.0 million, while product revenue declined to $35.6 million from $48.1 million. Management attributed much of the growth to U.S. Air Force NETCENTS orders, particularly network solutions. Quarterly services margins improved, but product margins weakened; nine-month gross margin edged down year over year.
SG&A was $11.1 million in Q3 and $28.5 million year to date, with increases including legal costs, labor and performance-based bonuses. Nine-month interest expense was $5.1 million, up from $4.6 million; income tax expense was $4.6 million, up from $2.2 million. Management said preferred-stock noncash interest materially affects the estimated tax rate.
Cash flow and liquidity: Operating cash flow for the first nine months was $19.4 million, versus $11.1 million a year earlier. Investing used $0.3 million, compared with $8.5 million in 2011, when the IT Logistics acquisition occurred. Financing used $19.1 million, primarily for preferred-stock redemptions, debt repayments and Telos ID distributions. Cash was $0.2 million at September 30; working capital was $9.7 million, down from $15.2 million at year-end 2011. The company reported $16.0 million of unused availability under its asset-based credit facility.
Debt and capital structure: Total assets were $83.8 million and total liabilities $183.5 million; stockholders’ deficit was $99.7 million. Management reported $138.7 million of debt and long-term obligations, including redeemable preferred stock treated as liabilities. The balance sheet carried $111.5 million of public preferred stock and $4.0 million of senior redeemable preferred stock. Facility borrowings were reported as $6.9 million outstanding, with a 4.25% stated rate at quarter-end and maturity in May 2014. The IT Logistics subordinated note had a $12.5 million carrying value and begins accruing 6% interest November 1, 2012.
Material changes versus the prior comparable period
- Revenue rose 26.3% in Q3 and 25.0% for the first nine months, mainly reflecting increased NETCENTS-related services work.
- Operating income increased 41.7% in Q3 and 49.8% year to date. Telos-attributable net income also increased, though Q3 remained modest at $0.5 million.
- Facility borrowings fell from $17.9 million at December 31, 2011 to $6.9 million at September 30, 2012; unused availability increased from $5.3 million to $16.0 million.
- Senior redeemable preferred stock was reduced through $4.0 million of redemptions during 2012. The accumulated undeclared dividends on that class were $2.9 million at September 30, down from $6.0 million at year-end.
- Total backlog was $591.2 million, down from $636.8 million a year earlier and $609.6 million at December 31, 2011. Funded backlog was $105.5 million, versus $174.7 million a year earlier.
Outlook, risks, contingencies and unusual items
- No numerical earnings or revenue guidance was provided. Management believes cash and facility availability should be sufficient for operating needs, debt service and projected capital expenditures for the foreseeable future, and anticipates continued need for a similar credit facility.
- Liquidity depends heavily on the Wells Fargo facility, whose borrowing base fluctuates with eligible receivables and other collateral. It is secured by substantially all company assets and includes financial covenants; Telos reported compliance at quarter-end. The facility restricts dividends and stock redemptions.
- Public preferred stock carries a cumulative 12% dividend and senior redeemable preferred stock a cumulative 14.125% dividend. Dividends and scheduled redemptions have not been paid as originally scheduled; the company classifies the preferred obligations as noncurrent liabilities. Public preferred stock carrying value includes substantial accrued dividends, and the capital structure is highly leveraged relative to reported assets.
- Backlog includes unfunded orders; the filing notes that government task-order timing, customer mix and delivery schedules can cause significant period-to-period variation. Management said revenue mix changes were not then indicative of a trend.
- Two shareholder-related matters remain material litigation risks. A Maryland appellate court remanded the Costa Brava matter for further proceedings; Telos petitioned for review. The Hamot litigation had trial scheduled to begin December 3, 2012. Management said other ordinary-course litigation was not expected to materially adversely affect the company, based on information available.
- Other notable matters include the $0.4 million gain on redemption of senior preferred stock during the first nine months, the IT Logistics note accretion, and post-quarter revised executive employment agreements that provide specified change-in-control payments.
Investor verification priorities
- Review NETCENTS order concentration, future task-order awards, and the conversion of total and funded backlog into revenue and cash.
- Confirm borrowing-base availability, covenant compliance, facility renewal or refinancing plans before its May 2014 maturity, and the impact of slower collections or collateral requirements.
- Reconcile the full preferred-stock obligations, accrued dividends, redemption restrictions and payment priority with the company’s reported $99.7 million stockholders’ deficit.
- Assess the status and potential financial consequences of the Costa Brava and Hamot litigation and the change-in-control obligations in executive agreements.
- Track services and product gross margins, SG&A growth, tax expense and the cash-versus-noncash components of interest expense.