TLS

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended September 30, 2002, for TELOS CORPORATION, a Maryland corporation. The Company operates primarily in two continuing segments: Products (government IT solutions) and Xacta (enterprise risk management). A third segment, Systems and Support Services (TCC), was sold on July 19, 2002, and is reported as a discontinued operation. As of October 1, 2002, the Company had no public market for its Common Stock.

Key Financial Metrics

Note: Net Income for the period includes a one-time gain of $10.9 million from the sale of the TCC subsidiary. Excluding this gain, the Company reported a loss from continuing operations.

Material Changes vs. Prior Period

• Revenue Decline: Sales for the nine months ended September 30, 2002, decreased by 16.3% ($12.4 million) compared to the same period in 2001. This was driven by a $11.4 million drop in the Products segment due to reduced government contract volume (e.g., IS-1, RAPIDS) and lower wireless product orders.
• Margin Compression: Gross margins collapsed from 22.7% in the prior year to 10.5% for the nine months of 2002. This was caused by lower sales volume, a shift to lower-margin products, and a $1.7 million inventory obsolescence charge recorded in September 2002.
• Operating Loss: The Company shifted from an operating income of $4.6 million in the prior year to an operating loss of $6.3 million for the nine-month period.
• Discontinued Operations: The sale of TCC generated a pre-tax gain of $10.9 million (adjusted to $13.2 million in Q4 2002 due to working capital adjustments), which significantly impacted net income figures.

Outlook, Risks, and Management Commentary

• Liquidity and Refinancing: The Company faced a liquidity crunch with only $72,000 in cash at period end. However, on October 21, 2002 (subsequent to the reporting period), Telos secured a new $22.5 million Senior Credit Facility maturing in 2005. Proceeds were used to retire $3 million of subordinated notes and pay down the old credit facility.
• Backlog: Funded backlog increased to $37.1 million. However, total backlog dropped significantly to $43.1 million from $830.0 million in 2001, primarily due to the divestiture of TCC, which held a massive potential backlog from the US Army CECOM contract.
• Preferred Stock Dividends: The Company has not declared dividends on its Senior Redeemable Preferred Stock or Public Preferred Stock since 1991. Cumulative undeclared dividends totaled approximately $36.4 million as of September 30, 2002.
• Risks: Key risks include heavy reliance on U.S. Government contracts (subject to termination), the ability to convert backlog to revenue, and the financial health of its investment in Enterworks (notes fully reserved). The Company also faces potential impairment of deferred tax assets if forecasted taxable income is not achieved.

Investor Verification Checklist

• Debt Covenants: Verify compliance with the new $22.5 million credit facility covenants (tangible net worth, operating earnings) to ensure no immediate default risk.
• Preferred Stock Obligations: Assess the impact of $36.4 million in accrued, undeclared preferred dividends on future cash flow and potential redemption requirements.
• Government Contract Stability: Confirm the status of key contracts (IS-1, RAPIDS, DCN) given the Company's high exposure to U.S. Government spending and potential post-9/11 reprioritization.
• Inventory Valuation: Review the $1.7 million inventory write-down to determine if further obsolescence charges are likely in future quarters.
• Enterworks Investment: Monitor the status of the Enterworks investment, as all notes receivable have been fully reserved due to the investee's losses.