Business context and reporting period
Telos Corporation’s Form 10-K covers the fiscal year ended December 31, 2016. Telos provides cybersecurity, secure mobility, identity-management, and IT solutions, primarily to U.S. government customers. Federal customers generated 96.7% of 2016 revenue. The company reported one operating segment and no public market for its common stock.
Financial performance
| Metric | 2016 | 2015 |
|---|---|---|
| Revenue | $134.9 million | $120.6 million |
| Gross profit / margin | $43.4 million / 32.2% | $30.7 million / 25.4% |
| Operating income (loss) / margin | $2.1 million / 1.6% | $(3.6) million / (3.0)% |
| Net loss, consolidated | $(3.7) million | $(13.5) million |
| Net loss attributable to Telos Corporation | $(7.2) million | $(15.9) million |
| Cash from operating activities | $13.9 million | $2.7 million |
| Cash and cash equivalents at year-end | $0.7 million | $0.1 million |
Revenue increased 11.8%, largely from higher sales under the U.S. Air Force NETCENTS-2 contract. Services revenue rose 15.6% to $112.9 million; product revenue fell 4.3% to $22.0 million. Gross margin improved mainly because of contract and solution mix, including greater Cyber Security sales. SG&A rose 20.5% to $41.3 million, including higher bonuses and labor costs. Interest expense was $5.5 million, including $3.9 million of accrued preferred-stock dividends.
At December 31, 2016, total assets were $56.8 million, total liabilities were $186.8 million, and stockholders’ deficit was $130.0 million. Current assets of $25.0 million were below current liabilities of $33.6 million, producing negative working capital of $8.6 million. Capital-lease obligations were $19.9 million; subordinated debt of $3.0 million was classified as short-term and due July 1, 2017. Public and senior redeemable preferred-stock carrying amounts totaled approximately $129.8 million.
2016 quarterly revenue was $26.1 million in the December quarter, versus $26.9 million a year earlier. The December-quarter loss attributable to Telos was $4.3 million, compared with $9.4 million in the prior-year quarter.
Material changes versus prior periods
- Revenue rose from $120.6 million in 2015, reversing part of the decline from $127.6 million in 2014. Management attributed the 2016 improvement primarily to NETCENTS-2 orders after the replacement contract opened for new orders in May 2015.
- Gross margin increased to 32.2% from 25.4% in 2015 and 19.6% in 2014. Operating results turned positive, although the company continued to report a net loss.
- Operating cash flow increased to $13.9 million from $2.7 million. Management attributed cash generation to operations and the timing of collections, vendor and employee payments, and inventory turnover.
- Telos repaid and terminated its Wells Fargo revolving facility in July 2016, replacing it with receivables-sale and receivables-advance arrangements. It sold approximately $35.3 million of receivables during 2016 and recorded $0.2 million in related losses.
- A government contract re-compete lost in 2015 accounted for approximately 11% of 2016 revenue and ended in May 2016. A separate contract re-compete lost in October 2016 represented approximately 6% of 2016 revenue; related litigation remained pending at filing.
Outlook, risks, contingencies, and unusual items
- Financing and liquidity: In January 2017, Telos borrowed $11 million under a senior secured term loan maturing in 2022. The stated accrual rate is 13.0% annually, with specified circumstances that can increase it; the loan includes a cash-interest component and permits payment-in-kind for remaining interest. Warrants issued with the financing represent rights to purchase approximately 2.5% of common equity on a fully diluted basis. Management believed existing financing capacity, including this loan and receivables facilities, could fund the next 12 months, but gave no assurance.
- Receivables financing: The RCA purchase arrangement allows up to $10 million of eligible receivables outstanding, with RCA retaining discretion over purchases. Action Capital’s advance facility has a $5 million maximum; there were no borrowings under it at year-end. Management warned that loss or replacement of these sources could materially harm liquidity.
- Debt and preferred obligations: The $2.5 million Porter Notes, plus accrued interest, were due July 2017 and bear 12% interest; payment restrictions had prevented cash interest payments. Preferred stock accrues cumulative dividends at 14.125% and 12%, respectively, and substantial dividends and redemption obligations remain unpaid. Public preferred stock’s carrying value was $127.7 million, versus an estimated fair value of $31.9 million.
- Operating and customer risks: Revenue is highly concentrated in federal government contracts, which depend on appropriations and may be delayed, changed, competed, or terminated. Approximately 76% of 2016 revenue came from fixed-price contracts, exposing Telos to cost overruns. Government budget uncertainty, contract protests, competitive pressure, and reliance on selected suppliers may affect results.
- Contract proceedings: A joint venture’s challenge to the award of the contract representing approximately 6% of 2016 revenue was denied by the GAO; a Court of Federal Claims case and request to block transition remained unresolved. The company also disclosed longstanding shareholder and director litigation for which management said outcomes could not be reasonably determined.
- Tax and impairment: Telos maintained a full valuation allowance against deferred tax assets. No goodwill impairment was recorded, but management noted that contract losses or failure to meet growth projections could lead to future impairment.
- Spending and guidance: Telos anticipated approximately $2.0 million of 2017 capital expenditures, subject to change, and said spending or indirect-cost growth could be curtailed if needed. The filing provides no specific revenue or earnings guidance.
- Audit and controls: The auditor issued an unqualified opinion on the consolidated financial statements. Management concluded disclosure controls and internal control over financial reporting were effective as of year-end; the auditor was not engaged to opine on internal-control effectiveness.
Important facts for investors to verify
- Whether NETCENTS-2 and other contract awards sustain revenue growth and the improved gross margin, while accounting for the lost contracts.
- Whether the January 2017 $11 million loan and receivables facilities provide adequate liquidity, and the resulting cash-interest, fees, covenants, and refinancing requirements.
- How Telos will address the July 2017 Porter Notes maturity and its substantial accumulated preferred dividends and redemption obligations.
- The outcome and financial impact of the pending contract protest and longstanding shareholder/director litigation.
- Whether government funding delays, fixed-price cost exposure, or contract concentration affect operating cash flow and the ability to meet near-term obligations.