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Business Context and Reporting Period

Company: Telos Corporation (Maryland)

Filing Type: Form 10-Q (Unaudited)

Reporting Period: Three months ended March 31, 2003

Telos Corporation operates primarily through two continuing segments: the Products Group, which provides secure wireless networking and messaging solutions to U.S. Government agencies, and Xacta, which offers enterprise risk management and security solutions. The company exited its Systems and Support Services business in July 2002, reporting those results as discontinued operations.

Key Financial Metrics

Debt Composition (March 31, 2003): Senior Credit Facility ($1.6 million), Senior Subordinated Notes ($5.2 million), and Capital Lease Obligations ($10.6 million).

Liquidity: Cash flow from operating activities provided $31,000. Investing activities provided $4.0 million primarily from asset sales. Financing activities used $4.3 million, largely to repay debt.

Material Changes vs. Prior Period

• Revenue Mix Shift: Total sales decreased 11.4% year-over-year. This was driven by a $3.9 million decline in the Products Group, offset by a $1.8 million increase in Xacta sales.
• Margin Expansion: Gross margin improved significantly from 11.3% to 18.3%, attributed to higher volume in high-margin Xacta products and lower volume in lower-margin traditional government contracts.
• Non-Recurring Gain: Net income turned positive due to a $10.1 million gain on the sale of the company's 50% interest in TelosOK LLC. Excluding this gain, the company would have reported a net loss of approximately $4.8 million.
• Debt Reduction: The company reduced its Senior Credit Facility balance by approximately $5 million using proceeds from the TelosOK LLC sale.

Outlook, Risks, and Contingencies

Backlog: Total backlog stood at $31.6 million as of March 31, 2003, with $27.9 million funded. Xacta backlog increased to $12.4 million, while Products Group backlog decreased to $19.2 million.

Management Commentary: Management is focusing on value-added solutions and reducing corporate indebtedness. The exit from the Systems and Support Services business has made the company more reliant on short-term, less predictable revenue streams, though with projected higher gross margins.

Risks and Contingencies:

• Government Dependence: A high percentage of revenue is derived from U.S. Government contracts, which are subject to termination, budget delays, and reprioritization due to national security concerns (e.g., Iraq war funding).
• Preferred Stock Dividends: The company has not declared dividends on its Senior Redeemable Preferred Stock or Public Preferred Stock since 1991. Accrued undeclared dividends on Senior Preferred Stock totaled $4.4 million, and Public Preferred Stock accrued dividends totaled over $34 million (including stock dividend accruals).
• Debt Covenants: The Senior Credit Facility contains covenants restricting mergers, asset sales, and dividends. Covenants were amended in March 2003 to reflect future projections.

Investor Verification Checklist

• Recurring Profitability: Verify the company's ability to generate operating income without the one-time $10.1 million gain from the TelosOK LLC sale.
• Liquidity Position: Assess the sustainability of operations with only $63,000 in cash and cash equivalents against significant debt obligations.
• Preferred Stock Obligations: Review the terms of the $61.5 million in redeemable preferred stock and the impact of accrued, unpaid dividends on future cash flow and refinancing options.
• Government Contract Stability: Monitor the status of U.S. Government funding and the risk of contract termination or reprioritization affecting the Products Group.
• Debt Maturity: Confirm the company's ability to refinance or repay the $5.2 million in Senior Subordinated Notes maturing in October 2004, which carry interest rates of 14% to 17%.