Item 2.
Management'sManagement’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words "believes," "anticipates," "plans," "expects"“believes,” “anticipates,” “plans,” “expects” and similar expressions are intended to identify forward-looking statements. There are a number of important factors that could cause the Company'sCompany’s actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth in the risk factors section included in the Company'sCompany’s Form 10-K for the year ended December 31, 2017,2018, as filed with the SEC.
General
Our goal is to deliver superior IT solutions that meet or exceed our customers'customers’ expectations. We focus on secure enterprise solutions that address the unique requirements of the federal government, the military, and the intelligence community, as well as commercial enterprises that require secure solutions. Our IT solutions consist of the following:
| ● | Cyber Operations and Defense ("(“CO&D"&D”): |
o | Cyber Security – Solutions and services that assure the security of our customers'customers’ information, systems, and networks, including the Xacta suite for IT governance, risk management, and compliance. Our information and cyber security consulting services include security assessments, digital forensics, and continuous compliance monitoring. |
o | Secure Mobility – Design, engineering and delivery of secure solutions that empower the mobile and deployed workforce in business and government. Our solutions protect sensitive communication while delivering voice, data, and video at the point of work in classified and unclassified environments. |
| ● | Identity Management – Solutions that establish trusted identities in order to ensure authenticated physical access to offices, workstations, and other facilities; secure digital access to databases, host systems, and other IT resources; and protect people and organizations against insider threats. |
| ● | IT and Enterprise Solutions – We have the experience with solution development and global integration to meet the requirements of business and government enterprises with secure IT solutions, from organizational messaging and data visualization to network construction and management. |
Backlog
Many of our contracts with the U.S. Government are funded year to year by the procuring U.S. Government agency as determined by the fiscal requirements of the U.S. Government and the respective procuring agency. Such a contracting process results in two distinct categories of backlog: funded and unfunded. Total backlog 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 not. Funded backlog consists of the aggregate contract revenues remaining to be earned by us at a given time, but only to the extent, in the case of U.S. Government contracts, when funded by the procuring U.S. Government agency and allotted to the specific contracts. Unfunded backlog is the difference between total backlog and funded backlog. Included in unfunded backlog are revenues which may be earned only when and if customers exercise delivery orders and/or renewal options to continue such existing contracts.
A number of contracts that we undertake extend beyond one year and, accordingly, portions of contracts are carried forward from one year to the next as part of the backlog. Because many factors affect the scheduling and continuation of projects, no assurance can be given as to when revenue will be realized on projects included in our backlog.
At June 30, 20182019 and 2017,2018, we had total backlog from existing contracts of approximately $261.4$255.0 million and $118.5$261.4 million, respectively. Such backlog was $256.3$290.8 million at December 31, 2017.2018. Such amounts are the maximum possible value of additional future orders for systems, products, maintenance and other support services presently allowable under those contracts, including renewal options available on the contracts if fully exercised by the customer.customers.
Funded backlog as of June 30, 2019 and 2018 and 2017 was $70.2$74.1 million and $77.3$70.2 million, respectively. Funded backlog was $98.5$79.3 million at December 31, 2017.2018.
While backlog remains a measurement consideration, in recent years we, as well as other U.S. Government contractors, experienced a material change in the manner in which the U.S. Government procures equipment and services. These procurement changes include the growth in the use of General Services Administration ("GSA") schedules which authorize agencies of the U.S. Government to purchase significant amounts of equipment and services. The use of the GSA schedules results in a significantly shorter and much more flexible procurement cycle, as well as increased competition with many companies holding such schedules. Along with the GSA schedules, the U.S. Government is awarding a large number of omnibus contracts with multiple awardees. Such contracts generally require extensive marketing efforts by the multiple awardees to procure such business.business under the omnibus contract through separate task or delivery orders. The use of GSA schedules and omnibus contracts, while generally not providing immediate backlog, provide areas of growth that we continue to aggressively pursue.
Consolidated Results of Operations (Unaudited)
The accompanying condensed consolidated financial statements include the accounts of Telos Corporation and its subsidiaries including Ubiquity.com, Inc., Xacta Corporation, and Teloworks, Inc., all of whose issued and outstanding share capital is owned by Telos Corporation (collectively, the "Company"“Company” or "Telos"“Telos” or "We"“We”). We have also consolidated the results of operations of Telos ID (see Note 2 – Non-controlling Interests). All intercompany transactions have been eliminated in consolidation.
Our operating cycle involves many types of solutions, product and service contracts with varying delivery schedules. Accordingly, results of a particular quarter, or quarter-to-quarter comparisons of recorded sales and operating profits may not be indicative of future operating results and the following comparative analysis should therefore be viewed in such context.
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.
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 indefinite delivery/indefinite quantity ("IDIQ"(“IDIQ”) and government-wide acquisition contracts ("GWAC"(“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. The period of performance for the original NETCENTS contract ended on September 30, 2013. Previously awarded task orders that contain periods of performance that extended past September 30, 2013, including exercisable option years under existing task orders, were not affected by the contract expiration. We were selected for an award on the NETCENTS replacement contract, NETCENTS-2 Network Operations and Infrastructure Solutions Small Business Companion, on March 27, 2014. Although no protest was filed over the Telos contract award, protests filed by other bidders resulted in a recommendation by the Government Accountability Office ("GAO"(“GAO”) that the U.S. Air Force re-evaluate proposals and make a new source selection decision. Subsequent to the Air Force'sForce’s reevaluation of the NETCENTS-2 procurement related to the protests, we were selected for an award on April 3, 2015 and the contract was opened for issuance of new orders in May 2015. We have also been awarded other IDIQ/GWACs, including the Department of Homeland Security'sSecurity’s EAGLE II, GSA Alliant 2, and blanket purchase agreements under our GSA schedule. However, we have not been awarded significant delivery orders under EAGLE II, or GSA Alliant 2 as it was not ready for agencies to use until July 1, 2018.
On October 13, 2016, we were notified that we were not awarded the re-compete of a contract within our Cyber Operations & Defense area for a government agency that we had bid as part of a joint venture. The contract had a total funded value of over $22 million over the prior three years and accounted for approximately 6% of revenue for 2016. The joint venture filed a protest of the award to another bidder with the GAO on October 24, 2016, which denied the protest on February 2, 2017. The joint venture then filed a claim with the COFC on February 10, 2017, together with a motion seeking to stay and enjoin the transition of the contract. The COFC denied the requests for injunctive relief on February 14, 2017, but initiated a one-month extension on the current contract so as to allow the CODC to address the joint venture's protest, hold a hearing and issue a decision in advance of any final contract transition. On April 27, 2017, the COFC issued a final decision in favor of the government. The period of performance on the contract ended on May 2, 2017.
During the first quarter of 2018, there were a number of budgetary actions taken by the U.S. Government that affect defense spending. On February 9, 2018,July 22, 2019, the President
signedand Congressional leaders reached an agreement to raise the
Bipartisan Budget Act of 2018 (BBA of 2018), which increased thediscretionary spending limits for
both defense and non-defense discretionary funding for governmentU.S. Government fiscal years
(FY) 20182020 and
20192021 (the U.S.
Government'sGovernment’s fiscal year begins on October 1 and ends on September 30)
establishedset under the Budget Control Act of 2011
(the(BCA) and suspend the federal debt ceiling until July 31, 2021. The agreement is intended to prevent the possibility of a partial government shutdown in the fall of 2019 and stabilize appropriations plans for all aspects of federal agencies until after the 2020 presidential election. The legislation resulting from this agreement, called the Bipartisan Budget
Control Act)Agreement for Fiscal Years 2020 and 2021 (BBA),
among other items. The defense spending limits were increasedwas subsequently passed by
$80 billion to $629 billion for FY 2018both the House of Representatives and
the Senate, and signed into law by
$85 billion to $647 billion for FYthe President on August 2, 2019. The
FY 2018BBA raises spending
limit is consistent with the funding level authorized by Congress in the FY 2018 National Defense Authorization Act (NDAA) and exceeded the President's FY 2018 budget request by $26 billion. The BBA of 2018 also suspended the debt ceiling through March 1, 2019, at which time the debt limit will be increased to the amount of U.S. Government debt outstanding on that date.
On February 12, 2018, the President submitted a budget proposal for FY 2019 to Congress, which includes a base budgetlimits for national defense
of $647to $738 billion
inclusive of $617 billion for the U.S. DoD. The base budget request for national defense is consistent with the revised spending limits established under the BBA of 2018 and represents an increase of nearly $18 billion over the FY 2018 funding level, most of which relates to increases in the DoD's budget. Congress must approve or revise the President's FY 2019 budget proposal through enactment of appropriations bills and other policy legislation, which would then require final approval from the President.
On March 23, 2018, the Consolidated Appropriations Act of 2018 (the Appropriations Act of 2018) was signed into law, providing discretionary funding for the U.S. Government for FY 2018. The Appropriations Act of 2018 provides a base budget of $629 billion for national defense, inclusive of $600 billion for the DoD. The base budget request for national defense is consistent with the revised spending limits established under the BBA of 2018 and represents an increase of nearly $78 billion over the FY 2017 funding level, most of which relates to increases in the DoD's budget.
Currently, U.S. defense spending in FY 2020 and $740.5 billion in FY 2021 remains2021. Both totals include OCO funding which is not subject to the statutory spending limits established by the Budget Control Act.BCA. The Budget Control Actproposed national security spending limits were modifiedin both FY 2020 and 2021 represent an increase over the FY 2019 enacted amount of $716 billion. Appropriations legislation must still be enacted to authorize spending for fiscal years 2013 through 2019 by the American Taxpayer Relief Act of 2012, the Bipartisan Budget Act of 2013, the Bipartisan Budget Act of 2015,DoD and most recently the BBA of 2018. However, these acts do not alter the spending limits beyondother government agencies for FY 2019. As currently enacted, the Budget Control Act limits defense spending2020. If Congress is unable to $576 billion (including approximately $550 billion for DoD) for fiscalreach a timely agreement on full year 2020 with a modest increase to $590 billion (including approximately $563 billion for DoD) in 2021. The President's defense budget estimatesappropriations for FY 2020, and beyond exceed the spending limits established by the Budget Control Act. Asthere is a result, continued budget uncertainty and the risk of future sequestration cuts remain unless the BCA is repealedgovernment shutdowns or significantly modified.disruptions, or funding under a continuing resolution.
We anticipate there will continue to be a significant amount of debate and negotiations within the U.S. Government over federal and defense spending. In the context of these negotiations, it is possible that the U.S. Government, or portions of the U.S. Government, could be shut down or disrupted for periods of time, and that government programs could be modified, cut or replaced as part of broader reforms to reduce the federal deficit.
The principal elementelements of the Company'sCompany’s operating expenses as a percentage of sales for the three and six months ended June 30, 20182019 and 20172018 are as follows:
| | (unaudited) | | Three Months Ended June 30, | | Six Months Ended June 30, |
| | Three Months Ended June 30, | | | Six Months Ended June 30, | | 2019 | | 2018 | | 2019 | | 2018 |
| | 2018 | | | 2017 | | | 2018 | | | 2017 | | | | (unaudited) | | |
| | | | | | | | | | | | | | | | | | | |
Revenue | | | 100.0 | % | | | 100.0 | % | | | 100.0 | % | | | 100.0 | % | 100.0% | | 100.0% | | 100.0% | | 100.0% |
Cost of sales | | | 65.4 | | | | 65.0 | | | | 66.9 | | | | 64.2 | | 72.2 | | 65.4 | | 71.8 | | 66.9 |
Selling, general, and administrative expenses | | | 28.4 | | | | 41.4 | | | | 30.0 | | | | 41.6 | | 29.0 | | 28.4 | | 30.9 | | 30.0 |
| | | | | | | | | | | | | | | | | |
Operating income (loss) | | | 6.2 | | | | (6.4 | ) | | | 3.1 | | | | (5.8 | ) | |
| | | | | | | | | | | | | | | | | |
Operating (loss) income | | (1.2) | | 6.2 | | (2.7) | | 3.1 |
Other income | | | ---- | | | | ---- | | | | ---- | | | | ---- | | 0.5 | | ---- | | 0.3 | | ---- |
Interest expense | | | (4.9 | ) | | | (7.9 | ) | | | (5.0 | ) | | | (7.4 | ) | (4.8) | | (4.9) | | (5.2) | | (5.0) |
| | | | | | | | | | | | | | | | | |
Income (loss) before income taxes | | | 1.3 | | | | (14.3 | ) | | | (1.9 | ) | | | (13.2 | ) | |
Provision for income taxes | | | ---- | | | | (0.7 | ) | | | (0.1 | ) | | | (0.7 | ) | |
Net income (loss) | | | 1.3 | | | | (15.0 | ) | | | (2.0 | ) | | | (13.9 | ) | |
Less: Net income attributable to non-controlling interest | | | (1.5 | ) | | | (1.1 | ) | | | (1.1 | ) | | | (0.8 | ) | |
(Loss) income before income taxes | | (5.5) | | 1.3 | | (7.6) | | (1.9) |
Benefit (provision) for income taxes | | ---- | | ---- | | 0.3 | | (0.1) |
Net (loss) income | | (5.5) | | 1.3 | | (7.3) | | (2.0) |
Less: Net loss (income) attributable to non-controlling interest | | 0.7 | | (1.5) | | (0.3) | | (1.1) |
Net loss attributable to Telos Corporation | | | (0.2 | )% | | | (16.1 | )% | | | (3.1 | )% | | | (14.7 | )% | (4.8)% | | (0.2)% | | (7.6)% | | (3.1)% |
Three Months Ended June 30, 20182019 Compared with Three Months Ended June 30, 20172018
Revenue increased by 65.6%3.2% to $34.9$36.0 million for the second quarter of 2018,2019, from $21.1$34.9 million for the same period in 2017.2018. Services revenue increased to $30.9$34.4 million for the second quarter of 20182019 from $18.4$30.9 million for the same period in 2017,2018, primarily attributable to increases in sales of $8.4$3.4 million of CO&D's Secure Mobility&D’s Cyber Security deliverables, $2.4$1.7 million of Identity Management solutions and $1.8$0.7 million of CO&D's Cyber Security deliverables,IT & Enterprise solutions, offset by a decrease in sales of $0.1$2.3 million of IT & Enterprise solutions.CO&D’s Secure Mobility deliverables. The change in product and services revenue varies from period to period depending on the mix of solutions sold and the nature of such solutions, as well as the timing of deliverables. Product revenue increaseddecreased to $4.1$1.7 million for the second quarter of 20182019 from $2.7$4.1 million for the same period in 2017,2018, primarily attributable to increasesdecreases in sales of $1.6 million of CO&D's&D’s Cyber Security proprietary software deliverables and $1.1 million of Identity Management solutions, offset by a decreasean increase in sales of $0.2$0.4 million of CO&D's Secure Mobility resold product deliverables.IT & Enterprise solutions.
Cost of sales increased to $22.9$26.0 million for the second quarter of 20182019, from $13.7$22.9 million for the same period in 2017,2018, primarily due to increases in revenue of $13.8$1.1 million, coupled with an increased cost of sales as a percentage of revenue of 0.5%6.8%. Cost of sales for services increased by $9.5$3.8 million, and as a percentage of services revenue increased by 4.3%3.9%, due to a change in the mix of the programs and timing of certain Telos-installed solutions in CO&D's&D’s Secure Mobility deliverables. Cost of sales for products decreased by $0.3$0.6 million, and as a percentage of product revenue decreasedincreased by 28.8%14.9% due primarily to an increasea decrease in proprietary software sales which carry lower cost of sales. The increase in cost of sales as a percentage of services revenue and the decrease in cost of sales as a percentage of product revenue is not necessarily indicative of a trend as the mix of solutions sold and the nature of such solutions can vary from period to period, and further can be affected by the timing of deliverables.
Gross profit increaseddecreased by 63.4%17.1% to $12.1$10.0 million for the second quarter of 20182019 from $7.4$12.1 million for the same period in 2017.2018. Gross margin decreased to 34.6%27.8% in the second quarter of 2018,2019, from 35.0%34.6% for the same period in 2017.2018. Services gross margin decreased to 26.7% in 2019 from 30.5% in 2018 from 34.8% in 2017 due to the change in program mix during the period as noted above, and product gross margin increaseddecreased to 50.3% in 2019 from 65.2% in 2018, from 36.4% in 2017, due primarily to an increasea decrease in proprietary software sales.
Selling, general, and administrative expense (SG&A) increased by 13.5%5.2% to $9.9$10.4 million for the second quarter of 2018,2019, from $8.7$9.9 million for the same period in 2017,2018, primarily attributable to the capitalization and related amortization of software development costs of $0.6 million, and increases in accrued bonuses of $0.4 million, labor costs of $0.3 million and trade shows expenses of $0.2 million, offset by the decreases in outside services of $0.2 million and legal fees of $0.1$0.2 million.
Operating incomeloss was $2.2$0.4 million for the second quarter of 2018,2019, compared to an operating lossincome of $1.4$2.2 million for the same period in 2017,2018, due primarily to an increasea decrease in gross profit as noted above.
Interest expense increased by 3.0%1.8% to $1.7 million for the second quarter of 2018,2019, from $1.7 million for the same period in 2017,2018, primarily due to an increase in interest on the EnCap senior term loan.an equipment purchase arrangement.
Income tax provision was $6,000$20,000 for the second quarter of 2018,2019, compared to $139,000$6,000 for the same period in 2017,2018, which is based on the estimated annual effective tax rate applied to the pretax loss incurred for the quarter plus discreet tax items, based on our expectation of pretax loss for the fiscal year.
Net loss attributable to Telos Corporation was $87,000$1.7 million for the second quarter of 2018,2019, compared to $3.4 million$87,000 for the same period in 2017,2018, primarily attributable to the increase in operating incomeloss for the quarter as discussed above.
Six Months Ended June 30, 20182019 Compared with Six Months Ended June 30, 20172018
Revenue increaseddecreased by 52.3%0.2% to $67.3$67.2 million for the six months ended June 30, 20182019, from $44.2$67.3 million in the same period in 2017.2018. Services revenue increased to $59.7$62.4 million for the six months ended June 30, 20182019, from $38.1$59.7 million for the same period in 2017,2018, primarily attributable to increases in sales of $13.0$4.9 million of CO&D's Secure Mobility&D’s Cyber Security deliverables, $5.9$1.6 million of Identity Management solutions, $2.6 million of CO&D's Cyber Security deliverables, and $0.1$1.2 million of IT & Enterprise solutions.solutions, offset by a decrease in sales of $5.0 million of CO&D’s Secure Mobility deliverables. The change in product and services revenue varies from period to period depending on the mix of solutions sold and the nature of such solutions, as well as the timing of deliverables. Product revenue increaseddecreased to $7.7$4.8 million for the six months ended June 30, 20182019, from $6.1$7.7 million for the same period in 2017,2018, primarily attributable to decreases in sales of $3.0 million of CO&D’s Cyber Security proprietary software deliverables and $0.2 million of Identity Management solutions, offset by an increase in sales of $3.1 million of CO&D's Cyber Security proprietary software deliverables, offset by decreases in sales of $0.9$0.4 million of IT & Enterprise solutions, $0.4 million of CO&D's Secure Mobility deliverables, and $0.3 million of Identity Management solutions.
Cost of sales increased by 58.7%7.1% to $45.0$48.2 million for the six months ended June 30, 20182019, from $28.4$45.0 million for the same period in 2017,2018, primarily due to increases in services revenue of $23.1$2.7 million, coupled with an increased cost of sales as a percentage of revenue of 2.7%4.9%. Cost of sales for services increased by $17.0$3.4 million, and as a percentage of services revenue increased by 4.7%2.4%, due to a change in the mix of the programs and timing of certain Telos-installed solutions in CO&D's&D’s Secure Mobility deliverables. Cost of sales for products decreased by $0.3$0.2 million, and as a percentage of product revenue decreasedincreased by 15.1%19.1% due primarily to an increasea decrease in proprietary software sales which carry lower cost of sales. The increase in cost of sales as a percentage of services revenue and the decrease in cost of sales as a percentage of product revenue is not necessarily indicative of a trend as the mix of solutions sold and the nature of such solutions can vary from period to period, and further can be affected by the timing of deliverables.
Gross profit increaseddecreased by 40.9%14.9% to $22.3$19.0 million for the six months ended June 30, 20182019, from $15.8$22.3 million compared to the same period in 2017,2018, due primarily to the change in the mix of the solutions sold as discussed above. Gross margin decreased to 33.1%28.2% for the six months ended June 30, 2018,2019, from 35.8%33.1% in the same period in 2017.2018.
SG&A expense increased by 9.7%3.1% to $20.2$20.8 million for the six months ended June 30, 20182019, from $18.4$20.2 million for the same period in 2017,2018, primarily attributable to the capitalization and related amortization of software development costs of $0.4 million, and the increasesan increase in accrued bonuses of $0.5 million, labor costs of $0.6$1.0 million, trade shows expensesoffset by a decrease in outside services of $0.3 million, and legal fees of $0.1$0.4 million.
Operating incomeloss was $2.1$1.8 million for the six months ended June 30, 2018,2019, compared to an operating lossincome of $2.6$2.1 million for the same period in 2017,2018, due primarily to an increasea decrease in gross profit offset byand an increase in SG&A as noted above.
Interest expense increased by 3.5%3.4% to $3.4$3.5 million for the six months ended June 30, 2018,2019, from $3.3$3.4 million for the same period in 2017,2018, primarily due to an increase in interest on the EnCap senior term loan.an equipment purchase arrangement.
Income tax provisionbenefit was $65,000$177,000 for the six months ended June 30, 2018,2019, compared to $318,000income tax provision of $65,000 for the same period in 2017,2018, which is based on the estimated annual effective tax rate applied to the pretax loss incurred for the six month period plus discreet tax items, adjusted for the income tax provisionbenefit previously provided, based on our expectation of pretax loss for the fiscal year.
Net loss attributable to Telos Corporation was $2.1$5.2 million for the six months ended June 30, 2018,2019, compared to $6.5$2.1 million for the same period in 2017,2018, primarily attributable to the increase in operating incomeloss as discussed above.
Liquidity and Capital Resources
As described in Note 5 – Current Liabilities and Debt Obligations, we maintain a Credit Agreement with EnCap and a Purchase Agreement with RCA and a Financing Agreement with Action Capital.RCA. The willingness of RCA to purchase our accounts receivable under the Purchase Agreement and of Action Capital to make advances under the Financing Agreement, and our ability to obtain additional financing, may be limited due to various factors, including the eligibility of our receivables, the status of our business, global credit market conditions, and perceptions of our business or industry by EnCap, RCA, Action Capital, or other potential sources of financing. If we are unable to maintain the Purchase Agreement and the Financing Agreement, we would need to obtain additional credit to fund our future operations. If credit is available in that event, lenders may impose more restrictive terms and higher interest rates that may reduce our borrowing capacity, increase our costs, or reduce our operating flexibility. The failure to maintain, extend, renew or replace the Purchase Agreement and the Financing Agreement with a comparable arrangement or arrangements that provide similar amounts of liquidity for the Company would have a material negative impact on our overall liquidity, financial and operating results.
While a variety of factors related to sources and uses of cash, such as timeliness of accounts receivable collections, vendor credit terms, or significant collateral requirements, ultimately impact our liquidity, such factors may or may not have a direct impact on our liquidity based on how the transactions associated with such circumstances impact our availability under our credit arrangements. For example, a contractual requirement to post collateral for a duration of several months, depending on the materiality of the amount, could have an immediate negative effect on our liquidity, as such a circumstance would utilize cash resources without a near-term cash inflow back to us. Likewise, the release of such collateral could have a corresponding positive effect on our liquidity, as it would represent an addition to our cash resources without any corresponding near-term cash outflow. Similarly, a slow-down of payments from a customer, group of customers or government payment office would not have an immediate and direct effect on our availability unless the slowdown was material in amount and over an extended period of time. Any of these examples would have an impact on our cash resources, our financing arrangements, and therefore ultimately our liquidity.
Management may determine that, in order to reduce capital and liquidity requirements, planned spending on capital projects and indirect expense growth may be curtailed, subject to growth in operating results. Additionally, management may seek to put in place a credit facility with a commercial bank, although no assurance can be given that such a facility could be put in place under terms acceptable to the Company. Should management determine that additional capital is required, management would likely look first to the sources of funding discussed above to meet any requirements, although no assurances can be given that these investors would be able to invest or that the Company and the investors would agree upon terms for such investments.
Our working capital was $(1.2)$(4.5) million and $(4.1)$2.1 million as of June 30, 20182019 and December 31, 2017,2018, respectively. Although no assurances can be given, we expect that our financing arrangements with EnCap and RCA, collectively, and Action Capital, collectively,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 provided by operating activities was $3.5$5.9 million for the six months ended June 30, 2018,2019, compared to $4.0$3.5 million cash used in operating activities for the same period in 2017.2018. Cash provided by or used in operating activities is primarily driven by the Company'sCompany’s operating income, the timing of receipt of customer payments, the timing of its 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, net loss was $4.9 million for the six months ended June 30, 2019, compared to $1.3 million for the six months ended June 30, 2018, compared to $6.1 million for the six months ended June 30, 2017.2018.
Cash used in investing activities was approximately $1.8$3.7 million and $1.2$1.8 million for the six months ended June 30, 20182019 and 2017,2018, respectively, due primarily to the purchase of property and equipment of $2.4 million and $1.0 million for the six months ended June 30, 2019 and 2018, respectively, and the capitalization of software development costs of $1.3 million and $0.8 million for each of the six months ended June 30, 2019 and 2018, and 2017, and the purchase of property and equipment.respectively.
Cash used in financing activities for the six months ended June 30, 20182019 was $1.4$1.5 million, compared to $4.5$1.4 million cash provided by financing activities for the same period in 2017,2018, primarily attributable to distribution of $1.0 million to the Telos ID Class B member and payments under finance leases for the six months ended June 30, 2019, compared to distribution of $0.9 million to the Telos ID Class B member and payments under finance leases for the six months ended June 30, 2018, compared to the proceeds of $9.4 million from the EnCap senior term loan, offset by distribution of $2.3 million to the Telos ID Class B member, and the redemption of $2.1 million senior preferred stock for the six months ended June 30, 2017.2018.
Additionally, our capital structure consists of redeemable preferred stock and common stock. The capital structure is complex and requires an understanding of the terms of the instruments, certain restrictions on scheduled payments and redemptions of the various instruments, and the interrelationship of the instruments especially as it relates to the subordination hierarchy. Therefore, a thorough understanding of how our capital structure impacts our liquidity is necessary and, accordingly, we have disclosed the relevant information about each instrument as follows:
Enlightenment Capital Credit Agreement
On January 25, 2017, we entered into a Credit Agreement (the "Credit Agreement") with Enlightenment Capital Solutions Fund II, L.P., as agent (the "Agent"), and the lenders party thereto (the "Lenders"), (together referenced as "EnCap"“EnCap”). The Credit Agreement provides for an $11 million senior term loan (the "Loan") with a maturity date of January 25, 2022, subject to acceleration in the event of customary events of default.
All borrowings under the Credit Agreement will accrue interest at the rate of 13.0% per annum (the "Accrual Rate"“Accrual Rate”). If, at the request of the Company, the Agent executes an intercreditor agreement with another senior lender under which the Agent and the Lenders subordinate their liens (an "Alternative Interest Rate Event"), the interest rate will increase to 14.5% per annum. After the occurrence and during the continuance of any event of default, the interest rate will increase 2.0%. The Company is obligated to pay accrued interest in cash on a monthly basis at a rate of not less than 10.0% per annum or, during the continuance of an Alternate Interest Rate Event, 11.5% per annum. The Company may elect to pay the remaining interest in cash, by payment-in-kind (by addition to the principal amount of the Loan) or by combination of cash and payment-in-kind. Upon thirty days prior written notice, the Company may prepay any portion or the entire amount of the Loan.
An amount of approximately $1.1 million was netted from the proceeds on the Loan as a prepayment of all interest due and payable at the Accrual Rate during the period from January 25, 2017 to October 31, 2017. A separate fee letter executed by the Company and the Agent, dated January 25, 2017, sets forth the fees payable to the Agent in connection with the Credit Agreement.
The Credit Agreement contains representations, warranties, covenants, terms and conditions customary for transactions of this type. In connection with the Credit Agreement, the Agent has been granted, for the benefit of the Lenders, a security interest in and general lien upon various property of the Company, subject to certain permitted liens and any intercreditor agreement. The occurrence of an event of default under the Credit Agreement could result in the Loan and other obligations becoming immediately due and payable and allow the Lenders to exercise all rights and remedies available to them under the Credit Agreement or as a secured party under the UCC, in addition to all other rights and remedies available to them.
In connection with the Credit Agreement, on January 25, 2017, the Company issued warrants (each, a "Warrant") to Agent and certain of the Lenders representing in the aggregate the right to purchase in accordance with their terms 1,135,284.333 shares of the Class A Common Stock of the Company, no par value per share, which is equivalent to approximately 2.5% of the common equity interests of the Company on a fully diluted basis. The exercise price is $1.321 per share and each Warrant expires on January 25, 2027. The value of the warrants were determined to be de minimis and no value was allocated to them on a relative fair value basis in accounting for the debt instrument.
Effective February 23, 2017, the Credit Agreement was amended to change the required timing of certain post-closing items to allow for more time to complete the legal and administrative requirements around such items. On April 18, 2017, the Credit Agreement was further amended (the "Second Amendment"“Second Amendment”) to incorporate the parties'parties’ agreement to subordinate certain debt owed by the Company to the affiliated entities of Mr. John R. C. Porter (the "Subordinated Debt"“Subordinated Debt”) and to redeem all outstanding shares of the Series A-1 Redeemable Preferred Stock and the Series A-2 Redeemable Preferred Stock, including those owned by Mr. John R.C. Porter and his affiliates, for an aggregate redemption price of $2.1 million.
In connection with the Second Amendment and that subordination of debt, on April 18, 2017, we also entered into Subordination and Intercreditor Agreements (the "Intercreditor Agreements"“Intercreditor Agreements”) with affiliated entities of Mr. John R. C. Porter (together referenced as "Porter"“Porter”), in which Porter agreed that the Subordinated Debt is fully subordinated to the amended Credit Agreement and related documents, and that required payments, if any, under the Subordinated Debt are permitted only if certain conditions are met.
The Credit Agreement also includesincluded an $825,000 exit fee, which is payable upon any repayment or prepayment of the loan. This amount has been included in the total principal due and treated as an unamortized discount on the debt, which will be amortized over the term of the loan, using the effective interest method at a rate of 15.0%. We incurred fees and transaction costs of approximately $374,000 related to the issuance of the Credit Agreement, which are being amortized over the life of the Credit Agreement.
On March 30, 2018, the Credit Agreement was amended (the "Third Amendment"“Third Amendment”) to waive any actual or potential non-compliance with covenants in 2017 and to reset the covenants for 2018 measurement periods to more accurately reflect the Company'sCompany’s projected performance for the year. The measurement against the covenants for consolidated leverage ratio and consolidated fixed charge coverage ratio were agreed to not be measured as of December 31, 2017 and were reset for 2018 measurement periods. Additionally, a minimum revenue covenant and a net working capital covenant were added. In consideration of these amendments, the interest rate on the loan was increased by 1%, which will revert back to the original rate upon achievement of two consecutive quarters of a specified fixed charge coverage ratio as defined in the agreement. The Company may elect to pay the increase in interest expense in cash or by payment-in-kind (by addition to the principal amount of the Loan). The increase in interest expense washas been paid in cash during the three months ended June 30, 2018.cash. Contemporaneously with the Third Amendment, Mr. John B. Wood agreed to transfer 50,000 shares of the Company'sCompany’s Class A Common Stock owned by him to EnCap. As of June 30, 2018, we wereWe are in compliance with the Credit Agreement'sAgreement’s financial covenants, based on an agreement between the Company and EnCap on the definition of certain input factors that determine the measurement against the covenants.
On July 19, 2019, we entered into the Fourth Amendment to Credit Agreement and Waiver; First Amendment to Fee Letter (“Fourth Amendment”) to amend the Credit Agreement. As a result of the Fourth Amendment, several terms of the Credit Agreement were amended, including the following:
| ● | The Company borrowed an additional $5 million from the Lenders, increasing the total amount of the principal to $16 million. |
| ● | The maturity date of the Credit Agreement was amended from January 25, 2022 to January 15, 2021. |
| ● | The prepayment price was amended as follows: (a) from January 26, 2019 through January 25, 2020, the prepayment price is 102% of the principal amount, (b) from January 26, 2020 through October 14, 2020, the prepayment price is 101% of the principal amount, and (c) from October 15, 2020 to the maturity date, the prepayment price will be at par. However, the prepayment price for the additional $5 million loan attributable to the Fourth Amendment will be at par. |
| ● | The following financial covenants, as defined in the Credit Agreement, were amended and updated: Consolidated Leverage Ratio, Consolidated Senior Leverage Ratio, Consolidated Capital Expenditures, Minimum Fixed Charge Coverage Ratio, and Minimum Consolidated Net Working Capital. |
| ● | Any actual or potential non-compliance with the applicable provisions of the Credit Agreement were waived. |
| ● | The borrowing under the Credit Agreement continues to be collateralized by substantially all of the Company’s assets including inventory, equipment and accounts receivable. |
| ● | The Company paid the Agent a fee of $110,000 in connection with the Fourth Amendment. |
| ● | The exit fee was increased from $825,000 to $1,200,000. |
We incurred interest expense in the amount of $0.4 million and $0.8 million for each of the three and six months ended June 30, 2018, respectively,2019 and $0.4 million and $0.7 million for the three and six months ended June 30, 2017,2018, respectively, under the Credit Agreement.
Accounts Receivable Purchase Agreement
On July 15, 2016, we entered into an Accounts Receivable Purchase Agreement (the "Purchase Agreement"“Purchase Agreement”) with Republic Capital Access, LLC ("RCA"(“RCA” or "Buyer"“Buyer”), pursuant to which we may offer for sale, and RCA, in its sole discretion, may purchase, eligible accounts receivable relating to U.S. governmentGovernment prime contracts or subcontracts of the Company (collectively, the "Purchased Receivables"“Purchased Receivables”). Upon purchase, RCA becomes the absolute owner of any such Purchased Receivables, which are payable directly to RCA, subject to certain repurchase obligations of the Company. The total amount of Purchased Receivables is subject to a maximum limit of $10 million of outstanding Purchased Receivables (the "Maximum Amount"“Maximum Amount”) at any given time. The Purchase Agreement had an initial term expiring on June 30, 2018 and automatically renews for successive 12-month renewal periods unless terminated in writing by either the Company or RCA. On March 2, 2018, the term of the Purchase Agreement was extended to June 30, 2020. No fee or consideration of any kind was paid in connection with this extension.
The initial purchase price of a Purchased Receivable is equal to 90% of the face value of the receivable if the account debtor is an agency of the U.S. government,Government, and 85% if the account debtor is not an agency of the U.S. government;Government; provided, however, that RCA has the right to adjust these initial purchase price rates in its sole discretion. After collection by RCA of the portion of a Purchased Receivable in excess of the initial purchase price, RCA shall pay the Company the residual 10% or 15% of such Purchased Receivable, as appropriate, less (i) a discount factor equal to 0.30%, for federal government prime contracts (or 0.56% for non-federal government investment grade account obligors or 0.62% for non-federal government non-investment grade account obligors) of the face amounts of Purchased Receivables; (ii) a program access fee equal to 0.008% of the daily ending account balance for each day that Purchased ReceivableReceivables are outstanding; (iii) a commitment fee equal to 1% per annum of the Maximum Amount minus the amount of Purchased Receivables outstanding; and (iv) fees, costs and expenses relating to the preparation, administration and enforcement of the Purchase Agreement and any other related agreements.
The Purchase Agreement provides that in the event, but only to the extent, that the conveyance of Purchased Receivables by the Company is characterized by a court or other governmental authority as a loan rather than a sale, the Company shall be deemed to have granted RCA, effective as of the date of the first purchase under the Purchase Agreement, a security interest in all of the Company'sCompany’s right, title and interest in, to and under all of the Purchased Receivables, whether now or hereafter owned, existing or arising.
The Company provides a power of attorney to RCA to take certain actions in the Company'sCompany’s stead, including (a) to sell, assign or transfer in whole or in part any of the Purchased Receivables; (b) to demand, receive and give releases to any account debtor with respect to amounts due under any Purchased Receivables; (c) to notify all account debtors with respect to the Purchased Receivables; and (d) to take any actions necessary to perfect RCA'sRCA’s interests in the Purchased Receivables.
The Company is liable to the Buyer for any fraudulent statements and all representations, warranties, covenants, and indemnities made by the Company pursuant to the terms of the Purchase Agreement. It is considered an event of default if (a) the Company fails to pay any amounts it owes to RCA when due (subject to a cure period); (b) the Company has voluntary or involuntary bankruptcy proceedings commenced by or against it; (c) the Company is no longer solvent or is generally not paying its debts as they become due; (d) any voluntary liens, garnishments, attachments, or the like are issued against or attach to the Purchased Receivables; (e) the Company breaches any warranty, representation, or covenant (subject to a cure period); (f) the Company is not in compliance or has otherwise defaulted under any document or obligation in favor of RCA or an RCA affiliate; or (g) the Purchase Agreement or any material provision terminates (other than in accordance with the terms of the Purchase Agreement) or ceases to be effective or to be a binding obligation of the Company. If any such event of default occurs, then RCA may take certain actions, including ceasing to buy any eligible receivables, declaring any indebtedness or other obligations immediately due and payable, or terminating the Purchase Agreement.
Financing and Security Agreement
On July 15, 2016, we entered into a Financing and Security Agreement (the "Financing Agreement"“Financing Agreement”) with Action Capital Corporation ("(“Action Capital"Capital”), pursuant to which Action Capital agreed to provide the Company with advances of up to 90% of the net amount of certain acceptable customer accounts of the Company that have been assigned as collateral to Action Capital (the "Acceptable Accounts"“Acceptable Accounts”). The maximum outstanding principal amount of advances under the Financing Agreement was $5 million. The Financing Agreement hashad a term of two years, provided that the Company may terminate it at any time without penalty upon written notice. On August 13, 2018, the Financing Agreement was extended through January 2, 2019. No fee or consideration of any kind was paid in connection with this extension.
The Company shall pay Action Capital interest on the advances outstanding under the Financing Agreement at a rate equal to the prime rate of Wells Fargo Bank, N.A. in effect on the last business day of the prior month plus 2%, and a monthly fee equal to 0.50%. All interest calculations are based on a year of 360 days. The Company's obligations under the Financing Agreement are secured by certain assets of the Company pertaining to the Acceptable Accounts, including all accounts, accounts receivable, earned and unbilled revenue, contract rights, chattel paper, documents, instruments, general intangibles, reserves, reserve accounts, rebates, books and records, and all proceeds of the foregoing.was not extended beyond this date.
Pursuant to the terms of the Financing Agreement, Action Capital shall have full recourse against the Company when an Acceptable Account is not paid in full by the respective customer within 90 days of the date of purchase or if for any reason it ceases to be an Acceptable Account, including the right to charge-back any such Acceptable Account. It is considered an event of default if the Company breaches any covenant or warranty, knowingly provides false or incorrect material information to Action Capital, or otherwise defaults on any of its material obligations under the Financing Agreement or any other material agreements with Action Capital (subject to a cure period). If any such events of default occur, then Action Capital may take certain actions, including declaring any indebtedness immediately due and payable, requiring any customers with Acceptable Accounts to make payments directly to Action Capital, exercising its power of attorney from the Company to take actions in the Company's stead with respect to any of Company's Acceptable Accounts, or terminating the Financing Agreement.
As of June 30, 2018, there were no outstanding borrowings under the Financing Agreement.
Subordinated Debt
On March 31, 2015, the Company entered into Subordinated Loan Agreements and Subordinated Promissory Notes ("(“Porter Notes"Notes”) with affiliated entities of Mr. John R. C. Porter (together referenced as "Porter"“Porter”). Mr. Porter and Toxford Corporation, of which Mr. Porter is the sole shareholder, own 35.0% of our Class A Common Stock. Under the terms of the Porter Notes, Porter lent the Company $2.5 million on or about March 31, 2015. Telos also entered into Subordination and Intercreditor Agreements (the “Subordination Agreements”) with Porter and a prior senior lender, in which the Porter Notes were fully subordinated to the financing provided by that senior lender, and payments under the Porter Notes were permitted only if certain conditions are met. According to the original terms of the Porter Notes, the outstanding principal sum bears interest at the fixed rate of twelve percent (12%) per annum which would be payable in arrears in cash on the 20th day of each May, August, November and February, with the first interest payment date due on August 20, 2015. The Porter Notes do not call for amortization payments and are unsecured. The Porter Notes, in whole or in part, may be repaid at any time without premium or penalty. The unpaid principal, together with interest, was originally due and payable in full on July 1, 2017.
On April 18, 2017, we amended and restated the Porter Notes to reduce the interest rate from twelve percent (12%) to six percent (6%) per annum, to be accrued, and extended the maturity date from July 1, 2017 to July 25, 2022. Telos also entered into the Intercreditor Agreements with Porter and EnCap, in which the Porter Notes are fully subordinated to the Credit Agreement and any subsequent senior lenders, (including Action Capital), and payments under the Porter Notes are permitted only if certain conditions are met. All other terms remain in full force and effect. We incurred interest expense in the amount of $82,000 and $162,000 for the three and six months ended June 30, 2019, respectively, and $76,000 and $151,000 for the three and six months ended June 30, 2018, respectively, and $45,000 and $119,000 for the three and six months ended June 30, 2017, respectively, on the Porter Notes. As a result of June 30, 2019, approximately $947,000 of accrued interest was payable according to the amendment and restatementstated interest rate of the Porter Notes, we recorded a gain on extinguishmentNotes.
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Public Preferred Stock
A maximum of 6,000,000 shares of the Public Preferred Stock, par value $.01 per share, has been authorized for issuance. We initially issued 2,858,723 shares of the Public Preferred Stock pursuant to the acquisition of the Company during fiscal year 1990. The Public Preferred Stock was recorded at fair value on the date of original issue, November 21, 1989, and we made periodic accretions under the interest method of the excess of the redemption value over the recorded value. We adjusted our estimate of accrued accretion in the amount of $1.5 million in the second quarter of 2006. The Public Preferred Stock was fully accreted as of December 2008. We declared stock dividends totaling 736,863 shares in 1990 and 1991. Since 1991, no other dividends, in stock or cash, have been declared. In November 1998, we retired 410,000 shares of the Public Preferred Stock. The total number of shares issued and outstanding at June 30, 20182019 and December 31, 20172018 was 3,185,586. The Public Preferred Stock is quoted as "TLSRP"“TLSRP” on the OTCQB marketplace and the OTC Bulletin Board.
Since 1991, no dividends were declared or paid on our Public Preferred Stock, based upon our interpretation of restrictions in our Articles of Amendment and Restatement, limitations in the terms of the Public Preferred Stock instrument, specific dividend payment restrictions in the Credit Agreement and the Porter Notesvarious financing documents to which the Public Preferred Stock is subject, other senior obligations currently or previously in existence, and Maryland law limitations in existence prior to October 1, 2009. Subsequent to the 2009 Maryland law change, dividend payments continuehave continued to be prohibited except under certain specific circumstances as set forth in Maryland Code Section 2-311, which the Company did not satisfy as of the measurement dates.2-311. Pursuant to the terms of the Articles of Amendment and Restatement, we were scheduled, but not required, to redeem the Public Preferred Stock in five annual tranches during the period 2005 through 2009. However, due to our substantial senior obligations currently or previously in existence, limitations set forth in the covenants in the Credit Agreement andvarious financing documents to which the Porter Notes,Public Preferred Stock is subject, foreseeable capital and operational requirements, and restrictions and prohibitions of our Articles of Amendment and Restatement, we were and remain unable to meet the redemption schedule set forth in the terms of the Public Preferred Stock as of the measurement dates. Moreover, the Public Preferred Stock is not payable on demand, nor callable, for failure to redeem the Public Preferred Stock in accordance with the redemption schedule set forth in the instrument. Therefore, we classify these securities as noncurrent liabilities in the condensed consolidated balance sheets as of June 30, 20182019 and December 31, 2017.2018.
On January 25, 2017, we became parties with certain of our subsidiaries to the Credit Agreement with EnCap. Under the Credit Agreement, we agreed that, until full and final payment of the obligations under the Credit Agreement, we would not make any distribution or declare or pay any dividends (other than common stock) on our stock, or purchase, acquire, or redeem any stock, or exchange any stock for indebtedness, or retire any stock. Additionally, the Porter Notes contain similar prohibitions on dividend payments or stock redemptions.
Accordingly, as stated above, we will continue to classify the entirety of our obligation to redeem the Public Preferred Stock as a long-term obligation. The Credit Agreement andVarious financing documents to which the Porter NotesPublic Preferred Stock is subject prohibit, among other things, the redemption of any stock, common or preferred, other than as described above. The Public Preferred Stock by its terms also cannot be redeemed if doing so would violate the terms of an agreement regarding the borrowing of funds or the extension of credit which is binding upon us or any of our subsidiaries, and it does not include any other provisions that would otherwise require any acceleration of the redemption of or amortization of payments with respect to the Public Preferred Stock. Thus, the Public Preferred Stock is not and will not be due on demand, nor callable, within 12 months from June 30, 2018.2019. This classification is consistent with ASC 210-10, "Balance Sheet"210, “Balance Sheet” and 470-10, "Debt"470, “Debt” and the FASB ASC Master Glossary definition of "Current“Current Liabilities."”
ASC 210-10210 and the FASB ASC Master Glossary define current liabilities as follows: The term current liabilities is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities. As a balance sheet category, the classification is intended to include obligations for items which have entered into the operating cycle, such as payables incurred in the acquisition of materials and supplies to be used in the production of goods or in providing services to be offered for sale; collections received in advance of the delivery of goods or performance of services; and debts that arise from operations directly related to the operating cycle, such as accruals for wages, salaries, commissions, rentals, royalties, and income and other taxes. Other liabilities whose regular and ordinary liquidation is expected to occur within a relatively short period of time, usually twelve months, are also intended for inclusion, such as short-term debts arising from the acquisition of capital assets, serial maturities of long-term obligations, amounts required to be expended within one year under sinking fund provisions, and agency obligations arising from the collection or acceptance of cash or other assets for the account of third persons.
ASC 470-10470 provides the following: The current liability classification is also intended to include obligations that, by their terms, are due on demand or will be due on demand within one year (or operating cycle, if longer) from the balance sheet date, even though liquidation may not be expected within that period. It is also intended to include long-term obligations that are or will be callable by the creditor either because the debtor'sdebtor’s violation of a provision of the debt agreement at the balance sheet date makes the obligation callable or because the violation, if not cured within a specified grace period, will make the obligation callable.
If, pursuant to the terms of the Public Preferred Stock, we do not redeem the Public Preferred Stock in accordance with the scheduled redemptions described above, the terms of the Public Preferred Stock require us to discharge our obligation to redeem the Public Preferred Stock as soon as we are financially capable and legally permitted to do so. Therefore, by its very terms, the Public Preferred Stock is not due on demand or callable for failure to make a scheduled payment pursuant to its redemption provisions and is properly classified as a noncurrent liability.
We pay dividends on the Public Preferred Stock when and if declared by the Board of Directors. The Public Preferred Stock accrues a semi-annual dividend at the annual rate of 12% ($1.20) per share, based on the liquidation preference of $10 per share, and is fully cumulative. Dividends in additional shares of the Public Preferred Stock for 1990 and 1991 were paid at the rate of 6% of a share for each $.60 of such dividends not paid in cash. For the cash dividends payable since December 1, 1995, we have accrued $101.6$105.4 million and $99.7$103.5 million as of June 30, 20182019 and December 31, 2017,2018, respectively. We accrued dividends on the Public Preferred Stock of $1.0 million and $1.9 million for each of the three and six months ended June 30, 20182019 and 2017,2018, respectively, which was recorded as interest expense. Prior to the effective date of ASC 480-10480 on July 1, 2003, such dividends were charged to stockholders'stockholders’ accumulated deficit.
Senior Redeemable Preferred Stock
The Senior Redeemable Preferred Stock was senior to all other outstanding equity of the Company, including the Public Preferred Stock. The Series A-1 ranked on a parity with the Series A-2. The components of the authorized Senior Redeemable Preferred Stock were 1,250 shares of Series A-1 and 1,750 shares of Series A-2 Senior Redeemable Preferred Stock, each with $.01 par value. The Senior Redeemable Preferred Stock carried a cumulative per annum dividend rate of 14.125% of its liquidation value of $1,000 per share. The dividends were payable semiannually on June 30 and December 31 of each year. We had not declared dividends on our Senior Redeemable Preferred Stock since its issuance, other than in connection with the redemptions from 2010 to 2013. The liquidation preference of the Senior Redeemable Preferred Stock was the face amount of the Series A-1 and A-2 ($1,000 per share), plus all accrued and unpaid dividends.
Due to the terms of the Credit Agreement, the Porter Notes, other senior obligations currently or previously in existence, the Senior Redeemable Preferred Stock and applicable provisions of Maryland law governing the payment of distributions, we had been precluded from redeeming the Senior Redeemable Preferred Stock and paying any accrued and unpaid dividends on the Senior Redeemable Preferred Stock, other than the redemptions that occurred from 2010 to 2013. In addition, certain holders of the Senior Redeemable Preferred Stock had entered into standby agreements whereby, among other things, those holders would not demand any payments in respect of dividends or redemptions of their instruments and the maturity dates of the instruments had been extended. As a result of such standby agreements, as of March 31, 2017, instruments held by Toxford Corporation ("Toxford"), the holder of 76.4% of the Senior Redeemable Preferred Stock, would mature on May 31, 2018.
At March 31, 2017, the total number of shares of the Senior Redeemable Preferred Stock issued and outstanding was 197 shares and 276 shares for Series A-1 and Series A-2, respectively. At March 31, 2017, cumulative undeclared, unpaid dividends relating to the Senior Redeemable Preferred stock totaled $1.6 million.
We accrued dividends on the Senior Redeemable Preferred Stock of $3,000 and $20,000 for the three and six months ended June 30, 2017, respectively, which were reported as interest expense. Prior to the effective date of ASC 480-10, "Distinguishing Liabilities from Equity," on July 1, 2003, such dividends were charged to stockholders' deficit.
In accordance with the requirements of the Second Amendment to the EnCap Credit Agreement, we redeemed all outstanding shares of the Senior Redeemable Preferred Stock on April 18, 2017 for $2.1 million.
Recent Accounting Pronouncements
See Note 1 of the Condensed Consolidated Financial Statements for a discussion of recently issued accounting pronouncements.
Critical Accounting Policies
Except as set forth below, during the three months ended June 30, 2018,2019, there were no material changes to our critical accounting policies as reported in our Annual Report on Form 10-K for the year ended December 31, 20172018 as filed with the SEC on April 2, 2018.1, 2019.
Revenue RecognitionLeases
We accountIn February 2016, the Financial Accounting Standard Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-02, “Leases (ASC Topic 842)”, which requires lessees to recognize a right-of-use asset and lease liability on the balance sheet and expands disclosures about leasing arrangements for revenue in accordance with ASCboth lessees and lessors, among other items, for most lease arrangements. The new standard is effective for fiscal years beginning after December 15, 2018, which made the new standard effective for us on January 1, 2019. In July 2018, the FASB issued ASU 2018-11, “Leases (ASC Topic 606, "Revenue from Contracts with Customers."842): Targeted Improvements,” which allows for an additional transition method under the modified retrospective approach for the adoption of ASU 2016-02. The unittwo permitted transition methods are (a) to apply the new lease requirements at the beginning of account in ASC 606the earliest period presented (the Comparative Method) and (b) to apply the new lease requirements at the effective date (the Effective Date Method). Under both transition methods there is a performance obligation,cumulative effect adjustment. We adopted the standard on January 1, 2019 by applying the new lease requirements utilizing the Effective Date Method for all leases with terms greater than 12 months. We elected the package of practical expedients permitted under the transition guidance within the new standard, which is a promise,included carrying forward historical assessments of: (1) whether contracts are or contain leases, (2) lease classification and (3) initial direct costs. The adoption of this standard resulted 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),recognition of right-of-use assets of $2.0 million and recognizing revenueadditional lease liabilities of $2.0 million as the performance obligations are satisfied. Timingof January 1, 2019. The adoption 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 maystandard did not 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 basedmaterial impact on our best estimateoperating results or cash flows. The comparative periods have not been restated for the adoption of standalone selling price.ASU 2016-02.
We account for a contract after it has been approved by the parties to the contract, the rights and the payment terms of the parties are identified, the contract has commercial substance and collectability is probable, which is presumed for our U.S. government customers and prime contractors for which we perform as subcontractors to U.S. government end-customers.
The majority of our revenue is recognized over time, as control is transferred continuously to our customers, 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 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 Cyber Operations and Defense ("CO&D") and IT & Enterprise Solutions business groups and for the sale of resold products in Telos ID and CO&D 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. 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.
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.
As a result of the adoption of the ASC 606 standard on January 1, 2018, we determined that certain contractual arrangements required adjustment in order to appropriately reflect revenue recognition under the new standard. For contracts for term-based license subscriptions that were in process at January 1, 2018 it was determined that the license was a distinct performance obligation where transfer of control of the license to the customer had occurred. Accordingly, the amount of revenue allocated to those performance obligations was reflected in the cumulative adjustment to our accumulated deficit in accordance with our election of the modified retrospective transition method as prescribed by the new standard. This adjustment included two contracts for an aggregate cumulative adjustment to accumulated deficit of $3.8 million. The remaining performance obligations under the contracts were adjusted to reflect the adjusted allocation of the transaction price to these performance obligations. Additionally, upon adoption of the new standard it was determined that certain contractual arrangements for the provision of resold information technology products that had previously been accounted for on a gross revenue basis under the prior standard would appropriately be recognized on a net revenue basis and reflected in services revenue. There were no contracts of this type in process that were included in the accumulated deficit adjustment.
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 condensed consolidated balance sheet.
Billed receivables are amounts billed and due from our customers that are classified as billed receivables and are reported within accounts receivable, net of reserve on the condensed consolidated balance sheet. 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 typically 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 condensed consolidated balance sheet on a net contract basis at the end of each reporting period.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
N/A.None.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
An evaluation of the effectiveness of our disclosure controls and procedures as of June 30, 2018,2019 was performed under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in its reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and that information required to be disclosed by the Company in the reports the Company files or submits under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Internal Control over Financial Reporting
There has been no change in our internal control over financial reporting during the quarter ended June 30, 20182019 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II—OTHER INFORMATION
Item 1. Legal Proceedings
Information regarding legal proceedings may be found in Note 8 – Commitments, Contingencies and ContingenciesSubsequent Events to the condensed consolidated financial statements.
There were no material changes in the period ended June 30, 20182019 in our risk factors as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2017.2018.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Defaults upon Senior Securities
12% Cumulative Exchangeable Redeemable Preferred Stock
Through November 21, 1995, we had the option to pay dividends in additional shares of Public Preferred Stock in lieu of cash (provided there were no restrictions on payment as further discussed below). As more fully explained in the next paragraph, dividends are payable by us, when and if declared by the Board of Directors, commencing June 1, 1990, and on each six month anniversary thereof. Dividends in additional shares of the Preferred Stock for 1990 and 1991 were paid at the rate of 6% of a share for each $.60 of such dividends not paid in cash. Dividends for the years 1992 through 1994, and for the dividend payable June 1, 1995, were accrued under the assumption that such dividends would be paid in additional shares of preferred stock and were valued at $4.0 million. Had we accrued these dividends on a cash basis, the total amount accrued would have been $15.1 million. However, as a result of the redemption of the 410,000 shares of the Public Preferred Stock in November 1998, such amounts were reduced and adjusted to $3.5 million and $13.4 million, respectively. As more fully disclosed in Note 6 – Redeemable Preferred Stock, in the second quarter of 2006, we accrued an additional $9.9 million in interest expense to reflect our intent to pay cash dividends in lieu of stock dividends, for the years 1992 through 1994, and for the dividend payable June 1, 1995. We have accrued $101.6$105.4 million and $99.7$103.5 million in cash dividends as of June 30, 20182019 and December 31, 2017,2018, respectively.
Since 1991, no dividends were declared or paid on our Public Preferred Stock, based upon our interpretation of restrictions in our Articles of Amendment and Restatement, limitations in the terms of the Public Preferred Stock instrument, specific dividend payment restrictions in the Credit Agreement and the Porter Notesvarious financing documents to which the Public Preferred Stock is subject, other senior obligations currently or previously in existence, and Maryland law limitations in existence prior to October 1, 2009. Subsequent to the 2009 Maryland law change, dividend payments continuehave continued to be prohibited except under certain specific circumstances as set forth in Maryland Code Section 2-311, which the Company did not satisfy as of the measurement dates.2-311. Pursuant to the terms of the Articles of Amendment and Restatement, we were scheduled, but not required, to redeem the Public Preferred Stock in five annual tranches during the period 2005 through 2009. However, due to our substantial senior obligations currently or previously in existence, limitations set forth in the covenants in the Credit Agreement andvarious financing documents to which the Porter Notes,Public Preferred Stock is subject, foreseeable capital and operational requirements, and restrictions and prohibitions of our Articles of Amendment and Restatement, we were and remain unable to meet the redemption schedule set forth in the terms of the Public Preferred Stock as of the measurement dates. Moreover, the Public Preferred Stock is not payable on demand, nor callable, for failure to redeem the Public Preferred Stock in accordance with the redemption schedule set forth in the instrument. Therefore, we classify these securities as noncurrent liabilities in the condensed consolidated balance sheets as of June 30, 20182019 and December 31, 2017.2018.
Item 4. Mine Safety Disclosures
Not applicable.
Item 5. Other Information
None.
| | |
Exhibit Number | | Description of Exhibit |
| | |
10.1* | | |
31.1* | | |
31.2* | | |
32* | | |
101.INS** | | XBRL Instance Document |
101.SCH** | | XBRL Taxonomy Extension Schema |
101.CAL** | | XBRL Taxonomy Extension Calculation Linkbase |
101.DEF** | | XBRL Taxonomy Extension Definition Linkbase |
101.LAB** | | XBRL Taxonomy Extension Label Linkbase |
101.PRE** | | XBRL Taxonomy Extension Presentation Linkbase |
| |
* filed herewith
** in accordance with Regulation S-T, the XBRL-related information in Exhibit 101 to this Quarterly Report on Form 10-Q shall be deemed to be "furnished"“furnished” and not "filed"“filed”
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: August 14, 20182019 | | TELOS CORPORATION |
| | |
| | /s/ John B. Wood |
| | John B. Wood Chief Executive Officer (Principal Executive Officer) |
| | /s/ Michele Nakazawa |
| | Michele Nakazawa Chief Financial Officer (Principal Financial and Accounting Officer) |
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