10-K 1 form10k.htm  
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K
☒  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) THE SECURITIES EXCHANGE ACT OF 1934
      For the fiscal year ended December 31, 2018
OR
☐  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) THE SECURITIES EXCHANGE ACT OF 1934
Commission file number: 001-08443

TELOS CORPORATION
(Exact name of registrant as specified in its charter)

Maryland
52-0880974
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
19886 Ashburn Road, Ashburn, Virginia
20147
(Address of principal executive offices)
(Zip Code)

Registrant's telephone number, including area code: (703) 724-3800

Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:

12% Cumulative Exchangeable Redeemable Preferred Stock, par value $.01 per share

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes      No 
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes      No 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes      No 
 
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes     No 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer    
Accelerated filer                             
Non-accelerated filer     
Smaller reporting company  
 
Emerging growth company  
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes      No 

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant as of June 30, 2018:  Not applicable

As of March 25, 2019, the registrant had outstanding 45,158,460 shares of Class A Common Stock, no par value; and 4,037,628 shares of Class B Common Stock, no par value.

DOCUMENTS INCORPORATED BY REFERENCE:

Certain of the information required in Part III of this Form 10-K is incorporated by reference to the Registrant's definitive proxy statement to be filed for the Annual Meeting of Stockholders to be held on May 14, 2019.

1

TABLE OF CONTENTS
 
   
Page
     
PART I
   
     
Item 1.
3
Item 1A.
9
Item 1B.
12
Item 2.
12
Item 3.
12
Item 4.
12
     
PART II
   
     
Item 5.
13
Item 6.
13
Item 7.
14
Item 7A.
27
Item 8.
28
Item 9.
63
Item 9A
63
Item 9B.
63
     
PART III
   
     
Item 10.
64
Item 11.
64
Item 12.
64
Item 13.
64
Item 14.
64
     
PART IV
   
     
Item 15.
65
Item 16.
67
 
68

Special Note Regarding Forward-Looking Statements

This annual report contains statements that constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. In addition, in the future the Company, and others on its behalf, may make statements that constitute forward-looking statements. Such forward-looking statements may include, without limitation, statements relating to the Company’s plans, objectives or goals; future economic performance or prospects; the potential effect on the Company’s future performance of certain contingencies; and assumptions underlying any such statements.

Words such as “believes,” “anticipates,” “expects,” “intends” and “plans” and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. The forward-looking statements are and will be based upon management’s then current views and assumptions regarding future events and operating performance and are only applicable as of the dates of such statements. The Company does not intend to update these forward-looking statements except as may be required by applicable laws.

By their very nature, forward-looking statements involve inherent risks and uncertainties, both general and specific, and risks exist that predictions, forecasts, projections and other outcomes described or implied in forward-looking statements will not be achieved. The Company cautions you that a number of important factors could cause results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements, including without limitation the risks described under the caption “Risk Factors” in this Annual Report on Form 10-K. You are cautioned not to place undue reliance on the Company’s forward-looking statements.

PART I
Item 1.  Business

Overview

Telos Corporation, together with its subsidiaries, (the “Company” or “Telos” or “We”) is an information technology leader focused on designing and providing advanced technologies to deliver solutions that empower and protect the world’s most demanding enterprises. We empower our customers with secure solutions that leverage mobile communication, cloud technology, and real-time collaboration.  We protect vital assets that include the critical operational and tactical systems of our customers so that they can safely conduct their global missions. Our customer base consists primarily of military, intelligence and civilian agencies of the federal government and NATO allies around the world.

We generate approximately 74.9% of our revenues by delivering these solutions at a fixed price to our customers. This focus on fixed price delivery has enabled us to significantly reduce life cycle costs for our customers. We have been able to achieve this by investing in intellectual property development so that we can use automation, when appropriate.

While we were incorporated in 1971, we liquidated and/or sold our original businesses and refocused on delivering secure solutions beginning in 1997. Our Company includes Telos Corporation, Xacta Corporation, Teloworks, Inc., and a 50% interest in Telos Identity Management Solutions, LLC (“Telos ID”).

We were incorporated in Maryland, our headquarters are located at 19886 Ashburn Road, Ashburn, VA 20147, and our telephone number is (703) 724-3800. Our website is www.telos.com.

Our Mission

Our mission is to protect critical information assets with solutions and services for cyber security, secure mobility, and identity management.

We believe that our customer focus is the foundation of our success to date. We also believe that this focus is critical for the creation of long-term value.

How We Provide Value to Our Customers

We serve our customers by developing solutions that are quickly and efficiently deployed so that our customers have the assurance that they can safely conduct their vital missions around the world. Some of the key benefits we offer our customers include:

Protecting and Securing Assets. Whether we are guarding access to systems, networks, communications, or people, our solutions work to protect what is most important to today’s security-conscious enterprises.

Applying Specialized Expertise. Our teams of security professionals, such as those we provide to protect the Pentagon’s critical networks, are some of the industry’s most experienced in the design and operation of communications systems that must be reliable and secured 24/7.

Achieving Regulatory Compliance. From embedding the latest security standards in our information assurance software, to complying with network security requirements on a particular military base, our solutions give our customers confidence in their ability to meet established security regulations.

Ensuring the Reliability of Operations. Our testing is comprehensive, assuring our customers of a dependable product when delivered. Our support is worldwide, extending from helpdesk resources for government agencies and our commercial customers throughout the country to field support overseas.

Leveraging Customers’ Existing Infrastructure. Our pre-deployment assessment of our customers’ environments, ranging from secure network site surveys to evaluations of physical security access, assures our customers of the technical and operational compatibility of our solutions.

Selected Examples of How We Accomplish Our Mission

We protect the systems of our customers through the development and delivery of our Xacta software (“Xacta”). Xacta is the premier solution for continuous assessment and authorization, and is used throughout the Department of Defense (“DoD”), intelligence communities and civilian government, as well as by commercial businesses. We have performed thousands of certifications and our product has been adopted by numerous enterprises as their solution of choice for risk management and ongoing compliance.

We streamline and automate the process of selecting, applying, and monitoring security controls for cloud-based systems and applications so that security-conscious organizations can migrate their workloads to the cloud faster and more efficiently. Our solutions make it easier to automate compliance and generate associated documentation, streamlining our customers’ ability to demonstrate that they meet the relevant security standards in their respective industries.

We offer Telos Ghost, a cybersecurity solution that gives organizations an anonymous way to do business, connect with global resources, and conduct research online.  Telos Ghost eliminates cyber attack surfaces by obfuscating and encrypting data, masking user identity and location, and hiding network resources. It is useful for intelligence gathering, cyber threat protection, securing critical infrastructure, and protecting communications and applications.

We protect and extend the wireless networks of our customers with secure mobility solutions that reduce their exposure to risk and assure they can safely communicate across the enterprise and around the world. Our solutions help customers securely connect to any information source, using any device, over any wireless medium, providing access to real-time information that is secure, accurate, and reliable.

We protect and enhance the communications of our customers through the development and delivery of our Telos Automated Message Handling System (“AMHS”), which has been adopted by the DoD to carry all official message traffic and is implemented throughout all branches of the military, the intelligence community, and other critical civilian agencies. AMHS is also used by U.S. Central Command to meet its critical organization and communications requirements in the CENTCOM Theater of Operations including Iraq and Afghanistan.

Through an exclusive subcontractor relationship with Telos ID, we assess, design, and deliver identity and access solutions to protect national security assets, people, and facilities. Among these programs is the leading designated aviation channeling service for the general aviation industry, serving nearly 90 airports, airlines, and aviation customers across the country. Telos ID also supports the premier federal identity application, which has issued almost 45,700,000 smart card based secure credentials for active duty uniformed service personnel, Selected Reserve, DoD civilian employees, and eligible contractor personnel. Additionally, we provide near real-time data collection on personnel movement and location information for operating forces, government civil servants, and government contractors in specified operational theaters. This system has captured over 597,000,000 scans by more than 2,900,000 U.S. Government, U.S. Military and company contractors since its inception.

We would not be able to design, deliver, install, and support any of our solutions without our employees. They are a vital element of our success. We provide competitive pay and benefits and a work environment that promotes employee retention.

Solutions for Our Customers

Our solution development philosophy involves responding to proven market demand with rapid development and continuous innovation in an effort to meet and anticipate our customers’ dynamic and evolving requirements.  

Our solutions consist of the following:

Cyber Operations and Defense (CO&D):
o
Cyber Security – Solutions and services that assure the security of our 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.

The Technology Behind Our Solutions

Techniques: We employ development and production methodologies such as Agile and ISO 9001 to ensure predictability, repeatability, and quality. Techniques such as continuous integration are employed to accelerate the solution development and testing process while at the same time reducing cost and improving quality. We believe such techniques are critical for providing our customers with a high quality user experience.

Architecture:  The nature of our customers’ missions requires our solutions to be highly secure and scalable. Aside from architecting our solutions with these core objectives in mind, we also employ open standards and technologies that afford a high degree of flexibility and interoperability needed to support web-based and netcentric operations.

Intellectual Property

We invest in the creation of intellectual property and employ various forms of legal intellectual property protection mechanisms including the use of copyright, trademark, patent, and trade secret laws in North America and other jurisdictions. We have intellectual property reviews as an integral part of our development process in order to identify intellectual property as early as possible in the development process so the appropriate form of protection can be obtained. We also vigorously control access to intellectual property via physical and logical protection mechanisms. All of our employees sign agreements that govern intellectual property ownership and confidentiality. We also enter into intellectual property, confidentiality and non-disclosure agreements with partners and other third parties.

Patents, Trademarks, Trade Secrets and Licenses

We have made it a practice of obtaining patent, copyright and/or trademark protection on our products, processes and marks where possible. We own a number of patents and copyrights, which we believe to be of material importance to the Company. Our patents and copyrights extend for varying periods of time based on the date of application or registration. Generally, registered copyright protection continues for a term of at least 70 years. Trademark and service mark protection for registered marks generally continues for as long as the marks are used.

Telos and Xacta are trademarks of Telos Corporation. Telos ID is a trademark of Telos ID.

Sales and Marketing

We target decision makers in government agencies and departments, and commercial businesses who have a need for secure enterprise solutions. Decisions regarding contract awards by our customers typically are based upon an assessment of the quality of our past performance, responsiveness to proposal requirements, uniqueness of the offering itself, price, and other competitive factors.

Our products and services in many instances combine a wide range of skills drawn from each of our major product and service offerings. Accordingly, we must maintain expert knowledge of federal agency policies, procedures and operations.
   
We employ marketing and business development professionals who identify, qualify, and sell opportunities for us. Virtually all of our officers and managers, including the chief executive officer, other executive officers, vice presidents, and division managers, actively engage in new business development.

We have strategic business relationships with certain companies in the information technology industry. These strategic partners have business objectives compatible with ours, and offer products and services that complement ours. We intend to continue developing such relationships wherever they support our marketing, growth and solution offering objectives.

The majority of our business is awarded through submission of formal competitive bids. Commercial bids are frequently negotiated as to terms and conditions such as schedule, specifications, delivery and payment. However, in government proposals, in most cases, the customer specifies the terms, conditions and form of the contract.

Our contracts and subcontracts are generally composed of a wide range of contract types including indefinite delivery/indefinite quantity (“IDIQ”) and government-wide acquisition contracts (known as “GWACs”) which are generally firm fixed-priced or time-and-materials contracts. For 2018, 2017, and 2016, the Company’s revenue derived from firm fixed-price contracts was 74.9%, 83.1%, and 76.0%, respectively, cost plus contracts was 12.9%, 7.4%, and 16.4%,  respectively, and time-and-material contracts was 12.2%, 9.5%, and 7.6%, respectively.

We derive a substantial portion of our revenues from contracts and subcontracts with the U.S. Government. 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 and services provider. To that end, although we continue to offer resold products through our contract vehicles, we have focused on selling solutions and services and outsourcing product sales, as well as designing and delivering Telos manufactured technology products. In general, 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 IT solutions primarily involve the design and integration of commercial off-the-shelf IT products into integrated solutions deliverables. Such equipment is generally available from several sources, although several factors including technical specifications, proprietary or brand-specific equipment requirements, or contractual channel agreements may limit the availability of sourcing options. We utilize more than 300 vendors as direct materials suppliers, subcontractors, and service providers. The vendors utilized in any given measurement period vary based on the mix and the timing of the solutions delivered, but typically our contracts are a smaller subset that comprises the majority of the direct cost of sales on an annual basis. Therefore, while a smaller subset of suppliers, subcontractors, and service providers may be employed to deliver the majority of the revenue for a particular period, were there to be an unforeseen disruption to one of these vendors, the delay would likely be short-term in nature due to the existence of alternate sourcing options.

We derived a substantial portion of our revenues from contracts and subcontracts with the U.S. Government. Revenue by customer sector for the last three fiscal years is as follows:

   
2018
   
2017
   
2016
 
               
(dollar amounts in thousands)
             
                                     
Federal
 
$
129,279
     
93.7
%
 
$
101,519
     
94.2
%
 
$
130,415
     
96.7
%
State & Local, and Commercial
   
8,737
     
6.3
%
   
6,208
     
5.8
%
   
4,453
     
3.3
%
Total
 
$
138,016
     
100.0
%
 
$
107,727
     
100.0
%
 
$
134,868
     
100.0
%

We build market awareness of Telos and our solutions through a variety of marketing programs, including regular briefings with industry analysts, public relations activities, government relations initiatives, web seminars, trade show exhibitions, speaking engagements and web site marketing. When appropriate, we pursue joint marketing and selling efforts with our strategic partners.

Our People and Culture

As of December 31, 2018, we employed 627 people, which includes 65 from Teloworks, and 99 from Telos ID. Of our employees, 408 hold security clearances of secret or higher.

Our people are proficient in many fields such as computer science, information security and vulnerability testing, networking technologies, physics, engineering, operations research, mathematics, economics, and business administration. We place a high value on our people. As a result, we seek to remain competitive in terms of salary structures, incentive compensation programs, fringe benefits, opportunities for growth, and individual recognition and award programs.

Our management team is committed to maintaining a corporate culture that fosters mutual respect and job satisfaction for our people, while delivering innovation and value to customers and shareholders. This commitment is reflected in our core values.

Always with integrity, at Telos we:

Build trusted relationships,
Work hard together,
Design and deliver superior solutions, and
Have fun doing it.

These values are woven throughout the fabric of Telos. They are reflected in our hiring practices, reinforced regularly, and reviewed during appraisals. They are written into annual and quarterly objectives for staff and managers alike, as well as department and company business goals. Employees are encouraged to challenge themselves and each other to exhibit the core values in everyday activities.

Our employees also are given avenues of communication and interaction should they observe activities that are inconsistent with the Company’s core values. Encouraged first to speak openly about any issues, a hotline provides an opportunity to express concerns anonymously.

We consider the foundational value of integrity to be a non-negotiable requirement of employment, and an expectation of suppliers, partners, and our customers. We guard our reputation and will take aggressive action to protect it. An essential part of our brand promise is that we always engage employees, customers, partners, suppliers, and investors with integrity.

Competition

We operate in a highly competitive marketplace. There are other companies that provide solutions similar to ours. Although these companies provide offerings that overlap with some of our solutions, we are not aware of any single company that provides competitive solutions in all of the areas where we compete. The companies that our solution areas compete with range from integrators that provide products and services such as Booz Allen Hamilton, General Dynamics, Lockheed Martin, Northrop Grumman, SAIC and Daon, to more software-specific organizations such as Agiliance and RSA Archer.

The majority of our business is in response to competitive requests from potential and current customers. Decisions regarding contract awards by our customers typically are based upon an assessment of the quality of our past performance, responsiveness to proposal requirements, uniqueness of the offering itself, price, and other competitive factors.

Aside from other companies that compete in our space, we sometimes face indirect competition from solutions that are developed “in-house” by some of our customers.

Government Contracts and Regulation

Our business is heavily regulated. We must comply with and are affected by laws and regulations relating to the formation, administration and performance of U.S. Government and other contracts. These laws and regulations, among other things: 

impose specific and unique cost accounting practices that may differ from Generally Accepted Accounting Principles (“GAAP”) in the United States of America and therefore require reconciliation;

impose acquisition regulations that define reimbursable and non-reimbursable costs; and

restrict the use and dissemination of information classified for national security purposes and the export of certain products and technical data.

Government contracts are subject to congressional funding. Consequently, at the outset of a program, a contract is usually partially funded, and Congress annually determines if additional funds are to be appropriated to the contract. All of our customers have the right to terminate their contract with us at their convenience or in the event that we default.

A portion of our business is classified by the U.S. Government and cannot be specifically described. The operating results of these classified programs are included in our consolidated financial statements.

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 December 31, 2018 and 2017, we had total backlog from existing contracts of approximately $290.8 million and $256.3 million, respectively.  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 customers.
 
Funded backlog as of December 31, 2018 and 2017 was $79.3 million and $98.5 million, respectively.

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 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.

Seasonality

We derive a substantial portion of our revenues from U.S. Government contracting, and as such we are annually subject to the seasonality of the U.S. Government purchasing. As the U.S. Government fiscal year ends on September 30, it is not uncommon for U.S. Government agencies to award extra tasks in the weeks immediately prior to the end of its fiscal year in order to avoid the loss of unexpended fiscal year funds. As a result of this cyclicality, we have historically experienced higher revenues in the third and fourth fiscal quarters, ending September 30 and December 31, respectively, with the pace of orders substantially reduced during the first and second fiscal quarters ending March 31 and June 30, respectively.

Item 1A. Risk Factors

In addition to other information in this Form 10-K, the following risk factors should be carefully considered in evaluating the Company and its businesses because these factors currently have, or may have, a significant impact on our business, operating results or financial condition. Actual results could differ materially from those projected in the forward-looking statements contained in this Form 10-K as a result of the risk factors discussed below and elsewhere in this Form 10-K.

Our inability to maintain sufficient access to the capital markets to provide the necessary capital to fund our operations would have a significant impact on our business.
Our primary source of funds to meet our liquidity and capital requirements is an Accounts Receivable Purchase Agreement (the “Purchase Agreement”) with Republic Capital Access, LLC (“RCA”). Under the Purchase Agreement, we may offer for sale, and RCA, in its sole discretion may purchase, up to $10 million of eligible accounts receivable relating to U.S. Government prime contracts or subcontracts outstanding at any given time. The willingness of RCA to purchase our accounts receivable under the Purchase Agreement, and our ability to obtain additional financing, may be limited due to various factors, including the eligibility of our accounts receivable under those agreements, the status of our business, global credit market conditions, or perceptions of our business or industry by RCA, or other potential sources of financing. In January 2017, we borrowed $11 million under a credit agreement with Enlightenment Capital Solutions Fund II, L.P. to raise additional working capital and retire certain long-term obligations. If we are unable to maintain the Purchase 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 our new sources of financing 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.

We depend on the U.S. Government for a significant portion of our sales and a significant decline in U.S. Government defense spending could have an adverse impact on our financial condition and results of operations.
Our sales are highly concentrated with the U.S. Government. The customer relationship with the U.S. Government involves certain risks that are unique. The programs in which we participate must compete with other programs and policy imperatives during the budget and appropriations process.  In each of the past three years, a substantial portion of our net sales were to the U.S. Government, particularly the DoD. U.S. defense spending has historically been cyclical. Defense budgets have received their strongest support when perceived threats to national security raise the level of concern over the country’s safety. As these threats subside, spending on the military tends to decrease. Rising budget deficits, increasing national debt, the cost of the global war on terrorism, and increasing costs for entitlement programs continue to put pressure on all areas of discretionary spending, which could ultimately impact the defense budget.

U.S. Government appropriations have been and continue to be affected by larger U.S. government budgetary issues and related legislation. In 2011, Congress enacted the Budget Control Act of 2011 (the “BCA”), which established specific limits on annual appropriations for fiscal years 2012-2021. The BCA has been amended a number of times, most recently by the Bipartisan Budget Act of 2018 (the “BBA”). As a result, DoD funding levels have fluctuated over this period and have been difficult to predict, but the impact of the BCA has been to essentially freeze DoD spending for the past five years.

According to the Congressional Research Service, federal outlays devoted to defense programs have fallen as a share of Gross Domestic Product (GDP) in every year since enactment of the BCA. Moreover, under the BCA, National Defense Discretionary Budget Authority in FY 2017 was $551 billion, which was actually $4 billion less than the amount authorized in FY 2012.

With FY 2019 appropriations finalized, Congress and the President must agree on FY 2020 appropriations legislation prior to October 1, 2019; failing to do so by then will likely mean DoD will again be funded for an unknown period of time under another Continuing Resolution, which would again restrict new spending initiatives.  This is consistent with the practice for a number of years, where the U.S. Government has been unable to complete its budget and appropriation process prior to the beginning of the next fiscal year, resulting in actual or threatened governmental shut-downs and repeated use for extended time periods each year of Continuing Resolutions to fund the government.

Finally, while the two-year budget agreement enacted in February 2018 as part of the BBA allows for significantly increased defense appropriations in both fiscal years 2018 and 2019, if the underlying BCA is not further amended before FY 2020, the much lower spending limits for defense and non-defense spending imposed by the BCA will again take effect in FY 2020. Further, if the U.S. Government debt ceiling is not raised and the national debt reaches the statutory debt ceiling, the U.S. Government could default on its debts.

As a result of these and any other possible unforeseen factors, future U.S. Government defense spending levels are difficult to predict. Significant changes in defense spending or changes in U.S. Government priorities, policies and requirements could have a material adverse effect on our results of operations, financial condition or liquidity. In addition, a shutdown of the U.S. Government, or portions of the U.S. Government, or the failure of the Congress and the President to agree on and enact appropriations legislation for future fiscal years, could have a material adverse effect on our results of operations, financial condition and liquidity.

Our U.S. Government contracts are subject to competitive bidding, both upon initial issuance and re-competition. If we are unable to successfully compete in the bidding process or if we fail to win re-competitions, it could adversely affect our operating performance and lead to an unexpected loss of revenue.
Substantially all of our U.S. Government contracts are awarded through a competitive bidding process upon initial award and renewal, and we expect that this will continue to be the case. There is often significant competition and pricing pressure as a result of this process. The competitive bidding process presents a number of risks, including the following:

we may expend substantial funds and time to prepare bids and proposals for contracts that may ultimately be awarded to one of our competitors;
we may be unable to accurately estimate the resources and costs that will be required to perform any contract we are awarded, which could result in substantial cost overruns;
we may encounter expense and delay if our competitors protest or challenge awards of contracts, and any such protest or challenge could result in a requirement to resubmit bids on modified specifications or in the termination, reduction or modification of the awarded contract. Additionally, the protest of contracts awarded to us may result in the delay of program performance and the generation of revenue while the protest is pending; and
if we are not given the opportunity to re-compete for U.S. Government contracts previously awarded to us, we may incur expenses to protect such decision and ultimately may not succeed in competing for or winning such contract renewal.

The U.S. Government contracts for which we compete typically have multiple option periods, and if we fail to win a contract or a task order, we generally will be unable to compete again for that contract for several years. If we fail to win new contracts or to receive renewal contracts upon re-competition, it may result in additional costs and expenses and possible loss of revenue, and we will not have an opportunity to compete for these contract opportunities again until such contracts expire.

U.S. Government contracts generally are not fully funded at inception and are subject to amendment or termination, which places a significant portion of our revenues at risk and could adversely impact our earnings.
Our U.S. Government sales are funded by customer budgets, which operate on an October-to-September fiscal year. In February of each year, the President of the United States presents to the Congress the budget for the upcoming fiscal year. This budget proposes funding levels for every federal agency and is the result of months of policy and program reviews throughout the Executive branch. From February through September of each year, the appropriations and authorization committees of Congress review the President’s budget proposals and establish the funding levels for the upcoming fiscal year in appropriations and authorization legislation. Once these levels are enacted into law, the Executive Office of the President administers the funds to the agencies. There are two primary risks associated with this process. First, the process may be delayed or disrupted. Changes in congressional schedules, negotiations for program funding levels or unforeseen world events can interrupt the funding for a program or contract. Second, funds for multi-year contracts can be changed in subsequent years in the appropriations process. In addition, the U.S. Government has increasingly relied on IDIQ contracts and other procurement vehicles that are subject to a competitive bidding and funding process even after the award of the basic contract, adding an additional element of uncertainty to future funding levels. Delays in the funding process or changes in funding can impact the timing of available funds or can lead to changes in program content or termination at the government’s convenience. The loss of anticipated funding or the termination of multiple or large programs could have an adverse effect on our future sales and earnings.

We are subject to substantial oversight from federal agencies that have the authority to suspend our ability to bid on contracts.
As a U.S. Government contractor, we are subject to oversight by many agencies and entities of the U.S. Government that may investigate and make inquiries of our business practices and conduct audits of contract performance and cost accounting. Depending on the results of any such audits and investigations, the U.S. Government may make claims against us. Under U.S. Government procurement regulations and practices, an indictment of a U.S. Government contractor could result in that contractor being fined and/or suspended for a period of time from eligibility for bidding on, or for the award of, new U.S. Government contracts. A conviction could result in debarment for a specified period of time. To the best of management’s knowledge, there are no pending investigations, inquiries, claims or audits against the Company likely to have a material adverse effect on our business or our consolidated results of operations, cash flows or financial position.
We enter into fixed-price and other contracts that could subject us to losses if we experience cost growth that cannot be billed to customers.
Generally, our customer contracts are either fixed-priced or cost reimbursable contracts. Under fixed-priced contracts, which represented approximately 74.9% of our 2018 revenues, we receive a fixed price irrespective of the actual costs we incur and, consequently, we carry the burden of any cost overruns. Due to their nature, fixed-priced contracts inherently have more risk than cost reimbursable contracts, particularly fixed-price development contracts where the costs to complete the development stage of the program can be highly variable, uncertain and difficult to estimate. Under cost reimbursable contracts, subject to a contract-ceiling amount in certain cases, we are reimbursed for allowable costs and paid a fee, which may be fixed or performance based. If our costs exceed the contract ceiling and are not authorized by the customer or are not allowable under the contract or applicable regulations, we may not be able to obtain reimbursement for all such costs and our fees may be reduced or eliminated. Because many of our contracts involve advanced designs and innovative technologies, we may experience unforeseen technological difficulties and cost overruns. Under both types of contracts, if we are unable to control costs or if our initial cost estimates are incorrect, we can lose money on these contracts. In addition, some of our contracts have provisions relating to cost controls and audit rights, and if we fail to meet the terms specified in those contracts, we may not realize their full benefits. Lower earnings caused by cost overruns and cost controls would have a negative impact on our results of operations.

We depend on third parties in order to fully perform under our contracts and the failure of a third party to perform could have an adverse impact on our earnings.
We rely on subcontractors and other companies to provide raw materials, major components and subsystems for our products or to perform a portion of the services that we provide to our customers. Occasionally, we rely on only one or two sources of supply, which, if disrupted, could have an adverse effect on our ability to meet our commitments to customers. We depend on these subcontractors and vendors to fulfill their contractual obligations in a timely and satisfactory manner in full compliance with customer requirements. If one or more of our subcontractors or suppliers is unable to satisfactorily provide on a timely basis the agreed-upon supplies or perform the agreed-upon services, our ability to perform our obligations as a prime contractor may be adversely affected.

Our future profitability depends, in part, on our ability to develop new technologies and maintain a qualified workforce to meet the needs of our customers.
Virtually all of the products that we produce and sell are highly engineered and require sophisticated manufacturing and system integration techniques and capabilities. The government market in which we primarily operate is characterized by rapidly changing technologies. The product and program needs of our government and commercial customers change and evolve regularly. Accordingly, our future performance in part depends on our ability to identify emerging technological trends, develop and manufacture competitive products, and bring those products to market quickly at cost-effective prices. In addition, because of the highly specialized nature of our business, we must be able to hire and retain the skilled and appropriately qualified personnel necessary to perform the services required by our customers. If we are unable to develop new products that meet customers’ changing needs or successfully attract and retain qualified personnel, future sales and earnings may be adversely affected.

The business environment in which we operate is highly competitive and may impair our ability to achieve revenue growth.
We operate in industry segments that are diverse. Based upon our current market analysis, there is no single company or small group of companies in a dominant competitive position. Some large competitors offer capabilities in a number of markets that overlap many of the same areas in which we offer services, while certain companies are focused upon only one or a few of such markets.  Some of the firms that compete with us in multiple areas include: Northrop Grumman, Lockheed Martin and General Dynamics. In addition, we compete with smaller specialty companies, including risk and compliance management companies, organizational messaging companies, and security consulting organizations, and companies that provide secure network offerings. If we do not compete effectively, we may suffer price reductions, reduced gross margins, and loss of market share.

Some of our security solutions have lengthy sales and implementation cycles, which could impact significantly our results of operations if projected orders are not realized.
We market the majority of our security solutions directly to U.S. Government customers. The sale and implementation of our services to these entities typically involves a lengthy education process and a significant technical evaluation and commitment of capital and other resources. This process is also subject to the risk of delays associated with customers’ internal budgeting and other procedures for approving large capital expenditures, deploying new technologies within their networks and testing and accepting new technologies that affect key operations. As a result, the sales and implementation cycles associated with certain of our services can be lengthy. Our quarterly and annual operating results could be materially harmed if orders forecasted for a specific customer for a particular quarter are not realized.

Our business could be negatively affected by cyber or other security threats or other disruptions.
As a U.S. defense contractor, we face cyber threats, threats to the physical security of our facilities and employees, and terrorist acts, as well as the potential for business disruptions associated with information technology failures, natural disasters, or public health crises. We routinely experience cyber security threats, threats to our information technology infrastructure and attempts to gain access to our sensitive information, as do our customers, suppliers, subcontractors and joint venture partners. We may experience similar security threats at customer sites that we operate and manage as a contractual requirement. Prior cyber attacks directed at us have not had a material impact on our financial results, and we believe our threat detection and mitigation processes and procedures are adequate. The threats we face vary from attacks common to most industries to more advanced and persistent, highly organized adversaries who target us because we protect national security information. If we are unable to protect sensitive information, our customers or governmental authorities could question the adequacy of our threat mitigation and detection processes and procedures.  Due to the evolving nature of these security threats, however, the impact of any future incident cannot be predicted. Occurrence of any of these events could adversely affect our internal operations, the services we provide to our customers, loss of competitive advantages derived from our research and development efforts or other intellectual property, early obsolescence of our products and services, our future financial results, or our reputation.

If we are unable to protect our intellectual property, our revenues may be impacted adversely by the unauthorized use of our products and services.
Our success depends on our internally developed technologies, patents and other intellectual property. Despite our precautions, it may be possible for a third party to copy or otherwise obtain and use our trade secrets or other forms of intellectual property without authorization. Furthermore, the laws of foreign countries may not protect our proprietary rights in those countries to the same extent U.S. law protects these rights in the United States. In addition, it is possible that others may independently develop substantially equivalent intellectual property. If we do not effectively protect our intellectual property, our business could suffer. In the future, we may have to resort to litigation to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. This type of litigation, regardless of its outcome, could result in substantial costs and diversion of management and technical resources.

If we are unable to license third-party technology that is used in our products and services to perform key functions, the loss could have an adverse affect on our revenues.
The third-party technology licenses used by us may not continue to be available on commercially reasonable terms or at all. Our business could suffer if we lost the rights to use these technologies. A third-party could claim that the licensed software infringes a patent or other proprietary right. Litigation between the licensor and a third-party or between us and a third-party could lead to royalty obligations for which we are not indemnified or for which indemnification is insufficient, or we may not be able to obtain any additional license on commercially reasonable terms or at all. The loss of, or our inability to obtain or maintain, any of these technology licenses could delay the introduction of new products or services until equivalent technology, if available, is identified, licensed and integrated. This could harm our business.

We are involved in a number of legal proceedings. We cannot predict the outcome of litigation and other contingencies with certainty.
Our business may be adversely affected by the outcome of legal proceedings and other contingencies that cannot be predicted with certainty. As required by GAAP, we estimate loss contingencies and establish reserves based on our assessment of contingencies where liability is deemed probable and reasonably estimable in light of the facts and circumstances known to us at a particular point in time. Subsequent developments in legal proceedings may affect our assessment and estimates of the loss contingency recorded as a liability or as a reserve against assets in our financial statements. For a description of our current legal proceedings, see Note 13 – Commitments and Contingencies to the consolidated financial statements.

Any potential future acquisitions, strategic investments, divestitures, mergers or joint ventures may subject us to significant risks, any of which could harm our business.
Our long-term strategy may include identifying and acquiring, investing in or merging with suitable candidates on acceptable terms, or divesting of certain business lines or activities. In particular, over time, we may acquire, make investments in, or merge with providers of product offerings that complement our business or may terminate such activities. Mergers, acquisitions, and divestitures include a number of risks and present financial, managerial and operational challenges, including but not limited to:
diversion of management attention from running our existing business;
possible material weaknesses in internal control over financial reporting;
increased expenses including legal, administrative and compensation expenses related to newly hired or terminated employees;
increased costs to integrate the technology, personnel, customer base and business practices of the acquired company with us;
potential exposure to material liabilities not discovered in the due diligence process;
potential adverse effects on reported operating results due to possible write-down of goodwill and other intangible assets associated with acquisitions; and
unavailability of acquisition financing or unavailability of such financing on reasonable terms.

Any acquired business, technology, service or product could significantly under-perform relative to our expectations, and may not achieve the benefits we expect from possible acquisitions. For all these reasons, our pursuit of an acquisition, investment, divestiture, merger, or joint venture could cause its actual results to differ materially from those anticipated.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

We lease approximately 191,700 square feet of space for our corporate headquarters, integration facility, and primary service depot in Ashburn, Virginia. The lease expires in May 2029.

We sublease 27,000 square feet of space at the Ashburn, Virginia facility to our affiliate, Telos ID, which space serves as Telos ID’s corporate headquarters. This sublease will expire on December 31, 2019.

We lease additional office space in four separate facilities located in California, Maryland, New Jersey and Nevada under various leases expiring through January 2024.

We believe that the current space is substantially adequate to meet our operating requirements.

Item 3. Legal Proceedings

Information regarding legal proceedings may be found in Note 13 – Commitments and Contingencies to the Consolidated Financial Statements.

Item 4. Mine Safety Disclosures

Not applicable.

PART II

Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

        No public market exists for our Class A or Class B Common Stock. As of March 4, 2019, there were 242 record holders of our Class A Common Stock and 10 record holders of our Class B Common Stock. We have not paid dividends on either class of our Common Stock during the last two fiscal years. For a discussion of restrictions on our ability to pay dividends, see Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources and Note 6 – Current Liabilities and Debt Obligations to the consolidated financial statements.

As of December 31, 2018, there were 45,158,460 and 4,037,628 shares issued and outstanding of Class A and Class B Common Stock, respectively.

Our 12% Cumulative Exchangeable Redeemable Preferred Stock (“Public Preferred Stock”) trades over the OTC Bulletin Board and the OTCQB marketplace under the symbol “TLSRP”. The total number of shares issued and outstanding at December 31, 2018 was 3,185,586. See Note 7 – Redeemable Preferred Stock to the consolidated financial statements.

No public market existed for our Series A-1 and Series A-2 Redeemable Preferred Stock (“Senior Redeemable Preferred Stock”), prior to their redemption in April 2017.  See Note 7 – Redeemable Preferred Stock to the consolidated financial statements.

Item 6. Selected Financial Data

The following should be read in connection with the accompanying information presented in Item 7 and Item 8 of this Form 10-K.

OPERATING RESULTS

   
Years Ended December 31,
 
   
2018
   
2017
   
2016
   
2015
   
2014
 
   
(amounts in thousands)
 
Sales
 
$
138,016
   
$
107,727
   
$
134,868
   
$
120,634
   
$
127,562
 
Operating income (loss)
   
9,014
     
414
     
2,112
     
(3,617
)
   
(11,644
)
Income (loss) before income taxes
   
1,768
     
(6,265
)
   
(3,335
)
   
(9,237
)
   
(16,600
)
Net loss attributable to Telos Corporation
   
(1,640
)
   
(5,833
)
   
(7,175
)
   
(15,940
)
   
(12,288
)


FINANCIAL CONDITION

   
As of December 31,
 
   
2018
   
2017
   
2016
   
2015
   
2014
 
   
(amounts in thousands)
 
Total assets
 
$
74,489
   
$
74,421
   
$
56,799
   
$
59,964
   
$
73,820
 
Senior term loan (1)
   
10,984
     
10,786
     
----
     
----
     
----
 
Senior credit facility, long-term (1)
   
----
     
----
     
----
     
7,144
     
8,590
 
Subordinated debt, long-term (1)
   
2,597
     
2,289
     
----
     
2,500
     
----
 
Capital lease obligations, long-term (2)
   
16,865
     
17,980
     
18,990
     
19,908
     
20,735
 
Deferred income taxes, long-term (3)
   
818
     
741
     
3,391
     
3,199
     
----
 
Senior redeemable preferred stock (4)
   
----
     
----
     
2,092
     
2,025
     
1,958
 
Public preferred stock (4)
   
135,387
     
131,565
     
127,742
     
123,919
     
120,097
 


(1)
See Note 6 to the Consolidated Financial Statements in Item 8 regarding our debt obligations.
(2)
See Note 10 to the Consolidated Financial Statements in Item 8 regarding our capital lease obligations.
(3)
See Note 9 to the Consolidated Financial Statements in Item 8 regarding our income taxes.
(4)
See Note 7 to the Consolidated Financial Statements in Item 8 regarding our redeemable preferred stock.


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

General
Our goal is to deliver superior IT solutions that meet or exceed our 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”):
o
Cyber Security – Solutions and services that assure the security of our 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.

Critical Accounting Policies and Estimates

The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions used in the preparation of our consolidated financial statements include revenue recognition, allowance for doubtful accounts receivable, allowance for inventory obsolescence, the valuation allowance for deferred tax assets, income taxes, contingencies and litigation, potential impairments of goodwill and intangible assets, estimated pension-related costs for our foreign subsidiaries and accretion of Public Preferred Stock.  Actual results could differ from those estimates.

        The following is a summary of the most critical accounting policies used in the preparation of our consolidated financial statements.

Revenue Recognition
We account for revenue in accordance with Accounting Standard Codification (“ASC”) Topic 606, “Revenue from Contracts with Customers.” The unit of account in ASC 606 is a performance obligation, which is a promise, 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), and recognizing revenue as the performance obligations are satisfied. Timing 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 may 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 based on our best estimate of standalone selling price.

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 who receive and consume benefits as we perform, 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 Federal Acquisition Regulation (the 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.  We have revised and re-submitted several years of incurred cost submissions reflecting certain indirect rate structure changes as a result of regular Defense Contract Audit Agency (“DCAA”) audits of incurred cost submissions.  This resulted in signed final rate agreement letters for 2011 to 2013 and conformed incurred cost submissions for 2014 to 2015. We evaluated the resulting changes to revenue under the applicable cost plus fixed fee contracts for the years 2011 to 2015 as variable consideration, and determined the most likely amount to which we expect to be entitled, to the extent that no constraint exists that would preclude recognizing this revenue or result in a significant reversal of cumulative revenue recognized. We have included these estimated amounts of variable consideration in the transaction price and as performance on these contracts is complete, we have recognized revenue of $6.0 million in the current period.

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.

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 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 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 consolidated balance sheet on a net contract basis at the end of each reporting period.

We have one reportable segment. We treat sales to U.S. customers as sales within the U.S. regardless of where the services are performed. Substantially all of our revenues are from U.S. customers as revenue derived from international customers is de minimus. The following tables disclose revenue (in thousands) by customer type and contract type for the periods presented.  Prior period amounts have not been adjusted under the modified retrospective method.

   
2018
   
2017
   
2016
 
 
Federal
 
$
129,279
   
$
101,519
   
$
130,415
 
State & Local, and Commercial
   
8,737
     
6,208
     
4,453
 
Total
 
$
138,016
   
$
107,727
   
$
134,868
 

   
2018
   
2017
   
2016
 
 
Firm fixed-price
 
$
103,454
   
$
89,516
   
$
102,514
 
Time-and-materials
   
16,795
     
10,222
     
10,181
 
Cost plus fixed fee
   
17,767
     
7,989
     
22,173
 
Total
 
$
138,016
   
$
107,727
   
$
134,868
 

The following table discloses contract receivables (in thousands):
   
December 31,
2018
   
January 1, 2018
   
December 31, 2017
 
Billed accounts receivable
 
$
18,848
   
$
11,736
   
$
11,736
 
Unbilled receivables
   
16,000
     
13,195
     
13,195
 
Allowance for doubtful accounts
   
(306
)
   
(411
)
   
(411
)
Receivables – net
 
$
34,542
   
$
24,520
   
$
24,520
 

The following table discloses contract liabilities (in thousands):

   
December 31,
2018
   
January 1,
2018
   
December 31, 2017
 
Contract liabilities
 
$
5,232
   
$
10,073
   
$
10,073
 

As of December 31, 2018, we had $79.3 million of remaining performance obligations, which we also refer to as funded backlog. We expect to recognize approximately 97.2% of our remaining performance obligations as revenue in 2019, an additional 2.6% by 2020 and the balance thereafter. For the year ended December 31, 2018, the amount of revenue recognized during the year that was included in the opening contract liabilities balance was $9.4 million.

Inventories
Inventories are stated at the lower of cost or net realizable value, where cost is determined primarily on the weighted average cost method. Inventories consist primarily of purchased customer off-the-shelf hardware and software, and component computer parts used in connection with system integration services that we perform. Inventories also include spare parts utilized to support certain maintenance contracts. Spare parts inventory is amortized on a straight-line basis over two to five years, which represents the shorter of the warranty period or estimated useful life of the asset. An allowance for obsolete, slow-moving or non-salable inventory is provided for all other inventory. This allowance is based on our overall obsolescence experience and our assessment of future inventory requirements.

Goodwill
We evaluate the impairment of goodwill in accordance with ASC Topic 350, “Intangibles - Goodwill and Other,” which requires goodwill and indefinite-lived intangible assets to be assessed on at least an annual basis for impairment using a fair value basis. Between annual evaluations, if events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount, then impairment must be evaluated. Such circumstances could include, but are not limited to: (1) a significant adverse change in legal factors or business climate, or (2) a loss of key contracts or customers.

As the result of an acquisition, we record any excess purchase price over the net tangible and identifiable intangible assets acquired as goodwill. An allocation of the purchase price to tangible and intangible net assets acquired is based upon our valuation of the acquired assets. Goodwill is not amortized, but is subject to annual impairment tests. We complete our goodwill impairment tests as of December 31st each year. Additionally, we make evaluations between annual tests if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The evaluation is based on the estimation of the fair values of our three reporting units, Cyber Operations and Defense (“CO&D”), Identity Management, and IT & Enterprise Solutions, of which goodwill is housed in the CO&D reporting unit, in comparison to the reporting unit’s net asset carrying values. Our discounted cash flows required management judgment with respect to forecasted revenue streams and operating margins, capital expenditures and the selection and use of an appropriate discount rate. We utilized the weighted average cost of capital as derived by certain assumptions specific to our facts and circumstances as the discount rate. The net assets attributable to the reporting units are determined based upon the estimated assets and liabilities attributable to the reporting units in deriving its free cash flows. In addition, the estimate of the total fair value of our reporting units is compared to the market capitalization of the Company. The Company’s assessment resulted in a fair value that was greater than the Company’s carrying value, therefore the second step of the impairment test, as prescribed by the authoritative literature, was not required to be performed and no impairment of goodwill was recorded as of December 31, 2018. Subsequent reviews may result in future periodic impairments that could have a material adverse effect on the results of operations in the period recognized. Recent operating results have reduced the projection of future cash flow growth potential, which indicates that certain negative potential events, such as a material loss or losses on contracts, or failure to achieve projected growth could result in impairment in the future. We estimate fair value of our reporting unit and compare the valuation with the respective carrying value for the reporting unit to determine whether any goodwill impairment exists. If we determine through the impairment review process that goodwill is impaired, we will record an impairment charge in our consolidated statements of operations. Goodwill is amortized and deducted over a 15-year period for tax purposes.

Income Taxes
We account for income taxes in accordance with ASC 740-10, “Income Taxes.” Under ASC 740-10, deferred tax assets and liabilities are recognized for the estimated future tax consequences of temporary differences and income tax credits. Deferred tax assets and liabilities are measured by applying enacted statutory tax rates that are applicable to the future years in which deferred tax assets or liabilities are expected to be settled or realized for differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Any change in tax rates on deferred tax assets and liabilities is recognized in net income in the period in which the tax rate change is enacted. We record a valuation allowance that reduces deferred tax assets when it is "more likely than not" that deferred tax assets will not be realized. We are required to establish a valuation allowance for deferred tax assets if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based on available evidence, realization of deferred tax assets is dependent upon the generation of future taxable income. We considered projected future taxable income, tax planning strategies, and reversal of taxable temporary differences in making this assessment. As such, we have determined that a full valuation allowance is required as of December 31, 2018 and 2017. As a result of a full valuation allowance against our deferred tax assets, a deferred tax liability (hanging credit) related to goodwill remained on our consolidated balance sheet at December 31, 2018 and 2017.  Due to the tax reform enacted on December 22, 2017, net operating losses generated in taxable years beginning after December 31, 2017 will have an indefinite carryforward period, which will be available to offset future taxable income created by the reversal of temporary taxable differences related to goodwill. As a result, we have adjusted the valuation allowance on our deferred tax assets and liabilities at December 31, 2018 and 2017. See additional information on tax reform and its impact on our income taxes in Note 9 – Income Taxes.

Results of Operations
We derive a substantial portion of our revenues from contracts and subcontracts with the U.S. Government. 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.  For 2018, 2017, and 2016, the Company’s revenue derived from firm fixed-price contracts was 74.9%, 83.1%, and 76.0%, respectively, cost-plus contracts was 12.9%, 7.4%, and 16.4%, respectively, and time-and-material contracts was 12.2%, 9.5%, and 7.6%, respectively.

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 IDIQ and 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”) that the U.S. Air Force re-evaluate proposals and make a new source selection decision. Subsequent to the Air Force’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’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.

On September 28, 2018 the Department of Defense and Labor, Health and Human Services, and Education Appropriations Act, 2019 and Continuing Appropriations Act, 2019 (the Appropriations Act) was passed by Congress and signed into law. The Appropriations Act provides discretionary funding for the Department of Defense (DoD) and the other titled agencies for fiscal year (FY) 2019 (the U.S. Government’s fiscal year begins on October 1 and ends on September 30). The Appropriations Act provides funding for the DoD for FY 2019 of $674.4 billion and the previously enacted Military Construction and Veteran’s Affairs appropriations provides additional funding for the DoD for FY 2019 of $10.3 billion, bringing total funding for the DoD for FY 2019 to $685 billion, which is comprised of $617 billion in base funding and $68 billion for the Overseas Contingency Operations (OCO) account to support the Global War on Terrorism (GWOT). The Appropriations Act adheres to the recently enacted Bipartisan Budget Act of 2018 (BBA of 2018), which provided an additional $80 billion for national defense over two years in FY 2018 and FY 2019. This was the largest year over year increase in base funding for the DoD in 15 years. However, the U.S. Government did not pass a full-year appropriations for all agencies.  A majority of U.S. Government agencies operated under continuing resolution funding measures through December 21, 2018.  Prior to that date, Congress was unable to reach an agreement on full-year appropriations.  Consequently, a majority of U.S. Government agencies were shut down through January 25, 2019 when an agreement was reached to provide funding under a continuing resolution funding measure through February 15, 2019.  This shutdown did not include our largest customer, the DoD.  Then, on February 15, 2019, the President signed into law a $333 million omnibus appropriations bill that funded the U.S. Government for the remainder of the 2019 fiscal year.

Currently, U.S. defense and other discretionary spending in FY 2020 and FY 2021 remains subject to statutory spending limits established by the Budget Control Act. The Budget Control Act spending limits were modified 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, and most recently the BBA of 2018. However, these acts do not alter the spending limits beyond FY 2019. As currently enacted, the Budget Control Act limits defense spending to $576 billion (including approximately $550 billion for DoD) for fiscal year 2020 with a modest increase to $590 billion (including approximately $563 billion for DoD) in 2021. The President’s defense budget estimates for FY 2020 and beyond exceed the spending limits established by the Budget Control Act. As a result, continued budget uncertainty and the risk of possible disruptions to U.S. Government operations and future sequestration cuts remain unless the BCA is repealed or significantly modified.

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. For more information on the risks and uncertainties related to U.S. Government contracts, see Part I – Item 1A Risk Factors in this Annual Report on the Form 10-K.

Statement of Operations Data
The following table sets forth certain consolidated financial data and related percentages for the periods indicated:

   
Years Ended December 31,
 
   
2018
   
2017
   
2016
 
   
(dollar amounts in thousands)
 
                                     
Revenue
 
$
138,016
     
100.0
%
 
$
107,727
     
100.0
%
 
$
134,868
     
100.0
%
Cost of sales
   
84,954
     
61.6
     
67,161
     
62.3
     
91,422
     
67.8
 
Selling, general and administrative expenses
   
44,048
     
31.9
     
40,152
     
37.3
     
41,334
     
30.6
 
Operating income
   
9,014
     
6.5
     
414
     
0.4
     
2,112
     
1.6
 
Other income (expenses):
                                               
Non-operating income
   
12
     
----
     
11
     
----
     
18
     
----
 
Interest expense
   
(7,258
)
   
(5.2
)
   
(6,690
)
   
(6.2
)
   
(5,465
)
   
(4.1
)
Income (loss) before income taxes
   
1,768
     
1.3
     
(6,265
)
   
(5.8
)
   
(3,335
)
   
(2.5
)
(Provision) benefit for income taxes
   
(31
)
   
----
     
2,767
     
2.6
     
(334
)
   
(0.2
)
Net income (loss)
   
1,737
     
1.3
     
(3,498
)
   
(3.2
)
   
(3,669
)
   
(2.7
)
Less: Net income attributable to non-controlling interest
   
(3,377
)
   
(2.4
)
   
(2,335
)
   
(2.2
)
   
(3,506
)
   
(2.6
)
Net loss attributable to Telos Corporation
 
$
(1,640
)
   
(1.1
)%
 
$
(5,833
)
   
(5.4
)%
 
$
(7,175
)
   
(5.3
)%

Years ended December 31, 2018, 2017, and 2016

Revenue.  Revenue increased by 28.1% to $138.0 million for 2018 from $107.7 million for 2017.  Such increase primarily consists of an increase in sales from the U.S. Air Force NETCENTS-2 contract. As discussed above, NETCENTS-2 is an IDIQ contract utilized by multiple government customers and sales under NETCENTS-2 vary from period to period according to the solution mix and timing of deliverables for a particular period. Services revenue increased by 48.3% to $121.0 million for 2018 from $81.6 million for 2017, primarily attributable to increases in sales of $22.7 million of CO&D’s Secure Mobility solutions under several NETCENTS delivery orders for Telos-installed solutions which included $6.0 million of revenue accruals for multiple contracts as a result of several years of cumulative indirect rate adjustments, $10.6 million of Identity Management solutions, $5.7 million of CO&D’s Cyber Security solutions, and $0.4 million of IT & Enterprise solutions. 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 decreased by 34.8% to $17.0 million for 2018 from $26.1 million for 2017, primarily attributable to decreases in sales of $9.2 million of Identity Management solutions, $2.0 million of resold products in CO&D’s Secure Mobility solutions, and $1.0 million of proprietary software in IT & Enterprise solutions, offset by an increase in sales of $3.1 million of CO&D’s Cyber Security solutions in proprietary software.

Revenue decreased by 20.1% to $107.7 million for 2017 from $134.9 million for 2016.  Such decrease primarily consists of a decrease in sales from the U.S. Air Force NETCENTS-2 contract. Services revenue decreased by 27.7% to $81.6 million for 2017 from $112.9 million for 2016, primarily attributable to decreases in sales of $29.7 million of CO&D’s Secure Mobility solutions under several NETCENTS delivery orders for Telos-installed solutions, and $4.5 million of IT & Enterprise solutions, due primarily to the loss of a contract as discussed above, offset by an increase in sales of $3.0 million of Identity Management solutions. 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 increased by 18.8% to $26.1 million for 2017 from $22.0 million for 2016, primarily attributable to increases in sales of $2.2 million of Identity Management solutions, $1.7 million of resold products in CO&D’s Secure Mobility solutions, and $1.0 million of proprietary software in IT & Enterprise solutions, offset by a decrease in sales of $0.7 million of CO&D’s Cyber Security solutions in proprietary software.

Cost of sales.  Cost of sales increased by 26.5% to $85.0 million for 2018 from $67.2 million for 2017 as a result of increases in revenue. Cost of sales for services increased by $26.9 million, and as a percentage of services revenue increased by 2.3%, due to a change in the mix and nature of the programs including an increase in sales of certain Telos-installed solutions in CO&D’s Secure Mobility solutions under NETCENTS-2 and due to other contracts in CO&D’s Cyber Security solutions, offset by the revenue accruals related to indirect rate adjustments discussed above which did not include direct costs in CO&D’s Secure Mobility deliverables. Cost of sales for product decreased by $9.1 million, primarily due to decreases in product revenue for resold products, and as a percentage of product revenue decreased by 18.3%, primarily due to declines in resold products, as well as increases in proprietary software sales.

Cost of sales decreased by 26.5% to $67.2 million for 2017 from $91.4 million for 2016 as a result of decreases in revenue. Cost of sales for services decreased by $27.6 million, and as a percentage of services revenue decreased by 7.5%, due to a change in the mix and nature of the programs including an increase in sales of certain Telos-installed solutions in CO&D’s Secure Mobility solutions under NETCENTS-2 and due to other contracts in CO&D’s Cyber Security solutions, as well as the loss of a contract in IT & Enterprise Solutions as discussed above. Cost of sales for product increased by $3.4 million, primarily due to increases in product revenue for resold products, and as a percentage of product revenue increased by 2.9%, primarily due to declines in resold product margins and proprietary software margins.

Gross profit.  Gross profit increased by 30.8% to $53.1 million for 2018 from $40.6 million for 2017. Gross margin increased to 38.4% for 2018 from 37.7% for 2017, due to various changes in the mix of contracts in all business lines, primarily increases in sales of CO&D’s Cyber Security solutions in proprietary software, as well as the revenue accruals related to indirect rate adjustments discussed above.

Gross profit decreased by 6.6% to $40.6 million for 2017 from $43.4 million for 2016. Gross margin increased to 37.7% for 2017 from 32.2% for 2016, due to various changes in the mix of contracts in all business lines.

Selling, general, and administrative expenses.  Selling, general, and administrative expenses increased by 9.7% to $44.0 million for 2018 from $40.2 million for 2017. Such increase is primarily attributable to increases in labor costs of $1.7 million, bonuses of $1.5 million, and capitalization and related amortization of software development costs of $0.6 million.

Selling, general, and administrative expenses decreased 2.9% to $40.2 million for 2017 from $41.3 million for 2016. Such decrease is primarily attributable to decreases in amortization of other intangible assets of $1.1 million, bonuses of $0.6 million, and bank and financing fees of $0.5 million, offset by an increase in outside services of $1.1 million.

Interest expense.  Interest expenses increased by 8.5% to $7.3 million for 2018 from $6.7 million for 2017, primarily due to an increase in interest on the EnCap senior term loan and an equipment purchase arrangement.

Interest expenses increased 22.4% to $6.7 million for 2017 from $5.5 million for 2016, primarily due to an increase in interest on the EnCap senior term loan.

Components of interest expense are as follows:

   
December 31,
 
   
2018
   
2017
   
2016
 
   
(amounts in thousands)
 
Commercial and subordinated note interest incurred
 
$
3,436
   
$
2,848
   
$
1,575
 
Preferred stock interest accrued
   
3,822
     
3,842
     
3,890
 
Total
 
$
7,258
   
$
6,690
   
$
5,465
 

Provision for income taxes.  Income tax provision was $31,000 for 2018, compared to income tax benefit of $2.8 million for 2017, primarily due to the decrease in the hanging credit deferred tax liability offset by the adjustment to the provisional estimate recorded for the hanging credit deferred tax liability under SAB 118. Income tax benefit was $2.8 million for 2017, compared to income tax provision of $0.3 million for 2016, primarily due to the decrease in the hanging credit deferred tax liability as a result of the enactment of the Tax Cuts and Jobs Act of 2017.

Liquidity and Capital Resources

As described in more detail below, we maintain a Credit Agreement with EnCap and a Purchase Agreement with RCA. The willingness of RCA to purchase our accounts receivable under the Purchase 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, or other potential sources of financing. If we are unable to maintain the Purchase 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 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 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 $2.1 million and $(4.1) million as of December 31, 2018 and 2017, respectively. Although no assurances can be given, we expect that our financing arrangements with EnCap and RCA, collectively, and 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 of $6.3 million for the year ended December 31, 2018, compared to cash used in operating activities of $0.6 million for 2017, and cash provided by operating activities of $13.9 million for 2016. Cash provided by operating activities is primarily driven by our operating income, the timing of receipt of customer payments, the timing of 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.  In 2018, net income was $1.7 million, which included $1.1 million of amortization of capitalized software development costs. In 2017, net loss was $3.5 million, which included $2.8 million of income tax benefit. In 2016, net loss was $3.7 million, which included $0.3 million of income tax provision and $1.1 million of amortization of intangible assets.
Cash used in investing activities for the year ended December 31, 2018, 2017, and 2016 was $4.1 million, $2.2 million, and $0.6 million, respectively, which, for the year ended December 31, 2018 and 2017, consisted of the capitalization of software development costs of $1.6 million and $1.5 million, respectively, and the purchases of property and equipment of $2.5 million and $0.7 million, respectively.
Cash used in financing activities for the year ended December 31, 2018 was $2.7 million, compared to cash provided by financing activities of $2.8 million for 2017, and cash used in financing activities $12.6 million for 2016. The financing activities in 2018 consisted of $1.7 million to the Class B Member of Telos ID and repayments of $1.0 million under capital leases. The financing activities in 2017 consisted primarily of net proceeds of $9.4 million from the EnCap senior term loan, redemption of $2.1 million of senior preferred stock, repayments of $0.9 million under capital leases, and distributions of $3.7 million to the Class B Member of Telos ID.  The financing activities in 2016 consisted primarily of net repayments of $6.7 million under the facilities, repayments of $3.2 million of a term loan, repayments of $0.8 million under capital leases, and distributions of $1.9 million to the Class B Member of Telos ID.
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”). 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 accrue interest at the rate of 13.0% per annum (the “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”) to incorporate the parties’ agreement to subordinate certain debt owed by the Company to the affiliated entities of Mr. John R. C. Porter (the “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”) with affiliated entities of Mr. John R. C. Porter (together referenced as “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 includes 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”) to waive certain covenant defaults and to reset the covenants for 2018 measurement periods to more accurately reflect the Company’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 has been paid in cash. Contemporaneously with the Third Amendment, Mr. Wood agreed to transfer 50,000 shares of the Company’s Class A Common Stock owned by him to EnCap. As of December 31, 2018, we were in compliance with the Credit Agreement’s financial covenants.

We incurred interest expense in the amount of $1.7 million and $1.5 million for the year ended December 31, 2018 and 2017, respectively, under the Credit Agreement.

Accounts Receivable Purchase Agreement
On July 15, 2016, we entered into an Accounts Receivable Purchase Agreement (the “Purchase Agreement”) with Republic Capital Access, LLC (“RCA” or “Buyer”), pursuant to which we may offer for sale, and RCA, in its sole discretion, may purchase, eligible accounts receivable relating to U.S. Government prime contracts or subcontracts of the Company (collectively, the “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”) 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, and 85% if the account debtor is not an agency of the U.S. 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 the Purchased Receivable is outstanding; (iii) a commitment fee equal to 1% per annum of 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’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’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’s interests in the Purchased Receivables.

The Company is liable to 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”) with Action Capital Corporation (“Action 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”). The maximum outstanding principal amount of advances under the Financing Agreement was $5 million. The Financing Agreement has 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 Financing Agreement was not extended beyond this date.

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.

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 December 31, 2018 and 2017, 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”) with affiliated entities of Mr. John R. C. Porter (together referenced as “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 $308,000, $292,000, and $300,000 for 2018, 2017, and 2016, respectively, on the Porter Notes. As a result of the amendment and restatement of the Porter Notes, we recorded a gain on extinguishment of debt of approximately $1 million, which consisted of the remeasurement of the debt at fair value. As the extinguishment was with a related party, the transaction was deemed to be a capital transaction and the gain was recorded in the Company’s stockholders’ deficit as of December 31, 2017.

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 December 31, 2018 and 2017, was 3,185,586. The Public Preferred Stock is quoted as “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 various financing agreements  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 continue 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. 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 and the Porter Notes, 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 consolidated balance sheets as of December 31, 2018 and 2017.

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 and the Porter Notes 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 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 December 31, 2018.  This classification is consistent with ASC 210-10, “Balance Sheet” and 470-10, “Debt” and the FASB ASC Master Glossary definition of “Current Liabilities.”

ASC 210-10 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 470-10 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’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 $103.5 million and $99.7 million as of December 31, 2018 and 2017, respectively. We accrued dividends on the Public Preferred Stock of $3.8 million for each of the years ended December 31, 2018, 2017, and 2016, which was recorded as interest expense. Prior to the effective date of ASC 480-10 on July 1, 2003, such dividends were charged to 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 have been extended. As a result of such standby agreements, as of December 31, 2016, instruments held by Toxford Corporation (“Toxford”), the holder of 76.4% of the Senior Redeemable Preferred Stock, would mature on May 31, 2018. 

At December 31, 2016, the total number of shares of Senior Redeemable Preferred Stock issued and outstanding was 197 shares and 276 shares for Series A-1 and Series A-2, respectively. Due to the limitations, contractual restrictions, and agreements described above, the Senior Redeemable Preferred Stock was classified as noncurrent as of December 31, 2016.

At December 31, 2016, cumulative undeclared, unpaid dividends relating to Senior Redeemable Preferred stock totaled $1.6 million. 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.

We accrued dividends on the Senior Redeemable Preferred Stock of $0, $20,000, and $67,000 for the years ended December 31, 2018, 2017, and 2016, 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.

Contractual Obligations

The following summarizes our contractual obligations and our redeemable preferred stock at December 31, 2018 (in thousands):

         
Payments due by Period
 
   
Total
   
2019
     
2020 - 2022
     
2023 - 2025
   
2026 and later
 
                                   
Capital lease obligations (1)
 
$
23,408
   
$
1,996
   
$
6,293
   
$
6,775
   
$
8,344
 
Senior term loan (2)
   
16,503
     
1,525
     
14,978
     
----
     
----
 
Subordinated debt (3)
   
3,905
     
----
     
3,905
     
----
     
----
 
Operating lease obligations
   
2,740
     
885
     
1,492
     
363
     
----
 
   
$
46,556
   
$
4,406
   
$
26,668
   
$
7,138
   
$
8,344
 
                                         
Public preferred stock (4)
   
135,387
                                 
Total
 
$
181,943
                                 
(1)   Includes interest expense:  
$
5,428
   
$
881
   
$
2,268
   
$
1,576
   
$
703
 
(2)   Amount represents the carrying value as of December 31, 2018, plus interest and fee accrual of $5.5 million, is due and payable in full on January 25, 2022.
(3)   Amount represents the carrying value as of December 31, 2018, plus interest accrual of $1.3 million, is due and payable in full on July 25, 2022.
(4)   In accordance with ASC 480, the public preferred stock was reclassified from equity to liability in July 2003.  Amount represents the carrying value as of December 31, 2018, and includes accrual of accumulated dividends and accretion of $129.0 million.  Payment of such amount presumes conditions precedent being satisfied (See Note 7 – Redeemable Preferred Stock) and as such, redemption date is unknown and accordingly payment is not reflected in a particular period. Amount does not reflect additional dividends and accretion through the redemption date as such date is unknown. Such additional dividends accrue annually in the amount of $3.8 million. Such accretion has been fully accreted as of December 31, 2008.


Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements (as defined in Item 303, paragraph (a)(4)(ii) of Regulation S-K) that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, sales or expenses, results of operations, liquidity, capital expenditures or capital resources.

Capital Expenditures
Capital expenditures for property and equipment were $2.5 million, $0.7 million, and $0.6 million for 2018, 2017, and 2016, respectively. We presently anticipate capital expenditures of approximately $6.0 million in 2019; however, there can be no assurance that this level of capital expenditures will occur. We believe that available cash and borrowings under the Purchase Agreement and Financing Agreement will be sufficient to generate adequate amounts of cash to fund our projected capital expenditures for 2019.

Capital Leases and Related Obligations
We have various lease agreements for property and equipment that, pursuant to ASC 840, “Leases,” require us to record the present value of the minimum lease payments for such equipment and property as an asset in our consolidated financial statements. Such assets are amortized on a straight-line basis over the term of the related lease or their useful life, whichever is shorter.

Inflation
The rate of inflation has been moderate over the past five years and, accordingly, has not had a significant impact on the Company. We have generally been able to pass through any increased costs to customers through higher prices to the extent permitted by competitive pressures.

Recent Accounting Pronouncements
See Note 1 – Summary of Significant Accounting Policies of the Consolidated Financial Statements for a discussion of recently issued accounting pronouncements.

Item 7A. Quantitative and Qualitative Disclosures about Market Risk
None.


Item 8. Consolidated Financial Statements and Supplementary Data


TELOS CORPORATION AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 
Page
29
   
30
   
31
   
32 - 33
   
34 - 35
   
36
   
37 – 62


Report of Independent Registered Public Accounting Firm

Shareholders and Board of Directors
Telos Corporation
Ashburn, Virginia
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Telos Corporation (the “Company”) and subsidiaries as of December 31, 2018 and 2017, the related consolidated statements of operations, comprehensive loss, stockholders’ deficit, and cash flows for each of the three years in the period ended December 31, 2018, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company and subsidiaries at December 31, 2018 and 2017, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2018, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.


/s/ BDO USA, LLP
We have served as the Company's auditor since 2007.
McLean, Virginia
April 1, 2019

TELOS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(amounts in thousands)

   
Years Ended December 31,
 
   
2018
   
2017
   
2016
 
Revenue (Note 5)
                 
Services
 
$
120,990
   
$
81,606
   
$
112,881
 
Products
   
17,026
     
26,121
     
21,987
 
     
138,016
     
107,727
     
134,868
 
Costs and expenses
                       
Cost of sales – Services
   
76,857
     
49,965
     
77,578
 
Cost of sales – Products
   
8,097
     
17,196
     
13,844
 
     
84,954
     
67,161
     
91,422
 
Selling, general and administrative expenses
   
44,048
     
40,152
     
41,334
 
                         
Operating income
   
9,014
     
414
     
2,112
 
Other income (expenses)
                       
Non-operating income
   
12
     
11
     
18
 
Interest expense
   
(7,258
)
   
(6,690
)
   
(5,465
)
Income (loss) before income taxes
   
1,768
     
(6,265
)
   
(3,335
)
(Provision) benefit for income taxes (Note 9)
   
(31
)
   
2,767
     
(334
)
                         
Net income (loss)
   
1,737
     
(3,498
)
   
(3,669
)
                         
Less: Net income attributable to non-controlling interest (Note 2)
   
(3,377
)
   
(2,335
)
   
(3,506
)
Net loss attributable to Telos Corporation
 
$
(1,640
)
 
$
(5,833
)
 
$
(7,175
)

The accompanying notes are an integral part of these consolidated financial statements.

TELOS CORPORATION AND SUBSIDIARIES  
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
 (amounts in thousands)

   
Years Ended December 31,
 
   
2018
   
2017
   
2016
 
Net income (loss)
 
$
1,737
   
$
(3,498
)
 
$
(3,669
)
Other comprehensive (loss) income, net of tax:
                       
Foreign currency translation adjustments
   
(15
)
   
7
     
(12
)
Comprehensive income attributable to non-controlling interest
   
(3,377
)
   
(2,335
)
   
(3,506
)
Comprehensive loss attributable to Telos Corporation
 
$
(1,655
)
 
$
(5,826
)
 
$
(7,187
)

The accompanying notes are an integral part of these consolidated financial statements.

TELOS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(amounts in thousands)

ASSETS

   
December 31,
 
   
2018
   
2017
 
Current assets
           
Cash and cash equivalents
 
$
72
   
$
600
 
Accounts receivable, net of reserve of $306 and $411, respectively (Note 5)
   
34,542
     
24,520
 
Inventories, net of obsolescence reserve of $520 and $1,484, respectively (Note 1)
   
4,389
     
13,520
 
Deferred program expenses
   
244
     
2,071
 
Other current assets
   
1,985
     
1,439
 
Total current assets
   
41,232
     
42,150
 
Property and equipment (Note 1)
               
Furniture and equipment
   
12,756
     
8,964
 
Leasehold improvements
   
2,503
     
2,389
 
Property and equipment under capital leases
   
30,832
     
30,832
 
     
46,091
     
42,185
 
Accumulated depreciation and amortization
   
(28,665
)
   
(25,841
)
     
17,426
     
16,344
 
 
Goodwill (Note 3)
   
14,916
     
14,916
 
Other assets
   
915
     
1,011
 
Total assets
 
$
74,489
   
$
74,421
 


The accompanying notes are an integral part of these consolidated financial statements.


TELOS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(amounts in thousands, except share data)

LIABILITIES, REDEEMABLE PREFERRED STOCK,
AND STOCKHOLDERS' DEFICIT

   
December 31,
 
   
2018
   
2017
 
Current liabilities
           
Accounts payable and other accrued payables (Note 6)
 
$
21,779
   
$
25,693
 
Accrued compensation and benefits
   
9,082
     
7,456
 
Contract liabilities
   
5,232
     
10,073
 
Capital lease obligations – short-term (Note 10)
   
1,115
     
1,013
 
Other current liabilities
   
1,895
     
1,990
 
Total current liabilities
   
39,103
     
46,225
 
Senior term loan, net of unamortized discount and issuance costs (Note 6)
   
10,984
     
10,786
 
Subordinated debt (Note 6)
   
2,597
     
2,289
 
Capital lease obligations (Note 10)
   
16,865
     
17,980
 
Deferred income taxes (Note 9)
   
818
     
741
 
Public preferred stock (Note 7)
   
135,387
     
131,565
 
Other liabilities (Note 9)
   
838
     
872
 
Total liabilities
   
206,592
     
210,458
 
Commitments and contingencies (Notes 10 and 13)
   
--
     
--
 
                 
Stockholders’ deficit (Note 8)
               
Telos stockholders’ deficit
               
Class A common stock, no par value, 50,000,000 shares authorized, 45,158,460 and 45,213,461 shares issued and outstanding, respectively
   
65
     
65
 
Class B common stock, no par value, 5,000,000 shares authorized, 4,037,628 shares issued and outstanding
   
13
     
13
 
Additional paid-in capital
   
4,310
     
4,310
 
Accumulated other comprehensive income
   
17
     
32
 
Accumulated deficit
   
(139,129
)
   
(141,370
)
Total Telos stockholders’ deficit
   
(134,724
)
   
(136,950
)
Non-controlling interest in subsidiary (Note 2)
   
2,621
     
913
 
Total stockholders’ deficit
   
(132,103
)
   
(136,037
)
Total liabilities, redeemable preferred stock, and stockholders’ deficit
 
$
74,489
   
$
74,421
 


The accompanying notes are an integral part of these consolidated financial statements.

TELOS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(amounts in thousands)

   
Years Ended December 31,
 
   
2018
   
2017
   
2016
 
Operating activities:
                 
Net income (loss)
 
$
1,737
   
$
(3,498
)
 
$
(3,669
)
Adjustments to reconcile net income (loss) to cash provided by (used in) operating activities:
                       
Stock-based compensation
   
--
     
50
     
--
 
Dividends of preferred stock as interest expense
   
3,822
     
3,843
     
3,890
 
Depreciation and amortization
   
3,028
     
1,999
     
2,898
 
Provision for inventory obsolescence
   
30
     
73
     
215
 
Benefit for doubtful accounts receivable
   
(105
)
   
(18
)
   
(56
)
Amortization of debt issuance costs
   
198
     
160
     
65
 
Deferred income tax provision (benefit)
   
77
     
(2,710
)
   
192
 
Loss on disposal of fixed asssets
   
3
     
4
     
--
 
Changes in assets and liabilities:
                       
(Increase) decrease in accounts receivable
   
(9,917
)
   
(5,415
)
   
14
 
Decrease (increase) in inventories
   
9,101
     
(10,041
)
   
(866
)
Decrease (increase) in deferred program expenses
   
1,828
     
(1,886
)
   
548
 
(Increase) decrease in other current assets and other assets
   
(465
)
   
1,086
     
1,824
 
(Decrease) increase in accounts payable and other accrued payables
   
(3,914
)
   
10,376
     
3,722
 
Increase (decrease) in accrued compensation and benefits
   
1,626
     
(615
)
   
3,316
 
(Decrease) increase in contract liabilities
   
(960
)
   
5,173
     
1,434
 
Increase in other current liabilities and other liabilities
   
179
     
828
     
328
 
Cash provided by (used in) operating activities
   
6,268
     
(591
)
   
13,855
 
Investing activities:
                       
Capitalized software development costs
   
(1,649
)
   
(1,481
)
   
--
 
Purchases of property and equipment
   
(2,465
)
   
(748
)
   
(624
)
Cash used in investing activities
   
(4,114
)
   
(2,229
)
   
(624
)
Financing activities:
                       
Proceeds from senior credit facilities
   
--
     
--
     
70,032
 
Repayments of senior credit facilities
   
--
     
--
     
(75,640
)
Repayments of term loan
   
--
     
--
     
(3,200
)
Decrease in book overdrafts
   
--
     
--
     
(1,083
)
Proceeds from senior term loan
   
--
     
9,439
     
--
 
Redemption of senior preferred stock
   
--
     
(2,112
)
   
--
 
Payments under capital lease obligations
   
(1,013
)
   
(915
)
   
(827
)
Distributions to Telos ID Class B member – non-controlling interest
   
(1,669
)
   
(3,651
)
   
(1,912
)
Cash (used in) provided by financing activities
   
(2,682
)
   
2,761
     
(12,630
)
(Decrease) increase in cash and cash equivalents
   
(528
)
   
(59
)
   
601
 
Cash and cash equivalents, beginning of the year
   
600
     
659
     
58
 
Cash and cash equivalents, end of year
 
$
72
   
$
600
   
$
659
 

   
Years Ended December 31,
 
   
2018
   
2017
   
2016
 
Supplemental disclosures of cash flow information:
                 
Cash paid during the year for:
                 
Interest
 
$
2,483
   
$
2,395
   
$
1,320
 
Income taxes
 
$
19
   
$
26
   
$
60
 
Noncash:
                       
Dividends of preferred stock as interest expense
 
$
3,822
   
$
3,843
   
$
3,890
 
Debt issuance costs and prepayment of interest on senior term loan
 
$
--
   
$
1,561
   
$
--
 
Gain on extinguishment of subordinated debt
 
$
--
   
$
1,031
   
$
--
 

The accompanying notes are an integral part of these consolidated financial statements.

TELOS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' DEFICIT
(amounts in thousands)

   
Telos Corporation
             
   
Class A Common
Stock
   
Class B
Common
Stock
   
Additional
Paid–in Capital
   
Accumulated
Other Comprehensive Income
   
Accumulated
Deficit
   
Non-Controlling Interest
   
Total
Stockholders’
Deficit
 
Balance December 31, 2015
 
$
65
   
$
13
   
$
3,229
   
$
37
   
$
(128,362
)
 
$
635
   
$
(124,383
)
Net (loss) income
   
--
     
--
     
--
     
--
     
(7,175
)
   
3,506
     
(3,669
)
Foreign currency translation loss
   
--
     
--
     
--
     
(12
)
   
--
     
--
     
(12
)
Distributions
   
--
     
--
     
--
     
--
     
--
     
(1,912
)
   
(1,912
)
Balance December 31, 2016
 
$
65
   
$
13
   
$
3,229
   
$
25
   
$
(135,537
)
 
$
2,229
   
$
(129,976
)
Net (loss) income
   
--
     
--
     
--
     
--
     
(5,833
)
   
2,335
     
(3,498
)
Gain on extinguishment of subordinated debt
   
--
     
--
     
1,031
     
--
     
--
     
--
     
1,031
 
Stock-based compensation
   
--
     
--
     
50
     
--
     
--
     
--
     
50
 
Foreign currency translation gain
   
--
     
--
     
--
     
7
     
--
     
--
     
7
 
Distributions
   
--
     
--
     
--
     
--
     
--
     
(3,651
)
   
(3,651
)
Balance December 31, 2017
 
$
65
   
$
13
   
$
4,310
   
$
32
   
$
(141,370
)
 
$
913
   
$
(136,037
)
Net (loss) income
   
--
     
--
     
--
     
--
     
(1,640
)
   
3,377
     
1,737
 
Cumulative effect adjustment due to change in accounting policy
   
--
     
--
     
--
     
--
     
3,881
     
--
     
3,881
 
Foreign currency translation loss
   
--
     
--
     
--
     
(15
)
   
--
     
--
     
(15
)
Distributions
   
--
     
--
     
--
     
--
     
--
     
(1,669
)
   
(1,669
)
Balance December 31, 2018
 
$
65
   
$
13
   
$
4,310
   
$
17
   
$
(139,129
)
 
$
2,621
   
$
(132,103
)



The accompanying notes are an integral part of these consolidated financial statements.

TELOS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Summary of Significant Accounting Policies

Business and Organization
Telos Corporation, together with its subsidiaries, (the “Company” or “Telos” or “We”) is an information technology solutions and services company addressing the needs of U.S. Government and commercial customers worldwide. We own all of the issued and outstanding share capital of Xacta Corporation, a subsidiary that develops, markets and sells government-validated secure enterprise solutions to government and commercial customers. We also own all of the issued and outstanding share capital of Ubiquity.com, Inc., a holding company for Xacta Corporation. We also have a 50% ownership interest in Telos Identity Management Solutions, LLC (“Telos ID”) and a 100% ownership interest in Teloworks, Inc. (“Teloworks”).

Principles of Consolidation and Basis of Presentation
The accompanying consolidated financial statements include the accounts of Telos and its subsidiaries, including Ubiquity.com, Inc., Xacta Corporation, and Teloworks, all of whose issued and outstanding share capital is owned by the Company. We have also consolidated the results of operations of Telos ID (see Note 2 – Non-controlling Interests). Intercompany transactions have been eliminated on consolidation.

In preparing these consolidated financial statements, we have evaluated subsequent events through the date that these consolidated financial statements were issued.

Segment Reporting
Operating segments are defined as components of an enterprise for which separate financial information is available and evaluated regularly by the chief operating decision maker (“CODM”), or decision making group, in deciding how to allocate resources and assess performance. We currently operate in one operating and reportable business segment for financial reporting purposes. Our Chief Executive Officer is the CODM. The CODM only evaluates profitability based on consolidated results.

Use of Estimates
The preparation of consolidated financial statements in conformity with Generally Accepted Accounting Principles (“GAAP”) in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions used in the preparation of our consolidated financial statements include revenue recognition, allowance for doubtful accounts receivable, allowance for inventory obsolescence, the valuation allowance for deferred tax assets, income taxes, contingencies and litigation, potential impairments of goodwill and estimated pension-related costs for our foreign subsidiaries. Actual results could differ from those estimates.

Revenue Recognition
We account for revenue in accordance with ASC Topic 606, “Revenue from Contracts with Customers.” The unit of account in ASC 606 is a performance obligation, which is a promise, 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), and recognizing revenue as the performance obligations are satisfied. Timing 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 may 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 based on our best estimate of standalone selling price.

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 who receive and consume benefits as we perform, 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 Federal Acquisition Regulation (the 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.  We have revised and re-submitted several years of incurred cost submissions reflecting certain indirect rate structure changes as a result of regular DCAA audits of incurred cost submissions.  This resulted in signed final rate agreement letters for 2011 to 2013 and conformed incurred cost submissions for 2014 to 2015. We evaluated the resulting changes to revenue under the applicable cost plus fixed fee contracts for the years 2011 to 2015 as variable consideration, and determined the most likely amount to which we expect to be entitled, to the extent that no constraint exists that would preclude recognizing this revenue or result in a significant reversal of cumulative revenue recognized. We have included these estimated amounts of variable consideration in the transaction price and as performance on these contracts is complete, we have recognized revenue of $6.0 million in the current period.

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.

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 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 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 consolidated balance sheet on a net contract basis at the end of each reporting period.

We have one reportable segment. We treat sales to U.S. customers as sales within the U.S. regardless of where the services are performed. Substantially all of our revenues are from U.S. customers as revenue derived from international customers is de minimus. The following tables disclose revenue (in thousands) by customer type and contract type for the periods presented.  Prior period amounts have not been adjusted under the modified retrospective method.

   
2018
   
2017
   
2016
 
Firm fixed-price
 
$
103,454
   
$
89,516
   
$
102,514
 
Time-and-materials
   
16,795
     
10,222
     
10,181
 
Cost plus fixed fee
   
17,767
     
7,989
     
22,173
 
Total
 
$
138,016
   
$
107,727
   
$
134,868
 

The following table discloses contract receivables (in thousands):

   
December 31, 2018
   
January 1, 2018
   
December 31, 2017
 
Billed accounts receivable
 
$
18,848
   
$
11,736
   
$
11,736
 
Unbilled receivables
   
16,000
     
13,195
     
13,195
 
Allowance for doubtful accounts
   
(306
)
   
(411
)
   
(411
)
Receivables – net
 
$
34,542
   
$
24,520
   
$
24,520
 

The following table discloses contract liabilities (in thousands):

   
December 31, 2018
   
January 1, 2018
   
December 31, 2017
 
Contract liabilities
 
$
5,232
   
$
10,073
   
$
10,073
 

As of December 31, 2018, we had $79.3 million of remaining performance obligations, which we also refer to as funded backlog. We expect to recognize approximately 97.2% of our remaining performance obligations as revenue in 2019, an additional 2.6% by 2020 and the balance thereafter. For the year ended December 31, 2018, the amount of revenue recognized during the year that was included in the opening contract liabilities balance was $9.4 million.

Cash and Cash Equivalents
We consider all highly liquid investments with an original maturity of three months or less at the date of purchase to be cash equivalents. Our cash management program utilizes zero balance accounts. Accordingly, all book overdraft balances have been reclassified to accounts payable and other accrued payables.

Accounts Receivable
Accounts receivable are stated at the invoiced amount, less allowances for doubtful accounts. Collectability of accounts receivable is regularly reviewed based upon managements’ knowledge of the specific circumstances related to overdue balances. The allowance for doubtful accounts is adjusted based on such evaluation. Accounts receivable balances are written off against the allowance when management deems the balances uncollectible.

Inventories
Inventories are stated at the lower of cost or net realizable value, where cost is determined on the weighted average method. Substantially all inventories consist of purchased customer off-the-shelf hardware and software, and component computer parts used in connection with system integration services that we perform. An allowance for obsolete, slow-moving or nonsalable inventory is provided for all other inventory. This allowance is based on our overall obsolescence experience and our assessment of future inventory requirements. This charge is taken primarily due to the age of the specific inventory and the significant additional costs that would be necessary to upgrade to current standards as well as the lack of forecasted sales for such inventory in the near future. Gross inventory was $4.9 million and $15.0 million at December 31, 2018 and 2017, respectively.  As of December 31, 2018, it is management’s judgment that we have fully provided for any potential inventory obsolescence.

The components of the allowance for inventory obsolescence are set forth below (in thousands):

   
Balance
Beginning of
Year
   
Additions Charge to Costs and Expense
   
Recoveries
   
Balance
End of
Year
 
                         
Year Ended December 31, 2018
 
$
1,484
   
$
30
   
$
(994
)
 
$
520
 
Year Ended December 31, 2017
 
$
1,672
   
$
73
   
$
(261
)
 
$
1,484
 
Year Ended December 31, 2016
 
$
1,457
   
$
215
   
$
--
   
$
1,672
 

Property and Equipment

Property and equipment is recorded at cost. Depreciation is provided on the straight-line method at rates based on the estimated useful lives of the individual assets or classes of assets as follows:

Furniture and equipment
3-5   Years
Leasehold improvements
Lesser of life of lease or useful life of asset
Property and equipment under capital leases
Lesser of life of lease or useful life of asset

Leased property meeting certain criteria is capitalized at the present value of the related minimum lease payments. Amortization of property and equipment under capital leases is computed on the straight-line method over the lesser of the term of the related lease and the useful life of the related asset.

Upon sale or retirement of property and equipment, the costs and related accumulated depreciation are eliminated from the accounts, and any gain or loss on such disposition is reflected in the consolidated statements of operations. For the years ended December 31, 2018, 2017, and 2016, such amounts are negligible. Expenditures for repairs and maintenance are charged to operations as incurred.

Long-lived assets, such as fixed assets, are reviewed for impairment whenever circumstances indicate that the carrying amount of the asset exceeds its estimated fair value. Considerable management judgment is necessary to estimate its fair value. Accordingly, actual results could differ from such estimates. No events have been identified that caused an evaluation of the recoverability of long-lived assets.

Our policy on internal use software is in accordance with ASC Topic 350, “Intangibles- Goodwill and Other.” This standard requires companies to capitalize qualifying computer software costs which are incurred during the application development stage and amortize them over the software’s estimated useful life. We expensed all such software development costs in 2018, 2017, and 2016, as we believe that such amounts are immaterial.

Depreciation and amortization expense related to property and equipment, including property and equipment under capital leases was $3.0 million, $2.0 million, and $1.8 million for the years ended December 31, 2018, 2017, and 2016, respectively.

Income Taxes
We account for income taxes in accordance with ASC 740-10, “Income Taxes.”  Under ASC 740-10, deferred tax assets and liabilities are recognized for the estimated future tax consequences of temporary differences and income tax credits.  Deferred tax assets and liabilities are measured by applying enacted statutory tax rates that are applicable to the future years in which deferred tax assets or liabilities are expected to be settled or realized for differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities.  Any change in tax rates on deferred tax assets and liabilities is recognized in net income in the period in which the tax rate change is enacted.  We record a valuation allowance that reduces deferred tax assets when it is “more likely than not” that deferred tax assets will not be realized. We are required to establish a valuation allowance for deferred tax assets if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based on available evidence, realization of deferred tax assets is dependent upon the generation of future taxable income.  We considered projected future taxable income, tax planning strategies, and reversal of taxable temporary differences in making this assessment. As such, we have determined that a full valuation allowance is required as of December 31, 2018 and 2017. As a result of a full valuation allowance against our deferred tax assets, a deferred tax liability (“hanging credit”) related to goodwill remains on our consolidated balance sheet at December 31, 2018 and 2017. Due to the tax reform enacted on December 22, 2017, net operating losses generated in taxable years beginning after December 31, 2017 will have an indefinite carryforward period, which will be available to offset future taxable income created by the reversal of temporary taxable differences related to goodwill.  As a result, we have adjusted the valuation allowance on our deferred tax assets and liabilities at December 31, 2018 and 2017.  See additional information on tax reform and its impact on our income taxes in Note 9 – Income Taxes.

We follow the provisions of ASC 74-10 related to accounting for uncertainty in income taxes. The accounting estimates related to liabilities for uncertain tax positions require us to make judgments regarding the sustainability of each uncertain tax position based on its technical merits. If we determine it is more likely than not that a tax position will be sustained based on its technical merits, we record the impact of the position in our consolidated financial statements at the largest amount that is greater than fifty percent likely of being realized upon ultimate settlement. These estimates are updated at each reporting date based on the facts, circumstances and information available. We are also required to assess at each reporting date whether it is reasonably possible that any significant increases or decreases to our unrecognized tax benefits will occur during the next 12 months.

Goodwill
We evaluate the impairment of goodwill in accordance with ASC Topic 350, which requires goodwill and indefinite-lived intangible assets to be assessed on at least an annual basis for impairment using a fair value basis. Between annual evaluations, if events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount, then impairment must be evaluated. Such circumstances could include, but are not limited to: (1) a significant adverse change in legal factors or business climate, or (2) a loss of key contracts or customers.

As the result of an acquisition, we record any excess purchase price over the net tangible and identifiable intangible assets acquired as goodwill. An allocation of the purchase price to tangible and intangible net assets acquired is based upon our valuation of the acquired assets. Goodwill is not amortized, but is subject to annual impairment tests. We complete our goodwill impairment tests as of December 31st each year. Additionally, we make evaluations between annual tests if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The evaluation is based on the estimation of the fair values of our three reporting units, Cyber Operations and Defense (“CO&D”), Identity Management, and IT & Enterprise Solutions, of which goodwill is housed in the CO&D reporting unit, in comparison to the reporting unit’s net asset carrying values. Our discounted cash flows required management judgment with respect to forecasted revenue streams and operating margins, capital expenditures and the selection and use of an appropriate discount rate. We utilized the weighted average cost of capital as derived by certain assumptions specific to our facts and circumstances as the discount rate. The net assets attributable to the reporting units are determined based upon the estimated assets and liabilities attributable to the reporting units in deriving its free cash flows. In addition, the estimate of the total fair value of our reporting units is compared to the market capitalization of the Company. The Company’s assessment resulted in a fair value that was greater than the Company’s carrying value, therefore the second step of the impairment test, as prescribed by the authoritative literature, was not required to be performed and no impairment of goodwill was recorded as of December 31, 2018. Subsequent reviews may result in future periodic impairments that could have a material adverse effect on the results of operations in the period recognized. Recent operating results have reduced the projection of future cash flow growth potential, which indicates that certain negative potential events, such as a material loss or losses on contracts, or failure to achieve projected growth could result in impairment in the future. We estimate fair value of our reporting unit and compare the valuation with the respective carrying value for the reporting unit to determine whether any goodwill impairment exists. If we determine through the impairment review process that goodwill is impaired, we will record an impairment charge in our consolidated statements of operations. Goodwill is amortized and deducted over a 15-year period for tax purposes.

Stock-Based Compensation
Compensation cost is recognized based on the requirements of ASC 718, “Stock Compensation,” for all share-based awards granted.  Since June 2008, we have issued restricted stock (Class A common) to our executive officers, directors and employees. In May 2017, we granted 5,005,000 shares of restricted stock to our executive officers and employees. Such stock is subject to a vesting schedule as follows:  25% of the restricted stock vests immediately on the date of grant, thereafter, an additional 25% will vest annually on the anniversary of the date of grant subject to continued employment or services. As of December 31, 2018, there were 2,427,500 shares of restricted stock that remained subject to vesting. In the event of death of the employee or a change in control, as defined by the Telos Corporation 2008 Omnibus Long-Term Incentive Plan, the 2013 Omnibus Long-Term Incentive Plan, or the 2016 Omnibus Long-Term Incentive Plan, all unvested shares shall automatically vest in full. In accordance with ASC 718, we recorded immaterial compensation expense for any of the issuances as the value of the common stock was nominal, based on the deduction of our outstanding debt, capital lease obligations, and preferred stock from an estimated enterprise value, which was estimated based on discounted cash flow analysis, comparable public company analysis, and comparable transaction analysis. Additionally, we determined that a significant change in the valuation estimate for common stock would not have a significant effect on the consolidated financial statements.

Software Development Costs
Our policy on software to be sold is in accordance with ASC Topic 985, “Software.” Software development costs for software to be sold, leased or otherwise marketed are expensed as incurred until technological feasibility is reached, at which time additional costs are capitalized until the product is available for general release to customers. Technological feasibility is established when all planning, designing, coding and testing activities have been completed, and all risks have been identified. Beginning with the second quarter of 2017, software development costs are capitalized and amortized over the estimated product life of 2 years on a straight-line basis. As of December 31, 2018 and 2017, we capitalized $3.1 million and $1.5 million of software development costs, respectively, which are included as a part of property and equipment. Amortization expense was $1.1 million and $0.2 million for the year ended December 31, 2018 and 2017, respectively. Accumulated amortization was $1.3 million and $0.2 million as of December 31, 2018 and 2017, respectively. The Company analyzes the net realizable value of capitalized software development costs on at least an annual basis and has determined that there is no indication of impairment of the capitalized software development costs as forecasted future sales are adequate to support amortization costs. During 2018, 2017 and 2016, we incurred salary costs for research and development of approximately $3.5 million, $3.2 million and $2.6 million, respectively, which were included as part of the selling, general and administrative expense in the consolidated statements of operations.

Earnings (Loss) per Share
As we do not have publicly held common stock or potential common stock, no earnings per share data is reported for any of the years presented.

Comprehensive Income
Comprehensive income includes changes in equity (net assets) during a period from non-owner sources. Our accumulated other comprehensive income was comprised of a loss from foreign currency translation of $90,000 and $75,000 as of December 31, 2018 and 2017, respectively; and actuarial gain on pension liability adjustments in Teloworks of $107,000 as of December 31, 2018 and 2017.

Financial Instruments
We use various methods and assumptions to estimate the fair value of our financial instruments. Due to their short-term nature, the carrying value of cash and cash equivalents, accounts receivable and accounts payable approximates fair value. The fair value of long-term debt is based on the discounted cash flows for similar term borrowings based on market prices for the same or similar issues.

  Fair value estimates are made at a specific point in time, based on relevant market information. These estimates are subjective in nature and involve matters of judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Recent Accounting Pronouncements Adopted
In May 2014, the Financial Accounting Standard Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers,” which requires an entity to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. In July 2015, the FASB finalized the delay of the effective date by one year, making the new standard effective for interim periods and annual period beginning after December 15, 2017. In March 2016, the FASB issued ASU 2016-08, “Revenues from Contract with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net),” which clarifies the implementation guidance in ASU 2014-09 relating to principal versus agent considerations. In April 2016, the FASB issued ASU 2016-10, “Revenue from Contracts with Customers (Topic 606) - Identifying Performance Obligations and Licensing,” which further clarifies the implementation guidance relating to identifying performance obligations and the licensing implementation guidance. In May 2016, the FASB issued ASU 2016-12, "Revenue from Contracts with Customers (Topic 606):  Narrow Scope Improvements and Practical Expedients," which clarifies the implementation guidance related to collectability, presentation of sales tax, noncash consideration, contract modifications and completed contracts at transition. These standards can be applied retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of the change recognized at the date of the initial application. We adopted the standard on January 1, 2018 using the modified retrospective method, and reflecting cumulative changes in accumulated deficit.

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 decrease accumulated deficit of $3.9 million, which adjusted contract liabilities by the same amount. 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.

In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230): Classification of certain cash receipts and cash payments,” which intends to reduce the diversity in practice in how certain transactions are classified on the statement of cash flows. This standard will be effective retrospectively for interim and annual reporting periods beginning after December 31, 2017, and early adoption is permitted. The adoption of this ASU did not have a material impact on our consolidated financial position, results of operations and cash flows.

In November 2016, the FASB issued ASU 2016-18, “Statement of Cash Flows (Topic 230) – Restricted Cash,” which requires the presentation of changes in restricted cash or restricted cash equivalents on the statement of cash flows. This standard will be effective for interim and annual reporting periods beginning after December 15, 2017, with early adoption permitted. The adoption of this ASU did not have a material impact on our consolidated financial position, results of operations and cash flows.

In May 2017, the FASB issued ASU 2017-09, “Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting,” which amends the scope of modification accounting for share-based payment arrangements, provides guidance on the types of