10-K 1 form10k.htm TELOS CORP 10-K 12-31-2013

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549


FORM 10-K
 
þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2013
¨ 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  x
 
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  x

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  x    No  ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post such files). Yes x    No o 

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. x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer    ¨
Accelerated filer   ¨
Non-accelerated filer   x
Smaller reporting company ¨
 
 
(Do not check if a smaller reporting company) 

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

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant as of June 30, 2013:  Not applicable

As of March 24, 2014, the registrant had outstanding 40,218,461 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 13, 2014.
 


 
TABLE OF CONTENTS
Item
 
Page
 
 
 
PART I
 
 
 
 
 
Item 1.
3
Item 1A.
8
Item 1B.
11
Item 2.
11
Item 3.
11
Item 4.
11
 
 
 
PART II
 
 
 
 
 
Item 5.
12
Item 6.
12
Item 7.
13
Item 7A.
23
Item 8.
24
Item 9.
54
Item 9A
54
Item 9B.
55
 
 
 
PART III
 
 
 
 
 
Item 10.
56
Item 11.
56
Item 12.
56
Item 13.
56
Item 14.
56
 
 
 
PART IV
 
 
 
 
 
Item 15.
57
 
59


Page 2 of 59


 
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 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 84.1% 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 60% interest in Telos Identity Management Solutions, LLC (“Telos ID”).  In July 2011, we acquired all of the assets of IT Logistics, Inc. (“ITL”), see Note 3 – Acquisition of IT Logistics, Inc. to the consolidated financial statements.

We are incorporated in Maryland, and 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 secure critical assets by protecting communications, systems, networks, and access.

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.

Page 3 of 59

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 the 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 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 and enhance the communications of our customers through the development and delivery of our Telos Secure Information eXchange (T-6) platform for unified communication and collaboration.  T-6 includes Telos Automated Message Handling System (“AMHS”), which has been adopted by the Department of Defense 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.

We protect the systems of our customers through the development and delivery of our Xacta IA Manager software (“Xacta”). Our Xacta solution is the dominant provider of continuous certification and is used throughout the Department of Defense, intelligence communities and civilian government.  To date, we have performed over 5,000 certifications and our product has been adopted as the risk management framework for numerous enterprises.

We deploy, protect and extend the networks of our customers around the world, as well as secure the communications on the network. We also empower our customers with advanced applications that leverage mobile devices and multi-user, multi-touch interfaces to put mission-critical information literally at users’ fingertips.

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 premier federal identity application, which has issued more than 32,500,000 smart card based secure credentials for active and retired military, military dependents and contractors.  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 436,000,000 scans by more than 2,500,000 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 rapid development and continuous innovation in an effort to keep pace with the dynamic and evolving nature of our customers’ requirements.  

Our IT solutions consist of the following:

· Cyber Operations and Defense – Secure wired and wireless network solutions for Department of Defense (“DoD”) and other federal agencies.  We provide an extensive range of wired and wireless voice, data, and video secure network solutions and mobile application development to support defense and civilian missions.  In July 2011, we acquired all of the assets of ITL and incorporated such assets into our Secure Networks business solutions.  Our software products and consulting services automate, streamline, and enforce IT security and risk management processes enterprise-wide.  We offer information assurance consulting services and Xacta brand GRC (governance, risk, and compliance) solutions to protect and defend IT systems, ensuring their availability, integrity, authentication, and confidentiality.

· Secure Communications – The next-generation messaging solution supporting warfighters throughout the world.  Telos Secure Information eXchange (T-6) and the AMHS platform offer secure, automated, Web-based capabilities for distributing and managing enterprise messages formatted for the Defense Messaging System as well as collaborating in real-time through video, text, whiteboarding, and document sharing.

· Telos ID – End-to-end logical and physical security from the gate to the network.  Our identity management solutions provide control of physical access to bases, offices, workstations, and other facilities, as well as control of logical access to databases, host systems, and other IT resources.

Page 4 of 59

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 and/or copyright protection on our products and processes 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 2013, 2012, and 2011, the Company’s revenue derived from firm fixed-price contracts was 84.1%, 82.7%, and 88.8%, respectively, and time-and-material contracts was 15.9%, 17.3%, and 11.2%, respectively.

We derive substantially all 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.
Page 5 of 59

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 substantially all 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:

 
 
2013
   
2012
   
2011
 
 
 
(dollar amounts in thousands)
 
 
 
   
   
   
   
   
 
Federal
 
$
203,917
     
98.3
%
 
$
224,010
     
99.1
%
 
$
188,162
     
99.1
%
Commercial
   
3,477
     
1.7
%
   
2,086
     
0.9
%
   
1,726
     
0.9
%
 
                                               
Total
 
$
207,394
     
100.0
%
 
$
226,096
     
100.0
%
 
$
189,888
     
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, 2013, we employed 536 people, which includes 39 from Teloworks, and 66 from Telos ID.  Of our employees, 394 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.

Page 6 of 59

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 U.S. generally accepted accounting principles (GAAP) 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.  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.

Funded backlog as of December 31, 2013 and 2012 was $95.3 million and $99.1 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 such business.  The use of GSA schedules and omnibus contracts, while generally not providing immediate backlog, provide areas of growth that we continue to aggressively pursue.

Page 7 of 59

Seasonality

We derive substantially all of our revenue 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 availability on our revolving credit facility or sufficient access to capital markets to replace that facility would have a significant impact on our business.
We maintain a revolving credit facility (the “Facility”) with Wells Fargo Capital Finance, Inc.  Borrowings under the Facility are collateralized by substantially all of our assets including inventory, equipment, and accounts receivable.  The amount of available borrowings fluctuates based on the underlying asset-borrowing base, in general 85% of our trade accounts receivable, as adjusted by certain reserves (as further defined in the Facility agreement). The Facility provides us with virtually all of the liquidity we require to meet our operating, investing and financing needs. Therefore maintaining sufficient availability on the Facility is the most critical factor in our liquidity.  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 the Facility.  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 availability on the Facility 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 availability 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 on the Facility unless the slow-down was material in amount and occurred over an extended period of time. Any of the examples described above could have an impact on the Facility, and therefore our liquidity.

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, substantially all of our net sales were to the U.S. Government, particularly the Department of Defence (“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 domestic programs continue to put pressure on all areas of discretionary spending, which could ultimately impact the defense budget. A decrease in U.S. Government defense spending or changes in spending allocation could result in one or more of our programs being reduced, delayed or terminated.

Uncertainty regarding federal funding has been resolved for the remainder of Fiscal Year 2014, and budget parameters have been agreed to for Fiscal Year 2015. However, Congress and the Administration must still enact the appropriations legislation needed to actually fund the government in Fiscal Year 2015 in order to avoid a return of such uncertainty.
Enactment in December 2013 of the Bipartisan Budget Act of 2013 (BBA), establishing a two-year budget framework for Fiscal Years 2014 and 2015, and the subsequent enactment in January 2014 of the Consolidated Appropriations Act, 2014, have resulted in full-year funding being provided for the remainder of Fiscal Year 2014 to our government customer organizations, rather than stopgap funding through continuing resolution(s) based on prior year appropriations. This full-year funding also eliminated the possibility of a government shutdown for the remainder of Fiscal Year 2014 and the disruption that would entail.  The BBA further modified the spending caps established by the Budget Control Act of 2011, and passage of the Consolidated Appropriations Act, 2014, which comported with the modified caps, eliminated the threat of sequestration for the remainder of Fiscal Year 2014. 

The two-year budget parameters set by the BBA also provide a framework that can guide Congress in enacting FY 2015 appropriations legislation that could similarly avoid the need for continuing resolutions, the threat of a government shutdown and/or sequestration for the next fiscal year, provided such appropriations legislation is enacted. Until that happens, there will still be uncertainty on the part of our government customers with respect to future funding. This uncertainty, combined with overall budget levels established by the BBA that reflect decreased federal spending in accordance with the Budget Control Act’s spending caps as modified, may adversely affect our ability to sustain and grow our future sales and earnings.
Page 8 of 59

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 indefinite delivery, indefinite quantity (“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 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.
Page 9 of 59

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 company 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 14 – 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.

Page 10 of 59

Item 1B.  Unresolved Staff Comments

Not applicable to us as we are not an “accelerated filer” or “large accelerated filer” as such terms are defined in Rule 12b-2 under the Exchange Act or a “well-known seasoned issuer” as defined in Rule 405 of the Securities Act.

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 October 2026.  The lease includes an option to purchase, assign to, or designate a purchaser on June 1, 2014, which requires notice of intent to exercise the option by March 31, 2014.

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, 2014.

We lease additional office space in seven separate facilities located in Alabama, California, Colorado, Maryland, Mississippi, and New Jersey under various leases expiring through July of 2016.

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 14 – Commitments, Contingencies and Subsequent Events to the Consolidated Financial Statements.

Item 4.  Mine Safety Disclosures

Not applicable.

Page 11 of 59

PART II

Item 5.  Market for Registrant's Common Equity and 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 3, 2014, there were 201 holders of our Class A Common Stock and 10 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 7 – Current Liabilities and Debt Obligations to the Consolidated Financial Statements.

No public market exists for our Series A-1 and Series A-2 Redeemable Preferred Stock (“Senior Redeemable Preferred Stock”).  See Note 8 – Redeemable Preferred Stock to the Consolidated Financial Statements.

Our 12% Cumulative Exchangeable Redeemable Preferred Stock (“Public Preferred Stock”) trades over the OTC Bulletin Board and the OTCQB marketplace.  See Note 8 – Redeemable Preferred Stock to the Consolidated Financial Statements.

As of December 31, 2013, there were 40,218,461 Class A and 4,037,628 Class B Common shares issued and outstanding.

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,
 
 
 
2013
   
2012
   
2011
   
2010
   
2009
 
 
 
(amounts in thousands)
 
Sales
 
$
207,394
   
$
226,096
   
$
189,888
   
$
225,797
   
$
275,681
 
Operating income
   
6,111
     
17,700
     
12,687
     
15,006
     
13,713
 
Income before income taxes
   
867
     
16,725
     
6,741
     
8,952
     
6,572
 
Net (loss) income attributable to Telos Corporation
   
(2,618
)
   
7,435
     
1,454
     
3,047
     
1,277
 


FINANCIAL CONDITION

 
 
As of December 31,
 
 
 
2013
   
2012
   
2011
   
2010
   
2009
 
 
 
(amounts in thousands)
 
Total assets
 
$
88,609
   
$
79,156
   
$
89,837
   
$
74,804
   
$
104,927
 
Senior credit facility, long-term (1)
   
19,141
     
18,559
     
17,501
     
13,786
     
9,198
 
Senior subordinated debt (1)
   
----
     
----
     
----
     
----
     
4,179
 
Note payable (1)
   
----
     
----
     
12,056
     
----
     
----
 
Capital lease obligations, long-term (2)
   
14,901
     
3,803
     
4,948
     
5,950
     
6,896
 
Senior redeemable preferred stock (3)
   
1,891
     
4,010
     
8,227
     
10,190
     
10,294
 
Public preferred stock (3)
   
116,274
     
112,451
     
108,628
     
104,806
     
100,983
 

(1) See Note 7 to the Consolidated Financial Statements in Item 8 regarding our debt obligations.

(2) See Note 11 to the Consolidated Financial Statements in Item 8 regarding our capital lease obligations.

(3) See Note 8 to the Consolidated Financial Statements in Item 8 regarding our redeemable preferred stock.

Page 12 of 59


 
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 – Secure wired and wireless network solutions for Department of Defense (“DoD”) and other federal agencies.  We provide an extensive range of wired and wireless voice, data, and video secure network solutions and mobile application development to support defense and civilian missions.  In July 2011, we acquired all of the assets of IT Logistics, Inc. (“ITL”) and incorporated such assets into our Secure Networks business solutions.  Our software products and consulting services automate, streamline, and enforce IT security and risk management processes enterprise-wide.  We offer information assurance consulting services and Xacta brand GRC (governance, risk, and compliance) solutions to protect and defend IT systems, ensuring their availability, integrity, authentication, and confidentiality.

· Secure Communications – The next-generation messaging solution supporting warfighters throughout the world.  Telos Secure Information eXchange (T-6) and the AMHS platform offer secure, automated, Web-based capabilities for distributing and managing enterprise messages formatted for the Defense Messaging System as well as collaborating in real-time through video, text, whiteboarding, and document sharing.

· Telos ID – End-to-end logical and physical security from the gate to the network.  Our identity management solutions provide control of physical access to bases, offices, workstations, and other facilities, as well as control of logical access to databases, host systems, and other IT resources.

Critical Accounting Policies and 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, goodwill and intangible assets, income taxes, contingencies and litigation, and assumptions used in evaluating 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
Revenues are recognized in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) ASC 605-10-S99.  We consider amounts earned upon evidence that an arrangement has been obtained, services are delivered, fees are fixed or determinable, and collectability is reasonably assured. Additionally, revenues on arrangements requiring the delivery of more than one product or service are recognized in accordance with ASC 605-25, “Revenue Arrangements with Multiple Deliverables,” which addresses and requires the separation and allocation at the inception of the arrangement of all deliverables based on their relative selling prices.  This determination is made first by employing vendor-specific objective evidence (“VSOE”), to the extent it exists, then third-party evidence (“TPE”) of selling price, to the extent that it exists. Given the nature of the deliverables contained in our multi-element arrangements, which often involve the design and/or delivery of complex or technical solutions to the government, we have not obtained TPE of selling prices on multi-element arrangements due to the significant differentiation which makes obtaining comparable pricing of products with similar functionality impractical.  Therefore we do not utilize TPE.  If VSOE and TPE are not determinable, we use our best estimate of selling price (“ESP”) as defined in ASC 605-25, which represents our best estimate of the prices under the terms and conditions of a particular order for the various elements if they were sold on a stand-alone basis.

We recognize revenues for software arrangements upon persuasive evidence of an arrangement, delivery of the software, and determination that collection of a fixed or determinable license fee is probable.  Revenues for software licenses sold on a subscription basis are recognized ratably over the related license period. For arrangements where the sale of software licenses are bundled with other products, including software products, upgrades and enhancements, post-contract customer support (“PCS”), and installation, the relative fair value of each element is determined based on VSOE.  VSOE is defined by ASC 985-605, “Software Revenue Recognition,” and is limited to the price charged when the element is sold separately or, if the element is not yet sold separately, the price set by management having the relevant authority.  When VSOE exists for undelivered elements, the remaining consideration is allocated to delivered elements using the residual method.  If VSOE does not exist for the allocation of revenue to the various elements of the arrangement, all revenue from the arrangement is deferred until the earlier of the point at which (1) such VSOE does exist or (2) all elements of the arrangement are delivered.  PCS revenues, upon being unbundled from a software license fee, are recognized ratably over the PCS period. Software arrangements requiring significant production, modification, or customization of the software are accounted for in accordance with ASC 605-35 “Construction-Type and Production-Type Contracts”.
Page 13 of 59

We may use subcontractors and suppliers in the course of performing on contracts and under certain contracts we provide supplier procurement services and materials for our customers.  Some of these arrangements may fall within the scope of ASC 605-45, “Reporting Revenue Gross as a Principal versus Net as an Agent.” We presume that revenues on our contracts are recognized on a gross basis, as we generally provide significant value-added services, assume credit risk, and reserve the right to select subcontractors and suppliers, but we evaluate the various criteria specified in the guidance in making the determination of whether revenue should be recognized on a gross or net basis.

A description of the business lines, the typical deliverables, and the revenue recognition criteria in general for such deliverables follows:

Cyber Operations and Defense:

In the first quarter of 2012, our Secure Networks and Information Assurance solutions areas were merged to create our Cyber Operations and Defense business line.

Regarding our deliverables of secure network solutions, we provide wireless and wired networking solutions consisting of hardware and services to our customers. Also, within our  Cyber Operations and Defense solutions area is our Emerging Technologies Group creating innovative, custom-tailored solutions for government and commercial enterprises.  The solutions within the Cyber Operations and Defense and Emerging Technologies groups are generally sold as firm-fixed price (“FFP”) bundled solutions.  Certain of these networking solutions involve contracts to design, develop, or modify complex electronic equipment configurations to a buyer's specification or to provide network engineering services, and as such fall within the scope of ASC 605-35. Revenue is earned upon percentage of completion based upon proportional performance, such performance generally being defined by performance milestones.  Certain other solutions fall within the scope of ASC 605-10-S99, such as resold information technology products, like laptops, printers, networking equipment and peripherals, and ASC 605-25, such as delivery orders for multiple solutions deliverables. For product sales, revenue is recognized upon proof of acceptance by the customer, otherwise it is deferred until such time as the proof of acceptance is obtained.  For example, in delivery orders for Department of Defense customers, which comprise the majority of the Company’s customers, such acceptance is achieved with a signed Department of Defense Form DD-250 or electronic invoicing system equivalent. Services provided under these contracts are generally provided on a FFP basis, and as such fall within the scope of ASC 605-10-S99. Revenue for services is recognized based on proportional performance, as the work progresses. FFP services may be billed to the customer on a percentage-of-completion basis or based upon milestones, which may approximate the proportional performance of the services under the agreements, as specified in such agreements. To the extent that customer billings exceed the performance of the specified services, the revenue would be deferred. Revenue is recognized under time-and-materials (“T&M”) services contracts based upon specified billing rates and other direct costs as incurred.

Regarding our information assurance deliverables, we provide Xacta IA Manager software and cybersecurity services to our customers.  The software and accompanying services fall within the scope of ASC 985-605, “Software Revenue Recognition,” as fully discussed above.  We provide consulting services to our customers under either a FFP or T&M basis. Such contracts fall under the scope of ASC 605-10-S99. Revenue for FFP services is recognized on a proportional performance basis. FFP services may be billed to the customer on a percentage-of-completion basis or based upon milestones as appropriate under a particular contract, which may approximate the proportional performance of the services under the agreements, as specified in such agreements. To the extent that customer billings exceed the performance of the specified services, the revenue would be deferred. Revenue is recognized under T&M contracts based upon specified billing rates and other direct costs as incurred. For cost plus fixed fee (“CPFF”) contracts, revenue is recognized in proportion to the allowable costs incurred unless indicated otherwise in the terms of the contract.

Secure Communications – We provide Secure Information eXchange (T-6) suite of products which include the flagship product the Automated Message Handling System (“AMHS”), Secure Collaboration, Secure Discovery, Secure Directory and Cross Domain Communication, as well as related services to our customers. The system and accompanying services fall within the scope of ASC 985-605, as fully discussed above. Other services fall within the scope of ASC 605-10-S99 for arrangements that include only T&M contracts and ASC 605-25 for contracts with multiple deliverables such as T&M elements and FFP services.  Under such arrangements, the T&M elements are established by direct costs.  Revenue is recognized on T&M contracts according to specified rates as direct labor and other direct costs are incurred. For cost plus fixed fee (“CPFF”) contracts, revenue is recognized in proportion to the allowable costs incurred unless indicated otherwise in the terms of the contract. Revenue for FFP services is recognized on a proportional performance basis. FFP services may be billed to the customer on a percentage-of-completion basis or based upon milestones, which may approximate the proportional performance of the services under the agreements, as specified in such agreements. To the extent that customer billings exceed the performance of the specified services, the revenue would be deferred.

Telos ID – We provide our identity assurance and access management solutions and services and sell information technology products, such as computer laptops and specialized printers, and consumables, such as identity cards, to our customers. The solutions are generally sold as FFP bundled solutions, which would typically fall within the scope of ASC 605-25 and ASC 605-10-S99.  Revenue for services is recognized based on proportional performance, as the work progresses. FFP services may be billed to the customer on a percentage-of-completion basis or based upon milestones, which may approximate the proportional performance of the services under the agreements, as specified in such agreements. To the extent that customer billings exceed the performance of the specified services, the revenue would be deferred. Revenue is recognized under T&M contracts based upon specified billing rates and other direct costs as incurred.
Page 14 of 59

Estimating future costs and, therefore, revenues and profits, is a process requiring a high degree of management judgment.  In the event of a change in total estimated contract cost or profit, the cumulative effect of a change is recorded in the period the change in estimate occurs. To the extent contracts are incomplete at the end of an accounting period, revenue is recognized on the percentage-of-completion method, on a proportional performance basis, using costs incurred in relation to total estimated costs, or costs are deferred as appropriate under the terms of a particular contract. In the event cost estimates indicate a loss on a contract, the total amount of such loss, excluding overhead and general and administrative expense, is recorded in the period in which the loss is first estimated.

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 and intangible assets
We evaluate the impairment of goodwill and intangible assets in accordance with ASC 350, “Goodwill and Intangible Assets,”  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”), Secure Communications, and Telos ID, 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, 2013. Subsequent reviews may result in future periodic impairments that could have a material adverse effect on the results of operations in the period recognized.   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.

Intangible assets consist primarily of customer relationship enhancements. Intangible assets are amortized on a straight-line basis over their estimated useful lives of 5 years.  The amortization is based on a forecast of approximately equal annual customer orders over the 5-year period.  Intangible assets are subject to impairment review if there are events or changes in circumstances that indicate that the carrying amount is not recoverable.  As of December 31, 2013, no impairment charges were taken.

Income Taxes
We account for income taxes in accordance with ASC 740, “Income Taxes.”  Under ASC 740, 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.

Page 15 of 59

Results of Operations
We derive substantially all 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 2013, 2012, and 2011, the Company’s revenue derived from firm fixed-price was 84.1%, 82.7%, and 88.8%, respectively, and time-and-material contracts was 15.9%, 17.3%, and 11.2%, respectively.

We provide different solutions and are party to contracts of varying revenue types under the NETCENTS (Network-Centric Solutions) contract to the U.S. Air Force.  NETCENTS is an indefinite delivery/indefinite quantity (“IDIQ”) and government-wide acquisition contract (“GWAC”), therefore any government customer may utilize the NETCENTS vehicle to meet its purchasing needs. Consequently, revenue earned on the underlying NETCENTS 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 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 NETCENTS contract was awarded in 2004 and has been modified 40 times since that time, including numerous modifications to extend the period of performance. The contract itself does not fund any orders and it states that the contract is for an indefinite delivery and indefinite quantity.The period of performance for the award of new task orders under the contract ended on September 30, 2013.  Previously awarded task orders that contain periods of performance that extend past September 30, 2013, including exercisable option years under existing task orders, are not affected by the contract expiration. While we derive a substantial amount of revenue from task/delivery orders under the NETCENTS contract, we have also been awarded other IDIQ/GWACs, including blanket purchase agreements under our GSA schedule.

The implementation of the March 1, 2013 budget sequester has produced significant uncertainty with respect to future government programs and funding of our government customer organizations.  The timing and implementation of the sequestration of appropriations in government fiscal year 2013 imposed by the Budget Control Act of 2011 (Budget Act) are likely to continue to produce delays in awards of future contracts.  While we believe the that the effects of the sequester have impacted the timing of contract awards, primarily in our Cyber Operations and Defense solution area, the specific effects of sequestration are difficult to quantify or predict on a longer term basis.

Statement of Operations Data

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

 
 
Years Ended December 31,
 
 
 
2013
   
2012
   
2011
 
 
 
(dollar amounts in thousands)
 
 
 
   
   
   
   
   
 
Revenue
 
$
207,394
     
100.0
%
 
$
226,096
     
100.0
%
 
$
189,888
     
100.0
%
Cost of sales
   
168,794
     
81.4
     
171,290
     
75.8
     
142,345
     
74.9
 
Selling, general and administrative expenses
   
32,489
     
15.7
     
37,106
     
16.4
     
34,856
     
18.4
 
 
                                               
Operating income
   
6,111
     
2.9
     
17,700
     
7.8
     
12,687
     
6.7
 
Other income (expenses):
                                               
Gain on early extinguishment of debt
   
----
     
----
     
5,187
     
2.3
     
----
     
----
 
Non-operating income
   
239
     
0.1
     
470
     
0.2
     
319
     
0.2
 
Interest expense
   
(5,483
)
   
(2.6
)
   
(6,632
)
   
(2.9
)
   
(6,265
)
   
(3.3
)
 
                                               
Income before income taxes
   
867
     
0.4
     
16,725
     
7.4
     
6,741
     
3.6
 
Provision for income taxes
   
(1,678
)
   
(0.8
)
   
(7,230
)
   
(3.2
)
   
(3,238
)
   
(1.7
)
Net (loss) income
   
(811
)
   
(0.4
)
   
9,495
     
4.2
     
3,503
     
1.9
 
 
Less:  Net income attributable to non-controlling interest
   
(1,807
)
   
(0.9
)
   
(2,060
)
   
(0.9
)
   
(2,049
)
   
(1.1
)
 
Net (loss) income attributable to Telos Corporation
 
$
(2,618
)
   
(1.3
)%
 
$
7,435
     
3.3
%
 
$
1,454
     
0.8
%

Page 16 of 59

Results of Operations

Years ended December 31, 2013, 2012, and 2011
Revenue.  Revenue decreased by 8.3% to $207.4 million for 2013 from $226.1 million for 2012.  Such decrease is primarily attributable to decreased sales from the U.S. Air Force NETCENTS contract.  As discussed above, NETCENTS is an IDIQ contract utilized by multiple government customers and sales under NETCENTS varied from period to period according to the solution mix and timing of deliverables for a particular period. Services revenue decreased by 19.1% to $143.5 million for 2013 from $177.3 million for 2012, primarily attributable to decreases in sales of $20.2 million of Cyber Operations and Defense in secure networks solutions deliverables under several NETCENTS delivery orders for Telos-installed solutions, $10.6 million of Cyber Operations and Defense in information assurance deliverables, and $5.1 million of Secure Communications solutions, offset by an increase in sales of $2.1 million of Telos ID 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 for 2013 increased by 30.9% to $63.9 million from $48.8 million for 2012, primarily attributable to an increase in sales of $26.2 million of Cyber Operations and Defense in resold products, offset by decreases in sales of $8.2 million of Telos ID solutions, $2.8 million of proprietary software sales in Cyber Operations and Defense information assurance deliverables, and $0.1 million of Secure Communications solutions.  The increase in resold product revenue was the result of decisions taken by management to increase all revenue sources in response to the impact of the budget sequestration discussed above. The increase in product revenue is not consistent with the Company’s longer term strategy of focusing on solutions and servces and as such is expected to be temporary while mitigating the effects of the budget sequestration.

Revenue increased by 19.1% to $226.1 million for 2012 from $189.9 million for 2011.  Such increase is primarily attributable to increased sales from the U.S. Air Force NETCENTS contract.  Services revenue increased by 41.8% to $177.3 million for 2012 from $125.0 million for 2011, primarily attributable to increases in sales of $43.9 million of Cyber Operations and Defense in secure networks solutions deliverables under several NETCENTS delivery orders for Telos-installed solutions, $8.0 million of Cyber Operations and Defense in information assurance deliverables, and $2.5 million of Telos ID solutions, offset by a decrease in sales of $2.1 million of Secure Communications 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 for 2012 decreased by 24.8% to $48.8 million from $64.9 million for 2011, primarily attributable to decreases in sales of $10.4 million of Cyber Operations and Defense in secure networks solutions deliverables, $5.6 million of Telos ID solutions, $0.2 million of Secure Communications solutions, offset by an increase in sales of $0.1 million of Cyber Operations and Defense in information assurance deliverables.

Cost of sales.  Cost of sales decreased by 1.5% to $168.8 million for 2013 from $171.3 million for 2012 as a result of decreases in revenue.  Cost of sales for services decreased by $22.2 million, and as a percentage of services revenue increased by 2.0%, due to a change in the mix and nature of the programs including an increase in certain Telos-installed solutions in Cyber Operations and Defense in secure networks solutions deliverables under NETCENTS.  Cost of sales for product increased by $19.7 million, and as a percentage of product revenue increased by 11.9%, primarily due to increases in product revenue for resold product and decreases in proprietary software revenue.  The decrease in cost of sales is not necessarily indicative of a trend as the mix of solutions sold and the nature of such solutions can vary from period to period, and further can be affected by the timing of deliverables.

Cost of sales increased by 20.3% to $171.3 million for 2012 from $142.3 million for 2011 as a result of increases in revenue.  Cost of sales for services increased by $40.6 million; and as a percentage of services revenue increased by 1.3%, due to a change in the mix and nature of the programs including an increase in certain Telos-installed solutions in Cyber Operations and Defense network solutions deliverables under NETCENTS.  Cost of sales for product decreased by $11.6 million, and as a percentage of product revenue increased by 2.1%, primarily due to decreases in product revenue for Telos-manufactured technology solutions under NETCENTS.  The increase in cost of sales is not necessarily indicative of a trend as the mix of solutions sold and the nature of such solutions can vary from period to period, and further can be affected by the timing of deliverables.

Gross profit.  Gross profit decreased by 29.6% to $38.6 million for 2013 from $54.8 million for 2012.  Gross margin decreased 5.6% to 18.6% for 2013 from 24.2% for 2012, due to various changes in the mix of contracts in all business lines, primarily increases in resold products and decreases in solutions deliveries in the Cyber Operations and Defense business line and decreases in proprietary software sales.

Gross profit increased by 15.3% to $54.8 million for 2012 from $47.5 million for 2011.  Gross margin decreased 0.9% to 24.2% for 2012 from 25.1% for 2011, due to various changes in the mix of contracts in all business lines, primarily solutions delivery in the Cyber Operations and Defense business line and continued emphasis on selling solutions while outsourcing product sales.

Selling, general, and administrative expenses.  Selling, general, and administrative expenses decreased 12.4% to $32.5 million for 2013 from $37.1 million for 2012.  Such decrease is primarily attributable to decreases in bonuses of $2.0 million, labor costs of $1.7 million, legal fees of $0.6 million, and travel costs of $0.2 million.

Selling, general, and administrative expenses increased 6.5% to $37.1 million for 2012 from $34.9 million for 2011.  Such increase is primarily attributable to increases in legal fees of $2.0 million and amortization of intangible assets of $1.1 million, offset by decreases in bonuses of $0.6 million, and trade shows expenses of $0.3 million.
Page 17 of 59

Interest expense.  Interest expenses decreased 17.3% to $5.5 million for 2013 from $6.6 million for 2012, primarily due to a decrease in interest expense due to the early extinguishment of the ITL Note in 2012, and a reduction of interest expense due to the partial redemption of the senior redeemable preferred stock.

Interest expenses increased 5.9% to $6.6 million for 2012 from $6.3 million for 2011, primarily due to an increase in interest expense due to accretion on notes payable to ITL as a result of the ITL acquisition, offset by a reduction of interest expense due to the partial redemption of the senior redeemable preferred stock.  Components of interest expense are as follows:

 
 
December 31,
 
 
 
2013
   
2012
   
2011
 
 
 
(amounts in thousands)
 
Commercial and subordinated note interest incurred
 
$
1,557
   
$
1,786
   
$
1,745
 
Preferred stock interest accrued
   
3,926
     
4,051
     
4,159
 
ITL note accretion
   
----
     
795
     
361
 
 
Total
 
$
5,483
   
$
6,632
   
$
6,265
 

Provision for income taxes.  Provision for income taxes decreased to $1.7 million for 2013 from $7.2 million for 2012, primarily due to a decrease in pretax income.  Provision for income taxes increased to $7.2 million for 2012 from $3.2 million for 2011, primarily due to an increase in pretax income, and changes in book and tax basis of goodwill due to the early extinguishment of the ITL Note.

Liquidity and Capital Resources

As described in more detail below, we maintain a revolving credit facility (the “Facility”) with Wells Fargo Capital Finance, Inc. (“Wells Fargo”) which was formerly Wells Fargo Foothill, Inc.  Borrowings under the Facility are collateralized by substantially all of our assets including inventory, equipment, and accounts receivable.  The amount of available borrowings fluctuates based on the underlying asset-borrowing base, in general 85% of our trade accounts receivable, as adjusted by certain reserves (as further defined in the Facility agreement). The Facility provides us with virtually all of the liquidity we require to meet our operating, investing and financing needs. Therefore maintaining sufficient availability on the Facility is the most critical factor in our liquidity.  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 the Facility.  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 availability on the Facility 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 availability 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 on the Facility unless the slowdown was material in amount and over an extended period of time. Any of these examples would have an impact on the Facility, and therefore our liquidity.  Management believes that the Company’s borrowing capacity is sufficient to fund our capital and liquidity needs for the foreseeable future.

Cash provided by operating activities was $4.8 million for the year ended December 31, 2013, compared to cash provided by operating activities of $16.1 million for the year ended December 31, 2012, and cash provided by operating activities of $14.9 million for 2011.  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 2013, net loss was $0.8 million, which included $2.3 million of amortization of intangible assets resulting from the ITL acquisition.   In 2012, net income was $9.5 million, which included $5.2 million gain from early extinguishment of the ITL note, and $2.3 million of amortization of intangible assets resulting from the ITL acquisition.  In 2011, net income was $3.5 million, which included $1.1 million of amortization of intangible assets resulting from the ITL acquisition.

Cash used in investing activities for the year ended December 31, 2013 was $0.5 million, which consisted of the purchases of property and equipment.  Cash used in investing activities for the year ended December 31, 2012 was $0.6 million, which consisted of the purchases of property and equipment.  Cash used in investing activities for the year ended December 31, 2011 was $8.6 million, which primarily consisted of the $8.0 million initial payment for the acquisition of ITL, and the purchase of $0.6 million of property and equipment.
Page 18 of 59

 
Cash used in financing activities for year ended December 31, 2013 was $4.4 million, compared to $15.5 million for 2012, and $6.2 million for 2011.  The financing activities in 2013 consisted primarily of net proceeds of $1.0 million from the Facility, redemption of $2.0 million of senior preferred stock, repayments of $1.2 million under capital leases,  repayments of a $0.4 million of a term loan, and distributions of $1.8 million to the Class B Member of Telos ID.  The financing activities in 2012 consisted primarily of net proceeds of $2.7 million from the Facility, payment of $10.9 million of ITL notes, redemption of $4.0 million of senior preferred stock, repayments of $0.9 million under capital leases,  repayments of a $0.4 million of a term loan, and distributions of $2.0 million to the Class B Member of Telos ID.  The financing activities in 2011 consisted primarily of net proceeds of $2.8 million from the Facility, payment of $3.5 million of ITL notes, repayments of $0.9 million under capital leases,  repayments of a $0.4 million of a term loan, distributions of $2.1 million to the Class B Member of Telos ID, and redemption of $2.1 million of senior preferred stock.

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:

Senior Revolving Credit Facility

On July 31, 2013, we amended our $30 million revolving credit facility (the “Facility”) with Wells Fargo Capital Finance, LLC (“Wells Fargo”) to extend the maturity date to November 13, 2014 from May 17, 2014.  On March 27, 2014, we further amended the Facility to extend the maturity date to November 13, 2015.  In addition, Wells Fargo issued a waiver of certain existing defaults under the Facility including failure to maintain required EBITDA (as defined in the Facility) covenants.  The March 2014 amendment also amends the terms of the Facility with respect to repayment on the term loan component.  Since 2010, the principal of the term loan component has been repaid in quarterly installments of $93,750.  The amended Facility requires quarterly installment payments of $250,000 beginning July 1, 2014, with a final installment of the unpaid principal amount payable on November 13, 2015, the maturity date of the amended Facility.  In consideration for the closing of this amendment, we paid Wells Fargo a fee of $75,000, plus expenses related to the closing. The interest rate on the term loan component is the same as that on the revolving credit component of the Facility, which is the higher of the Wells Fargo Bank “prime rate” plus 1%, the Federal Funds rate plus 1.5%, or the 3-month LIBOR rate plus 2%. In lieu of having interest charged at the foregoing rates, the Company may elect to have the interest on all or a portion of the advances on the revolving credit component be a rate based on the LIBOR Rate (as defined in the Facility) plus 3.75%.  As of December 31, 2013, we have not elected the LIBOR Rate option.  Borrowings under the Facility are collateralized by substantially all of the Company’s assets including inventory, equipment, and accounts receivable.

As of December 31, 2013, the interest rate on the Facility was 4.25%.   We incurred interest expense in the amount of $0.6 million, $0.8 million, and $0.7 million for the years ended December 31, 2013, 2012, and 2011, respectively, on the Facility.

On April 8, 2011, a portion of the Senior Redeemable Preferred Stock was redeemed  (see Note 8 – Redeemable Preferred Stock).  Additionally, on May 11, 2012, the Facility was amended to allow for the redemption of Senior Redeemable Preferred Stock, under certain conditions, at a discount from par value plus accrued dividends of at least 10%, at an aggregate price not to exceed $4.0 million.  On May 16, 2012 and on August 24, 2012, a portion of the Senior Redeemable Preferred Stock was redeemed (see Note 8 – Redeemable Preferred Stock).

On December 17, 2012, Wells Fargo consented to the payment of approximately $7.6 million of the ITL note.

On June 11, 2013, the Facility was further amended to allow for the further redemption of Senior Redeemable Preferred Stock, under certain conditions, at a discount from par value plus accrued dividends of at least 10%, at an aggregate price not to exceed $2.0 million.  On June 14, 2013, a portion of the Senior Redeemable Preferred Stock was redeemed (see Note 8 – Redeemable Preferred Stock).

The Facility has various covenants that may, among other things, affect our ability to merge with another entity, sell or transfer certain assets, pay dividends and make other distributions beyond certain limitations.  The financial covenants also include minimum EBITDA, minimum recurring revenue and a limit on capital expenditures.  In conjunction with the March 2014 amendment,  Wells Fargo issued a waiver of certain existing defaults under the Facility including failure to maintain required EBITDA covenants.  Prior to the March 2014 amendment, the term loan component of the Facility amortizes at 5% per year, which is paid in quarterly installments and is classified as current on the consolidated balance sheets.  Effective July 1, 2014, the quarterly installment repayments will be $250,000.  The remaining balance of the term loan, or $5.5 million, and the revolving component of the Facility mature over the period 2014 and 2015.

At December 31, 2013, we had outstanding borrowings of $19.8 million on the Facility, which included the $6.2 million term loan, of which $0.7 million was short-term.   At December 31, 2012, the outstanding borrowings on the Facility were $18.9 million, which included the $6.6 million term loan, of which $0.4 million was short-term.  At December 31, 2013 and 2012, we had unused borrowing availability on the Facility of $9.2 million and $2.2 million, respectively.  The effective weighted average interest rates on the outstanding borrowings under the Facility were 5.3% and 5.6% for the years ended December 31, 2013 and 2012, respectively.

Page 19 of 59

 
Redeemable Preferred Stock
We currently have two primary classes of redeemable preferred stock - Senior Redeemable Preferred Stock and Public Preferred Stock.  These classes of stock carry cumulative dividend rates of 14.125% and 12%, respectively.  We accrue dividends on both classes of redeemable preferred stock and provide for accretion related to the Public Preferred Stock.  As of December 31, 2008, the Public Preferred Stock has been fully accreted.  The total carrying amount of redeemable preferred stock, including accumulated and unpaid dividends was $118.2 million and $116.5 million at December 31, 2013 and 2012, respectively.  We recorded dividends of $3.9 million and $4.1 million each for the years ended December 31, 2013 and 2012, respectively, on the two classes of redeemable preferred stock, and such amounts have been included in interest expense.

Senior Redeemable Preferred Stock
The Senior Redeemable Preferred Stock is senior to all other outstanding equity of the Company, including the Public Preferred Stock. The Series A-1 ranks on a parity with the Series A-2.  The components of the authorized Senior Redeemable Preferred Stock are 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 carries a cumulative per annum dividend rate of 14.125% of its liquidation value of $1,000 per share. The dividends are payable semiannually on June 30 and December 31 of each year. We have not declared dividends on our Senior Redeemable Preferred Stock since its issuance. The liquidation preference of the Senior Redeemable Preferred Stock is 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 Facility and of the Senior Redeemable Preferred Stock, we have been and continue to be precluded from paying any accrued and unpaid dividends on the Senior Redeemable Preferred Stock, other than described below. Certain holders of the Senior Redeemable Preferred Stock have entered into standby agreements whereby, among other things, those holders will 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, 2013, instruments held by Toxford Corporation ( “Toxford”), the holder of 76.4% of the Senior Redeemable Preferred Stock, will mature on February 28, 2016.

On or about March 15, 2011, Mr. John Porter, the beneficial owner of 39.3% of our Class A Common Stock, acquired a total of 75 shares and 105 shares of Series A-1 and Series A-2 Redeemable Preferred Stock, respectively, from other holders of the Senior Redeemable Preferred Stock.  As of December 31, 2013, Mr. Porter held 6.3% of the Senior Redeemable Preferred Stock.  In the aggregate, as of December 31, 2013, Mr. Porter and Toxford held a total of 163 shares and 228 shares of Series A-1 and Series A-2 Redeemable Preferred Stock, respectively, or 82.7% of the Senior Redeemable Preferred Stock.  Mr. Porter is the sole stockholder of Toxford.

On April 8, 2011, with the consent of the holders of the outstanding shares of Senior Redeemable Preferred Stock, 22.3% of the Senior Redeemable Preferred Stock with a carrying value of $2.3 million was redeemed for $2.1 million, resulting in a gain in the amount of approximately $0.2 million, representing a discount of 10%, which was recorded in other income on the consolidated statements of operations.  Subsequent to such redemption, the total number of shares of Senior Redeemable Preferred Stock issued and outstanding was 923 shares and 1,292 shares for Series A-1 and Series A-2, respectively.

On May 11, 2012, the Facility was amended to allow for the redemption of Senior Redeemable Preferred Stock, under certain conditions, at a discount from par value plus accrued dividends of at least 10%, at an aggregate price not to exceed $4.0 million.  On May 16, 2012, with the consent of the holders of the outstanding shares of Senior Redeemable Preferred Stock, 26.7% of the Senior Redeemable Preferred Stock with a carrying value of $2.2 million was redeemed for $2.0 million, resulting in a gain in the amount of approximately $0.2 million, representing a discount of 10%, which was recorded in other income on the consolidated statements of operations.  Subsequent to such redemption, the total number of shares of Senior Redeemable Preferred Stock issued and outstanding was 677 shares and 947 shares for Series A-1 and Series A-2, respectively.

On August 24, 2012, with the consent of the holders of the outstanding shares of Senior Redeemable Preferred Stock, 36.0% of the Senior Redeemable Preferred Stock with a carrying value of $2.2 million was redeemed for $2.0 million, resulting in a gain in the amount of approximately $0.2 million, representing a discount of 10%, which was recorded in other income on the consolidated statements of operations.  Subsequent to such redemption, the total number of shares of Senior Redeemable Preferred Stock issued and outstanding was 433 shares and 607 shares for Series A-1 and Series A-2, respectively.

On June 11, 2013, the Facility was further amended to allow for the redemption of Senior Redeemable Preferred Stock, under certain conditions, at a discount from par value plus accrued dividends of at least 10%, at an aggregate price not to exceed $2.0 million.  On June 14, 2013, with the consent of the holders of the outstanding shares of Senior Redeemable Preferred Stock, 54.5% of the Senior Redeemable Preferred Stock with a carrying value of $2.2 million was redeemed for $2.0 million, resulting in a gain in the amount of approximately $0.2 million, representing a discount of 10%, which was recorded in other income on the condensed consolidated statements of operations.  Subsequent to such redemption, 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.

At December 31, 2013, 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.  At December 31, 2012, the total number of shares of Senior Redeemable Preferred Stock issued and outstanding was 433 shares and 607 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 is classified as noncurrent as of December 31, 2013.
Page 20 of 59

At December 31, 2013 and 2012, cumulative undeclared, unpaid dividends relating to Senior Redeemable Preferred stock totaled $1.4 million and $3.0 million, respectively.  We accrued dividends on the Senior Redeemable Preferred Stock of $103,000, $228,000, and $337,000 for the years ended December 31, 2013, 2012, and 2011, 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.

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, 2013 and 2012, was 3,185,586. The Public Preferred Stock is quoted as TLSRP on the OTCQB marketplace and the OTC Bulletin Board.

Since 1991, no other dividends were declared or paid on our Public Preferred Stock, based upon our interpretation of restrictions in our Articles of Amendment and Restatement, limitations in the terms of the Public Preferred Stock instrument, specific dividend payment restrictions in the Facility entered into with Wells Fargo to which the Public Preferred Stock is subject, other senior obligations, and Maryland law limitations in existence prior to October 1, 2009.  Pursuant to their terms, 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, limitations set forth in the covenants in the Facility, foreseeable capital and operational requirements, and restrictions and prohibitions of our Articles of Amendment and Restatement, we were unable to meet the redemption schedule set forth in the terms of the Public Preferred Stock. 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, 2013 and 2012.

We are parties with certain of our subsidiaries to the Facility agreement with Wells Fargo, whose term expires on November 13, 2015.  Under the Facility, we agreed that, so long as any credit under the Facility is available and until full and final payment of the obligations under the Facility, 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.

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 Facility prohibits, among other things, the redemption of any stock, common or preferred, other than as described above.  The Public Preferred Stock by its terms 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, 2013.  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.

Page 21 of 59

 
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 $84.4 million and $80.6 million as of December 31, 2013 and 2012, respectively.   We accrued dividends on the Public Preferred Stock of $3.8 million for the years ended December 31, 2013, 2012, and 2011, 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.

The carrying value of the accrued Paid-in-Kind (“PIK”) dividends on the Public Preferred Stock for the period 1992 through June 1995 was $4.0 million.  Had we accrued such dividends on a cash basis for this time period, the total amount accrued would have been $15.1 million.  However, as a result of the redemption of the 410,000 shares of the Public Preferred Stock in November 1998, such amounts were reduced and adjusted to $3.5 million and $13.4 million, respectively.  Our Articles of Amendment and Restatement, Section 2(a) states, “Any dividends payable with respect to the Exchangeable Preferred Stock (“Public Preferred Stock”) during the first six years after the Effective Date (November 20, 1989) may be paid (subject to restrictions under applicable state law), in the sole discretion of the Board of Directors, in cash or by issuing additional fully paid and nonassessable shares of Exchangeable Preferred Stock …”.  Accordingly, the Board had the discretion to pay the dividends for the referenced period in cash or by the issuance of additional shares of Public Preferred Stock.  During the period in which we stated our intent to pay PIK dividends, we stated our intention to amend our Charter to permit such payment by the issuance of additional shares of Public Preferred Stock.  In consequence, as required by applicable accounting requirements, the accrual for these dividends was recorded at the estimated fair value (as the average of the ask and bid prices) on the dividend date of the shares of Public Preferred Stock that would have been (but were not) issued.  This accrual was $9.9 million lower than the accrual would be if the intent was only to pay the dividend in cash, at that date or any later date.

In May 2006, the Board concluded that the accrual of PIK dividends for the period 1992 through June 1995 was no longer appropriate.  Since 1995, we have disclosed in the footnotes to our audited financial statements the carrying value of the accrued PIK dividends on the Public Preferred Stock for the period 1992 through June 1995 as $4.0 million, and that had we accrued cash dividends during this time period, the total amount accrued would have been $15.1 million. As stated above, such amounts were reduced and adjusted to $3.5 million and $13.4 million, respectively, due to the redemption of 410,000 shares of the Public Preferred Stock in November 1998.  On May 12, 2006, the Board voted to confirm that our intent with respect to the payment of dividends on the Public Preferred Stock for this period changed from its previously stated intent to pay PIK dividends to that of an intent to pay cash dividends.  We therefore changed the accrual from $3.5 million to $13.4 million, the result of which was to increase our negative shareholder equity by the $9.9 million difference between those two amounts, by recording an additional $9.9 million charge to interest expense for the second quarter of 2006, resulting in a balance of $116.3 million and $112.5 million for the principal amount and all accrued dividends on the Public Preferred Stock as of December 31, 2013 and 2012, respectively. This action is considered a change in assumption that results in a change in accounting estimate as defined in ASC 250-10, which sets forth guidance concerning accounting changes and error corrections.

Borrowing Capacity
Our working capital was $17.3 million and $15.0 million as of December 31, 2013 and 2012, respectively.

At December 31, 2013, we had outstanding debt and long-term obligations of $152.9 million, consisting of $19.1 million under the Facility, $14.9 million in capital lease obligations, $118.2 million in redeemable preferred stock, which is classified as a liability pursuant to ASC 480-10, and $0.7 million in deferred tax and other liabilities.

We believe that available cash and borrowings under the Facility will be sufficient to generate adequate amounts of cash to meet our needs for operating expenses, debt service requirements, and projected capital expenditures for the foreseeable future.   We anticipate the continued need for a credit facility upon terms and conditions substantially similar to the Facility in order to meet our long term needs for operating expenses, debt service requirements, and projected capital expenditures.  Although no assurances can be given, we expect that we will be in compliance throughout the term of the Facility with respect to the financial and other covenants in the Facility agreement.

Page 22 of 59

Contractual Obligations
The following summarizes our contractual obligations and our redeemable preferred stock at December 31, 2013 (in thousands):

 
 
   
Payments due by Period
 
 
 
Total
   
2014
     
2015 - 2017
     
2018 - 2020
   
2021 and later
 
 
 
   
                   
 
Capital lease obligations (1)
 
$
22,435
   
$
1,533
   
$
4,762
   
$
5,093
   
$
11,047
 
Senior revolving credit facility (2)
   
19,829
     
688
     
19,141
     
----
     
----
 
Operating lease obligations
   
3,721
     
645
     
1,256
     
864
     
956
 
 
 
$
45,985
   
$
2,866
   
$
25,159
   
$
5,957
   
$
12,003
 
 
                                       
Senior preferred stock (3)
 
$
1,891
                                 
Public preferred stock (4)
   
116,274
                                 
 
 
$
118,165
                                 
Total
 
$
164,150
                                 
        (1)    Includes interest expense:
 
$
6,877
   
$
875
   
$
2,379
   
$
1,905
   
$
1,718
 
(2) Amount does not include interest on the Facility as we are unable to predict the amounts of interest due to the short-term nature of the advances and repayments.   Interest expense for 2013 was $0.6 million.
(3) In accordance with ASC 480, the senior preferred stock was reclassified from equity to liability in July 2003.  Amount represents the carrying value as of December 31, 2013, and includes accrual of accumulated dividends of $1.4 million.  Payment of such amount presumes conditions precedent being satisfied (See Note 8 – 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 through the redemption date as such date is unknown.  Such additional dividends accrue annually in the amount of $67,000.
(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, 2013, and includes accrual of accumulated dividends and accretion of $109.9 million.  Payment of such amount presumes conditions precedent being satisfied (See Note 8 – 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 $0.6 million each in 2013, 2012, and 2011.  We presently anticipate capital expenditures of approximately $1.2 million in 2014; however, there can be no assurance that this level of capital expenditures will occur.  We believe that available cash and borrowings under the amended Facility will be sufficient to generate adequate amounts of cash to fund our projected capital expenditures for 2014.

Capital Leases and Related Obligations
We have various lease agreements for property and equipment that, pursuant to ASC 840, 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
We are exposed to interest rate volatility with regard to our variable rate debt obligations under the Facility.  As of December 31, 2013, interest on the Facility is charged at 4.25%.  The effective average interest rates on the outstanding borrowings under the Facility in 2013 and 2012 were 5.3% and 5.6%, respectively.  The Facility had an outstanding balance of $19.8 million at December 31, 2013.
Page 23 of 59


 
Item 8.  Consolidated Financial Statements and Supplementary Data

TELOS CORPORATION AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 
Page
 
 
Report of Independent Registered Public Accounting Firm
25
 
 
Consolidated Statements of Operations for the Years Ended December 31, 2013, 2012 and 2011
26
 
 
Consolidated Statements of Comprehensive (Loss) Income for the Years Ended December 31, 2013, 2012 and 2011
27
 
 
Consolidated Balance Sheets as of December 31, 2013 and 2012
28 - 29
 
 
Consolidated Statements of Cash Flows for the Years Ended December 31, 2013, 2012, and 2011
30 - 31
 
 
Consolidated Statements of Changes in Stockholders' Deficit for the Years Ended December 31, 2013, 2012, and 2011
32
 
 
Notes to Consolidated Financial Statements
33 – 54

Page 24 of 59

Report of Independent Registered Public Accounting Firm

Board of Directors and Stockholders
Telos Corporation
Ashburn, Virginia

We have audited the accompanying consolidated balance sheets of Telos Corporation and Subsidiaries (the Company”) as of December 31, 2013 and 2012 and the related consolidated statements of operations, comprehensive (loss)  income, changes in stockholders’ deficit, and cash flows for each of the three years in the period ended December 31, 2013.  These financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting.  Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, 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.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Telos Corporation and Subsidiaries at December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2013, in conformity with accounting principles generally accepted in the United States of America.


/s/ BDO USA, LLP

Bethesda, Maryland

March 31, 2014

Page 25 of 59

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

 
 
Years Ended December 31,
 
 
 
2013
   
2012
   
2011
 
Revenue (Note 6)
 
   
   
 
Services
 
$
143,489
   
$
177,266
   
$
124,988
 
Products
   
63,905
     
48,830
     
64,900
 
 
   
207,394
     
226,096
     
189,888
 
Costs and expenses
                       
Cost of sales  –  Services
   
109,676
     
131,906
     
91,353
 
Cost of sales  –  Products
   
59,118
     
39,384
     
50,992
 
 
   
168,794
     
171,290
     
142,345
 
Selling, general and administrative expenses
   
32,489
     
37,106
     
34,856
 
 
                       
Operating income
   
6,111
     
17,700
     
12,687
 
Other income (expenses)
                       
Gain on early extinguishment of debt (Note 3)
   
----
     
5,187
     
----
 
Non-operating income
   
239
     
470
     
319
 
Interest expense
   
(5,483
)
   
(6,632
)
   
(6,265
)
Income before income taxes
   
867
     
16,725
     
6,741
 
Provision for income taxes (Note 10)
   
(1,678
)
   
(7,230
)
   
(3,238
)
 
                       
Net (loss) income
   
(811
)
   
9,495
     
3,503
 
 
                       
Less:  Net income attributable to non-controlling interest (Note 2)
   
(1,807
)
   
(2,060
)
   
(2,049
)
 
Net (loss) income attributable to Telos Corporation
 
$
(2,618
)
 
$
7,435
   
$
1,454
 


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

Page 26 of 59

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

 
 
Years Ended December 31,
 
 
 
2013
   
2012
   
2011
 
Net (loss) income
 
$
(811
)
 
$
9,495
   
$
3,503
 
Other comprehensive income (loss):
                       
Foreign currency translation adjustments
   
(24
)
   
(19
)
   
8
 
Actuarial gain on pension liability adjustments, net of tax
   
----
     
56
     
53
 
Total other comprehensive income (loss), net of tax
   
(24
)
   
37
     
61
 
Comprehensive income attributable to non-controlling interest
   
(1,807
)
   
(2,060
)
   
(2,049
)
Comprehensive (loss) income attributable to Telos Corporation
 
$
(2,642
)
 
$
7,472
   
$
1,515
 


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

Page 27 of 59

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

ASSETS

 
 
December 31,
 
 
 
2013
   
2012
 
Current assets (Note 7)
 
   
 
Cash and cash equivalents
 
$
94
   
$
229
 
Accounts receivable, net of reserve of $321 and $319, respectively (Note 6)
   
45,632
     
33,879
 
Inventories, net of obsolescence reserve of $417 and $416, respectively
   
4,885
     
10,277
 
Deferred income taxes (Note 10)
   
----
     
192
 
Deferred program expenses
   
576
     
5,281
 
Other current assets
   
1,271
     
2,254
 
 
Total current assets
   
52,458
     
52,112
 
 
Property and equipment (Note 7)
               
Furniture and equipment
   
11,008
     
10,829
 
Leasehold improvements
   
2,756
     
1,941
 
Property and equipment under capital leases
   
25,170
     
14,148
 
 
   
38,934
     
26,918
 
Accumulated depreciation and amortization
   
(24,316
)
   
(23,035
)
 
   
14,618
     
3,883
 
Goodwill (Note 4)
   
14,916
     
14,916
 
Other intangible assets (Note 4)
   
5,643
     
7,900
 
Other assets (Note 7)
   
974
     
345
 
 
Total assets
 
$
88,609
   
$
79,156
 


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

Page 28 of 59

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

LIABILITIES, REDEEMABLE PREFERRED STOCK,
AND STOCKHOLDERS' DEFICIT

 
 
December 31,
 
 
 
2013
   
2012
 
Current liabilities
 
   
 
Accounts payable and other accrued payables (Note 7)
 
$
23,290
   
$
23,138
 
Accrued compensation and benefits
   
5,941
     
4,965
 
Deferred revenue
   
2,768
     
6,095
 
Deferred income taxes – current (Note 10)
   
25
     
191
 
Senior credit facility – short-term (Note 7)
   
688
     
375
 
Capital lease obligations – short-term (Note 11)
   
657
     
1,241
 
Other current liabilities
   
1,782
     
1,070
 
 
Total current liabilities
   
35,151
     
37,075
 
 
Senior revolving credit facility (Note 7)
   
19,141
     
18,559
 
Capital lease obligations (Note 11)
   
14,901
     
3,803
 
Deferred income taxes (Note 10)
   
169
     
----
 
Senior redeemable preferred stock (Note 8)
   
1,891
     
4,010
 
Public preferred stock (Note 8)
   
116,274
     
112,451
 
Other liabilities
   
490
     
53
 
 
Total liabilities
   
188,017
     
175,951
 
 
Commitments,contingencies and subsequent events (Notes 11 and 14)
   
----
     
----
 
 
               
Stockholders’ deficit (Note 9)
               
Telos stockholders’ deficit
               
Class A common stock, no par value, 50,000,000 shares authorized, 40,218,461 and 35,908,961 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
   
146
     
103
 
Accumulated other comprehensive income
   
48
     
72
 
Accumulated deficit
   
(100,134
)
   
(97,516
)
 
Total Telos stockholders’ deficit
   
(99,862
)
   
(97,263
)
 
Non-controlling interest in subsidiary (Note 2)
   
454
     
468
 
 
Total stockholders’ deficit
   
(99,408
)
   
(96,795
)
 
Total liabilities, redeemable preferred stock, and stockholders’ deficit
 
$
88,609
   
$
79,156
 


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

Page 29 of 59

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

 
 
Years Ended December 31,
 
 
 
2013
   
2012
   
2011
 
Operating activities:
 
   
   
 
Net (loss) income
 
$
(811
)
 
$
9,495
   
$
3,503
 
Adjustments to reconcile net (loss) income to cash provided by operating activities:
                       
Gain on early extinguishment of debt
   
----
     
(5,187
)
   
----
 
Gain on redemption of senior preferred stock
   
(222
)
   
(444
)
   
(230
)
Stock-based compensation
   
43
     
----
     
----
 
Dividends of preferred stock as interest expense
   
3,926
     
4,050
     
4,159
 
Accretion of notes payable
   
----
     
655
     
361
 
Depreciation and amortization
   
3,817
     
3,812
     
2,728
 
Provision for inventory obsolescence
   
1
     
111
     
51
 
Provision (benefit) for doubtful accounts receivable
   
2
     
(53
)
   
17
 
Amortization of debt issuance costs
   
71
     
71
     
71
 
Deferred income tax provision (benefit)
   
195
     
2,039
     
(809
)
Changes in assets and liabilities:
                       
(Increase) decrease in accounts receivable
   
(11,755
)
   
3,120
     
17,122
 
Decrease (increase) in inventories
   
5,391
     
4,323
     
(7,232
)
Decrease (increase) in deferred program expenses
   
4,705
     
(2,645
)
   
22
 
Decrease (increase) in other current assets and other assets
   
259
     
589
     
(64
)
Increase (decrease) in accounts payable and other accrued payables
   
390
     
(71
)
   
(5,677
)
Increase (decrease) in accrued compensation and benefits
   
976
     
(3,126
)
   
1,211
 
(Decrease) increase in deferred revenue
   
(3,327
)
   
1,708
     
1
 
Increase (decrease) in other current liabilities and other liabilities
   
1,149
     
(2,397
)
   
(334
)
 
Cash provided by operating activities
   
4,810
     
16,050
     
14,900
 
Investing activities:
                       
Acquisition of ITL (Note 3)
   
----
     
----
     
(8,000
)
Purchases of property and equipment
   
(539
)
   
(591
)
   
(596
)
 
Cash used in investing activities
   
(539
)
   
(591
)
   
(8,596
)
Financing activities:
                       
Proceeds from senior credit facility
   
244,746
     
260,717
     
257,023
 
Repayments of senior credit facility
   
(243,476
)
   
(259,284
)
   
(252,933
)
Repayments of term loan
   
(375
)
   
(375
)
   
(375
)
(Decrease) increase in book overdrafts
   
(238
)
   
1,262
     
(1,309
)
Repayments of notes payable
   
----
     
(10,860
)
   
(3,500
)
Payments under capital lease obligations
   
(1,242
)
   
(937
)
   
(914
)
Redemptions of senior preferred stock
   
(2,000
)
   
(4,000
)
   
(2,070
)
Distributions to Telos ID Class B membership unit – non-controlling interest
   
(1,821
)
   
(1,973
)
   
(2,122
)
 
Cash used in financing activities
   
(4,406
)
   
(15,450
)
   
(6,200
)
 
(Decrease) increase in cash and cash equivalents
   
(135
)
   
9
     
104
 
Cash and cash equivalents, beginning of the year
   
229
     
220
     
116
 
 
Cash and cash equivalents, end of year
 
$
94
   
$
229
   
$
220
 

Page 30 of 59

 
 
 
Years Ended December 31,
 
 
 
2013
   
2012
   
2011
 
Supplemental disclosures of cash flow information:
 
   
   
 
Cash paid during the year for:
 
   
   
 
Interest
 
$
1,585
   
$
1,807
   
$
1,727
 
Income taxes
 
$
849
   
$
5,903
   
$
4,485
 
 
                       
Noncash: Interest on redeemable preferred stock
 
$
3,926
   
$
4,050
   
$
4,159
 
Net assets of acquired company
 
$
----
   
$
----
   
$
26,673
 
Acquisition financed through issuance of notes payable
 
$
----
   
$
----
   
$
18,673
 
Financing of capital leases
 
$
11,712
   
$
99
   
$
----
 


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

Page 31 of 59

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

 
 
Telos Corporation
   
   
 
 
 
Class A
Common
Stock
   
Class B
Common
Stock
   
AdditionalPaid –in
Capital
   
Accumulated
Other Comprehen-sive Income
   
Accumulated
Deficit
   
Non-Controlling Interest
   
Total
Stockholders’
Deficit
 
Balance December 31, 2010
 
$
65
   
$
13
   
$
103
   
$
(26
)
 
$
(106,405
)
 
$
454
   
$
(105,796
)
 
Net income for the year
   
----
     
----
     
----
     
----
     
1,454
     
2,049
     
3,503
 
Foreign currency translation income
   
----
     
----
     
----
     
8
     
----
     
----
     
8
 
Pension liability adjustments
   
----
     
----
     
----
     
53
     
----
     
----
     
53
 
Distributions
   
----
     
----
     
----
     
----
     
----
     
(2,122
)
   
(2,122
)
 
Balance December 31, 2011
 
$
65
   
$
13
   
$
103
   
$
35
   
$
(104,951
)
 
$
381
   
$
(104,354
)
 
Net income for the year
   
----
     
----
     
----
     
----
     
7,435
     
2,060
     
9,495
 
Foreign currency translation loss
   
----
     
----
     
----
     
(19
)
   
----
     
----
     
(19
)
Pension liability adjustments
   
----
     
----
     
----
     
56
     
----
     
----
     
56
 
Distributions
   
----
     
----
     
----
     
----
     
----
     
(1,973
)
   
(1,973
)
 
Balance December 31, 2012
 
$
65
   
$
13
   
$
103
   
$
72
   
$
(97,516
)
 
$
468
   
$
(96,795
)
 
Net (loss) income for the year
   
----
     
----
     
----
     
----
     
(2,618
)
   
1,807
     
(811
)
Foreign currency translation loss
   
----
     
----
     
----
     
(24
)
   
----
     
----
     
(24
)
Stock-based compensation
   
----
     
----
     
43
     
----
     
----
     
----
     
43
 
Distributions
   
----
     
----
     
----
     
----
     
----
     
(1,821
)
   
(1,821
)
 
Balance December 31, 2013
 
$
65
   
$
13
   
$
146
   
$
48
   
$
(100,134
)
 
$
454
   
$
(99,408
)


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

Page 32 of 59

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 and, prior to its dissolution in December 2012, Telos Delaware, Inc.  We also have a 60% 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).  Significant 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.  We currently have the following three business lines:  Cyber Operations and Defense, Secure Communications, and Telos ID.  Our Chief Executive Officer is the CODM. Our CODM manages our business primarily by function and reviews financial information on a consolidated basis, accompanied by disaggregated information by line of business as well as certain operational data, for purposes of allocating resources and evaluating financial performance. 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, goodwill and intangible assets, income taxes, contingencies and litigation, and assumptions used in evaluating 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.

Revenue Recognition
Revenues are recognized in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) ASC 605-10-S99.  We consider amounts earned upon evidence that an arrangement has been obtained, services are delivered, fees are fixed or determinable, and collectability is reasonably assured. Additionally, revenues on arrangements requiring the delivery of more than one product or service are recognized in accordance with ASC 605-25, “Revenue Arrangements with Multiple Deliverables,” which addresses and requires the separation and allocation at the inception of the arrangement of all deliverables based on their relative selling prices.  This determination is made first by employing vendor-specific objective evidence (“VSOE”), to the extent it exists, then third-party evidence (“TPE”) of selling price, to the extent that it exists. Given the nature of the deliverables contained in our multi-element arrangements, which often involve the design and/or delivery of complex or technical solutions to the government, we have not obtained TPE of selling prices on multi-element arrangements due to the significant differentiation which makes obtaining comparable pricing of products with similar functionality impractical.  Therefore we do not utilize TPE.  If VSOE and TPE are not determinable, we use our best estimate of selling price (“ESP”) as defined in ASC 605-25, which represents our best estimate of the prices under the terms and conditions of a particular order for the various elements if they were sold on a stand-alone basis.

We recognize revenues for software arrangements upon persuasive evidence of an arrangement, delivery of the software, and determination that collection of a fixed or determinable license fee is probable.  Revenues for software licenses sold on a subscription basis are recognized ratably over the related license period. For arrangements where the sale of software licenses are bundled with other products, including software products, upgrades and enhancements, post-contract customer support (“PCS”), and installation, the relative fair value of each element is determined based on VSOE.  VSOE is defined by ASC 985-605, “Software Revenue Recognition,” and is limited to the price charged when the element is sold separately or, if the element is not yet sold separately, the price set by management having the relevant authority.  When VSOE exists for undelivered elements, the remaining consideration is allocated to delivered elements using the residual method.  If VSOE does not exist for the allocation of revenue to the various elements of the arrangement, all revenue from the arrangement is deferred until the earlier of the point at which (1) such VSOE does exist or (2) all elements of the arrangement are delivered.  PCS revenues, upon being unbundled from a software license fee, are recognized ratably over the PCS period. Software arrangements requiring significant production, modification, or customization of the software are accounted for in accordance with ASC 605-35 “Construction-Type and Production-Type Contracts”.
Page 33 of 59

We may use subcontractors and suppliers in the course of performing on contracts and under certain contracts we provide supplier procurement services and materials for our customers.  Some of these arrangements may fall within the scope of ASC 605-45, “Reporting Revenue Gross as a Principal versus Net as an Agent.” We presume that revenues on our contracts are recognized on a gross basis, as we generally provide significant value-added services, assume credit risk, and reserve the right to select subcontractors and suppliers, but we evaluate the various criteria specified in the guidance in making the determination of whether revenue should be recognized on a gross or net basis.

A description of the business lines, the typical deliverables, and the revenue recognition criteria in general for such deliverables follows:

Cyber Operations and Defense:

In the first quarter of 2012, our Secure Networks and Information Assurance solutions areas were merged to create our Cyber Operations and Defense business line.

Regarding our deliverables of secure network solutions, we provide wireless and wired networking solutions consisting of hardware and services to our customers. Also, within our Cyber Operations and Defense solutions area is our Emerging Technologies Group creating innovative, custom-tailored solutions for government and commercial enterprises.  The solutions within the Cyber Operations and Defense and Emerging Technologies groups are generally sold as firm-fixed price (“FFP”) bundled solutions.  Certain of these networking solutions involve contracts to design, develop, or modify complex electronic equipment configurations to a buyer's specification or to provide network engineering services, and as such fall within the scope of ASC 605-35. Revenue is earned upon percentage of completion based upon proportional performance, such performance generally being defined by performance milestones.  Certain other solutions fall within the scope of ASC 605-10-S99, such as resold information technology products, like laptops, printers, networking equipment and peripherals, and ASC 605-25, such as delivery orders for multiple solutions deliverables. For product sales, revenue is recognized upon proof of acceptance by the customer, otherwise it is deferred until such time as the proof of acceptance is obtained.  For example, in delivery orders for Department of Defense customers, which comprise the majority of the Company’s customers, such acceptance is achieved with a signed Department of Defense Form DD-250 or electronic invoicing system equivalent. Services provided under these contracts are generally provided on a FFP basis, and as such fall within the scope of ASC 605-10-S99. Revenue for services is recognized based on proportional performance, as the work progresses. FFP services may be billed to the customer on a percentage-of-completion basis or based upon milestones, which may approximate the proportional performance of the services under the agreements, as specified in such agreements. To the extent that customer billings exceed the performance of the specified services, the revenue would be deferred. Revenue is recognized under time-and-materials (“T&M”) services contracts based upon specified billing rates and other direct costs as incurred.

Regarding our information assurance deliverables, we provide Xacta IA Manager software and cybersecurity services to our customers.  The software and accompanying services fall within the scope of ASC 985-605, “Software Revenue Recognition,” as fully discussed above.  We provide consulting services to our customers under either a FFP or T&M basis. Such contracts fall under the scope of ASC 605-10-S99. Revenue for FFP services is recognized on a proportional performance basis. FFP services may be billed to the customer on a percentage-of-completion basis or based upon milestones as appropriate under a particular contract, which may approximate the proportional performance of the services under the agreements, as specified in such agreements. To the extent that customer billings exceed the performance of the specified services, the revenue would be deferred. Revenue is recognized under T&M contracts based upon specified billing rates and other direct costs as incurred. For cost plus fixed fee (“CPFF”) contracts, revenue is recognized in proportion to the allowable costs incurred unless indicated otherwise in the terms of the contract.

Secure Communications – We provide Secure Information eXchange (T-6) suite of products which include the flagship product the Automated Message Handling System (“AMHS”), Secure Collaboration, Secure Discovery, Secure Directory and Cross Domain Communication, as well as related services to our customers. The system and accompanying services fall within the scope of ASC 985-605, as fully discussed above. Other services fall within the scope of ASC 605-10-S99 for arrangements that include only T&M contracts and ASC 605-25 for contracts with multiple deliverables such as T&M elements and FFP services.  Under such arrangements, the T&M elements are established by direct costs.  Revenue is recognized on T&M contracts according to specified rates as direct labor and other direct costs are incurred. For cost plus fixed fee (“CPFF”) contracts, revenue is recognized in proportion to the allowable costs incurred unless indicated otherwise in the terms of the contract. Revenue for FFP services is recognized on a proportional performance basis. FFP services may be billed to the customer on a percentage-of-completion basis or based upon milestones, which may approximate the proportional performance of the services under the agreements, as specified in such agreements. To the extent that customer billings exceed the performance of the specified services, the revenue would be deferred.

Telos ID  – We provide our identity assurance and access management solutions and services and sell information technology products, such as computer laptops and specialized printers, and consumables, such as identity cards, to our customers. The solutions are generally sold as FFP bundled solutions, which would typically fall within the scope of ASC 605-25 and ASC 605-10-S99.  Revenue for services is recognized based on proportional performance, as the work progresses. FFP services may be billed to the customer on a percentage-of-completion basis or based upon milestones, which may approximate the proportional performance of the services under the agreements, as specified in such agreements. To the extent that customer billings exceed the performance of the specified services, the revenue would be deferred. Revenue is recognized under T&M contracts based upon specified billing rates and other direct costs as incurred.

Page 34 of 59

Estimating future costs and, therefore, revenues and profits, is a process requiring a high degree of management judgment.  In the event of a change in total estimated contract cost or profit, the cumulative effect of a change is recorded in the period the change in estimate occurs. To the extent contracts are incomplete at the end of an accounting period, revenue is recognized on the percentage-of-completion method, on a proportional performance basis, using costs incurred in relation to total estimated costs, or costs are deferred as appropriate under the terms of a particular contract. In the event cost estimates indicate a loss on a contract, the total amount of such loss, excluding overhead and general and administrative expense, is recorded in the period in which the loss is first estimated.

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, to the extent that availability of funds exists on our revolving credit facility.

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 is $5.3 million and $10.7 million at December 31, 2013 and 2012, respectively.  As of December 31, 2013, 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
   
Deductions
   
Balance
End of
Year
 
 
 
   
   
   
 
Year Ended December 31, 2013
 
$
416
   
$
1
   
$
----
   
$
417
 
Year Ended December 31, 2012
 
$
315
   
$
111
   
$
(10
)
 
$
416
 
Year Ended December 31, 2011
 
$
319
   
$
51
   
$
(55
)
 
$
315
 

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:

Buildings
20   Years
Machinery and equipment
3-5   Years
Office furniture and fixtures
5   Years
Leasehold improvements
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, 2013, 2012, and 2011, such amounts are negligible.  Expenditures for repairs and maintenance are charged to operations as incurred.

Our policy on internal use software is in accordance with ASC 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 2013, 2012, and 2011, 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 $1.6 million each for the years ended December 31, 2013, 2012, and 2011.
Page 35 of 59

Income Taxes
We account for income taxes in accordance with ASC 740, “Income Taxes.”  Under ASC 740, 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 follow the provisions of ASC 740 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 and intangible assets
We evaluate the impairment of goodwill and intangible assets in accordance with ASC 350, “Goodwill and Intangible Assets,” 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 Operation and Defense (“CO&D”), Secure Communications, and Telos ID, 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, 2013. Subsequent reviews may result in future periodic impairments that could have a material adverse effect on the results of operations in the period recognized.

Intangible assets consist primarily of customer relationship enhancements. Intangible assets are amortized on a straight-line basis over their estimated useful lives of 5 years.  The amortization is based on a forecast of approximately equal annual customer orders over the 5-year period.  Intangible assets are subject to impairment review if there are events or changes in circumstances that indicate that the carrying amount is not recoverable.  As of December 31, 2013, no impairment charges were taken.

Stock-Based Compensation
Compensation cost is recognized based on the requirements of ASC 718, “Stock Compensation,” for all share-based awards granted.  We have not granted any options since December 31, 2005.

Restricted Stock Grants
Since June 2008, we have issued restricted stock (Class A common) to our executive officers, directors and employees.  In February 2011, we granted 2,330,804 shares of restricted stock (Class A common) to our executive officers, directors and employees.  In March 2012, we granted 10,000 shares to an employee.  In March 2013, we granted an additional 4,312,000 shares of restricted stock to our executive officers and employees. As of December 31, 2013, there were 19,047,259 shares of restricted stock outstanding.  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.  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, all unvested shares shall automatically vest in full.  In accordance with ASC 718, we recorded immaterial compensation expense for the 2013 grants 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.
Page 36 of 59

Research and Development
For all years presented, we charge all research and development costs to expense as incurred.  For research and development costs for software to be sold, leased or otherwise marketed, such costs are capitalized once technological feasibility is reached.  Technological feasibility is established when all planning, designing, coding and testing activities have been completed, and all risks have been identified.  To date, no such costs have been capitalized, as costs incurred after reaching technological feasibility have been insignificant.  During 2013, 2012, and 2011, we incurred salary costs for research and development of approximately $1.7 million, $1.2 million, and $1.0 million, respectively, which are recorded as 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 (loss) 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 comprehensive income was comprised of a loss from foreign currency translation of $61,000, $37,000, and $18,000 as of December 31, 2013, 2012, and 2011, respectively; and actuarial gain on pension liability adjustments in Teloworks of $109,000, $109,000 and $53,000 as of December 31, 2013, 2012, and 2011, respectively.

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.  See Note 5 – Fair Value Measurements for fair value disclosures of the senior redeemable preferred stock.

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
In February 2013, the FASB issued Accounting Standards Update (“ASU”) 2013-02, “Comprehensive Income,” that requires companies to present either in a single note or on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income, and the income statement line items affected by the reclassification. If a component is not required to be reclassified to net income in its entirety, companies would instead cross reference to the related footnote for additional information.    ASU 2013-02 is effective for fiscal years and interim periods beginning after December 15, 2012.  The adoption of this guidance did not have a material effect on our consolidated financial position, results of operations or cash flows.

In July 2013, the FASB issued ASU No. 2013-11, “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists.”  ASU 2013-11 clarifies guidance and eliminates diversity in practice on the presentation of unrecognized tax benefits when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists at the reporting date. This guidance is effective for annual reporting periods beginning on or after December 15, 2013, and subsequent interim periods. The adoption of this guidance is not expected to have a material effect on our consolidated financial position, results of operations or cash flows.
Page 37 of 59

Note 2.  Non-controlling Interests

On April 11, 2007, Telos ID was formed as a limited liability company under the Delaware Limited Liability Company Act. We contributed substantially all of the assets of our Identity Management business line and assigned our rights to perform under our U.S. Government contract with the Defense Manpower Data Center (“DMDC”) to Telos ID at their stated book values. The net book value of assets we contributed totaled $17,000. Until April 19, 2007, we owned 99.999% of the membership interests of Telos ID and certain private equity investors (“Investors”) owned 0.001% of the membership interests of Telos ID. On April 20, 2007, we sold an additional 39.999% of the membership interests to the Investors in exchange for $6 million in cash consideration.   In accordance with ASC 505-10, “Equity-Overall,” we recognized a gain of $5.8 million.   As a result, we own 60% of Telos ID, and therefore continue to account for the investment in Telos ID using the consolidation method.

The Amended and Restated Operating Agreement of Telos ID (“Operating Agreement”) provides for a Board of Directors comprised of five members.  Pursuant to the Operating Agreement, John B. Wood, Chairman and CEO of Telos, has been designated as the Chairman of the Board of Telos ID.  The Operating Agreement also provides for two subclasses of membership units:  Class A, held by us and Class B, held by certain private equity investors.  The Class A membership unit owns 60% of Telos ID, as mentioned above, and as such is allocated 60% of the profits, which was $2.7 million, $3.1 million and $3.1 million for 2013, 2012, and 2011, respectively, and is entitled to appoint three members of the Board of Directors.  The Class B membership unit owns 40% of Telos ID, and as such is allocated 40% of the profits, which was $1.8 million, $2.1 million and $2.0 million for 2013, 2012, and 2011, respectively, and is entitled to appoint two members of the Board of Directors.  The Class B membership unit is the non-controlling interest.

Distributions are made to the members only when and to the extent determined by the Telos ID’s Board of Directors, in accordance with the Operating Agreement.  During the year ended December 31, 2013, 2012, and 2011, the Class B membership unit received a total of $1.8 million, $2.0 million and $2.1 million, respectively, of such distributions.  

The following table details the changes in non-controlling interest for the years ended December 31, 2013, 2012, and 2011 (in thousands):

 
 
2013
   
2012
   
2011
 
Non-controlling interest, beginning of period
 
$
468
   
$
381
   
$
454
 
Net income
   
1,807
     
2,060
     
2,049
 
Distributions
   
(1,821
)
   
(1,973
)
   
(2,122
)
 
Non-controlling interest, end of period
 
$
454
   
$
468
   
$
381
 

Page 38 of 59

Note 3.   Acquisition of IT Logistics, Inc.

On July 1, 2011, we entered into, and concurrently completed the transactions contemplated by, the Asset Purchase Agreement with IT Logistics Inc., an Alabama corporation (“ITL”), and its sole stockholder.  We purchased certain assets relating to the operation of ITL’s business of providing survey, design, engineering, and installation services of inside and outside plant secure networking infrastructure and program management expertise.  Under the terms of the asset purchase agreement, Telos assumed certain liabilities of ITL, principally liabilities that accrued on or after July 1, 2011, under certain contracts assumed by Telos.

The purchase price for the assets (in addition to the assumed liabilities described above) consisted of (1) $8 million payable on July 1, 2011, (2) $7 million payable in ten monthly payments of $700,000, together with interest on the unpaid balance of such amount at the rate of 0.50% per annum, beginning on August 1, 2011 and on the first day of each subsequent month thereafter, and (3) a subordinated promissory note (the “Note”) with a principal amount of $15 million.  The Note accrued interest at a rate of 6.0% per annum beginning November 1, 2012, and was payable on July 1, 2041.  The entire unpaid principal balance plus accrued and unpaid interest was due and payable upon the occurrence of a Change in Control (as defined in the Note), provided that all “Senior Obligations” were satisfied prior to or concurrent with such Change in Control.  For purposes of the Note, “Senior Obligations” means, collectively, all (1) outstanding indebtedness of Telos, and (2) amounts due to the holders of the outstanding shares of the Company’s Series A-1 Redeemable Preferred Stock, Series A-2 Redeemable Preferred Stock, and 12% Cumulative Exchangeable Preferred Stock (or any securities redeemable or exchangeable for any of the foregoing) upon a Change in Control, upon the voluntary or involuntary liquidation, dissolution, or winding up of the affairs of Telos, or otherwise.   Based on the total fair value of the consideration paid, the total purchase price was determined to be $26.5 million.

On December 18, 2012, we prepaid and satisfied in full our obligations under the Note.  As a condition to the prepayment of the Note, ITL accepted payment in the amount of $7.6 million, which is the sum of $7.5 million in principal plus $0.1 million in accrued interest. This amount represents a discount of 50% off of the principal amount of the Note. No penalties were due to ITL in connection with the prepayment of the Note.  As a result of this transaction, a gain in the amount of $5.2 million was recorded in other income on the consolidated statements of operations.   On or about December 17, 2012, ITL and Telos signed an agreement in which ITL agreed to accept the prepayment and discount in full satisfaction of the Note.  Wells Fargo consented to the payment of approximately $7.6 million on December 17, 2012. 

At December 31, 2012, the $7 million payable in ten monthly payments had also been fully paid.  We incurred interest expense in the amount of $4,000 and $12,000 on the $7 million note in 2012 and 2011, respectively.

ITL had been a Telos subcontractor for several years, utilized by our former Secure Networks Solutions business line. The acquisition allows the Company to internally maintain the capacity for the work ITL performs, instead of subcontracting such work.

The asset purchase agreement and the complete terms of the notes were filed as exhibits to the Form 8-K filed by the Company on July 8, 2011.  Borrowings of $8.0 million were drawn from the Facility in order to finance the initial cash consideration.

The operating results of ITL have been included in the Company’s consolidated financial statements as of the acquisition date of July 1, 2011.  The acquisition has been accounted for under the purchase method of accounting.  Under the purchase method of accounting, the total purchase price was allocated to ITL’s net tangible and intangible assets acquired based on their estimated fair values as of July 1, 2011. The excess of the purchase price over the net tangible and intangible assets was recorded as goodwill.  Goodwill is amortized and deducted over a 15-year period for tax purposes.

Note 4. Goodwill and Intangible Assets

The goodwill balance was $14.9 million as of December 31, 2013 and 2012.  Goodwill is subject to annual impairment tests and if triggering events are present before the annual tests, we will assess impairment.  As of December 31, 2013, no impairment charges were taken.

Intangible assets consist primarily of customer relationship enhancements. Intangible assets are amortized on a straight-line basis over their estimated useful lives of 5 years.  The amortization is based on a forecast of approximately equal annual customer orders over the 5-year period.  Amortization expense for 2013 and 2012 was $2.3 million.  Amortization expense will be $2.3 million annually for the next 2.5 years.  Intangible assets are subject to impairment review if there are events or changes in circumstances that indicate that the carrying amount is not recoverable.  As of December 31, 2013, no impairment charges were taken.
Page 39 of 59



Intangible assets consist of the following:
 
 
December 31, 2013
   
Dcember 31, 2012
 
 
 
Cost
   
Accumulated
Amortization
   
Cost
   
Accumulated
Amortization
 
Intangible assets
 
$
11,286
   
$
5,643
   
$
11,286
   
$
3,386
 
 
 
$
11,286
   
$
5,643
   
$
11,286
   
$
3,386
 

Note 5.    Fair Value Measurements

The accounting standard for fair value measurements provides a framework for measuring fair value and expands disclosures about fair value measurements.  The framework requires the valuation of investments using a three-tiered approach.  The statement requires fair value measurement to be classified and disclosed in one of the following categories:

Level 1:  Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets and liabilities;

Level 2:  Quoted prices in the markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; or

Level 3:  Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market activity).

As of December 31, 2013 and 2012, we did not have any financial instruments with significant Level 3 inputs and we did not have any financial instruments that are measured at fair value on a recurring basis.

On April 8, 2011, 22.3% of the senior redeemable preferred stock (the “Senior Redeemable Preferred Stock”) was redeemed for $2.1 million, on May 16, 2012, 26.7% of the Senior Redeemable Preferred Stock was redeemed for $2.0 million, on August 24, 2012, 36.0% of the Senior Redeemable Preferred Stock was redeemed for $2.0 million, and on June 14, 2013, 54.5% of the Senior Redeemable Preferred Stock was redeemed for $2.0 million (see Note 8 – Redeemable Preferred Stock).  As of December 31, 2013 and 2012, the carrying value of the Senior Redeemable Preferred Stock was $1.9 million and $4.0 million, respectively.  Since there have been no material changes in the Company’s financial condition and no material modifications to the financial instruments, the estimated fair value of the Senior Redeemable Preferred Stock remains consistent with amounts recorded as of December 31, 2013.

As of December 31, 2013 and 2012, the carrying value of the Company’s 12% Cumulative Exchangeable Redeemable Preferred Stock, par value $.01 per share (the “Public Preferred Stock”) was $116.3 million and $112.5 million, respectively, and the estimated fair market value was $48.9 million and $47.8 million, respectively, based on quoted market prices.

Note 6.  Revenue and Accounts Receivable

Revenue resulting from contracts and subcontracts with the U.S. Government accounted for 98.3%, 99.1%, and 99.1% of consolidated revenue in 2013, 2012, and 2011, respectively.  As our primary customer base includes agencies of the U.S. Government, we have a concentration of credit risk associated with our accounts receivable, as 95.0% of our billed accounts receivable were directly with U.S. Government customers. While we acknowledge the potentially material and adverse risk of such a significant concentration of credit risk, our past experience of collecting substantially all of such receivables provide us with an informed basis that such risk, if any, is manageable.  We perform ongoing credit evaluations of all of our customers and generally do not require collateral or other guarantee from our customers.  We maintain allowances for potential losses.

The components of accounts receivable are as follows (in thousands):

 
 
December 31,
 
 
 
2013
   
2012
 
Billed accounts receivable
 
$
29,492
   
$
21,476
 
Unbilled receivables
   
16,461
     
12,722
 
Allowance for doubtful accounts
   
(321
)
   
(319
)
 
 
$
45,632
   
$
33,879
 


Page 40 of 59

The activities in the allowance for doubtful accounts are set forth below (in thousands):

 
 
Balance Beginning
of Year
   
Bad Debt
Expenses (1)
   
Deductions (2)
   
Balance
End
of Year
 
 
 
   
   
   
 
Year ended December 31, 2013
 
$
319
   
$
2
   
$
----
   
$
321
 
Year ended December 31, 2012
 
$
375
   
$
(53
)
 
$
(3
)
 
$
319
 
Year ended December 31, 2011
 
$
358
   
$
17
   
$
----
   
$
375
 

(1) Accounts receivable reserves and reversal of allowance for subsequent collections, net
(2) Accounts receivable written-off and subsequent recoveries, net

Revenue by Major Market and Significant Customers

We derived substantially all 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:

 
 
2013
   
2012
   
2011
 
 
 
(dollar amounts in thousands)
 
 
 
   
   
   
   
   
 
Federal
 
$
203,917
     
98.3
%
 
$
224,010
     
99.1
%
 
$
188,162
     
99.1
%
Commercial
   
3,477
     
1.7
%
   
2,086
     
0.9
%
   
1,726
     
0.9
%
 
                                               
Total
 
$
207,394
     
100.0
%
 
$
226,096
     
100.0
%
 
$
189,888
     
100.0
%

Note 7. Current Liabilities and Debt Obligations

Accounts Payable and Other Accrued Payables
As of December 31, 2013 and 2012, the accounts payable and other accrued payables consisted of $17.3 million and $16.4 million, respectively, in trade account payables and $6.0 million and $6.7 million, respectively, in accrued payables.

Senior Revolving Credit Facility
On July 31, 2013, we amended our $30 million revolving credit facility (the “Facility”) with Wells Fargo Capital Finance, LLC (“Wells Fargo”) to extend the maturity date to November 13, 2014 from May 17, 2014.  On March 27, 2014, we further amended the Facility to extend the maturity date to November 13, 2015.  In addition, Wells Fargo issued a waiver of certain existing defaults under the Facility including failure to maintain required EBITDA (as defined in the Facility) covenants.  The March 2014 amendment also amends the terms of the Facility with respect to repayment on the term loan component.  Since 2010, the principal of the term loan component has been repaid in quarterly installments of $93,750.  The amended Facility requires quarterly installment payments of $250,000 beginning July 1, 2014, with a final installment of the unpaid principal amount payable on November 13, 2015, the maturity date of the amended Facility.  In consideration for the closing of this amendment, we paid Wells Fargo a fee of $75,000, plus expenses related to the closing.

The interest rate on the term loan component is the same as that on the revolving credit component of the Facility, which is the higher of the Wells Fargo Bank “prime rate” plus 1%, the Federal Funds rate plus 1.5%, or the 3-month LIBOR rate plus 2%. In lieu of having interest charged at the foregoing rates, the Company may elect to have the interest on all or a portion of the advances on the revolving credit component be a rate based on the LIBOR Rate (as defined in the Facility) plus 3.75%.  As of December 31, 2013, we have not elected the LIBOR Rate option.  Borrowings under the Facility are collateralized by substantially all of the Company’s assets including inventory, equipment, and accounts receivable.

As of December 31, 2013, the interest rate on the Facility was 4.25%.   We incurred interest expense in the amount of $0.6 million, $0.8 million, and $0.7 million for the years ended December 31, 2013, 2012, and 2011, respectively, on the Facility.

On April 8, 2011, a portion of the Senior Redeemable Preferred Stock was redeemed (see Note 8 – Redeemable Preferred Stock).  Additionally, on May 11, 2012, the Facility was amended to allow for the redemption of Senior Redeemable Preferred Stock, under certain conditions, at a discount from par value plus accrued dividends of at least 10%, at an aggregate price not to exceed $4.0 million.  On May 16, 2012 and on August 24, 2012, a portion of the Senior Redeemable Preferred Stock was redeemed (see Note 8 – Redeemable Preferred Stock).

On December 17, 2012, Wells Fargo consented to the payment of approximately $7.6 million of the ITL note.

Page 41 of 59

 
On June 11, 2013, the Facility was further amended to allow for the further redemption of Senior Redeemable Preferred Stock, under certain conditions, at a discount from par value plus accrued dividends of at least 10%, at an aggregate price not to exceed $2.0 million.  On June 14, 2013, a portion of the Senior Redeemable Preferred Stock was redeemed (see Note 8 – Redeemable Preferred Stock).

The Facility has various covenants that may, among other things, affect our ability to merge with another entity, sell or transfer certain assets, pay dividends and make other distributions beyond certain limitations.  The financial covenants also include minimum EBITDA, minimum recurring revenue and a limit on capital expenditures.    In conjunction with the March 2014 amendment, Wells Fargo issued a waiver of certain existing defaults under the Facility including failure to maintain required EBITDA covenants.  Prior to the March 2014 amendment, the term loan component of the Facility amortizes at 5% per year, which is paid in quarterly installments and is classified as current on the consolidated balance sheets.  Effective July 1, 2014, the quarterly installment repayments will be $250,000.  The remaining balance of the term loan, or $5.5 million, and the revolving component of the Facility mature over the period 2014 and 2015.

At December 31, 2013, we had outstanding borrowings of $19.8 million on the Facility, which included the $6.2 million term loan, of which $0.7 million was short-term.   At December 31, 2012, the outstanding borrowings on the Facility were $18.9 million, which included the $6.6 million term loan, of which $0.4 million was short-term.  At December 31, 2013 and 2012, we had unused borrowing availability on the Facility of $9.2 million and $2.2 million, respectively.  The effective weighted average interest rates on the outstanding borrowings under the Facility were 5.3% and 5.6% for the years ended December 31, 2013 and 2012, respectively.

The following are maturities of the Facility presented by year (in thousands):

 
 
2014
   
2015
   
Total
 
Short-term:
 
   
   
 
Term loan
 
$
688
   
$
----
   
$
688
1 
Long-term:
                       
Term loan
 
$
----
   
$
5,500
   
$
5,500
1 
Revolving credit
   
----
     
13,641
     
13,641
2 
Subtotal
 
$
----
   
$
19,141
   
$
19,141
 
Total
 
$
688
   
$
19,141
   
$
19,829
 

1 The principal will be repaid in 2 quarterly installments of $93,750 in the first half of 2014, and effective July 1, 2014, quarterly installments of $250,000, with a final installment of the unpaid principal amount payable on November 13, 2015.
2 Balance due represents balance as of December 31, 2013, with fluctuating balances based on working capital requirements of the Company.

Page 42 of 59

 
Note 8.   Redeemable Preferred Stock

Senior Redeemable Preferred Stock
The Senior Redeemable Preferred Stock is senior to all other outstanding equity of the Company, including the Public Preferred Stock. The Series A-1 ranks on a parity with the Series A-2.  The components of the authorized Senior Redeemable Preferred Stock are 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 carries a cumulative per annum dividend rate of 14.125% of its liquidation value of $1,000 per share. The dividends are payable semiannually on June 30 and December 31 of each year. We have not declared dividends on our Senior Redeemable Preferred Stock since its issuance. The liquidation preference of the Senior Redeemable Preferred Stock is 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 Facility and of the Senior Redeemable Preferred Stock, we have been and continue to be precluded from paying any accrued and unpaid dividends on the Senior Redeemable Preferred Stock, other than described below. Certain holders of the Senior Redeemable Preferred Stock have entered into standby agreements whereby, among other things, those holders will 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, 2013, instruments held by Toxford Corporation ( “Toxford”), the holder of 76.4% of the Senior Redeemable Preferred Stock, will mature on February 28, 2016. 

On or about March 15, 2011, Mr. John Porter, the beneficial owner of 39.3% of our Class A Common Stock, acquired a total of 75 shares and 105 shares of Series A-1 and Series A-2 Redeemable Preferred Stock, respectively, from other holders of the Senior Redeemable Preferred Stock.  As of December 31, 2013, Mr. Porter held 6.3% of the Senior Redeemable Preferred Stock.  In the aggregate, as of December 31, 2013, Mr. Porter and Toxford held a total of 163 shares and 228 shares of Series A-1 and Series A-2 Redeemable Preferred Stock, respectively, or 82.7% of the Senior Redeemable Preferred Stock.  Mr. Porter is the sole stockholder of Toxford.

On April 8, 2011, with the consent of the holders of the outstanding shares of Senior Redeemable Preferred Stock, 22.3% of the Senior Redeemable Preferred Stock with a carrying value of $2.3 million was redeemed for $2.1 million, resulting in a gain in the amount of approximately $0.2 million, representing a discount of 10%, which was recorded in other income on the consolidated statements of operations.  Subsequent to such redemption, the total number of shares of Senior Redeemable Preferred Stock issued and outstanding was 923 shares and 1,292 shares for Series A-1 and Series A-2, respectively.

On May 11, 2012, the Facility was amended to allow for the redemption of Senior Redeemable Preferred Stock, under certain conditions, at a discount from par value plus accrued dividends of at least 10%, at an aggregate price not to exceed $4.0 million.  On May 16, 2012, with the consent of the holders of the outstanding shares of Senior Redeemable Preferred Stock, 26.7% of the Senior Redeemable Preferred Stock with a carrying value of $2.2 million was redeemed for $2.0 million, resulting in a gain in the amount of approximately $0.2 million, representing a discount of 10%, which was recorded in other income on the consolidated statements of operations.  Subsequent to such redemption, the total number of shares of Senior Redeemable Preferred Stock issued and outstanding was 677 shares and 947 shares for Series A-1 and Series A-2, respectively.

On August 24, 2012, with the consent of the holders of the outstanding shares of Senior Redeemable Preferred Stock, 36.0% of the Senior Redeemable Preferred Stock with a carrying value of $2.2 million was redeemed for $2.0 million, resulting in a gain in the amount of approximately $0.2 million, representing a discount of 10%, which was recorded in other income on the consolidated statements of operations.  Subsequent to such redemption, the total number of shares of Senior Redeemable Preferred Stock issued and outstanding was 433 shares and 607 shares for Series A-1 and Series A-2, respectively.

On June 11, 2013, the Facility was further amended to allow for the redemption of Senior Redeemable Preferred Stock, under certain conditions, at a discount from par value plus accrued dividends of at least 10%, at an aggregate price not to exceed $2.0 million.  On June 14, 2013, with the consent of the holders of the outstanding shares of Senior Redeemable Preferred Stock, 54.5% of the Senior Redeemable Preferred Stock with a carrying value of $2.2 million was redeemed for $2.0 million, resulting in a gain in the amount of approximately $0.2 million, representing a discount of 10%, which was recorded in other income on the condensed consolidated statements of operations.  Subsequent to such redemption, 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.

At December 31, 2013, 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.  At December 31, 2012, the total number of shares of Senior Redeemable Preferred Stock issued and outstanding was 433 shares and 607 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 is classified as noncurrent as of December 31, 2013.

At December 31, 2013 and 2012, cumulative undeclared, unpaid dividends relating to Senior Redeemable Preferred stock totaled $1.4 million and $3.0 million, respectively.  We accrued dividends on the Senior Redeemable Preferred Stock of $103,000, $228,000, and $337,000 for the years ended December 31, 2013, 2012, and 2011, 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.

Page 43 of 59

 
12% Cumulative Exchangeable Redeemable 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, 2013 and 2012, 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 the Facility entered into with Wells Fargo to which the Public Preferred Stock is subject, other senior obligations, and Maryland law limitations in existence prior to October 1, 2009.  Pursuant to their terms, 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, limitations set forth in the covenants in the Facility, foreseeable capital and operational requirements, and restrictions and prohibitions of our Articles of Amendment and Restatement, we were unable to meet the redemption schedule set forth in the terms of the Public Preferred Stock. 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, 2013 and 2012.

We are parties with certain of our subsidiaries to the Facility agreement with Wells Fargo, whose term expires on November 13, 2015.  Under the Facility, we agreed that, so long as any credit under the Facility is available and until full and final payment of the obligations under the Facility, 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.

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 Facility prohibits, among other things, the redemption of any stock, common or preferred, other than as described above.  The Public Preferred Stock by its terms 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, 2013.  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.

Page 44 of 59

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 $84.4 million and $80.6 million as of December 31, 2013 and 2012, respectively.   We accrued dividends on the Public Preferred Stock of $3.8 million for the years ended December 31, 2013, 2012, and 2011, 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.

The carrying value of the accrued Paid-in-Kind (“PIK”) dividends on the Public Preferred Stock for the period 1992 through June 1995 was $4.0 million.  Had we accrued such dividends on a cash basis for this time period, the total amount accrued would have been $15.1 million.  However, as a result of the redemption of the 410,000 shares of the Public Preferred Stock in November 1998, such amounts were reduced and adjusted to $3.5 million and $13.4 million, respectively.  Our Articles of Amendment and Restatement, Section 2(a) states, “Any dividends payable with respect to the Exchangeable Preferred Stock (“Public Preferred Stock”) during the first six years after the Effective Date (November 20, 1989) may be paid (subject to restrictions under applicable state law), in the sole discretion of the Board of Directors, in cash or by issuing additional fully paid and nonassessable shares of Exchangeable Preferred Stock …”.  Accordingly, the Board had the discretion to pay the dividends for the referenced period in cash or by the issuance of additional shares of Public Preferred Stock.  During the period in which we stated our intent to pay PIK dividends, we stated our intention to amend our Charter to permit such payment by the issuance of additional shares of Public Preferred Stock.  In consequence, as required by applicable accounting requirements, the accrual for these dividends was recorded at the estimated fair value (as the average of the ask and bid prices) on the dividend date of the shares of Public Preferred Stock that would have been (but were not) issued.  This accrual was $9.9 million lower than the accrual would be if the intent was only to pay the dividend in cash, at that date or any later date.

In May 2006, the Board concluded that the accrual of PIK dividends for the period 1992 through June 1995 was no longer appropriate.  Since 1995, we have disclosed in the footnotes to our audited financial statements the carrying value of the accrued PIK dividends on the Public Preferred Stock for the period 1992 through June 1995 as $4.0 million, and that had we accrued cash dividends during this time period, the total amount accrued would have been $15.1 million. As stated above, such amounts were reduced and adjusted to $3.5 million and $13.4 million, respectively, due to the redemption of 410,000 shares of the Public Preferred Stock in November 1998.  On May 12, 2006, the Board voted to confirm that our intent with respect to the payment of dividends on the Public Preferred Stock for this period changed from its previously stated intent to pay PIK dividends to that of an intent to pay cash dividends.  We therefore changed the accrual from $3.5 million to $13.4 million, the result of which was to increase our negative shareholder equity by the $9.9 million difference between those two amounts, by recording an additional $9.9 million charge to interest expense for the second quarter of 2006, resulting in a balance of $116.3 million and $112.5 million for the principal amount and all accrued dividends on the Public Preferred Stock as of December 31, 2013 and 2012, respectively. This action is considered a change in assumption that results in a change in accounting estimate as defined in ASC 250-10, which sets forth guidance concerning accounting changes and error corrections.

Page 45 of 59

Note 9.  Stockholders' Deficit, Option Plans, and Employee Benefit Plan

Common Stock
The relative rights, preferences, and limitations of the Class A common stock and the Class B common stock are in all respects identical. The holders of the common stock have one vote for each share of common stock held.  Subject to the priority rights of the Public Preferred Stock and any series of the Senior Preferred Stock, holders of Class A and Class B common stock are entitled to receive such dividends as may be declared.

Restricted Stock Grants
Since June 2008, we have issued restricted stock (Class A common) to our executive officers, directors and employees.  In February 2011, we granted 2,330,804 shares of restricted stock (Class A common) to our executive officers, directors and employees.  In March 2012, we granted 10,000 shares to an employee.  In March 2013, we granted an additional 4,312,000 shares of restricted stock to our executive officers and employees.  As of December 31, 2013, there were 19,047,259 shares of restricted stock outstanding.  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.  In the event of death of the employee or a change in control, as defined by the Telos Corporation 2008 Omnibus Long-Term Plan, all unvested shares shall automatically vest in full.  In accordance with ASC 718, we recorded immaterial compensation expense for the 2013 grants 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.

Stock Options
We have granted stock options to certain of our employees under five plans.  The Long-Term Incentive Compensation Plan was adopted in 1990 (“1990 Stock Option Plan”) and had option grants under it through 2000.  In 1993, stock option plan agreements were reached with certain employees (“1993 Stock Option Plan”).  In 1996, the Board of Directors approved and the shareholders ratified the 1996 Stock Option Plan (“1996 Stock Option Plan”).

In 2000, the Board of Directors approved two stock option plans, one for Telos Delaware, Inc. (“Telos Delaware Stock Incentive Plan”) and one for Xacta Corporation (“Xacta Stock Incentive Plan”), both wholly owned subsidiaries of the Company.  All stock options issued under these plans have expired as of December 31, 2012.

As determined by the members of the Compensation Committee, we generally grant options under our respective plans at the estimated fair value at the date of grant, based upon all information available to it at the time.

1996 Stock Option Plan
The 1996 Stock Option Plan allowed for the award of options to purchase up to 6,644,974 shares of Class A common stock at an exercise price of not lower than the estimated fair value at the date of grant.  Vesting of the stock options for key employees was based both upon the passage of time, generally four years, and certain key events occurring including an initial public offering or a change in control.  The stock options may be exercised over a ten-year period subject to the vesting requirements. Effective May 10, 2004, the 1996 Stock Option Plan was amended by the Board of Directors to increase the total amount of authorized shares of Class A common stock to 7,345,433, an increase of 700,459 shares, to reflect those options granted to Mr. Wood that were not exercised under the 1993 Stock Option Plan.  The 1996 Stock Option Plan expired in March 2006, with its remaining 516,000 unissued options canceled.  There were 20,000 options outstanding at December 31, 2013 and 2012.  A total of 2,463,500 options were exchanged for restricted stock in June 2008.

Telos Delaware Stock Incentive Plan
During the third quarter of 2000, our Board of Directors approved a new stock option plan for Telos Delaware, Inc., a wholly owned subsidiary of the Company.  Certain of our key executives and employees were eligible to receive stock options under the plan.  Under the plan, we may award up to 3,500,000 shares of common stock as either incentive or non-qualified stock options. An incentive option must have an exercise price of not lower than fair value on the date of grant.  A non-qualified option would not have an exercise price any lower than 85% of the fair value on the date of grant.  All options had a term of ten years and vested no less rapidly than the rate of 20% per year for each of the first five years unless changed by the Compensation Committee of the Board of Directors.  There were no options outstanding at December 31, 2013 and 2012.  A total of 0, 6,564, and 10,252 options expired during 2013, 2012, and 2011, respectively; 0, 0, and 2,000 options were canceled in 2013, 2012, and 2011, respectively; and 983,379 options were exchanged for restricted stock in June 2008.  Telos Delaware, Inc. was dissolved in December 2012.

Xacta Stock Incentive Plan
In the third quarter of 2000, Xacta Corporation, a wholly owned subsidiary of the Company, initiated a stock option plan under which up to 3,500,000 shares of Xacta common stock may be awarded to key employees and associates.  The options may be awarded as incentive or non-qualified, had a term of ten years, and vested no less rapidly than the rate of 20% per year for each of the first five years unless changed by the Compensation Committee of the Board of Directors.  The exercise price may not be less than the estimated fair value on the date of grant for an incentive option, or less than 85% of the estimated fair value on the date of grant for a non-qualified stock option.  There were no options outstanding at December 31, 2013 and 2012.   A total of 0, 3,750, and 8,564 options expired during 2013, 2012, and 2011, respectively; 0, 0, and 4,250 options were canceled in 2013, 2012, and 2011, respectively; and 2,498,564 options were exchanged for restricted stock in June 2008.

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A summary of the status of our stock options for the years ended December 31, 2013, 2012, and 2011 is as follows:

 
 
Number of Shares
(000’s)
   
Weighted Average
Exercise Price
 
2013  Stock Option Activity
 
   
 
 
 
   
 
Outstanding at beginning of year
   
20
   
$
0.62
 
Granted
   
----
     
----
 
Exercised
   
----
     
----
 
Canceled
   
----
     
----
 
Outstanding at end of year
   
20
   
$
0.62
 
Exercisable at end of year
   
20
   
$
0.62
 
 
               
2012  Stock Option Activity
               
 
               
Outstanding at beginning of year
   
30
   
$
1.33
 
Granted
   
----
     
----
 
Exercised
   
----
     
----
 
Canceled
   
(10
)
   
2.72
 
Outstanding at end of year
   
20
   
$
0.62
 
Exercisable at end of year
   
20
   
$
0.62
 
 
               
2011  Stock Option Activity
               
 
               
Outstanding at beginning of year
   
55
   
$
1.75
 
Granted
   
----
     
----
 
Exercised
   
----
     
----
 
Canceled
   
(25
)
   
2.27
 
Outstanding at end of year
   
30
   
$
1.33
 
Exercisable at end of year
   
30
   
$
1.33
 

The aggregate intrinsic value for options outstanding and exercisable at year end 2013 is negligible.  The aggregate intrinsic value represents the total pretax intrinsic value (the difference between our fair market value as determined by management and the exercise price, multiplied by the number of share-based awards) that would have been received by the option holders had all option holders exercised their options on December 31, 2013.

The following table summarizes information about stock options outstanding and exercisable at December 31, 2013 and 2012:

December 31, 2013:
 
 
 
 
 
 
 
 
 
 
 
 
Options Outstanding
 
Options Exercisable
Range of Exercise Prices
 
Number Outstanding
(000’s)
 
Weighted Remaining Contractual Life in Years
 
Weighted Average Exercise Price
 
Number Exercisable (000’s)
 
Weighted Average Exercise Price
$0.50 – $0.99
 
20
 
0.6 years
 
$     0.62
 
20
 
$     0.62

December 31, 2012:
 
 
 
 
 
 
 
 
 
 
 
 
Options Outstanding
 
Options Exercisable
Range of Exercise Prices
 
Number Outstanding
(000’s)
 
Weighted Remaining Contractual Life in Years
 
Weighted Average Exercise Price
 
Number Exercisable (000’s)
 
Weighted Average Exercise Price
$0.50 – $0.99
 
20
 
1.6 years
 
$     0.62
 
20
 
$     0.62

As of December 31, 2013 and 2012, all outstanding options under the plans are vested.

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Telos Shared Savings Plan

We sponsor a defined contribution employee savings plan (the “Plan”) under which substantially all full-time employees are eligible to participate.  The Plan holds 3,658,536 shares of Telos Class A common stock. Since no public market exists for Telos Class A common stock, the Trustees of the Plan and their professional advisors undertake an annual evaluation, based upon the most recent audited financial statements. To date, the Plan’s trustees have priced the stock at the exact midpoint of the evaluated range of the value of the stock.  We match one-half of employee contributions to the Plan up to a maximum of 2% of such employee’s eligible annual base salary.  Participant contributions vest immediately, and Company contributions vest at the rate of 20% for each year, with full vesting occurring after completion of five years of service.  Our total contributions to this Plan for 2013, 2012, and 2011 were $598,000, $649,000, and $591,000, respectively.

Additionally, effective September 1, 2007, Telos ID sponsors a defined contribution savings plan under which substantially all full-time employees are eligible to participate.   Telos ID  matches one-half of employee contributions to the Plan up to a maximum of 2% of such employee’s eligible annual base salary. The total 2013, 2012, and 2011 Telos ID contributions to this plan were $83,000, $77,000, and $69,000, respectively.

Note 10.  Income Taxes

The provision (benefit) for income taxes attributable to income from operations includes the following (in thousands):

 
 
For the Years Ended December 31,
 
 
 
2013
   
2012
   
2011
 
Current provision
 
   
   
 
Federal
 
$
1,219
   
$
4,362
   
$
3,426
 
State
   
264
     
829
     
621
 
 
                       
Total current
   
1,483
     
5,191
     
4,047
 
 
                       
Deferred provision (benefit)
                       
Federal
   
133
     
1,881
     
(718
)
State
   
62
     
158
     
(91
)
 
                       
Total deferred
   
195
     
2,039
     
(809
)