TELOS CORP - Annual Report: 2002 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2002

Commission file number: 1-8443

TELOS CORPORATION

(Exact name of registrant as specified in its charter)

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 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 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

No public market exists for the registrant’s Common Stock.

As of December 31, 2002, the registrant had 21,171,202 shares of Class A Common Stock, no par value; 4,037,628 shares of Class B Common Stock, no par value; and 3,185,586 shares of 12% Cumulative Exchangeable Redeemable Preferred Stock, par value $.01 per share, outstanding.

INCORPORATION BY REFERENCE:

None

Number of pages in this report (excluding exhibits): 66

PART 1

Item 1. Business

History and Introduction

Founded in 1968, Telos Corporation (“Telos” or the “Company”) delivers enterprise security and integration solutions and services to the U.S. Government worldwide. Telos addresses critical needs of customers through its solutions in the area of secure wireless networking, secure message handling, secure local area networks (“LAN”) data integration and enterprise risk management.

Our principle offices are located at 19886 Ashburn Road, Ashburn, Virginia 20147. Our home page is www.telos.com. You can learn more about the Company by reviewing our SEC filings on our web site. The SEC also maintains a web site at www.sec.gov that contains reports, proxy statements and other information regarding SEC registrants, including Telos. We make our website content available for information purposes only. It should not be relied upon for investment purposes, nor is it incorporated by reference into this Form 10-K.

Since 1996, Telos has identified and sold a number of business units that were considered as no longer material to its operational objectives and strategic direction. Most recently in 2002 Telos sold its wholly owned subsidiary, Telos Corporation-California (TCC) for approximately $20 million dollars. In 2000, Telos contributed the net assets of its Ft Sill operations to a newly created joint venture with Oklahoma investors, resulting in a 50% ownership of TelosOK LLC for consideration of $9 million dollars consisting of cash, accounts receivable and a note receivable. The Company sold the remaining 50% ownership in TelosOK LLC in March 2003. See Note 13 Subsequent Events for more information. In 1999, Enterworks, a subsidiary of Telos, was significantly funded by third parties and deconsolidated from Telos. Telos presently owns 21.5% of Enterworks Stock.

Reportable Operating Segments

The Company’s operations, as of December 31, 2002, are comprised of two operating segments: the Products Group and Xacta Corporation (“Xacta”), a wholly owned subsidiary. Prior to July 2002, the Company had three operating segments. The third operating segment, Systems and Supports Services consisting primarily of a wholly owned subsidiary, Telos Corporation-California (TCC), was sold on July 19, 2002 and is being treated as a discontinued operation according to SFAS 144. For additional information related to this transaction refer to the Consolidated Financial Statements Note 4 – Sale of Telos Corporation-California. All historical financial information has been reclassified to be consistent with the current segment presentation. Financial information with respect to the Company’s operating segments appear in Note 12, “Reportable Business Segments”, in the Notes to Consolidated Financial Statements.

Products Group: The Company’s Products Group delivers solutions that combine information technology products and services to address various customer issues and requirements. Solutions from the Products Group consist of a combination of commercial-off-the-shelf (“COTS”) products from major original equipment manufacturers (“OEMs”), Telos proprietary products, Telos and subcontractor services and Telos proprietary practices. Product lines include, among others, secure wireless networking and secure messaging solutions. Telos’ secure wireless networking solutions enable customers to securely access databases from non-networked locations thereby permitting the customer to safely and securely perform its required tasks. Telos’ secure messaging solution, known as the Automated Message Handling System (“AMHS”), is a recognized standard within the Department of Defense. The AMHS solution enables users to securely access, send, search, and profile message traffic. For 2002, the Products Group generated revenue of $78.8 million, down 20.1% from 2001 due in part to a $8.7 million decrease in revenue from product lines that the company has closed out, a delay in the roll-out of the wireless solution, and lower commodity sales in our IS-1 and U.S. Courts contracts. The Products Groups’ revenue represents 87.1% of the Company’s total reported consolidated revenue for 2002. Customers of the Products Group are primarily agencies of the U.S. Government including the military services, various other Defense Agencies, the Treasury Department, the U.S. Courts and various other civilian agencies of the U.S. Government.

Xacta Corporation: Xacta develops enterprise risk management software and related solutions to help organizations to proactively manage and monitor the security of their network environments in accordance with internationally recognized industry and security standards. Xacta has developed and sells two products: Xacta Web C&A and Xacta Commerce Trust. Xacta Web C&A automates the rigorous and time-consuming process of security certification and accreditation. Xacta Web C&A simplifies certification and accreditation by guiding users through a step-by-step process which determines the customer’s information security posture and assesses system and network configuration compliance with applicable regulations, standards, and industry best practices and processes. With Xacta Commerce Trust, organizations are able to perform holistic security risk management on a continuous basis in accordance with internationally recognized industry standards and best practices. For 2002, Xacta generated revenue of $11.7 million, down 13.7% from 2001 due to decreased orders for its information security products and solutions, which represents 12.9% of the Company’s total

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consolidated revenue for 2002. Xacta currently sells its solutions to agencies of the U.S. Government, state and local agencies, as well as federally insured depository institutions.

Systems and Support Services (sold July 2002): This group provides post-deployment and post-production software and systems development and support services including technology insertion, systems redesign and software re-engineering. The Group’s principal operations are located in proximity to its largest customer, the U.S. Army’s Communications and Electronics Command (“CECOM”), located at Fort Monmouth, NJ.

This Group consisted primarily of the Company’s wholly owned subsidiary, TCC, which was sold on July 19, 2002. The company has excluded this group from its operating revenues and expenses and reported as a discontinued operation according to SFAS 144.

Results from the Systems and Support Services Group at Ft. Sill were also included in this groups financial results until its deconsolidation in July 2000. During July 2000 the Company contributed its Ft. Sill business to TelosOK LLC. The Company remained as the prime contractor on the Ft. Sill contract until March 2002 when the contract was novated by the U.S. Government to TelosOK LLC. The Company sold its remaining interest in TelosOK LLC March 10, 2003. More information with respect to the sale of the Company’s interest in TelosOK LLC appears in Note 13, “Subsequent Events”, in the Notes to Consolidated Financial Statements which note is hereby incorporated by reference.

Revenue by Major Market and Significant Customers

The Company derived 95.8%, 96.7% and 94.2% of its revenues from contracts and subcontracts with the U.S. Government in 2002, 2001 and 2000, respectively. Total consolidated revenue derived from the U.S. Government for includes 31.6%, 36.2% and 43.8% of revenue from contracts with the United States Army for 2002, 2001 and 2000, respectively, 24.2%, 34.1% and 34.3% of revenue with other Department of Defense customers for 2002, 2001 and 2000, respectively, and 32.0%, 29.7% and 21.9% of revenue from Federal Civilian Agencies for 2002, 2001 and 2000, respectively. Revenue from Federal Civilian Agencies includes revenue of 49.4%, 70.8% and 71.6% for 2002, 2001 and 2000, respectively from the U.S. Courts.

Government Contracts

The U.S. Government is the Company’s primary customer. All U.S. Government contracts and subcontracts may be modified, curtailed or terminated at the convenience of the U.S. Government if program requirements or budgetary constraints change. In the event that a contract is terminated for convenience, the Company is generally reimbursed for its allowable costs through the date of termination and is paid a proportionate amount of the stipulated profit or fee attributable to the work actually performed.

Although in the past contract and program modifications, curtailments or terminations have not had a material adverse effect on the Company, no future assurance can be given that such modifications, curtailments or terminations will not have a material adverse effect on the financial condition or results of operations of the Company.

The Company’s business with the U.S. Government and other customers is generally performed under time-and-materials and fixed-price contracts. Under time-and-materials contracts, the Company is paid for labor hours at negotiated, fixed hourly rates and reimbursed for other allowable direct costs at actual costs plus allocable indirect costs. Under fixed-priced contracts, the Company is required to provide services or stipulated products for a fixed price. Because the Company assumes the risk of performing a firm fixed-price contract at a set price, the failure to accurately estimate ultimate final costs or to control costs during the contract performance could result, and in some instances has resulted, in reduced profits or losses for particular contracts.

During fiscal year 2002 approximately 77.3% and 22.7% of the Company’s revenues were derived from fixed-price and time-and-materials contracts, respectively.

Contract costs for services or products supplied to the U.S. Government, including allocated indirect costs, are subject to audit and possible adjustments to the approved provisional rates. These approved provisional rates are established at the beginning of each calendar year for billing, revenue, and pricing purposes. At the end of each calendar year, actual indirect rates are determined and submitted to DCAA through Incurred Cost Submissions for audit purposes of determining final audited indirect rates. These final audit indirect rates are used to “close-out” contracts for that calendar year and true-up contract billings and possible revenues for the calendar year on contracts that are still active and ongoing. Substantially all the Company’s indirect contract costs and final indirect rates have been agreed upon through calendar year 1995. Proposed actual year-end indirect rates and costs for calendar years 1996 through 1999 are currently under audit. Contract revenues for subsequent years have been recorded based on provisional rates and in some cases trued-up to year-end actual rates when “quick close-outs” are required and expected to be confirmed subject to the above referenced audit process. However, no assurance can be given that audits and adjustments for subsequent years will not result in decreased revenues or profits for such years.

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Competition

The segments of the industry in which the Company operates are highly fragmented with no single company or small group of companies in a dominant position. Some of the large competitors offer capabilities in a number of markets which overlap many of the same areas in which the Company offers services, while certain companies are focused upon only one or a few of these markets. The firms that compete with the Company are computer services firms, applications software companies and consulting firms, the computer service arms of computer manufacturing companies and defense and aerospace firms.

The Company believes that the principal competitive factors in the segments of the enterprise integration and security solutions market in which it competes include project management capability, technical expertise, reputation for providing quality service, price and contract vehicles. The Company believes its technical competence in computer engineering, systems software, will enable it to compete favorably in the information and network technology market.

Employees

The Company employed 358 people as of December 31, 2002. The services the Company provides require proficiency in many fields, such as computer science, information security and vulnerability testing, wireless networking technologies, physics, engineering, operations research, economics, and business administration. Of the total Company personnel, 153 are in the Products Group and 111 in Xacta. An additional 94 employees provide corporate and administrative services functions.

Backlog

Many of the Company’s contracts with the U.S. Government are funded year to year by the procuring U. S. Government agency as determined by the U.S. Government and the procuring agencies’ fiscal requirements. Such a contracting process results in two different categories of backlog: funded and unfunded. Total backlog consists of the aggregate contract revenues remaining to be earned by the Company at a given time over the life of its contracts, whether funded or not. Funded backlog consists of the aggregate contract revenues remaining to be earned by the Company at a given time, but only to the extent, in the case of U.S. Government contracts, when funded by the procuring U. S. Government agency and allotted to the specific contracts. Unfunded backlog is the difference between total backlog and funded backlog. Included in unfunded backlog are revenues which may be earned only if customers exercise delivery orders and/or renewal options to continue such existing contracts.

A number of contracts undertaken by the Company 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 the Company’s backlog.

At December 31, 2002 and 2001, the Company had total backlog from existing contracts of approximately $31.7 million and $830.0 million, respectively. This is the maximum value of additional future orders for systems, products, maintenance and other support services presently allowable under those contracts, including renewal options available on the contracts if exercised by the customer, over periods extending up to seven years. The decrease in total backlog is primarily attributable to the sale of TCC which included a dual award of the US Army CECOM SEC contract to the Company’s 50% owned joint venture, ITel Solutions. The Company was a subcontractor to this joint venture, and estimated upon the successful award of competing task orders total backlog up to approximately $700 million.

Approximately $28.9 million and $28 million of the total backlog was funded backlog at December 31, 2002 and 2001, respectively.

While backlog remains a measurement consideration, in recent years the Company, as well as other U.S. Government contractors, experienced a 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 allow 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 awardees to procure business. The use of GSA schedules and omnibus contracts, while generally not providing immediate backlog, provide areas of growth that the Company continues to aggressively pursue.

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Item 2. Properties

The Company leases 191,700 square feet of space for its corporate headquarters, integration facility, and primary service depot in Ashburn, Virginia. The lease expires in March 2016, with a ten-year extension available at the Company’s option. This facility supports all of the Company’s operating segments.

The Company subleases 21,816 rentable square feet of space at its Ashburn, Virginia facility to its affiliate, Enterworks, Inc. for its corporate headquarters and operating segments. This sublease will expire on March 31, 2003.

The Company leases additional space for regional contract work sites, training and sales offices in 5 separate facilities located in California, New Jersey, the District of Columbia and Europe under various leases, which expire on various dates through March of 2006.

Item 3. Legal Proceedings

The Company is a party to various lawsuits arising in the ordinary course of business. In the opinion of management, while the results of litigation cannot be predicted with certainty, the final outcome of such matters will not have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.

Item 4. Submission of Matters to a Vote of Security Holders

The Company’s annual meeting of common shareholders was held on November 13, 2002. There were two matters presented for vote at the meeting. The first was the election of directors. The shareholders of the common stock necessary to constitute a quorum were present either in person or represented by proxy or attorney. Dr. Fred Charles Ikle, John B. Wood, Norman P. Byers, Dr. Stephen D. Bryen, and David S. Aldrich were elected to a term of approximately one year, a term to expire at the next annual meeting of shareholders upon the election of their successors. Effective February 24, 2003, Mr. Aldrich resigned as director of the Company.

The second matter presented for vote was the resolution to modify the Long Term Incentive Plan which was adopted, and provided the Company to grant stock options in the Telos DE and Xacta DE subsidiaries, and that such options can be exercised only upon a change of control or other specifically designated events.

With regard to the holders of the 12% Cumulative Exchangeable Preferred Stock, shareholders of such stock necessary to constitute a quorum were not present and, therefore, the nominations of Malcolm M.B. Sterrett and Geoffrey B. Baker were not considered. Subsequent to the shareholders meeting, Malcolm M.B. Sterrett, appointed Geoffrey B. Baker and himself to fill the term, for a period of one year, to expire at the next annual meeting of shareholders, and upon the election of their successors. Such appointment by Mr. Sterrett was consistent with Article Fifth (C)7(b)(vi) of the Company’s Articles of Amendment and Restatement.

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PART II

Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters

No public market exists for the Company’s Class A or Class B Common Stock. As of December 31, 2002, there were 94 holders of the Company’s Class A Common Stock and 5 holders of the Company’s Class B Common Stock.

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 document.

OPERATING RESULTS

FINANCIAL CONDITION

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

Government oversight

As a U.S. Government contractor, the Company is subject to U.S. Government oversight. The U.S. Government may investigate and make inquiries of the Company’s business practices and conduct audits of contract performance and cost accounting. Depending on the results of these audits and investigations, the U. S. Government may make claims against the Company. 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 award of, new U.S. Government contracts. A conviction could result in debarment for a specified period of time. Although the outcome of such investigations and inquiries cannot be predicted, in the opinion of management, there are no claims, audits or investigations pending against the Company that are likely to have a material adverse affect on the Company’s business or its consolidated results of operations, cash flows or financial position.

General

During 2002, the Company continued to focus on its commitment to creating unique, value added solutions, and reducing corporate indebtedness.

The Company created value added solutions through its wholly-owned subsidiary, Xacta, to address the ever increasing market for reliable and secure communication. Xacta provides solutions to both U.S. Government and commercial customers to handle certain of these critical security requirements. Specifically, Xacta solutions help organizations proactively manage and monitor the security of their network environments in accordance with internationally recognized information security and privacy standards, regulations, guidelines and industry best practices.

The Company’s Products Group continues to better serve its customers with innovative product offerings, including the Products Group’s secure wireless networking and secure messaging solutions. Telos’ secure wireless networking solutions allow customers to securely and safely access databases from non-networked locations. Telos’ secure messaging solution is known as the Automated Message Handling System (“AMHS”) and is recognized as a standard within the Department of Defense. The AMHS solution allows users to securely access, send, search, and profile message traffic.

The Company made significant strides in reducing corporate indebtedness in 2002. The Company’s term facility balance has been reduced by approximately 47% from the December 31, 2001 balance, primarily due to cash received from the sale of TCC. The Company was also able to retire $3 million of its Series C Subordinated Notes in 2002. For more information on the sale of TCC, see Note 4 to the Consolidated Financial Statements on the Sale of Telos Corporation (California).

Critical Accounting Policies and Estimates

The preparation of consolidated financial statements requires management to make judgments based upon estimates and assumptions that are inherently uncertain. Such judgments affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Management continuously evaluates its estimates and assumptions including those related to contract percentage of completion methodology for revenue recognition purposes, inventories, long-lived assets, warranty obligations, income taxes, contingencies and litigation and the carrying values of assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

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

The Company recognizes revenue from time and materials contracts as services are performed and costs are incurred. Revenue from fixed price services contracts is generally recognized over the contract term using the percentage of completion method. Such revenues are recorded based on the percentage that costs incurred to date bear to the most recent estimates of total costs to complete each

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contract. 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. In the event cost estimates indicate a loss on a contract, the total amount of such loss, excluding general and administrative expense, is recorded in the period in which the loss is first estimated. The Company generally recognizes product revenue as products are shipped, although certain revenue recognition practices are dependent upon contract terms. Revenue for maintenance contracts is recognized as such services are performed.

Inventories are stated at the lower of cost or market, where cost is determined primarily on the first-in, first-out method. Inventories consist primarily of purchased customer off-the-shelf hardware and software, and component computer parts used in connection with system integration services performed by the Company. Inventories also include spare parts utilized to support certain maintenance contracts. Spare parts inventory is amortized on a straight-line basis over five years. An allowance for obsolete, slow-moving or non-salable inventory is provided for all other inventory. This allowance is based on the Company’s overall obsolescence experience and its assessment of future inventory requirements.

We record a liability in connection with various warranty obligations. Our warranty obligations are affected by product failure rates and material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required, resulting in additional income statement charges.

We record a valuation allowance to adjust our deferred tax asset that is more likely than not to be realized. In the event that we can no longer substantiate future liabilities based on projected earnings, the adjustment to the deferred tax asset would decrease income in the period such determination is made.

Exit From the Systems and Support Services Business

The Company has completed its exit from the Systems and Support Services business with the sale of TCC in July 2002. The Solutions Services Group was characterized primarily by large, long-term time-and-material services contracts with consistent and predictable revenue and cash flow streams. With the exit from such business, the Company is now more reliant on short term, less predictable revenue and cash flow streams, although with projected higher margins from its realigned business opportunities. Such a possible negative impact to the Company’s liquidity, however, is projected to be offset by its focus on Xactas’ product subscription offering, which, as a subscription, is paid for by the customer upon sale.

The Company sold its 50% share of TelosOK LLC, on March 10, 2003 which is reported in Note 13 “Subsequent Events” of the Consolidated Financial Statements. The primary business of TelosOK LLC was to provide post-deployment and post-production software and systems development and support services including technology insertion, system redesign and software re-engineering. The largest customer of TelosOK LLC was the U.S. Army’s Communications and Electronics Command (“CECOM”) with significant operations at Ft. Sill in Lawton, Oklahoma. TelosOK LLC tasks were performed on a time and materials basis and on a firm fixed price basis.

Results of Operations

The Company did not receive its anticipated volume of orders by September 30, 2002, the end of the U.S. Government fiscal year. In addition, the 2003 U.S. Government budget approval process was delayed by several months. Such negative factors caused the Company to experience a decline in sales from the fourth quarter of 2002 as compared to the comparable period in 2001.

Approximately 95.8% of the Company’s total revenues in 2002 were attributable to contracts with the U.S. Government. The Company’s revenues are generated from a number of contract vehicles. In general, the Company believes its contract portfolio is characterized as having low to moderate financial risk as the Company has limited long-term fixed price development contracts. The Company’s firm fixed price contracts consist principally of contracts for the purchase of computer equipment at established contract prices or contracts for certification and accreditation services offerings. The company’s time and

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material contracts generally allow the pass-through of allowable costs plus a profit margin. For 2002, revenue by contract type was as follows: time and materials, 22.7% and firm fixed price 77.3%. While the Company has not experienced any significant recent terminations or contract renegotiations, U.S. Government contracts may be terminated or renegotiated at any time at the convenience of the U.S. Government.

Statement of Operations Data

The following table sets forth certain consolidated financial data and related percentages for the periods indicated. The financial data has been reclassified to present all years reported consistent with current operating segments:

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Financial Data by Operating Segment

The Company has two reportable operating segments: Products and Xacta. Sales, gross profit and gross margin by market segment for the periods designated below are as follows:

Results of Continuing Operations

Sales from continuing operations decreased $21.7 million or 19.3% to $90.5 million for the year ended December 31, 2002, from $112.2 million for the comparable 2001 period. The decrease for the period includes an $19.8 million decrease in Product’s sales, and a decrease of $1.9 million in Xacta revenue. The Company’s Products Group revenues declined $19.8 million in 2002 from 2001 due in part to $8.7 million from product lines that the Company closed out after 2001. The remaining $11.1 million decrease is due to a delay in the roll-out of the wireless solution and lower commodity sales in our IS-1 and courts contracts. The Xacta Group decrease in revenue was primarily due to decreased orders of information security products and solutions.

Cost of sales was 87.8% of sales for the year ended December 31, 2002, as compared to 79.6% for the same period in 2001. The increase in cost of sales as a percentage of sales were primarily attributable to decreased profits realized on Product Group contracts such as the Company’s subcontracts to the Bureau of Census, and from reduced profits under the Company’s wireless products business. The reduction in the wireless products business profits were caused primarily by delays in projected orders while maintaining personnel and infrastructure costs necessary to fulfill such orders. Xacta also experienced lower margins as a result of a decrease in sales volume. The Company recognized inventory obsolescence charges of $2.2 million during 2002 cosisting primarily of $1.7 million to adjust certain software inventory to market value. This charge was taken due to the age of the 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. Such obsolescence charge was included in cost of goods sold during the month of September 2002. The Company also recognized a reserve for bad debt of $470,000 to during the year 2002 as an estimate of uncollectable accounts receivable at December 31, 2002.

Gross profit decreased $11.9 million in the twelve-month period to $11.1 million in 2002, from $22.9 million in the comparable 2001 period. The decrease is attributable to the decreases in overall sales volume discussed above with a relatively higher percentage of sales concentrated in lower margin products.

Selling, general, and administrative expense (“SG&A”) remained flat on a fixed dollar basis in 2002 compared to 2001. SG&A, however, increased as a percentage of revenue from 16.5% in 2001 to 21.6% in 2002 primarily due to the sale of TCC and the resulting reclassification of revenues and expenses as discontinued operations. The Company also recorded employee costs related to certain severance agreements resulting in a $960,000 charge to SG&A in fiscal 2002. Also included in SG&A is a reserve in the amount of $1.5 million to reduce the carrying amount of Notes Receivable from Enterworks to $0. See Note 2 “Investment in Enterworks” in the Notes to the Consolidated Financial Statements for more information. In accordance with APB 18 and EITF 98-13 “Accounting by an Equity Method Investor for Investee Losses when the Investor has Loans to and Investments in Other Securities of the Investee”, the Company has reduced the

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carrying amounts of Enterworks notes receivable and investment account to zero during 2001 and 2002, as the Company’s share of the Enterworks losses exceeded the carrying value of the notes receivable and Enterworks investment account. The Company has therefore, recognized a reserve in the amount of $397,000 in December 2002 to accrue costs related to an agreement with Enterworks to provide certain administrative and support services and sub-leased office space for a period of six months ending June 30, 2003.

Goodwill amortization expense for 2001 has been reported separately under operating income (loss) from discontinued operations to account for the sale of “TCC”. Beginning January 2002 the Company no longer amortizes its goodwill asset according to SFAS 142. The Company no longer carries a Goodwill asset as a result of the sale of TCC in 2002. (see Note 4 – Sale of Telos Corporation (California)).

Interest expense from continuing operations decreased approximately $847,000 to $2.3 million for the year ended December 31, 2002 from approximately $3.2 million in the comparable 2001 period. These decreases are primarily due to decreased debt levels in 2002 as compared to 2001.

In order to present the statement of operations in accordance with APB 18, the revenues and costs of sales for the Ft. Sill operation contributed to TelosOK LLC were presented in one line item “Equity in Net Earnings of TelosOK LLC for the year ended December 31, 2000 (See Note 3). Consistent with prior years, the Company, under APB 18, is unable to recognize its pro rata share of the income generated by TelosOK LLC for 2002, as the Company’s capital account for TelosOK LLC is negative.

The Company recorded an income tax benefit from continuing operations for the year ended December 31, 2002 and 2001 of approximately $3.4 million and $240,000, respectively. The tax benefit at December 31, 2002 is primarily due to net operating loss carry forwards associated with the losses generated by the Company. The Company’s net deferred tax assets totaled $11.5 million at December 31, 2002. Failure to achieve forecasted taxable income may affect the ultimate realization of the net deferred tax assets. Management believes the Company will generate taxable income in excess of operating losses in amounts sufficient to realize the net deferred tax assets.

Profit from continuing operations decreased $9.0 million to a $7.5 million loss from continuing operations for the year ended December 31, 2002 from a $1.5 million profit from continuing operations for the same period in 2001. Such a decrease in profit from continuing operations is mostly attributable to the decrease in gross profit discussed above.

Discontinued Operations

Telos Corporation-California

The Company reported a loss from discontinued operations of $1.1 million, $2.2 million and $869,000 in 2002, 2001 and 2000, respectively. In addition to the 2002 loss from discontinued operations, the Company reported a one-time gain of $12.6 million for the sale of TCC.

Years ended December 31, 2001 and 2000

Sales increased $15.3 million or 15.8% to $112.2 million for the year ended December 31, 2001, from $96.9 million for the comparable 2000 period. The increase includes a $10.8 million increase in Products’ sales and an increase of $4.5 million in Xacta revenue. This increase in revenue is primarily due to increased sales in Xacta’s information security product line of $4.5 million and an increase in the Product’s Group Rapids contract of $4.7 million.

Cost of sales was 79.6% of sales for the year ended December 31, 2001, as compared to 83.6% for the same period in 2000. The decrease in cost of sales as a percentage of sales is primarily attributable to increased profits realized under certain Products contracts including, but not limited to, increased profits realized on Products Group traditional contracts, such as IS-1 and US Courts, and from increased profits from sales of the Company’s information security product line.

Gross profit increased approximately $7.0 million to $22.9 million in 2001 from $15.9 million in 2000. Gross margin was 20.4% for 2001 as compared to 16.4% for the same period of 2000. The increase in gross margin was attributable to the cost of sales decreases explained above.

Selling, general, and administrative expense (“SG&A”) increased by approximately $5.3 million or 39.9%, to $18.5 million for the year ended

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December 31, 2001 from $13.2 million in the comparable period of 2000. This increase is due primarily to the Company’s increased investment in the product development, sales and marketing effort for Xacta and two one-time charges of approximately $600,000 to write-off of an investment made in an international joint venture, and a $1.8 million reserve recorded against the Enterworks notes receivable held by the Company (See Note 2 to the Financial Statements). SG&A as a percentage of revenues for the twelve-month period ended December 31, 2001 increased to 16.5% from 13.7% compared to the same period in 2000.

Income from continuing operations for 2001 was $1.5 million, as compared to a loss from continuing operations of $925,000 in 2000. Profitability increased principally as a result of increased sales volume from both Groups, coupled with improved profits under the Company’s traditional businesses and its information security channel business in its Products Group as well as increased margins in its Xacta subsidiary.

Liquidity and Capital Resources

The Company’s capital structure consists of a revolving credit facility, subordinated notes, redeemable preferred stock, and common stock.

On October 21, 2002, the Company entered into a $22.5 million Senior Credit Facility agreement (“Facility”) with a financial institution that matures on October 21, 2005 and is collateralized by substantially all of the Company’s assets including inventory, equipment and accounts receivable. The amount of any borrowings fluctuates based upon the underlying asset borrowing base as well as the Company’s working capital requirements. The Facility has various covenants that may, among other things, restrict the ability of the Company to merge with another entity, sell or transfer certain assets, pay dividends and make other distributions beyond certain limitations. The Facility also requires the Company to meet certain net worth and operating goals. At December 31, 2002, the Company had outstanding borrowings of $6.6 million and available credit of $4.9 million on the facility. As of December 31, 2002, the interest rate on the facility was 5.75%.

The Company’s subordinated notes are held principally by common shareholders and totaled $5.2 million at December 31, 2002. These subordinated notes bear interest at rates between 14% and 17%, due and payable on October 31, 2004. During 2002, the Company paid $1.1 million in interest to subordinated note holders.

The Company currently has two primary classes of redeemable preferred stock – Senior Redeemable Preferred Stock and Public Preferred Stock. Each class carries cumulative dividend rates of 12% to 14.125%. At December 31, 2002 the total carrying amount of redeemable preferred stock, including accumulated and unpaid dividends was $60.9 million. The Company accrues dividends and provides for accretion related to the redeemable preferred stock. During 2002, the Company recorded $4.2 million of dividends on the two classes of redeemable preferred stock. Mandatory redemption for all shares of the Senior Redeemable Preferred Stock plus all accrued dividends on those shares is due on October 31, 2004, and on or before August 15, 2004, to the extent the redemption date of the Preferred Stock has not been extended to a date later than October 31, 2005, Preferred Stockholders agree to extend the redemption date to a date no earlier than October 31, 2005, subject to the legal availability of funds. Mandatory redemption for the Public Preferred Stock is required from 2005 through 2009, subject to the legal availability of funds.

Cash used by operating activities was $9.3 million in 2002, due primarily to the operating losses the Company incurred during the year. Cash provided by investing activities was $18.2 million in 2002. This is primarily due to proceeds of the sale of Telos Corporation (California) during July 2002 partially offset by $338,000 in capital expenditures. The Company used cash for financing activities in the amount of $8.7 million in 2002, consisting primarily of $3 million in payments made to reduce the Subordinated Debt and $5.8 million in payments to reduce the Facility.

In July 2000, the Company entered into a subscription agreement with certain investors that provided for the formation of an Oklahoma limited liability company, TelosOK, LLC (See Note 3 to the Consolidated Financial Statements). The Company owns 50% of this joint venture and has guaranteed 50% of the outstanding balance of a term loan TelosOK LLC has with a bank. The balance of this loan was $1.5 million at December 31, 2002. In March 2003, the Company disposed of the remaining 50% ownership interest in TelosOK LLC and was released from the loan guarantee (See discussion in Note 13 – Subsequent Events).

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Capital Expenditures

The Company believes that its business is generally not capital intensive. Capital expenditures for property and equipment were $338,000 in 2002, $656,000 in 2001 and $1.7 million in 2000. The Company anticipates capital expenditures of approximately $900,000 in 2003; however, there can be no assurance that this level of capital expenditures will occur.

Capital Leases and Related Obligations

The Company has various lease agreements for property and equipment that have met one or more of the tests, as defined in FAS 13 “Accounting for Leases”, that require recording the present value of the minimum lease payments for such equipment and property as an asset in the Companys consolidated financial statements. Such assets are amortized on a straight-line basis over the term of the related lease.

Inflation

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

Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (“FASB”) approved Statement of Financial Accounting Standards (“SFAS”) No 142, “Goodwill and Other Intangible Assets”. SFAS No. 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. Implementation of this Statement requires the Company to cease amortization of goodwill, and goodwill is tested for impairment at least annually at the reporting unit level. Goodwill is tested for impairment on an interim basis if any event occurs or circumstances change that would “more likely than not” reduce the fair value of a reporting unit below its carrying value. Intangible assets that are subject to amortization will be reviewed for impairment in accordance with SFAS 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of”. The Company adopted the provisions of SFAS 142 on January 1, 2002. The Company no longer amortizes goodwill to expense, but instead reviews goodwill periodically for impairment. The adoption of SFAS 142 reduced goodwill amortization expense by $250,000 annually. No material changes to the carrying value of goodwill were made as a result of the adoption of SFAS 142. As of December 31, 2002, the Company did not have any goodwill balances due to the sale of TCC in July 2002.

In October 2001, FASB Statement No. 144 (SFAS 144) “Accounting for the Impairment or Disposal of Long-lived Assets” was issued. SFAS 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets and this statement supercedes FASB Statement No. 121, “Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed Of”. The Company has restated the Consolidated Financial Statements to account for the sale of TCC as a discontinued operation in accordance with SFAS 144. For more information, refer to Note 4 – Sale of Telos Corporation-CA in the Notes to the Consolidated Financial Statements.

In July 2002, SFAS No. 146 (SFAS 146) “Accounting for Costs Associated with Exit or Disposal Activities” was issued. The standard requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS 146 replaces EITF Issue. No. 94-3, “Liability recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The Company is currently evaluating the provisions of SFAS 146 to determine the Statements impact on the Company’s financial statements.

In November 2002, the FASB issued Interpretation No. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others.” The interpretation requires disclosure about the nature and terms of obligations under certain guarantees that

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the Company has issued. The interpretation also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing a guarantee. The initial recognition and initial measurement provisions are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements in this interpretation are effective immediately. The Company, in response to this interpretation, has provided further disclosure as it relates to product warranties and can be found in Note 10 “Commitments and Contigencies”.

In December 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation and Disclosure – an amendment of FASB Statement No. 123” (FAS 148). This statement amends FASB Statement No. 123, “Accounting for Stock-Based Compensation”, to provide alternative transition methods for a voluntary change to fair value accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of FAS 123 to require more prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. Management does not expect to adopt fair value accounting for stock-based employee compensation.

In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The company believes that the adoption of this standard will have no material impact on its financial statements.

Forward-Looking Statements

This Annual Report on Form 10-K contains forward-looking statements. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes,” “anticipates,” “plans,” “expects” and similar expressions are intended to identify forward-looking statements. There are a number of important factors that could cause the Company’s actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth below under the caption “Certain Factors That May Affect Future Results.”

Certain Factors That May Affect Future Results

The following important factors, among others, could cause actual results to differ materially from those indicated by forward-looking statements made in this Annual Report on Form 10-K and presented elsewhere by management from time to time.

A number of uncertainties exist that could affect the Company’s future operating results, including, without limitation, general economic conditions which in the present period of economic downturn may include, and adversely affect, the cost and continued availability of the Company to secure adequate capital and financing to support its business; the impact of adverse economic conditions on the Company’s customers and suppliers; the ability to sell assets or to obtain alternative sources of commercially reasonable refinancing for the Company’s debt; or the ability to successfully restructure its debt obligations. Additional uncertainties include the Company’s ability to convert contract backlog to revenue, the success of the Company’s investment in Enterworks and Xacta and the Company’s access to ongoing development, product support and viable channel partner relationships with Enterworks and Xacta.

While in the past the Company has not experienced contract terminations with the U.S. Government, the U.S. Government can terminate at its convenience. Should such a termination occur, the Company’s operating results could be adversely impacted.

Due to heightened security awareness and the ongoing war in Iraq, all U.S. Government programs, especially those pertaining to national security, have been subject to review and reprioritization as evidenced by the Homeland Defense Act and the pending funding of the war in Iraq. While the Company believes its products and services are well positioned to benefit from such reprioritization of demands, the magnitude of recent and prospective events pertaining to national security certainly serves to emphasize how the Company’s high percentage of revenue derived from business with the U.S. Government could alternatively be dramatically, swiftly and adversely impacted.

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In addition, as a high percentage of the Company’s revenue is derived from business with the U.S. Government, the Company’s operating results could also be adversely impacted should the U.S. Government’s annual budget not be approved in a timely fashion.

The Company has many patents and patents pending, trademarks and copyrights and other valuable proprietary information, and the Company has taken reasonable and prudent steps to protect its intellectual property. With regard to the Company’s wholly owned subsidiary, Xacta, whose software products require constant monitoring as it develops future releases and creates additional intellectual property, vigilant oversight of such intellectual property rights is imperative. Similarly, the intellectual property associated with our wireless division and our automated message handling system division require constant oversight with regard to the development and protection of their respective intellectual property. Accordingly, any event that brings into question the Company’s ownership of its intellectual property could, therefore, materially and adversely impact the Company.

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Item 7a. Quantitative and Qualitative Disclosures About Market Risk

The Company’s exposure to market risk for changes in interest rates relates primarily to the Company’s long-term debt obligations.

The Company is exposed to interest rate volatility with regard to its variable rate debt obligations under its Senior Credit Facility. This facility bears interest at 1.25%, subject to certain adjustments, over the bank’s base rate. The weighted average interest rate of the facility in 2002 was 6.89%. As of December 31, 2002, the interest rate of this facility was 5.75%. This facility expires on October 21, 2005 and has an outstanding balance of $6.6 million at December 31, 2002.

The Company’s other long-term debt at December 31, 2002 consists of Senior Subordinated Notes B and C which bear interest at fixed rates ranging from 14% to 17%. The Senior Subordinated Notes principal balance at December 31, 2002 is $5.2 million, and this principal amount matures on October 31, 2004. The Company has no cash flow exposure due to rate changes for its Senior Subordinated Notes.

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Item 8. Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

INDEX TO SCHEDULES

All schedules are omitted because they are not applicable or the required information is included in the consolidated financial statements or notes thereto.

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Report of Independent Accountants

To the Board of Directors and Stockholders

of Telos Corporation:

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of cash flows and of changes in stockholders’ deficit present fairly, in all material respects, the financial position of Telos Corporation and its subsidiaries (“the Company”) at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. 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 of these statements in accordance with auditing standards generally accepted in the United States of America which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit 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, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

/s/ PRICEWATERHOUSECOOPERS LLP

McLean, VA

March 28, 2003

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TELOS CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(amounts in thousands)

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

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TELOS CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(amounts in thousands)

ASSETS

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

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TELOS CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(amounts in thousands, except share data)

LIABILITIES, MANDATORILY REDEEMABLE PREFERRED STOCK,

AND STOCKHOLDERS’ DEFICIT

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

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TELOS CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(amounts in thousands)

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

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TELOS CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT

(amounts in thousands)