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TELOS CORP - Annual Report: 2003 (Form 10-K)

Form 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


 

FORM 10-K

 


 

x   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2003

 

¨   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) THE SECURITIES EXCHANGE ACT OF 1934

 

Commission file number: 1-8443

 


 

TELOS CORPORATION

(Exact name of registrant as specified in its charter)

 


 

Maryland   52-0880974
(State of Incorporation)   (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 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

 

Title of Class


 

Number of Shares Outstanding

on December 31, 2003


Class A Common Stock, no par value

  21,171,202

Class B Common Stock, no par value

  4,037,628

Series A-1 Redeemable Preferred Stock, $.01 par value

  1,250

Series A-2 Redeemable Preferred Stock, $.01 par value

  1,750

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

 

3,185,586

 

The registrant’s 12% Cumulative Exchangeable Redeemable Preferred Stock is traded on the NASDAQ/OTCBB Exchange.

 

INCORPORATION BY REFERENCE: None

 

Number of pages in this report (excluding exhibits): 52

 



Table of Contents

TABLE OF CONTENTS

 

PART I

    

Item 1.

   Business    3

Item 2.

   Properties    6

Item 3.

   Legal Proceedings    6

Item 4.

   Submission of Matters to a Vote of Security Holders    6

PART II

    

Item 5.

   Market for the Registrant’s Common Equity and Related Stockholder Matters    7

Item 6.

   Selected Financial Data    7

Item 7.

   Management’s Discussion and Analysis of Results of Operations    8

Item 7A.

   Quantitative and Qualitative Disclosures about Market Risk    14

Item 8.

   Financial Statements and Supplementary Data    15

Item 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    44

Item 9A.

   Controls and Procedures    44

PART III

    

Item 10.

   Directors and Executive Officers of the Registrant    45

Item 11.

   Executive Compensation    47

Item 12.

   Security Ownership of Certain Beneficial Owners and Management    50

Item 13.

   Certain Relationships and Related Transactions    52

Item 14.

   Principal Accountant Fees and Services    52

PART IV

    

Item 15.

   Exhibits, Financial Statement Schedules, and Reports on Form 8-K    53

Signatures

   56


Table of Contents

PART 1

 

Item 1. Business

 

History and Introduction

 

Telos Corporation (the “Company” or “Telos”) is a systems integration and services company addressing the information technology needs of federal government customers worldwide. The Company also owns Xacta Corporation, a wholly-owned subsidiary, that develops, markets, and sells government-validated secure enterprise solutions to government and commercial customers.

 

Our principle offices are located at 19886 Ashburn Road, Ashburn, Virginia 20147. The Company’s web site is www.telos.com, and Xacta’s web site is www.xacta.com. You can learn more about the Company by reviewing its SEC filings on the Telos 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 the Company. 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, the Company sold its 50% ownership in TelosOK LLC in March 2003. See Note 3 – Sale of TelosOK LLC for more information. In 2002 the Company sold its wholly-owned subsidiary, Telos Corporation-California (TCC) for approximately $20 million. See Note 4 – Sale of Telos Corporation (California).

 

The Company also owns 21.5% of Enterworks, Inc. (“Enterworks”). See Note 2 – Investment in Enterworks for more information.

 

Reportable Operating Segments

 

For the year ended December 31, 2003, Telos generated revenue of $88.4 million. Prior to December 2003, the Products Group and Xacta Corporation (“Xacta”) were the Company’s two operating segments.

 

Xacta is recognized as a leading provider of secure enterprise solutions to the U.S. Government and financial services organizations. In order to take advantage of the Xacta brand strength, Telos has initiated the consolidation of all of its security-related offerings into Xacta. Additionally, such consolidation will simplify the messages and offerings of the respective segments for the Company’s customers, partners, and employees. In particular, the Company’s wireless and messaging solutions have been consolidated into Xacta and accordingly will be reported in such manner. It is the Company’s intention to re-brand the wireless and messaging lines in 2004 from “Telos” to “Xacta” offerings connoting the secure aspects of these solutions. In addition, the Products Group has been renamed “IT Solutions Group” (see below).

 

The IT Solutions Group: The IT Solutions Group develops, markets and sells integration services and value-added reseller offerings that address a wide range of Government Information Technology (“IT”) requirements. The IT Solutions Group offerings consist of reselling commercial-off-the-shell (“COTS”) products from major original equipment manufacturers (“OEMs”), which are augmented by Telos with various value-added support services. The IT Solutions Group also provides professional services that support various Federal Government integration programs. For 2003, the IT Solutions Group generated revenue of $41.7 million, which represents a decrease of 19.9% over 2002.

 

Xacta Corporation: Xacta, while established in February of 2000 to address the growing demand for secure enterprise solutions, is the successor to the Company’s fifteen years of experience in security services with the U.S. Government. Today Xacta develops, markets and sells government-validated secure enterprise solutions to the U.S. Government, state and local government, and commercial customers. Xacta’s solutions have been validated by leading U.S. government organizations. For example, our Organizational Messaging solution is certified by the Defense Information Systems Agency. Our Wireless Maintenance solution has been approved as part of the Air Force Infrastructure Technology Resource Model and has integrated security enabling it to comply with Federal Information Processing Standards (“FIPS”) and stringent Air Force connection approval requirements, such as Certificate to Operate and NIPRNET accreditation. Additionally, our Security Management solutions are the only products of their type to comply with the U.S. Government’s mandatory certification process (National Information Assurance Partnership (“NIAP”), i.e., NSTISSP 11). Each of these qualifications evidences the fact that Xacta solutions are government-validated and serve as significant competitive differentiators for Xacta.

 

Xacta products and services include a wide range of security management solutions to include certification and accreditation, vulnerability identification and remediation solutions, perimeter security management, operational security management, as well as high assurance credentialing solutions. Additionally Xacta, consistent with the consolidation referenced above, provides organizational messaging and wireless maintenance solutions. For 2003, Xacta generated revenue of $46.7 million which represents an increase of 21.6% over 2002.

 

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Major Markets and Significant Activities

 

Telos operates in a highly competitive marketplace. The Company obtains the majority of its business in response to competitive requests from potential and current customers. Additionally, Telos faces indirect competition from certain government agencies that perform “in-house” services similar to those provided by Telos. The Company knows of no single competitor that is dominant in its relative fields of technology, solutions and services.

 

The entire range of Telos’ services and solutions are offered to U.S. Government agencies and state and local governments. Accordingly, the Company must maintain expert knowledge of federal, state and local agency policies and operations. The Company’s work for U.S. Government agencies in many instances combine a wide range of skills drawn from each of its major product and service offerings. The Company’s commercial client base consists primarily of federally insured depositories which have purchased Xacta’s solutions and large defense and aerospace organizations.

 

Decisions regarding contract awards by the Company’s U.S. Government customers typically are based on assessment of the quality of Telos’ past performance, responsiveness to proposal requirements, uniqueness of the offering itself, price, and other competitive factors.

 

Telos has strategic business relationships with certain companies in the information technology industry. These strategic partners have business objectives compatible with those of the Company, and offer products and services that complement those of the Company’s. The Company intends to continue development of such relationships wherever they support its marketing, growth and service offering objectives.

 

Marketing and new business development for the Company is undertaken by virtually all officers and managers of the Company, including the chief executive officer, executive officers, vice presidents, and division managers. The Company employs marketing, new business development and sales professionals who identify and qualify contract and sales opportunities, primarily in the U.S. Government marketplace. The Company’s proprietary software systems are sold primarily by full time sales persons. The Company also has established agreements for the resale of certain third party software products.

 

The majority of the Company’s business is awarded through submission of formal competitive bids. Commercial bids are frequently negotiated as to terms and conditions for schedule, specifications, delivery and payment. However, with respect to bids for U.S. Government proposals, in most cases the customer specifies the terms, conditions and form of the contract. In situations where the customer-imposed contract type and/or terms appear to expose the Company to inappropriate risk, the Company may seek alternate arrangements or opt not to bid for such potentially high risk work.

 

Essentially all contracts with the United States Government, and many contracts with state and local government agencies, permit the customers to terminate the contract at any time at their convenience or for default by the contractor. The Company acknowledges the risk that such terminations may occur and therefore have a material, adverse impact on operations. Throughout the Company’s 35 years in business, such terminations have been rare and, generally, have not materially and adversely affected operations. As with other companies that do business with the U.S. Government, the Company’s business is subject to funding decisions and actions that are beyond its control. The Company’s contracts and subcontracts are generally composed of a wide range of contract vehicles 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 2003, the Company’s revenue derived from fixed price and time and material contracts was 80.7% and 19.3%, respectively.

 

The Company derived substantially all of its revenues from contracts and subcontracts with the U.S. Government. Revenue by customer sector for the last three years is as follows:

 

     2003

    2002

    2001

 
     (amount in thousands)  

Department of Defense

     $69,503    78.6 %   $ 58,960    65.2 %   $ 77,036    68.7 %

Federal Civilian

     15,055    17.0 %     27,728    30.6 %     31,519    28.1 %

Commercial

     3,885    4.4 %     3,829    4.2 %     3,633    3.2 %
    

  

 

  

 

  

Total

   $ 88,443    100.0 %   $ 90,517    100.0 %   $ 112,188    100.0 %
    

  

 

  

 

  

 

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 such markets. Some of the firms that compete with the Company include: EDS, SAIC, and CSC as well as other small and mid-size firms. In addition, Xacta’s business competes with risk and compliance management companies, organizational messaging companies, security consulting organizations, as well as companies that provide secure wireless offerings.

 

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Employees

 

The Company employed 343 people as of December 31, 2003. 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, 83 are in the IT Solutions Group and 176 in Xacta. An additional 84 employees provide corporate, sales and administrative services.

 

The Company places a high value on its employees and constantly competes for highly skilled professionals in virtually all of its competitive arenas. The success and growth of the Company’s businesses is directly related to its ability to recruit, train, promote and retain high quality people at all levels of the organization. As a result, the Company requires its management to proactively assure themselves that the Company will always remain competitive in terms of salary structures, incentive compensation programs, fringe benefits, opportunities for growth, and individual recognition and award programs.

 

The Company has published policies and procedures that establish high standards for the conduct of its employees in recognition of its highly regulated U.S. Government contractor responsibility. The Company requires each of its employees, consultants, officers, and directors to annually execute and affirm a code of ethics and other corporate compliance policies and procedures. Each employee must annually reaffirm their specific awareness of, and commitment to complying with the code of ethics and corporate compliance, policies and procedures.

 

Patents, Trademarks, Trade Secrets and Licenses

 

Intellectual property is critical to the long-term value and success of the Company. As such the Company has invested heavily in intellectual property, in the form of trademarks, service marks, copyrights, patents and other proprietary assets. The Company is committed to protecting its intellectual property and proprietary information and will use every available resource to protect such investment.

 

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 fiscal requirements of the U.S. Government and the respective procuring agency. Such a contracting process results in two distinct categories of backlog: funded and unfunded. Total backlog consists of the aggregate contract revenues remaining to be earned by 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 when and 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, 2003 and 2002, the Company had total backlog from existing contracts of approximately $40.2 million and $31.7 million, respectively. Of these amounts, approximately $31.0 million and $20.3 million, respectively, were for Xacta’s business with the remaining amount attributed to the IT Solutions Group. Such amounts are 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.

 

Approximately $31.8 million and $28.9 million of the total backlog was funded backlog at December 31, 2003 and 2002, respectively.

 

While backlog remains a measurement consideration, in recent years the Company, 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 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 such business. The use of GSA schedules and omnibus contracts, while generally not providing immediate backlog, provide areas of growth which 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 the Ashburn, Virginia facility to its affiliate, Enterworks, Inc. which serves as Enterworks’ corporate headquarters and hosts its operating segments. This sublease will expire on March 31, 2005.

 

The Company leases additional space in 5 separate facilities located in California, New Jersey, the District of Columbia and Germany under various leases expiring through March of 2011.

 

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 known matters will not, based upon all available information, 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, 2003. The only matter set forth at the meeting 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. Norman P. Byers, Dr. Fred Charles Ikle, Ambassador Langhorne (Tony) A. Motley, and John B. Wood were elected to a term of one year, a term to expire at the next annual meeting of shareholders upon the election of their successors.

 

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 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, 2003, there were 94 holders of the Company’s Class A Common Stock and 5 holders of the Company’s Class B Common Stock.

 

No public market exists for the Company’s Series A-1 and Series A-2 Redeemable Preferred Stock (“Senior Redeemable Preferred Stock”). See Note 7 – Redeemable Preferred Stock.

 

The Company’s 12% Cumulative Exchangeable Redeemable Preferred Stock (“Public Preferred Stock”) is traded on the NASDAQ/OTCBB Exchange. See Note 7 - Redeemable Preferred 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

 

 

     Year Ended December 31,

 
     2003

    2002

    2001

    2000

    1999

 
     (amounts in thousands)  

Sales (1)

   $ 88,443     $ 90,517     $ 112,188     $ 96,881     $ 93,663  

Operating (loss) income

     (1,943 )     (7,596 )     5,911       1,174       2,200  

Income (loss) before income taxes

     1,802       (10,835 )     1,267       (1,177 )     (17,832 )

Net (loss) income

     (8,685 )     4,025       (671 )     (1,794 )     (1,964 )

 

FINANCIAL CONDITION

 

     As of December 31,

     2003

   2002

   2001

   2000

   1999

     (amounts in thousands)

Total assets (1)

   $ 33,611    $ 45,020    $ 48,760    $ 71,781    $ 51,899

Senior credit facility

     6,497      6,618      12,387      25,460      16,508

Senior subordinated debt

     5,179      5,179      8,179      8,537      8,537

Capital lease obligations, long-term (2)

     10,243      10,647      10,722      11,030      11,362

Senior redeemable preferred stock (3)

     7,751      7,327      6,903      6,480      6,054

Public preferred stock (3)

     59,425      53,561      47,876      42,352      36,975

(1)   See Notes 3 & 4 to the Consolidated Financial Statements in Item 8 regarding the sale of TelosOK LLC and Telos Corporation (California)
(2)   See Note 10 to the Consolidated Financial Statements in Item 8 regarding the capital lease obligations of the Company.
(3)   See Note 7 to the Consolidated Financial Statements in Item 8 regarding redeemable preferred stock of the Company.

 

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

 

General

 

During 2003, the Company continued to invest in creating value added solutions in an effort to address the ever increasing market for systems integration services and secure enterprise solutions. For example, with the release of Xacta Web C&A 4.0 in March of 2003, Xacta achieved its vision of developing a continuous business process which enables automated and continuous security risk and compliance management. The “Continuous Assessment” functionality provided in the Xacta 4.0 release allows organizations to manage security compliance and risk in an automated and on-going manner. Additionally, Xacta recently introduced Xacta IA Manager which provides continuous and automated vulnerability management and remediation, allowing organizations to identify and remediate vulnerabilities from a centralized location. Xacta IA Manager when fully deployed will save systems administrators time and effort as well as keep the network “aware” of new vulnerabilities that can appear daily.

 

The Company’s messaging solution is called the Automated Message Handling System (“AMHS”). AMHS version 2003 was approved by Defense Information Systems Agency and released in July of 2003 after extensive evaluation and testing. AMHS 2003 is the U.S. Government’s exclusive certified stand-alone messaging application. The AMHS 2003 stand-alone architecture is more efficient and cost effective than competitive client/server architectures as it enables users to access their messages securely from a single server using a simple web browser. In addition to its more intuitive user interface, AMHS 2003 provides outbound message processing and numerous advanced message management capabilities such as retrospective search and simplified user profiling, which functionality is essential to large organizations with time sensitive formal message requirements. Such retrospective search and user profiling capabilities facilitate message distribution to important staff elements, as well as research and coordination of formal message origination and response.

 

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.

 

In May 2003, the FASB issued SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS 150 requires that certain financial instruments, which under previous guidance were accounted for as equity, must now be accounted for as liabilities. The financial instruments affected include mandatory redeemable stock, certain financial instruments that require or may require the issuer to buy back some of its shares in exchange for cash or other assets and certain obligations that can be settled with shares of stock. SFAS 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. On November 7, 2003, the FASB issued FSP FAS 150-3 which deferred certain areas of FAS 150 including the measurement provisions of mandatory redeemable preferred stock. Accordingly, the Company has continued to accrue dividends on the preferred stock, but was required to reclassify its preferred stock as a liability in accordance with the standard. Also, dividends are now required to be reported as a component of interest expense.

 

For the year ended December 31, 2003, the Company concluded that a full valuation allowance is required for the deferred tax assets, as required under SFAS 109, “Accounting for Income Taxes”. Accordingly, a valuation allowance totaling $9.7 million was provided at December 31, 2003.

 

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 carrying amounts of Enterworks notes receivable and investment account in Enterworks and Enterworks International to zero, as the Company’s share of the Enterworks losses exceeded the carrying value of the notes receivable and Enterworks investment account. See Note 2 – Investment in Enterworks for more information. Other transactions with Enterworks also have been evaluated, based on the investee relationship and resulted in additional losses being recorded in 2003.

 

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 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 delivered, although certain revenue recognition practices are dependent upon contract terms. Revenue for maintenance contracts is recognized over the term of the maintenance contracts.

 

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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.

 

The Company records a liability in connection with various warranty obligations. Such 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.

 

Exit from the Systems and Support Services Business

 

The Company effectively completed its exit from the Systems and Support Services business with the sale of TCC in July 2002. The Systems and Support 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. It is anticipated that any potential negative impact to the Company’s liquidity from such business realignment will be offset by other higher margin offerings such as its Xacta security management, organizational messaging, and wireless maintenance solutions.

 

The Company sold its 50% share of TelosOK LLC, on March 10, 2003 which is reported in Note 3—Sale of TelosOK LLC 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’s tasks were performed on a time and materials basis and on a firm fixed price basis.

 

Results of Operations

 

The Company derived substantially all of its revenues from contracts and subcontracts with the U.S. Government. The Company’s revenues are generated from a number of contract vehicles and task orders. In general, the Company believes its contract portfolio is characterized as having low to moderate financial risk due to the limited number of 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 material contracts generally allow the pass-through of allowable costs plus a profit margin. For 2003, revenue by contract type was as follows: time and materials, 19.3% and firm fixed price 80.7%.

 

Statement of Operations Data

 

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

 

     Year Ended December 31,

 
     2003

    2002

    2001

 
     (dollar amounts in thousands)        

Sales

   $ 88,443     100.0 %   $ 90,517     100.0 %   $ 112,188     100.0 %

Cost of sales

     71,359     80.7       79,457     87.8       89,258     79.6  

Selling, general and administrative expenses

     19,027     21.5       18,656     20.6       17,019     15.2  
    


 

 


 

 


 

Operating (loss) income

     (1,943 )   (2.2 )     (7,596 )   (8.4 )     5,911     5.2  

Gain from sale of 50% interest in TelosOK LLC

     10,121     11.4       —       —         —       —    

Losses from affiliates

     (848 )   (0.9 )     (901 )   (1.0 )     (1,516 )   (1.4 )

Other income

     14     —         10     —         67     0.1  

Interest expense

     (5,542 )   (6.3 )     (2,348 )   (2.6 )     (3,195 )   (2.8 )
    


 

 


 

 


 

Income (loss) before income taxes

     1,802     2.0       (10,835 )   (12.0 )     1,267     1.1  

Income tax (provision) benefit

     (11,487 )   (12.9 )     3,361     3.7       240     0.2  
    


 

 


 

 


 

Income (loss) from continuing operations

     (9,685 )   (10.9 )     (7,474 )   (8.3 )     1,507     1.3  

Loss from discontinued operations

     —       —         (1,078 )   (1.2 )     (2,178 )   (1.9 )

Gain on sale of TCC

     1,000     1.1       12,577     13.9       —       —    
    


 

 


 

 


 

Net income (loss)

   $ (8,685 )   (9.8 )%   $ 4,025     4.4 %   $ (671 )   (0.6 )%
    


 

 


 

 


 

 

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Financial Data by Operating Segment

 

The Company has two reportable operating segments: IT Solutions Group and Xacta. Prior to December 2003, the Company had two operating segments, the Product Group and the Xacta Group. Sales, gross profit and gross margin by market segment for the periods designated below are as follows:

 

     Year Ended December 31,

 
     2003

    2002

    2001

 
     (dollar amounts in thousands)  

Sales:

                        

IT Solutions and other services

   $ 41,722     $ 52,090     $ 67,538  

Xacta

     46,721       38,427       44,650  
    


 


 


Total

   $ 88,443     $ 90,517     $ 112,188  
    


 


 


Gross Profit:

                        

IT Solutions and other services

   $ 954     $ (272 )   $ 7,359  

Xacta

     16,130       11,332       15,571  
    


 


 


Total

   $ 17,084     $ 11,060     $ 22,930  
    


 


 


Gross Profit Percentage:

                        

IT Solutions and other services

     2.3 %     (0.5 )%     10.9 %

Xacta

     34.5 %     29.5 %     34.9 %

Total

     19.3 %     12.2 %     20.4 %

 

Results of Continuing Operations

 

Years ended December 31, 2003 and 2002

 

Sales decreased by $2.1 million or 2.3% to $88.4 million for the year ended December 31, 2003, from $90.5 million for the comparable 2002 period. The decrease for the period includes a $10.4 million decrease in the IT Solutions Group’s sales, and an increase of $8.3 million in Xacta. Included in the IT Solutions Group’s sales is a $900,000 services fee from TelosOK LLC since March of 2003. See Note 3 – Sale of TelosOK LLC. The IT Solutions Group’s decrease in revenues is due primarily to its decline in reselling sales and information technology services. Xacta’s increase in revenue was primarily due to an increase in sales of its organizational messaging and deployable maintenance solutions, as well as increased orders for its information security products and solutions.

 

Cost of sales was 80.7% of sales for the year ended December 31, 2003, a decrease of 7.1% as compared to 87.8% for the same period in 2002. The decrease in cost of sales as a percentage of sales was primarily attributable to the increase in higher margin business lines, combined with a reduction in overhead expenses. In addition, the 2003 cost of sales included a credit of $1.1 million settlement received in July 2003 as a result of litigation against a former business partner. During 2002, the Company recognized inventory obsolescence charges of $2.2 million consisting 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. Such obsolescence charge was included in cost of goods sold during the month of September 2002.

 

Gross profit increased by $6.0 million or 54.5% from 2002 to 2003. The increase is primarily attributable to the above-referenced favorable change in revenue mix from lower margin sales to higher margin business.

 

Selling, general, and administrative expenses (“SG&A”) increased by $371,000 to $19.0 million in 2003 compared to $18.7 million in 2002. As a percentage of revenue, SG&A increased by 0.9% from 20.6% in 2002 to 21.5% in 2003. Such increase was primarily due to a $2.0 million increase in bonus accruals, off-set by various cost reduction measures and a decrease in severance costs of $1.0 million.

 

For the year ended December 31, 2003, the Company recorded $848,000 of losses from affiliates, which included the write-down of the $500,000 investment in Enterworks International, and expenses of $900,000 related to rent and services provided to Enterworks pursuant to an earn-out provision of a two-year Original Equipment Manufacturer (OEM) software license agreement with Enterworks, see Note 2 – Investment in Enterworks. Such losses were partially off-set by a $556,000 cash distribution received from TelosOK. For the comparable period in 2002, the Company recorded $901,000 of losses from affiliates, principally consisting of reserves of $1.5 million on Enterworks notes due to the application of the equity method of accounting 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”, whereby the Company reduced the 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 the Enterworks investment account. See Note 2 – Investment in Enterworks for more information.

 

 

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Interest expense increased by approximately $3.2 million to $5.5 million for the year ended December 31, 2003 from approximately $2.3 million in the comparable 2002 period. Such increase is primarily due to the reclassification of preferred stock dividends and accretion as interest in accordance with FAS 150. Components of interest expense are as follows:

 

     December 31,

 
     2003

   2002

    2001

 
     (amounts in thousands)  

Commercial interest incurred

   $ 2,386    $ 2,955     $ 4,073  

Preferred stock interest accrued

     3,156      —         —    

Interest reclassified to discontinued operations

     —        (607 )     (878 )
    

  


 


Total

   $ 5,542      $2,348     $ 3,195  
    

  


 


 

Income before income taxes increased by $12.6 million to $1.8 million for the year ended December 31, 2003 from that of a loss of $10.8 million for the same period in 2002. Such increase is primarily due to an increase in the sales of the Company’s higher margin offerings, and a gain of $10.1 million from the sale of TelosOK LLC. See Note 3 – Sale of TelosOK LLC.

 

The Company recorded an income tax provision from continuing operations for the year ended December 31, 2003 of approximately $11.5 million, primarily as a result of the full valuation allowance provided in accordance with FAS 109. For a comparable 2002 period, an income tax benefit of $3.4 million was recorded, primarily due to the net operating loss carryforwards associated with the losses generated by the Company.

 

Years ended December 31, 2002 and 2001

 

Sales 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 a $15.4 million decrease in the IT Solutions Group’s sales, and a decrease of $6.2 million in Xacta sales. The Company’s IT Solutions Group sales declined due in part to the fact that the Company closed out certain product lines after 2001. The remaining decrease was due to lower reselling sales. Xacta’s sales decreased primarily due to decreased orders of information security products and solutions as well as a delay in the rollout of its wireless maintenance 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 was primarily attributable to decreased profits realized on the IT Solutions Group contracts and from reduced profits under the Company’s deployable wireless solutions. The reduction in the deployable wireless solutions profits was caused primarily by delays in projected orders while maintaining personnel and infrastructure costs necessary to fulfill such orders. The Company also recognized inventory obsolescence charges of $2.2 million during 2002 consisting 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. Such obsolescence charge was included in cost of goods sold during the month of September 2002. The Company also recognized a provision for bad debt of $470,000 during the year 2002 as an estimate of uncollectible 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 offerings.

 

Selling, general, and administrative expense (“SG&A”) increased by $1.6 million to $18.7 million in 2002 over 2001. SG&A increased as a percentage of revenue from 15.2% in 2001 to 20.6% in 2002. The increase in SG&A was primarily due to employee costs related to certain severance agreements.

 

For the year ended December 31, 2002, the Company recorded $901,000 of losses from affiliates, principally consisting of reserves of $1.5 million on Enterworks notes due to the application of the equity method of accounting, as previously discussed, offset by a $556,000 distribution from TelosOK. For the comparable period in 2001, the Company recorded $1.5 million of losses from affiliates, primarily consisting of reserves of $1.8 million on Enterworks notes, offset by a $284,000 cash distribution received from TelosOK.

 

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).

 

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Interest expense 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.

 

Income before income taxes decreased by $12.1 million to a $10.8 million loss for the year ended December 31, 2002 from a $1.3 million in income for the comparable period in 2001. Such a decrease in income is substantially attributable to the changes referenced above.

 

The Company recorded an income tax benefit 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 carryforwards associated with the losses generated by the Company.

 

Discontinued Operations

 

Telos Corporation-California:

 

The Company reported a gain of $1.0 million, which represents a release of $1.0 million held in escrow, and $12.6 million for the sale of TCC in 2003 and 2002, respectively. An additional $0.8 million is to be released from escrow during 2004, and another $0.8 million during 2007. Additionally, the Company reported a loss from discontinued operations of $1.1 million and $2.2 million in 2002 and 2001, respectively. See Note 4 – Sale of Telos Corporation (California).

 

Liquidity and Capital Resources

 

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

 

Revolving Credit Facility

 

On October 21, 2002, the Company entered into a $22.5 million Senior Credit Facility Agreement (“Facility”) with Wells Fargo Foothill, Inc. (formerly known as Foothill Capital Corporation) that matures on October 21, 2005. Borrowings under the Facility are collateralized by substantially all of the Company’s assets including inventory, equipment and accounts receivable. The amount of available borrowings fluctuates based upon the eligible underlying asset borrowing base, as defined in the Facility agreement. The Facility has various covenants that may, among other things, affect 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 financial covenants, including tangible net worth and operating earnings. Certain financial covenants were amended and restated to more accurately reflect the Company’s future performance based upon revised projections. At December 31, 2003 the Company was in compliance with its covenants pursuant to the Facility. However, due to the 15-day extension to file Form 10-K, the Company has not provided annual financial statements to the bank within the required 90-day period. In addition, it was probable that certain 2004 cash flow covenants would not be achieved. Accordingly, the Company has obtained a waiver for any such covenant violations and the Company and Wells Fargo Foothill have agreed upon modified cash flow covenants through October 21, 2005. The amended negative covenants require the Company to meet cash flow targets based on EBITDA as defined in the Facility. At December 31, 2003, the Company had outstanding borrowings of $6.5 million and unused borrowing availability of $2.0 million on the Facility. As of December 31, 2003, the interest rate on the Facility was 5.75%.

 

Cash used by operating activities was $4.3 million in 2003, due primarily to the operating losses the Company incurred during the year. Cash provided by investing activities was $4.7 million in 2003. This is primarily due to $4.0 million proceeds from the sale of TelosOK LLC in March 2003 and a release of a $1.0 million escrow payment received in October 2003 in connection with the sale of TCC, offset by the purchase of property and equipment. The Company used cash for financing activities in the amount of $654,000 in 2003, primarily due to payments made to reduce capital lease obligations and the Facility.

 

Management believes that the borrowing capacity under its Facility is sufficient to fund its capital and liquidity needs for the foreseeable future.

 

Senior Subordinated Notes

 

The Company’s subordinated notes (“Subordinated Notes”) are held principally by common shareholders and totaled $5.2 million at December 31, 2003. These subordinated notes bear interest at rates between 14% and 17%, due and payable on October 31, 2004. During 2003, the Company paid $757,000 in interest to subordinated note holders. In addition, these notes have a cumulative prepayment premium of 13.5% per annum payable only upon certain circumstances, which if in effect, would be approximately $10.0 million at December 31, 2003. See Note 6 – Debt Obligations.

 

Redeemable Preferred Stock

 

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, 2003 the total carrying amount of redeemable preferred stock, including accumulated and unpaid dividends was $67.2 million. The Company accrues dividends and provides for accretion related to the redeemable preferred stock. During 2003, 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. In accordance with certain requirements in the Facility, on or before August 15, 2004, to the extent the redemption date of the Senior Redeemable Preferred Stock has not been extended to a date later than October 31, 2004, Senior Redeemable Preferred Stockholders have agreed 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 contractually scheduled from 2005 through 2009.

 

Since 1991, the Company has not declared or paid any dividends on its Public Preferred Stock, based upon its interpretation of restrictions in its corporate charter, limitations in the terms of the Public Preferred Stock, specific dividend payment restrictions in the $22.5 million Facility entered into with Wells Fargo Foothill, and other senior obligations and limitations pursuant to Maryland law. Pursuant to their terms, the Company is required to redeem the Public Preferred Stock in five annual tranches during the period 2005 through 2009. Due to its substantial senior obligations, limitations set forth in the covenants in the Facility, foreseeable capital and operational requirements, corporate charter restrictions and prohibitions, and provisions of Maryland law, and assuming sufficient liquidity to undertake any stock redemption (which is presently unquantifiable), the Company believes that the likelihood is that it will not be able to meet the redemption schedule set forth in the terms of the Public Preferred Stock.

 

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The Company has noted in previous filings (see Form 10-Q for the period ending September 30, 2003 – Reclassifications) that its ability to successfully restructure its debt obligations could affect the Company’s future operating results and that for a variety of reasons, the Company believes it will more likely than not be unable to meet the redemption schedule set forth in the terms of the Company’s Public Preferred Stock.

 

On March 26, 2004, the Company’s Board of Directors authorized the Company’s management to commence the process of planning for and, if appropriate, implementing the activities set forth below. Before any definitive action is undertaken in connection with such authorization (including without limitation any issuance, redemption or exchange of any equity securities of the Company), further review and approval by the Board is required.

 

In an effort to address its capital structure and the adverse impact of SFAS150 (Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity), which reclassified the redeemable preferred stock from equity to liability (see Note 7 – Redeemable Preferred Stock), the Company intends to immediately engage such professional service providers it deems reasonable and appropriate to advise management with regard to such recapitalization and any other transaction. The Company contemplates that such engagement will include, but may not be limited to, consideration of a swap of all debt instruments into common shares, the filing of an S-8 or other appropriate filings in order to issue the remaining authorized, but un-issued shares of Public Preferred Stock or to take such other steps as may be recommended to facilitate such recapitalization. The company will use its best efforts to reach a decision on such recapitalization within 60 days. There is no assurance that any such transaction can or will be effected, or if effected what the form of such transactions would be or when they might occur.

 

None of the Company’s present directors has any material financial interest in any holder of the Senior Redeemable Preferred Stock or the Subordinated Notes. Also, other than directors fees received for their service as members of the Board of Directors of the Company or fees for service as members of the Company’s Proxy Board, none of the non-executive directors receive any consulting or advisory fees or other compensation from the Company or any of its subsidiaries. Subject to further review, the full Board will continue to address the Company’s capital structure and any recommendations of the professional service providers pertaining thereto.

 

Aggregate Contractual Obligations and Off-Balance Sheet Arrangements

 

The following summarizes the Company’s contractual obligations at December 31, 2003, both on and off balance sheet, and their anticipated impact upon the Company’s liquidity and cash flow in future periods (in millions):

 

          Payments due by Period

     Total

  

Less than
1 Year


   1 - 3
Years


   3 - 5
Years


   More than
5 Years


Long term debt

   $11,676    $ —      $ 11,676    $ —      $ —  

Capital lease obligations

   20,808      1,777      3,554      3,404      12,073

Operating lease obligations

   2,967      449      933      829      756

Preferred stock redemption (1)

   59,425      —        23,770      23,770      11,885
    
  

  

  

  

Total

   $94,876    $ 2,226    $ 39,933    $ 28,003    $ 24,714
    
  

  

  

  


(1)   excludes dividends and accretion accrual

 

Capital Expenditures

 

Capital expenditures for property and equipment were $335,000 in 2003, $338,000 in 2002 and $626,000 in 2001. The Company anticipates capital expenditures of approximately $1.6 million in 2004; 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, pursuant to FAS 13 “Accounting for Leases”, require the Company to record the present value of the minimum lease payments for such equipment and property as an asset in the Company’s 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 any 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 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. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46 resulting in multiple effective dates in 2003 and 2004 based on the nature as well as the creation date of the variable interest entity. The revised FIN 46 will be effective for non-SPE variable interest entities created prior to February 1, 2003 no later than the first quarter of 2004. For variable interest entities created or acquired after January 31, 2003, the provisions of FIN 46 must be applied. The Company is the process of assessing the impact of this pronouncement for 2004. The adoption of FIN 46 applicable to 2003 did not have a material impact on its financial position or results of operations.

 

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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 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 its partners and suppliers.

 

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 military and peacekeeping actions in Iraq and Afghanistan, 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 continued funding requirements of the U.S. activities in Iraq and Afghanistan. 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 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.

 

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. All of the Company’s propriety solutions 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.

 

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

 

The Company is exposed to interest rate volatility with regard to its variable rate debt obligations under its Senior Credit Facility. Interest on the Facility is charged at 1.25%, subject to certain adjustments, over the bank’s base rate, which was 5.75% upon initial funding. The weighted average interest rate of the Facility in 2003 was 6.66%. The Facility had an outstanding balance of $6.5 million at December 31, 2003.

 

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Item 8. Financial Statements and Supplementary Data

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Report of Independent Auditors

   16

Consolidated Statements of Operations for the Years Ended December 31, 2003, December 31, 2002, and December 31, 2001

   17

Consolidated Balance Sheets as of December 31, 2003 and December 31, 2002

   18-19

Consolidated Statements of Cash Flows for the Years Ended December 31, 2003, December 31, 2002, and December 31, 2001

   20-21

Consolidated Statements of Changes in Stockholders’ Deficit for the Years Ended December 31, 2003, December 31, 2002, and December 31, 2001

   22

Notes to Consolidated Financial Statements

   23-43

 

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 Auditors

 

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’ investment (deficit) present fairly, in all material respects, the financial position of Telos Corporation and its subsidiaries (“the Company”) at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, 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.

 

As discussed in Notes 1 and 7, effective July 1, 2003, the Company adopted Statement of Financial “Accounting Standard No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” Accordingly, the Company changed its method of accounting for its Senior Redeemable Preferred Stock and Public Preferred Stock.

 

/s/ PricewaterhouseCoopers LLP

 

McLean, Virginia

April 14, 2004

 

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TELOS CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(amounts in thousands)

 

     Year Ended December 31,

 
     2003

    2002

    2001

 

Revenue

     88,443       90,517       112,188  

Costs and expenses

                        

Cost of sales

     71,359       79,457       89,258  

Selling, general and administrative expenses

     19,027       18,656       17,019  
    


 


 


       90,386       98,113       106,277  
    


 


 


Operating (loss) income

     (1,943 )     (7,596 )     5,911  

Other income (expenses)

                        

Non-operating income

     14       10       67  

Losses from affiliates

     (848 )     (901 )     (1,516 )

Gain from sale of 50% interest in TelosOK LLC

     10,121       —         —    

Interest expense

     (5,542 )     (2,348 )     (3,195 )
    


 


 


Income (loss) before income taxes

     1,802       (10,835 )     1,267  

(Provision) benefit for income taxes

     (11,487 )     3,361       240  
    


 


 


(Loss) income from continuing operations

     (9,685 )     (7,474 )     1,507  

Discontinued operations: (Note 4)

                        

Loss from discontinued operations (net of tax)

     —         (1,078 )     (2,178 )

Gain on sale of TCC

     1,000       12,577       —    
    


 


 


Net (loss) income

     (8,685 )     4,025       (671 )

Accretion and dividends of redeemable preferred stock

     (3,133 )     (6,109 )     (5,947 )
    


 


 


Net loss attributable to common equity

   $ (11,818 )   $ (2,084 )   $ (6,618 )
    


 


 


 

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

 

     December 31,

 
     2003

    2002

 

Current assets

                

Cash and cash equivalents (includes restricted cash of $54 at December 31, 2003 and 2002)

   $ 64     $ 358  

Accounts receivable, net of reserve of $487 and $381, respectively

     17,232       18,820  

Inventories, net of obsolescence reserve of $546 and $2,291, respectively

     3,967       1,531  

Deferred income taxes

     —         3,477  

Other current assets

     2,068       496  
    


 


Total current assets

     23,331       24,682  
    


 


Property and equipment

                

Furniture and equipment

     7,025       7,053  

Leasehold improvements

     441       412  

Property and equipment under capital leases

     14,377       14,163  
    


 


       21,843       21,628  

Accumulated depreciation and amortization

     (12,475 )     (11,285 )
    


 


       9,368       10,343  
    


 


Deferred income taxes, long term

     —         8,000  

Other assets

     912       1,995  
    


 


Total assets

   $ 33,611     $ 45,020  
    


 


 

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

 

     December 31,

 
     2003

    2002

 

Current liabilities

                

Accounts payable

   $ 8,392     $ 8,021  

Accrued compensation and benefits

     5,520       5,558  

Deferred revenue

     8,296       8,074  

Current portion, capital lease obligations

     457       408  

Other current liabilities

     2,042       1,872  
    


 


Total current liabilities

     24,707       23,933  

Senior credit facility

     6,497       6,618  

Senior subordinated notes

     5,179       5,179  

Capital lease obligations

     10,243       10,647  

Senior redeemable preferred stock (Note 7)

     7,751       —    

Public preferred stock (Note 7)

     59,425       —    
    


 


Total liabilities

     113,802       46,377  
    


 


Senior redeemable preferred stock (Note 7)

     —         7,327  

Public preferred stock (Note 7)

     —         53,561  
    


 


       —         60,888  
    


 


Stockholders’ deficit

                

Class A common stock, no par value, 50,000,000 shares authorized, 21,171,202 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  

Capital in excess of par

     —         6,127  

Accumulated deficit

     (80,269 )     (68,450 )
    


 


Total stockholders’ deficit

     (80,191 )     (62,245 )
    


 


     $ 33,611     $ 45,020  
    


 


 

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)

 

     Year Ended December 31,

 
     2003

    2002

    2001

 

Operating activities:

                        

(Loss) income from continuing operations

   $ (9,685 )   $ (7,474 )   $ 1,507  

Adjustments to reconcile (loss) income from continuing operations to cash provided by (used in) operating activities:

                        

Gain from on sale of 50% interest in TelosOK LLC

     (10,121 )     —         —    

Dividends and accretion of preferred stock as interest expense

     3,155       —         —    

Depreciation and amortization

     1,587       1,784       1,779  

Telos OK LLC note receivable

     —         —         500  

Provision for inventory obsolescence

     664       2,236       514  

Provision for doubtful accounts receivable

     (173 )     470       —    

Deferred income tax provision (benefit)

     11,477       (3,912 )     (571 )

Changes in assets and liabilities

                        

Decrease (increase) in accounts receivable

     1,761       (268 )     17,290  

(Increase) decrease in inventories

     (3,379 )     204       2,082  

(Increase) decrease in other assets

     (489 )     (1,798 )     (206 )

Increase (decrease) in accounts payable and other liabilities

     904       507       (8,728 )
    


 


 


Cash (used in) provided by continuing operating activities

     (4,299 )     (8,251 )     14,167  

Cash used in discontinued operating activities

     —         (1,092 )     (406 )
    


 


 


Net cash (used in) provided by operating activities

     (4,299 )     (9,343 )     13,761  
    


 


 


Investing activities:

                        

Net proceeds from sale of TelosOK LLC

     3,994       —         —    

Net proceeds from sale of TCC

     1,000       18,586       —    

Purchase of property and equipment

     (335 )     (338 )     (626 )
    


 


 


Cash provided by (used in) continuing operations investing activities

     4,659       18,248       (626 )

Cash used in discontinued investing activities

     —         —         (30 )
    


 


 


Net cash provided by (used in) investing activities

     4,659       18,248       (656 )
    


 


 


Financing activities:

                        

Payments of Senior Credit Facility

     (121 )     (5,769 )     (13,073 )

Repayment of Series C Subordinated Note

     —         (3,000 )     (358 )

(Decrease) increase in book overdrafts

     (178 )     501       470  

Payments under capital lease obligations

     (355 )     (394 )     (315 )
    


 


 


Cash (used in) financing activities

     (654 )     (8,662 )     (13,276 )
    


 


 


Increase (decrease) in cash and cash equivalent

     (294 )     243       (171 )

Cash and cash equivalents at beginning of the year

     358       115       286  
    


 


 


Cash and cash equivalents at end of year

   $ 64     $ 358     $ 115  
    


 


 


 

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     Year Ended December 31,

     2003

   2002

   2001

Supplemental disclosures of cash flow information:

                    

Cash paid during the year for:

                    

Interest

   $ 2,413    $ 3,094    $ 4,001
    

  

  

Income taxes

   $ 18    $ 28    $ 522
    

  

  

Supplemental disclosure of non cash investing:

                    

Equipment acquired under capital lease obligations

   $ —      $ 390    $ —  
    

  

  

Non-cash:

                    

Interest on redeemable preferred stock

   $ 3,155    $ —      $ —  
    

  

  

 

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)

 

    

Class A

Common

Stock


  

Class B

Common

Stock


  

Capital

In Excess

of Par


   

Stockholders

Accumulated

Deficit


   

Total

Deficit


 

Balance December 31, 2000

   $ 65    $ 13    $ 5,627     $ (59,748 )   $ (54,043 )
    

  

  


 


 


Senior redeemable preferred stock dividend

     —        —        —         (423 )     (423 )

Public preferred stock dividend

     —        —        —         (3,822 )     (3,822 )

Public preferred stock accretion

     —        —        —         (1,702 )     (1,702 )

Contribution of assets to TelosOK LLC

     —        —        500       —         500  

Net loss for the year

     —        —        —         (671 )     (671 )
    

  

  


 


 


Balance December 31, 2001

   $ 65    $ 13    $ 6,127     $ (66,366 )   $ (60,161 )
    

  

  


 


 


Senior redeemable preferred stock dividend

     —        —        —         (424 )     (424 )

Public preferred stock dividend

     —        —        —         (3,823 )     (3,823 )

Public preferred stock accretion

     —        —        —         (1,862 )     (1,862 )

Net loss for the year

     —        —        —         4,025       4,025  
    

  

  


 


 


Balance December 31, 2002

   $ 65    $ 13    $ 6,127     $ (68,450 )   $ (62,245 )
    

  

  


 


 


Senior redeemable preferred stock dividend

     —        —        —         (211 )     (211 )

Public preferred stock dividend

     —        —        —         (1,912 )     (1,912 )

Public preferred stock accretion

     —        —        —         (1,011 )     (1,011 )

Sale of Telos OK LLC

     —        —        (6,127 )     —         (6,127 )

Net loss for the year

     —        —        —         (8,685 )     (8,685 )
    

  

  


 


 


Balance December 31, 2003

   $ 65    $ 13    $ —       $ (80,269 )   $ (80,191 )
    

  

  


 


 


 

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

 

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TELOS CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Note 1. Summary of Significant Accounting Policies

 

Business and Organization

 

Telos Corporation (the “Company” or “Telos”) is a systems integration and services company addressing the information technology needs of U.S. Government customers worldwide. The Company also owns Xacta Corporation, a wholly-owned subsidiary, that develops, markets and sells U.S. Government-validated secure enterprise solutions to federal, state and local government agencies and to financial institutions.

 

Since 1996, Telos has identified and sold a number of business units that were no longer a part of its strategic plan. These businesses were: Telos Consulting Services, Telos Information Systems, Telos Field Engineering and Telos Corporation (California). In 2003, the Company sold its 50% interest in TelosOK LLC for consideration of $4.0 million. Refer to Note 3—Sale of TelosOK LLC for more information. These business dispositions and ventures have enabled Telos to reduce corporate indebtedness from a high of $56.9 million in 1997 to $11.7 million at December 31, 2003.

 

Principles of Consolidation

 

The accompanying consolidated financial statements include the accounts of Telos Corporation and its wholly owned subsidiaries including Xacta Corporation and Telos Delaware, Inc. (collectively, the “Company”). The accounts of the Company’s investment in Enterworks, Inc. (“Enterworks”) have been deconsolidated as of December 30, 1999, and therefore have been removed from the consolidated balance sheet and statement of changes in stockholders equity. The Company has applied the equity method of accounting for the remaining Enterworks investment. Significant intercompany transactions have been eliminated.

 

Use of Estimates

 

The preparation of financial statements in conformity with generally accepted accounting principles 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 financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions used in the preparation of the Company’s consolidated financial statements include contract percentage-of-completion methodology, allowance for doubtful accounts receivable, allowance for inventory obsolescence, the valuation allowance for deferred tax assets, employee benefits, property and equipment and other non-current assets, including software development costs. Actual results could differ from those estimates.

 

Revenue Recognition

 

The majority of the Company’s sales are made directly or indirectly to the U.S. Government. For time and materials contracts, revenue is recognized 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. Product reselling revenue is generally recognized as products are delivered to customers, although certain revenue recognition practices are dependent upon contract terms. Revenue for maintenance contracts is recognized over the term of the maintenance contracts. Any required loss provisions for contracts are recorded at the time such losses are identified. Revenue generated from software subscription contracts is recognized ratably over the subscription period, generally up to 3 years.

 

Cash and Cash Equivalents

 

The Company considers all highly liquid investments with an original maturity of three months or less at the date of purchase to be cash equivalents. The Company’s cash management program utilizes zero balance accounts. Accordingly, all book overdraft balances have been reclassified to accounts payable.

 

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Inventories

 

Inventories are stated at the lower of cost or market, where cost is determined on the first-in, first-out 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 performed by the Company. Inventories also include spare parts of $788,000 and $685,000 at December 31, 2003 and 2002, respectively, which are utilized to support maintenance contracts. Spare parts inventory is amortized on a straight-line basis over four to 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. The Company’s cost of sales includes charges for inventory obsolescence of $2.2 million during 2002 consisting primarily of a $1.7 million charge taken in September 2002 included in the IT Solutions Group cost of goods sold. This charge was 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 $5.6 million and $5.1 million at December 31, 2003 and 2002, respectively. As of December 31, 2003, it is management’s judgment that the Company is fully reserved 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, 2003

   $ 2,291    $ 664    $ (2,409 )   $ 546

Year Ended December 31, 2002

   $ 884    $ 2,236    $ (829 )   $ 2,291

Year Ended December 31, 2001

   $ 1,777    $ 514    $ (1,407 )   $ 884

 

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

   Life of Lease

 

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 term of the related lease.

 

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 statement of operations. Expenditures for repairs and maintenance are charged to operations as incurred.

 

The Company’s policy on internal use software is in accordance with Statement of Position 98-1 (“SOP 98-1”), “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” 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.

 

Depreciation and amortization expense related to property and equipment, including property and equipment under capital leases, was $1,307,000, $1,526,000 and $1,598,000 for the years ended December 31, 2003, 2002 and 2001, respectively.

 

Goodwill

 

Goodwill arose principally from the acquisition of Telos Corporation (California) (“TCC”) in 1992 and was initially assigned a useful life of twenty years. The useful life considered a number of factors including the Company’s maintenance of long-term significant customer relationships for periods of up to twenty-seven years and its strong positions in the marketplace.

 

Goodwill amortization expense for 2001 has been reported separately under operating income (loss) from discontinued operations due to the sale of TCC. Beginning January 2002 the Company no longer amortized its goodwill asset according to SFAS 142. The Company does not have any goodwill assets recorded on the balance sheet as of December 31, 2003 due to the sale of TCC. See Note 4 - Sale of Telos Corporation (California).

 

    

For the year ended December 31,

(amount in thousands)


 
     2003

    2002

   2001

 

Reported net income (loss)

   $ (8,685 )   $ 4,025    $ (671 )

Add back: Goodwill amortization

     —         —        250  
    


 

  


Adjusted net income (loss)

   $ (8,685 )   $ 4,025    $ (421 )
    


 

  


 

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Other Assets

 

The balance as of December 31, 2003 consists primarily of certain escrow deposits related to the sale of TCC. See Note 4 – Sale of Telos Corporation (California).

 

Income Taxes

 

The Company accounts for income taxes under Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes”. Under this asset and liability method, 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 to the 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. The Company provides a valuation allowance that reduces deferred tax assets when it is “more likely than not” that deferred tax assets will not be realized.

 

Accounting for Stock Based Compensation

 

The Company accounts for stock-based compensation consistent with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under APB 25, compensation cost is measured as the excess, if any, of the fair market value of the Company’s common stock at the date of grant over the exercise price of the option granted. Compensation cost for stock options, if any, is recognized over the vesting period. The Company has provided additional pro forma disclosures as if the fair value measurement provisions of SFAS No. 123 had been used in determining compensation expense (See Note 8).

 

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.

 

There were no options granted from any plan during 2003. There were no options granted in the 1990 or 1993 Stock Option Plan in 2002 or 2001. The weighted-average fair value of options granted under the 1996 Stock Option Plan, the 2000 Telos Delaware Stock Option Plan, and the 2000 Xacta Stock Option Plan was $0.20, $0.41, and $0.08, respectively, in 2002, and $0.30, $0.50, and $0.10, respectively, in 2001. Had the Company recorded compensation cost consistent with SFAS No. 123 methodology, net income (loss) would have been:

 

     December 31,

 
     2003

    2002

    2001

 
     (amounts in thousands)  

Net (loss) income

   $ (8,685 )   $ 4,025     $ (671 )

SFAS 123 compensation expense using fair value method

     (271 )     (724 )     (588 )
    


 


 


Adjusted net (loss) income

   $ (8,956 )   $ 3,301     $ (1,259 )
    


 


 


 

Significant assumptions used in determining the fair value of each option grant at the date of grant were as follows:

 

     1990 Stock Option Plan

    1993 Stock Option Plan

 
     2003

    2002

    2001

    2003

    2002

    2001

 

Expected dividend yield

   0.0 %   0.0 %   0.0 %   0.0 %   0.0 %   0.0 %

Expected stock price volatility

   0.0 %   0.0 %   0.0 %   0.0 %   0.0 %   0.0 %

Risk free interest rate

   —       —       —       —       —       —    

Expected life of options

   —       —       —       —       —       —    

 

     1996 Stock Option Plan

  

2000 Telos Delaware

Stock Option Plan


     2003

   2002

   2001

   2003

   2002

   2001

Expected dividend yield

   0.0%    0.0%    0.0%    0.0%    0.0%    0.0%

Expected stock price volatility

   0.0%    0.0%    0.0%    0.0%    0.0%    0.0%

Risk free interest rate

   —      3.13%    4.96%    —      3.56%    4.70%

Expected life of options

   —      6.6 yrs    6.6 yrs    —      3.1 yrs    3.0 yrs

 

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2000 Xacta

Stock Option Plan


     2003

   2002

   2001

Expected dividend yield

   0.0%    0.0%    0.0%

Expected stock price volatility

   0.0%    0.0%    0.0%

Risk free interest rate

   —      3.53%    4.70%

Expected life of options

   —      3.1 yrs    3.0 yrs

 

Research and Development

 

The Company charges all research and development costs to expense as incurred. For software research and development expenses, such costs are capitalized once technological feasibility is reached. During 2003, 2002 and 2001, the Company incurred approximately $0.9 million, $1.4 million and $1.3 million in research and development salary costs, respectively.

 

Earnings per Share

 

As the Company does not have publicly held common stock or potential common stock, no earnings per share data is reported for any of the years presented.

 

Comprehensive Income

 

Comprehensive income includes changes in equity (net assets) during a period from non-owner sources. The Company has no comprehensive income (loss) components other than its net income (loss).

 

Financial Instruments

 

The Company uses various methods and assumptions to estimate the fair value of its financial instruments. Due to their short-term nature, the carrying value of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses 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. The Company has not estimated the fair value of its subordinated debt or its redeemable preferred stock. The Company does not deem such estimation practicable due to the unique features of these instruments.

 

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.

 

Reclassifications

 

Certain reclassifications have been made to the 2003, 2002 and 2001 financial statements to conform to the current period presentation. Additional material reclassifications had been required in order to conform to the recent accounting pronouncements of FAS 150 (as discussed below and in Note 7 – Redeemable Preferred Stock).

 

Recent Accounting Pronouncements

 

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. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46 resulting in multiple effective dates in 2003 and 2004 based on the nature as well as the creation date of the variable interest entity. The revised FIN 46 will be effective for non-SPE variable interest entities created prior to February 1, 2003 no later than the first quarter of 2004. For variable interest entities created or acquired after January 31, 2003, the provisions of FIN 46 must be applied. The Company is the process of assessing the impact of this pronouncement for 2004. The adoption of FIN 46 applicable to 2003 did not have a material impact on its financial position or results of operations.

 

Preferred Stock

 

In May 2003, the FASB issued SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS 150 requires that certain financial instruments, which under previous guidance were accounted for as equity, must now be accounted for as liabilities. The financial instruments affected include mandatory redeemable stock, certain financial instruments that require or may require the issuer to buy back some of its shares in exchange for cash or other assets and certain obligations that can be settled with shares of stock. SFAS 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. On November 7, 2003, the FASB issued FSP FAS 150-3 which deferred certain areas of FAS 150 including the measurement provisions of mandatory redeemable preferred stock. Accordingly, the Company has continued to accrue dividends on the preferred stock, but was required to reclassify its preferred stock as a liability in accordance with the standard. Also, dividends are now required to be reported as a component of interest expense.

 

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Note 2. Investment in Enterworks

 

As of December 31, 2003, the Company owns 17,153,059 shares of Enterworks, Inc. (“Enterworks”)’s common stock and holds warrants to purchase 4,499,997 underlying common stock shares which equates to a fully diluted ownership percentage of 21.5%. The Company accounts for its investment in Enterworks under the equity method of accounting as prescribed by APB18.

 

The Company also owns notes receivable from Enterworks a lease and totaling $3,260,000. Such notes were received in exchange for rent and professional services performed by the Company pursuant to a lease and an inter-company services agreement. 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 carrying amounts of the notes to zero during 2003 and 2002, as the Company’s share of the Enterworks losses exceeded the carrying value of the notes. All of such notes issued to the Company in 2003 and 2002 include a provision for repayment of four times principal and accrued interest in the event that Enterworks liquidates, enters into dissolution or seeks bankruptcy protection.

 

In December 2003, the Company purchased a 50% interest in Enterworks International, which at the time of the transaction was a wholly-owned subsidiary of Enterworks, for $500,000. Pursuant to the terms of the stock purchase agreement and the stockholder agreement setting forth the transaction, the Company agreed to fund up to 50% of Enterworks International’s 2004 operating costs for an amount not to exceed $300,000 in the year 2004, and 50% of such operating costs thereafter.

 

Separately, in December 2003, the Company entered into a two-year Original Equipment Manufacturer (OEM) software license agreement (“SLA”) with Enterworks, which, pursuant to an earn-out provision is comprised of cumulative license fees and/or Company services to Enterworks equal to at least $2.0 million. The Company provided initial consideration of $1.0 million, comprised of a $100,000 cash payment and Company services in the amount of $900,000, including $300,000 for rent and services from July 2003 to December 2003, and an additional $600,000 for rent and services for 2004. In addition to the above-described exchange, the Company has agreed to pay royalties of $1.0 million over the course of the next two years and, upon payment of cumulative license fees and/or company services to Enterworks equal to at least $2.0 million, will own a worldwide, non-exclusive, perpetual, irrevocable, royalty-free, fully paid-up license for the Enterworks Process Exchange (EPX) software.

 

The Company has capitalized the $100,000 license cash payment to Enterworks as a fixed asset. In accordance with APB18 and EITF 98-13, the Company has accounted for both the investment in Enterworks International and the SLA as losses from affiliates and accordingly written off $1.4 million.

 

Note 3. Sale of TelosOK LLC

 

On March 10, 2003 the Company and other TelosOK LLC investors (“Purchaser”) entered into a unit purchase agreement whereby the Company sold all of its 50% interest in TelosOK LLC for a total cash consideration of $4.0 million. The Company had accounted for its investment in TelosOK LLC under the equity method and, at the time of this transaction, had negative basis for its investment. The parties also agreed to 12 monthly payments to the Company in the amount of $45,000 per month, expiring on March 10, 2004, or a total of $540,000, to recover its fixed infrastructure costs associated with providing certain accounting and support services, and the Company has recorded these payments as other service revenue.

 

In a separate agreement, the Company would continue to provide certain accounting and support services to TelosOK LLC for a period of 12 months, expiring on March 10, 2004, in the additional amount of $45,000 per month, or an additional total of $540,000. These payments have been recorded as other service revenue.

 

As additional consideration for the sale of the membership units, the Company and TelosOK LLC committed to certain “non-compete” and “non-solicitation” agreements between the two parties. The “non-solicitation” commitment provided for a sole exception relating to the employment by TelosOK LLC of the former President, CEO and Director of the Company. At the effective date of closing, all Telos Corporation employees serving as officers of TelosOK LLC resigned said positions in TelosOK LLC.

 

Upon the sale of its interest in TelosOK LLC, the Company recognized a gain of approximately $10.1 million, comprised of $6.1 million of deferred gain and $4.0 million of gain from the proceeds received in March 2003. The deferred gain was recorded in July 2000 as a result of Staff Accounting Bulletin No. 81 which required the gain be deferred until the Company disposed of its interest in TelosOK LLC.

 

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Note 4. Sale of Telos Corporation (California)

 

On July 19, 2002, the Company and L-3 Communications Corporation (“L-3”) entered into a Stock Purchase Agreement whereby the Company sold all of the issued and outstanding shares of its wholly owned subsidiary, Telos Corporation (California) (“TCC”) to L-3 for a purchase price of approximately $20 million which included: 1) approximately $15.3 million to the Company at closing; 2) $2.0 million held in an escrow account, $1.0 million of which was released and paid in October 2003 with the remaining $1.0 million to be paid January 2005. During the 30 month period after July 19, 2002 the escrow amount may be subject to a reduction if any claims for indemnification by L-3 arise that are finally determined in favor of L-3 per the terms and conditions of the mutually agreed upon dispute resolution process; and 3) approximately $2.7 million held back as deposits for liabilities relating to leased properties in which at the time of closing TCC was a lessee or guarantor. Approximately $1 million of such hold-back was released and paid in August 2002 with the remaining $0.8 million scheduled to be released in 2004, and another $0.8 million in 2007. The resulting gain of $10.9 million included the write-off of $2.5 million of goodwill previously recorded for TCC.

 

According to the Stock Purchase Agreement, the purchase price was to be increased or decreased on a dollar for dollar basis by the amount by which the closing date net assets deviated from $2.3 million. The closing date net assets were $4.6 million, an increase of an additional $2.3 million. Such amount was invoiced by the Company and collected in October 2002 from L-3. Accordingly, as a result of the increase in purchase price during the fourth quarter 2002, the Company adjusted the gain by $2.3 million to $13.2 million. The Company recognized a bonus accrual for certain key employees considered critical to the sale in the amount of $560,000 and accordingly the gain was adjusted to $12.6 million. In accordance with the Company’s Senior Credit Facility, proceeds from the sale were used to pay down the Company’s Facility.

 

As additional consideration for the sale of the shares of TCC, the Company and its affiliates committed to certain “Non-Compete” and “Non-Solicitation” provisions relating primarily to the business and employees associated with its TCC/Ft. Monmouth operations.

 

The sale of TCC has been treated as a discontinued operation in accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Pursuant to SFAS 144, the revenue, costs and expenses of TCC have been excluded from their respective captions in the Company’s consolidated statements of operations and the net results of these operations have been reported separately as “Income (loss) from discontinued operations”. Results from discontinued operations are reported net of tax benefit of $761,000 and $756,000 for the years 2002 and 2001, respectively. Also included in the discontinued results from operations is allocated interest expense of $608,000 and $878,000 for the years 2002 and 2001, respectively. Interest has been allocated based on the net assets of the discontinued operation in relation to the Company’s consolidated net assets plus non-specific debt. TCC had revenue of $24.7 million and $58.1million for the years 2002 and 2001, respectively.

 

The assets and liabilities of discontinued operations and the related results of operations have been reclassified for all periods presented.

 

The following summarizes the operating results of discontinued operations (in thousands):

 

     For the Years Ended December 31,

 
     2003

   2002

    2001

 

Sales

   $ —      $ 24,715     $ 58,073  

Loss from discontinued operations

     —        (1,078 )     (2,178 )

Gain on sale of TCC

     1,000      12,577       —    

 

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Note 5. Revenue and Accounts Receivable

 

Revenue resulting from contracts and subcontracts with the U.S. Government, and state and local governments accounted for 95.6%, 95.8% and 96.8% of consolidated revenue in 2003, 2002 and 2001, respectively. Total consolidated revenue derived from the U.S. Government for 2003 includes 78.6% of revenue from contracts with the Department of Defense agencies, and 17.0% or revenue from Federal Civilian Agencies. As the Company’s primary customer base is agencies of the U.S. Government, the Company has a concentration of credit risk associated with its accounts receivable. While the Company acknowledges the potentially material and adverse risk of such a significant concentration of credit risk, the Company’s past experience of collecting substantially all of such receivables provide it with an informed basis that any such risk is manageable. The Company performs ongoing credit evaluations of all of its customers and generally does not require collateral or other guarantee from its customers. The Company maintains allowances for potential losses.

 

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

 

     December 31,

 
     2003

    2002

 

Billed accounts receivable

   $ 13,718     $ 17,552  

Amounts currently billable and other

     4,001       1,649  

Allowance for doubtful accounts

     (487 )     (381 )
    


 


     $ 17,232     $ 18,820  
    


 


 

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

 

     Balance
Beginning
Of Year


  

Bad Debt

Expenses


   Deductions (1)

   

Balance

End of Year


Year ended December 31, 2003

   $ 381    $ 173    $ (67 )   $ 487

Year ended December 31, 2002

   $ 1,221    $ 470    $ (1,310 )   $ 381

Year ended December 31, 2001

   $ 1,810      —      $ (589 )   $ 1,221

(1)   Accounts receivable written-off or reserve reversals

 

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Note 6. Debt Obligations

 

Senior Revolving Credit Facility

 

On October 21, 2002 the Company entered into a $22.5 million Senior Revolving Credit Facility (“Facility”) with Wells Fargo Foothill, Inc. (“Wells Fargo Foothill”) (formerly known as Foothill Capital Corporation) that matures on October 21, 2005. Borrowings under the Facility are collateralized by substantially all of the Company’s assets including inventory, equipment, and accounts receivable. The amount of available borrowings fluctuates based on the underlying asset-borrowing base, as defined in the Facility agreement.

 

The Company paid an origination fee of $225,000 at the date of closing. Unused availability on the Facility was $2.0 million at December 31, 2003; however, such availability fluctuates on a daily basis based on the amount of underlying assets in the borrowing base. Interest on the Facility is charged at 1.25%, subject to certain adjustments, over the bank’s base rate, which was 5.75% per annum upon initial funding. The weighted average interest rate on the outstanding borrowings under the Facility was 6.66% for 2003 compared with 6.89% for 2002.

 

The Facility has various covenants, which among other things, affect 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 financial covenants, including tangible net worth and operating earnings. Certain financial covenants during 2003 were amended and restated to more accurately reflect the Company’s future performance based upon revised projections. At December 31, 2003 the Company was in compliance with its covenants pursuant to the Facility. However, due to a 15 day extension to file Form 10-K, the Company has not provided annual financial statements to the bank within the required 90-day period. In addition, it was probable that certain 2004 cash flow covenants would not be achieved. Accordingly, the Company has obtained a waiver for any such covenant violations and the Company and Wells Fargo Foothill have agreed upon modified cash flow covenants through October 21, 2005. The amended negative covenants require the Company to meet cash flow targets based on EBITDA as defined in the Facility.

 

A separate facility with a different bank was paid in full from the proceeds of the sale of TCC in July 2002 and subsequently terminated prior to the current Facility.

 

Senior Subordinated Notes

 

In 1995, the Company issued Senior Subordinated Notes (“Notes”) to certain shareholders. Such Notes are classified as either Series B or Series C. The Series B Notes are secured by the Company’s property and equipment. The Series C Notes are unsecured. The maturity date of such Notes is October 31, 2004 with interest rates ranging from 14% to 17%, and paid quarterly on January 1, April 1, July 1, and October 1 of each year. The senior subordinated note holders have extended the maturity date of the Notes to a date no earlier than October 31, 2004. The Notes can be prepaid at the Company’s option. The Notes have a cumulative prepayment premium of 13.5% per annum payable only upon certain circumstances, which include, but are not limited to, an initial public offering of the Company’s common stock or a significant refinancing (“qualifying triggering event”), to the extent that net proceeds from either of the above events are received to pay such cumulative prepayment premium. Due to the contingent nature of the cumulative premium payment, any associated premium expense can only be quantified and recorded subsequent to the occurrence of such a qualifying triggering event. At December 31, 2003, if such a qualifying triggering event were to occur, the cumulative prepayment premium would be approximately $10.0 million.

 

The Company retired $3 million of the Series B Notes in October 2002 upon the initial funding of the Facility. In consideration for such requested payment, the note holders waived the prepayment penalty on such Notes, which were due May 2003.

 

The balances of the Series B and C Notes were $2.5 million and $2.7 million, respectively, each at December 31, 2003 and 2002.

 

The following are maturities of obligations presented by year:

 

     Year

   Obligation Due

Senior Subordinated Debt

   2004    5,179,0001

Senior Credit Facility

   2005    6,497,0002

1   Pursuant to Section 17 of a Subordination Agreement entered into in conjunction with the Facility, the senior subordinated note holders and the Company have agreed to extend the maturity date of the Notes, on or before August 15, 2004, to a date no earlier than October 31, 2005.
2   Balance due represents balance as of December 31, 2003, however, the Senior Credit Facility is a revolving credit facility with fluctuating balances based on working capital requirements of the Company.

 

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Note 7. Redeemable Preferred Stock

 

Senior Redeemable Preferred Stock

 

The components of the authorized, issued and outstanding senior redeemable preferred stock (“Senior Redeemable Preferred Stock”) are 1,250 Series A-1 and 1,750 Series A-2 senior redeemable preferred shares, respectively, 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 semi-annually on June 30 and December 31 of each year. 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. The Company is required to redeem all shares and accrued dividends outstanding on October 31, 2004. The Senior Redeemable Preferred Stockholders and the Company have agreed to extend the redemption date, on or before August 15, 2004, to a date no earlier than October 31, 2005. Mandatory redemptions are subject to legal availability of funds and required to be paid from excess cash flows, as defined in the Corporate Charter. The Senior Redeemable Preferred Stock is senior to all other present and future equity of the Company. The Series A-1 is senior to the Series A-2. The Company has not declared dividends on its Senior Redeemable Preferred Stock since its issuance. At December 31, 2003 and 2002 cumulative undeclared, unpaid dividends relating to Series A-1 and A-2 Redeemable Preferred Stock totaled $4,751,000 and $4,327,000 respectively.

 

During 2003, 2002, and 2001 the Company recorded senior redeemable preferred stock dividends of $424,000, $424,000 and $423,000, respectively.

 

12% Cumulative Exchangeable Redeemable Preferred Stock

 

A maximum of 6,000,000 shares of 12% Cumulative Exchangeable Redeemable Preferred Stock (the “Public Preferred Stock”), par value $.01 per share, has been authorized for issuance. The Company 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 the Company makes periodic accretions under the interest method of the excess of the redemption value over the recorded value. Accretion for the years ended December 31, 2003 and 2002 was $2,042,000 and $1,862,000, respectively. The Company 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, the Company retired 410,000 shares of the Public Preferred Stock. The total number of shares issued and outstanding at December 31, 2003 was 3,185,586. The stock trades over the NASDAQ/ OTCBB Exchange.

 

Since 1991, the Company has not declared or paid any dividends on its Public Preferred Stock, based upon its interpretation of restrictions in its corporate charter, limitations in the terms of the Public Preferred Stock, specific dividend payment restrictions in the $22.5 million Facility entered into with Wells Fargo Foothill, and other senior obligations and limitations pursuant to Maryland law. Pursuant to their terms, the Company is required to redeem the Public Preferred Stock in five annual tranches during the period 2005 through 2009. Due to its substantial senior obligations, limitations set forth in the covenants in the Facility, foreseeable capital and operational requirements, corporate charter restrictions and prohibitions, and provisions of Maryland law, and assuming sufficient liquidity to undertake any stock redemption (which is presently unquantifiable), the Company believes that the likelihood is that it will not be able to meet the redemption schedule set forth in the terms of the Public Preferred Stock.

 

On any dividend payment date after November 21, 1991, the Company may exchange the Public Preferred Stock, in whole or in part, for 12% Junior Subordinated Debentures that are redeemable upon terms substantially similar to the Public Preferred Stock and subordinated to all indebtedness for borrowed money and like obligations of the Company.

 

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 Preferred Stock were paid at the rate of 6% of a share for each $.60 of such dividends not paid in cash. Any such dividends payable by the Company, when and if declared by the Board of Directors, commencing June 1, 1990, and on each six month anniversary thereafter were paid out of legally available funds in accordance with Maryland law. For the years 1992 through 1994 and for the dividend payable June 1, 1995, the Company has accrued undeclared dividends in additional shares of Public Preferred Stock. Such accrued dividends were valued at $3,950,000. Had the Company accrued such dividends on a cash basis, the total amount accrued would have been $15,101,000. For the cash dividends payable since December 1, 1995, the Company has accrued $33,968,000 as of December 31, 2003. During 2003, 2002 and 2001 the Company recorded preferred stock dividends of $3.8 million each year.

 

In accordance with SFAS 150, both the Senior Redeemable Preferred Stock and the Public Preferred Stock have been reclassified from equity to liability. Consequently, the preferred dividend accrued from July 1, 2003 to December 31, 2003 in the amount of $3.1 million was recorded as interest expense. The aggregate fair value of the public preferred stock at December 31, 2003 was $4.7 million.

 

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Note 8. Stockholders’ Equity, Warrants, Option Plan, 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 prior rights of the Public Preferred Stock and any series of the Senior Preferred Stock, holders of Class A and the Class B common stock are entitled to receive such dividends as may be declared.

 

Stock Warrants

 

In 1994, Toxford Corporation contributed $3 million to the Company to increase the borrowing capacity under the Company’s prior Facility. In exchange, Toxford Corporation was issued 500,000 shares of Class A common stock for which the Company recorded additional interest expense of $410,000. The Company also granted Toxford Corporation warrants to acquire 7,228,916 shares of the Company’s Class A common stock at a purchase price of $.83 per share which approximated the estimated market value of the Company’s common stock at the issuance date. In November 1998, 840,000 of these warrants were transferred to certain other shareholders of the Company. The warrant is fully exercisable and has a term of ten years from the date of issue.

 

Stock Options

 

The Company has granted stock options to certain employees of the Company 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 of the Company approved two new 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.

 

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

 

1990 Stock Option Plan

 

Under the terms of the 1990 Stock Option Plan, 2,168,215 shares of the Company’s Class A common stock are available for issuance under options to key employees, including officers and directors. The options have a life of 10 years from the date of grant. The option price determined by the Board of Directors was not less than the fair market value at the date of the grant and the options generally vest over a four-year period. Additional information as to these options is as follows:

 

     Stock Option Activity

    

Number of Shares

(000’s)


    Weighted Average
Exercise Price


Outstanding at December 31, 2000

   2,022     $ 1.23

Granted

   —         —  

Exercised

   —         —  

Canceled

   (377 )     1.19
    

 

Outstanding at December 31, 2001

   1,645     $ 1.24
    

 

Granted

   —         —  

Exercised

   —         —  

Canceled

   (221 )     1.22
    

 

Outstanding at December 31, 2002

   1,424     $ 1.25
    

 

Granted

   —         —  

Exercised

   —         —  

Canceled

   (427 )     1.29
    

 

Outstanding at December 31, 2003

   997     $ 1.22
    

 

 

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1993 Option Plan

 

In 1993, stock option plan agreements were reached to provide Mr. John Wood, Executive Chairman, and Mr. Joseph Beninati, former Chairman, with options to each purchase up to 700,459 shares of the Company’s Class A common stock from the Company at $0.50 per share. Under the terms of the agreements, 350,230 shares vested immediately and the remainder vested ratably over the next twelve months. The Company recorded compensation expense related to these options based upon the difference between the exercise price and the estimated fair value of $0.82 per share at the measurement date of the stock option. Mr. Beninati’s agreement was canceled in 1996 and the shares now available will be administered under the same terms as the 1996 Stock Option Plan. These options have a life of 10 years from the date of grant. Additional information as to these options follows:

 

     Stock Option Activity

    

Number of Shares

(000’s)


   

Weighted Average

Exercise Price


Outstanding at December 31, 2000

   1,083     $ 0.68

Granted

   —         —  

Exercised

   —         —  

Canceled

   (60 )     1.01
    

 

Outstanding at December 31, 2001

   1,023     $ 0.66
    

 

Granted

   —         —  

Exercised

   —         —  

Canceled

   (8 )     1.01
    

 

Outstanding at December 31, 2002

   1,015     $ 0.66
    

 

Granted

   —         —  

Exercised

   —         —  

Canceled

   (1,000 )(1)     .65
    

 

Outstanding at December 31, 2003

   15     $ 1.01
    

 


(1)   Mr. Wood’s 700,459 options granted in October 1993 have expired in October 2003.

 

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1996 Stock Option Plan

 

The 1996 Stock Option Plan allows for the award of up to 6,644,974 shares of Class A common stock at an exercise price of not lower than fair market value at the date of grant. Vesting of the stock options for key employees is based both upon the passage of time and certain key events occurring including an initial public offering or a change in control. Vesting for options granted to employees is based upon the passage of time, generally four years. The stock options may be exercised over a ten-year period subject to the vesting requirements. Additional information as to these options follows:

 

     Stock Option Activity

    

Number of Shares

(000’s)


   

Weighted Average

Exercise Price


Outstanding at December 31, 2000

   5,186     $ 1.02

Granted

   150       1.07

Exercised

   —         —  

Canceled

   (611 )     1.13
    

 

Outstanding at December 31, 2001

   4,725     $ 1.02
    

 

Granted

   50       1.07

Exercised

   —         —  

Canceled

   (245 )     1.13
    

 

Outstanding at December 31, 2002

   4,530     $ 1.01
    

 

Granted

   —         —  

Exercised

   —         —  

Canceled

   (179 )     1.07
    

 

Outstanding at December 31, 2003

   4,351     $ 1.01
    

 

 

In 1996, Mr. Wood was granted 700,459 shares that were exercisable only to the extent that certain options in the 1993 Plan were not exercised.

 

Telos Delaware Stock Incentive Plan

 

During the third quarter of 2000, the Board of Directors of the Company approved a new stock option plan for Telos Delaware, Inc., a wholly owned subsidiary of the Company. Certain key executives and employees of the Company are eligible to receive stock options under the plan. Under the plan, the Company 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 market value on the date of grant. A non-qualified option will not have an exercise price any lower than 85% of the fair market value on the date of grant. All options have a term of ten years and vest no less rapidly than the rate of 20% per year for each of the first five years unless changed by the option committee of the Board of Directors. Additional information as to these options follows:

 

     Stock Option Activity

    

Number of Shares

(000’s)


   

Weighted Average

Exercise Price


Outstanding at December 31, 2000

   1,738     $ 3.85

Granted

   811       3.85

Exercised

   —         —  

Canceled

   (360 )     3.85
    

 

Outstanding at December 31, 2001

   2,189     $ 3.85
    

 

Granted

   108       3.85

Exercised

   —         —  

Canceled

   (518 )     3.85
    

 

Outstanding at December 31, 2002

   1,779     $ 3.85
    

 

Granted

   —         —  

Exercised

   —         —  

Canceled

   (497 )     3.85
    

 

Outstanding at December 31, 2003

   1,282     $ 3.85
    

 

 

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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, have a term of ten years, and vest no less rapidly than the rate of 20% per year for each of the first five years unless changed by the option committee of the Board of Directors. The exercise price may not be less than the fair market value on the date of grant for an incentive option, or less than 85% of the fair market value on the date of grant for a non-qualified stock option. Additional information as to these options follows:

 

     Stock Option Activity

    

Number of Shares

(000’s)


   

Weighted Average

Exercise Price


Outstanding at December 31, 2000

   1,208     $ 0.75

Granted

   930       0.75

Exercised

   —         —  

Canceled

   (291 )     0.75
    

 

Outstanding at December 31, 2001

   1,847     $ 0.75
    

 

Granted

   97       0.75

Exercised

   —         —  

Canceled

   (280 )     0.75
    

 

Outstanding at December 31, 2002

   1,664     $ 0.75
    

 

Granted

   —         —  

Exercised

   —         —  

Canceled

   (598 )     0.75
    

 

Outstanding at December 31, 2003

   1,066     $ 0.75
    

 

 

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The following table summarizes information about stock options outstanding and exercisable at December 31, 2003:

 

          Options Outstanding

   Options Exercisable

    

Range of

Exercise Prices


  

Average

Number

Outstanding

(000’s)


  

Weighted

Remaining

Contractual

Life in Years


  

Weighted

Average

Exercise
Price


  

Number

Exercisable

(000’s)


  

Weighted

Average

Exercise

Price


1990 Stock Option

   $ 1.07    483    4.4 years    $ 1.07    483    $ 1.07
     $ 1.35    189    5.7 years    $ 1.35    189    $ 1.35
     $ 1.37    322    6.8 years    $ 1.37    316    $ 1.37
     $ 1.40    3    4.6 years    $ 1.40    3    $ 1.40
    

  
  
  

  
  

     $ 1.07 -$1.40    997    5.4 years    $ 1.22    991    $ 1.22
    

  
  
  

  
  

1993 Stock Options

   $ 1.01    15    3.1 years    $ 1.01    15    $ 1.01
    

  
  
  

  
  

     $ 1.01    15    3.1 years    $ 1.01    15    $ 1.01
    

  
  
  

  
  

1996 Stock Option Plan

   $ 0.95    3,001    2.4 years    $ 0.95    1,939    $ 0.95
     $ 0.97    41    2.6 years    $ 0.97    41    $ 0.97
     $ 1.00    40    8.8 years    $ 1.00    12    $ 1.00
     $ 1.01    413    3.2 years    $ 1.01    329    $ 1.01
     $ 1.07    571    5.9 years    $ 1.07    413    $ 1.07
     $ 1.35    215    5.9 years    $ 1.35    202    $ 1.35
     $ 1.40    70    4.7 years    $ 1.40    70    $ 1.40
    

  
  
  

  
  

     $ 0.95 -$1.40    4,351    2.7 years    $ 1.00    3,006    $ 1.00
    

  
  
  

  
  

2000 Telos Delaware Option Plan

   $ 3.85    1,282    6.5 years    $ 3.85    958    $ 3.85
    

  
  
  

  
  

2000 Xacta Option Plan

   $ 0.75    1,066    6.5 years    $ 0.75    757    $ 0.75
    

  
  
  

  
  

 

Telos Shared Savings Plan

 

The Company sponsors a defined contribution employee savings plan (the “Plan”) under which substantially all full-time employees are eligible to participate. The Company has 3,658,536 shares of Telos Class A common stock in the plan representing 17% of the class. Since no public market exists for Telos Class A common stock, the Trustees of the plan engage annually an outside investment firm to evaluate the stock. The Plan’s trustees price the stock at the exact midpoint of the range defined by the outside investment firm. The Company matches one-half of voluntary participant contributions to the Plan up to a maximum Company contribution of 3% of a participant’s salary. Total Company contributions to this Plan for 2003, 2002, and 2001 were $516,000, $654,000 and $707,000 respectively.

 

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Note 9. Income Taxes

 

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

 

     For the Years Ended
December 31,


 
     2003

   2002

    2001

 

Current provision (benefit)

                       

Federal

   $ —      $ (257 )   $ 162  

State

     10      7       28  
    

  


 


Total current

     10      (250 )     190  
    

  


 


Deferred provision (benefit)

                       

Federal

     11,091      (3,396 )     (366 )

State

     386      285       (64 )
    

  


 


Total deferred

     11,477      (3,111 )     (430 )
    

  


 


Total provision (benefit)

   $ 11,487    $ (3,361 )   $ (240 )
    

  


 


 

The provision (benefit) for income taxes related to continuing operations varies from the amount determined by applying the federal income tax statutory rate to the income or loss before income taxes. The reconciliation of these differences is as follows:

 

     For the Years Ended
December 31,


 
     2003

    2002

    2001

 

Computed expected income tax provision (benefit)

   34.0 %   (34.0 )%   34.0 %

State income taxes, net of federal income tax benefit

   14.0     0.4     (42.8 )

Change in valuation allowance for deferred tax assets

   529.3     1.4     (15.0 )

Meals and entertainment

   2.6     0.5     4.8  

Dividend and accretion on preferred stock

   59.5     —       —    

Other

   (2.0 )   0.7     0.1 %
    

 

 

     637.4 %   (31.0 )%   (18.9 )%
    

 

 

 

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The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2003 and 2002 are as follows (in thousands):

 

     December 31,

 
     2003

    2002

 

Deferred tax assets:

                

Accounts receivable, principally due to allowance for doubtful accounts

   $ 185     $ 155  

Allowance for inventory obsolescence and amortization

     293       892  

Accrued liabilities not currently deductible

     3,059       2,746  

Accrued compensation

     1,578       917  

Property and equipment, principally due to differences in depreciation methods

     736       805  

Basis difference in TelosOK LLC interest

     —         2,504  

Net operating loss carryforwards

     3,753       3,609  

Alternative minimum tax credit carry forward

     386       386  
    


 


Total gross deferred tax assets

     9,990       12,014  

Less valuation allowance

     (9,730 )     (193 )
    


 


Net deferred tax assets

     260       11,821  
    


 


Deferred tax liabilities:

                

Unbilled accounts receivable, deferred for tax purposes

     (260 )     (344 )
    


 


Total deferred tax liabilities

     (260 )     (344 )
    


 


Net deferred tax assets

   $ —       $ 11,477  
    


 


 

The components of the valuation allowance are as follows (in thousands):

 

    

Balance at

Beginning

of Period


  

Additions

Charged to

Expenses


   Deductions

   

Balance At

End of

Period


December 31, 2003

   $ 193    $ 9,537    $ —       $ 9,730

December 31, 2002

   $ 44    $ 149    $ —       $ 193

December 31, 2001

   $ 234    $ —      $ (190 )   $ 44

 

In accordance with FAS 109, a full valuation allowance has been provided at December 31, 2003, due principally to the evidence that it is more likely than not that the deferred tax assets will be realized in the future.

 

At December 31, 2003, for federal income tax purposes there were approximately $9,863,000 net operating loss carryforwards to offset future regular taxable income. These net operating loss carryforwards expire in 2023. Additionally, approximately $7,753,000 of alternative minimum tax net operating loss carryforwards is available to offset future alternative minimum taxable income. These alternative minimum tax net operating loss carryforwards also expire in 2023. In addition, the Company has $386,000 of alternative minimum tax credits available to be carried forward indefinitely to reduce future regular tax liabilities.

 

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Note 10. Commitments and Contingencies

 

Leases

 

The Company leases office space and equipment under non-cancelable operating and capital leases with various expiration dates, some of which contain renewal options.

 

On March 1, 1996, the Company entered into a twenty-year capital lease for a building in Ashburn, Virginia, that serves as its corporate headquarters. The Company has accounted for this transaction as a capital lease and has accordingly recorded assets and a corresponding liability of approximately $12.3 million. Under the terms of the lease, the landlord furnished the Company with $1.3 million to fund tenant improvements and other building costs.

 

The following is a schedule by years of future minimum payments under capital leases together with the present value of the net minimum lease payments as of December 31, 2003 (in thousands):

 

     Property

    Equipment

    Total

 

2004

     1,666       111       1,777  

2005

     1,666       111       1,777  

2006

     1,666       111       1,777  

2007

     1,666       72       1,738  

2008

     1,666       —         1,666  

Remainder

     12,073       —         12,073  
    


 


 


Total minimum obligations

     20,403       405       20,808  

Less amounts representing interest

     (10,017 )     (91 )     (10,108 )
    


 


 


Net present value of minimum obligations

     10,386       314       10,700  

Less current portion

     (381 )     (76 )     (457 )
    


 


 


Long-term capital lease obligations at December 31, 2003

   $ 10,005     $ 238     $ 10,243  
    


 


 


 

Accumulated amortization for property and equipment under capital leases at December 31, 2003 and 2002 is $5.0 million and $4.3 million respectively. Future minimum lease payments for all non-cancelable operating leases at December 31, 2003 are as follows (in thousands):

 

2004

   $ 449

2005

     458

2006

     475

2007

     423

2008

     406

Remainder

     756
    

Total minimum lease payments

   $ 2,967
    

 

Net rent expense charged to operations for 2003, 2002 and 2001, totaled $516,000, $492,000, and $613,000, respectively.

 

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Legal

 

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 known matters will not, based upon all available information, have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.

 

Warranties

 

The Company provides product warranties for products sold through certain U.S. Government contract vehicles and is reported as deferred revenues on the Company’s Consolidated Balance Sheet. Warranties are valued using historical warranty usage trends and recorded as a liability on the Company’s books when items are sold and amortized over the contractual warranty period, currently three or five years depending on the contract.

 

    

Balance,

Beginning

Of Year


   Accruals

  

Warranty

Expenses


   

Balance,

End of

Year


Year Ended December 31, 2003

   $ 1,985    $ 1,211    $ (1,078 )   $ 2,118

Year Ended December 31, 2002

   $ 2,519    $ 863    $ (1,397 )   $ 1,985

Year Ended December 31, 2001

   $ 3,609    $ 1,715    $ (2,805 )   $ 2,519

 

Note 11. Certain Relationships and Related Transactions

 

Information concerning certain relationships and related transactions between the Company and certain of its current and former officers and directors is set forth below.

 

Mr. John R. C. Porter, the owner of a majority of the Company’s Class A Common Stock, has a consulting agreement with the Company whereby he is compensated for consulting services provided to the Company in the areas of marketing, product development, strategic planning and finance as requested by the Company. Mr. Porter was paid $260,000 by the Company in 2003, 2002, and 2001 pursuant to this agreement, which amounts were determined by negotiation between the Company and Mr. John R.C. Porter.

 

Mr. David S. Aldrich, former President and Chief Executive Officer of the Company, entered into an agreement with the Company whereby Mr. Aldrich will serve as an advisor to the Company from December 31, 2002 through March 31, 2005. In return, Mr. Aldrich will be paid $350,000 per annum from January 1, 2003 through March 31, 2005. The Company will also continue to provide Mr. Aldrich with medical and insurance benefits during that same period.

 

Mr. Gerald Calhoun, former Vice President of Human Resources and Corporate Secretary, entered into a settlement agreement with the Company to resolve a dispute over Mr. Calhoun’s employment contract with the Company. The Company paid Mr. Calhoun 24 months of severance in installments from 2000 until April 19, 2002. Mr. Calhoun also received medical and insurance benefits through the Company for the same two-year period. Mr. Calhoun’s payment of salary and fringe benefits amounted to approximately $189,000 per annum.

 

Mr. William L.P. Brownley, former Vice President and General Counsel of the Company, entered into an agreement with the Company whereby Mr. Brownley served as an of counsel attorney to the Company from December 31, 2000 through March 31, 2003. In return, Mr. Brownley was paid $220,000 per annum from January 1, 2001 through March 31, 2003. The Company provided Mr. Brownley with medical and insurance benefits during that same period.

 

Mr. Lorenzo Tellez, former Vice President, Treasurer, and Chief Financial Officer of the Company, entered into a settlement agreement with the Company to resolve a dispute on Mr. Tellez’s employment contract with the Company. The Company paid Mr. Tellez the equivalent of 24 months of severance in installments during 2001. Mr. Tellez also received medical and insurance benefits through the Company for the same two-year period. Mr. Tellez’s payment of salary and fringe benefits amounted to approximately $243,000 per annum. The Company completed its payments of the salary portion of the contract to Mr. Tellez on December 7, 2001. In March 2003, pursuant to the final settlement of arbitration proceedings, the Company paid Mr. Tellez a bonus of $96,000 and legal fees in the amount of $53,000.

 

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Note 12. Reportable Business Segments

 

At December 31, 2003, the Company’s operations are comprised of two operating segments, the IT Solutions Group and Xacta. The segment information below has been reclassified to conform with management’s new internal operating structure. Principally, the Company has included the results of its wireless and messaging solutions product line in the Xacta Segment, which was previously included as part of the Products Group Segment. Prior to December 2003, the Company had two operating segments: the Products Group and the Xacta Group.

 

The IT Solutions Group: markets and sells integration services and value-added reseller solutions that address a wide range Government Information Technology (IT) requirements. Telos solutions consist of reselling commercial-off-the-shelf (“COTS”) products from major original equipment manufacturers (“OEMs”), which are augmented with various value added support service. Telos also provides professional services that support various U.S. Government integration programs. For example, Telos currently has a significant VAR partnership with Hewlett Packard (HP) Public Sector for the purpose of reselling HP-centric solutions, principally to the Department of Defense.

 

For 2003, the IT Solutions Group generated revenue of $41.7million, which represents 47.2% of the Company’s total consolidated revenue. Customers of Telos are primarily agencies of the U.S. Government including the military services, various other Defense Agencies, U.S. Courts, and various other civilian agencies of the U.S. Government.

 

Xacta: markets and sells Government-validated enterprise security solutions to the U.S. Government and financial institutions. Xacta, a wholly-owned subsidiary of Telos, was established in February 2000 to address the growing demand for information security solutions. Over the last few years, Xacta brand name within the U.S. Government and the financial services vertical is one which connotes to its customers that its solutions are secure. In order to capitalize on Xacta’s brand strength, Telos has consolidated its security-oriented solutions which was previously included in the Products Group into Xacta. As a result, the Company’s Deployable Wireless and Organizational Messaging solutions have moved into Xacta, and it is the Company’s intention to market and sell these as Xacta solutions. This change also serves to simplify the respective messages of Telos and Xacta for our customers and our employees. Moving forward, all security-related offerings will be marketed and sold as Xacta solutions.

 

The accounting policies of the reportable segments are the same as those described in Note 1 – Summary of Significant Accounting Policies. The Company evaluates the performance of its operating segments based on revenue, gross profit, segment profit (loss) before income taxes and other income or expenses.

 

Summarized financial information concerning the Company’s reportable segments is shown in the following table. The “other” column includes corporate related items.

 

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     IT Solutions
and Other
Services


    Xacta

    Other (1)

   Total

 

2003

                               

External revenues

   $ 41,722     $ 46,721            $ 88,443  

Gross margin

     954       16,130              17,084  

Segment (loss) income (3)

     (3,414 )     1,471              (1,943 )

Total assets

     10,121       12,431       11,059      33,611  

Capital expenditures

     32       89       114      235  

Depreciation & amortization (2)

     329       254       1,004      1,587  

2002

                               

External revenues

   $ 52,090     $ 38,427     $ —      $ 90,517  

Gross margin

     (272 )     11,332       —        11,060  

Segment loss (3)

     (5,053 )     (2,543 )     —        (7,596 )

Total assets

     2,998       17,887       24,135      45,020  

Capital expenditures

     12       157       169      338  

Depreciation & amortization (2)

     328       344       1,112      1,784  

2001

                               

External revenues

   $ 67,538     $ 44,650     $ —      $ 112,188  

Gross margin

     7,359       15,571       —        22,930  

Segment income (3)

     2,894       3,017       —        5,911  

Total assets

     14,567       9,417       18,779      42,763  

Capital expenditures

     55       250       321      626  

Depreciation & amortization (2)

     315       317       1,147      1,779  

(1)   Corporate assets are principally property and equipment, cash and other assets.
(2)   Depreciation and amortization includes amounts relating to property and equipment, capital leases and spare parts inventory.
(3)   Segment profit (loss) represents operating income (loss) before goodwill amortization.

 

The Company does not have material international revenues, profit (loss), assets or capital expenditures. The Company’s business is not concentrated in a specific geographical area within the United States, as it has 5 separate facilities located in various states, the District of Columbia and Europe.

 

Revenue by Major Market and Significant Customers

 

The Company derived substantially all of its revenues from contracts and subcontracts with the U.S. Government. Revenue by customer sector for the last three years is as follows:

 

     2003

    2002

    2001

 
     (amount in thousands)  

Department of Defense

   $ 69,503    78.6 %   $ 58,960    65.2 %   $ 77,036    68.7 %

Federal Civilian

     15,055    17.0 %     27,728    30.6 %     31,519    28.1 %

Commercial

     3,885    4.4 %     3,829    4.2 %     3,633    3.2 %
    

  

 

  

 

  

Total

   $ 88,443    100.0 %   $ 90,517    100.0 %   $ 112,188    100.0 %
    

  

 

  

 

  

 

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Note 13. Summary of Selected Quarterly Financial Data (Unaudited)

 

The following is a summary of selected quarterly financial data for the previous two years (in thousands). Certain reclassifications have been made to prior quarter financial data to conform to the presentation used in the December 31, 2003 consolidated financial statements.

 

     Quarters Ended

 
     March 31

    June 30

    Sept. 30

    Dec. 31

 

2003

                                

Sales

   $ 16,823     $ 15,412     $ 30,329     $ 25,879  

Gross profit

     3,072       2,680       6,365       4,967  

Income (loss) from continuing operations

     5,300       (865 )     (1,011 )     (13,109 )

Loss from discontinued operations

     —         —         —         —    

Gain on sale of TCC

     —         —         —         1,000  

Net income (loss)

     5,300       (865 )     (1,011 )     (12,109 )

2002

                                

Sales

   $ 18,984     $ 19,562     $ 25,293     $ 26,678  

Gross profit

     2,024       3,151       1,452       4,433  

Loss from continuing operations

     (1,194 )     (1,591 )     (2,011 )     (2,678 )

Loss from discontinued operations

     (373 )     (378 )     (105 )     (222 )

Gain on sale of TCC

     —         —         10,879       1,698  

Net (loss) income

     (1,567 )     (1,969 )     8,763       (1,202 )

 

Note 14. Recent Significant Company Filing

 

On April 9, 2004, the Company filed a Form 8-K report, which, due to its recent nature, is included herein in its entirety as follows:

 

Item 5, Other Events

 

The Board of Directors (the “Board”) of Telos Corporation (“Telos” or “the Company”) has authorized management of the Company to commence the process of planning for and, if appropriate, implementing the activities set forth below. Before any definitive action is undertaken in connection with such authorization (including without limitation any issuance, redemption or exchange of any equity securities of the Company), further review and approval by the Board is required.

 

The Company has noted in previous filings [see Form 10-Q for the period ending September 30, 2003 – “Reclassifications”] that its ability to successfully restructure its debt obligations could affect the Company’s future operating results and that for a variety of reasons, the Company believes it will more likely than not be unable to meet the redemption schedule set forth in the terms of the Company’s 12% Cumulative Exchangeable Redeemable Preferred Stock (“Public Preferred Stock”).

 

In an effort to address its capital structure and the adverse impact of FAS150 (“Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”), the Company intends to immediately engage such professional service providers it deems reasonable and appropriate to advise with regard to such recapitalization. The Company contemplates that such engagement will include, but may not be limited to, consideration of a swap of all debt instruments into common shares, the filing of an S-8 or other appropriate filings in order to issue the remaining authorized, but un-issued shares of Public Preferred Stock or to take such other steps as may be recommended to facilitate such recapitalization. The Company will use its best efforts to reach a decision on such recapitalization within 60 days. There is no assurance that any such transaction can or will be effected, or if effected what the form of such transactions would be or when they might occur.

 

None of the Company’s present directors has any material financial interest in any holder of the Senior Redeemable Preferred Stock or the Senior Subordinated Notes. Also, other than directors fees received for their service as members of the Board of Directors of the Company or fees for service as members of the Company’s Proxy Board, none of the non-executive directors receive any consulting or advisory fees or other compensation from the Company or any of its subsidiaries. Subject to further review, the full Board will continue to address the Company’s capital structure and any recommendations of the professional service providers pertaining thereto.

 

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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

None

 

Item 9A. Control and Procedures

 

The Company’s chief executive officer and chief financial officer have evaluated the Company’s disclosure controls and procedures (as defined in Rule 13a-14(c) and Rule 15d-14(c) under the Exchange Act), within 90 days prior to the filing of this annual report, and concluded that those disclosure controls and procedures are effective in timely alerting them to material changes in information required to be included in the Company’s periodic Securities and Exchange Commission filings.

 

Since such evaluation, such officers are unaware of any significant subsequent changes in the Company’s internal controls or in other factors that could significantly affect internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

The Company intends to continue its diligent review and evaluation of the design and effectiveness of the controls with the intention of making continuous improvements to such controls, and to correct in a timely manner any significant deficiencies and material weaknesses that may be discovered. The Company’s goal is to provide senior management with detailed information and timely access to all material information concerning the business. While the Company believes the present design of its disclosure controls and procedures effectively achieve its objectives, future unforeseen events may cause the Company to significantly modify such disclosure controls and procedures.

 

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PART III

 

Item 10. Directors and Executive Officers of the Registrant

 

Directors and Executive Officers

 

The following is certain biographical information concerning the directors and executive officers of the Company. The term of each of the directors to be elected at the Annual Meeting continues until the next annual meeting of shareholders and until his successor is elected and qualified, except that the directorships held by the Class D Directors will terminate whenever all accumulated dividends on the Public Preferred Stock have been paid.

 

John B. Wood, President, Chief Executive Officer, Chairman of the Board and Director

 

Mr. Wood (age 40) joined Telos Corporation in 1992 as Executive Vice President and Chief Operating Officer and in 1994 was named President and Chief Executive Officer. In March 2000 he was appointed to the newly created position of Executive Chairman of the Board which he held until he became Chairman of the Board subsequent to a restructuring of the Board of Directors in 2002. In January of 2003, Mr. Wood resumed the positions of President and Chief Executive Officer. Mr. Wood has also served as Chairman and CEO of Enterworks since January 1996. Prior to joining Telos Corporation, Mr. Wood worked on Wall Street for Dean Witter Reynolds, UBS Securities, and his own boutique investment bank. Mr. Wood graduated from Georgetown University where he earned a Bachelor of Science in Business Administration in finance and computer science. Mr. Wood also serves on two private company boards and two foundation boards.

 

David Borland, Director

 

Mr. Borland (age 56) was elected to the Board of Directors on March 26, 2004 after retiring as Deputy CIO of the U.S. Army with more than 30 years of experience in the Federal government. Mr. Borland’s career Army experience also includes serving as Vice Director of Information Systems for Command, Control, Communications, and Computers (DISC4); Director of the Information Systems Selection and Acquisition Agency (ISSAA); and numerous other positions. From 1966 through 1970, Mr. Borland served in the U.S. Air Force. Mr. Borland has received numerous awards, including the Meritorious Presidential Rank Award for Senior Executive Service Members (1996) and the Distinguished Presidential Rank Award (2000). He has been named Federal Computer Week Fed 100 four times and Government Computer News Department of Defense Executive of the Year in November 2000.

 

Norman P. Byers, Director

 

Mr. Byers (age 57) was elected to the Board of Directors on January 31, 1994. He is Vice President and General Manager of Foxhunt Incorporated, a provider of contract and long-term technical staffing and executive recruiting services in McLean, Virginia. Previously, Mr. Byers was President and CEO of Virginia-based Classwise, Incorporated, a distance learning ISP. Prior to his work at Classwise, Mr. Byers was COO of The Carpe Diem Group, President of Telos International Corporation, and managing partner of International Strategies Limited. From 1968 until his retirement in 1989, Mr. Byers served in a variety of operational and staff positions in the United States Air Force.

 

Dr. Fred Charles Iklé, Director

 

Dr. Iklé (age 79) was elected to the Company’s Board of Directors on January 31, 1994 and Chairman of the Board in January 1995. He resigned from his position as Chairman of the Board on March 26, 2002. He is Chairman of Conservation Management Corporation and a member of the Defense Policy Board of the Secretary of Defense. Dr. Iklé is on the Board of Governors of the Smith Richardson Foundation and is a Distinguished Scholar at the Center for Strategic & International Studies. From 1981 to 1988, Dr. Iklé served as Under Secretary of Defense for Policy.

 

Ambassador Longhorne (Tony) A. Motley, Director

 

Ambassador L. Anthony Motley (age 66) was elected to the Company’s Board of Directors on January 13, 2003. Since 1985, Ambassador Motley has headed two successive international trade consulting firms that serve US companies in pursuing their international business goals. Additionally, Ambassador Motley has co-chaired the Department of State’s ambassadorial seminars and is a frequent lecturer for programs in the Department of State, Department of Defense, and other foreign affairs agencies. Ambassador Motley was previously the United States Ambassador to Brazil from 1981 until 1983 and the Assistant Secretary of State for Inter-American Affairs from 1983 to July of 1985. Ambassador Motley, in addition to his Board service for Telos Corporation, serves on the Board of Directors of the US-Brazil Business Council, Junior Achievement International, and the American Academy of Diplomacy.

 

Geoffrey B. Baker, Class D Director

 

Mr. Baker (age 54) was appointed as a Class D Director on November 6, 2001. Mr. Baker is a private investor and since 1983 has been a partner in Baker & Donaldson, a private investment firm, having served on various corporate and civic boards. A graduate of Stanford University and Georgetown University Law Center, he previously served as Legislative Director to U.S. Senator Lowell P. Weicker, Jr., and as Professional Staff Member on the U.S. Senate Committee on Commerce, Science and Transportation.

 

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Malcolm M. B. Sterrett, Class D Director

 

Mr. Sterrett (age 61) is a private investor and was elected to the Company’s Board of Directors on July 31, 1998 as Class D Director. From 1989 to 1993, he was a partner at the law firm of Pepper Hamilton & Scheetz in Washington, D.C. From 1988 to 1989, he served as General Counsel to the U.S. Department of Health and Human Services and from 1982 to 1988 he was a Commissioner on the U.S. Interstate Commerce Commission. Prior thereto, he was Vice President and General Counsel to the United States Railway Association and served as Staff Director and Counsel to the U.S. Senate Committee on Commerce, Science and Transportation. Mr. Sterrett is also a member of the Board of Directors of Trans World Corporation.

 

Michael P. Flaherty, Executive Vice President, General Counsel and Chief Administrative Officer

 

Mr. Flaherty (age 58) was appointed Executive Vice President, General Counsel and Chief Administrative Officer on January 3, 2001. Prior to joining Telos Corporation, Mr. Flaherty was of counsel in the law firm of O’Donnell & Shaeffer, LLC and principal shareholder and Chief Executive Officer of First Continental Group, Inc. Mr. Flaherty has extensive experience in all aspects of civil litigation, serving as lead trial counsel for major corporations. Mr. Flaherty has also served as General Counsel of the U.S. House of Representatives Committee on Banking, Finance and Urban Affairs and Counsel to the Speaker of the House of Representatives. Additionally, Mr. Flaherty is the past chairman of the Executive Committee of the Federal Bar Association’s Banking Law Committee.

 

Robert J. Marino, Executive Vice President and Chief Sales and Marketing Officer

 

Mr. Marino (age 67) joined the Company in 1988 as Senior Vice President of Sales and Marketing. In 1990, his responsibilities were expanded to include Program Management in addition to Sales and Marketing. On January 1, 1994, Mr. Marino was appointed to President of Telos Systems Integration, and on January 1, 1998, he was appointed to his current position. Prior to joining the Company in February 1988, Mr. Marino held the position of Senior Vice President of Sales and Marketing with Centel Federal Systems and M/A.com Information Systems, both of which are U.S. Government contractors.

 

Edward L. Williams, Executive Vice President and Chief Operating Officer

 

Mr. Williams (age 43) joined the company in 1993 as a Senior Vice President responsible for finance, pricing, purchasing, and DCAA compliance. In 1994, his responsibilities were expanded to include accounting and business development. In 1996, Mr. Williams was appointed to manage the Company’s networking business unit. In 2000, his responsibilities were expanded to include management of Telos operations. Mr. Williams was named Executive Vice President and Chief Operating Officer in 2003. Prior to joining Telos Corporation, Mr. Williams was the Chief Financial Officer for Centel Federal Systems and M/A.com Information Systems, both of which are U.S. Government contractors. Mr. Williams has a B.S. in Finance from the University of Maryland. On October 15, 2003, Mr. Williams was appointed to serve as interim Chief Financial Officer.

 

Richard P. Tracy, Senior Vice President and Chief Security Officer

 

Mr. Tracy (age 42) was appointed Chief Security Officer in February 2004. He joined Telos in October 1986 where he held a number of management positions within the Telos NJ operation. In February 1996, Mr. Tracy started the Telos information security consulting practice. In February of 2000, Mr. Tracy was selected to manage Xacta operations. Mr. Tracy is identified as the chief inventor on all of Xacta’s patent applications.

 

Therese K. Hathaway, Vice President, Corporate Secretary and Corporate Counsel

 

Ms. Hathaway (age 49) joined the Company in 2001 as a Legal Consultant. In January 2002 she was appointed Corporate Counsel and in May 2003 Corporate Secretary. In January 2004 she was named Vice President. Prior to joining Telos Corporation, Ms. Hathaway funded and managed Hathaway Communications, specializing in legal translation services for law firms and government agencies, including the Justice Department. Ms. Hathaway has also served as Management Consultant to IDS Corporation, a private firm, and as Law Clerk to the International Trade Policy Counsel of General Electric Company. Ms. Hathaway holds a law degree from the University of Berne/Switzerland and a Master of Comparative Law from George Washington University.

 

Each of the directors and executive officers of the Company is a United States citizen.

 

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Item 11. Executive Compensation

 

The following table shows for the years ended December 31, 2003, 2002 and 2001, the cash compensation paid by the Company as well as certain other compensation paid or accrued for those years, to the chief executive officer and the four other most highly compensated executive officers of the Company in fiscal year 2003.

 

          Annual Compensation

  

Long-Term

Compensation
Awards
Securities
Underlying
Options (1)


    All Other
Compensation (4)


 

Name and Principal Position


   Year

   Salary

    Bonus

    

John B. Wood

(Chairman, President and Chief Executive Officer)

   2003
2002
2001
   $
$
$
345,969
335,873
350,002
(7)
(7)
(7)
  $
$
$
380,000
100,000
125,000
   —  
10,000
510,000
 
(2)
(3)
  $
$
$
10,201
12,182
28,859
 
(5)
(5)

Michael P. Flaherty

(Exec. V.P., General Counsel and Chief Administrative Officer)

   2003
2002
2001
   $
$
$
300,019
300,019
300,018
 
 
 
  $
$
$
250,000
200,000
132,692
   —  
—  
300,000
 
 
(3)
  $
$
$
12,715
12,715
6,229
 
 
 

Robert J. Marino

(Executive V. P. and Chief Sales and Marketing Officer)

   2003
2002
2001
   $
$
$
227,094
227,094
222,390
 
 
 
  $
$
$
239,659
15,000
70,000
   —  
—  
—  
 
 
 
  $
$
$
13,635
110,039
23,517
 
(6)
 

Edward L. Williams

(Exec. V. P., Chief Operating Officer, Chief Financial Officer)

   2003
2002
2001
   $
$
$
227,136
226,200
198,600
 
 
 
  $
$
$
250,000
136,000
100,000
   —  
—  
—  
 
 
 
  $
$
$
6,938
6,445
5,888
 
 
 

Richard P. Tracy

(Senior V. P., Chief Security Officer)

   2003
2002
2001
   $
$
$
160,514
160,110
145,285
 
 
 
  $
 
$
125,000
—  
41,500
   —  
—  
—  
 
 
 
  $
$
$
4,142
4,146
3,938
 
 
 

(1)   There are no restricted stock awards or payouts pursuant to long-term investment plans.
(2)   Options granted in 2002 are in the Company’s Class A common stock.
(3)   Options granted in 2001 are in Telos, Telos Delaware, and Xacta common stock.
(4)   All other compensation represents Company contributions made on behalf of the executive officers to the Telos Shared Savings Plan, and life insurance premiums paid by the Company for the benefit of the executives.
(5)   Included in these amounts are $2,500 in 2002, and $10,000 in 2001 for director’s fees paid.
(6)   Included in this amount is cash surrender value payment from life insurance policy.
(7)   The Company and its affiliate, Enterworks, Inc., have an agreement whereby Enterworks, Inc. reimbursed the Company for $108,000 for 2003, $250,000 for 2002 and 2001, of Mr. Wood’s annual salary.

 

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Table of Contents

Management Stock Options

 

The following table shows, as to the individuals named in the Summary Compensation table, the number of shares acquired during such period through the exercise of options, and the number of shares subject to and value of all unexercised options held as of December 31, 2003.

 

AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR

AND FY-END OPTION/SAR VALUES

 

Name


  

Shares Acquired

On Exercise


  

Value

Realized


  

Number of

Securities

Underlying

Unexercised

Options/SARs

At FY-End

Exercisable/
Unexercisable


   Value of
Unexercised
In-the-Money
Options/SARs
At FY-End (1)
Exercisable/
Unexercisable


John B. Wood (Chairman, President and Chief Executive Officer)

   —      —      1,679,745/ 1,498,245    $0 /$0

Michael P. Flaherty (Exec. V.P., General Counsel and Chief Administrative Officer)

   —      —      301,500 / 128,500    $0 /$0

Robert J. Marino (Exec. V. P., Chief Sales and Marketing Officer)

   —      —      718,400 / 271,500    $0 /$0

Edward L. Williams (Exec. V. P., Chief Operating Officer, Chief Financial Officer)

   —      —      504,000 / 24,000    $0 /$0

Richard P. Tracy (Senior V.P., Chief Security Officer)

   —      —      151,000 / 24,000    $0 /$0

(1)   These aggregate values include values for exercisable options to purchase the Class A Common Stock of the Company. These values are based upon an estimated fair market value at December 31, 2003 of $.62 per share for the Company’s Class A Common Stock. These values were derived from valuations performed by an independent third party for the trustees of the Telos Shared Savings Plan, a defined contribution employee savings plan in which substantially all full-time employees are eligible to participate.

 

 

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Compensation of Directors

 

During the fiscal year ended December 31, 2003, outside directors and proxy holders Mr. Byers, Dr. Ikle, and Ambassador Motley were paid $42,000, $32,000, and $34,000, respectively for their services as directors and proxy holders. Proxy holder services were paid pursuant to the 1994 proxy agreement between the Company, the Defense Security Service, and Mr. John R.C. Porter. The outside Class D directors, Mr. Sterrett and Mr. Baker, were paid $34,000 and $32,000, respectively.

 

Effective March 27, 2002, the Board of Directors adopted a new structure for the annual compensation of the Board members which provides for the following: $25,000 annually for Proxy holder directors; $25,000 annually for Class D Directors; $0 for employee directors and committee participation; $5,000 for the Chairman of the Board’s annual retainer; $5,000 for the Proxy Board Chairman’s annual retainer; $5,000 annually for the Chairmen of the Audit Committee; $2,000 annually for the Chairmen of the Management Development and Compensation Committee; and $2,000 annually for membership in the Audit, Management Development and Compensation Committee, or Nominating/Corporate Governance Committee. Each director who is not an employee director is entitled to receive $1,250 for each meeting attended, for a maximum of four meetings per year.

 

Employment Contracts

 

As of December 31, 2003, the Company was a party to agreements with certain of its executive officers. Mr. John Wood, President, Chief Executive Officer, Chairman and Director; Mr. Michael Flaherty, Executive Vice President, General Counsel and Chief Administrative Officer; Mr. Edward Williams, Executive Vice President, Chief Operating Officer and Chief Financial Officer; and Mr. Robert Marino, Executive Vice President and Chief Sales and Marketing Officer, currently have employment contracts with the Company. The agreements are for one-year terms and provide, respectively, for payment to Mr. Wood and Mr. Marino of the equivalent of 24 months base salary then in effect, and for payment to Mr. Flaherty and Mr. Williams of the equivalent of 18 months base salary then in effect, if involuntarily terminated or if the agreements are not extended.

 

Accordingly, Messrs. Wood and Marino would receive annually $350,000 and $227,000, respectively, for a two-year period, and Messrs. Flaherty and Williams would receive 18 months of their annual salaries of $300,000 and $227,000, respectively.

 

In addition to base salary, the executives are eligible for a discretionary bonus and for the grant of stock options under the agreements. The amount of any such discretionary bonus and the grant of any such stock options is subject to, depending on the individual, the review and/or approval of the Compensation Committee and its report to and approval by the Board of Directors.

 

Each year, the Company renegotiates such employment contracts as part of the yearly review process. Accordingly in 2004, the Company expects to review the contracts described above. In addition, strategic hires or promotions may increase the number of executives who have employment contracts.

 

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Item 12. Security Ownership of Certain Beneficial Owners and Management

 

Title of Class


  

Name and Address of

Beneficial Owner


  

Amount and Nature of

Beneficial Ownership as of
December 31, 2003


   Percent of
Class


 

Class A Common Stock

  

John R.C. Porter

34 Rue Concorde

1050 Brussels Belgium

   22,190,718 shares (A)    80.52 %

Class A Common Stock

  

Telos Corporation Shared

Savings Plan

19886 Ashburn Road

Ashburn, VA 20147

   3,658,536 shares    17.28 %

Class B Common Stock

  

Graphite Enterprise Trust PLC

Berkley Square House, 4th Floor

London W1J 6BQ England

   1,681,960 shares (B)    41.66 %

Class B Common Stock

  

Graphite Enterprise Trust LP

Berkley Square House, 4th Floor

London W1J 6BQ England

   420,490 shares (B)    10.41 %

Class B Common Stock

  

Hare & Company

c/o Bank of New York

P.O. Box 11203

New York, NY 10249

   1,186,720 shares    29.39 %

Class B Common Stock

  

Cudd & Company

c/o Chase Manhattan Bank

Corporate Actions Department Four

New York Plaza, 11th Floor

New York, NY 10004

   669,888 shares    16.59 %

Class A Common Stock

   John B. Wood    1,383,631 shares (C)    6.15 %

Class A Common Stock

   Robert J. Marino    649,535 shares (C)    2.98 %

Class A Common Stock

   Michael P. Flaherty    167,233 shares (C)    0.78 %

Class A Common Stock

   Edward L. Williams    501,575 shares (C)    2.33 %

Class A Common Stock

   Richard P. Tracy    80,151 shares (C)    0.38 %

Class A Common Stock

   Norman P. Byers    7,000 shares    0.03 %

Class A Common Stock

   Fred C. Ikle    7,000 shares    0.03 %

Class A Common Stock

   Malcom M.B. Sterrett    3,000 shares    0.01 %

Class A Common Stock

  

All Officers and Directors

As a Group (9 persons)

   2,800,130 shares (D)    11.79 %

12% Cumulative

Exchangeable Redeemable

Preferred Stock

  

Value Partners, Ltd.

Ewing & Partners

4514 Cole Avenue, Suite 808

Dallas, TX 75205

   714,317 shares (E)    22.42 %

12% Cumulative

Exchangeable Redeemable

Preferred Stock

  

Wynnefield Partners Small Cap Value, L.P.

Wynnefield Partners Small Cap Value, L.P. I

Channel Partnership II, L.P. Wynnefield Small Cap Value Offshore Fund, Ltd.

450 Seventh Avenue, Suite

509 New York, NY 10123

   466,200 shares (F)    14.63 %

12% Cumulative

Exchangeable Redeemable

Preferred Stock

  

Athena Capital Management, Inc. Minerva Group, LP

David P. Cohen

4 Tower Bridge #222

200 Barr Harbor Drive

West Conshohocken, PA 19428

   162,362 shares (G)    5.10 %

 

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Table of Contents
(A)   Mr. John R. C. Porter’s holdings include 6,388,916 shares of Class A Common Stock purchasable upon exercise of a warrant.

 

(B)   Graphite Enterprise Trust PLC and Graphite Enterprise Trust LP did not provide the Company with the addresses of the respective beneficial owners.

 

(C)   The common stock holdings of Messrs. Flaherty, Marino, Tracy, Williams and Wood include 3,233; 23,083; 33,151; 30,599; and 39,244 shares of the Company’s Class A Common Stock, respectively, held for their beneficial interest by the Telos Corporation Savings Plan. Messrs. Flaherty, Marino, Tracy, Williams and Wood hold options to acquire 164,000; 614,400; 47,000; 400,000; and 1,335,995 shares of the Company’s Class A Common Stock, respectively, in addition to their current common stock holdings. These shares are purchasable upon exercise of the options and are exercisable within 60 days of March 1, 2004.

 

(D)   The common stock holdings of the Company’s officers and directors as a group include 130,315 shares of the Company’s Class A Common Stock held for their beneficial interest by the Telos Corporation Savings Plan. Under the Company’s stock option plan and certain stock option agreements, all officers and directors as a group hold options to acquire 2,578,395 shares of Class A Common Stock exercisable within 60 days of March 1, 2004.

 

(E)   Value Partners Ltd. (“VP”) and Ewing & Partners (“E&P”) have filed a joint Schedule 13D under which they disclosed that they may act as a “group” within the meaning of Section 13(d) of the Securities Exchange Act. Each of the reporting persons disclosed that it might be deemed to beneficially own the aggregate of 714,317 shares of the Exchangeable Preferred Stock held of record by the reporting persons collectively.

 

According to the Schedule 13D, each of VP, E&P and Timothy G. Ewing may be deemed to have the sole power to vote and to dispose of the shares of the Exchangeable Preferred Stock held of record by the reporting persons collectively.

 

(F)   Wynnefield Partners Small Cap Value, L.P., (“WPSCV”), Wynnefield Partners Small Cap Value L.P. I (“WPSCVI”), Channel Partnership II, L.P. (“CP”), Wynnefield Small Cap Value Offshore Fund, Ltd. (“WSCVOF”), Wynnefield Capital Management, LLC (“WCM”), Wynnefield Capital, Inc. (“WCI”) and Mr. Nelson Obus have filed a joint Schedule 13D under which they disclosed that they may act as a “group” within the meaning of Section 13(d) of the Securities Exchange Act. Each of the reporting persons disclosed that it might be deemed to beneficially own the aggregate of 466,200 shares of the Exchangeable Preferred Stock held of record by the reporting persons collectively. According to the Schedule 13D, WCM is the sole general partner of WPSCV and WPSCVI, Messrs. Nelson Obus and Joshua Landes are the co-managing members of WCM. WCI is the sole investment manager of WSCVOF, Messrs. Obus and Landes are the principal executive officers of WCI. Mr. Obus as general partner of CP and Messrs. Obus and Landes, as co-managing members of WCM and principal executive officers of WCI, have the power to vote or to direct the vote and the power to dispose and to direct the disposition of the shares of Exchangeable Preferred Stock owned by WPSCV, WPSCVI, CP and WSCVOF, respectively.

 

(G)   Athena Capital Management, Inc. (“ACM”), Minerva Group, LP (“MG”), and Mr. David Cohen have filed a joint Schedule 13G in which ACM has the shared power to vote or to direct the vote and the shared power to dispose or to direct the disposition of 111,429 shares; MG and Mr. Cohen have the sole power to vote or to direct the vote and the sole power to dispose or to direct the disposition of 43,500 and 7,433 shares, respectively.

 

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Table of Contents

Item 13. Certain Relationships and Related Transactions

 

Information concerning certain relationships and related transactions between the Company and certain of its current and former officers and directors is set forth below.

 

Mr. John R.C. Porter, the owner of a majority of the Company’s Class A Common Stock, has a consulting agreement with the Company whereby he is compensated for consulting services provided to the Company in the areas of marketing, product development, strategic planning and finance as requested by the Company. Mr. Porter was paid $260,000 by the Company in 2002, 2001, and 2000 pursuant to this agreement, which amounts were determined by negotiation between the Company and Mr. Porter.

 

Mr. David S. Aldrich, former President and Chief Executive Officer of the Company, entered into an agreement with the Company whereby Mr. Aldrich will serve as an advisor to the Company from December 31, 2002 through March 31, 2005. In return, Mr. Aldrich will be paid $350,000 per annum from January 1, 2003 through March 31, 2005. The Company will also continue to provide Mr. Aldrich with medical and insurance benefits during that same period.

 

Mr. Gerald Calhoun, former Vice President of Human Resources and Corporate Secretary, entered into a settlement agreement with the Company to resolve a dispute over Mr. Calhoun’s employment contract with the Company. The Company paid Mr. Calhoun 24 months of severance in installments from 2000 until April 19, 2002. Mr. Calhoun also received medical and insurance benefits through the Company for the same two-year period. Mr. Calhoun’s payment of salary and fringe benefits amounted to approximately $189,000 per annum.

 

Mr. William L.P. Brownley, former Vice President and General Counsel of the Company, entered into an agreement with the Company whereby Mr. Brownley served as an of counsel attorney to the Company from December 31, 2000 through March 31, 2003. In return, Mr. Brownley was paid $220,000 per annum from January 1, 2001 through March 31, 2003. The Company provided Mr. Brownley with medical and insurance benefits during that same period.

 

Mr. Lorenzo Tellez, former Vice President, Treasurer, and Chief Financial Officer of the Company, entered into a settlement agreement with the Company to resolve a dispute on Mr. Tellez’s employment contract with the Company. The Company paid Mr. Tellez the equivalent of 24 months of severance in installments during 2001. Mr. Tellez also received medical and insurance benefits through the Company for the same two-year period. Mr. Tellez’s payment of salary and fringe benefits amounts to approximately $243,000 per annum. The Company completed its payments of the salary portion of the contract to Mr. Tellez on December 7, 2001. In March 2003, pursuant to the final settlement of arbitration proceedings, the Company paid Mr. Tellez a bonus of $96,000 and legal fees in the amount of $53,000.

 

Item 14. Principal Accountant Fees and Services

 

PricewaterhouseCoopers LLP has served as the principal accountant for the Company since the fiscal year ended December 31, 1997. Aggregate fees for professional services rendered to the Company by PricewaterhouseCoopers LLP for the year ended December 31, 2003 and 2002 are summarized as follows:

 

     2003

   2002

Audit fees

   $ 198,300    $ 183,400

All other fees

     48,431      63,380
    

  

Total

   $ 246,731    $ 246,780
    

  

 

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Table of Contents

PART IV

 

Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K

 

(a)   1. Financial Statements

 

All financial statements of the registrant as set forth under Item 8 of this report on Form 10-K.

 

(a)   2. Financial Statement Schedules

 

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

 

(a)   3. Exhibits:

 

Exhibits marked with (1*) are incorporated by reference to the Company’s Registration Statement No. 2-84171 filed June 2, 1983. Exhibits marked with (3*) are incorporated by reference to the Company’s Form 10-K report for the fiscal year ended March 31, 1987. Exhibits marked with (4*) are incorporated by reference to the Company’s Form 10-K report for the fiscal year ended March 31, 1989. The registrant will furnish to stockholders a copy of other exhibits upon payment of $.20 per page to cover the expense of furnishing such copies. Requests should be directed to the attention of Investor Relations at Telos Corporation, 19886 Ashburn Road, Ashburn, Virginia 20147-2358.

 

2.6   Stock Purchase Agreement dated as of January 14, 1992, by and among C3, Inc., Telos Corporation and Contel Federal Systems, Inc. (Incorporated by reference to C3, Inc.
   

Form 8-K filed January 29, 1992)

3.1 (1*)  

Articles of Amendment and Restatement of C3, Inc.

3.2 (1*)  

Articles of Amendment of C3, Inc. dated August 31, 1981.

3.3 (3*)  

Articles supplementary of C3, Inc. dated May 31, 1984.

3.4 (4*)  

Articles of Amendment of C3, Inc. dated August 18, 1988.

3.5   Articles of Amendment and Restatement Supplementary to the Articles of Incorporation dated August 3, 1990. (Incorporated by reference to C3, Inc. 10-Q for the quarter ended June 30, 1990)
3.6   Restated Bylaws of C3, Inc. (Incorporated by reference to C3, Inc. 10-Q for the quarter ended December 31, 1990)
3.7  

Articles of Amendment of C3, Inc. dated April 13, 1995

4.1   Form of Indenture between the Registrant and Bankers Trust Company, as Trustee, relating to the 12% Junior Subordinated Debentures Due 2009. (Incorporated herein by reference to C3’s Registration Statement on Form S-4 filed October 20, 1989
4.3   Form of the terms of the 12% Cumulative Exchangeable Redeemable Preferred Stock of the Registrant. (Incorporated herein by reference to C3’s Registration Statement on Form S-4 filed October 20, 1989)
4.4   Shareholders Agreement dated as of August 3, 1990 by and among C3, Inc.; Union de Banques Suisses(Luxembourg), S.A.; C3 Investors, L.P.; Anthony Craig, together with the investors; the Class A holders; MIM Limited; Knoll and Associates, Inc.; Murray Enterprises PLC; Electra Development Holdings; and Hartley Limited. (Incorporated by reference to C3, Inc. 10-Q for the quarter ended June 30, 1990)
4.5   Articles of Amendment and Restatement of the Company, filed with the Secretary of State of the State of Maryland on January 14, 1992. (Incorporated by reference to C3, Inc. Form 8-K filed January 29, 1992)
10.20   Revolving and Reducing Senior Facility Credit Agreement dated as of January 14, 1992, among C3, Inc., Telos Corporation and NationsBank, N.A. (Incorporated by reference to C3, Inc. Form 8-K filed January 29, 1992)
10.31  

September 27, 1993 Settlement Agreement among John R.C. Porter, Toxford Corporation, Cantrade Nominees Ltd., Cantrade Trust Company (Cayman) Ltd., Cantrade Trustee, AG, Fred Knoll, Cottonwood Holdings, C3 Investors L.P., C3, Inc., Telos Corporation,

Joseph P. Beninati, John B. Wood and Beninati & Wood, Inc. (Incorporated by reference to C3, Inc. Form 8-K filed October 18, 1993)

10.32   September 27, 1993 Stock Purchase and Sale Agreement between Mr. John R.C. Porter and C3 Investors, L.P. (Incorporated by reference to C3, Inc. Form 8-K filed October 18, 1993)
10.33   September 27, 1993 Stock Purchase and Sale Agreement between Mr. John R.C. Porter and Cottonwood Holdings, Inc. (Incorporated by reference to C3, Inc. Form 8-K filed October 18, 1993)
10.34   September 27, 1993 Note Interest Purchase and Sale Agreement among Mr. John R.C. Porter, Cottonwood and C3, Inc. (Incorporated by reference to C3, Inc. Form 8-K filed October 18, 1993)
10.35   October 8, 1993 Promissory Note in the amount of $8,438,000 issued by Mr. John R.C. Porter in favor of C3 Investors, L.P. (Incorporated by reference to C3, Inc. Form 8-K filed October 18, 1993)
10.36   October 8, 1993 Promissory Note in the amount of $1,562,000 issued by Mr. John R.C. Porter in favor of Cottonwood Holdings, Inc. (Incorporated by reference to C3, Inc. Form 8-K filed October 18, 1993)

 

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10.37    September 27, 1993 Collateral Agency, Security and Pledge Agreement among Mr. John R.C. Porter, Mr. Fred Knoll, Cottonwood Holdings, C3 Investors, L.P., C3, Inc., Telos Corporation, Toxford Corporation, Cantrade Nominees Limited, Mr. Robert M. Ercole and Mr. Frank S. Jones, Jr. (Incorporated by reference to C3, Inc. Form 8-K filed October 18, 1993)
10.38    September 27, 1993 Standstill Agreement among Mr. John R.C. Porter, Mr. Fred Knoll, Mr. Alfredo Frohlich and C3, Inc. (Incorporated by reference to C3, Inc. Form 8-K filed October 18, 1993)
10.39    September 27, 1993 Mutual Release among Mr. John R.C. Porter, Mr. Fred Knoll, Cottonwood Holdings, C3 Investors, L.P., C3, Inc., Telos Corporation, Mr. Joseph P. Beninati, Mr. John B. Wood, and Beninati & Wood, Inc. (Incorporated by reference to C3, Inc. Form 8-K filed October 18, 1993)
10.40    September 27, 1993 Consulting Agreement among Mr. Fred Knoll, C3, Inc. and Telos Corporation. (Incorporated by reference to C3, Inc. Form 8-K filed October 18, 1993)
10.43    Amendment to Revolving and Reducing Senior Credit Facility dated as of December 31, 1993 among C3, Inc., Telos Corporation and NationsBank, N.A.
10.44    Amendment to Revolving and Reducing Senior Credit Facility dated as of April 11, 1994 among C3, Inc., Telos Corporation and NationsBank, N.A.
10.45    Amendment to Revolving and Reducing Senior Credit Facility dated as of June 8, 1994 among C3, Inc., Telos Corporation and NationsBank, N.A.
10.46    Amendment to Revolving and Reducing Senior Credit Facility dated as of October 7, 1994 among C3, Inc., Telos Corporation and NationsBank, N.A.
10.47    October 7, 1994 Letter Agreement among C3, Inc., Toxford Corporation, and NationsBank, N.A. regarding cash collateral held on behalf of the Company.
10.48    October 25, 1994 General Release and Settlement memorandum among Sapiens International Corporation N.V., Sapiens International Corporation B.V., Sapiens U.S.A., Inc., C3, Inc. and Telos Corporation
10.49    Amendment to Revolving and Reducing Senior Credit Facility dated as of January 5, 1995 among C3, Inc., Telos Corporation and NationsBank, N.A.
10.50    Amendment to Revolving and Reducing Senior Credit Facility dated as of January 12, 1995 among C3, Inc., Telos Corporation and NationsBank, N.A.
10.51    Waiver and Amendment to Revolving and Reducing Senior Credit Facility dated as of April 17, 1995 among C3, Inc., Telos Corporation and NationsBank, N.A.
10.58    Series B Senior Subordinated Secured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and Drayton English and International Investment Trust
10.59    Series B Senior Subordinated Secured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and J. O. Hambro Investment Management, Ltd.
10.60    Series B Senior Subordinated Secured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and North Atlantic Smaller Companies Investment Trust, PLC
10.61    Series B Senior Subordinated Secured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and Mr. John R.C. Porter
10.62    Series B Senior Subordinated Secured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and Sir Leslie Porter
10.63    Series B Senior Subordinated Secured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and Second Consolidated Trust, PLC
10.64    Series B Senior Subordinated Secured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and Toxford Corp.
10.65    Series C Senior Subordinated Unsecured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and Drayton English and International Investment Trust
10.66    Series C Senior Subordinated Unsecured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and J.O. Hambro Investment Management, Ltd.
10.67    Series C Senior Subordinated Unsecured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and North Atlantic Smaller Companies Investment Trust, PLC
10.68    Series C Senior Subordinated Unsecured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and Mr. John R.C. Porter
10.69    Series C Senior Subordinated Unsecured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and Sir Leslie Porter
10.70    Series C Senior Subordinated Unsecured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and Second Consolidated Trust, PLC
10.71    Series C Senior Subordinated Unsecured Note due October 1, 2000 as of October 13, 1995 between Telos Corporation (Maryland) and Toxford Corp.
10.72    Amendment to Revolving and Reducing Senior Credit Facility dated as of August 4, 1995 Telos Corporation(Maryland), Telos Corporation (California) and NationsBank N.A.
10.73    Amendment to Revolving and Reducing Senior Credit Facility dated as of October 13, 1995 Telos Corporation (Maryland), Telos Corporation (California) and NationsBank N.A.
10.74    1996 Stock Option Plan
10.76    Sixteenth Amendment to Credit Facility and Tenth Amended and Restated Promissory Note
10.77    Enterworks, Inc. 1996 Stock Option Plan
10.78    Form of Series A Senior Subordinated Unsecured Note
10.79    Form of Enterworks, Inc., inc. Capital Stock Purchase Series A Warrant
10.80    Asset Purchase Agreement
10.81    Amendment No. 1 to Asset Purchase Agreement
10.82    Amended and Restated Credit Agreement between Telos Corporation, a Maryland corporation; Telos Corporation, a California corporation; and NationsBank, N.A. dated as of July 1, 1997

 

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10.83    Asset Purchase Agreement
10.84    Interim Agreement
10.85    Share Purchase Agreement between Telos Corporation, a Maryland corporation, formerly named and known as C3, Inc. and Union Bank of Switzerland, dated May 7, 1998
10.86    Series D Senior Subordinated Unsecured Note due October 1, 2000 as of November 20, 1998 between Telos Corporation(Maryland) and Foreign and Colonial Enterprise Trust PLC
10.87    Series D Senior Subordinated Unsecured Note due October 1, 2000 as of November 20, 1998 between Telos Corporation(Maryland) and Foreign and Colonial Enterprise Trust LP
10.88    Common Stock Purchase Series D Warrant between Telos Corporation (Maryland) and Foreign and Colonial Enterprise Trust PLC
10.89    Common Stock Purchase Series D Warrant between Telos Corporation (Maryland and Foreign and Colonial Enterprise Trust LP
10.90    Form of Stock Purchase Agreement
10.91    Asset Purchase Agreement, dated as of September 29, 1999 between Telos Corporation (Maryland), Telos Corporation (California), Telos Field Engineering, Inc. and TFE Technology Holdings, Inc.
10.92    Letter to Bank of America concerning Enterworks private placement
10.93    Form of Enterworks Subdebt conversion letter
10.94    Form of Telos Subdebt conversion letter
10.95    Listing of Subdebt conversion parties
10.96    Transaction agreement between Telos and Enterworks
21    Schedule of Subsidiaries
31.1    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32    Certification pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

(b) Reports filed on Form 8-K:

 

1. 8-K filed August 5, 2002. Item 2. Sale of Telos Corporation (California) to L-3 Communications Corporation.

 

2. 8-K filed November 1, 2002. Item 5. Disclosing Loan and Security Agreement with Foothill Capital Corporation.

 

3. 8-K filed January 14, 2003. Item 5. Announcing the resignation of David S. Aldrich as CEO of Telos Corporation and the appointment of John B. Wood.

 

4. 8-K filed March 10, 2003. Item 5. Announcing the resignation of David S. Aldrich as Telos Corporation Director.

 

5. 8-K filed March 24, 2003. Item 5. Announcing the sale of TelosOK LLC.

 

6. 8-K filed May 14, 2003. Item 5. Announcing the resignation of Thomas J. Ferrara as CFO of Telos Corporation and the appointment of David E. Pearson.

 

7. 8-K filed October 23, 2003. Item 5. Announcing the resignation of David E. Pearson as CFO of Telos Corporation and the appointment of Edward L. Williams.

 

8. 8-K filed April 9, 2004. Item 5. Intent to obtain professional advice concerning potential recapitalization of Telos Corporation.

 

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Table of Contents

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Telos Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

TELOS CORPORATION

By:

 

/s/ Edward L. Williams


    Interim Chief Financial Officer

Date:

  April 14, 2004

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following person on behalf of Telos Corporation and in the capacities and on the dated indicated.

 

Signature


  

Title


 

Date


/s/ John B. Wood


John B. Wood

  

Chief Executive Officer

  April 14, 2004
    

/s/ Fred Charles Ikle


Fred Charles Ikle

  

Director

  April 14, 2004
    

/s/ Norman P. Byers


Norman P. Byers

  

Director

  April 14, 2004
    

/s/ Malcom M.B. Sterrett


Malcolm M.B. Sterrett

  

Director

  April 14, 2004
    

/s/ Geoffrey B. Baker


Geoffrey B. Baker

  

Director

  April 14, 2004
    

/s/ L. Anthony Motley


Ambassador L. Anthony Motley

  

Director

  April 14, 2004
    

/s/ Edward L. Williams


Edward L. Williams

  

Interim Chief Financial Officer

  April 14, 2004
    

 

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