TELOS CORP - Quarter Report: 2011 September (Form 10-Q)

form10q.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

þ	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended: September 30, 2011

¨	Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission file number: 001-08443

TELOS CORPORATION

(Exact name of registrant as specified in its charter)

Maryland		52-0880974
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

19886 Ashburn Road, Ashburn, Virginia		20147-2358
(Address of principal executive offices)		(Zip Code)

(703) 724-3800

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No ¨

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

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

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

As of November 7, 2011, the registrant had outstanding 35,906,461 shares of Class A Common Stock, no par value; and 4,037,628 shares of Class B Common Stock, no par value.

TELOS CORPORATION AND SUBSIDIARIES

INDEX

PART I - FINANCIAL INFORMATION

		Page
Item 1.	Financial Statements

	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2011 and 2010 (unaudited)	3
	Condensed Consolidated Balance Sheets as of September 30, 2011 (unaudited) and December 31, 2010	4-5
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2011 and 2010 (unaudited)	6
	Notes to Condensed Consolidated Financial Statements (unaudited)	7-29

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	30-40

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	40

Item 4.	Controls and Procedures	40

	PART II - OTHER INFORMATION

Item 1.	Legal Proceedings	40

Item 1A.	Risk Factors	40

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	40

Item 3.	Defaults upon Senior Securities	41

Item 6.	Exhibits	42

SIGNATURES		43

Index

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

TELOS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(amounts in thousands)

	Three Months Ended September 30,						Nine Months Ended September 30,

	2011			2010			2011			2010
Revenue
Products	$	24,335		$	29,064		$	48,100		$	78,458
Services		28,647			28,566			94,004			96,176
		52,982			57,630			142,104			174,634
Costs and expenses
Cost of sales - Products		17,906			21,877			36,863			65,534
Cost of sales - Services		23,379			20,495			70,324			74,186
		41,285			42,372			107,187			139,720
Selling, general and administrative expenses		9,035			8,708			24,840			24,181

Operating income		2,662			6,550			10,077			10,733
Other income (expense)
Other income		40			110			320			150
Interest expense		(1,655	)		(1,505	)		(4,575	)		(4,725	)

Income before income taxes		1,047			5,155			5,822			6,158
Income tax benefit (provision) (Note 8)		137			(3,060	)		(2,170	)		(3,557	)

Net income		1,184			2,095			3,652			2,601

Less: Net income attributable to non-controlling interest (Note 2)		(1,100	)		(459	)		(1,672	)		(747	)

Net income attributable to Telos Corporation	$	84		$	1,636		$	1,980		$	1,854

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

Index

TELOS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(amounts in thousands)

	September 30, 2011 (Unaudited)		December 31, 2010
ASSETS
Current assets (Note 6)
Cash and cash equivalents	$	162	$	116
Accounts receivable, net of reserve of $343 and $358, respectively		42,927		54,085
Inventories, net of obsolescence reserve of $287 and $319, respectively		19,466		7,309
Deferred program expenses		2,457		2,658
Other current assets		3,031		2,878

Total current assets (Note 6)		68,043		67,046

Property and equipment, net of accumulated depreciation of $20,602 and $19,950, respectively		5,107		5,742
Deferred income taxes, long-term		1,665		1,665
Goodwill		15,058		----
Other intangible assets		10,722		----
Other assets		302		351

Total assets (Note 6)	$	100,897	$	74,804

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

Index

TELOS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(amounts in thousands)

	September 30, 2011 (Unaudited)			December 31, 2010
LIABILITIES, REDEEMABLE PREFERRED STOCK,
NON-CONTROLLING INTEREST AND STOCKHOLDERS’
DEFICIT
Current liabilities
Accounts payable and other accrued payables (Note 6)	$	33,935		$	28,933
Accrued compensation and benefits		7,023			6,880
Deferred revenue		5,680			4,386
Deferred income taxes		275			434
Senior credit facility – short-term (Note 6)		375			375
Notes payable – short-term (Note 6)		5,561			----
Capital lease obligations – short-term		1,006			945
Other current liabilities		2,896			3,832

Total current liabilities		56,751			45,785

Senior revolving credit facility (Note 6)		14,299			13,786
Notes payable (Note 6)		11,892			----
Capital lease obligations		5,217			5,950
Senior redeemable preferred stock (Note 7)		8,148			10,190
Public preferred stock (Note 7)		107,673			104,806
Other liabilities		112			83

Total liabilities		204,092			180,600

Commitments and contingencies (Note 9)		----			----

Stockholders’ deficit
Telos stockholders’ deficit
Common stock		78			78
Additional paid-in capital		103			103
Accumulated other comprehensive loss		(56	)		(26	)
Accumulated deficit		(104,425	)		(106,405	)

Total Telos stockholders’ deficit		(104,300	)		(106,250	)

Non-controlling interest in subsidiary (Note 2)		1,105			454

Total stockholders’ deficit		(103,195	)		(105,796	)

Total liabilities, redeemable preferred stock, non-controlling interest and stockholders’ deficit	$	100,897		$	74,804

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

Index

TELOS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(amounts in thousands)

	Nine Months Ended September 30,
	2011			2010
Operating activities:
Net income	$	3,652		$	2,601
Adjustments to reconcile net income to cash provided by operating activities:
Gain on redemption of senior preferred stock		(230	)		(92	)
Dividends of preferred stock as interest expense		3,125			3,183
Accretion of note payable		163			----
Depreciation and amortization		1,731			1,233
Amortization of debt issuance costs		54			97
Deferred income tax benefit		(159	)		----
Other noncash items		58			74
Changes in other operating assets and liabilities		2,683			(4,979	)
Cash provided by operating activities		11,077			2,117

Investing activities:
Acquisition of ITL (Note 11)		(8,000	)		----
Purchases of property and equipment		(532	)		(709	)
Cash used in investing activities		(8,532	)		(709	)

Financing activities:
Proceeds from senior credit facility		187,915			183,105
Repayments of senior credit facility		(187,121	)		(187,898	)
Proceeds from term loan		----			7,500
Decrease in book overdrafts		2,134			1,889
Repayments of term loan		(281	)		(94	)
Repayments of note payable		(1,383	)		----
Payments under capital lease obligations		(672	)		(612	)
Redemption of senior preferred stock		(2,070	)		(430	)
Payment of senior subordinated notes		----			(4,179	)
Payment of debt issuance costs		----			(75	)
Distributions to Telos ID Class B membership unit – non-controlling interest		(1,021	)		(612	)
Cash used in financing activities		(2,499	)		(1,406	)
Effect of exchange rate changes on cash and cash equivalents		----			5

Increase in cash and cash equivalents		46			7
Cash and cash equivalents at beginning of period		116			78
Cash and cash equivalents at end of period	$	162		$	85

Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	1,280		$	1,732
Income taxes	$	3,882		$	1,135
Noncash:
Interest on redeemable preferred stock	$	3,125		$	3,183
Acquisition financed through issuance of notes payable	$	18,673		$	----

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

Index

TELOS CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. General and Basis of Presentation

Telos Corporation, together with its subsidiaries (the “Company” or “Telos” or “We”), is an information technology solutions and services company addressing the needs of U.S. Government and commercial customers worldwide. Our principal offices are located at 19886 Ashburn Road, Ashburn, Virginia 20147. The Company was incorporated as a Maryland corporation in October 1971. Our web site is www.telos.com.

The accompanying condensed consolidated financial statements include the accounts of Telos and its subsidiaries, including Ubiquity.com, Inc., Xacta Corporation and Telos Delaware, Inc., all of whose issued and outstanding share capital is owned by the Company. We have also consolidated the results of operations of Telos Identity Management Solutions, LLC (“Telos ID”) (see Note 2 – Sale of Assets), and Teloworks, Inc. (“Teloworks”) (see Note 3 – Investment in Teloworks). All intercompany transactions have been eliminated in consolidation.

In our opinion, the accompanying condensed consolidated financial statements reflect all adjustments (which include normal recurring adjustments) and reclassifications necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”). The presented interim results are not necessarily indicative of fiscal year performance for a variety of reasons including, but not limited to, the impact of seasonal and short-term variations. We have continued to follow the accounting policies (including the critical accounting policies) set forth in the consolidated financial statements included in our 2010 Annual Report on Form 10-K filed with the SEC. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

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

Segment Reporting

Operating segments are defined as components of an enterprise for which separate financial information is available and evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and assess performance. The Company currently has one reportable segment for financial reporting purposes.

Recent Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (International Financial Reporting Standards).” This guidance is effective for the first interim or annual period beginning on or after December 15, 2011, and will be applied prospectively beginning in the period of adoption. The amendments change the wording used to describe requirements for measuring fair value under U.S. GAAP to be more consistent with IFRSs. The adoption of this guidance is not expected to have a material effect on our condensed consolidated financial position, results of operations or cash flows.

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income.” ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity, which is our current presentation, and also requires presentation of reclassification adjustments from other comprehensive income to net income on the face of the financial statements. ASU 2011-05 is effective for annual and interim reporting periods beginning after December 15, 2011. The adoption of ASU 2011-05 will have no impact on our condensed consolidated financial position, results of operations or cash flows, though it will change our financial statement presentation.

In September 2011, the FASB issued ASU 2011-08, “Testing Goodwill for Impairment,” that amends the accounting guidance on goodwill impairment testing. The amended guidance will allow companies to assess qualitative factors to determine if it is more-likely-than-not that goodwill might be impaired and whether it is necessary to perform the two-step goodwill impairment test required under current accounting standards. This guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. The adoption of this guidance is not expected to have a material effect on our condensed consolidated financial position, results of operations or cash flows.

Index

Revenue Recognition

Revenues are recognized in accordance with ASC 605-10-S99, “Revenue Recognition.” We consider amounts earned upon evidence that an arrangement has been obtained, services are delivered, fees are fixed or determinable, and collectibility is reasonably assured. Additionally, revenues on arrangements requiring the delivery of more than one product or service are recognized in accordance with ASC 605-25.

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

Substantially all of our contracts are contracts with the U.S. Government involving the complex delivery of technology products and services. Accordingly, these contracts are within the scope of the American Institute of Certified Public Accountant’s Audit and Accounting Guide for Audits of Federal Government Contractors. To the extent contracts are incomplete at the end of an accounting period, revenue is recognized on the percentage-of-completion method, on a proportional performance basis, using costs incurred in relation to total estimated costs.

We may use subcontractors and suppliers in the course of performing on contracts. Some of these arrangements may fall within the scope of ASC 605-45. We presume that revenues on our contracts are recognized on a gross basis, as we generally provide significant value-added services, assume credit risk, and reserve the right to select subcontractors and suppliers, but we evaluate the various criteria specified in the guidance in making the determination of whether revenue should be recognized on a gross or net basis.

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

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

Secure Networking Solutions – We provide wireless and wired networking solutions consisting of hardware and services to our customers. Also within the Secure Networks solution area is our Emerging Technologies Group, which creates innovative, custom-tailored solutions for government and commercial enterprises. The solutions within Secure Networks and Emerging Technologies are generally sold as FFP bundled solutions. Certain of these networking solutions involve contracts to design, develop, or modify complex electronic equipment configurations to a buyer's specification or to provide network engineering services related to the performance of such contracts, and as such fall within the scope of ASC 605-35. Revenue is earned upon percentage of completion based upon proportional performance, such performance generally being defined by performance milestones. Certain other solutions fall within the scope of ASC 605-10-S99, such as resold information technology products, like laptop computers, printers, networking equipment and peripherals, and ASC 605-25. Revenue is recognized based upon objective reliable evidence of fair value of the elements, such as upon delivery of the hardware product or other direct costs (“ODC”) and the ongoing maintenance.

Index

For product sales, revenue is recognized upon proof of acceptance by the customer, otherwise it is deferred until such time as the proof of acceptance is obtained. For example, in delivery orders for Department of Defense customers, which comprise the majority of the Company’s customers, such acceptance is achieved with a signed Department of Defense Form DD-250. Services provided under these contracts are generally provided on a FFP basis, and as such fall within the scope of ASC 605-10-S99. Revenue for services is recognized based on proportional performance, as the work progresses. FFP services may be billed to the customer on a percentage-of-completion basis or based upon milestones, which may approximate the proportional performance of the services under the agreements, as specified in such agreements. To the extent that customer billings exceed the performance of the specified services, the revenue would be deferred. Revenue is recognized under T&M services contracts based upon specified billing rates and other direct costs as incurred.

Information Assurance – We provide Xacta Information Assurance Manager software and cybersecurity services to our customers. The software and accompanying services fall within the scope of ASC 985-605, as fully discussed above. We provide consulting services to our customers under either a FFP or T&M basis. Such contracts fall under the scope of ASC 605-10-S99. Revenue for FFP services is recognized on a proportional performance basis. FFP services may be billed to the customer on a percentage-of-completion basis or based upon milestones, which may approximate the proportional performance of the services under the agreements, as specified in such agreements. To the extent that customer billings exceed the performance of the specified services, the revenue would be deferred. Revenue is recognized under T&M contracts based upon specified billing rates and other direct costs as incurred.

Identity Management – We provide our identity assurance and access management solutions and services and sell information technology products, such as laptop computers and specialized printers, and consumables, such as identity cards, to our customers. The solutions are generally sold as FFP bundled solutions, which would typically fall within the scope of ASC 605-25 and ASC 605-10-S99. Revenue is recognized based upon objective reliable evidence of fair value of the elements, such as upon delivery of the hardware product or ODC’s and the ongoing maintenance. Revenue for services is recognized based on proportional performance, as the work progresses. FFP services may be billed to the customer on a percentage-of-completion basis or based upon milestones, which may approximate the proportional performance of the services under the agreements, as specified in such agreements. To the extent that customer billings exceed the performance of the specified services, the revenue would be deferred. Revenue is recognized under T&M contracts based upon specified billing rates and other direct costs as incurred.

Accounts Receivable

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

Inventories

Inventories are stated at the lower of cost or net realizable value, where cost is determined on the weighted average method. Substantially all inventories consist of purchased commercial off-the-shelf hardware and software, and component computer parts used in connection with system integration services that we perform. Inventories also include spare parts which are utilized to support maintenance contracts. Spare parts inventory is amortized on a straight-line basis over two to five years, which represents the shorter of the warranty period or useful life. An allowance for obsolete, slow-moving or nonsalable inventory is provided for all other inventory. This allowance is based on our overall obsolescence experience and our assessment of future inventory requirements. This charge is taken primarily due to the age of the specific inventory and the significant additional costs that would be necessary to upgrade to current standards as well as the lack of forecasted sales for such inventory in the near future. Gross inventory consisted of finished goods of $19.8 million and $7.5 million as of September 30, 2011 and December 31, 2010, respectively; and work-in-process of $0 and $0.1 million as of September 30, 2011 and December 31, 2010, respectively.

Income Taxes

We account for income taxes in accordance with ASC 740, “Income Taxes.” Under ASC 740, deferred tax assets and liabilities are recognized for the estimated future tax consequences of temporary differences and income tax credits. Deferred tax assets and liabilities are measured by applying enacted statutory tax rates that are applicable to the future years in which deferred tax assets or liabilities are expected to be settled or realized for differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Any change in tax rates on deferred tax assets and liabilities is recognized in net income in the period in which the tax rate change is enacted. We record a valuation allowance that reduces deferred tax assets when it is "more likely than not" that deferred tax assets will not be realized.

Index

We follow the provisions of ASC 740 related to accounting for uncertainty in income taxes. The accounting estimates related to liabilities for uncertain tax positions require us to make judgments regarding the sustainability of each uncertain tax position based on its technical merits. If we determine it is more likely than not that a tax position will be sustained based on its technical merits, we record the impact of the position in our consolidated financial statements at the largest amount that is greater than fifty percent likely of being realized upon ultimate settlement. These estimates are updated at each reporting date based on the facts, circumstances and information available. We are also required to assess at each reporting date whether it is reasonably possible that any significant increases or decreases to our unrecognized tax benefits will occur during the next twelve months.

As of September 30, 2011 and December 31, 2010, we had $405,000 and $501,000, respectively, of unrecognized tax benefits, which would have an effect on the effective tax rate, if recognized. Income taxes are provided based on the liability method for financial reporting purposes. For the three and nine months ended September 30, 2011, there were $20,000, and $27,000 of interest and penalties recorded and included in tax expense, respectively. For the three and nine months ended September 30, 2010, there were $3,000, and $13,000 of interest and penalties recorded and included in tax expense, respectively.

The provision for income taxes in interim periods is computed by applying the estimated annual effective tax rate against earnings before income tax expense for the period. In addition, non-recurring or discrete items are recorded during the period in which they occur.

Goodwill and other intangible assets

As the result of acquisitions, we record any excess purchase price over the net tangible and identifiable intangible assets acquired as goodwill. A preliminary allocation of the purchase price to tangible and intangible net assets acquired is based upon a preliminary valuation, and our estimates and assumptions may be subject to change. To date intangible assets consist primarily of customer relationship enhancements. Intangible assets are amortized on a straight-line basis over their estimated useful lives of 5 years.

Restricted Stock Grants

In June 2008, we issued 4,774,273 shares of restricted stock (Class A common) in exchange for the majority of stock options outstanding under the Telos Corporation, Xacta Corporation and Telos Delaware, Inc. stock option plans. In addition, we granted 7,141,501 shares of restricted stock to our executive officers and employees. In September 2008 and December 2009, we granted 480,000 shares and 80,000 shares, respectively, of restricted stock to certain of our directors. In February 2011, we granted an additional 2,330,804 shares of restricted stock to our executive officers, directors and employees. Such stock is subject to a vesting schedule as follows: 25% of the restricted stock vested immediately on the date of grant, thereafter, an additional 25% will vest annually on the anniversary of the date of grant subject to continued employment or services. In accordance with ASC 718, we reported no compensation expense for any of the issuances as the value of the common stock was negligible, based on the deduction of our outstanding debt, capital lease obligations, and preferred stock from an estimated enterprise value, which was estimated based on discounted cash flow analysis, comparable public company analysis, and comparable transaction analysis.

Other Comprehensive Income

Our functional currency is the U.S. Dollar. For one of our wholly owned subsidiaries, the functional currency is the local currency. For this subsidiary, the translation of its foreign currency into U.S. Dollars is performed for assets and liabilities using current foreign currency exchange rates in effect at the balance sheet date and for revenue and expense accounts using average foreign currency exchange rates during the period. Translation gains and losses are included in stockholders’ deficit as a component of accumulated other comprehensive income. Accumulated other comprehensive income included within stockholders’ deficit consists of the following (in thousands):

	September 30, 2011			December 31, 2010
Cumulative foreign currency translation adjustment	$	(56	)	$	(26	)
Accumulated other comprehensive loss	$	(56	)	$	(26	)

Index

Note 2. Sale of Assets

On April 11, 2007, Telos ID was formed as a limited liability company under the Delaware Limited Liability Company Act, specifically with the purpose of performing substantially all of our Identity Management business. We assigned the rights to perform under our U.S. Government contract with the Defense Manpower Data Center (“DMDC”) to Telos ID and contributed substantially all of the assets of the business line at their stated book values. The net book value of assets we contributed totaled $17,000. Until April 19, 2007, we owned 99.999% of the membership interests of Telos ID and certain private equity investors ("Investors") owned 0.001% of the membership interests of Telos ID. On April 20, 2007, we sold an additional 39.999% of the membership interests to the Investors in exchange for $6 million in cash consideration. In accordance with ASC 505-10, we recognized a gain of $5.8 million. As a result, we own 60% of Telos ID, and therefore continue to account for the investment in Telos ID using the consolidation method. Legal and investment banking expenses directly associated with the transaction amounted to approximately $190,000.

The Amended and Restated Operating Agreement of Telos ID (“Operating Agreement”) provides for a Board of Directors comprised of five members. Pursuant to the Operating Agreement, John B. Wood, Chairman and CEO of Telos, has been designated as the Chairman of the Board of Telos ID. The Operating Agreement also provides for two subclasses of membership units: Class A, held by us and Class B, held by certain private equity investors. The Class A membership unit owns 60% of Telos ID, as mentioned above, and as such is allocated 60% of the profit or loss, which was $1.7 million, and $2.5 million for the three and nine months ended September 30, 2011, respectively, and $0.7 million and $1.1 million for the three and nine months ended September 30, 2010, respectively, and is entitled to appoint three members of the Board of Directors. The Class B membership unit owns 40% of Telos ID, and as such is allocated 40% of the profit or loss, which was $1.1 million and $1.7 million profit for the three and nine months ended September 30, 2011, respectively, and $0.5 million and $0.7 million for the three and nine months ended September 30, 2010, respectively, and is entitled to appoint two members of the Board of Directors. The Class B membership unit is the non-controlling interest as defined by ASC 810, “Consolidation.”

In accordance with the Operating Agreement, quarterly distributions of $450,000 were required to be made to the Class B membership unit for the initial eighteen month period after the sale of the Telos ID membership interests. Further, subsequent to the initial eighteen month period, distributions were to be made to the members in the subsequent period only when and to the extent determined by the Telos ID’s Board of Directors, in accordance with the Operating Agreement. The Class B member received a total of $0.4 million and $1.0 million for the three and nine months ended September 30, 2011, respectively, and $0.3 million and $0.6 million for the three and nine months ended September 30, 2010, respectively, of such distributions.

The following table details the changes in non-controlling interest for the three and nine months ended September 30, 2011 and 2010 (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
Non-controlling interest, beginning of period	$	410		$	(293	)	$	454		$	328
Net income		1,100			459			1,672			747
Distributions		(405	)		(289	)		(1,021	)		(612	)

Non-controlling interest, end of period	$	1,105		$	463		$	1,105		$	463

Index

Note 3. Investment in Teloworks

Effective January 1, 2008, Telos owns 100% of Teloworks. As previously reported, we had recorded all fundings to Teloworks as expense in our consolidated statement of operations. Effective January 1, 2009, we accounted for the investment in Teloworks using the consolidation method.

In 2008, Teloworks formed a wholly-owned subsidiary, Teloworks BPO Solutions Philippines, Inc., for the purpose of starting up a business-process outsourcing business in the Philippines, which began operations in the third quarter of 2009 but had not generated significant revenue, and in January 2011 operations were suspended. We are currently evaluating the future direction of the business. The results of this entity have also been consolidated.

Note 4. Investment in Enterworks

As of September 30, 2011, we owned 671,301 shares of common stock, 729,732 shares of Series A-1 Preferred Stock, 1,793,903 shares of Series B-1 Preferred Stock, and 8,571,429 shares of Series D Preferred Stock of Enterworks, Inc. (“Enterworks”) and warrants to purchase 1,785,714 underlying common stock shares, representing a fully diluted ownership percentage of 8.2% of Enterworks. Since our initial investment in Enterworks, we accounted for our investment under the equity method of accounting, due to our significant influence on Enterworks’ operations through our representation on the Board of Directors of Enterworks. However, effective January 1, 2008, we discontinued the equity method of accounting for our investment in Enterworks due to our significantly diminished role in Enterworks’ operations. We previously reduced the carrying value of our investment in Enterworks to zero.

Index

Note 5. Fair Value Measurements

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

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

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

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

As of September 30, 2011 and December 31, 2010, we did not have any financial instruments with significant Level 3 inputs and we did not have any financial instruments that are measured at fair value on a recurring basis.

At September 30, 2011, as a result of the acquisition of IT Logistics, Inc. (see Note 11 – Acquisition of IT Logistics, Inc.), the outstanding balance of the $7 million note was $5.6 million. Additionally, the $15 million subordinated promissory note was recorded at its fair value of $11.7 million and has been accreted to its current carrying value of $11.9 million as of September 30, 2011. The $15 million subordinated promissory note will be accreted to its face value over 60 months.

On September 27, 2010, 4.9% of the senior redeemable preferred stock (the “Senior Redeemable Preferred Stock”) was redeemed for $430,000 and subsequently on April 8, 2011, 22.3% of the Senior Redeemable Preferred Stock was redeemed for $2.1 million (see Note 7 – Redeemable Preferred Stock). As of September 30, 2011 and December 31, 2010, the carrying value of the Senior Redeemable Preferred Stock was $8.1 million and $10.2 million, respectively. Since there have been no material changes in the Company’s financial condition and no material modifications to the financial instruments, the estimated fair value of the Senior Redeemable Preferred Stock remains consistent with those disclosed as of December 31, 2010, adjusted for the redemption and accrual of dividends on the Senior Redeemable Preferred Stock.

As of September 30, 2011 and December 31, 2010, the carrying value of the Company’s 12% Cumulative Exchangeable Redeemable Preferred Stock, par value $.01 per share (the “Public Preferred Stock”) was $107.7 million and $104.8 million, respectively, and the estimated fair market value was $73.3 million and $66.9 million, respectively, based on quoted market prices.

Index

Note 6. Current Liabilities and Debt Obligations

Accounts Payable and Other Accrued Payables

As of September 30, 2011 and December 31, 2010, the accounts payable and other accrued payables consisted of $21.4 million and $22.6 million, respectively, in trade account payables and $12.5 million and $6.3 million, respectively, in accrued trade payables.

Senior Revolving Credit Facility

On May 17, 2010, we amended our $25 million revolving credit facility (the “Facility”) with Wells Fargo Capital Finance, Inc. (“Wells Fargo”). Under the amended terms, the maturity date of the Facility was extended to May 17, 2014 from September 30, 2011, the limit on the Facility was increased to $30 million from $25 million, and a term loan component of $7.5 million was added to the Facility. The principal of the term loan component will be repaid in quarterly installments of $93,750, with a final installment of the unpaid principal amount payable on May 17, 2014. The interest rate on the term loan component is the same as that on the revolving credit component of the Facility, which was changed to the higher of the Wells Fargo Bank “prime rate” plus 1%, the Federal Funds rate plus 1.5%, or the 3-month LIBOR rate plus 2%. In lieu of having interest charged at the foregoing rates, the Company may elect to have the interest on all or a portion of the advances on the revolving credit component be a rate based on the LIBOR Rate (as defined in the Facility) plus 3.75%. As of September 30, 2011, we have not elected the LIBOR Rate option. Borrowings under the Facility continue to be collateralized by substantially all of the Company’s assets including inventory, equipment, and accounts receivable. The financial covenants were updated to include minimum EBITDA (as defined in the Facility), minimum recurring revenue and a limit on capital expenditures. The Facility’s anniversary fee was discontinued and the collateral management fee was reduced. Additionally, the Facility was amended to permit the full repayment of the entire principal amount of the Notes (as defined below).

In accordance with the stated use of proceeds for the term loan component of the Facility, $4.2 million was paid concurrent with the closing of the amendment to each of the holders of the Notes (as defined below) in full repayment of the principal and accrued but unpaid interest on the Notes through May 17, 2010.

On September 27, 2010, the Facility was further amended to allow for the redemption of up to $2.5 million of the aggregate value of the Senior Redeemable Preferred Stock at a discount from par value of at least 10%. On September 27, 2010 and on April 8, 2011, a portion of the Senior Redeemable Preferred Stock was redeemed (see Note 7 – Redeemable Preferred Stock).

As of September 30, 2011, the interest rate on the Facility was 4.25%. We incurred interest expense in the amount of $0.2 million and $0.5 million each for the three and nine months ended September 30, 2011 and 2010, respectively, on the Facility.

The Facility has various covenants that may, among other things, affect our ability to merge with another entity, sell or transfer certain assets, pay dividends and make other distributions beyond certain limitations. As of September 30, 2011, we were in compliance with the Facility’s financial covenants, including EBITDA covenants. The term loan component of the Facility amortizes at 5% per year, or $0.4 million, which is paid in quarterly installments and is classified as current on the condensed consolidated balance sheets. The remaining balance of the term loan, or $6.7 million, and the revolving component of the Facility mature over the period 2011 through 2014 and are classified as a noncurrent liability as of September 30, 2011.

Index

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

	2011		2012		2013		2014		Total
Short-term:
Term loan	$	375	$	----	$	----	$	----	$	375	1
Long-term:
Term loan	$	----	$	375	$	375	$	5,906	$	6,656	1
Revolving credit		----		----		---		7,643		7,643	2

Subtotal	$	----	$	375	$	375	$	13,549	$	14,299

Total	$	375	$	375	$	375	$	13,549	$	14,674

The principal will be repaid in quarterly installments of $93,750, with a final installment of the unpaid principal amount payable on May 17, 2014.

Balance due represents balance as of September 30, 2011, with fluctuating balances based on working capital requirements of the Company.

Notes payable – IT Logistics, Inc.

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

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

At September 30, 2011, the outstanding balance of the $7 million note was $5.6 million. Additionally, the $15 million subordinated promissory note was recorded at its fair value of $11.7 million and has been accreted to its current carrying value of $11.9 million as of September 30, 2011. The $15 million subordinated promissory note will be accreted to its face value over 60 months.

Index

Senior Subordinated Notes

In 1995, we issued Senior Subordinated Notes (“Subordinated Notes”) to certain shareholders. Such Subordinated Notes are classified as either Series B or Series C. The Series B Subordinated Notes were secured by our property and equipment, but subordinate to the security interests of Wells Fargo under the Facility. The Series C Subordinated Notes were unsecured. The maturity date of such Subordinated Notes had been extended to December 31, 2011, 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 Subordinated Notes could be prepaid at our option; however, the Subordinated Notes contained a cumulative prepayment premium of 13.5% per annum payable upon certain circumstances, which included, but were not limited to, an initial public offering of our common stock or a significant refinancing (“qualifying triggering event”), to the extent that sufficient net proceeds from either of the above events were received to pay such cumulative prepayment premium. Due to the contingent nature of the cumulative prepayment premium, any associated premium expense could only be quantified and recorded subsequent to the occurrence of such a qualifying triggering event.

On May 17, 2010, the principal balances of the Subordinated Notes plus accrued interest totaling $4.2 million were paid in full, with the prepayment penalties on the repayment waived by the note holders. We incurred interest expense in the amount of $0 million and $0.2 million for the three and nine months ended September 30, 2010, respectively, on the Subordinated Notes.

Warranty Liability

We provide warranty services to our customers primarily in the Secure Networks business line. The majority of our warranty services involves contractual coverage with the Original Equipment Manufacturer (“OEM”) and primarily involves referrals to the OEM for service calls. Additionally, certain contracts and programs require that we provide an enhanced level of warranty coverage. The balance of our accrued warranty liability as of September 30, 2011 and December 31, 2010 was $1.0 million and $1.1 million, respectively.

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Note 7. Redeemable Preferred Stock

Senior Redeemable Preferred Stock

The Senior Redeemable Preferred Stock is senior to all other outstanding equity of the Company, including the Public Preferred Stock. The Series A-1 ranks on parity with the Series A-2. The components of the authorized Senior Redeemable Preferred Stock are 1,250 shares of Series A-1 and 1,750 shares of Series A-2 Senior Redeemable Preferred Stock, each with $.01 par value. The Senior Redeemable Preferred Stock carries a cumulative per annum dividend rate of 14.125% of its liquidation value of $1,000 per share. The dividends are payable semiannually on June 30 and December 31 of each year. We have not declared dividends on our Senior Redeemable Preferred Stock since its issuance. The liquidation preference of the Senior Redeemable Preferred Stock is the face amount of the Series A-1 and A-2 ($1,000 per share), plus all accrued and unpaid dividends.

Due to the terms of the Facility and of the Senior Redeemable Preferred Stock, we have been and continue to be precluded from paying accrued and unpaid dividends on the Senior Redeemable Preferred Stock, other than as described below. Certain holders of the Senior Redeemable Preferred Stock have entered into standby agreements whereby, among other things, those holders will not demand any payments in respect of dividends or redemptions of their instruments and the maturity dates of the instruments have been extended. As a result of such standby agreements, as of September 30, 2011, instruments held by Toxford Corporation (“Toxford”), the holder of 76.4% of the Senior Redeemable Preferred Stock, will mature on August 31, 2014, and instruments held by North Atlantic Smaller Companies Investment Trust PLC, the holder of 5.8% of the Senior Redeemable Preferred Stock, will mature on December 31, 2011.

On September 27, 2010, the Facility was amended to allow for the redemption of up to $2.5 million of the aggregate value of the Senior Redeemable Preferred Stock under certain conditions, the most significant being the redemption at a discount from par value of at least 10%. In accordance with the terms of the Senior Redeemable Preferred Stock, however, any redemption must be pro rata among the holders of the Senior Redeemable Preferred Stock unless such holders waive their rights to have their shares redeemed. Due to the limitations, contractual restrictions, and agreements described above, the Senior Redeemable Preferred Stock is classified as noncurrent as of September 30, 2011.

On September 27, 2010, with the consent and waiver of the remaining holders of the outstanding shares of Senior Redeemable Preferred Stock, 4.9% of the Senior Redeemable Preferred Stock with a carrying value of $522,000 was redeemed for $430,000, resulting in a gain in the amount of $92,000, representing a discount of approximately 17.5%, which was recorded in other income on the consolidated statements of operations.

On or about March 15, 2011, Mr. John Porter, the beneficial owner of 44.0% of our Class A Common Stock, acquired a total of 75 shares and 105 shares of Series A-1 and Series A-2 Redeemable Preferred Stock, respectively, from other holders of the Senior Redeemable Preferred Stock. As of September 30, 2011, Mr. Porter held 6.3% of the Senior Redeemable Preferred Stock, of which 3.1% will mature on December 31, 2011. In the aggregate, as of September 30, 2011, Mr. Porter and Toxford held a total of 763 shares and 1,069 shares of Series A-1 and Series A-2 Redeemable Preferred Stock, respectively, or 82.7% of the Senior Redeemable Preferred Stock. Mr. Porter is the sole stockholder of Toxford.

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

At September 30, 2011, the total number of shares of Senior Redeemable Preferred Stock issued and outstanding was 923 shares and 1,292 shares for Series A-1 and Series A-2, respectively. At December 31, 2010, the total number of shares of Senior Redeemable Preferred Stock issued and outstanding was 1,188 shares and 1,664 shares for Series A-1 and Series A-2, respectively.

Index

At September 30, 2011 and December 31, 2010, cumulative undeclared, unpaid dividends relating to Senior Redeemable Preferred stock totaled $5.9 million and $7.4 million, respectively. We accrued dividends on the Senior Redeemable Preferred Stock of $79,000 and $258,000 for the three and nine months ended September 30, 2011, respectively, and $106,000 and $316,000 for the three and nine months ended September 30, 2010, respectively, which were reported as interest expense. Prior to the effective date of ASC 480-10, “Distinguishing Liabilities from Equity,” on July 1, 2003, such dividends were charged to stockholders’ deficit.

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. We initially issued 2,858,723 shares of the Public Preferred Stock during fiscal year 1990. The Public Preferred Stock was recorded at fair value on the date of original issue, November 21, 1989, and we made periodic accretions under the effective interest method of the excess of the redemption value over the recorded value. We adjusted our estimate of accrued accretion in the amount of $1.5 million in the second quarter of 2006. The Public Preferred Stock was fully accreted as of December 2008. We declared stock dividends totaling 736,863 shares in 1990 and 1991. Since 1991, no other dividends, in stock or cash, have been declared. In November 1998, we retired 410,000 shares of the Public Preferred Stock. The total number of shares issued and outstanding at September 30, 2011 and December 31, 2010 was 3,185,586. The Public Preferred Stock is no longer quoted on the OTCBB, and is now quoted as TLSRP on the OTCQB marketplace.

Since 1991, no other dividends were declared or paid on our Public Preferred Stock, based upon our interpretation of restrictions in our Articles of Amendment and Restatement, limitations in the terms of the Public Preferred Stock instrument, specific dividend payment restrictions in the Facility entered into with Wells Fargo to which the Public Preferred Stock is subject, other senior obligations, and Maryland law limitations in existence prior to October 1, 2009. Pursuant to their terms, we were scheduled, but not required, to redeem the Public Preferred Stock in five annual tranches during the period 2005 through 2009. However, due to our substantial senior obligations, limitations set forth in the covenants in the Facility, foreseeable capital and operational requirements, and restrictions and prohibitions of our Articles of Amendment and Restatement, we were unable to meet the redemption schedule set forth in the terms of the Public Preferred Stock. Moreover, the Public Preferred Stock is not payable on demand, nor callable, for failure to redeem the Public Preferred Stock in accordance with the redemption schedule set forth in the instrument. Therefore, we classify these securities as noncurrent liabilities in the condensed consolidated balance sheets as of September 30, 2011 and December 31, 2010.

We are parties with certain of our subsidiaries to the Facility agreement with Wells Fargo, whose term expires on May 17, 2014. Under the Facility, we agreed that, so long as any credit under the Facility is available and until full and final payment of the obligations under the Facility, we would not make any distribution or declare or pay any dividends (other than common stock) on our stock, or purchase, acquire, or redeem any stock, or exchange any stock for indebtedness, or retire any stock.

Accordingly, as stated above, we will continue to classify the entirety of our obligation to redeem the Public Preferred Stock as a long-term obligation. The Facility prohibits, among other things, the redemption of stock, common or preferred, other than as described above. The Public Preferred Stock by its terms cannot be redeemed if doing so would violate the terms of an agreement regarding the borrowing of funds or the extension of credit which is binding upon us or any of our subsidiaries, and it does not include any other provisions that would otherwise require any acceleration of the redemption of or amortization payments with respect to the Public Preferred Stock. Thus, the Public Preferred Stock is not and will not be due on demand, nor callable, within twelve months from September 30, 2011. This classification is consistent with ASC 210-10 and 470-10 and the FASB ASC Master Glossary definition of “Current Liabilities.”

Index

ASC 210-10 and the FASB ASC Master Glossary define current liabilities as follows: The term current liabilities is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities. As a balance sheet category, the classification is intended to include obligations for items which have entered into the operating cycle, such as payables incurred in the acquisition of materials and supplies to be used in the production of goods or in providing services to be offered for sale; collections received in advance of the delivery of goods or performance of services; and debts that arise from operations directly related to the operating cycle, such as accruals for wages, salaries, commissions, rentals, royalties, and income and other taxes. Other liabilities whose regular and ordinary liquidation is expected to occur within a relatively short period of time, usually twelve months, are also intended for inclusion, such as short-term debts arising from the acquisition of capital assets, serial maturities of long-term obligations, amounts required to be expended within one year under sinking fund provisions, and agency obligations arising from the collection or acceptance of cash or other assets for the account of third persons.

ASC 470-10 provides the following: The current liability classification is also intended to include obligations that, by their terms, are due on demand or will be due on demand within one year (or operating cycle, if longer) from the balance sheet date, even though liquidation may not be expected within that period. It is also intended to include long-term obligations that are or will be callable by the creditor either because the debtor’s violation of a provision of the debt agreement at the balance sheet date makes the obligation callable or because the violation, if not cured within a specified grace period, will make the obligation callable.

If, pursuant to the terms of the Public Preferred Stock, we do not redeem the Public Preferred Stock in accordance with the scheduled redemptions described above, the terms of the Public Preferred Stock require us to discharge our obligation to redeem the Public Preferred Stock as soon as we are financially capable and legally permitted to do so. Therefore, by its very terms, the Public Preferred Stock is not due on demand or callable for failure to make a scheduled payment pursuant to its redemption provisions and is properly classified as a noncurrent liability.

We pay dividends on the Public Preferred Stock when and if declared by the Board of Directors. The Public Preferred Stock accrues a semi-annual dividend at the annual rate of 12% ($1.20) per share, based on the liquidation preference of $10 per share and is fully cumulative. Dividends in additional shares of the Public Preferred Stock for 1990 and 1991 were paid at the rate of 6% of a share for each $.60 of such dividends not paid in cash. For the cash dividends payable since December 1, 1995, the Company has accrued $75.8 million and $72.9 million as of September 30, 2011 and December 31, 2010, respectively, which was recorded as interest expense.

In accordance with ASC 480-10, both the Senior Redeemable Preferred Stock and the Public Preferred Stock have been reclassified from equity to liability. Consequently, dividends totaling $1.0 million and $3.1 million for the three and nine months ended September 30, 2011, respectively, and $1.1 million and $3.2 million for the three and nine months ended September 30, 2010, respectively, were accrued and reported as interest expense in the respective periods. Prior to the effective date of ASC 480-10 on July 1, 2003, such dividends were charged to stockholders’ accumulated deficit.

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

Index

In May 2006, the Board concluded that the accrual of PIK dividends for the period 1992 through June 1995 was no longer appropriate. Since 1995, we have disclosed in the footnotes to our audited financial statements the carrying value of the accrued PIK dividends on the Public Preferred Stock for the period 1992 through June 1995 as $4.0 million, and that had we accrued cash dividends during this time period, the total amount accrued would have been $15.1 million. As stated above, such amounts were reduced and adjusted to $3.5 million and $13.4 million, respectively, due to the redemption of 410,000 shares of the Public Preferred Stock in November 1998. On May 12, 2006, the Board voted to confirm that its intent with respect to the payment of dividends on the Public Preferred Stock for this period changed from its previously stated intent to pay PIK dividends to that of an intent to pay cash dividends. We therefore changed the accrual from $3.5 million to $13.4 million, the result of which was to increase our negative shareholder equity by the $9.9 million difference between those two amounts, by recording an additional $9.9 million charge to interest expense for the second quarter of 2006, resulting in a balance of $107.7 million and $104.8 million for the principal amount and all accrued dividends on the Public Preferred Stock as of September 30, 2011 and December 31, 2010, respectively. This action is considered a change in assumption that results in a change in accounting estimate as defined in ASC 250-10, which sets forth guidance concerning accounting changes and error corrections.

Note 8. Income Taxes

The income tax provision for interim periods is determined using an estimated annual effective tax rate adjusted for discrete items, if any, which are taken into account in the quarterly period in which they occur. We review and update our estimated annual effective tax rate each quarter. For the three and nine months ended September 30, 2011 and 2010, our estimated annual effective tax rate was primarily impacted by the permanent item related to the noncash interest of our redeemable preferred stock. Accordingly, we recorded $0.1 million income tax benefit and $2.2 million income tax expense for the three and nine months ended September 30, 2011, respectively. We recorded approximately $3.1 million and $3.6 million income tax expense for the three and nine months ended September 30, 2010, respectively.

We implemented the provisions of ASC 740 as of January 1, 2007 and determined that there were approximately $405,000 and $501,000 of unrecognized tax benefits required to be recorded as of September 30, 2011 and December 31, 2010, respectively. We believe that the total amounts of unrecognized tax benefits will not significantly increase or decrease within the next 12 months. The period for which tax years are open, 2007 to 2010, has not been extended beyond applicable statute of limitations.

Index

Note 9. Commitments and Contingencies

Financial Condition and Liquidity

As described in Note 6 – Current Liabilities and Debt Obligations, we maintain a revolving Facility with Wells Fargo. Borrowings under the Facility are collateralized by substantially all of our assets including inventory, equipment, and accounts receivable. The amount of available borrowings fluctuates based on the underlying asset-borrowing base, in general 85% of our trade accounts receivable, as adjusted by certain reserves (as further defined in the Facility agreement). The Facility provides us with virtually all of the liquidity we require to meet our operating, investing and financing needs. Therefore, maintaining sufficient availability on the Facility is the most critical factor in our liquidity. While a variety of factors related to sources and uses of cash, such as timeliness of accounts receivable collections, vendor credit terms, or significant collateral requirements, ultimately impact our liquidity, such factors may or may not have a direct impact on our liquidity, based on how the transactions associated with such circumstances impact our availability under the Facility. For example, a contractual requirement to post collateral for a duration of several months, depending on the materiality of the amount, could have an immediate negative effect on our liquidity, as such a circumstance would utilize availability on the Facility without a near-term cash inflow back to us. Likewise, the release of such collateral could have a corresponding positive effect on our liquidity, as it would represent an addition to our availability without any corresponding near-term cash outflow. Similarly, a slow-down of payments from a customer, group of customers or government payment office would not have an immediate and direct effect on our availability on the Facility unless the slowdown was material in amount and over an extended period of time. Any of these examples could have an impact on the Facility, and therefore our liquidity.

We believe that available cash and borrowings under the Facility will be sufficient to generate adequate amounts of cash to meet our needs for operating expenses, debt service requirements, and projected capital expenditures through the foreseeable future. We anticipate the continued need for a credit facility upon terms and conditions substantially similar to the Facility in order to meet our long term needs for operating expenses, debt service requirements, and projected capital expenditures. Our working capital was $11.3 million and $21.3 million as of September 30, 2011 and December 31, 2010, respectively. Although no assurances can be given, we expect that we will be in compliance throughout the term of the Facility with respect to the financial and other covenants.

Legal Proceedings

Costa Brava Partnership III, L.P., et al. v. Telos Corporation, et al.

As previously reported, Costa Brava Partnership III, L.P. (“Costa Brava”), a holder of our Public Preferred Stock, filed a lawsuit (hereinafter the “Complaint”) on October 17, 2005 in the Circuit Court for the City of Baltimore in the State of Maryland (“the Court”) against the Company, its directors, and certain of its officers. As of September 30, 2011, Costa Brava owns 12.7% of the outstanding Public Preferred Stock.

The Complaint alleged that the Company and its officers and directors had engaged in tactics to avoid paying mandatory dividends on the Public Preferred Stock, and asserted that the Public Preferred Stock had characteristics of debt instruments even though it was issued by the Company in the form of stock. Costa Brava alleged, among other things, that the Company and an independent committee of the Board of Directors had done nothing to improve what they claimed to be the Company’s insolvency, or its ability to redeem the Public Preferred Stock and pay accrued dividends. They also challenged the bonus payments to the Company’s officers and directors, and consulting fees paid to the holder of a majority of the Company’s common stock.

On December 22, 2005, the Company’s Board of Directors established a special litigation committee (“Special Litigation Committee”) composed of independent directors to review and evaluate the matters raised in the derivative suit filed against the Company by Costa Brava.

On January 9, 2006, the Company filed a motion to dismiss the Complaint or, in the alternative, to stay the action until the Special Litigation Committee had sufficient time to properly investigate and respond to Costa Brava’s demands. On March 30, 2006, the Court granted the motion to dismiss in part and denied it in part, and denied the alternative request for a stay.

On February 8, 2006, Wynnefield Small Cap Value, L.P. (“Wynnefield”) filed a motion to intervene. An order was entered on May 25, 2006 by the Court, designating Wynnefield Partners as the plaintiff with Costa Brava in the lawsuit. On May 31, 2006, an Amended Complaint was filed in which Wynnefield joined as a Plaintiff. Costa Brava and Wynnefield are hereinafter referred to as “Plaintiffs.”

Index

On May 26, 2006, Plaintiffs filed a motion for a preliminary injunction to prevent the sale or disposal of Xacta Corporation, a subsidiary of the Company, or any of its assets until the lawsuit is resolved on the merits. Subsequently, an order was issued dismissing the motion without prejudice on October 26, 2006, and then reissued on January 26, 2007.

On August 30, 2006, Plaintiffs filed a motion for receivership following the resignations of six of the nine members of the Board of Directors on August 16, 2006. Within a week of the resignations, three new independent board members were added and two more were added in October 2006, bringing the total board membership to eight. Thus, the board and all board committees, including the Special Litigation Committee and the Transaction Committee, were fully reconstituted. The Plaintiffs’ motion for receivership was denied on November 29, 2006. In its Memorandum Opinion denying the motion for receivership, the Court concluded that the Plaintiffs’ holdings in the Public Preferred Stock represented a minority equity interest (not a fixed liability), and that their minority equity interest did not provide a guarantee to payment of dividends or redemption of their shares. The Court further stated that it could not find that the Plaintiffs’ expectations were objectively reasonable, and concluded that the Plaintiffs had not been denied any rights as defined by the proxy statement and prospectus forming the terms of the Public Preferred Stock.

On February 15, 2007, the Plaintiffs filed their second Motion for Preliminary Injunction to prevent the sale or disposal of any corporate assets outside the ordinary course of business until such time that two new Class D directors could be elected. On April 19, 2007, the Court denied the Plaintiffs’ motion. Two new Class D Directors, Messrs. Seth W. Hamot and Andrew R. Siegel, were elected at the June 18, 2007 special meeting of the holders of Public Preferred Stock.

On February 27, 2007, the Plaintiffs filed a Second Amended Complaint and added Mr. John R. C. Porter, then majority shareholder, as a defendant. The Company filed its motion to strike/dismiss and motion for summary judgment on March 28, 2007. On June 6, 2007, the Court granted the motion to dismiss in part and denied it in part. The following counts were dismissed: allegations of fraudulent conveyance (Count I); request for permanent and preliminary injunction related to the fraudulent conveyance allegations (Count II); and allegations of shareholder oppression against Mr. John Porter (Count V). The following counts were not dismissed: request for appointment of a receiver (Count III); request to dissolve the corporation (Count IV); breach of fiduciary duty by directors (Count VI); and breach of fiduciary duty by officers (Count VII).

On May 29, 2007, Telos filed a Counterclaim (“Telos Counterclaim”) against the Plaintiffs alleging interference with its relationship with Wells Fargo, and a related motion for a preliminary injunction. On June 4, 2007, the Court entered a consent order in which the Plaintiffs agreed to cease and desist communications with Wells Fargo. On August 28, 2007, the Court issued a ruling granting Telos’ motion for a preliminary injunction.

On July 20, 2007, counsel for the Special Litigation Committee issued its final report, which found that the available evidence did not support the derivative claims, and there was no instance of bad faith, breach of fiduciary duty or self-interested action or inaction that would make it in the Company's best interests to support the derivative claims. Further, Special Litigation Committee counsel recommended that the Company take all action necessary, appropriate and consistent with such findings.

Thus, on August 24, 2007, the Company filed a motion to dismiss the derivative claims as recommended by the Special Litigation Committee and its report. On January 7, 2008, the Court granted the Company’s motion to dismiss the derivative claims and dismissed Counts VI and VII of the Second Amended Complaint, leaving only Counts III and IV remaining. Accordingly, all counts against the individual defendants were dismissed. Subsequently, the Company filed a motion for Summary Judgment on February 1, 2008 to dismiss the remaining counts.

On February 12, 2008, the Plaintiffs filed a Third Amended Complaint which included all the previous counts from the original Complaint and the Second Amended Complaint as well as additional counts. The additional counts were as follows: breach of contract against Telos (Count VIII); preliminary and permanent injunction to prevent the Company from entering into a transaction to dispose of assets that allegedly would unjustly enrich the officers and directors (Count IX); and a request for an accounting alleging that the Company failed to prepare financial statements as required under Maryland law (Count X). The Company filed a Motion to Dismiss or to Strike the Third Amended Complaint or for Summary Judgment on February 19, 2008.

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On March 3, 2008, the Plaintiffs and all the Defendants to the litigation entered into a Stipulation regarding the Third Amended Complaint. All parties stipulated that the Third Amended Complaint alleges causes of action against the Company only and not against the individual defendants. The parties stipulated that, for purposes of appellate preservation only, the Third Amended Complaint contained allegations concerning parties who, and causes of action which, had been dismissed by prior orders of the Court. The parties further stipulated that all causes of action asserted against the individual defendants in the Third Amended Complaint, and Counts I, II, V, VI and VII of the Third Amended Complaint, were dismissed with prejudice in accordance with the Court's prior rulings. The parties stipulated that the Plaintiffs were not seeking reconsideration of the Court's previous rulings concerning parties or causes of action that had been dismissed.

On April 15, 2008, the Court issued an order dismissing with prejudice the remaining counts (Counts III, IV, VIII, IX, and X) of the Plaintiffs’ Third Amended Complaint against the Company.

On June 19, 2008, the Plaintiffs filed a Motion for Leave to Serve Discovery on Wells Fargo in connection with the Telos Counterclaim. The Company filed its opposition to the motion on July 8, 2008. On December 2, 2008, the Company filed a motion for voluntary dismissal of the counterclaim without prejudice, and the Plaintiffs filed their opposition to the motion on December 19, 2008. A hearing was held on January 23, 2009 before Judge W. Michel Pierson. On the same day, Judge Pierson issued an order granting the Company’s motion to dismiss the counterclaim without prejudice and denying the Plaintiffs’ motion for leave to service discovery as moot.

On February 23, 2009, the Plaintiffs filed a Notice of Appeal to the Court of Special Appeals of Maryland.

On March 6, 2009, the Plaintiffs (now Appellants) filed the Civil Appeal Information Report. The Appellees include the Company and the directors and officers previously named in the dismissed complaints. The Appellants listed a total of 12 issues and sub-issues for review.

On April 8, 2009, the Appellants filed a Petition for Writ of Certiorari to Court of Special Appeals with the Court of Appeals of Maryland. On June 12, 2009, the Court of Appeals of Maryland denied the Petition for Writ of Certiorari, stating that “there has been no showing that review by certiorari is desirable and in the public interest.” The oral arguments were held before the Maryland Court of Special Appeals on May 3, 2010. The court has yet to render a decision on the matter.

At this stage of the appeal process, it is impossible to reasonably determine the degree of probability related to Plaintiffs’ (Appellants’) success in any of their assertions. Although there can be no assurance as to the ultimate outcome of this appeal process, the Company and its officers and directors strenuously deny Plaintiffs’ claims, will continue to vigorously defend the matter, and oppose the relief sought.

Hamot et al. v. Telos Corporation

On August 2, 2007, Messrs. Seth W. Hamot and Mr. Andrew R. Siegel, principals of Costa Brava Partnership III L.P. (“Costa Brava”) and Class D Directors of Telos (“Class D Directors”), filed a verified complaint against the Company and a motion for a temporary restraining order in the Circuit Court for the City of Baltimore, Maryland (“the Court” or “Circuit Court”). The complaint alleged that certain company documents and records had not been promptly provided to them as requested, and that these documents were necessary to fulfill their fiduciary duty as directors.

On August 22, 2007 the Class D Directors filed an amended verified complaint and an amended motion for temporary restraining order alleging that the Company was denying them the ability to effectively review, examine, consider and question future regulatory filings and other important actions and undertakings of the Company.

On August 28, 2007, the Court converted the motion for temporary restraining order into a request for a preliminary injunction and entered a preliminary injunction stating that the Class D Directors were entitled to documents in response to reasonable requests for information pertinent and necessary to perform their duties as members of the Board. In addition, the Court noted that during the pendency of the shareholder litigation, it was not inclined to permit the Class D Directors, through the guise of their newly acquired director status, to avoid their currently binding commitments under the stipulation and protective order entered on July 7, 2006. Pursuant to the terms of that order the Company is entitled to designate documents produced in discovery or submitted to the Court as “confidential” or “highly confidential” and to withhold from the Class D Directors information protected by the work product doctrine or attorney-client privilege.

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On September 24, 2007, the Class D Directors filed a new motion for temporary restraining order and a second amended verified complaint in which they requested that the Court “compel Telos to adhere to the Telos Amended and Restated Bylaws” and alleged that provisions concerning the noticing of Board committee meetings and the recording of Board meeting minutes had been violated and that Mr. Wood’s service as both CEO and Chairman of the Board was improper and impermissible under the Company’s Bylaws. The Court denied the Class D Directors’ motion on October 12, 2007. On the same day, the Court issued an amended preliminary injunction stating that the Class D Directors are entitled to receive written responses to requests for Board of Directors or Board committee minutes within seven (7) days of any such requests and copies of such minutes within fifteen (15) days of any such requests, as well as written responses to all other requests for information and/or documents related to their duties as directors within seven (7) days of such requests, and all Board of Directors appropriate information and/or documents within thirty (30) days of any such requests. The Court further stated that in all other respects, the preliminary injunction order of August 28, 2007 shall remain in full force and effect.

On April 16, 2008, the Company’s independent auditor, Reznick Group, P.C. (“Reznick”), resigned. In its resignation letter addressed to the Chairman of the Audit Committee, Reznick stated that it believed that its independence had been impaired due to communications from the Class D Directors that it perceived as threats of litigation and attempts to influence its opinion on certain accounting issues. The communications included a March 28, 2008 letter that was sent on the letterhead of Roark, Rearden & Hamot Capital Management, LLC (“RRHCM”), which is the general partner of Costa Brava, and of which Seth Hamot, Class D Director, is the managing member, to Goodman & Company, L.L.P. (“Goodman”), which had served as the Company’s independent auditor prior to the engagement of Reznick. The letter also was blind-copied to Reznick. The letter demanded that Goodman withdraw its audit opinion for the years 2006, 2005, and 2004, and threatened further legal action against Goodman, stating “Costa Brava reserves its right to bring claims against Goodman for any damages resulting from clean audit opinions relating to past or future financial statements.”

After Reznick resigned citing impairment to its independence as a result of communications from the Class D Directors, the Company filed a Counterclaim on April 23, 2008, in an effort to prevent the Class D Directors from engaging in any further acts of misrepresentation, interference and improper influence upon the Company’s independent auditors regarding, among other things, a specific accounting treatment (from that of a non-current liability to that of a current liability) for their holdings in the Company’s Public Preferred Stock. The Counterclaim states claims against the Class D Directors for Tortious Interference with Contractual Relationship with Goodman (Count I); Tortious Interference with Contractual Relationship with Reznick (Count II); Tortious Inference with Economic or Business Relations with Goodman (Count III); Tortious Inference with Economic or Business Relations with Reznick (Count IV); Breach of Fiduciary Duty by Hamot (Count V); and Breach of Fiduciary Duty by Siegel (Count VI).

On May 1, 2008, the Court issued an order “to preserve the status quo until a hearing may be conducted.” The Status Quo Order, among other things, stated that the Class D Directors must “cease, desist and refrain from any and all direct or indirect, verbal or written, contact or communication with the Company’s past, current and future auditors, including without limitation Goodman & Company, LLP, (“Goodman”) and Reznick Group (“Reznick”), acting either singly or in concert with others, and either directly with any such auditors and/or with their agents or employees.”

On June 20, 2008, the Company filed its First Amended Counterclaim supplementing and updating its allegations.

On June 27, 2008, the Court granted the Company’s Motion for Preliminary Injunction against the Class D Directors regarding their interference with the Company’s relationship with its current and former auditors. The Court ordered Hamot and Siegel to:

… cease, desist and refrain from any and all direct and indirect contact or communications (whether verbal, written, or otherwise) with Goodman, Reznick, or any other former, current or future auditors of Telos Corporation, or with any agents or representatives of any such auditors, regarding the conduct herein prohibited, during the pendency of this litigation or until such time as Telos obtains audited financial statements for 2007 and files its 10-K with the SEC.

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The Court further prohibited Hamot and Siegel from:

… engaging in contacts, communications or other conduct prohibited by this Order acting either singly or in concert with others, including any entities that they control or through which they operate, including, but not limited to, Costa Brava, RRHCM and RRH [Roark, Rearden, & Hamot Capital Management, LLC and Roark, Rearden & Hamot entities, respectively]. It also specifically prohibits any such actions or conduct undertaken through or in concert or collusion with other persons or entities, including, but not limited to, Wynnefield Partners Small Cap Value, L.P. (“Wynnefield”), Paul Berger or any other holders of the Public Preferred Stock.

The Order further states:

In this case, Telos has contractual relationships with both Reznick and Goodman, which are reflected in their engagement letters with Telos, and Hamot and Siegel had knowledge of these relationships. The record further indicates that Hamot and Siegel intentionally interfered with these relationships, and that their interference caused the non-performance by Reznick and Goodman of the services they were engaged to perform, as well as Reznick’s termination of the engagement. Thus, Telos has raised a substantial claim for tortious interference with contract under the facts presented.

… As discussed above, the record indicates that Telos is likely to demonstrate that Hamot and Siegel intentionally sought to interfere with Reznick’s audit through questionable and potentially misleading communications and barely-veiled threats of litigation, and that their interference caused Reznick to resign. Telos, therefore, has also raised claims going to the merits of its count for tortious interference with business or economic relations.

The Order also states that “Telos is likely to demonstrate that their conduct was not just wrongful, but unlawful.” It further states that “Telos is likely to show that Hamot and Siegel used potentially misleading communications and threats of litigation in an effort to dictate the accounting treatment that Reznick should adopt, thereby running afoul of Sarbanes-Oxley section 303 and SEC Rule 13b2-2 and providing another basis for liability for tortious interference with business or economic relations.”

In addition, the Order states:

Here, the conduct by Hamot and Siegel indicates that they put their interests ahead of the corporation they were supposed to be serving and sought to disrupt the company’s essential relationships to serve their own ends. Indeed, even after being advised at Telos’ April 2, 2008, board meeting that their conduct was jeopardizing the company’s relationship with its auditor, they continued to send more communications to Reznick attempting to influence its opinions. … Given the record before the Court, it appears that Telos likely will be able to demonstrate that Hamot and Siegel breached their fiduciary duties to the Company.

Lastly, the Order states that “the public interest favors Telos.” It states:

When directors with conflicted interests are allowed to interfere with [the audit] process, the public’s interest in the integrity of the process – and its interest in the integrity of the financial information that ultimately will be provided to the investing public – suffers. Moreover, it also is in the public interest to protect the operational status quo of an ongoing viable business, which employs over 500 people and provides essential services to the United States military.

The Class D Directors filed a Motion to Dismiss the Counterclaim on May 21, 2008 and it was denied on July 24, 2008.

On July 16, 2008, the Class D Directors filed a Motion for Stay of Enforcement of Interlocutory Order in the Circuit Court seeking a stay of enforcement of the June 27, 2008 preliminary injunction. The Circuit Court denied the Class D Directors’ motion on August 15, 2008.

On July 25, 2008, the Class D Directors filed a Notice of Appeal of the June 27, 2008 Preliminary Injunction.

On July 30, 2008, the Class D Directors filed in the Court of Special Appeals of Maryland a motion to stay enforcement of the June 27, 2008 preliminary injunction pending appeal of the preliminary injunction. The motion was denied without prejudice by the Court of Special Appeals on August 5, 2008. The Class D Directors filed a renewed motion to stay the preliminary injunction in the Court of Special Appeals on August 20, 2008 and that motion was denied on September 15, 2008.

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On October 2, 2008, the Company filed a Second Amended Counterclaim which added a Count VII, requesting that the Court issue a declaratory judgment that the Class D Directors are not entitled to indemnification or the advancement of expenses under Maryland law.

The oral argument on the Class D Directors’ appeal of the June 27, 2008 preliminary injunction took place before the Court of Special Appeals on November 3, 2008. The Court of Special Appeals took the matter under advisement and, to date, has not issued a decision on the appeal.

Through a letter dated December 17, 2008, the Company informed the Court of Special Appeals that the audit of the Company’s 2007 financial statements had been completed and the Company had filed its 2007 Form 10-K with the SEC as of that date. In their response letter of December 19, 2008 to the Court of Special Appeals, the Class D Directors reiterated their position that the “controversy between the parties is capable of repetition, yet evading appellate review” and further argued that, in any event, the Court should decide the issue of whether the appeal was moot “only upon a fully-briefed motion.” The Company responded on December 23, 2008 that it would be amenable to additional briefing. Thus, on December 30, 2008, the Court of Special Appeals issued an order directing the parties to submit further briefing on the issue of whether the Company’s filing of its 2007 Form 10-K mooted the Class D Directors appeal of the June 27, 2008 preliminary injunction or whether the appeal remained justicable, and if so, under what theory. The Company and the Class D Directors filed their respective Supplemental Memoranda on the mootness issue on January 14, 2009. On January 21, 2009, the Company and the Class D Directors filed their respective Supplemental Reply Memoranda on the mootness issue. On May 6, 2009, the Court of Special Appeals dismissed the appeal of the June 27, 2008 preliminary injunction as moot.

On April 1, 2009, the Class D Directors filed a Petition for Constructive Civil Contempt with the Circuit Court for Baltimore City. The Petition alleges that the Company violated the Court’s August 28, 2007 and October 12, 2007 Orders, referenced above, for failing to provide requested documents or information that the Class D Directors allege is “pertinent and necessary to Plaintiffs’ duties as Telos’ directors.” In addition, on April 21, 2009, the Company filed a motion to dismiss the petition and to dismiss the complaint as moot. On December 30, 2009, the Court ordered that the petition be dismissed. The Court stated “the remedy of civil contempt is not appropriate upon the circumstances before the court. Plaintiffs should not be permitted to resort to this remedy when they failed to engage in good faith exchange with defendant to address the concerns that were raised by defendant or even to acknowledge defendant’s response to their demands for documents.” However, the Court denied the Company’s motion to dismiss the complaint but stated it would schedule a status conference at a later date to review the matter with counsel.

On April 12, 2010, regarding the Hamot et al. v. Telos matter, the Class D Directors filed a Motion for the Advancement of Legal Fees and Expenses. The Class D Directors demand that the Company advance legal fees and expenses incurred in defending against the counterclaim brought by Telos. The Class D Directors allege that since they were party to a lawsuit by reason of their service as Company board members, they should be indemnified. The Class D Directors claim that Maryland law and the Company bylaws entitle them to indemnification. In the counterclaim filed by the Company on April 23, 2008, the Company sought a preliminary injunction to prevent further unlawful interference with the Company’s relationship with the former and current outside auditors, which eventually led to the resignation of the Company’s outside auditors at the time. The Company was successful in obtaining a preliminary injunction against the Class D Directors. On June 25, 2008, the Class D Directors filed an appeal to the preliminary injunction but that appeal was dismissed as moot on May 6, 2009. On September 8, 2008, the Class D Directors submitted a letter through counsel demanding indemnification and reimbursement for expenses incurred related to the counterclaim. On October 2, 2008, the Board of Directors determined that the Class D Directors were not entitled to advancement or indemnification. That same day, the Company filed a second amended counterclaim, adding Count Seven which sought a declaratory judgment that as directors, the Plaintiffs were not entitled to advancement or indemnification of legal fees and expenses.

The Company filed its opposition brief on May 11, 2010 to the Plaintiffs’ Motion for Advancement of Legal Fees and Expenses. The Company states that the Plaintiffs failed to meet the basic statutory requirements of the law in seeking indemnification. The hearing on this matter took place on August 17, 2010.

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On November 3, 2011, the Court denied the Plaintiffs’ Motion for Advancement, as well as the Plaintiffs’ motion for partial summary judgment and request for fees. The Court found that the Plaintiffs had not met the statutory standard of appropriate standard of conduct. The Court stated:

It must be emphasized that a determination that an affirmation of good faith is insufficient is unusual, requiring a high degree of proof. Given the purpose of advancement provisions, they should be construed liberally in favor of advancement, and such a construction weighs against an overly intrusive examination into whether an affirmation was made in good faith. Furthermore, a court must take pains to avoid conducting an indemnification inquiry under the guise of an advancement determination. Therefore, it is a rare case where the court could conclude that a lack of good faith precludes advancement. This is such a rare case. Under the particular circumstances of this case, the court concludes that the record demonstrates that Hamot and Siegel could not have entertained a good faith belief that they met the statutory standards for indemnification.

The Court noted that the Plaintiffs filed their motion 18 months after the conclusion of the Company’s Motion for Preliminary Injunction, “long after Telos rejected the demand for advancement and long after any other activity in the litigation.” When the Plaintiffs sought reimbursement, it was for the expenses incurred in the unsuccessful defense of the preliminary injunction proceedings in which the court had concluded that they had been guilty of a breach of their duties as directors. The opinion notes that Judge Matricciani explicitly stated that the Plaintiffs’ acts and omissions were committed in bad faith. “These findings are inconsistent with the conclusion that Hamot and Siegel met the statutory standard for indemnification.” Therefore, the Plaintiffs “could not entertain a good faith belief that they met the standard, at least insofar as they requested advancement of expenses for litigation of the preliminary injunction.” In addition, the court stated that since the Plaintiffs were “seeking reimbursement for expenses relating to the proceedings that culminated in those findings, those findings must furnish the standard by which their good faith relief should be measured. Their belief is inconsistent with those findings.”

However, the court refused to rule at this time as to whether the Plaintiffs were entitled to an advance for future expenses incurred related to the counterclaim. In that case, the court stated that its analysis of the good faith affirmation will be different. It would depend on the nature of the relief sought by the Company and the basis for the claims asserted. Therefore, the court refused to determine at this time that the Plaintiffs were not entitled to advancement as a matter of law, and denied the Company’s motion for summary judgment on the matter.

On July 19, 2010, the Plaintiffs filed a Motion to Enforce Preliminary Injunction with the Circuit Court of Baltimore City. The Plaintiffs claim that the Company failed to respond to their letter request for documents. Subsequent to the filing, the parties exchanged further correspondence on the matter. On July 23, 2010, the Plaintiffs filed to dismiss its motion.

At this stage of the litigation and appeal process, it is impossible to reasonably determine the degree of probability related to the Class D Directors’ success in any of their assertions and claims. Although there can be no assurance as to the ultimate outcome of these proceedings, the Company and its officers and directors strenuously deny the Class D Directors’ claims, and will vigorously defend the matter, and continue to oppose the relief sought.

Andrew Siegel v. Telos Corporation, et. al.

On June 30, 2010, Mr. Andrew Siegel filed a Complaint against Telos Corporation, Doe I-XX, and Roe Corporation I-XX in the U.S. District Court for the Eastern District of Virginia, Alexandria Division. Subsequently, Mr. Siegel withdrew the lawsuit on August 19, 2010.

Other Litigation

In addition, the Company is a party to litigation arising in the ordinary course of business. In the opinion of management, while the results of such litigation cannot be predicted with any reasonable degree of 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.

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Note 10. Related Party Transactions

The brother of our Chairman and CEO, Emmett Wood, has been an employee of the Company since 1996. The amounts paid to this individual as compensation were $77,000 and $242,000 for the three and nine months ended September 30, 2011, respectively, and $95,000 and $223,000 for the three and nine months ended September 30, 2010, respectively. Additionally, Mr. Wood owned 250,000 shares and 50,000 shares of the Company’s Class A Common Stock and Class B Common Stock, respectively, as of September 30, 2011.

On April 8, 2011, the Company redeemed a total of 637 shares of Senior Redeemable Preferred Stock, including 220 shares and 307 shares of Series A-1 and Series A-2 Redeemable Preferred Stock, respectively, held by Mr. Porter and Toxford, the beneficial owner of 44.0% of our Class A Common Stock. Mr. Porter is the sole stockholder of Toxford. Subsequent to such redemption, Mr. Porter and Toxford held 763 shares and 1,069 shares of Series A-1 and Series A-2, respectively, or 82.7% of the Senior Redeemable Preferred Stock.

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Note 11. Acquisition of IT Logistics, Inc.

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

ITL had been a Telos subcontractor for several years, utilized by our Secure Networks Solutions business line. The acquisition allows the Company to internally maintain the capacity for the work ITL performs, instead of subcontracting such work. Major General John W. Maluda, who serves on the Company’s board of directors, served on the advisory board of ITL, and this relationship was disclosed to the Company’s board of directors before its consideration of the acquisition. General Maluda did not have any financial stake in ITL and did not receive any benefit from the sale of its assets to Telos.

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

The operating results of ITL have been included in the Company’s condensed consolidated financial statements as of the acquisition date of July 1, 2011. The acquisition has been accounted for under the purchase method of accounting. Under the purchase method of accounting, the total purchase price was allocated to ITL’s net tangible and intangible assets acquired based on their estimated fair values as of the Closing Date of the acquisition. The excess of the purchase price over the net tangible and intangible assets was recorded as goodwill. Telos has made a preliminary allocation of the estimated purchase price as follows (amounts in thousands):

Inventories, net	$	221
Property and equipment, net		108
Goodwill		15,058
Other intangible assets		11,286
Total preliminary estimated purchase price allocation	$	26,673

Of the total purchase price, a preliminary estimate of approximately $11.3 million has been allocated to amortizable intangible assets acquired and a preliminary estimate of approximately $0.3 million has been allocated to tangible net assets assumed in connection with the acquisition.

On a pro forma combined basis, the revenue effect of the ITL acquisition is immaterial as Telos was ITL’s primary revenue source prior to the acquisition. On a pro forma combined basis, net income for the three months ended September 30, 2011 and 2010 was $1.2 million and $1.6 million, respectively. On a pro forma combined basis, net income for the nine months ended September 30, 2011 and 2010 was $3.6 million and $3.6 million, respectively.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes,” “anticipates,” “plans,” “expects” 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 in the risk factors section included in the Company’s Form 10-K for the year ended December 31, 2010, as filed with the SEC.

General

Our goal is to deliver superior IT solutions that meet or exceed our customers’ expectations. We focus on secure enterprise solutions that address the unique requirements of the federal government, the military, and the intelligence community, as well as commercial enterprises that require secure solutions. Our IT solutions consist of the following:

Secure Networks – Secure wired and wireless network solutions for Department of Defense and other federal agencies. We provide an extensive range of wired and wireless voice, data, and video secure network solutions and services to support defense and civilian missions. Also, within the Secure Networks solution area, is our Emerging Technologies Group, which creates innovative, custom-tailored solutions for government and commercial enterprises.

Information Assurance – Software products and consulting services to automate, streamline, and enforce IT security and risk management processes enterprise-wide. We offer information assurance consulting services and Xacta brand GRC (governance, risk, and compliance) solutions to protect and defend IT systems, ensuring their availability, integrity, authentication, and confidentiality.

Secure Communications (formerly Secure Messaging) – The next generation offering, Secure Information eXchange (T-6), supports warfighters throughout the world. Our suite of offerings provides secure, automated, web-based solutions for collaboration, distribution, and management of enterprise messages for our customers.

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

Backlog

Our total backlog was $636.8 million and $668.7 million at September 30, 2011 and 2010, respectively. Backlog was $632.2 million at December 31, 2010.

Such backlog amounts include both funded backlog (unfilled firm orders for our products for which funding has been both authorized and appropriated), and unfunded backlog (firm orders for which funding has not been appropriated). Funded backlog as of September 30, 2011 and 2010 was $174.7 million and $152.1 million, respectively. Funded backlog was $124.3 million at December 31, 2010.

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Consolidated Results of Operations (Unaudited)

The accompanying condensed consolidated financial statements include the accounts of Telos Corporation and its subsidiaries including Ubiquity.com, Inc., Xacta Corporation and Telos Delaware, Inc., all of whose issued and outstanding share capital is owned by Telos Corporation (collectively, the “Company” or “Telos” or “We”). We have also consolidated the results of operations of Telos ID (see Note 2 – Sale of Assets) and Teloworks (see Note 3 – Investment in Teloworks). All intercompany transactions have been eliminated in consolidation.

Our operating cycle involves many types of solution, product and service contracts with varying delivery schedules. Accordingly, results of a particular quarter, or quarter-to-quarter comparisons of recorded sales and operating profits, may not be indicative of future operating results and the following comparative analysis should therefore be viewed in such context.

The principal element of the Company’s operating expenses as a percentage of sales for the three and nine months ended September 30, 2011 and 2010 are as follows:

	(unaudited)
	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010

Revenue		100.0	%		100.0	%		100.0	%		100.0	%
Cost of sales		77.9			73.5			75.4			80.0
Selling, general, and administrative expenses		17.1			15.1			17.5			13.8

Operating income		5.0			11.4			7.1			6.2

Other income		0.1			0.1			0.2			0.1
Interest expense		(3.1	)		(2.6	)		(3.2	)		(2.7	)

Income before income taxes		2.0			8.9			4.1			3.6
Income tax benefit (provision)		0.3			(5.3	)		(1.5	)		(2.0	)
Net income		2.3			3.6			2.6			1.6
Less: Net income attributable to non-controlling interest		(2.1	)		(0.8	)		(1.2	)		(0.5	)

Net income attributable to Telos Corporation		0.2	%		2.8	%		1.4	%		1.1	%

Three Months Ended September 30, 2011 Compared with Three Months Ended September 30, 2010

Revenue decreased by 8.1% to $53.0 million for the third quarter of 2011, from $57.6 million for the same period in 2010. Such decrease consists of decreased sales of $5.7 million of Secure Network solutions, $2.1 million of Information Assurance solutions, and $1.1million of Secure Communications solutions, offset by an increase in sales of $4.3 million of Identity Management solutions. Product revenue decreased to $24.3 million for the third quarter of 2011 from $29.1 million for the same period in 2010, primarily attributable to decreases in sales of $7.7 million of Secure Networks solutions due to continued emphasis on selling solutions and services while outsourcing product sales, $1.0 million of Secure Communications solutions, and $0.5 million in sales of Information Assurance solutions, offset by an increase in sales of $4.4 million of Identity Management solutions. Services revenue increased to $28.7 million for the third quarter of 2011 from $28.6 million for the same period in 2010, primarily attributable to an increase in sales of $2.0 million of Secure Networks solutions, offset by decreases in sales of $1.6 million of Information Assurance solutions, $0.2 million of Secure Communications solutions and $0.1 million of Identity Management solutions. The change in product and services revenue varies from period to period as to the mix of solutions sold and the nature of such solutions, as well as the timing of deliverables.

Index

Cost of sales decreased by 2.6% to $41.3 million for the third quarter of 2011 from $42.4 million for the same period in 2010, primarily due to a decrease in product revenue of $4.7 million. Cost of sales for products decreased by $4.0 million, and as a percentage of product revenue decreased by 1.7%, primarily due to the decrease in product revenue for resold products. This was a direct result of continued emphasis on selling solutions and services while outsourcing product sales. Cost of sales for services increased by $2.9 million and as a percentage of services revenue increased by 9.9%, due to $3.1 million of direct contract costs incurred on a Secure Networks contract that has been terminated. The decrease in cost of sales is not necessarily indicative of a trend as the mix of solutions sold and the nature of such solutions can vary from period to period, and further can be affected by the timing of deliverables.

Gross profit decreased by 23.3% to $11.7 million for the third quarter of 2011 from $15.3 million for the same period in 2010. Gross margin decreased to 22.1% in the third quarter of 2011, from 26.5% for the same period in 2010. Product gross margin increased to 26.4% from 24.7%, due primarily to a decrease in products revenue for resold products. Services gross margin decreased to 18.4% from 28.3%, due primarily to the Secure Networks contract termination noted above.

Selling, general, and administrative expense increased by 3.8% to $9.0 million for the third quarter of 2011, from $8.7 million for the same period in 2010, primarily attributable to an increase of $0.6 million due to amortization of other intangible assets, offset by a decrease of $0.3 million in bonuses.

Operating income decreased 59.4% to $2.7 million for the third quarter of 2011, from $6.6 million for the same period in 2010, due primarily to the decrease in gross profit due to the Secure Networks contract termination as noted above.

Interest expense increased 10.0% to $1.7 million for the third quarter of 2011, from $1.5 million for the same period in 2010, primarily due to the accretion of the notes payable related to the ITL acquisition.

Income tax benefit was $0.1 million for the third quarter of 2011, compared to $3.1 million income tax expense for the same period in 2010, which is based on the estimated annual effective tax rate applied to the pretax income incurred for the quarter, based on our expectation of pretax income for the fiscal year.

Net income attributable to Telos Corporation for the third quarter of 2011 was $0.1 million, compared to net income of $1.6 million for the same period in 2010, primarily attributable to the decrease in operating income as discussed above.

Nine Months Ended September 30, 2011 Compared with Nine Months Ended September 30, 2010

Revenue decreased by 18.6% to $142.1 million for the nine months ended September, 2011 from $174.6 million in the same period in 2010. Such decrease consists of decreased sales of $31.0 million of Secure Network solutions, $6.2 million in Information Assurance solutions, and $0.7 million of Secure Communications solutions, offset by an increase in sales of $5.4 million in sales of Identity Management solutions. Product revenue decreased to $48.1 million for the nine months ended September, 2011 from $78.5 million for the same period in 2010, primarily attributable to decreases in sales of $33.6 million of Secure Networks solutions due to continued emphasis on selling solutions and services while outsourcing product sales, $1.6 million of Information Assurance solutions, and $1.0 million of Secure Communications solutions, offset by an increase in sales of $5.8 million of Identity Management solutions. Services revenue decreased to $94.0 million for the nine months ended September, 2011 from $96.2 million for the same period in 2010, primarily attributable to decreases in sales of $4.7 million of Information Assurance solutions and $0.4 million of Identity Management solutions, offset by increases in sales of $2.5 million of Secure Network solutions and $0.4 million of Secure Communications solutions.

Index

Cost of sales decreased by 23.3% to $107.2 million for the nine months ended September 30, 2011 from $139.7 million for the same period in 2010, due primarily to the decrease in product sales in the Secure Networks solutions as discussed above.

Gross profit was $34.9 million for the nine months ended September 30, 2011 and 2010. Gross margin increased to 24.6% for the nine months ended September 30, 2011, from 20.0% in the same period in 2010, due primarily to the mix of solutions sold and the nature of such solutions, as well as the timing of deliverables, with continued emphasis on selling solutions and services while outsourcing product sales.

Selling, general, and administrative expense increased 2.7% to $24.8 million for the nine months ended September 30, 2011 from $24.2 million for the same period in 2010, primarily due to increases of $0.6 million in amortization of other intangible assets, $0.3 in labor costs and $0.3 million in consulting fees, offset by $0.2 million of advertising, $0.2 million of travel costs, and $0.1 million of litigation-related expenses net of insurance reimbursements.

Operating income decreased 6.1% to $10.1 million for the nine months ended September 30, 2011, from $10.7 million for the same period in 2010, due primarily to the decrease in gross profit as noted above.

Interest expense decreased 3.2% to $4.6 million for the nine months ended September 30, 2011, from $4.7 million for the same period in 2010, primarily due to reduction of interest expense resulting from the payoff of the senior subordinated notes in May 2010.

Provision for income taxes was $2.2 million for the nine months ended September 30, 2011, compared to $3.6 million for the nine months ended September 30, 2010, which is based on the estimated annual effective tax rate applied to the pretax income or loss for the nine month period, adjusted for the income tax benefit previously provided, based on our expectation of pretax income for the fiscal year.

Net income attributable to Telos Corporation for the nine months ended September 30, 2011 was $2.0 million, compared to $1.9 million for the nine months ended September 30, 2010, primarily attributable to the reduction in income tax expense, offset by an increase in income attributable to non-controlling interest.

Index

Liquidity and Capital Resources

As described in more detail below, we maintain a revolving credit facility (“the Facility”) with Wells Fargo Capital Finance, Inc. (“Wells Fargo”) which was formerly Wells Fargo Foothill, Inc. Borrowings under the Facility are collateralized by substantially all of our assets including inventory, equipment, and accounts receivable. The amount of available borrowings fluctuates based on the underlying asset-borrowing base, in general 85% of our trade accounts receivable, as adjusted by certain reserves (as further defined in the Facility agreement). The Facility provides us with virtually all of the liquidity we require to meet our operating, investing and financing needs. Therefore, maintaining sufficient availability on the Facility is the most critical factor in our liquidity. While a variety of factors related to sources and uses of cash, such as timeliness of accounts receivable collections, vendor credit terms, or significant collateral requirements, ultimately impact our liquidity, such factors may or may not have a direct impact on our liquidity, based on how the transactions associated with such circumstances impact our availability under the Facility. For example, a contractual requirement to post collateral for a duration of several months, depending on the materiality of the amount, could have an immediate negative effect on our liquidity, as such a circumstance would utilize availability on the Facility without a near-term cash inflow back to us. Likewise, the release of such collateral could have a corresponding positive effect on our liquidity, as it would represent an addition to our availability without any corresponding near-term cash outflow. Similarly, a slow-down of payments from a customer, group of customers or government payment office would not have an immediate and direct effect on our availability on the Facility unless the slowdown was material in amount and over an extended period of time. Any of these examples could have an impact on the Facility, and therefore our liquidity. Management believes that the Company’s borrowing capacity is sufficient to fund our capital and liquidity needs for the foreseeable future.

Cash provided by operating activities was $11.1 million for the nine months ended September 30, 2011, compared to $2.1 million for the same period in 2010. Cash provided by or used in operating activities is primarily driven by the Company’s operating income, the timing of receipt of customer payments, and the timing of its payments to vendors and employees, and the timing of inventory turnover, adjusted for certain non cash items that do not impact cash flows from operating activities. Additionally, for the nine months ended September 30, 2011, net income was $3.7 million compared to $2.6 million for the nine months ended September 30, 2010.

Cash used in investing activities was approximately $8.5 million for the nine months ended September 30, 2011, compared to $0.7 million for the same period in 2010, due to the acquisition of ITL in July 2011.

Cash used in financing activities for the nine months ended September 30, 2011 was $2.5 million, primarily attributable to the redemption of $2.1 million of the Company’s senior redeemable preferred stock (the “Senior Redeemable Preferred Stock”), repayments of note payable of $1.4 million, distributions of $1.0 million to the Class B Member of Telos ID, payments under capital lease obligations of $0.7 million, and repayment of term loan of $0.3 million, offset by net proceeds of $2.9 million from the Facility. Cash used in financing activities for the nine months ended September 30, 2010 was $1.4 million, primarily attributable to the repayment of $4.2 million of the Company’s senior subordinated notes, net repayment of $2.9 million of the Facility, distributions of $0.6 million to the Class B Member of Telos ID, redemption of $0.5 million of Senior Redeemable Preferred Stock, offset by net proceeds of $7.4 million from term loan.

Additionally, our capital structure consists of redeemable preferred stock and common stock. The capital structure is complex and requires an understanding of the terms of the instruments, certain restrictions on scheduled payments and redemptions of the various instruments, and the interrelationship of the instruments especially as it relates to the subordination hierarchy. Therefore, a thorough understanding of how our capital structure impacts our liquidity is necessary and accordingly we have disclosed the relevant information about each instrument as follows:

Index

Senior Revolving Credit Facility

In accordance with the stated use of proceeds for the term loan component of the Facility, $4.2 million was paid concurrent with the closing of the amendment to each of the holders of the Subordinated Notes (as defined below) in full repayment of the principal and accrued but unpaid interest on the Subordinated Notes through May 17, 2010.

At September 30, 2011, we had outstanding borrowings of $14.7 million on the Facility, which included the $7.0 million term loan, of which $0.4 million was due within one year. At December 31, 2010, we had outstanding borrowings of $14.2 million on the Facility, which included the $7.3 million term loan, of which $0.4 million was due within one year. At September 30, 2011 and December 31, 2010, we had unused borrowing availability on the Facility of $12.2 million and $9.1 million, respectively. The effective weighted average interest rates on the outstanding borrowings under the Facility were 6.6% and 7.4% for the nine months ended September 30, 2011 and 2010, respectively. The effective weighted average rates (including interest and various fees paid whether capitalized or expensed pursuant to the Facility agreement and related amendments) on the outstanding borrowings under the Facility were 7.1% and 8.7% for the nine months ended September 30, 2011 and 2010, respectively.

Notes payable – IT Logistics, Inc.

Index

At September 30, 2011, the outstanding balance of the $7 million note was $5.6 million. Additionally, the $15 million subordinated promissory note related to the acquisition of IT Logistics, Inc. was recorded at its fair value of $11.7 million and has been accreted to its current carrying value of $11.9 million as of September 30, 2011. The $15 million subordinated promissory note will be accreted to its face value over 60 months.

Senior Subordinated Notes

Redeemable Preferred Stock

We currently have two primary classes of redeemable preferred stock - Senior Redeemable Preferred Stock and Public Preferred Stock. Each class carries cumulative dividend rates of 14.125% and 12%, respectively. We accrue dividends on both classes of redeemable preferred stock and provided for accretion related to the Public Preferred Stock. As of December 31, 2008, the Public Preferred Stock was fully accreted. The total carrying amount of redeemable preferred stock, including accumulated and unpaid dividends was $115.8 million and $115.0 million at September 30, 2011 and December 31, 2010, respectively. We recorded dividends of $1.0 million and $3.1 million for the three and nine months ended September 30, 2011, respectively; and $1.1 million and $3.2 million for the three and nine months ended September 30, 2010, respectively, on the two classes of redeemable preferred stock, and such amounts have been included in interest expense.

Senior Redeemable Preferred Stock

Index

Public Preferred Stock

Redemption Provisions

Since 1991, no other dividends were declared or paid on our Public Preferred Stock, based upon our interpretation of restrictions in our Articles of Amendment and Restatement, filed with the State of Maryland on January 5, 1992, as amended on April 14, 1995 (“Charter”), limitations in the terms of the Public Preferred Stock instrument, specific dividend payment restrictions in the Facility entered into with Wells Fargo, other senior obligations and Maryland law limitations in existence prior to October 1, 2009. Pursuant to their terms, we were scheduled, but not required, to redeem the Public Preferred Stock in five annual tranches during the period 2005 through 2009. However, due to our substantial senior obligations, limitations set forth in the covenants in the Facility, foreseeable capital and operational requirements, and restrictions and prohibitions of our Charter, we were unable to meet the redemption schedule set forth in the terms of the Public Preferred Stock instrument. Moreover, the Public Preferred Stock is not payable on demand, nor callable, for failure to redeem the Public Preferred Stock in accordance with the redemption schedule set forth in the instrument. Therefore, we classify these securities as noncurrent liabilities in the balance sheet as of September 30, 2011 and December 31, 2010.

Accordingly, as stated above, we will continue to classify the entirety of its obligation to redeem the Public Preferred Stock as a long-term obligation. The Facility prohibits, among other things, the redemption of stock, common or preferred, other than as described above. The Public Preferred Stock by its terms cannot be redeemed if doing so would violate the terms of an agreement regarding the borrowing of funds or the extension of credit which is binding upon us or any of our subsidiaries, and it does not include any other provisions that would otherwise require any acceleration of the redemption of or amortization payments with respect to the Public Preferred Stock. Thus, the Public Preferred Stock is not and will not be due on demand, nor callable, within twelve months from September 30, 2010. This classification is consistent with ASC 210-10, “Balance Sheet” and 470-10, “Debt” and the FASB ASC Master Glossary definition of “Current Liabilities.”

If, pursuant to the terms of the Public Preferred Stock, we do not redeem the Public Preferred Stock in accordance with the scheduled redemptions described above, the terms of the Public Preferred Stock require us to discharge its obligation to redeem the Public Preferred Stock as soon as we are financially capable and legally permitted to do so. Therefore, by its very terms, the Public Preferred Stock is not due on demand or callable for failure to make a scheduled payment pursuant to its redemption provisions and is properly classified as a noncurrent liability.

Index

Dividend Provisions

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

In May 2006, the Board concluded that the accrual of PIK dividends for the period 1992 through June 1995 was no longer appropriate. Since 1995, we have disclosed in the footnotes to our audited consolidated financial statements the carrying value of the accrued PIK dividends on the Public Preferred Stock for the period 1992 through June 1995 was $4.0 million, and that had we accrued cash dividends during this time period, the total amount accrued would have been $15.1 million. As stated above, such amounts were reduced and adjusted to $3.5 million and $13.4 million, respectively, due to the redemption of 410,000 shares of the Public Preferred Stock in November 1998. On May 12, 2006, the Board voted to confirm that our intent with respect to the payment of dividends on the Public Preferred Stock for this period changed from its previously stated intent to pay PIK dividends to that of an intent to pay cash dividends. We therefore changed the accrual from $3.5 million to $13.4 million, the result of which was to increase our negative shareholder equity by the $9.9 million difference between those two amounts, by recording an additional $9.9 million charge to interest expense for the second quarter of 2006, resulting in a balance of $107.7 million and $104.8 million for the principal amount and all accrued dividends on the Public Preferred Stock as of September 30, 2011 and December 31, 2010, respectively. This action is considered a change in assumption that results in a change in accounting estimate as defined in ASC 250-10, which sets forth guidance concerning accounting changes and error corrections.

Borrowing Capacity

Our working capital was $11.3 million and $21.3 million as of September 30, 2011 and December 31, 2010, respectively.

At September 30, 2011, we had outstanding debt and long-term obligations of $147.2 million, consisting of $14.3 million under the Facility, $5.2 million in capital lease obligations, $11.9 million note payable to ITL, and $115.8 million in redeemable preferred stock classified as liability pursuant to ASC 480-10.

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

Index

Recent Accounting Pronouncements

See Note 1 of the Condensed Consolidated Financial Statements for a discussion of recently issued accounting pronouncements.

Critical Accounting Policies

There have been no changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2010 as filed with the SEC on March 31, 2011.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are exposed to interest rate volatility with regard to our variable rate debt obligations under the Facility. As of September 30, 2011, interest on the Facility is charged at 4.25%. The effective weighted average interest rates on the outstanding borrowings under the Facility were 6.6% and 7.4% for the nine months ended September 30, 2011 and 2010, respectively. The Facility had an outstanding balance of $14.7 million at September 30, 2011.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

An evaluation of the effectiveness of our disclosure controls and procedures as of September 30, 2011, was performed under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in its reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and that information required to be disclosed by the Company in the reports the Company files or submits under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Internal Control over Financial Reporting

There has been no change in our internal control over financial reporting during the quarter ended September 30, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II—OTHER INFORMATION

Item 1. Legal Proceedings

Information regarding legal proceedings may be found in Note 9 – Commitments and Contingencies to the Condensed Consolidated Financial Statements.

Item 1A. Risk Factors

There were no material changes in the third quarter of 2011 in our risk factors as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2010.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Index

Item 3. Defaults upon Senior Securities

Senior Redeemable Preferred Stock

We have not declared dividends on our Senior Redeemable Preferred Stock, Series A-1 and A-2, since issuance. At September 30, 2011, total undeclared unpaid dividends accrued for financial reporting purposes are $5.9 million for the Senior Redeemable Preferred Stock. We were required to redeem all shares and accrued dividends outstanding on October 31, 2005. However, certain holders of the Senior Redeemable Preferred Stock have entered into standby agreements whereby, among other things, those holders will not demand any payments in respect of dividends or redemptions of their instruments and the maturity dates of the instruments have been extended. As a result of such standby agreements, as of September 30, 2011, instruments held by Toxford Corporation (“Toxford”), the holder of 76.4% of the Senior Redeemable Preferred Stock, will mature on August 31, 2014, and instruments held by North Atlantic Smaller Companies Investment Trust PLC, the holder of 5.8% of the Senior Redeemable Preferred Stock, will mature on December 31, 2011. On or about March 15, 2011, Mr. John Porter acquired a total of 75 shares and 105 shares of Series A-1 and Series A-2 Redeemable Preferred Stock, respectively, from other holders of the Senior Redeemable Preferred Stock. As of September 30, 2011, Mr. Porter held 6.3% of the Senior Redeemable Preferred Stock, of which 3.1% will mature on December 31, 2011. In the aggregate, as of September 30, 2011, Mr. Porter and Toxford held a total of 763 shares and 1,069 shares of Series A-1 and Series A-2 Redeemable Preferred Stock, respectively, or 82.7% of the Senior Redeemable Preferred Stock. Mr. Porter is the sole stockholder of Toxford. Subject to limitations set forth below, we were scheduled to redeem 14.7% of the outstanding shares and accrued dividends outstanding on October 31, 2005. Due to the terms of the Facility and of the Senior Redeemable Preferred Stock, we have been and continue to be precluded from paying any accrued and unpaid dividends on the Senior Redeemable Preferred Stock.

12% Cumulative Exchangeable Redeemable Preferred Stock

Through November 21, 1995, we had the option to pay dividends in additional shares of Public Preferred Stock in lieu of cash (provided there were no restrictions on payment as further discussed below). As more fully explained in the next paragraph, dividends are payable by us, when and if declared by the Board of Directors, commencing June 1, 1990, and on each six month anniversary thereof. Dividends in additional shares of the Preferred Stock for 1990 and 1991 were paid at the rate of 6% of a share for each $.60 of such dividends not paid in cash. Dividends for the years 1992 through 1994, and for the dividend payable June 1, 1995, were accrued under the assumption that such dividends would be paid in additional shares of preferred stock and were valued at $4.0 million. Had we accrued these dividends on a cash basis, the total amount accrued would have been $15.1 million. However, as a result of the redemption of the 410,000 shares of the Public Preferred Stock in November 1998, such amounts were reduced and adjusted to $3.5 million and $13.4 million, respectively. As more fully disclosed in Note 7 – Redeemable Preferred Stock, in the second quarter of 2006, we accrued an additional $9.9 million in interest expense to reflect our intent to pay cash dividends in lieu of stock dividends, for the years 1992 through 1994, and for the dividend payable June 1, 1995. We have accrued $75.8 million and $72.9 million in cash dividends as of September 30, 2011 and December 31, 2010, respectively.

Index

Item 6. Exhibits

Exhibit Number		Description of Exhibit

2		Asset Purchase Agreement, dated as of July 1, 2011, by and among Telos Corporation, IT Logistics, Inc. and Tim Wilbanks (Incorporated by reference to Exhibit 10.1 filed with the Company’s Form 8-K report on July 8, 2011)
4		Subordinated Non-Transferrable Promissory Note, dated July 1, 2011, issued to IT Logistics, Inc. by Telos Corporation in the principal amount of $15 million (Incorporated by reference to Exhibit 10.2 filed with the Company’s Form 8-K report on July 8, 2011)
31.1*		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2*		Certification of Chief Financial Officer 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
101.INS**		XBRL Instance Document
101.SCH**		XBRL Taxonomy Extension Schema
101.CAL**		XBRL Taxonomy Extension Calculation Linkbase
101.LAB**		XBRL Taxonomy Extension Label Linkbase
101.PRE**		XBRL Taxonomy Extension Presentation Linkbase

* filed herewith

** in accordance with Regulation S-T, the XBRL-related information in Exhibit 101 to this Quarterly Report on Form 10-Q shall be deemed to be “furnished” and not “filed”

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: November 14, 2011	TELOS CORPORATION

	/s/ John B. Wood
	John B. Wood
	Chief Executive Officer

	/s/ Michele Nakazawa
	Michele Nakazawa
	Chief Financial Officer