Description

I am recommending an investment in the thinly traded mandatory redeemable 12% PIK preferred stock of Telos Corporation that is trading at $10.55 per share versus a claim of $22.60 per share according to the recent 10Q from September 2005 or a claim of $35.09 per share as per an activist group of preferred stockholders. I believe that the pressure being applied by hostile preferred holders and the need to file audited financials before March 31, 2006 will cause the preferred stock to trade to a level between $20 and $37.71 per share. We believe the most likely scenario is a price in the mid - $20’s per share.

Telos is an IT contractor that provides integration and services to the federal government. It has a specific expertise in the area of secure messaging. Telos was selected as one of the 8 prime contractors (Northrop, Lockheed, General Dynamics, Booz Allen, Centech, Multimax, NCI Information and Telos) for the $9 billion NETCENTS contract in September of 2004. This money is expected be spent over 5 years and positions Telos for strong growth. Any defense contractor that is not one of the Primes listed above that wants to be part of this contract must either come into each bid as sub-contactor or buy one of the incumbents. To date, the small contractors on this list have won one-half of the approximately $500 million awarded.

Telos has recently won a number of additional contracts, including a wireless local area network (WLAN) contract for $1.3 million with the FAA which continues to receive add-on task orders, a $3 million five year contract with the General Service Administration to help in the agency’s effort to merge the Federal Technology and Federal Supply services, and a three-year, $18 million contract (the contract’s value could reach $34 million, if all options are exercised) to manage the Pentagon Telecommunications Center’s IT and telecommunications infrastructure.

The preferred stock was issued in October of 1989, at a substantial discount to its mandatory redemption value, and as part of the financing for the purchase of what was then known as C3. From the issue date until 1992 Telos elected to pay the mandatory dividends in the form of additional shares of preferred (PIK). During the period from 1992 – 1995, the company still chose to pay the PIK dividend but did not actually issue the additional shares in this period because of “certain inconsistencies and ambiguities in the Company’s articles of incorporation and certain of its debt agreements”. This non-payment of mandatory PIK dividends, which the Company recognized it owed in their 10-K’s from the period, represent the difference between the recent 10-Q filing amount and the dissident preferred holders valuation amount. An interesting note is that this non-payment coincides with the hiring of John Wood, the current CEO, as a senior executive, does not own any preferred stock and very little of the common stock, but does have substantial options on the common stock.

In 1994, the company unsuccessfully attempted to buy-out the preferred at approximately $2 each. In its 13E-3 filing at that time, the company interestingly disclosed that the officers and directors should be deemed to have common stock interests which conflict with the preferred holders. This is apparent today, as the value of the preferred has accrued tremendously since the 1990’s, due to the accrual of the 12% dividend and the accretion of the mandatory redemption value, and it now accounts for most of the company’s enterprise value. The 1994 disclosure may explain the questionable attempt to not distribute the PIK in 1992-1995 and the further the lack of accounting for such accrual in the financial statements.


When the cash dividend period began in 1996, the Company began accruing cash dividends from that date to present. There is a mandatory redemption feature that requires the Company to repurchase 20% of the PIK preferred annually through 2009, beginning December 1, 2005. Please note that since the Company did not declare the dividends and the preferred issue is fully cumulative, any proceeds received regarding this understatement would go to current preferred shareholders.

There are five large holders of the preferred stock according to the most recent proxy statement. They are Costa Brava (16.36%), Wynnfield Partners (11.72%), Value Partners (15.74%), Victor Morgenstern (5.71%) and Athena Capital (5.12%). Costa Brava has taken the lead in pushing management to deal honestly and fairly with the preferred shareholders. They have written two letters to the auditors detailing serious mistakes in the way the Company is accounting for the preferred shares. In the letter dated September 20, 2005, they pointed out that the Company was misapplying SFAS 6 by not recording the mandatorily redeemable part of the preferred stock as a current liability. In the letter dated November 11, 2005 they pointed out the $30 million understatement of the liability regarding the accrued amount of PIK preferred.

Costa Brava (CB) sued the Company and its executives and board of directors on October 17, 2005 (see 13-D-A dated October 18, 2005). The essence of the lawsuit is that management has fraudulently withheld paying mandatory dividends while paying themselves large undeserved salaries and bonuses, violated Sarbanes Oxley by knowingly issuing inaccurate financial statements, paid exorbitantly high interest rates on a loan from the controlling shareholder, paid said shareholder consulting fees and granted management stock options in the subsidiaries while stripping the parent company of assets and cash.

Costa Brava’s rationale is based on Maryland law, since the Company is a Maryland Corporation. CB notes that Telos has justified not paying dividends by claiming that it did not have sufficient legally available funds to fulfill its obligation to pay dividends. CB interprets this to mean that Telos admits that it has been insolvent since 1991 or that the payment of the dividends accrued since 1991 would have rendered the corporation insolvent. Against this background of insolvency the Company has paid its CEO cash salary and bonuses of about $2.3 million from 2002 to 2004 and paid its executives a total of $4.6 million in cash bonuses from 1998 to 2004. It also paid a 75% shareholder, John Porter, an interest rate of 17% on a $5 million loan plus annual consulting fees of between $200,000 and $260,000 (a total of $1,960,000) since 1997. Finally, Telos has been granting stock options to executives in its operating subsidiaries, which CB believes is an attempt to strip asset values away from preferred shareholders.

CB is asking the Court to look at the preferred shares as a debt rather than equity, since it is mandatory redeemable and is carried in the liability section and the dividends are treated as interest expense on this income statement. CB is asking for a receiver to be put it charge even if the preferred and accrued dividends are not deemed to be debt so that the value of the business can be maintained and recovered.

Since Telos is a government contractor it cannot afford to file bankruptcy or have its financial statements issued in an untimely manner. Therefore, they have until about March 31, 2006 to rectify this problem. While the outside directors probably have huge personal liability and executive management could face criminal charges for their misdeeds, neither event is beneficial to the preferred holders, we believe the ultimate goal of the lawsuits is to force an orderly sale of Telos.

The next question is what is Telos worth? In 13-D filings in May 2005, the five large holders submitted a joint letter to the Independent Committee of the board and laid out their best estimate (albeit conservative) of the value of the Company. Since Telos is run as a private company (the common stock is privately held), using EBITDA multiples on reported cash flows is not a useful measure of valuation. For the low-end valuations we used the lowest comparable public trading multiples of 8x EBITDA and .7x revenues to yield a value of between $80 million to $95 million. For the high-end valuation we used this week’s deal for Anteon (a strong comparable company) which was just bought for 1.5x LTM sales and 16x LTM EBITDA. The Stifel Nicolaus analyst William Loomis did a write-up on the Anteon deal, which shows that the average LTM sales and EBITDA multiples for public deals in this sector averaged 1.7x and 14.7x, respectively.

Trailing 12 months revenue for Telos is $135.8 million and we assume an EBITDA of $10 million by utilizing and industry average margin of about 7.5%. This is a best guess based on the level of obfuscation in the numbers due to management’s high level of compensation, the consulting fees and high level of interest rate on the loan from the major shareholder. The joint letter used $9.7 million for EBITDA by adding back management’s discretionary cash bonuses and consulting fees to the LTM EBITDA of $7.4 million. The value available to the preferred is shown below. I have not included the capital lease obligations since they represent a lease on office space in the high-demand Dulles office corridor which would be assumed as an ordinary course lease in the operation of the business. I have also deducted the senior subordinated note since it would be equitably subordinated to the preferred because it is from a 75% equity holder.

Low High Low High
EBITDA Multiple Sales Multiple
Methodology 8x 15x .7x 1.4x
($in millions)
Value Range $80,000 $150,000 $95,000 $190,000
- Senior Debt 8,586 8,586 8,586 8,586
- Sr Redeem Pfd Stock 8,492 8,492 8,492 8,492
Net Value to 12% Pfd $62,922 $132,922 $77,922 $172,922

Pfd Shares out 3,185,586

VP Value per share $19.75 $41.73 $24.46 $54.28


The low-end valuations give no weight to the potential growth in profits and revenues from the $9 billion NETCENTS contract and the value it would have to the Company or a potential acquirer who is not in the prime contactor list. Assuming Telos wins only 5% of the business equally over 5 years, and operates at a 7.5% EBITDA margin, the net present value of the contract using a 10% discount rate was approximately $25 million at contract signing. We believe an acquirer would value the contract at minimum of between $10 million and $20 million. This would help to support the valuations listed above.

Important dates to note

1. Telos must file their reply to the lawsuit by January 9, 2006.
2. Telos must file their 10-K by March 31, 2006.

Possible Scenarios
1. The Company has retained Jefferies to work with all stakeholders to come to an acceptable solution. This could include a sale of the Company or an offer to take preferred shareholders out at a discount to the full claim.
2. The lawsuit asks for a court appointed receiver or at least an ombudsman (overseer) to make sure that the Company is not wasting assets. If this occurs, it is likely that Telos would be quickly sold.
3. Senior management takes a buyout from preferred holders who gain control and sell the Company.
4. Management fights the lawsuit and delays the time in which the preferred shareholders receive fair value for the Company.
5. Senior management decides to take a scorched earth policy and bankrupt the business. If this occurs all value could be wiped out, since the Company could lose existing and future government contracts. It would also leave the directors personally liable for the losses due to their lack of action on senior management’s fraudulent activities after having had them pointed out publicly by CB. Management and directors would have the possibility of criminal charges levied on them.

Risks
1. Management has been liberal in their receipt of salary, bonus and consulting fees. If the lawsuit drags on, the preferred holders may end up with a lower recovery and reduced rates of return.
2. The switch to a smaller accounting firm could signal the financial statements are not as accurate as shareholders would prefer.
3. The federal government could view the Company’s situation as financially precarious and stop giving new business to Telos.

Catalyst

The lawsuit by Costa Brava should force management to deal the matured default on the mandatory redemption of 20 of the preferred issue.

Another catalyst is the hot environment for acquisitions in the Federal IT consulting space as evidenced by the Anteon transaction. Telos is a prime contractor on the $9 billion NETCENTS contract, which should make it a tempting target and possibly leave common shareholders with some equity value below the preferred.