SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | ||
For the quarter ended June 30, 2010 | ||
OR | ||
TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
Commission FileNo. 0-30821
TELECOMMUNICATION SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
MARYLAND | 52-1526369 | |
(State or Other Jurisdiction of Incorporation or Organization) | (I.R.S. Employer Identification No.) | |
275 West Street, Annapolis, MD (Address of principal executive offices) | 21401 (Zip Code) |
(410) 263-7616
(Registrant’s telephone number, including area code)
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 þ No o
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 ofRegulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of thisForm 10-K or any amendment to thisForm 10-K. o
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 Rule12b-2 of the Exchange Act. (Check one):
Large accelerated filero | Accelerated filerþ | Non-accelerated filero | Smaller reporting companyo | |||
(Do not check if a smaller reporting company) |
Indicate by check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act): Yes o No þ
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Shares outstanding | ||||
as of July 31, | ||||
Title of Each Class | 2010 | |||
Class A Common Stock, par value | ||||
$0.01 per share | 46,956,905 | |||
Class B Common Stock, par value | ||||
$0.01 per share | 6,116,334 | |||
Total Common Stock Outstanding | 53,073,239 | |||
INDEX
TELECOMMUNICATION SYSTEMS, INC.
Page | ||||||||
PART I. FINANCIAL INFORMATION | ||||||||
Item 1. | Financial Statements | |||||||
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3 | ||||||||
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36 | ||||||||
36 | ||||||||
PART II. OTHER INFORMATION | ||||||||
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TeleCommunication Systems, Inc.
Consolidated Statements of Income
(amounts in thousands, except per share data)
(unaudited)
Consolidated Statements of Income
(amounts in thousands, except per share data)
(unaudited)
Three Months Ended | Six Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2010 | 2009 | 2010 | 2009 | |||||||||||||
Revenue | ||||||||||||||||
Services | $ | 63,429 | $ | 34,594 | $ | 123,273 | $ | 65,218 | ||||||||
Systems | 29,233 | 32,542 | 60,306 | 72,419 | ||||||||||||
Total revenue | 92,662 | 67,136 | 183,579 | 137,637 | ||||||||||||
Direct costs of revenue | ||||||||||||||||
Direct cost of services revenue | 35,886 | 18,820 | 70,218 | 37,189 | ||||||||||||
Direct cost of systems revenue, including amortization of software development costs of $2,301, $762, $4,607 and $1,322, respectively | 23,588 | 18,266 | 46,624 | 45,154 | ||||||||||||
Total direct cost of revenue | 59,474 | 37,086 | 116,842 | 82,343 | ||||||||||||
Services gross profit | 27,543 | 15,774 | 53,055 | 28,029 | ||||||||||||
Systems gross profit | 5,645 | 14,276 | 13,682 | 27,265 | ||||||||||||
Total gross profit | 33,188 | 30,050 | 66,737 | 55,294 | ||||||||||||
Operating costs and expenses | ||||||||||||||||
Research and development expense | 6,571 | 4,915 | 15,089 | 9,789 | ||||||||||||
Sales and marketing expense | 5,967 | 4,172 | 11,946 | 8,163 | ||||||||||||
General and administrative expense | 9,802 | 8,398 | 18,264 | 15,290 | ||||||||||||
Depreciation and amortization of property and equipment | 2,257 | 1,434 | 4,233 | 2,888 | ||||||||||||
Amortization of acquired intangible assets | 1,171 | 122 | 2,343 | 159 | ||||||||||||
Total operating costs and expenses | 25,768 | 19,041 | 51,875 | 36,289 | ||||||||||||
Income from operations | 7,420 | 11,009 | 14,862 | 19,005 | ||||||||||||
Interest expense | (2,237 | ) | (225 | ) | (4,589 | ) | (413 | ) | ||||||||
Amortization of debt discount and debt issuance expenses | (216 | ) | (53 | ) | (376 | ) | (58 | ) | ||||||||
Other income, net | 495 | 105 | 985 | 284 | ||||||||||||
Income before income taxes | 5,462 | 10,836 | 10,882 | 18,818 | ||||||||||||
Provision for income taxes | (2,367 | ) | (4,230 | ) | (2,777 | ) | (7,345 | ) | ||||||||
Net income | $ | 3,095 | $ | 6,606 | $ | 8,105 | $ | 11,473 | ||||||||
Net income per share-basic | $ | 0.06 | $ | 0.14 | $ | 0.15 | $ | 0.25 | ||||||||
Net income per share-diluted | $ | 0.06 | $ | 0.13 | $ | 0.14 | $ | 0.22 | ||||||||
Weighted average shares outstanding-basic | 52,920 | 46,765 | 52,788 | 46,170 | ||||||||||||
Weighted average shares outstanding- diluted | 56,124 | 51,968 | 66,897 | 51,557 | ||||||||||||
See accompanying Notes to Consolidated Financial Statements.
1
TeleCommunication Systems, Inc.
(amounts in thousands, except share data)
June 30, | December 31, | |||||||
2010 | 2009 | |||||||
(unaudited) | ||||||||
Assets | ||||||||
Current assets: | ||||||||
Cash and cash equivalents | $ | 97,035 | $ | 61,426 | ||||
Accounts receivable, net of allowance of $427 in 2010 and $389 in 2009 | 51,156 | 65,476 | ||||||
Unbilled receivables | 25,923 | 23,783 | ||||||
Inventory | 3,724 | 9,331 | ||||||
Deferred income taxes | 10,228 | 9,507 | ||||||
Receivable from settlement of patent matter | — | 15,700 | ||||||
Income tax refund receivable | — | 5,438 | ||||||
Other current assets | 7,005 | 8,945 | ||||||
Total current assets | 195,071 | 199,606 | ||||||
Property and equipment, net of accumulated depreciation and amortization of $51,179 in 2010 and $46,960 in 2009 | 33,283 | 20,734 | ||||||
Software development costs, net of accumulated amortization of $14,548 in 2010 and $9,941 in 2009 | 40,613 | 45,384 | ||||||
Acquired intangible assets, net of accumulated amortization of $3,868 in 2010 and $1,526 in 2009 | 30,585 | 33,975 | ||||||
Goodwill | 166,948 | 164,350 | ||||||
Other assets | 7,711 | 8,176 | ||||||
Total assets | $ | 474,211 | $ | 472,225 | ||||
Liabilities and stockholders’ equity | ||||||||
Current liabilities: | ||||||||
Accounts payable and accrued expenses | $ | 39,768 | $ | 52,999 | ||||
Accrued payroll and related liabilities | 12,433 | 19,265 | ||||||
Deferred revenue | 18,860 | 9,938 | ||||||
Current portion of capital lease obligations and notes payable | 45,945 | 39,731 | ||||||
Total current liabilities | 117,006 | 121,933 | ||||||
Capital lease obligations and notes payable, less current portion | 137,591 | 143,316 | ||||||
Deferred income taxes | 13,635 | 15,435 | ||||||
Other long-term liability | 4,297 | 5,755 | ||||||
Stockholders’ equity: | ||||||||
Class A Common Stock; $0.01 par value: | ||||||||
Authorized shares — 225,000,000; issued and outstanding shares of 46,924,565 in 2010 and 46,157,025 in 2009 | 470 | 462 | ||||||
Class B Common Stock; $0.01 par value: | ||||||||
Authorized shares — 75,000,000; issued and outstanding shares of 6,116,334 in 2010 and 6,276,334 in 2009 | 61 | 63 | ||||||
Additional paid-in capital | 291,517 | 283,733 | ||||||
Accumulated other comprehensive income | 13 | 12 | ||||||
Accumulated deficit | (90,379 | ) | (98,484 | ) | ||||
Total stockholders’ equity | 201,682 | 185,786 | ||||||
Total liabilities and stockholders’ equity | $ | 474,211 | $ | 472,225 | ||||
See accompanying Notes to Consolidated Financial Statements.
2
TeleCommunication Systems, Inc.
Consolidated Statement of Stockholders’ Equity
(amounts in thousands, except share data)
(unaudited)
Consolidated Statement of Stockholders’ Equity
(amounts in thousands, except share data)
(unaudited)
Accumulated | ||||||||||||||||||||||||
Class A | Class B | Additional | Other | |||||||||||||||||||||
Common | Common | Paid-In | Comprehensive | Accumulated | ||||||||||||||||||||
Stock | Stock | Capital | Income | Deficit | Total | |||||||||||||||||||
Balance at January 1, 2010 | $ | 462 | $ | 63 | $ | 283,733 | $ | 12 | $ | (98,484 | ) | $ | 185,786 | |||||||||||
Options exercised for the purchase of 512,799 shares of Class A Common Stock | 5 | — | 1,784 | — | — | 1,789 | ||||||||||||||||||
Issuance of 95,823 shares of Class A Common Stock under Employee Stock Purchase Plan | 1 | — | 612 | — | — | 613 | ||||||||||||||||||
Conversion of 160,000 shares of Class B Common Stock to Class A Common Stock | 2 | (2 | ) | — | — | — | — | |||||||||||||||||
Issuance of shares of 15,107 Restricted Class A Common Stock | — | — | 17 | — | — | 17 | ||||||||||||||||||
Stock-based compensation expense | — | — | 5,371 | — | — | 5,371 | ||||||||||||||||||
Foreign currency translation adjustment | 1 | 1 | ||||||||||||||||||||||
Net income for the six-months ended June 30, 2010 | — | — | — | — | 8,105 | 8,105 | ||||||||||||||||||
Balance at June 30, 2010 | $ | 470 | $ | 61 | $ | 291,517 | $ | 13 | $ | (90,379 | ) | $ | 201,862 | |||||||||||
See accompanying Notes to Consolidated Financial Statements.
3
TeleCommunication Systems, Inc.
Consolidated Statements of Cash Flows
(amounts in thousands)
(unaudited)
Consolidated Statements of Cash Flows
(amounts in thousands)
(unaudited)
Six Months Ended | ||||||||
June 30, | ||||||||
2010 | 2009 | |||||||
Operating activities: | ||||||||
Net Income | $ | 8,105 | $ | 11,473 | ||||
Adjustments to reconcile net income to net cash provided by/(used in) operating activities: | ||||||||
Depreciation and amortization of property and equipment | 4,233 | 2,888 | ||||||
Amortization of acquired intangible assets | 2,343 | 159 | ||||||
Deferred tax provision | 2,777 | 6,695 | ||||||
Stock compensation expense | 5,371 | 2,183 | ||||||
Amortization of software development costs | 4,607 | 1,322 | ||||||
Amortization of deferred financing fees | 376 | 58 | ||||||
Impairment of marketable securities/ investment | 225 | 15 | ||||||
Other non-cash adjustments | 884 | (8 | ) | |||||
Changes in operating assets and liabilities: | ||||||||
Accounts receivable, net | 14,280 | 13,836 | ||||||
Unbilled receivables | (2,084 | ) | 2,617 | |||||
Inventory | 5,607 | (9,768 | ) | |||||
Other current assets | 20,947 | (732 | ) | |||||
Other assets | 465 | (1,217 | ) | |||||
Accounts payable and accrued expenses | (13,377 | ) | (9,253 | ) | ||||
Accrued payroll and related liabilities | (6,862 | ) | (5,950 | ) | ||||
Other liabilities | (5,146 | ) | — | |||||
Deferred revenue | 8,922 | 7,179 | ||||||
Subtotal — Changes in operating assets and liabilities | 22,752 | (3,288 | ) | |||||
Net cash provided by operating activities | 51,673 | 21,498 | ||||||
Investing activities: | ||||||||
Acquisitions, net of cash acquired | — | (15,000 | ) | |||||
Purchases of property and equipment, net of cash acquired | (11,075 | ) | (611 | ) | ||||
Capitalized software development costs | (2,172 | ) | (634 | ) | ||||
Total net cash used in investing activities | (13,247 | ) | (16,245 | ) | ||||
Financing activities: | ||||||||
Proceeds from issuance of long-term debt | — | 20,000 | ||||||
Payments on long-term debt and capital lease obligations | (5,218 | ) | (8,466 | ) | ||||
Proceeds from exercise of employee stock options and sale of stock | 2,402 | 3,250 | ||||||
Total net cash (used in)/provided by financing activities | (2,816 | ) | 14,784 | |||||
Net increase in cash | 35,610 | 20,037 | ||||||
Cash and cash equivalents at the beginning of the period | 61,425 | 38,977 | ||||||
Cash and cash equivalents at the end of the period | $ | 97,035 | $ | 59,014 | ||||
See accompanying Notes to Consolidated Financial Statements.
4
TeleCommunication Systems, Inc.
June 30, 2010
(amounts in thousands, except per share amounts)
(unaudited)
1. | Basis of Presentation and Summary of Significant Accounting Policies |
Basis of Presentation. The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions toForm 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three- and six-months ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ended December 31, 2010. These consolidated financial statements should be read in conjunction with our audited financial statements and related notes included in our 2009 Annual Report onForm 10-K. The terms “TCS”, “we”, “us” and “our” as used in thisForm 10-Q refer to TeleCommunication Systems, Inc. and its subsidiaries as a combined entity, except where it is made clear that such terms mean only TeleCommunication Systems, Inc.
Use of Estimates. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts and related disclosures. Actual results could differ from those estimates.
Other Comprehensive Income/(Loss). Comprehensive income/(loss) includes changes in the equity of a business during a period from transactions and other events and circumstances from non-owner sources. Other comprehensive income/loss refers to revenue, expenses, gains and losses that under U.S. generally accepted accounting principles are included in comprehensive income, but excluded from net income. For operations outside the U.S. that prepare financial statements in currencies other than the U.S. dollar, results of operations and cash flows are translated at average exchange rates during the period, and assets and liabilities are translated atend-of-period exchange rates. Translation adjustments for our European subsidiary are included as a component of accumulated other comprehensive income in stockholders’ equity.
Deferred Compensation Plan. During 2009, the Company adopted a non-qualified deferred compensation arrangement to fund certain supplemental executive retirement and deferred income plans. Under the terms of the arrangement, the participants may elect to defer the receipt of a portion of their compensation and each participant directs the manner in which their investments are deemed invested. The funds are held by the Company in a rabbi trust which include fixed income funds, equity securities, and money market accounts, or other investments for which there is an active quoted market. The funds are included in Other assets and Other long-term liability on the Consolidated Balance Sheet. Company contributions were made to the plan in 2009, but not in 2010.
Stock-Based Compensation. We have two stock-based employee compensation plans: our Amended and Restated Stock Incentive Plan (the “Stock Incentive Plan”) and our Second Amended and Restated Employee Stock Purchase Plan (the “ESPP”). In the past, we have issued restricted stock to directors and certain executives. We record compensation expense for all stock-based compensation plans using the fair value method prescribed by Financial Accounting Standards Board (the “FASB”) Accounting Standards Codification (“ASC”)718-10. Our stock compensation expense has been allocated to direct cost of revenue, research and development expense, sales and marketing expense, and general and administrative expense as detailed in Note 3.
5
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
Earnings per share. Basic income per common share is based upon the average number of shares of common stock outstanding during the period. Stock options to purchase approximately 7.8 million shares for the three-months ended June 30, 2010 and 5.9 million shares for the six-months ended June 30, 2010, and approximately 1.8 million shares for both the three- and six-months ended June 30, 2009 were excluded from the computation of diluted net income per share because their inclusion would have been anti-dilutive. Shares issuable upon conversion of convertible debt issued in the fourth quarter of 2009 were included in weighted average diluted shares for the six-months ended June 30, 2010 but were excluded from weighted average diluted shares for the second quarter of 2010 because the effect of their inclusion would have been anti-dilutive. A reconciliation of basic to diluted weighted average common shares outstanding is as follows:
Three Months | Six Months | |||||||||||||||
Ended | Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2010 | 2009 | 2010 | 2009 | |||||||||||||
Numerator: | ||||||||||||||||
Net income, basic | $ | 3,095 | $ | 6,606 | $ | 8,105 | $ | 11,473 | ||||||||
Adjustment for assumed dilution: | ||||||||||||||||
Interest on convertible debt, net of taxes | — | — | 1,457 | — | ||||||||||||
Net income, diluted | $ | 3,095 | $ | 6,606 | $ | 9,562 | $ | 11,473 | ||||||||
Denominator: | ||||||||||||||||
Total basic weighted-average common shares outstanding | 52,920 | 46,765 | 52,788 | 46,170 | ||||||||||||
Effect of dilutive stock options based on treasury stock method | 3,204 | 4,714 | 4,107 | 4,894 | ||||||||||||
Effect of dilutive warrants based on treasury stock method | — | 489 | — | 493 | ||||||||||||
Effect of dilutive 4.5% convertible debt, based on “if converted” method | — | — | 10,002 | — | ||||||||||||
Weighted average diluted shares | 56,124 | 51,968 | 66,897 | 51,557 | ||||||||||||
Basic earnings per common share: | ||||||||||||||||
Net income per share — basic | $ | 0.06 | $ | 0.14 | $ | 0.15 | $ | 0.25 | ||||||||
Diluted earnings per common share: | ||||||||||||||||
Net income per share-diluted | $ | 0.06 | $ | 0.13 | $ | 0.14 | $ | 0.22 | ||||||||
Income Taxes. Income tax amounts and balances are accounted for using the asset and liability method of accounting for income taxes as prescribed by ASC 740. Under this method, deferred income tax assets and liabilities are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
Effective January 1, 2007, the Company began recognizing the benefits of tax positions in the financial statements which are more likely than not to be sustained upon examination by the taxing authority and satisfy the appropriate measurement criteria. If the recognition threshold is met, the tax benefit is generally measured and recognized as the tax benefit having the highest likelihood, based on our judgment, of being realized upon ultimate settlement with the taxing authority, assuming full knowledge of the position and all relevant facts. At June 30, 2010, we had unrecognized tax benefits totaling approximately $1.7 million. The determination of these unrecognized amounts requires significant
6
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
judgments and interpretation of complex tax laws. Different judgments or interpretations could result in material changes to the amount of unrecognized tax benefits.
Recent Accounting Pronouncements.
In October 2009, the FASB issued Accounting ASU2009-14 to ASC topic 985, “Certain Revenue Arrangements That Include Software Elements.” that removes tangible products from the scope of software revenue guidance and provides guidance on determining whether software deliverables in an arrangement that includes a tangible product are covered by the scope of the software revenue guidance. ASU2009-14 will be applied prospectively for new or materially modified arrangements in fiscal years beginning after June 15, 2010 and early adoption is permitted. The Company is currently evaluating the impact the adoption will have on its consolidated financial statements.
In October 2009, the FASB issued ASU2009-13 to ASC topic 605 “Revenue Recognition — Multiple Deliverable Revenue Arrangements.” This update addresses how to determine whether an arrangement involving multiple deliverables contains one or more than one unit of accounting, and how the arrangement consideration should be allocated among the separate units of accounting. This update also established a selling price hierarchy for determining the selling price of a deliverable. The selling price used for each deliverable will be based on vendor-specific objective evidence if available, third-party evidence if vendor-specific evidence is not available, or estimated selling price if neither vendor — specified or third-party evidence is available. ASU2009-13 may be applied retrospectively or prospectively for new or materially modified arrangements in fiscal years beginning on or after June 15, 2010, with early adoption permitted. The Company is currently evaluating the impact the adoption will have on its consolidated financial statements.
2. | Acquisitions |
During 2009 the Company acquired four businesses. These acquisitions were accounted for using the acquisition method; accordingly, their total estimated purchase prices are allocated to the net tangible and intangible assets acquired and liabilities assumed, based on their estimated fair values as of the effective dates of the acquisitions. The allocations of purchase price were based upon management’s preliminary valuation of the fair value of tangible and intangible assets acquired and liabilities assumed, and such estimates and assumptions are subject to change as the company finalizes the allocation for each of the acquisitions.
On May 19, 2009, the Company acquired substantially all the assets of LocationLogic, LLC (“LocationLogic”), formerly Autodesk, Inc’s location services business. The LocationLogic business is reported as part of our commercial services. The purchase price of the LocationLogic’s assets was $25 million, comprised of $15 million cash and $10 million, or approximately 1.4 million shares, in the Company’s Class A Common Stock.
7
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
The following table summarizes the final purchase price allocation of the fair values of the assets acquired and liabilities assumed at the date of the acquisition:
Assets: | ||||
Accounts receivable, net | $ | 145 | ||
Unbilled accounts receivable | 1,081 | |||
Other current assets | 205 | |||
Property and equipment | 865 | |||
Acquired technology and software development costs | 3,703 | |||
Acquired intangible assets | 8,720 | |||
Goodwill | 12,206 | |||
Total assets | $ | 26,925 | ||
Liabilities: | ||||
Accounts payable and accrued expenses | $ | 1,273 | ||
Accrued payroll and related liabilities | 325 | |||
Total liabilities | $ | 1,598 | ||
Fair value of net assets acquired | $ | 25,327 | ||
On November 3, 2009, the Company purchased all of the outstanding stock of Solvern Innovations, Inc. (“Solvern”), a communications technology company focused on cyber-security. The Solvern business is reported as part of our government services. Solvern’s purchase consideration included cash, approximately 1 million shares of the Company’s Class A common stock, and contingent consideration based on the business’s gross profit in 2010 and 2011.
On November 16, 2009, the Company completed the acquisition of substantially all of the assets of Sidereal Solutions, Inc. (“Sidereal”), a satellite communications technology engineering, operations and maintenance support service company. The Sidereal business is reported as part of our government services. Consideration for the purchase of the Sidereal assets included cash and approximately 244,200 shares of the Company’s Class A common stock, and contingent consideration based on the business’s gross profit in 2010 and 2011.
The total estimated purchase price for the three acquisitions described above was $70 million. Approximately $49 million was preliminarily allocated to goodwill, approximately $0.1 million for other current and long-term assets net of liabilities, and $21 million to acquired definite-lived intangible assets, consisting of the value assigned to customer relationships of $3.7 million for LocationLogic, $7.3 million for Solvern and $2 million for Sidereal and developed technology of $8.7 million classified as capitalized software development costs for LocationLogic.
We also completed the acquisition of Networks in Motion, Inc. (“NIM”) on December 15, 2009. Pursuant to the merger agreement, TCS issued former NIM shareholders approximately $110 million in cash, $40 million in promissory notes, and approximately 2.2 million shares of the Company’s common stock valued at $20 million. The promissory notes bear simple interest at 6% and are due in three installments: $30 million on the 12 month anniversary of the closing, $5 million on the 18 month anniversary of the closing, and $5 million on the 24 month anniversary of the closing, subject to escrow adjustments. Note that for $20 million of the obligation due in December 2010, the Company has the option to settle using common stock, but the Company currently plans to satisfy this debt for cash.
Of the total estimated NIM purchase price of $170 million, approximately $113.9 million was preliminarily allocated to goodwill and $54.5 million to acquired definite-lived intangible assets, consisting
8
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
of the value assigned to NIM’s customer relationships of $20.1 million, and developed technology of $34.4 million classified as capitalized software development costs and approximately $1.6 million for other current and long-term assets net of liabilities.
During the six-months ending June 30, 2010, we made final adjustments to the preliminary purchase price allocations for LocationLogic, detailed above. We also made adjustments to the preliminary purchase price allocations for the other three acquisitions for a total adjustment to goodwill of $2.0 million, as a result of information not initially available. Prior to the end of the measurement period for finalizing the purchase price allocation, if information becomes available which would indicate adjustments are required to the purchase price allocation, such adjustments will be included in the purchase price allocation retrospectively. The measurement period is not to exceed 12 months from the acquisition dates.
The unaudited pro forma financial information for the three and six-months ended June 30, 2009 in the table below summarizes the consolidated results of operations for TCS and NIM (which was assessed as a significant and material acquisition for purposes of unaudited pro forma financial information disclosure), as though NIM was acquired at the beginning of 2009.
The following pro forma information is presented to include the effects of the acquisition of NIM using the acquisition method of accounting and the related TCS Class A common stock and promissory notes issued as part of consideration. The unaudited pro forma financial information is presented to also include the effects of $103.5 million Convertible Notes offering.
The pro forma financial information is not intended to represent or be indicative of the consolidated results of operations or financial condition of TCS that would have been reported had the acquisition been completed as of the dates presented, and should not be construed as representative of the future consolidated results of operations or financial condition of a consolidated entity.
The following unaudited pro forma financial information is presented below for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisitions and any borrowings undertaken to finance the acquisition had taken place at the beginning of 2009.
Three Months | Six Months | |||||||
Ended | Ended | |||||||
Pro Forma Information | June 30, 2009 | June 30, 2009 | ||||||
Revenue | $ | 86,622 | $ | 173,366 | ||||
Net income | $ | 8,592 | $ | 13,612 | ||||
Basic earnings per share | $ | 0.18 | $ | 0.28 | ||||
Diluted earnings per share | $ | 0.15 | $ | 0.25 | ||||
3. | Stock-Based Compensation |
We recognize compensation expense net of estimated forfeitures over the requisite service period for grants under our option plan, which is generally the vesting period of 5 years. The Company estimates the fair value of each stock option award on the date of grant using the Black-Scholes option-pricing model. Expected volatilities are based on historical volatility of the Company’s stock. The Company estimates forfeitures based on historical experience and the expected term of the options granted are derived from historical data on employee exercises. The risk free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant. The Company has not paid and does not anticipate paying dividends in the near future.
9
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
We also recognize non-cash stock compensation expense for restricted stock issued to directors and certain key executives. The restrictions expire at the end of one year for directors and expire in annual increments over three years for executives and are based on continued employment. We had 42 shares and 30 shares of restricted stock outstanding, respectively, as of June 30, 2010 and June 30, 2009. We expect to record future stock compensation expense of $184 as a result of the restricted stock grants outstanding as of June 30, 2010 that will be recognized over the remaining vesting period in 2010 and 2011.
The material components of our stock compensation expense are as follows:
Three Months | Six Months | |||||||||||||||
Ended June 30, | Ended June 30, | |||||||||||||||
2010 | 2009 | 2010 | 2009 | |||||||||||||
Stock-based compensation: | ||||||||||||||||
Stock options granted at fair value | $ | 2,110 | $ | 1,149 | $ | 5,141 | $ | 2,074 | ||||||||
Restricted stock | 69 | 40 | 122 | 65 | ||||||||||||
Employee stock purchase plan | 70 | 28 | 108 | 44 | ||||||||||||
Total stock compensation expense | $ | 2,249 | $ | 1,217 | $ | 5,371 | $ | 2,183 | ||||||||
Stock-based compensation is included in our operations in the accompanying Consolidated Statements of Income as follows:
Three Months | Six Months | |||||||||||||||
Ended June 30, | Ended June 30, | |||||||||||||||
2010 | 2009 | 2010 | 2009 | |||||||||||||
Stock-based compensation: | ||||||||||||||||
Direct cost of revenue | $ | 1,415 | $ | 784 | $ | 3,377 | $ | 1,406 | ||||||||
Research and development expense | 587 | 284 | 1,402 | 509 | ||||||||||||
Sales and marketing expense | 136 | 98 | 326 | 176 | ||||||||||||
General and administrative expense | 111 | 51 | 266 | 92 | ||||||||||||
Total stock compensation included in operating expenses | $ | 2,249 | $ | 1,217 | $ | 5,371 | $ | 2,183 | ||||||||
A summary of our stock option activity and related information for the six-months ended June 30, 2010 is as follows:
Weighted | ||||||||
Average | ||||||||
Number of | Exercise | |||||||
(Share amounts in thousands) | Options | Price | ||||||
Outstanding, beginning of year | 14,612 | $ | 5.32 | |||||
Granted | 1,818 | $ | 8.31 | |||||
Exercised | (512 | ) | $ | 3.53 | ||||
Expired | (131 | ) | $ | 6.51 | ||||
Forfeited | (658 | ) | $ | 8.21 | ||||
Outstanding, at June 30, 2010 | 15,129 | $ | 5.60 | |||||
Exercisable, at June 30, 2010 | 8,286 | $ | 4.02 | |||||
Vested and expected to vest at June 30, 2010 | 14,037 | $ | 5.41 | |||||
Weighted-average remaining contractual life of options outstanding at June 30, 2010 | 6.5 years | |||||||
10
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
Six Months | ||||||||
June 30, | ||||||||
2010 | 2009 | |||||||
Estimated weighted-average grant-date fair value of options granted during the period | $ | 4.58 | $ | 4.65 | ||||
Total fair value of options vested during the period | $ | 5,297 | $ | 3,999 | ||||
Intrinsic value of options exercised during the period | $ | 2,258 | $ | 4,786 | ||||
Exercise prices for options outstanding at June 30, 2010 ranged from $1.07 to $9.86 as follows (all share amounts in thousands):
Weighted-Average | ||||||||||||||||||||||||
Weighted-Average | Remaining | |||||||||||||||||||||||
Weighted-Average | Remaining | Weighted-Average | Contractual Life | |||||||||||||||||||||
Exercise Prices | Contractual Life | Options | Exercise Prices | of Options | ||||||||||||||||||||
Options | of Options | of Options | Vested and | of Options Vested | Vested and | |||||||||||||||||||
Exercise Prices | Outstanding | Outstanding | Outstanding (years) | Exercisable | and Exercisable | Exercisable (years) | ||||||||||||||||||
$1.07 - $1.84 | 81 | $ | 1.70 | 2.56 | 81 | $ | 1.70 | 2.56 | ||||||||||||||||
$1.92 - $2.99 | 2,415 | $ | 2.47 | 5.29 | 2,244 | $ | 2.47 | 5.25 | ||||||||||||||||
$3.05 - $4.68 | 4,972 | $ | 3.33 | 5.54 | 3,858 | $ | 3.35 | 5.01 | ||||||||||||||||
$4.83 - $7.45 | 2,229 | $ | 6.74 | 4.77 | 1,692 | $ | 6.73 | 3.52 | ||||||||||||||||
$7.95 - $9.86 | 5,432 | $ | 8.66 | 9.27 | 411 | $ | 8.17 | 8.35 | ||||||||||||||||
15,129 | 8,286 | |||||||||||||||||||||||
As of June 30, 2010, the aggregate intrinsic value of options outstanding was $8,266 and the aggregate intrinsic value of options vested and exercisable was $7,016. As of June 30, 2010, we estimate that we will recognize $20,700 in expense for outstanding, unvested options over their weighted average remaining vesting period of 3.7 years, of which we estimate $4,800 will be recognized during the remainder of 2010.
In using the Black-Scholes model to calculate the fair value of our stock options, our assumptions were as follows:
Six Months Ended June 30, | ||||
2010 | 2009 | |||
Expected life (in years) | 5.5 | 5.5 | ||
Risk-free interest rate(%) | 2.4%-2.8% | 1.65%-1.9% | ||
Volatility(%) | 59%-60% | 63%-64% | ||
Dividend yield(%) | 0% | 0% |
4. | Supplemental Disclosure of Cash Flow Information |
Property and equipment acquired under capital leases totaled $3,068 and $5,706 during the three- and six-months ended June 30, 2010, respectively. We acquired $2,530 and $4,579 of property under capital leases during the three- and six-months ended June 30, 2009, respectively.
Interest paid totaled $954 and $2,606 during the three- and six-months ended June 30, 2010, respectively. We paid $225 and $413 in interest for the three- and six-months ended June 30, 2009, respectively.
11
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
Income taxes and estimated state income taxes paid totaled $942 and $2,172 during the three- and six-months ended June 30, 2010 and were $500 and $879 for the three- and six-months ended June 30, 2009, respectively.
5. | Fair Value Measurements |
ASC820-10 discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flows), and the cost approach (cost to replace the service capacity of an asset or replacement cost). The statement utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:
Level 1: Observable inputs such as quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.
Level 3: Observable inputs that reflect the reporting entity’s own assumptions.
Our population of assets and liabilities subject to fair value measurements on a recurring basis and the necessary disclosures are as follow:
Fair Value | Fair Value Measurements at | |||||||||||||||
as of | 6/30/2010 | |||||||||||||||
6/30/2010 | Using Fair Value Hierarchy | |||||||||||||||
Total | Level 1 | Level 2 | Level 3 | |||||||||||||
Assets | ||||||||||||||||
Cash and cash equivalents | $ | 97,035 | $ | 97,035 | $ | — | $ | — | ||||||||
Deferred compensation plan investments | 1,005 | 1,005 | — | — | ||||||||||||
Assets at Fair Value | $ | 98,040 | $ | 98,040 | $ | — | $ | — | ||||||||
Liabilities | ||||||||||||||||
Deferred compensation | $ | 858 | $ | 858 | $ | — | $ | — | ||||||||
Contractual acquisition earnouts | 6,441 | — | — | 6,441 | ||||||||||||
Liabilities at Fair Value | $ | 7,299 | $ | 858 | $ | — | $ | 6,441 | ||||||||
The Company holds trading securities as part of a rabbi trust to fund certain supplemental executive retirement plans and deferred income plans. The funds held are all managed by a third party, and include fixed income funds, equity securities, and money market accounts, or other investments for which there is an active quoted market. The related Deferred compensation liabilities are valued based on the underlying investment selections held in each participant’s account. The Contractual acquisition earnouts were part of the consideration paid for certain 2009 acquisitions and were initially valued at the acquisition date at $7,753. The fair value of the earnouts is based on probability-weighted payouts under different scenarios, discounted using a discount rate commiserate with the risk.
12
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
The following table provides a summary of the changes in the Company’s Contractual acquisition earnouts measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the six-months ended June 30, 2010:
Fair Value | ||||
Measurements | ||||
Using Significant | ||||
Unobservable | ||||
Inputs (level 3) | ||||
Balance at March 31, 2010 | $ | 7,280 | ||
Fair value adjustment recognized in earnings | (839 | ) | ||
Balance at June 30, 2010 | $ | 6,441 | ||
The Company’s long-term debt consists of borrowings under a commercial bank term loan agreement, 4.5% convertible senior notes, and promissory notes payable to sellers of Networks in Motion, Inc. (see Note 11). The long-term debt is currently reported at the borrowed amount outstanding and the fair value of the Company’s long-term debt approximates its carrying amount.
The Company’s assets and liabilities that are measured at fair value on a non-recurring basis include long-lived assets, intangible assets, and goodwill. These items are recognized at fair value when they are considered to be other than temporarily impaired. In the first six-months ending June 30, 2010, there were no required fair value measurements for assets and liabilities measured at fair value on a non-recurring basis.
6. | Segment Information |
Our two operating segments are the Commercial and Government Segments.
Our Commercial Segment products and services enable wireless carriers to deliver short text messages, location-based information, internet content, and other enhanced communication services to and from wireless phones. Our Commercial Segment also provides E9-1-1 call routing, mobile location-based applications, and inter-carrier text message technology. Customers use our software functionality through connections to and from our network operations centers, paying us monthly fees based on the number of subscribers, cell sites, call center circuits, or message volume. We also provide hosted services under contracts with wireless carrier networks, as well as VoIP service providers.
Our Government Segment provides communication systems integration, information technology services, and software solutions to the U.S. Department of Defense and other government customers. We also own and operate secure satellite teleport facilities, and resell access to satellite airtime ( known as space segment.) We design, furnish, install and operate wireless and data network communication systems, including our SwiftLink® deployable communication systems which integrate high speed, satellite, and internet protocol technology, with secure Government-approved cryptologic devices.
Management evaluates segment performance based on gross profit. We do not maintain information regarding segment assets. Accordingly, asset information by reportable segment is not presented.
13
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
The following table sets forth results for our reportable segments for the three- and six-months ended June 30, 2010 and 2009, respectively. All revenues reported below are from external customers. A reconciliation of segment gross profit to net loss for the respective periods is also included below:
Three Months Ended June 30, | ||||||||||||||||||||||||
2010 | 2009 | |||||||||||||||||||||||
Comm. | Gvmt | Total | Comm. | Gvmt | Total | |||||||||||||||||||
Revenue | ||||||||||||||||||||||||
Services | $ | 41,323 | $ | 22,106 | $ | 63,429 | $ | 20,648 | $ | 13,946 | $ | 34,594 | ||||||||||||
Systems | 6,670 | 22,563 | 29,233 | 12,431 | 20,111 | 32,542 | ||||||||||||||||||
Total revenue | 47,993 | 44,669 | 92,662 | 33,079 | 34,057 | 67,136 | ||||||||||||||||||
Direct costs of revenue | ||||||||||||||||||||||||
Direct cost of services | 20,470 | 15,416 | 35,886 | 8,376 | 10,444 | 18,820 | ||||||||||||||||||
Direct cost of systems | 3,448 | 20,140 | 23,588 | 2,443 | 15,823 | 18,266 | ||||||||||||||||||
Total direct costs | 23,918 | 35,556 | 59,474 | 10,819 | 26,267 | 37,086 | ||||||||||||||||||
Gross profit | ||||||||||||||||||||||||
Services gross profit | 20,853 | 6,690 | 27,543 | 12,272 | 3,502 | 15,774 | ||||||||||||||||||
Systems gross profit | 3,222 | 2,423 | 5,645 | 9,988 | 4,288 | 14,276 | ||||||||||||||||||
Total gross profit | $ | 24,075 | $ | 9,113 | $ | 33,188 | $ | 22,260 | $ | 7,790 | $ | 30,050 | ||||||||||||
Six Months Ended June 30, | ||||||||||||||||||||||||
2010 | 2009 | |||||||||||||||||||||||
Comm. | Gvmt | Total | Comm. | Gvmt | Total | |||||||||||||||||||
Revenue | ||||||||||||||||||||||||
Services | $ | 80,601 | $ | 42,672 | $ | 123,273 | $ | 38,455 | $ | 26,763 | $ | 65,218 | ||||||||||||
Systems | 15,315 | 44,991 | 60,306 | 20,194 | 52,225 | 74,419 | ||||||||||||||||||
Total revenue | 95,916 | 87,663 | 183,579 | 58,649 | 78,988 | 137,637 | ||||||||||||||||||
Direct costs of revenue | ||||||||||||||||||||||||
Direct cost of services | 39,734 | 30,484 | 70,218 | 16,567 | 20,622 | 37,189 | ||||||||||||||||||
Direct cost of systems | 6,889 | 39,735 | 46,624 | 4,331 | 40,823 | 45,154 | ||||||||||||||||||
Total direct costs | 46,623 | 70,219 | 116,842 | 20,898 | 61,445 | 82,343 | ||||||||||||||||||
Gross profit | ||||||||||||||||||||||||
Services gross profit | 40,867 | 12,188 | 53,055 | 21,888 | 6,141 | 28,029 | ||||||||||||||||||
Systems gross profit | 8,426 | 5,256 | 13,682 | 15,863 | 11,402 | 27,265 | ||||||||||||||||||
Total gross profit | $ | 49,293 | $ | 17,444 | $ | 66,737 | $ | 37,751 | $ | 17,543 | $ | 55,294 | ||||||||||||
14
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
Three Months Ended | Six Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2010 | 2009 | 2010 | 2009 | |||||||||||||
Total segment gross profit | $ | 33,188 | $ | 30,050 | $ | 66,737 | $ | 55,294 | ||||||||
Research and development expense | (6,571 | ) | (4,915 | ) | (15,089 | ) | (9,789 | ) | ||||||||
Sales and marketing expense | (5,967 | ) | (4,172 | ) | (11,946 | ) | (8,163 | ) | ||||||||
General and administrative expense | (9,802 | ) | (8,398 | ) | (18,264 | ) | (15,290 | ) | ||||||||
Depreciation and amortization of property and equipment | (2,257 | ) | (1,434 | ) | (4,233 | ) | (2,888 | ) | ||||||||
Amortization of acquired intangible assets | (1,171 | ) | (122 | ) | (2,343 | ) | (159 | ) | ||||||||
Interest expense | (2,237 | ) | (225 | ) | (4,589 | ) | (413 | ) | ||||||||
Amortization debt discount and debt issuance expenses | (216 | ) | (53 | ) | (376 | ) | (58 | ) | ||||||||
Other income, net | 495 | 105 | 985 | 284 | ||||||||||||
Income before income taxes | 5,462 | 10,836 | 10,882 | 18,818 | ||||||||||||
Provision for income taxes | (2,367 | ) | (4,230 | ) | (2,777 | ) | (7,345 | ) | ||||||||
Net income | $ | 3,095 | $ | 6,606 | $ | 8,105 | $ | 11,473 | ||||||||
7. | Inventory |
Inventory consisted of the following:
June 30, | Dec. 31, | |||||||
2010 | 2009 | |||||||
Component parts | $ | 2,074 | $ | 5,658 | ||||
Finished goods | 1,650 | 3,673 | ||||||
Total inventory at period end | $ | 3,724 | $ | 9,331 | ||||
15
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
8. | Acquired Intangible Assets and Capitalized Software Development Costs |
Our acquired intangible assets and capitalized software development costs of our continuing operations consisted of the following:
June 30, 2010 | December 31, 2009 | |||||||||||||||||||||||
Gross | Gross | |||||||||||||||||||||||
Carrying | Accumulated | Carrying | Accumulated | |||||||||||||||||||||
Amount | Amortization | Net | Amount | Amortization | Net | |||||||||||||||||||
Acquired intangible assets: | ||||||||||||||||||||||||
Customer lists and other | $ | 12,951 | $ | 2,040 | $ | 10,911 | $ | 13,735 | $ | 1,151 | $ | 12,584 | ||||||||||||
Customer relationships | 20,138 | 1,473 | 18,665 | 20,402 | 113 | 20,289 | ||||||||||||||||||
Trademarks and patents | 1,364 | 355 | 1,009 | 1,364 | 262 | 1,102 | ||||||||||||||||||
Software development costs, including acquired technology | 55,161 | 14,548 | 40,613 | 55,325 | 9,941 | 45,384 | ||||||||||||||||||
Total acquired intangible assets and software dev. costs | $ | 89,614 | $ | 18,416 | $ | 71,198 | $ | 90,826 | $ | 11,467 | $ | 79,359 | ||||||||||||
Estimated future amortization expense: | ||||||||||||||||||||||||
Six Months ending December 31, 2010 | $ | 7,013 | ||||||||||||||||||||||
Year ending December 31, 2011 | $ | 13,772 | ||||||||||||||||||||||
Year ending December 31, 2012 | $ | 13,608 | ||||||||||||||||||||||
Year ending December 31, 2013 | $ | 13,557 | ||||||||||||||||||||||
Year ending December 31, 2014 | $ | 11,855 | ||||||||||||||||||||||
Thereafter | $ | 11,393 | ||||||||||||||||||||||
$ | 71,198 | |||||||||||||||||||||||
For the three-month and six-months ended June 30, 2010, we capitalized $1,352 and $2,172, respectively, of software development costs of continuing operations for certain software projects after the point of technological feasibility had been reached but before the products were available for general release. Accordingly, these costs have been capitalized and are being amortized over their estimated useful lives beginning when the products are available for general release. The capitalized costs relate to our location-based software. We believe that these capitalized costs will be recoverable from future gross profits generated by these products. For the three- and six-months ended June 30, 2009 we capitalized $492 and $636 of software development costs.
Preliminary gross carrying amounts have been adjusted during the six-months ended June 30, 2010 as a result of information not initially available. Prior to the end of the measurement period for the finalized purchase price allocation, which is 12 months from the acquisition dates, if information becomes available which would indicate adjustments are required to the purchase price these adjustments will be included in the purchase price allocation retrospectively.
We routinely update our estimates of the recoverability of the software products that have been capitalized. Management uses these estimates as the basis for evaluating the carrying values and remaining useful lives of the respective assets.
16
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
9. | Concentrations of Credit Risk and Major Customers |
Financial instruments that potentially subject us to significant concentrations of credit risk consist primarily of accounts receivable and unbilled receivables. Accounts receivable are generally due within thirty days and no collateral is required. We maintain allowances for potential credit losses and historically such losses have been within our expectations.
The following tables summarize revenue and accounts receivable concentrations from our significant customers:
% of Total | ||||||||||||||||||
% of Total Revenue For | Revenue For | |||||||||||||||||
the Three | the Six | |||||||||||||||||
Months Ended | Months Ended | |||||||||||||||||
June 30, | June 30, | |||||||||||||||||
Customer | Segment | 2010 | 2009 | 2010 | 2009 | |||||||||||||
Federal Agencies | Government | 36 | % | 35 | % | 36 | % | 42 | % | |||||||||
Customer A | Commercial | 28 | % | 28 | % | 29 | % | 24 | % |
As of June 30, 2010 | ||||||||||
Accounts | Unbilled | |||||||||
Customer | Segment | Receivable | Receivables | |||||||
U.S. Government | Government | 27 | % | 49 | % | |||||
Customer A | Commercial | 30 | % | 34 | % |
10. | Lines of Credit |
We have maintained a line of credit arrangement with our principal bank since 2003. On December 31, 2009, we amended our June 2009 Third Amended and Restated Loan Agreement with our principal bank. The amended agreement increased the line of credit to a $35,000 revolving line of credit (the “Line of Credit,”) from the June 2009 amount of $30,000. Our 2009 line of credit replaces the Company’s 2007 revolving line of credit availability of $22,000 with the bank. The Line of Credit maturity date is June 25, 2012.
The Line of Credit includes threesub-facilities: (i) a letter of creditsub-facility pursuant to which the bank may issue letters of credit, (ii) a foreign exchangesub-facility pursuant to which the Company may purchase foreign currency from the bank, and (iii) a cash managementsub-facility pursuant to which the bank may provide cash management services (which may include, among others, merchant services, direct deposit of payroll, business credit cards and check cashing services) and in connection therewith make loans and extend credit to the Company. The principal amount outstanding under the Line of Credit accrues interest at a floating per annum rate equal to the rate which is the greater of (i) 4% per annum, or (ii) the bank’s most recently announced “prime rate,” even if it is not the bank’s lowest prime rate. The principal amount outstanding under the Line of Credit is payable either prior to or on the maturity date and interest on the Line of Credit is payable monthly. Our potential borrowings under the Line of Credit are reduced by the amounts of cash management services sublimit which totaled $1,525 at June 30, 2010. As of June 30, 2010 and 2009, there were no borrowings on the line of credit and we had approximately $33,500 and $28,000, respectively, of unused borrowing availability under this line.
17
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
11. | Long-term Debt |
Long-term debt consisted of the following:
June 30, | Dec. 31, | |||||||
2010 | 2009 | |||||||
4.5% Convertible notes dated November 16, 2009 | $ | 103,500 | $ | 103,500 | ||||
6.0% Promissory note payable to NIM sellers dated December 16, 2009 | 40,000 | 40,000 | ||||||
4.5% Note payable to commercial banks dated December 31, 2009 | 26,667 | 30,000 | ||||||
Total long-term debt | 170,167 | 173,500 | ||||||
Less: current portion | (41,667 | ) | (36,667 | ) | ||||
Non-current portion of long-term debt | $ | 128,500 | $ | 136,833 | ||||
Aggregate maturities of long-term debt at June 30, 2010 are as follows:
2010 | $ | 33,333 | ||
2011 | 16,667 | |||
2012 | 6,667 | |||
2013 | 6,667 | |||
2014 | 106,833 | |||
Total long-term debt | $ | 170,167 | ||
During 2009, the Company entered into multiple financing agreements to fund corporate initiatives.
On November 10, 2009, the Company sold $103.5 million aggregate principal amount of 4.5% Convertible Senior Notes (the “Notes”) due 2014. The Notes are not registered and were offered under Rule 144A of the Securities Act of 1933, as amended. Concurrent with the issuance of the Notes, we entered into convertible note hedge transactions and warrant transactions, also detailed below, that are expected to reduce the potential dilution associated with the conversion of the Notes. Holders may convert the Notes at their option on any day prior to the close of business on the second “scheduled trading day” (as defined in the Indenture) immediately preceding November 1, 2014. The conversion rate will initially be 96.637 shares of Class A common stock per $1,000 principal amount of Notes, equivalent to an initial conversion price of approximately $10.35 per share of Class A common stock. The effect of the convertible note hedge and warrant transactions, described below, is an increase in the effective conversion premium of the Notes to 60% above the November 10th closing price, to $12.74 per share.
The convertible note hedge transactions cover, subject to adjustments, 10,001,303 shares of Class A common stock. Also, in connection with the sale of the Notes, the Company entered into separate warrant transactions with certain counterparties (collectively, the “Warrant Dealers”). The Company sold to the Warrant Dealers the warrants to purchase in the aggregate 10,001,303 shares of Class A common stock, subject to adjustments, at an exercise price of $12.74 per share of Class A common stock. The Company offered and sold the warrants to the Warrant Dealers in reliance on the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended.
The convertible note hedge and the warrant transactions are separate transactions, each entered into by the Company with the counterparties, which are not part of the terms of the Notes and will not affect the holders’ rights under the Notes. The cost of the convertible note hedge transactions to the Company was approximately $23.8 million, and has been accounted for as an equity transaction in accordance with
18
TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
ASC 815-40, Contracts in Entity’s own Equity. The Company received proceeds of approximately $13 million related to the sale of the warrants, which has also been classified as equity as the warrants meet the classification criteria underASC 815-40-25, in which the warrants and the convertible note hedge transactions require settlements in shares and provide the Company with the choice of a net cash or common shares settlement. As the convertible note hedge and warrants are indexed to our common stock, we recognized them inAdditional paid-in capital,and will not recognize subsequent changes in fair value as long as the instruments remain classified as equity.
Interest on the Notes is payable semiannually on November 1 and May 1 of each year, beginning May 1, 2010. The notes will mature and convert on November 1, 2014, unless previously converted in accordance with their terms. The notes will be TCS’s senior unsecured obligations and will rank equally with all of its present and future senior unsecured debt and senior to any future subordinated debt. The notes will be structurally subordinate to all present and future debt and other obligations of TCS’s subsidiaries and will be effectively subordinate to all of TCS’s present and future secured debt to the extent of the collateral securing that debt. The notes are not redeemable by TCS prior to the maturity date.
On December 15, 2009, the Company issued $40 million in promissory notes as part of the consideration paid for the acquisition of NIM, see Note 2 for a description of the terms of these notes.
On December 31, 2009, we refinanced our June 2009 commercial bank term loan agreement with a $40 million five year term loan (the “Term Loan”) that replaces the Company’s $20 million prior term loan. The company drew $30 million of the term funds available with a maturity date in June 2014, and the remaining $10 million is available to draw no later than September 2010. The principal amount outstanding under the Term Loan accrues interest at a floating per annum rate equal to the rate which is the greater of (i) 4% per annum, or (ii) 0.5% above the banks prime rate (3.25% at June 30, 2010). The principal amount outstanding under the Term Loan is payable in sixty equal installments of principal of $556 beginning on January 29, 2010 and interest is payable on a monthly basis. Funds from the increase in the amount of the Term Loan were used primarily to retire the June 2009 term loan. In June 2009, we financed a $20,000, five year term loan with interest calculated at a floating per annum rate equal to the rate which is the greater of (i) 4% per annum, or (ii) 0.5% above the banks prime rate, which was repayable in monthly installments of $333 plus interest. The additional funds provided in our June 2009 agreement were used primarily to retire our June 2007 five year bank term loan and for the acquisition of substantially of the assets of LocationLogic.
Our bank Loan Agreement contains customary representations and warranties and customary events of default. Availability under the Line of Credit is subject to certain conditions, including the continued accuracy of the Company’s representations and warranties. The Loan Agreement also contains subjective covenants that require (i) no material impairment in the perfection or priority of the bank’s lien in the collateral of the Loan Agreement, (ii) no material adverse change in the business, operations, or condition (financial or otherwise) of the Borrowers, or (iii) no material impairment of the prospect of repayment of any portion of the borrowings under the Loan Agreement. The Loan Agreement also contains covenants requiring the Company to maintain a minimum adjusted quick ratio and a fixed charge coverage ratio as well as other restrictive covenants including, among others, restrictions on the Company’s ability to dispose part of its business or property; to change its business, liquidate or enter into certain extraordinary transactions; to merge, consolidate or acquire stock or property of another entity; to incur indebtedness; to encumber its property; to pay dividends or other distributions or enter into material transactions with an affiliate. As of June 30, 2010, we were in compliance with the covenants related to the Loan Agreement and we believe that we will continue to comply with these covenants in the foreseeable future. If our performance does not result in compliance with any of these restrictive covenants, we would seek to further modify our financing arrangements, but there can be no assurance
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TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
that the bank would not exercise its rights and remedies under the Loan Agreement, including declaring all outstanding debt due and payable.
12. | Capital leases |
We lease certain equipment under capital leases. Property and equipment acquired under capital leases totaled $3,068 and $5,706 during the three- and six-months ended June 30, 2010, respectively. We acquired $2,530 and $4,579 of property under capital leases during the three- and six-months ended June 30, 2009, respectively. Capital leases are collateralized by the leased assets. Amortization of leased assets is included in depreciation and amortization expense.
Future minimum payments under capital lease obligations consisted of the following at June 30, 2010:
2010 | $ | 5,099 | ||
2011 | 4,784 | |||
2012 | 3,441 | |||
2013 | 1,668 | |||
Total minimum lease payments | 14,992 | |||
Less: amounts representing interest | (1,623 | ) | ||
Present value of net minimum lease payments (including current portion of $4,278) | $ | 13,369 | ||
13. | Income taxes |
Our provision for income taxes totaled $2,367 and $2,777 for the three and six-months ended June 30, 2010, respectively, as compared to $4,230 and $7,345 being recorded for the three- and six-months ended June 30, 2009. The expense recorded for the six-month period ended June 30, 2010 is comprised of current year tax expense of $4,528 recorded based on pretax income plus a discrete tax benefit of $1,751 recorded related to Research & Experimentation tax credits. Excluding discrete items, the effective tax rate was approximately 43% for the three-months ended June 30, 2010 and approximately 42% for the six-months ended June 30, 2010. The effective tax rate was approximately 39% for both the three- and six-months ended June 30, 2009.
The significant changes to unrecognized tax benefits during the three- and six-months ended June 30, 2010 apply to the reduction for Research & Experimentation tax credits as a result of the Company completing an in depth analysis during first quarter. We do not anticipate a significant change to the total amount of unrecognized tax benefits within the next twelve months.
14. | Commitments and Contingencies |
The Company has been notified that some customers will or may seek indemnification under its contractual arrangements with those customers for costs associated with defending lawsuits alleging infringement of certain patents through the use of our products and services in combination with the use of products and services of multiple other vendors. In some cases we have agreed to assume the defense of the case. In others, the Company will continue to negotiate with these customers in good faith because the Company believes its technology does not infringe on the cited patents and due to specific clauses within the customer contractual arrangements that may or may not give rise to an indemnification obligation. The Company cannot currently predict the outcome of these matters and the resolutions could have a material effect on our consolidated results of operations, financial position or cash flows.
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TeleCommunication Systems, Inc.
Notes to Consolidated Financial Statements — (Continued)
In November 2001, a shareholder class action lawsuit was filed against us, certain of our current officers and a director, and several investment banks that were the underwriters of our initial public offering (the “Underwriters”): Highstein v. TeleCommunication Systems, Inc., et al., United States District Court for the Southern District of New York, Civil ActionNo. 01-CV-9500. The plaintiffs seek an unspecified amount of damages. The lawsuit purports to be a class action suit filed on behalf of purchasers of our Class A Common Stock during the period August 8, 2000 through December 6, 2000. The plaintiffs allege that the Underwriters agreed to allocate our Class A Common Stock offered for sale in our initial public offering to certain purchasers in exchange for excessive and undisclosed commissions and agreements by those purchasers to make additional purchases of our Class A Common Stock in the aftermarket at pre-determined prices. The plaintiffs allege that all of the defendants violated Sections 11, 12 and 15 of the Securities Act, and that the underwriters violated Section 10(b) of the Exchange Act, andRule 10b-5 promulgated thereunder. The claims against us of violation ofRule 10b-5 have been dismissed with the plaintiffs having the right to re-plead. On February 15, 2005, the District Court issued an Order preliminarily approving a settlement agreement among class plaintiffs, all issuer defendants and their insurers, provided that the parties agree to a modification narrowing the scope of the bar order set forth in the settlement agreement. The parties agreed to a modification narrowing the scope of the bar order, and on August 31, 2005, the court issued an order preliminarily approving the settlement. On December 5, 2006, the United States Court of Appeals for the Second Circuit overturned the District Court’s certification of the class of plaintiffs who are pursuing the claims that would be settled in the settlement against the underwriter defendants. Plaintiffs filed a Petition for Rehearing and Rehearing En Banc with the Second Circuit on January 5, 2007 in response to the Second Circuit’s decision. On April 6, 2007, the Second Circuit denied plaintiffs’ rehearing petition, but clarified that the plaintiffs may seek to certify a more limited class in the District Court. On June 25, 2007, the District Court signed an Order terminating the settlement. On November 13, 2007, the issuer defendants in certain designated “focus cases” filed a motion to dismiss the second consolidated amended class action complaints that were filed in those cases. On March 26, 2008, the District Court issued an Opinion and Order denying, in large part, the motions to dismiss the amended complaints in the “focus cases.” On April 2, 2009, the plaintiffs filed a motion for preliminary approval of a new proposed settlement between plaintiffs, the underwriter defendants, the issuer defendants and the insurers for the issuer defendants. On June 10, 2009, the Court issued an opinion preliminarily approving the proposed settlement, and scheduling a settlement fairness hearing for September 10, 2009. On August 25, 2009, the plaintiffs filed a motion for final approval of the proposed settlement, approval of the plan of distribution of the settlement fund, and certification of the settlement classes. A settlement fairness hearing was held on September 10, 2009. On October 5, 2009, the Court issued an opinion granting plaintiffs’ motion for final approval of the settlement, approval of the plan of distribution of the settlement fund, and certification of the settlement classes. We intend to continue to defend the lawsuit until the matter is resolved. We have purchased a Directors and Officers insurance policy which we believe should cover any potential liability that may result from these laddering class action claims, but can provide no assurance that any or all of the costs of the litigation will ultimately be covered by the insurance. No reserve has been created for this matter. More than 300 other companies have been named in nearly identical lawsuits that have been filed by some of the same law firms that represent the plaintiffs in the lawsuit against us.
Other than the items discussed immediately above, we are not currently subject to any other material legal proceedings. However, we may from time to time become a party to various legal proceedings arising in the ordinary course of our business.
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Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
The following discussion and analysis of the financial condition and results of operations should be read in conjunction with the consolidated financial statements, related notes, and other detailed information included elsewhere in this Quarterly Report onForm 10-Q for the quarter ended June 30, 2010 (this“Form 10-Q”). ThisForm 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are statements other than historical information or statements of current condition. We generally identify forward-looking statements by the use of terms such as “believe”, “intend”, “expect”, “may”, “should”, “plan”, “project”, “contemplate”, “anticipate”, or other similar statements. Examples of forward looking statements in this Quarterly Report onForm 10-Q include, but are not limited to statements: (a) regarding our belief that our technology does not infringe the patents related to customer indemnification requests and our estimates of the indemnification requests effects on our results of operations; (b) regarding our expectations with regard to the notes hedge transactions; (c) that we believe we have sufficient capital resources to fund our operations for the next twelve months and that we currently plan to settle the December 2010 debt obligation with cash; (d) as to the sufficiency of our capital resources to meet our anticipated working capital and capital expenditures for at least the next twelve months, (e) that we expect to realize approximately $201.7 million of backlog in the next twelve months, (f) that we believe that capitalized software development costs will be recoverable from future gross profits (g) regarding our belief that we were in compliance with our loan covenants and that we believe that we will continue to comply with these covenants, (h) regarding our expectations with regard to income tax assumptions and assumptions related to future stock compensation expenses, (i) regarding our expectations related to allowances for potential credit losses, and (j) indicating our insurance policies should cover all of the costs of the claims in the IPO laddering class action lawsuit.
These forward-looking statements relate to our plans, objectives and expectations for future operations. We base these statements on our beliefs as well as assumptions made using information currently available to us. In light of the risks and uncertainties inherent in all such projected operational matters, the inclusion of forward-looking statements in this report should not be regarded as a representation by us or any other person that our objectives or plans will be achieved or that any of our operating expectations will be realized. Revenues, results of operations, and other matters are difficult to forecast and our actual financial results realized could differ materially from the statements made herein, as a result of the risks and uncertainties described in our filings with the Securities and Exchange Commission. These include without limitation risks and uncertainties relating to our financial results and our ability to (i) continue to rely on our customers and other third parties to provide additional products and services that create a demand for our products and services, (ii) conduct our business in foreign countries, (iii) adapt and integrate new technologies into our products, (iv) develop software without any errors or defects, (v) protect our intellectual property rights, (vi) implement our business strategy, (vii) realize backlog, (viii) compete with small business competitors, (ix) effectively manage our counterparty risks, (x) achieve continued revenue growth in the foreseeable future in certain of our business lines, (xi) have sufficient capital resources to fund the Company’s operations, and (xii) successfully integrate the assets and personnel obtained in our acquisitions. These factors should not be considered exhaustive; we undertake no obligation to release publicly the results of any future revisions we may make to forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. We caution you not to put undue reliance on these forward-looking statements.
The information in this “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” discusses our unaudited consolidated financial statements, which have been prepared in accordance with GAAP for interim financial information.
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Critical Accounting Policies and Estimates
Management’s Discussion and Analysis of Financial Condition and Results of Operations addresses our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We have identified our most critical accounting policies and estimates to be those related to the following:
- Revenue recognition,
- Acquired intangible assets,
- Impairment of goodwill,
- Stock compensation expense,
- Income taxes,
- Business combinations, and
- Legal and other contingencies.
This discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included in our Annual Report onForm 10-K for the year ended December 31, 2009 (the “2009Form 10-K”). See Note 1 to the unaudited interim consolidated financial statements included elsewhere in thisForm 10-Q for a list of the standards implemented for the six-months ended June 30, 2010.
Overview
Our business is reported using two business segments: (i) the Commercial Segment, which consists principally of communication technology for wireless networks, principally based on text messaging and location-based services, including our E9-1-1 application and other applications for wireless carriers and Voice Over IP service providers, and (ii) the Government Segment, which includes the engineering, deployment and field support of information processing and communication solutions, mainly satellite-based, and related services to government agencies.
2009 Acquisitions
During 2009, our company completed four acquisitions, the details of which are described in the Business Section and Financial Statement Footnote 2 of our 2009Form 10-K.
For the Commercial Segment:
• | On May 19, 2009, we acquired substantially all of the assets of LocationLogic LLC (“LocationLogic”), a provider of infrastructure, applications and services for carriers and enterprises to deploy location-based services. | |
• | On December 15, 2009, we acquired Networks In Motion, Inc., (“NIM”) a provider of wireless navigation solutions for GPS-enabled mobile phones. |
For the Government Segment:
• | On November 3, 2009, we acquired Solvern Innovations, Inc., (“Solvern”) a provider of comprehensive communications products and solutions, training, and technology services for cyber security-based platforms. |
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• | On November 16, 2009, we acquired substantially all of the assets of Sidereal Solutions, Inc., (“Sidereal”), a satellite communications technology engineering, operations and maintenance support services company. |
Operating results of each of these acquisitions are reflected in the Company’s consolidated financial statements from the date of acquisition.
This “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” provides information that our management believes to be necessary to achieve a clear understanding of our financial statements and results of operations. You should read this “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” together with Item 1A “Risk Factors” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our 2009Form 10-K as well as the unaudited interim consolidated financial statements and the notes thereto located elsewhere in thisForm 10-Q.
Indicators of Our Financial and Operating Performance
Our management monitors and analyzes a number of performance indicators in order to manage our business and evaluate our financial and operating performance. Those indicators include:
• | Revenue and gross profit. We derive revenue from the sales of systems and services including recurring monthly service and subscriber fees, maintenance fees, software licenses and related service fees for the design, development, and deployment of software and communication systems, and products and services derived from the delivery of information processing and communication systems to governmental agencies. | |
• | Gross profit represents revenue minus direct cost of revenue, including certain non-cash expenses. The major items comprising our cost of revenue are compensation and benefits, third-party hardware and software, amortization of software development costs, non-cash stock-based compensation, and overhead expenses. The costs of hardware and third-party software are primarily associated with the delivery of systems, and fluctuate from period to period as a result of the relative volume, mix of projects, level of service support required and the complexity of customized products and services delivered. Amortization of software development costs, including acquired technology, is associated with the recognition of systems revenue from our Commercial Segment. | |
• | Operating expenses. Our operating expenses are primarily compensation and benefits, professional fees, facility costs, marketing and sales-related expenses, and travel costs as well as certain non-cash expenses such as non-cash stock compensation expense, depreciation and amortization of property and equipment, and amortization of acquired intangible assets. | |
• | Liquidity and cash flows. The primary driver of our cash flows is the results of our operations. Other important sources of our liquidity are our convertible debt agreement, financial institution loan agreement, lease financings secured for the purchase of equipment and potential borrowings under our credit lines. | |
• | Balance sheet. We view cash, working capital, and accounts receivable balances and days revenues outstanding as important indicators of our financial health. |
Results of Operations
The comparability of our operating results in the three- and six-month period ended June 30, 2010 to the three- and six-month period ended June 30, 2009 is affected by our 2009 acquisitions, three of the four acquisitions occurred in the fourth quarter of 2009, so there was no impact on the revenue and costs and expense total in the first six-months of 2009. Our acquisitions did not result in the entry into a new line of business or product category; they added products and services with substantially similar features and functionality to our incumbent business. Where variances in our results of operations for the first six-
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months of 2010 compared to the first six-months of 2009 were clearly related to the acquisitions, such as revenue and increases in amortization of intangibles, we describe the effects. Operation of the acquired businesses has been fully integrated into our existing operations.
Revenue and Cost of Revenue
The following discussion addresses the revenue, direct cost of revenue, and gross profit for our two business segments.
Commercial Segment:
Three Months | Six Months | |||||||||||||||||||||||||||||||
Ended June 30, | 2010 vs. 2009 | Ended June 30, | 2010 vs. 2009 | |||||||||||||||||||||||||||||
($ in millions) | 2010 | 2009 | $ | % | 2010 | 2009 | $ | % | ||||||||||||||||||||||||
Services revenue | $ | 41.3 | $ | 20.7 | $ | 20.6 | 100 | % | $ | 80.6 | $ | 38.5 | $ | 42.1 | 109 | % | ||||||||||||||||
Systems revenue | 6.7 | 12.4 | (5.7 | ) | (46 | )% | 15.3 | 20.2 | (4.9 | ) | (24 | )% | ||||||||||||||||||||
Commercial segment revenue | 48.0 | 33.1 | 14.9 | 45 | % | 95.9 | 58.7 | 37.2 | 63 | % | ||||||||||||||||||||||
Direct cost of services revenue | 20.4 | 8.4 | 12.0 | 143 | % | 39.7 | 16.6 | 23.1 | 139 | % | ||||||||||||||||||||||
Direct cost of systems revenue | 3.5 | 2.4 | 1.1 | 46 | % | 6.9 | 4.3 | 2.6 | 60 | % | ||||||||||||||||||||||
Commercial segment cost of revenue | 23.9 | 10.8 | 13.1 | 121 | % | 46.6 | 20.9 | 25.7 | 123 | % | ||||||||||||||||||||||
Services gross profit | 20.9 | 12.3 | 8.6 | 70 | % | 40.9 | 21.9 | 19.0 | 87 | % | ||||||||||||||||||||||
% of revenue | 51 | % | 59 | % | 51 | % | 57 | % | ||||||||||||||||||||||||
Systems gross profit | 3.2 | 10.0 | (6.8 | ) | (68 | )% | 8.4 | 15.9 | (7.5 | ) | (47 | )% | ||||||||||||||||||||
% of revenue | 48 | % | 81 | % | 55 | % | 79 | % | ||||||||||||||||||||||||
Commercial segment gross profit(1) | $ | 24.1 | $ | 22.3 | $ | 1.8 | 8 | % | $ | 49.3 | $ | 37.8 | $ | 11.5 | 30 | % | ||||||||||||||||
% of revenue | 50 | % | 67 | % | 51 | % | 64 | % | ||||||||||||||||||||||||
1 | See discussion of segment reporting in Note 6 to the accompanying unaudited consolidated financial statements |
Commercial Services Revenue, Cost of Revenue, and Gross Profit:
Commercial services revenue increased by approximately 100% for both the three- and six-months ended June 30, 2010 versus the comparable periods of 2009.
Services revenue includes hosted wireless Location Based Service (LBS) applications includingturn-by-turn navigation, people-finder, asset tracker and E9-1-1 service for wireless and E9-1-1 for Voice over Internet Protocol (VoIP) service providers, and hosted wireless LBS infrastructure including Position Determining Entity (PDE) service. This revenue primarily consists of monthly recurring service fees recognized in the month earned. Subscriber service revenue is generated by client software applications for wireless subscribers, generally on a per-subscriber per month basis. E9-1-1, PDE, VoIP and hosted LBS service fees are priced based on units served during the period, such as the number of customer cell sites, the number of connections to Public Service Answering Points (PSAPs), or the number of customer subscribers. Maintenance fees on our systems and software licenses are usually collected in advance and recognized ratably over the contractual maintenance period. Unrecognized maintenance fees are included in deferred revenue. Custom software development, implementation and maintenance services may be provided under time and materials or fixed-fee contracts.
Commercial services revenue in the three- and six-months ended June 30, 2010 was $20.6 million and $42.1 million higher, respectively, than the same periods for 2009 from increased subscriber revenue for LBS applications, more service connection deployments of our E9-1-1 services for cellular and VoIP service providers, and an increase in software maintenance revenue. The NIM and LocationLogic
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acquisitions contributed additional subscriber applications revenue during the three- and six-months ended June 30, 2010.
The direct cost of commercial services revenue consists primarily of compensation and benefits, network access, data feed and circuit costs, and equipment and software maintenance. The direct costs of maintenance revenue consist primarily of compensation and benefits expense. For the three- and six-months ended June 30, 2010, the direct cost of services revenue was $12.0 million and $23.1 million higher, respectively, than the three- and six-months ended June 30, 2009 primarily due to increase in labor and other direct costs related to the addition of NIM and LocationLogic businesses. We also incurred an increase in labor and direct costs related to custom development efforts responding to customer requests and deployment requirements for E9-1-1 VoIP.
Commercial services gross profit was $20.9 million and $12.3 million for the three-months ended June 30, 2010 and 2009, respectively, based on higher revenue. Commercial services gross profit was $40.9 million for the six-months ended June 30, 2010 compared to $21.9 million for the same period in 2009. Commercial services gross profit for the three- and six-months ended June 30, 2010 was approximately 70% and 87% higher than the three- and six-months ended June 30, 2009, primarily due to the contributions of the LocationLogic and NIM acquisitions. The inclusion of this subscriber application revenue in the 2010 mix brought the gross profit as a percentage of revenue from 59% to 51% in the three-months ended June 30, 2010 and from 57% to 51% in the six-months ended June 30, 2010.
Commercial Systems Revenue, Cost of Revenue, and Gross Profit:
We sell communications systems to wireless carriers incorporating our licensed software for enhanced services, including text messaging and location-based services. These systems are designed to incorporate our licensed software. We design our software to ensure that it is compliant with all applicable standards. Licensing fees for our carrier software are generally a function of its volume of usage in our customers’ networks. As a carrier’s subscriber base or usage increases, the carrier must purchase additional capacity under its license agreement and we receive additional revenue. We also realize license revenue from patents.
Commercial systems revenue for the three- and six-months ended June 30, 2010 was 46% and 24%, respectively, lower than in the comparable periods of 2009, due mainly to lower revenue from high-margin messaging systems, which was partly offset by increased revenue from location-based infrastructure systems.
The direct cost of our commercial systems consists primarily of compensation and benefits, purchased equipment, third-party hardware and software, travel expenses, consulting fees as well as the amortization of both acquired and capitalized software development costs for all reported periods. During the three- and six-months ended June 30, 2010, direct costs of systems included $2.3 million and $4.6 million, respectively, of amortization of software development costs. In the three- and six-months ended June 30, 2009, the composition of the direct cost of our systems was about the same except for $0.8 million and $1.3 million, respectively, of amortization of software development costs. The increase of 46% and 60% in the direct costs of systems in the three- and six-months ended June 30, 2010, respectively, compared to the same periods in 2009, reflects an increase in labor and direct costs related to custom development efforts responding to customer requests and deployment requirements for location-based systems.
Our commercial systems gross profit was $3.2 million and $8.4 million in the three- and six-months ended June 30, 2010, respectively, versus $10.0 million and $15.9 in the comparable periods of 2009. Commercial systems gross profit decreased approximately 68% and 47% for the three- and six-months ended June 30, 2010 compared to the same periods in 2009, down due to less higher-margin license software capacity sales offset partially by higher location systems revenue.
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Government Segment:
Three Months | Six Months | |||||||||||||||||||||||||||||||
Ended June 30, | 2010 vs. 2009 | Ended June 30, | 2010 vs. 2009 | |||||||||||||||||||||||||||||
($ in millions) | 2010 | 2009 | $ | % | 2010 | 2009 | $ | % | ||||||||||||||||||||||||
Services revenue | $ | 22.1 | $ | 13.9 | $ | 8.2 | 59 | % | $ | 42.7 | $ | 26.7 | $ | 16.0 | 60 | % | ||||||||||||||||
Systems revenue | 22.6 | 20.1 | 2.5 | 12 | % | 45.0 | 52.2 | (7.2 | ) | (14 | )% | |||||||||||||||||||||
Government segment revenue | 44.7 | 34.0 | 10.7 | 31 | % | 87.7 | 78.9 | 8.8 | 11 | % | ||||||||||||||||||||||
Direct cost of services revenue | 15.4 | 10.4 | 5.0 | 48 | % | 30.5 | 20.6 | 9.9 | 48 | % | ||||||||||||||||||||||
Direct cost of systems revenue | 20.2 | 15.8 | 4.4 | 28 | % | 39.7 | 40.8 | (1.1 | ) | (3 | )% | |||||||||||||||||||||
Government segment cost of revenue | 35.6 | 26.2 | 9.4 | 36 | % | 70.2 | 61.4 | 8.8 | 14 | % | ||||||||||||||||||||||
Services gross profit | 6.7 | 3.5 | 3.2 | 91 | % | 12.2 | 6.1 | 6.1 | 100 | % | ||||||||||||||||||||||
% of revenue | 30 | % | 25 | % | 29 | % | 23 | % | ||||||||||||||||||||||||
Systems gross profit | 2.4 | 4.3 | (1.9 | ) | (44 | )% | 5.3 | 11.4 | (6.1 | ) | (54 | )% | ||||||||||||||||||||
% of revenue | 11 | % | 21 | % | 12 | % | 22 | % | ||||||||||||||||||||||||
Government segment gross profit | 9.1 | 7.8 | 1.3 | 17 | % | 17.5 | 17.5 | — | — | |||||||||||||||||||||||
% of revenue | 20 | % | 23 | % | 20 | % | 22 | % | ||||||||||||||||||||||||
1 | See discussion of segment reporting in Note 6 to the accompanying unaudited consolidated financial statements |
Government Services Revenue, Cost of Revenue, and Gross Profit:
Government services revenue primarily consists of professional communications engineering and field support, program management, help desk outsource, network design and management for government agencies, as well as operation of teleport (fixed satellite ground terminal) facilities for data connectivity via satellite including resale of satellite airtime. Systems maintenance fees are usually collected in advance and recognized ratably over the contractual maintenance periods. Government services revenue increased $8.2 million or 59% and $16.0 million or 60% for the three- and six-months ended June 30, 2010 compared to the three- and six-months ended June 30, 2009, respectively, as a result of revenue contributions from customer relationships associated with the Solvern and Sidereal operations added to our business during the fourth quarter of 2009, as well as new and expanded-scope contracts for professional services, satellite airtime services using our teleport facilities, and maintenance and field support. Direct cost of government services revenue consists of compensation, benefits and travel expenses incurred in delivering these services, as well as satellite space segment purchased for resale. These costs increased as a result of the increased volume of services.
Our gross profit from government services increased to $6.7 million and $12.2 in the three- and six-months ended June 30, 2010, respectively, up from $3.5 million and $6.1 million in the three- and six-months ended June 30, 2009, as a result of a higher volume of services, including business arising from the acquisitions of Sidereal and Solvern in November 2009. Government services gross profit was 30% and 25% of revenue for the three-months ended June 30, 2010 and 2009, respectively. Government services gross profit was 29% compared to 23% of revenue for the six-months ended June 30, 2010 and 2009, respectively, reflecting a more favorable mix of contracts.
Government Systems Revenue, Cost of Revenue, and Gross Profit:
We generate government systems revenue from the design, development, assembly and deployment of information processing and communication systems, primarily deployable satellite-based andline-of-sight communications systems, and integration of those systems into customer networks. These
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are largely variations on our SwiftLink® products, which are lightweight, secure, deployable communications systems, sold mainly to units of the U.S. Department of Defense, and other federal agencies.
Government systems sales were $22.6 million and $45.0 million in the three- and six-months ended June, 30 2010, compared to $20.1 million and $52.2 for the three- and six-months ended June 30, 2009. The fluctuations in the periods reported reflect changes in sales volume of our SwiftLink® and deployable communication systems due to the timing of government project funding.
The cost of our government systems revenue consists of costs related to purchased system components, compensation, benefits, travel, and the costs of third-party contractors. These costs have decreased as a direct result of the decrease in volume. These equipment and third-party costs are variable for our various types of products, and margins may fluctuate between periods based on pricing and product mixes.
Our government systems gross profit was $2.4 million or 11% of revenue in the three-months ended June 30, 2010, down from $4.3 million or 21% of revenue in the comparable period of 2009, due mainly to an increase of lower margin equipment pass-through sales. Our government systems gross profit was $5.3 million or 12% of revenue in the six-months ended June 30, 2010, down from $11.4 million or 22% of revenue in the six-months ended June 30, 2009, due mainly to an increase in lower margin equipment pass-through sales and lower sales volume of our SwiftLink® product line.
Revenue Backlog
As of June 30, 2010 and 2009, we had unfilled orders or backlog as follows:
($ in millions) | 2010 | 2009 | $ | % | ||||||||||||
Commercial Segment | $ | 261.0 | $ | 102.4 | $ | 158.6 | 155 | % | ||||||||
Government Segment | 82.4 | 62.8 | 19.6 | 31 | % | |||||||||||
Total funded contract backlog | $ | 343.4 | $ | 165.2 | $ | 178.2 | 108 | % | ||||||||
Commercial Segment | $ | 261.0 | $ | 102.4 | $ | 158.6 | 155 | % | ||||||||
Government Segment | 350.5 | 303.8 | 46.7 | 15 | % | |||||||||||
Total backlog of orders and commitments, including customer options | $ | 611.5 | $ | 406.2 | $ | 205.3 | 51 | % | ||||||||
Expected to be realized within next 12 months | $ | 201.7 | $ | 124.2 | $ | 77.5 | 62 | % | ||||||||
Funded contract backlog on June 30, 2010 was $343.4 million, of which the Company expects to recognize $201.7 million in the next twelve months. Total backlog was $611.5 million at the end of the first half of 2010. Funded contract backlog represents contracts for which fiscal year funding has been appropriated by our customers (mainly federal agencies), and for our hosted services is computed by multiplying the most recent month’s recurring revenue times the remaining months under existing long-term agreements, which we believe is the best available information for anticipating revenue under those agreements. Total backlog, as is typically measured by government contractors, includes orders covering optional periods of serviceand/or deliverables for which budgetary funding may not yet have been approved. Company backlog at any given time may be affected by a number of factors, including the availability of funding, contracts being renewed or new contracts being signed before existing contracts are completed. Some of our backlog could be canceled for causes such as late delivery, poor performance and other factors. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual actual revenue.
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Operating Expenses
Research and development expense:
Three Months | Six Months | |||||||||||||||||||||||||||||||
Ended | Ended | |||||||||||||||||||||||||||||||
June 30, | 2010 vs. 2009 | June 30, | 2010 vs. 2009 | |||||||||||||||||||||||||||||
($ in millions) | 2010 | 2009 | $ | % | 2010 | 2009 | $ | % | ||||||||||||||||||||||||
Research and development expense | $ | 6.6 | $ | 4.9 | $ | 1.7 | 35 | % | $ | 15.1 | $ | 9.8 | $ | 5.3 | 54 | % | ||||||||||||||||
% of total revenue | 7 | % | 7 | % | 8 | % | 7 | % |
Our research and development expense consists primarily of compensation, benefits, travel costs, and a proportionate share of facilities and corporate overhead. The costs of developing software products are expensed prior to establishing technological feasibility. Technological feasibility is established for our software products when a detailed program design is completed. We incur research and development costs to enhance existing packaged software products as well as to create new software products, including software hosted in our network operations centers. These costs primarily include compensation and benefits as well as costs associated with using third-party laboratory and testing resources. We expense such costs as they are incurred, unless technological feasibility has been reached and we believe that the capitalized costs will be recoverable, in which we capitalize and amortize over the product’s expected life.
The expenses we incur relate mainly to software applications which are being marketed to new and existing customers on a global basis. Throughout the three- and six-months ended June 30, 2010 and 2009, research and development was primarily focused on wireless location-based subscriber and carrier applications, including navigation, people-locator, cellular E9-1-1 and Voice over IP E9-1-1, enhancements to our hosted LBS platform for carrier infrastructure, and enhancements to our text messaging deliverables.
For the three- and six-months ended June 30, 2010, we capitalized $1.4 million and $2.2 million, respectively, of research and development costs for certain software projects in accordance with the above policy versus $0.5 million and $0.6 for the comparable periods in 2009. These costs will be amortized on aproduct-by-product basis using the straight-line method over the product’s estimated useful life, not longer than three years. Amortization is also computed using the ratio that current revenue for the product bears to the total of current and anticipated future revenue for that product (the revenue curve method). If this revenue curve method results in amortization greater than the amount computed using the straight-line method, amortization is recorded at that greater amount. We believe that these capitalized costs will be recoverable from future gross profits generated by these products.
Research and development expenses increased 35% and 54% for the three- and six-months ended June 30, 2010 versus the comparable period of 2009 primarily as a result of expenditures to improve location based application software for customers of the acquired NIM and LocationLogic businesses.
Sales and marketing expense:
Three Months | Six Months | |||||||||||||||||||||||||||||||
Ended | Ended | |||||||||||||||||||||||||||||||
June 30, | 2010 vs. 2009 | June 30, | 2010 vs. 2009 | |||||||||||||||||||||||||||||
($ in millions) | 2010 | 2009 | $ | % | 2010 | 2009 | $ | % | ||||||||||||||||||||||||
Sales and marketing expense | $ | 6.0 | $ | 4.2 | $ | 1.8 | 43 | % | $ | 11.9 | $ | 8.2 | $ | 3.7 | 45 | % | ||||||||||||||||
% of total revenue | 6 | % | 6 | % | 6 | % | 6 | % |
Our sales and marketing expenses include fixed and variable compensation and benefits, trade show expenses, travel costs, advertising and public relations costs as well as a proportionate share of facility-related costs which are expensed as incurred. Our marketing efforts also include speaking engagements and attending and sponsoring industry conferences. We sell our software products and services through our direct sales force and through indirect channels. We have also historically leveraged our relationship with original equipment manufacturers to market our software products to wireless carrier customers.
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We sell our products and services to agencies and departments of the U.S. Government primarily through direct sales professionals.
Sales and marketing expenses increased $1.8 million and $3.7 for the three- and six-months ended June 30, 2010 versus the comparable periods of 2009 due to increases in sales personnel, public relations fees, and variable compensation resulting mainly in support of the expansion enhanced by 2009 acquisitions.
General and administrative expense:
Three Months | Six Months | |||||||||||||||||||||||||||||||
Ended | Ended | |||||||||||||||||||||||||||||||
June 30, | 2010 vs. 2009 | June 30, | 2010 vs. 2009 | |||||||||||||||||||||||||||||
($ in millions) | 2010 | 2009 | $ | % | 2010 | 2009 | $ | % | ||||||||||||||||||||||||
General and administrative expense | $ | 9.8 | $ | 8.4 | $ | 1.4 | 17 | % | $ | 18.3 | $ | 15.3 | $ | 3.0 | 20 | % | ||||||||||||||||
% of total revenue | 11 | % | 13 | % | 10 | % | 11 | % |
General and administrative expense consists primarily of management, finance, legal, human resources and internal information systems functions. These costs include compensation, benefits, professional fees, travel, and a proportionate share of rent, utilities and other facilities costs which are expensed as incurred.
The $1.4 million and $3.0 million increase in General and Administrative expense for the three- and six-months ended June 30, 2010 compared to the same periods in 2009 was due primarily to the increased costs to support the operations we acquired during 2009, as well as investments for process control enhancement and legal and professional costs associated with intellectual property.
Depreciation and amortization of property and equipment:
Three Months | Six Months | |||||||||||||||||||||||||||||||
Ended | Ended | |||||||||||||||||||||||||||||||
June 30, | 2010 vs. 2009 | June 30, | 2010 vs. 2009 | |||||||||||||||||||||||||||||
($ in millions) | 2010 | 2009 | $ | % | 2010 | 2009 | $ | % | ||||||||||||||||||||||||
Depreciation and amortization of property and equipment | $ | 2.3 | $ | 1.4 | $ | 0.9 | 64 | % | $ | 4.2 | $ | 2.9 | $ | 1.3 | 45 | % | ||||||||||||||||
Average gross cost of property and equipment during the period | $ | 78.8 | $ | 57.5 | $ | 75.1 | $ | 56.2 |
Depreciation and amortization of property and equipment represents the period costs associated with our investment in information technology and telecommunications equipment, software, furniture and fixtures, and leasehold improvements. We compute depreciation and amortization using the straight-line method over the estimated useful lives of the assets, generally range from 5 years for furniture, fixtures, and leasehold improvements to three to four years for most other types of assets including computers, software, telephone equipment and vehicles.
In the three- and six-months ended June 30, 2010, our depreciable asset base increased primarily as a result of additions to property and equipment including purchases of about $16.8 million in the first half of 2010.
Amortization of acquired intangible assets:
Three Months | Six Months | |||||||||||||||||||||||||||||||
Ended | Ended | |||||||||||||||||||||||||||||||
June 30, | 2010 vs. 2009 | June 30, | 2010 vs. 2009 | |||||||||||||||||||||||||||||
($ in millions) | 2010 | 2009 | $ | % | 2010 | 2009 | $ | % | ||||||||||||||||||||||||
Amortization of acquired intangible assets | $ | 1.2 | $ | 0.1 | $ | 1.1 | 1100 | % | $ | 2.3 | $ | 0.2 | $ | 2.1 | 1050 | % |
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The amortization of acquired non-goodwill intangible assets relates to the 2009 acquisitions of wireless location-based application and infrastructure technology assets acquired from LocationLogic, NIM, and the cyber security assets acquired from Solvern, and the 2004 acquisition of Kivera digital mapping business assets. These assets are being amortized over their useful lives of between five and nineteen years. The expense recognized in the three- and six-months ended June 30, 2010 relates to customer lists, customer relationships, courseware, and patents. The expense recognized in the three- and six-months ended June 30, 2009 relates to the intangible assets, including customer lists and patents, associated with the 2004 Kivera acquisition and a proportion of the May 19, 2009 LocationLogic acquisition.
Interest expense:
Three Months | Six Months | |||||||||||||||||||||||||||||||
Ended | Ended | |||||||||||||||||||||||||||||||
June 30, | 2010 vs. 2009 | June 30, | 2010 vs. 2009 | |||||||||||||||||||||||||||||
($ in millions) | 2010 | 2009 | $ | % | 2010 | 2009 | $ | % | ||||||||||||||||||||||||
Interest expense incurred on bank and other notes payable | $ | 0.9 | $ | 0.1 | $ | 0.8 | 800 | % | $ | 1.9 | $ | 0.2 | $ | 1.7 | 850 | % | ||||||||||||||||
Interest expense incurred on 4.5% convertible debt financing | 1.2 | — | 1.2 | 100 | % | 2.3 | — | 2.3 | 100 | % | ||||||||||||||||||||||
Interest expense incurred on capital lease obligations | 0.2 | 0.1 | 0.1 | 100 | % | 0.4 | 0.2 | 0.2 | 100 | % | ||||||||||||||||||||||
Amortization of deferred financing fees | 0.2 | 0.1 | 0.1 | 100 | % | 0.4 | 0.1 | 0.3 | 300 | % | ||||||||||||||||||||||
Total interest and financing expense | $ | 2.5 | $ | 0.3 | $ | 2.2 | 733 | % | $ | 5.0 | $ | 0.5 | $ | 4.5 | 900 | % |
Interest expense is incurred under bank and other notes payable, convertible debt financing, and capital lease obligations. Financing expense reflects amortization of deferred up-front financing expenditures at the time of contracting for financing arrangements, which are being amortized over the term of the note or the life of the facility.
On November 16, 2009, the Company issued $103.5 million aggregate principal amount of 4.5% Convertible Senior Notes due 2014. Interest on the Notes is payable semiannually on November 1 and May 1 of each year, beginning May 1, 2010. The Notes will mature on November 1, 2014, unless previously converted in accordance with their terms. The Notes are TCS’s senior unsecured obligations and will rank equally with all of its present and future senior unsecured debt and senior to any future subordinated debt. The Notes are structurally subordinate to all present and future debt and other obligations of TCS’s subsidiaries and will be effectively subordinate to all of TCS’s present and future secured debt to the extent of the collateral securing that debt. The Notes are not redeemable by TCS prior to the maturity date.
Interest on the bank term loan is at the bank’s prime rate plus 0.5% per annum with a minimum rate of 4%. Interest on our capital leases is primarily at stated rates averaging about 7%.We have a commercial bank line of credit that has not been used for borrowings, and has therefore generated no interest expense, during the periods reported. Interest on our line of credit borrowing would be at the bank’s prime rate which was 3.25% per annum as of June 30, 2010 with a minimum rate of 4%. In June 2009, we entered into the Third Amended and Restated Loan and Security Agreement with our principal bank. The June 2009 agreement provided for a $30 million revolving line of credit that replaced the Company’s prior $22 million line of credit and a $20 million five year term loan that replaced the Company’s prior $10 million term loan. Further details about our bank facilities are provided under Liquidity and Capital Resources.
On December 15, 2009,we issued $40 million in promissory notes as part of the consideration paid for the acquisition of NIM. The promissory notes bear simple interest at 6% and are due in three installments: $30 million on the 12 month anniversary of the closing, $5 million on the 18 month anniversary of the closing, and $5 million on the 24 month anniversary of the closing, subject to escrow adjustments. The promissory notes are effectively subordinated to TCS’s secured debt and structurally subordinated to any present and future indebtedness and other obligations of TCS’s subsidiaries.
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Our capital lease obligations include interest at various amounts depending on the lease arrangements. Our interest under capital leases fluctuates depending on the amount of capital lease obligations in each year.
Overall our interest and financing expense was higher in the three- and six-months ended June 30, 2010 as a result of the increase in amounts financed in the fourth quarter of 2009, including the 4.5% convertible debt financing in November 2009. Interest expense on bank and other notes payable increased in the three- and six-months ended June 30, 2010 compared to the same periods in 2009 as a result of the NIM promissory notes and the December 2009 bank term loan. Interest on capital lease financing for the three- and six-months ended June 30, 2010 increased slightly for the three- and six-months ended June 30, 2009 due to additional funding for purchases of property and equipment. The higher 2010 amortization expense reflects the proration of fees to refinance our bank term loan and fees associated with the 4.5% convertible debt financing.
Other income/(expense), net:
Other income/(expense), net includes interest earned on investment accounts and foreign currency translation/transaction gain or loss, which is dependent on fluctuations in exchange rates. The other components of other income/(expense), net typically remain comparable between periods.
Income taxes:
Income tax expense was $2.8 million for the first half of 2010 against pre-tax income of $10.9 million for the first half of 2010, representing an effective tax rate of approximately 26%. The tax provision for the first half of 2010 was lower than would be normally expected as a result of a discrete adjustment to reduce the reserve against our deferred tax asset by about $1.8 million. Absent this adjustment, our effective tax rate for the first half of 2010 would have been approximately 42%. For the first six-months of 2009, we recorded a tax provision of $7.3 million, representing an effective tax rate of about 39%.
Net income:
Three Months | Six Months | |||||||||||||||||||||||||||||||
Ended | Ended | |||||||||||||||||||||||||||||||
June 30, | 2010 vs. 2009 | June 30, | 2010 vs. 2009 | |||||||||||||||||||||||||||||
($ in millions) | 2010 | 2009 | $ | % | 2010 | 2009 | $ | % | ||||||||||||||||||||||||
Net income | $ | 3.1 | $ | 6.6 | $ | (3.5 | ) | (53 | )% | $ | 8.1 | $ | 11.5 | $ | (3.4 | ) | (30 | )% |
Net income decreased for the three- and six-months ended June 30, 2010 versus the comparable periods of 2009. The Company’s higher revenue and gross profit were offset by an increase in interest expense as a result of our fourth quarter 2009 financing and an increase in operating expenses and depreciation and amortization expenses, primarily as a result of our 2009 acquisitions, and other factors discussed above.
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Liquidity and Capital Resources
Six Months | ||||||||||||||||
Ended | ||||||||||||||||
June 30, | 2010 vs. 2009 | |||||||||||||||
($ in millions) | 2010 | 2009 | $ | % | ||||||||||||
Net cash and cash equivalents provided by/(used in): | ||||||||||||||||
Income | $ | 8.1 | $ | 11.5 | $ | (3.4 | ) | (30 | )% | |||||||
Non-cash charges | 18.0 | 6.6 | 11.4 | 173 | % | |||||||||||
Deferred income tax provision | 2.8 | 6.7 | (3.9 | ) | (58 | )% | ||||||||||
Net changes in working capital including changes in other assets | 22.8 | (3.3 | ) | 26.1 | 791 | % | ||||||||||
Operating activities | 51.7 | 21.5 | 30.2 | 140 | % | |||||||||||
Acquisition of LocationLogic assets | — | (15.0 | ) | 15.0 | 100 | % | ||||||||||
Purchases of property and equipment | (16.8 | ) | (5.2 | ) | (11.6 | ) | (223 | )% | ||||||||
Capital purchases funded through leases | 5.7 | 4.6 | 1.1 | 24 | % | |||||||||||
Purchases of property and equipment, excluding assets funded by leasing | (11.1 | ) | (0.6 | ) | (10.5 | ) | (1750 | )% | ||||||||
Capitalized software development costs | (2.2 | ) | (0.6 | ) | (1.6 | ) | (267 | )% | ||||||||
Proceeds from new borrowings | — | 20.0 | (20.0 | ) | (100 | )% | ||||||||||
Other financing activities | (2.8 | ) | (5.3 | ) | 2.5 | 47 | % | |||||||||
Net increase in cash | $ | 35.6 | $ | 20.0 | $ | 15.6 | 78 | % | ||||||||
Days revenue in accounts receivable, including unbilled receivables at quarter-end | 75 | 92 |
Capital resources: We have funded our operations, acquisitions, and capital expenditures primarily using cash generated by our operations, as well as the capital leases to fund fixed asset purchases.
Sources and uses of cash: The Company’s cash and cash equivalents balance was approximately $97 million at June 30, 2010, a $38 million increase from $59 million at June 30, 2009.
Operations: Cash generated by operating activities was $51.7 million for the first half of 2010 as compared to $21.5 million for the first half of 2009. The increased in the first half of 2010 is primarily due to the receipt of $15.7 million cash payment for a 2009 patent-related gain, as well as an increase in deferred revenue due to timing of percentage of completion projects, a decrease in accounts payable relating to the timing of vendor payments, and a decrease in accrued payroll and related liabilities due to the timing of payments.
Investing activities: Fixed asset additions, excluding assets funded by leasing, were approximately $11.1 million and $0.6 million, for the six-months ended June 30, 2010 and 2009, respectively. Also, investments were made in development of carrier software for resale which had reached the stage of development calling for capitalization, in the amounts approximately $2.2 million and $0.6 million for the six-months ended June 30, 2010 and 2009, respectively. On May 19, 2009, the company completed the transaction to purchase the LocationLogic business for seller proceeds of $25 million consisting of $15 million in cash and approximately 1.4 million of Company shares valued at $10 million.
Financing activities: Financing activities during the six-months ended June 30, 2010 were limited to scheduled term debt service payments and capital leasing. Fixed assets acquired under capital leases were valued at $5.7 million and $4.6 million during the six-months ended June 30, 2010 and 2009, respectively.
Capital Resources: We have a $35 million revolving Line of Credit with our principal bank through June 2012 with borrowing available at the bank’s prime rate which was 3.25% per annum at June 30, 2010. Borrowings at any time are limited to an amount based principally on accounts receivable levels and working capital ratio, each as defined in the Line of Credit agreement. The Line of Credit available is also reduced by the amount of cash management services sublimit, which was $1.5 million June 30, 2010. As
33
of June 30, 2010, we had no borrowings outstanding under our bank Line of Credit and had approximately $33.5 million of unused borrowing availability under the line.
The Line of Credit includes threesub-facilities: (i) a letter of creditsub-facility pursuant to which the bank may issue letters of credit, (ii) a foreign exchangesub-facility pursuant to which the Company may purchase foreign currency from the bank, and (iii) a cash managementsub-facility pursuant to which the bank may provide cash management services (which may include, among others, merchant services, direct deposit of payroll, business credit cards and check cashing services) and in connection therewith make loans and extend credit to the Company. The principal amount outstanding under the Line of Credit accrues interest at a floating per annum rate equal to the rate which is the greater of (i) 4% per annum, or (ii) the bank’s most recently announced “prime rate,” even if it is not the Interest Rate. The principal amount outstanding under the Line of Credit is payable either prior to or on the maturity date and interest on the Line of Credit is payable monthly.
On November 16, 2009, the Company issued 4.5% Convertible Senior Notes to fund corporate initiatives which included the acquisition of NIM. Holders may convert the Notes at their option on any day prior to the close of business on the second “scheduled trading day” (as defined in the Indenture) immediately preceding November 1, 2014. The conversion rate will initially be 96.637 shares of our Class A common stock per $1,000 principal amount of the Notes, equivalent to an initial conversion price of approximately $10.348 per share of Class A common stock. At the time of this transaction, while this represented an approximately 30% conversion premium over the closing price of the Company’s Class A common stock on November 10, 2009 of $7.96 per share, the effect of the convertible note hedge and warrant transactions, described below increased the effective conversion premium of the Notes to 60% above the November 10th closing price, to $12.74 per share.
In connection with the sale of the Notes, the Company entered into convertible note hedge transactions with respect to the Class A common stock with certain counterparties. The convertible note hedge transactions cover, subject to adjustments, 10,001,303 shares of Class A common stock. Also, in connection with the sale of the Notes, the Company entered into separate warrant transactions with certain counterparties the Warrant Dealers. The Company sold to the Warrant Dealers, warrants to purchase in the aggregate 10,001,303 shares of Class A common stock, subject to adjustments, at an exercise price of $12.736 per share of Class A common stock. The Company offered and sold the warrants to the Warrant Dealers in reliance on the exemption from registration provided by Section 4(2) of the Securities Act. The Company used a portion of the gross proceeds of the offering to pay the Company’s cost of the convertible note hedge transactions. The convertible note hedge and the warrant transactions are separate transactions; each entered into by the Company with the counterparties, is not part of the terms of the Notes and will not affect the holders’ rights under the Notes.
On December 15, 2009, we issued $40 million in promissory notes as part of the consideration paid for the acquisition of NIM. The promissory notes bear simple interest at 6% and are due in three installments: $30 million on the 12 month anniversary of the closing, $5 million on the 18 month anniversary of the closing, and $5 million on the 24 month anniversary of the closing, subject to escrow adjustments. The promissory notes are effectively subordinated to TCS’s secured debt and structurally subordinated to any present and future indebtedness and other obligations of TCS’s subsidiaries.
On December 31, 2009, we refinanced facilities under our bank Loan Agreement. A $40 million five-year Term Loan replaced the Company’s $20 million prior term loan with the bank. The Company drew $30 million of the funds available. The remaining $10 million is available to draw no later than September 2010. The Term Loan maturity date is June 2014.
Under the Loan Agreement, the Company is obligated to repay all advances or credit extensions made pursuant to the Loan Agreement. The Loan Agreement is secured by substantially all of the Company’s tangible and intangible assets as collateral, except that the collateral does not include any of the Company’s intellectual property. The principal amount outstanding under the Term Loan accrues interest at the greater of (i) 4% per annum, or (ii) a floating per annum rate equal to one-half of one percentage point (0.5%) above the Interest Rate (3.25% at June 30, 2010). The principal amount outstanding under the Term Loan is payable in sixty (60) equal installments of principal beginning on January 29, 2010 and interest is payable on a
34
monthly basis ($0.6 million plus interest per month). As of June 30, 2010, the amount outstanding under the Term Loan was $27 million. Funds from the increase in the amount of the Term Loan were used primarily to retire the June 2009 term loan. In June of 2009, we refinanced the unamortized balance under our June 2007 $10 million five-year note payable loan with a $20 million five-year note.
The Loan Agreement contains customary representations and warranties and customary events of default. Availability under the Line of Credit is subject to certain conditions, including the continued accuracy of the Company’s representations and warranties. The Loan Agreement also contains subjective covenants that requires (i) no material impairment in the perfection or priority of the bank’s lien in the collateral of the Loan Agreement, (ii) no material adverse change in the business, operations, or condition (financial or otherwise) of the Company, or (iii) no material impairment of the prospect of repayment of any portion of the borrowings under the Loan Agreement. The Loan Agreement also contains covenants requiring the Company to maintain a minimum adjusted quick ratio and a fixed charge coverage ratio as well as other restrictive covenants including, among others, restrictions on the Company’s ability to dispose part of their business or property; to change their business, liquidate or enter into certain extraordinary transactions; to merge, consolidate or acquire stock or property of another entity; to incur indebtedness; to encumber their property; to pay dividends or other distributions or enter into material transactions with an affiliate of the Company.
As of June 30, 2010, we were in compliance with the covenants related to the Loan Agreement and we believe that we will continue to comply with these covenants. If our performance does not result in compliance with any of these restrictive covenants, we would seek to further modify our financing arrangements, but there can be no assurance that the bank would not exercise its rights and remedies under the Loan Agreement, including declaring all outstanding debt due and payable.
We currently believe that we have sufficient capital resources with cash generated from operations as well as cash on hand to meet our anticipated cash operating expenses, working capital, and capital expenditure and debt service needs for the next twelve months. We have borrowing capacity available to us in the form of capital leases as well as a line of credit arrangement with our principal bank which expires in June 2012. We may also consider raising capital in the public markets as a means to meet our capital needs and to invest in our business. Although we may need to return to the capital markets, establish new credit facilities or raise capital in private transactions in order to meet our capital requirements, we can offer no assurances that we will be able to access these potential sources of funds on terms acceptable to us or at all.
Contractual Commitments
As of June 30, 2010, our most significant commitments consisted of purchase obligations, term debt, obligations under capital leases and non-cancelable operating leases. Other long-term debt consists of contingent consideration included as part of the purchase price allocation of certain acquisitions. We lease certain furniture and computer equipment under capital leases. We lease office space and equipment under non-cancelable operating leases. Purchase obligations represent contracts for parts and services in connection with our government satellite services and systems offerings. As of June 30, 2010 our commitments consisted of the following:
Within 12 | 1-3 | 3-5 | More than | |||||||||||||||||
($ in millions) | Months | Years | Years | 5 Years | Total | |||||||||||||||
Term loan | $ | 7.7 | $ | 14.5 | $ | 6.8 | $ | — | $ | 29.0 | ||||||||||
4.5% Convertible debt interest obligation | 4.7 | 9.4 | 6.9 | — | 21.0 | |||||||||||||||
Promissory notes payable | 37.7 | 5.3 | — | — | 43.0 | |||||||||||||||
Other long-term debt | 3.0 | 3.4 | — | — | 6.4 | |||||||||||||||
Capital lease obligations | 5.1 | 8.2 | 1.7 | — | 15.0 | |||||||||||||||
Operating leases | 4.9 | 9.1 | 3.1 | 1.7 | 18.8 | |||||||||||||||
Purchase obligations | 4.7 | 3.1 | — | — | 7.8 | |||||||||||||||
Total contractual commitments | $ | 67.8 | $ | 53.0 | $ | 18.5 | $ | 1.7 | $ | 141.0 | ||||||||||
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Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
Interest Rate Risk
There have not been any material changes to our interest rate risk as described in Item 7A of our 2010 Annual Report onForm 10-K.
Foreign Currency Risk
For the three- and six months ended June 30, 2010, we generated $3.2 million and $6.3 million, respectively, of revenue outside the U.S, mostly denominated in U.S. dollars. A change in exchange rates would not have a material impact on our Consolidated Financial Statements. As of June 30, 2010, we had approximately $1.6 million of billed accounts receivable that are denominated in foreign currencies and would be exposed to foreign currency exchange risk. During the six-months ended June 30, 2010, our average receivables subject to foreign currency exchange risk was $1.4 million and our average deferred revenue balances subject to foreign currency exchange risk was $0.9 million. We had an average balance of $0.2 million of unbilled receivables denominated in foreign currency during the six-months ended June 30, 2010. We recorded immaterial transaction gains or losses on foreign currency denominated receivables and deferred revenue for the six-months ended June 30, 2010.
There have not been any other material changes to our foreign currency risk as described in Item 7A of our 2009 Annual Report onForm 10-K.
Item 4. | Controls and Procedures |
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, and summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required byRule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective at a reasonable assurance level as of June 30, 2010.
There have been no changes in the Company’s internal control over financial reporting during the latest fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II. — OTHER INFORMATION
Item 1. | Legal Proceedings |
In November 2001, a shareholder class action lawsuit was filed against us, certain of our current officers and a director, and several investment banks that were the underwriters of our initial public offering (the “Underwriters”): Highstein v. TeleCommunication Systems, Inc., et al., United States District Court for the Southern District of New York, Civil ActionNo. 01-CV-9500. The plaintiffs seek an unspecified amount of damages. The lawsuit purports to be a class action suit filed on behalf of purchasers of our Class A Common Stock during the period August 8, 2000 through December 6, 2000. The plaintiffs allege that the Underwriters agreed to allocate our Class A Common Stock offered for sale in our initial public offering to certain purchasers in exchange for excessive and undisclosed commissions and agreements by those purchasers to make additional purchases of our Class A Common Stock in the aftermarket at pre-determined prices. The plaintiffs allege that all of the defendants violated Sections 11, 12 and 15 of the Securities Act, and that the underwriters violated Section 10(b) of the Exchange Act, andRule 10b-5 promulgated thereunder. The claims against us of violation ofRule 10b-5 have been dismissed with the plaintiffs having the right to re-plead. On February 15, 2005, the District Court issued an Order preliminarily approving a settlement agreement among class plaintiffs, all issuer defendants and their insurers, provided that the parties agree to a modification narrowing the scope of the bar order set forth in the settlement agreement. The parties agreed to a modification narrowing the scope of the bar order, and on August 31, 2005, the court issued an order preliminarily approving the settlement. On December 5, 2006, the United States Court of Appeals for the Second Circuit overturned the District Court’s certification of the class of plaintiffs who are pursuing the claims that would be settled in the settlement against the underwriter defendants. Plaintiffs filed a Petition for Rehearing and Rehearing En Banc with the Second Circuit on January 5, 2007 in response to the Second Circuit’s decision. On April 6, 2007, the Second Circuit denied plaintiffs’ rehearing petition, but clarified that the plaintiffs may seek to certify a more limited class in the District Court. On June 25, 2007, the District Court signed an Order terminating the settlement. On November 13, 2007, the issuer defendants in certain designated “focus cases” filed a motion to dismiss the second consolidated amended class action complaints that were filed in those cases. On March 26, 2008, the District Court issued an Opinion and Order denying, in large part, the motions to dismiss the amended complaints in the “focus cases.” On April 2, 2009, the plaintiffs filed a motion for preliminary approval of a new proposed settlement between plaintiffs, the underwriter defendants, the issuer defendants and the insurers for the issuer defendants. On June 10, 2009, the Court issued an opinion preliminarily approving the proposed settlement, and scheduling a settlement fairness hearing for September 10, 2009. On August 25, 2009, the plaintiffs filed a motion for final approval of the proposed settlement, approval of the plan of distribution of the settlement fund, and certification of the settlement classes. A settlement fairness hearing was held on September 10, 2009. On October 5, 2009, the Court issued an opinion granting plaintiffs’ motion for final approval of the settlement, approval of the plan of distribution of the settlement fund, and certification of the settlement classes. We intend to continue to defend the lawsuit until the matter is resolved. We have purchased a Directors and Officers insurance policy which we believe should cover any potential liability that may result from these laddering class action claims, but can provide no assurance that any or all of the costs of the litigation will ultimately be covered by the insurance. No reserve has been created for this matter. More than 300 other companies have been named in nearly identical lawsuits that have been filed by some of the same law firms that represent the plaintiffs in the lawsuit against us.
Other than the items discussed immediately above, we are not currently subject to any other material legal proceedings. However, we may from time to time become a party to various legal proceedings arising in the ordinary course of our business.
Item 1A. | Risk Factors |
There have not been any material changes to the information previously disclosed in “Item 1A. Risk Factors” in our 2009 Annual Report onForm 10-K.
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Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
None.
Item 3. | Defaults Upon Senior Securities |
None.
Item 4. | Removed and Reserved |
Item 5. | Other Information |
(a) None
(b) None.
Item 6. | Exhibits |
Exhibit | ||||
Numbers | Description | |||
31 | .1 | Certification of CEO required by the Securities and Exchange CommissionRule 13a-14(a) or 15d-14(a) | ||
31 | .2 | Certification of CFO required by the Securities and Exchange CommissionRule 13a-14(a) or 15d-14(a) | ||
32 | .1 | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | ||
32 | .2 | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized on the 5th day of August 2010.
TELECOMMUNICATION SYSTEMS, INC.
By: | /s/ Maurice B. Tosé |
Maurice B. Tosé
Chairman, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated.
/s/Maurice B. Tosé Maurice B. Tosé August 5, 2010 | Chairman, President and Chief Executive Officer (Principal Executive Officer) | |
/s/Thomas M. Brandt, Jr. Thomas M. Brandt, Jr. August 5, 2010 | Senior Vice President and Chief Financial Officer (Principal Financial Officer) |
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