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SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission File No. 0-30821

TELECOMMUNICATION SYSTEMS, INC.

(410) 263-7616

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

      Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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TELECOMMUNICATION SYSTEMS, INC.

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TeleCommunication Systems, Inc.

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TeleCommunication Systems, Inc.

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TeleCommunication Systems, Inc.

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TeleCommunication Systems, Inc.

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TeleCommunication Systems, Inc.

1.     Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation 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-month periods ended June 30, 2002 are not necessarily indicative of the results that may be expected for the year ended December 31, 2002. These consolidated financial statements should be read in conjunction with the Company’s audited financial statements and related notes included in the Company’s 2001 annual report on Form 10-K.

2.     Supplemental Disclosure of Cash Flow Information

We acquired property and equipment under capital leases totaling $157 and $2,178 during the three months ended June 30, 2002 and 2001, respectively, and $174 and $2,309 during the six months ended June 30, 2002 and 2001, respectively.

Interest paid totaled $224 and $153 for the three month periods ended June 30, 2002 and 2001, respectively, and $501 and $259 for the six-month period ended June 30, 2002 and 2001, respectively.

3.     Segment Information

During the fourth quarter of 2001, management began evaluating segment performance based on earnings (loss) before interest, taxes and non-cash charges. We have restated prior period information for comparative purposes. The following table sets forth information on each of our reportable segments:

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Notes to Consolidated Financial Statements — (Continued)

A reconciliation of segment loss before interest, taxes and non-cash charges for both segments to loss from operations is as follows:

4.     Stock Options

During the second and third quarters of 2000, we granted incentive stock options to employees and directors to purchase 885,983 shares of Class A Common Stock. The options were granted at an exercise price less than the estimated market value of our Class A Common Stock at the date of grant.

For the three and six-month periods ended June 30, 2002, we recorded $443 and $867 of non-cash stock compensation expense related to these grants. We expect to record future stock compensation expense of approximately $4,237 as a result of these option grants that will be recognized ratably over the remaining vesting period.

5.     Goodwill and Other Intangible Assets

In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill will no longer be amortized but will be subject to annual impairment tests in accordance with the Statement. Other intangible assets will continue to be amortized over their useful lives.

The new rules of accounting for goodwill and other intangible assets became effective beginning in the first quarter of 2002. Application of the non-amortization provisions of the Statement did not have an effect on our operating results since we currently have no goodwill.

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Notes to Consolidated Financial Statements — (Continued)

Intangible assets consisted of the following as of June 30, 2002 and December 31, 2001:

6.     Derivative and Hedging Activities

Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (FAS 133), requires that all derivative instruments be reported on the balance sheet at fair value and that changes in a derivative’s fair value be recognized currently in earnings unless specified hedge criteria are met. Under FAS 133, if a foreign currency option is designated a cash flow hedge, the effective portions of the changes in fair value of the option are recorded in other comprehensive income. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings.

In January 2002, we entered into a contract to sell products and services, which is denominated in British Pounds Sterling. Fluctuations in the value of the British Pound Sterling relative to the United States Dollar could cause us to incur currency exchange losses. Under the terms of this contract, we will be paid in British Pounds Sterling which exposes us to foreign currency exchange risk.

In April 2002, we entered into several foreign currency option contracts primarily to manage our foreign currency exchange rate risk. All of the foreign currency options have been entered into with one financial institution acting as a counterparty. These foreign currency option contracts have various expiration dates between October 15, 2002 and March 17, 2003.

A portion of the option contracts were entered into to manage our exposure to changes in the foreign currency exchange rate related to the forecasted cash receipts under this contract. To ensure both appropriate use as a hedge and hedge accounting treatment, this portion of these options is designated according to the hedge objective against specific forecasted cash receipts. The notional amounts, rates and maturities of these foreign currency options are closely matched to the related forecasted cash receipts. For the three-month period ended June 30, 2002, no portion of the changes in fair value of the foreign currency cash flow hedges were determined to be ineffective. The asset associated with these foreign currency cash flow hedges of approximately $22 is included in the Other Current Assets caption on the Consolidated Balance Sheet.

The remaining portion of the foreign currency option contracts do not meet the criteria for hedge accounting treatment. These foreign currency options were entered into for speculative purposes. Therefore, the change in fair market value of these derivatives for the three months ended June 30, 2002 of $278, is included in Interest Income and Other Income (Expense) on the Consolidated Income Statement. The liability associated with this derivative of $278 is included in the Accounts Payable and Accrued Expenses caption on the Consolidated Balance Sheet.

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      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 on Form 10-Q. This report 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. Some forward-looking statements may be identified by the use of such terms as “believes”, “anticipates”, “intends”, or “expects”. For example, the statement regarding our belief as to the sufficiency of our cash position for the next twelve months is a forward-looking statement. These forward-looking statements relate to our plans, objectives and expectations for future operations. 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. Our actual financial results realized could differ materially from the statements made herein, depending in particular upon the risks and uncertainties described in our filings with the Securities and Exchange Commission (SEC). These include without limitation risks and uncertainties relating to our financial results and our ability to (i) reach profitability as early as anticipated, (ii) 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, (iii) conduct our business in foreign countries, (iv) adapt and integrate new technologies into our products, (v) expand our business offerings in the new wireless data industry, (vi) develop software without any errors or defects, (vii) protect our intellectual property rights, and (viii) implement our sales and marketing strategy. 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.

Critical Accounting Policies and Estimates

      Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. 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 judgements, including those related to revenue recognition, intangible assets, financing operations, and contingencies and litigation. Management bases its estimates and judgements 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 judgements 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 identified our most critical accounting policies to be those related to revenue recognition for our contracts accounted for using the percentage of completion method, capitalized software, intangible assets, and evaluation of impairment. We describe these accounting policies at relevant sections in this discussion and analysis and in the notes to the consolidated financial statements included in our 2001 annual report on Form 10-K.

Company Background

      We develop and license Network Application Software products that enable the delivery of internet content, short messages, location, presence and privacy information and other enhanced communication services to and from wireless devices, including phones, two-way pagers and personal digital assistants.

      Our Network Applications Services include enhanced wireless E9-1-1, cross-carrier text message distribution services, maintenance and deployment of our software products, and development of custom

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      Our Network Solutions segment designs, installs and operates wireless and wireline communication systems, including our Swiftlink™ compact deployable products, and high-speed, satellite, and internet protocol solutions for corporate and government customer enterprise networks.

      We were founded in 1987 and initially provided network solutions to the U.S. Department of Defense and other government customers. In 1996, we entered into a development agreement with Lucent Technologies to develop and co-own the Short Message Service Center application software for wireless carrier customers. In January 2001, we acquired Xypoint Corporation and as a result, have become a leading provider of enhanced E9-1-1 services and location software to wireless carriers.

      We have expanded our portfolio of proprietary wireless technology and, as of June 30, 2002, our customers included 43 wireless carrier networks around the world, including Verizon Wireless, Cingular Wireless, Voicestream, Telefonica and Hutchison 3G.

Overview

      We manage our business in two segments, network applications and network solutions. Our network applications segment consists of the development and licensing of software products and the provision of related services. Our network solutions segment includes the design, development and deployment of complex information processing and communication systems and the provision of related services. The following table sets forth information on each of our segments:

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      A reconciliation of segment loss before interest, taxes and non-cash charges for both segments to loss from operations is as follows:

      Our total backlog at June 30, 2002 was $61.7 million, an increase from $29.7 million at June 30, 2001. We expect to realize approximately $33.6 million of our backlog in the second half of 2002. The backlog at any given time may be affected by a number of factors, including contracts being renewed or new contracts being signed before existing contracts are completed. Accordingly, a comparison of backlog from period to period is not necessarily meaningful and may not be indicative of eventual actual shipments or future revenue.

      For the six-month period ended June 30, 2002, our aggregate revenue from various U.S. government agencies was approximately $16.5 million and revenue from our Lucent channel was approximately $2.9 million, compared to $10.4 million from the U.S. government and $5.5 million from Lucent for the same period in 2001. For the three months ended June 30, 2002, our aggregate revenue from various U.S. government agencies was approximately $11.1 million and revenue from our Lucent channel was approximately $1.4 million, compared to $5.3 million from the U.S. government and $1.8 million from Lucent for the same period in 2001.

      In February 2002 we entered into a master agreement under which Hutchison 3G UK Ltd. will license the TCS Xypoint® Location Platform. We are deploying our Xypoint® Location Platform in the UK and one other country. Orders have been received for this software to be deployed in two more countries and in the second half of 2002 we expect to receive orders for deployment of this technology in at least two additional countries. Hutchison has announced that its services will be available in Australia, Austria, Denmark, Hong Kong, Ireland, Israel, Italy, Sweden and the UK.

      Network Applications Revenue. We market our network application products and services by responding to requests for proposals, through our direct sales force and through channel partners. We generate network applications revenue from licensing of our software products, providing related maintenance and deployment services and from our service bureau offerings — enhanced E9-1-1 and Message Distribution Center. We also sell custom software applications. The Short Message Service Center, Wireless Internet Gateway and TCS Xypoint® Location Platform products are the principal generators of software license fees.

      We have historically sold some of our network application software products through our channel relationship with Lucent. This sales process typically includes participation of our engineers along with Lucent in presenting our products to prospective customers. Lucent pays us initial license fees generally equal to 50% of the revenue it generates from sales of the Short Message Service Center application that we developed under our 1996 development agreement. For sales of our Wireless Internet Gateway, Lucent pays us initial fees which we negotiate on a case by case basis.

      Initial licensing fees are a function of the number of subscribers in the network where our software is deployed. As a carrier’s subscriber base increases, the carrier must purchase additional capacity under its license agreement and we receive additional revenue. Generally, we recognize license fee revenue when each

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      Our network applications service revenue arises from our enhanced E9-1-1 service bureau business, annual maintenance fees for our packaged software products and fees from development, implementation and maintenance of custom software. Revenue from our service bureau offerings consists of monthly recurring service fees and is recognized in the month earned. Service fees are primarily dependent on the number of subscribers the carrier covers or cell sites that provide E9-1-1 services for the carrier. As the carrier’s number of subscribers or cell sites increases, the monthly recurring service fees increase. Maintenance fees on packaged software are collected in advance and recognized ratably over the 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. We recognize fixed-fee contract revenue using the percentage-of-completion method. We measure progress to completion using costs incurred compared to estimated total costs. We recognize estimated losses under long-term contracts in their entirety upon discovery. If we did not accurately estimate total costs to complete a contract or do not manage our contracts within the planned budget, then future margins may be negatively affected or losses on existing contracts may need to be recognized.

      Network Solutions Revenue. We generate network solutions revenue from the design, development and deployment of information processing and communication systems for corporate and government enterprises. Representative examples of recent network solutions projects include work performed under our agreements with the U.S. Department of Defense and U.S. Department of State. We have delivered our SwiftLink™ product, a lightweight, secure, deployable communications system to the U.S. Department of State and the U.S. Department of Defense. SwiftLink^TM provides secure voice, video and data communications, supports a worldwide network during trips abroad and throughout the United States and provides full network functionality and IP telephony capability using landlines and satellite-based technologies. During the first quarter of 2002, we began operation of our teleport facility in Baltimore, MD, which supports the integration of satellite communications and terrestrial wireless broadband with U.S. broadband networks. Through this teleport facility we now offer voice, video and data connectivity via satellite to North and South America, as well as Africa and Europe.

      We generally provide network solutions under long-term contracts. We recognize revenue under long-term contracts as billable costs are incurred and for fixed-price contracts using the percentage-of-completion method, measured by total costs incurred compared to total estimated costs. We recognize estimated losses on contracts in their entirety upon discovery. If we did not accurately estimate total costs to complete a contract or do not manage our contracts within the planned budget, then future margins may be negatively affected or losses on existing contracts may need to be recognized. Under our contracts with the U.S. government, contract costs, including the allocated indirect expenses, are subject to audit and adjustment by the Defense Contract Audit Agency. We record revenue under these contracts at estimated net realizable amounts.

      Direct Cost of Network Applications. Our direct cost of network applications consists primarily of compensation, benefits, purchased equipment, third-party software and travel expenses incurred when providing our services, as well as the cost of our network operations centers circuits for connectivity to carrier customers and Public Safety Answering Points.

      Direct Cost of Network Solutions. Our direct cost of network solutions consists primarily of compensation, benefits, travel, purchased equipment and the costs of third-party contractors that we engage. Our direct costs of providing services under long-term contracts include an allocation of indirect costs at rates that comply with federal contractor cost accounting regulations.

      Research and Development Expense. Our research and development expense consists of the costs of developing software products incurred prior to establishing technological feasibility. Technological feasibility is established when all planning, designing, coding, and testing activities that are necessary to establish that

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      Sales and Marketing Expense. Our sales and marketing expenses include compensation and benefits, trade show, travel, advertising and public relations costs which are expensed as incurred. Our marketing efforts also include speaking engagements and attending and sponsoring industry conferences. We sell our network applications products and services through our direct sales force and through indirect channels. We have also historically leveraged our relationship with Lucent to market our network application software products to wireless carrier customers and we added Motorola as a sales channel in 2001. We sell our network solutions primarily through direct sales professionals.

      General and Administrative Expense. General and administrative expense consists primarily of compensation costs and other costs associated with management, finance, human resources and internal information systems. These costs include compensation and benefits, rent, utilities and other facilities costs which are expensed as incurred.

      Non-Cash Stock-Based Compensation Expense. During the second and third quarters of 2000, we granted options to purchase 885,983 shares of Class A Common Stock to employees and directors at an exercise price less than the fair market value of our Class A Common Stock at the date of grant. We will record future additional stock compensation expense of approximately $4.2 million as a result of these option grants that will be recognized ratably over the remaining vesting period. During the first half of 2002, we recognized approximately $0.9 million of stock compensation expense related to these grants.

      Depreciation and Amortization Expense. Depreciation and amortization expense (other than amortization of software development costs) represents the period costs associated with our investment in computers, telephony equipment, software, furniture and fixtures, and leasehold improvements. We compute depreciation and amortization using the straight-line method over the estimated useful life of the assets.

      Amortization of Software Development Costs. We capitalize software development costs after we establish technological feasibility, and amortize those costs over the estimated useful life of the software beginning on the date when the software is first available for general release. We calculate amortization of software development costs on a product-by-product basis using the straight-line method over the remaining estimated economic life of the product, which is never greater than four years. We also compute amortization using the ratio that current revenue for the product bears to the total of current and anticipated future revenue for that product. If this revenue curve method results in amortization greater than the amount computed using the straight-line method, we record amortization at that greater amount. Amortization as a percentage of software license fees is generally a higher percentage in the early stages of a product’s life cycle. Our policies to determine when to capitalize software development costs and how much to amortize in a given period requires us to make subjective estimates and judgements. If our software products do not achieve the level of market acceptance that we expect and our future revenue estimates for these products change, the amount of amortization that we record may increase compared to prior periods.

      Amortization of Other Intangible Assets. Other intangible assets consist of acquired trade name. These intangible assets are being amortized over three years using the straight-line method. In assessing the recoverability of our intangible assets we make assumptions regarding the remaining useful life, estimated future cash flows and other factors to determine the fair value of the assets. These estimates could change significantly based on changes in our strategy and/or market conditions. If these estimates or related assumptions change in the future, we may be required to record an impairment charge for our intangible assets.

      Interest Income and Other Income (Expense). Interest income and other income (expense) consists of interest income earned on cash equivalents, foreign currency transaction gain or loss, and other income (expense) related to recording our investment activities.

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Results of Operations

Three Months Ended June 30, 2002 Compared to the Three Months Ended June 30, 2001

      Revenue. Total revenue increased $7.6 million, or 47%, to $23.9 million in the second quarter of 2002 from $16.3 million in the same period in 2001.

      Total network applications revenue increased $1.1 million, or 11%, to $10.9 million in the three months ended June 30, 2002 from $9.8 million in the same period in 2001. Network application software license revenue decreased $0.3 million, or 10%, to $2.8 million in the second quarter of 2002 from $3.1 million in the same period in 2001. The decrease is a result of a slowdown in carrier purchases of licenses that began in the second quarter of 2001 offset by license revenue from a large location platform project. Network application service revenue increased $1.3 million, or 20%, to $8.1 million in the second quarter of 2002 from $6.8 million in the second quarter of 2001. This increase is primarily due to the growth in our E9-1-1 business during 2001 and the first half of 2002.

      Network solutions revenue increased $6.6 million, or 103%, to $13.0 million for the second quarter of 2002 from $6.4 million in the same period in 2001. This increase is primarily due to the increase in revenue from the completion of a major component of a new multi-month project and sales of our SwiftLink™ deployable communication systems.

      Direct Cost of Revenue. Total direct cost of revenue increased $8.1 million, or 99%, to $16.3 million in the second quarter of 2002 from $8.2 million in the same period in 2001. As a percentage of revenue, direct cost of revenue increased to 68% in the second quarter of 2002 from 50% in the second quarter of 2001.

      Direct cost of network applications increased $2.4 million, or 64%, to $6.3 million in the second quarter of 2002 from $3.8 million for the same period in 2001. The increase in direct cost of network applications is primarily a result of an increase in costs associated with E9-1-1 deployment and operations and a large location platform project. As a percentage of related revenue, direct cost of network applications increased from 39% in the second quarter of 2001 to 58% in the first quarter of 2002. The increase in direct cost of network applications as a percentage of revenue is due to lower margins in our service bureau business resulting from pricing pressures as well as an increase in software projects that require significant customization. These types of software projects generally have a lower margin than software sales that do not require customization.

      Direct cost of network solutions increased $5.7 million, or 131%, to $10.0 million in the second quarter of 2002 from $4.3 million for the same period in 2001. The increase in direct cost of network solutions is a result of the increase in network solutions revenue. As a percentage of related revenue, direct cost of network solutions increased to 77% in the second quarter of 2002 from 68% for the second quarter 2001. Network solutions projects have variable margins that fluctuate based on the type and complexity of the projects. The variances in margins between periods are primarily due to changes in the mix of projects.

      Research and Development Expense. Research and development expense was $4.3 million for the three months ended June 30, 2002 compared to $5.0 million for the three months ended June 30, 2001. The decrease is due to the timing and mix of projects in development. Specifically in 2001, research and development expense included projects related to Nomad. Development on those projects were ceased, because management did not believe that market demand was sufficient to warrant further development and commitment of resources.