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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 by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act): Yes [  ]     No [ X ]

      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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INDEX

TELECOMMUNICATION SYSTEMS, INC.

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TeleCommunication Systems, Inc.

See accompanying Notes to Consolidated Financial Statements

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TeleCommunication Systems, Inc.

See accompanying Notes to Consolidated Financial Statements

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TeleCommunication Systems, Inc.

See accompanying Notes to Consolidated Financial Statements

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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 nine-month periods ended September 30, 2003 are not necessarily indicative of the results that may be expected for the year ended December 31, 2003. These consolidated financial statements should be read in conjunction with our audited financial statements and related notes included in our 2002 Annual Report on Form 10-K.

Use of Estimates. The preparation of financial statements in conformity with 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.

Reclassifications. Certain prior period balances have been reclassified to conform with current year presentation.

2.     Earnings and Loss Per Common Share

      Basic earnings or loss per common share is based upon the average number of shares of common stock outstanding during the period. Our potentially dilutive securities outstanding consist of stock options, restricted stock grants, and warrants. We calculate the potentially dilutive effect of such securities using the treasury stock method. For periods when we incurred a net loss, potentially dilutive securities were excluded from the computation because the result would be anti-dilutive. A reconciliation of the weighted average number of shares outstanding used for the computation of basic and diluted earnings per share is as follows (shares in thousands):

3.     Supplemental Disclosure of Cash Flow Information

      We did not acquire any property and equipment under capital leases during the three months ended September 30, 2003 or 2002. Property and equipment acquired under capital leases totaled $179 and $174 during the nine months ended September 30, 2003 and 2002, respectively.

      Interest paid totaled $236 and $204 for the three months ended September 30, 2003 and 2002, respectively, and $728 and $705 for the nine months ended September 30, 2003 and 2002, respectively.

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Notes to Consolidated Financial Statements — (Continued)

4.     Segment Information

      During the fourth quarter of 2002, management began evaluating our performance within three operating segments: network software, service bureau and network solutions. Management also began evaluating our performance based on gross profit. Gross profit is defined as revenue less direct cost of revenue, excluding the amortization of software development costs, which under accounting principles generally accepted in the United States, is considered in determining gross profit from software license revenues. We have restated prior period segment information for comparative purposes.

A reconciliation of gross profit to net loss is as follows:

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Notes to Consolidated Financial Statements — (Continued)

5.     Intangible Assets

      Intangible assets consisted of the following as of:

We routinely update our estimates of the recoverability of the software products that have been capitalized. Amortization expense for the nine months ended September 30, 2003 includes $7.0 million of additional amortization that was recorded during the second quarter of 2003 when it was determined that the expected margins to be realized from the sales of certain software products over their remaining amortization periods was less than their remaining book values plus costs to complete.

6.     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 insignificant and within our expectations.

The following table summarizes revenue concentrations from our significant customers:

As of September 30, 2003, total billed and unbilled receivables from agencies of the U.S. government aggregated approximately $10,500.

7.     Stock-Based Compensation

We have two stock-based employee compensation plans; our Third Amended and Restated 1997 Stock Incentive Plan (the “Stock Incentive Plan”) and our Employee Stock Purchase Plan. We record compensation expense for all stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25) and related Interpretations. Under APB 25, compensation expense is recorded over the vesting period to the extent that the fair value of the underlying stock on the date of grant exceeds the exercise or acquisition price of the stock or stock-based award. The following table illustrates the

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Notes to Consolidated Financial Statements — (Continued)

effect on net income/(loss) and income/(loss) per common share if we had applied the fair value recognition provisions of Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation(Statement No. 123), to stock-based employee compensation.

In calculating the fair value of our stock options using Black-Scholes, we assumed that the expected life was five years for options granted to employees and three years for options granted to non-employees, that the risk free interest rate was 3%, and that there was no dividend yield. We also assumed that the expected volatility of our stock was 130%.

Prior to our initial public offering in 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 Class A Common Stock at the date of grant. Net income/(loss), as reported, includes $249 and $429 of non-cash stock compensation expense related to these grants for the three months ended September 30, 2003 and 2002, respectively, and $844 and $1,296 of expense for the nine months ended September 30, 2003 and 2002, respectively. We expect to record future stock compensation expense of $1,209 as a result of option grants that will be recognized over the remaining vesting period of two years.

In the second quarter of 2003, we issued restricted stock to directors and certain key executives. The restrictions expire at the end of one year for directors and in annual increments over three years for executives and are based on continued employment. Net income/(loss) for the three and nine months ended September 30, 2003, as reported, includes $163 and $330, respectively, of non-cash stock compensation expense related to such stock grants. We expect to record future stock compensation expense of $1,551 as a result of these restricted stock grants that will be recognized over the remaining vesting period for directors and executives.

8.     Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). FIN 46 clarifies the requirements for consolidating certain entities in which equity investors do not have a controlling financial interest. We adopted FIN 46 during the second quarter of 2003. Since we are not affiliated with any variable interest entities, the adoption did not have an impact in the preparation of our consolidated financial statements.

In May 2003, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 149, “Derivatives and Hedging-Amendment of FASB Statement 133”

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Notes to Consolidated Financial Statements — (Continued)

(Statement No. 149). Statement No. 149 amends and clarifies accounting for derivative instruments, including derivatives embedded in other contracts, and hedging activities under the previously issued FASB Statement No. 133. We adopted Statement No. 149 during the third quarter of 2003. As we do not currently have any derivative contracts or hedging activities, the adoption did not have any impact on our consolidated financial statements.

Also in May 2003, the FASB issued Statement No. 150, “Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both” (Statement No. 150). Statement No. 150 amends accounting for mandatory redeemable shares, put options and forward purchase contracts, and obligations to be settled in shares having a fixed value. We adopted Statement No. 150 during the third quarter of 2003. As we have not issued any of the affected financial instruments, the adoption did not have any impact on our consolidated financial statements.

9.     Long-Term Debt

      During the nine months ended September 30, 2003, we borrowed approximately $5.3 million, primarily to fund equipment purchases. The debt bears interest at 7.75% and is secured by the accounts receivable owed to us by certain customers.

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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 capital resources to meet our anticipated working capital and capital expenditures for at least 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. These include without limitation risks and uncertainties relating to our financial results and our ability to (i) reach profitability as early as anticipated or at all, (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) develop software without any errors or defects, (vi) protect our intellectual property rights, (vii) implement our business strategy (viii) realize backlog, and (vix) achieve continued revenue growth in the foreseeable future for our E9-1-1 business. 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 U.S. generally accepted accounting principles. 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, including those related to intangible assets and contingencies and litigation. 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 identified our most critical accounting policies to be those related to revenue recognition for our software contracts with multiple elements, contracts accounted for using the percentage of completion method, and capitalized software. We describe these accounting policies in relevant sections of this discussion and analysis. This discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included in our 2002 Annual Report on Form 10-K.

Overview

      We manage our business in three segments:network software, service bureau and network solutions. Our network software segment develops, licenses, and maintains software products for cellular wireless carriers. Our service bureau segment provides our wireless E9-1-1 service and hosts

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      Gross profit is defined as revenue less direct cost of revenue, excluding depreciation and the amortization of software development costs, which under accounting principles generally accepted in the United States, is considered in determining gross profit from software license revenues. A reconciliation of segment gross profit to net income/(loss) is as follows (in thousands):