SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

Commission File No. 0-30821

 

TELECOMMUNICATION SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

 

(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 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation 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 this Form 10-K or any amendment to this Form 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 Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 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.

 

 

 

INDEX

 

TELECOMMUNICATION SYSTEMS, INC.

 

TeleCommunication Systems, Inc.

Consolidated Statements of Income
(amounts in thousands, except per share data)
(unaudited)

 

 

See accompanying Notes to Consolidated Financial Statements

TeleCommunication Systems, Inc.

Consolidated Balance Sheets
(amounts in thousands, except share data)

 

 

See accompanying Notes to Consolidated Financial Statements

TeleCommunication Systems, Inc.

Consolidated Statement of Stockholders’ Equity
(amounts in thousands, except share data)
(unaudited)

 

 

See accompanying Notes to Consolidated Financial Statements

TeleCommunication Systems, Inc.

Consolidated Statements of Cash Flows
(amounts in thousands)
(unaudited)

 

 

See accompanying Notes to Consolidated Financial Statements

March 31, 2010

(amounts in thousands, except per share amounts)

(unaudited)

 

 

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-months ended March 31, 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 on Form 10-K. The terms “TCS”, “we”, “us” and “our” as used in this Form 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 accounting principles generally accepted in the United States 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 at end-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.

 

Stock-Based Compensation.  We have two stock-based employee compensation plans: our Fifth Amended and Restated 1997 Stock Incentive Plan (the “Stock Incentive Plan”) and our Employee Stock Purchase Plan (the “ESPP”). We have also previously 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.

 

Earnings per share.  Basic income per common share is based upon the average number of shares of common stock outstanding during the period. At March 31, 2010 and 2009, stock options to purchase

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

approximately 5.5 million and 1.6 million shares, respectively, were excluded from the computation of diluted net income per share because their inclusion would have been anti-dilutive.

 

The following table summarizes the computations of basic and diluted earnings per share for the quarters ended March 31:

 

 

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 March 31, 2010, we had unrecognized tax benefits totaling approximately $1.7 million. The determination of these unrecognized amounts requires significant 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 ASU 2009-14 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. ASU 2009-14 will be applied prospectively for new or materially modified arrangements in fiscal years

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

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 ASU 2009-13 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. ASU 2009-13 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.

 

 

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 preliminary 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.

 

On November 3, 2009, we 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 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

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

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 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.

 

In the first quarter of 2010, we made adjustments to the preliminary purchase price allocations for all four acquisitions for a total adjustment to goodwill of $0.4 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.

 

 

We recognize compensation expense net of estimated forfeitures over the requisite service period, 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.

 

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 15 shares and 10 shares of restricted stock outstanding, respectively, as of March 31, 2010 and March 31, 2009. We expect to record future stock compensation expense of $53 as a result of the restricted stock grants outstanding as of March 31, 2010 that will be recognized over the remaining vesting period in 2010.

 

The material components of our stock compensation expense are as follows:

 

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

Stock compensation is included in our operations in the accompanying Consolidated Statements of Income as follows:

 

 

 

A summary of our stock option activity and related information for the three-months ended March 31, 2010 is as follows:

 

 

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

 

Exercise prices for options outstanding at March 31, 2010 ranged from $1.07 to $26.05 as follows (all share amounts in thousands):

 

 

As of March 31, 2010, the aggregate intrinsic value of options outstanding was $36,903 and the aggregate intrinsic value of options vested and exercisable was $36,155. As of March 31, 2010, we estimate that we will recognize $22,065 in expense for outstanding, unvested options over their weighted average remaining vesting period of 3.8 years, of which we estimate $6,982 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:

 

 

 

Property and equipment acquired under capital leases totaled $2,638 and $2,050 during the three-months ended March 31, 2010 and 2009, respectively.

 

Interest paid totaled $540 and $188 during the three-months ended March 31, 2010 and 2009, respectively.

 

Income taxes and state income taxes paid totaled $1,229 and $379 during the three-months ended March 31, 2010 and 2009, respectively.

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

 

ASC 820-10 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:

 

 

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.

 

The Company’s long-term debt consists of borrowings under a commercial bank term loan agreement, a 4.5% convertible senior notes, and promissory notes, see Note 10. 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 quarter of 2010, there were no required fair value measurements for assets and liabilities measured at fair value on a non-recurring basis.

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

 

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; that is, 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.

 

The following table sets forth results for our reportable segments for the three-months ended March 31, 2010 and 2009, respectively. All revenues reported below are from external customers. A reconciliation of segment gross profit to net income for the respective periods is also included below:

 

 

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

 

 

Inventory consisted of the following:

 

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

 

Our acquired intangible assets and capitalized software development costs of our continuing operations consisted of the following:

 

 

For the three-months ended March 31, 2010 and 2009, we capitalized $821 and $144, 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.

 

The gross carrying amounts decreased in the first quarter of 2010 due to adjustments to the preliminary purchase price allocations 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.

 

 

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

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

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:

 

 

 

 

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 three sub-facilities: (i) a letter of credit sub-facility pursuant to which the bank may issue letters of credit, (ii) a foreign exchange sub-facility pursuant to which the Company may purchase foreign currency from the bank, and (iii) a cash management sub-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 letters of credit outstanding and a cash management services sublimit which totaled $1,596 at March 31, 2010. As of March 31, 2010 and 2009, there were no borrowings on the line of credit and we had approximately $33,400 and $19,700, respectively, of unused borrowing availability under this line.

 

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

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

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 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 under ASC 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 in Additional 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 March 31, 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. As of March 31, 2010, the amount outstanding under the Term Loan was $28,333. 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

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

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 March 31, 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 that the bank would not exercise its rights and remedies under the Loan Agreement, including declaring all outstanding debt due and payable.

 

 

The provision for income taxes totaled $410 for the three-months ended March 31, 2010, as compared to $3,115 being recorded for the three-months ended March 31, 2009. The expense recorded for the three-months ended March 31, 2010 is comprised of current year tax expense of $2,161 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 39.5% for the three months ended March 31, 2010 and 39% for the three months ended March 31, 2009.

 

The significant changes to unrecognized tax benefits during the three-months ended March 31, 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.

 

 

The Company has been notified that some customers 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. Although the Company cannot currently predict the outcome of these matters, we do not expect the resolutions will have a material effect on our consolidated results of operations, financial position or cash flows.

 

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 Action No. 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

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

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, and Rule 10b-5 promulgated thereunder. The claims against us of violation of Rule 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.

 

On July 30, 2009, we filed suit in the United States District Court for the Eastern District of Virginia against Sybase 365, Inc., a subsidiary of Sybase Inc., for infringement related to U.S. patent Nos. 6,891,811, Short Message Service Center Mobile-Originated to Internet Communications, and 7,355,990, Mobile-Originated to HTTP Internet Communications, on technology for permitting two-way communication of short messages between an SMSC or wireless device and an HTTP device or Universal Resource Locator (URL). Sybase 365 has filed requests for reexamination of these patents claiming that the patents are invalid.

 

On August 19, 2009, we filed suit in the United States District Court for the District of Delaware against Sybase, Inc and iAnywhere Solutions, Inc, a subsidiary of Sybase, Inc., for patent infringement related to U.S. patent No. 6,560,604, entitled “System, Method, and Apparatus for Automatically and Dynamically Updating Options, Features, and/or Services Available to Client Device”, on technologies permitting automatic initialization, configuration and updating of client devices over-the-air (“O-T-A”) and other technology-based products, services and systems that offer the automatic O-T-A initialization, configuration and updating capability.

TeleCommunication Systems, Inc.

 

Notes to Consolidated Financial Statements — (Continued)

 

On October 2, 2009, Sybase 365 LLC filed suit against us in the United States District Court for the Eastern District of Virginia, for patent infringement related to U.S. patent No. 5,873,040, entitled “Wireless 911 Emergency Location” on technology integrating wireless emergency 911 communications into a wireless voice network, and U.S. patent No. 7,082,312, entitled, “Short Message Gateway, System and Method of Providing Information Service for Mobile Telephones” on technology permitting the provision of location-based information service for mobile telephones. We are reviewing the allegations made in Sybase’s complaint and intend to defend the lawsuit vigorously. No reserve has been created for this matter.

 

On March 24, 2010, we agreed to a confidential settlement with Sybase on all outstanding patent litigation between the parties.

 

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.

 

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 for the quarter ended March 31, 2010 (this “Form 10-Q”). This Form 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 on Form 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 that indemnification claims should not have a material effect 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 $197.8 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 future stock compensation expenses and (i) 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.

 

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 on Form 10-K for the year ended December 31, 2009 (the “2009 Form 10-K”). See Note 1 to the unaudited interim consolidated financial statements included elsewhere in this Form 10-Q for a list of the standards implemented for the three months ended March 31, 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 2009 Form 10-K.

 

For the Commercial Segment:

 

 

For the Government Segment:

 

 

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 2009 Form 10-K as well as the unaudited interim consolidated financial statements and the notes thereto located elsewhere in this Form 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:

 

 

Results of Operations

 

The comparability of our operating results in the first quarter of 2010 to the first quarter of 2009 is affected by our 2009 acquisitions, most of the acquisition activity occurred in the mid to late fourth quarter of 2009, so there was no impact on the revenue and costs and expense total in the first quarter of 2009. Where changes in our results of operations from the first quarter of 2010 compared to the first quarter of 2009 are clearly related to the acquisitions, such as revenue and increases in amortization of intangibles, we quantify the effects. Operation of the acquired businesses has been fully integrated into our existing operations. Our acquisitions did not result in the our entry into a new line of business or product category; they added products and services with substantially similar features and functionality.

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:

 

 

 

 

Commercial Services Revenue, Cost of Revenue, and Gross Profit:

 

Commercial services revenue increased 121% for the three-months ended March 31, 2010 versus the comparable period of 2009.

 

Services revenue includes hosted Location Based Service (LBS) applications including 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 first quarter of 2010 was up $21.5 million or more than double than the first quarter of 2009 from increased maintenance and E9-1-1 services revenue as well as an increase in subscriber applications revenue of approximately $17 million, due mainly to contributions from the NIM and LocationLogic businesses acquired subsequent to the first quarter of 2009.

 

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-months ended March 31, 2010, the direct cost of commercial services revenue increased 135% as compared to the first quarter of 2009, primarily due to increases 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 E-9-1-1 and VoIP.

 

Commercial services gross profit was $20 million and $9.6 million for the three-months ended March 31, 2010 and 2009, respectively, based on higher revenue. Commercial services gross profit was approximately 51% and 54% of revenue March 31, 2010 and 2009, respectively, mainly due to additional labor and fringe costs associated with costs associated with the NIM and LocationLogic businesses acquired subsequent to the first quarter of 2009.

 

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 increased 10% for the three-months ended March 31, 2010 versus the comparable period of 2009 due mainly to increased revenue from systems for location-based services, which was offset by lower revenue from messaging systems.

 

The direct cost of our commercial systems consists primarily of compensation, 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. In the first quarter of 2010, direct costs of systems consisted primarily of compensation, benefits, third-party hardware and software, and $2.3 million of amortization of software development costs.

 

Our commercial systems gross profit was $5.2 million in the three-months ended March 31, 2010 versus $5.9 million in the comparable period of 2009. Commercial systems gross profit was approximately 60% and 76% of revenue March 31, 2010 and 2009, respectively, down due to less license revenue partially offset by higher location systems revenue in the 2010 first quarter’s revenue mix.

 

Government Segment:

 

 

 

 

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 61% for the three-months ended March 31, 2010 compared to the three-months ended March 31, 2009 as a result of 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 $5.5 million in the first quarter of 2010 from $2.6 million in the first quarter of 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 27% and 20% of revenue March 31, 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 communications systems, and integration of those systems into customer networks. These are largely variations on our SwiftLink^® product line, which are lightweight, secure, deployable communications systems, sold to units of the U.S. Department of Defense, and other agencies.

 

Government systems sales were $22.4 million in the first quarter of 2010, down from $32.1 million for the three-months ended March 31, 2009. This decrease represents lower unit 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 $2.8 million in the first quarter of 2010, down from $7.1 million in the comparable period of 2009, due mainly to decreased sales volume. Government systems gross profit was 13% and 22% of revenue March 31, 2010 and 2009, respectively, reflecting a mix that included more lower margin pass-through sales in the first quarter of 2010.

Revenue Backlog

 

As of March 31, 2010 and 2009, we had unfilled orders or backlog as follows:

 

 

Funded contract backlog on March 31, 2010 was $301.1 million, of which the Company expects to recognize $197.8 million in the next twelve months. Total backlog was $586.1 million at the end of the first quarter 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 service and/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.

 

Operating Expenses

 

Research and development expense: