SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

For the quarter ended September 30, 2014

OR

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   ¨

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  þ    No  ¨

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.

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ¨    No   þ

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.

Consolidated Balance Sheets

(amounts in thousands, except share data)

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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TeleCommunication Systems, Inc.

Consolidated Statements of Operations

(amounts in thousands, except per share data)

(unaudited)

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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TeleCommunication Systems, Inc.

Consolidated Statements of Comprehensive Loss

(amounts in thousands)

(unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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TeleCommunication Systems, Inc.

Consolidated Statements of Cash Flows

(amounts in thousands)

(unaudited)

   

See accompanying Notes to Consolidated Financial Statements.

 

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TeleCommunication Systems, Inc.

Notes to Consolidated Financial Statements

September 30, 2014

(amounts in thousands, except per share amounts)

(unaudited)

 

 

1. Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation. The accompanying unaudited consolidated financial statements have been prepared in accordance with 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 months ended September 30, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014. These consolidated financial statements should be read in conjunction with our audited financial statements and related notes included in our 2013 Annual Report on Form 10-K. The terms “TCS,” “Company,” “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 these financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts and related disclosures. Significant estimates and assumptions in these consolidated financial statements include estimates used in revenue recognition, fair value of business combinations, fair value associated with goodwill, intangible assets and long-lived asset impairment tests, estimated values of software development costs, income taxes and deferred valuation allowances, the fair value of marketable securities and stock-based compensation, and legal and contingency fees. Actual results could differ from those estimates.

Interest Rate Hedging Activity. To reduce the risk of variability of cash flows associated with changes in interest rates on a portion of our floating rate debt, we entered into an interest rate swap (“hedge” or “swap”) agreement with our principal bank during the third quarter of 2014. The interest rate swap is designated as a cash flow hedge and its effect is recognized on the consolidated balance sheets at fair value. We formally documented the relationship between the interest rate swap and the hedged bank debt, as well as the risk management objective and the strategy for using the hedging instrument. We assess whether the relationship is highly effective at offsetting changes in the fair value both at inception of the hedging relationship and on an ongoing basis. Unrealized gains and losses are recognized as a component of accumulated other comprehensive income (loss) to the extent that the hedge is effective at offsetting the change in the fair value of the hedged item, and realized gains and losses are recognized in interest expense.

 

Goodwill. Goodwill represents the excess of cost over the fair value of assets of acquired businesses. Goodwill is not amortized, but instead is evaluated for impairment in the fourth quarter of each year, or sooner should there be an indicator of impairment. We may assess qualitative factors to determine whether it is more likely than not an event or circumstance might indicate the fair value of the reporting unit is less than its carrying value. Such indicators include a sustained, significant decline in the Company’s stock price and market capitalization, a decline in the Company’s expected future cash flows, a significant adverse change in legal factors or in the business climate, unanticipated competition, and/or slower expected growth, among others. After completing our assessment of such qualitative factors, and if it is determined that it is more likely than not that the fair value of a reporting unit is less than its carrying value, we perform a two-step process. The first step requires a comparison of the book value of net assets to the fair value of the reporting units that have goodwill assigned to them. If the fair value is determined to be less than the book value, a second step is performed to compute the amount of the impairment. In the second step, the implied fair value for goodwill is estimated, based in part on the fair value of the reporting unit used in the first step, and is compared to its carrying value. The shortfall of the fair value below carrying value, if any, would represent the amount of goodwill impairment.

Earnings per share. Basic net income (loss) per common share is based upon the average number of shares of common stock outstanding during the period. Stock options and restricted stock of 6,700 shares and 8,600 shares, respectively, for the three and nine months ended September 30, 2014 and 11,500 shares and 14,700 shares, respectively, for the three and nine months ended September 30, 2013, respectively, were excluded from the computation of diluted net income per share because their inclusion would have been anti-dilutive.

For the three and nine months ending September 30, 2014 and 2013, shares issuable upon conversion of convertible debt were excluded from the computation of diluted net income per share because their inclusion would have been anti-dilutive. Concurrent with the issuance of the convertible notes, we entered into convertible note hedge and warrant transactions. If the Company’s share price is greater than the warrant exercise price of $12.74 per share for any period presented, the warrants would be dilutive to the Company’s earnings per share. The convertible note hedge is excluded from the calculation of diluted earnings per share, as the impact is always considered anti-dilutive since the call option would be exercised by us when the exercise price is lower than the market price. For the

 

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three and nine months ending September 30, 2014 and 2013, the Company’s share price was less than the warrant exercise price of $12.74; therefore, no value was assigned to the warrants because the effect of their inclusion would have been anti-dilutive.

Our two classes of common stock (Class A and B) share equally in dividends declared or accumulated and have equal participation rights in undistributed earnings. In addition, our unvested restricted stock does not contain non-forfeitable rights to dividends and dividend equivalents. As such, unvested shares of restricted stock are not participating securities and our basic and diluted earnings per share are not impacted by the two-class method of computing earnings per share.

 

Recent Accounting Pronouncements. In August 2014, the Financial Accounting Standards Board ("FASB") issued new guidance for presentation of financial statements for going-concern, which addresses when and how to disclose going-concern uncertainties in the financial statements. The new standard requires management to perform interim and annual assessments of an entity’s ability to continue as a going concern within one year after the date the financial statements are issued. An entity must provide certain disclosures if conditions or events raise substantial doubt about the entity’s ability to continue as a going concern. The new guidance applies to all entities and is effective for annual periods ending after December 15, 2016, and interim periods thereafter, with early adoption permitted. The amended guidance is not expected to have a material impact on our consolidated financial statements.

 

In May 2014, the Financial Accounting Standards Board ("FASB") issued new guidance for revenue recognition. The new guidance provides a five-step revenue recognition model which replaces the prior revenue recognition guidance in its entirety. The core principle of the new standard is that an entity will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects what it expects in exchange for the goods or services. The standard also requires more detailed disclosures to enable users of the financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The guidance provides alternative methods of initial adoption; retrospectively applied to each prior reporting period or a modified retrospective approach, in which the cumulative effect of initially applying this new guidance is recognized at the date of initial application with additional disclosures. The guidance is effective for annual periods beginning after December 15, 2016 including interim periods within those annual periods. Early adoption is not permitted. We are currently evaluating the alternative transition methods and the impact that this standard will have on our consolidated financial statements.

 

In April 2014, the FASB amended guidance related to reporting discontinued operations and disposals of components of an entity. The amended guidance requires that a disposal representing a strategic shift that has (or will have) a major effect on an entity’s financial results or a business activity should be reported as discontinued operations. The amendment also expands the disclosure requirements for discontinued operations and adds new disclosures for individually significant dispositions that do not qualify as discontinued operations. The guidance is for fiscal years, and interim reporting periods within those years, beginning after December 15, 2014, with early adoption permitted only for disposals that have not been previously reported. The amended guidance is not expected to have a material impact on our consolidated financial statements.

 

In July 2013, the FASB amended guidance related to income taxes and the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar loss, or a tax credit carryforward exists. Under certain circumstances, unrecognized tax benefits should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. This amendment was adopted in January 1, 2014. The adoption did not have a material effect on our consolidated financial statements.

 

 

2. Stock-Based Compensation

Restricted Stock

We had 2,190 and 1,770 restricted stock units outstanding at a weighted-average grant date fair value per share of $2.42 and $2.75 as of September 30, 2014 and 2013, respectively. Total unrecognized share-based compensation expense is approximately $3,300 as of September 30, 2014 and 2013, which is expected to be recognized over a weighted-average period of approximately two years.

Stock Options

We had 16,142 and 17,506 stock options outstanding as of September 30, 2014 and 2013, respectively, of which 5,879 were “in-the-money” at September 30 2014. During the nine months ended September 30, 2014, we granted 2,123 options and 178 shares were exercised. Total unrecognized share-based compensation expense was approximately $4,600 and $6,700 as of September 30, 2014 and 2013, respectively, which is expected to be recognized over a weighted-average period of approximately three years.

 

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Total Stock-Based Compensation

We recognized total share-based compensation expense of $1,361 and $1,503 in the third quarters of 2014 and 2013, respectively, and $4,561 and $5,294 in the nine month period ended September 30, 2014 and 2013, respectively.

 

 

3. Supplemental Disclosure of Cash Flow Information

 

 

4. Marketable Securities

Available-for-sale marketable securities at September 30, 2014:

 

The following table summarizes the estimated fair value of available-for-sale marketable securities by contractual maturity at September 30, 2014:

 

Available-for-sale marketable securities at December 31, 2013:

 

The following table summarizes the estimated fair value of available-for-sale marketable securities by contractual maturity at December 31, 2013:

 

 

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5. Fair Value Measurements

Our assets and liabilities subject to fair value measurements on a recurring basis and the required disclosures:

 

 

 

 

The carrying values of financial instruments, including accounts receivable, unbilled receivables, and accounts payable approximate their fair values due to their short-term maturities.

We hold marketable securities that are investment grade and are classified as available-for-sale. The securities include corporate bonds, agency bonds, and mortgage and asset-backed securities that are carried at fair market value based on quoted market prices.

We hold trading securities as part of a rabbi trust to fund 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 in each participant’s account.

The interest rate swap was valued based on forward curves observable in the market, using Level 2 inputs; see Note 11. The effectiveness of the interest rate swap is computed by comparing the present value of the cumulative change in the expected future cash flows of the variable leg of the swap and the present value of the cumulative change in the expected future variable interest payments designated in the hedging relationship.

 

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The contractual acquisition earn-outs were part of the consideration paid for acquisitions. The fair value of the earn-outs was based on probability-weighted payouts under different scenarios, discounted using a discount rate commensurate with the risk. The following table provides a summary of the changes in the our contractual acquisition earn-outs measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the nine months ended September 30, 2014:  

 

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 using significant unobservable inputs and are classified as Level 3.

Long-term debt, excluding leases, consists of borrowings under Senior Credit Facilities, and 4.5% and 7.75% convertible senior notes; see Note 11. The long-term debt, excluding leases, is reported at the borrowed amounts outstanding. At September 30, 2014, the estimated fair value of long-term debt, excluding leases, was approximately $124,000 versus a carrying value of $125,390. At September 30, 2013, the estimated fair value of long-term debt, excluding leases, was approximately $129,000 versus a carrying value of $140,829. The estimated fair value is based on a market approach using quoted market prices or current market rates for similar debt with approximately the same remaining maturities, where possible, and are classified as Level 2.

There were no transfers in or out of Level 1, 2, or 3 (as defined in Note 1) during the nine months ended September 30, 2014.

 

 

6. Segment Information

We report operating results in two business segments:

Commercial Segment: We are one of two leading companies that enable 9-1-1 call delivery via cellular, VoIP, and next generation technology. Other TCS hosted and managed services include cellular network and device platforms and applications for text messaging and location-based services. We are also engaged in patent monetization activity which is included in this segment. Commercial Segment customers include wireless network operators, VoIP service providers, wireless device manufacturers, automotive industry suppliers, and state and local governments.

Government Segment: We provide professional services including cyber security training to U.S. Defense personnel and field support of wireless ground terminals. We own and operate secure satellite teleport facilities, resell access to satellite airtime (known as space segment), and design, furnish, and operate wireless communication systems and components, which integrate high-speed, satellite, and Internet Protocol technology with secure, federal government-approved cryptologic devices. Customers are primarily US federal agencies.

Management evaluates segment performance based on gross profit, and all revenues reported below are from external customers. We do not maintain information regarding segment assets. Accordingly, asset information by reportable segment is not presented.

 

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The following tables set forth the results of our reportable segments and a reconciliation of segment gross profit to net loss:

 

 

 

 

 

 

 

 

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7. Inventory

Inventory consisted of the following:

 

 

 

8. Acquired Intangible Assets, Capitalized Software Development Costs, and Goodwill

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

 

 

Estimated future amortization expense:

 

 

Software development costs:

For the three and nine months ended September 30, 2014, we capitalized $65 and $1,066, respectively, of software development costs after the point of technological feasibility had been reached but before the software was available for general release. For the three and nine months ended September 30, 2013, we capitalized $319 and $1,988 respectively, of software development costs. These costs are being amortized over their estimated useful lives beginning when the products are available for general release. We routinely update our estimates of the recoverability of the capitalized software product costs. Management uses these estimates as the basis for evaluating the carrying values and remaining useful lives of the respective assets.

Goodwill:

The carrying amount of goodwill is as follows:

 

 

 

 

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9. Concentrations of Credit Risk and Major Customers

The financial instruments that potentially subject us to concentrations of credit risk are accounts receivable and unbilled receivables. Those customers that comprised 10% or more of our total revenue or receivables (billed and unbilled) are summarized in the following tables:

 

 

Percentage of receivables (billed and unbilled) as of September 30:

 

 

10. Line of Credit

We have maintained a line of credit arrangement with our principal bank since 2003. On June 25, 2013, we closed on a new senior secured credit facility, as amended on June 9, 2014 (the “Senior Credit Facility” or “Credit Agreement”), with the Silicon Valley Bank and a syndicate of lenders. The Credit Agreement includes a revolving loan facility (“Revolving Loan Facility”) for up to $30,000 and matures on March 31, 2018. The principal amount outstanding under the Revolving Loan Facility is payable prior to or on the maturity date. Interest on the Revolving Loan Facility accrues at Eurodollar/LIBOR (beginning at L+3.75%) or Alternate Base Rate (“ABR”) (beginning at ABR +2.75%), which may be adjusted as provided in the Credit Agreement, payable monthly.

The Revolving Loan Facility includes two sub-facilities: (i) a $10,000 letter of credit sub-facility pursuant to which the bank may issue letters of credit, and (ii) a $5,000 swingline sub-facility.

As of September 30, 2014 and December 31, 2013, there were no borrowings under our Revolving Loan Facility, and we had $30,000 of unused borrowing availability.

 

11. Long-Term Debt

Long-term debt consisted of the following:  

 

 

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Aggregate maturities of long-term debt at September 30, 2014 are as follows:

 

 

Senior credit facilities

Our senior credit facilities under a June 25, 2013 agreement, as amended on June 9, 2014 (the “Senior Credit Facilities” or “Credit Agreement”) include (i) a $56,500 term loan A facility (“Term Loan A Facility”), and (ii) a $43,500 delayed draw term loan facility (“Delayed Draw Term Loan Facility”). The Senior Credit Facilities also include a $25,000 incremental loan arrangement subject to the Company’s future needs and bank approval, although no assurances can be given that this incremental loan amount will be available to us when and if needed. On July 23, 2014, we borrowed $3,360 under our Delayed Draw Term Loan Facility and the proceeds were used towards the retirement of a portion of our 4.5% Convertible Senior Notes. On November 3, 2014, we used $11,202 of the Delayed Draw Term Loan Facility to retire the remaining 4.5% Convertible Senior Notes. Under the agreement, $18,938 of the remaining Delayed Draw Term Loan Facility may be available to us in the second quarter of 2015 subject to our meeting certain financial covenants. Any amount of the Delayed Draw Term Loan Facility not drawn on April 30, 2015 will expire unused. The Credit Agreement provides that the banks hold at least $35,000 of the Company’s cash and marketable securities until December 15, 2015.

Interest Rate Hedging Activities

In August 2014, we entered into an interest rate swap agreement with our principal bank. Its $32,094 initial notional amount represents about half of the outstanding balances of the floating rate Term Loan A Facility and the Delayed Term Loan Facility to reduce the variability of interest expense due to changes in interest rates. The interest rate swap results in us paying a fixed rate of 5.165% on the notional amount of the swap until its June 25, 2018 maturity. The notional amount of the swap will change over time to reflect approximately 50% of the outstanding expected Term Loan A Facility and Delayed Draw Term Loan Facility balances. Interest rate reset and interest rate payment dates mirror those of the underlying Term Loan A Facility and Delayed Draw Term Loan Facility. The swap is expected to exactly offset changes in expected cash flows due to fluctuations in the one month LIBOR rate over the term of the hedge. The interest rate swap fair value as of September 30, 2014 was a $127 liability. For the three months ended September 30, 2014, the hedge was highly effective and no gains or losses were recognized in earnings.

Promissory notes payable to microDATA sellers

In July, 2012, we issued $14,250 in 6% promissory notes as part of the consideration for our acquisition of microDATA. The remaining outstanding balance of $4,750 was paid in accordance with the note terms on June 30, 2014.

 

12. Capital Leases

We lease certain equipment under capital leases which are collateralized by the leased assets. Amortization of leased assets is included in depreciation and amortization expense.

Future minimum payments under capital lease obligations consisted of the following at September 30, 2014:

 

 

 

 

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13. Income Taxes

We reported income tax expense of $2,607 and $2,200 for the three and nine months ended September 30, 2014, respectively,  compared to $1,194 and $4,642 of income tax benefits for the three and nine months ended September 30, 2013, respectively, (before our fourth quarter 2013 recording of a valuation allowance against all deferred tax assets.) As of September 30, 2014, we continued to provide a valuation allowance for all federal and some state deferred tax assets. The Company continually evaluates facts representing both positive and negative evidence in the determination of its ability to realize the deferred tax assets reported in footnotes to the annual financial statements. In the third quarter of 2014, we completed our reconciliation of the 2013 income tax return to the 2013 tax provision. As part of our reconciliation we identified an error in the calculation of our prior year valuation allowance of $1,300 while such error was deemed immaterial to our prior year financials, we corrected the effect of that error and updated our estimate of the effect of recoverability of net operating loss carryforward benefits associated with book/tax differences in goodwill accounting, resulting in the recording of a noncash accrual in the quarter of a net deferred tax liability.

We do not anticipate a significant change to the total amount of unrecognized tax benefits within the next twelve months.

 

14. Commitments and Contingencies

Some customers seek indemnification under their contractual arrangements with the Company for claims and other costs associated with defending lawsuits alleging infringement of patents through their use of our products and services, and the use of our products and services in combination with products and services of other vendors. In some cases we have agreed to assume the defense of the case. In others, the Company will negotiate with these customers in good faith because the Company believes its technology does not infringe the cited patents and due to specific clauses within the customer contractual arrangements that may or may not give rise to an indemnification obligation. The Company cannot predict the outcome of such matters and the resolutions could have a material effect on our consolidated results of operations, financial position, or cash flows. Due to the inherent difficulty of predicting the outcome of litigation and other legal proceedings and uncertainties regarding the Company’s existing litigation and other legal proceedings, the Company is unable to estimate the amount or range of reasonably possible loss in excess of amounts accrued. The Company’s assessments are based on estimates and assumptions that have been deemed reasonable by management, but that may prove to be incomplete or inaccurate, and unanticipated events and circumstances may occur that might cause the Company to change those estimates and assumptions. Therefore, it is possible that an unfavorable resolution of one or more pending litigation or other contingencies could have a material adverse effect on the Company’s consolidated financial statements in a future fiscal period.

The application and interpretation of applicable state and local sales and other tax laws to certain of our service and system offerings in certain jurisdictions is uncertain. In accordance with generally accepted accounting principles, the Company makes a provision for a liability for taxes when it is both probable that the liability has been incurred and the amount of the liability or range of liability can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted if necessary. At September 30, 2014, the Company is subject to an ongoing state and local tax audit by the Washington State Department of Revenue. As this and other tax audits progress in the normal course of business, the Company will review and adjust a provision for loss as appropriate.

Other than the items discussed immediately above, we are not currently subject to any other material legal proceedings. However, we may from time to time become a party to various legal proceedings arising in the ordinary course of our business.

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of the financial condition and results of operations should be read in conjunction with the consolidated financial statements, related notes, and other detailed information included elsewhere in this Quarterly Report on Form 10-Q for the quarter ended September 30, 2014 (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 our Senior credit facility, notes, notes hedge transactions and interest rate hedging activity; (c) that we believe we have sufficient capital resources to fund our operations for the next twelve months; (d) relating to our backlog; (e) that we believe that capitalized software development costs will be recoverable from future gross profits; (f) regarding our expectations with regard to income tax assumptions and future stock-based compensation expenses; (g) regarding our assumptions related to goodwill; (h) that a significant underperformance relative to historical or projected future operating results, significant change in the manner of our use of acquired assets, and significant negative industry or economic trends could cause us to conclude that impairment indicators exist and that our acquired intangible assets might be impaired; (i) relating to our research and development spending; (j) our belief that the declines in 2014 to date mainly reflect the timing of the funding of

 

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government programs for which our company is a service and system provider; and (k) our expectations that we have sufficient funds to complete the wind-down of the acquired location-based application business.

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 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 generally accepted accounting principles 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. Management evaluates its estimates and judgments on an ongoing basis. 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:

This discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included in our 2013 Form 10-K.

 

Overview

TeleCommunication Systems, Inc. develops and delivers highly reliable and secure wireless communication technology, the development of which has led to ownership of 373 patents and about 300 patent applications as of September 30, 2014. We deliver cellular network computing services that include public safety solutions for 9-1-1 call delivery, precision location platforms, and applications that include navigation, locator applications and text messaging, as well as secure wireless communications systems and professional services, including cybersecurity training and technology for defense and other government customers. Customers use

 

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our “mobile cloud” software functionality through connections to and from network operations centers, paying us monthly fees based on the number of subscribers, cell sites, call center circuits, or other metrics. We do business with the U.S. federal government as a prime contractor under major technology contract vehicles, as well as state, local and foreign government entities. We also monetize our intellectual property portfolio via patent sales and licensing of the technology as well as incorporation of our inventions in our deliverables.

We report operating results in two business segments:

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. It should be read together with Item 1A Risk Factors and Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in our 2013 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:

 

 

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Results of Operations

 

Revenue and Cost of Revenue by Segment

Commercial Segment  

 

NM = Not Meaningful

 

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

Our commercial services revenue is generated from hosting and maintaining software and networks for 9-1-1 service for wireless and VoIP service providers and operators of next generation 9-1-1 (“NG9-1-1”) infrastructure (mainly state and local governments), as well as hosting and maintaining applications and infrastructure software for Location-Based Services (“LBS”) and text messaging platform software. This revenue primarily consists of monthly recurring service fees recognized in the month earned. Hosted LBS service and E9-1-1 fees are generally priced based on units served during the period, such as the number of customer cell sites, the number of connections to Public Safety Answering Points (“PSAPs”), or the number of customer subscribers or sessions using our technology. Subscriber service revenue is generated by client software applications for wireless subscribers, generally on a per-subscriber per-month basis. We also earn services revenue through nonrecurring engineering (“NRE”) custom software development contracts. 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. Services also include custom software development, implementation, and related service projects under time and materials or fixed-fee contracts, which are reported using percentage-of-completion accounting.

Third quarter 2014 commercial services revenue was $5.3 million, or 14% higher than the third quarter of 2013 due mainly to a one-time $4.7 million payment by a navigation applications customer resulting from the resolution of a dispute and related adjustment for volume of past services provided. For the nine months ended September 30, 2014 commercial services revenue was $2.4 million, or 2% higher, compared to the nine months ended September 30, 2013 due to recognizing $4.7 million from a favorable adjustment to application subscriber-based revenue, an 8% increase in platform services revenue, offset by lower other application services and non-recurring project work revenue in 2014.

The direct cost of our commercial services revenue consists primarily of compensation and benefits, licensed location-based application content, network access, data feed and circuit costs for network operation centers and co-location facilities, and equipment and software maintenance. For the three and nine months ended September 30, 2013, the direct cost of services also included amortization of acquired and capitalized software development costs of $0.6 million and $1.8 million, respectively. There was no amortization of software development costs for the three and nine months ended September 30, 2014 as a result of the write-down of amortizable intangible assets in the fourth quarter of 2013.

Third quarter 2014 direct cost of services revenue was 6% or $0.9 million higher than in third quarter 2013 due to $0.9 million of costs associated with the dispute settlement reflected in the quarter’s revenue. In the nine months ended September 30, 2014 direct cost of services revenue was $2.1 million, or 4%, lower than during the same period in 2013, reflecting lower labor and direct costs related to custom development efforts and cost control, offset by the additional $0.9 million of costs related to the non-recurring navigation application subscriber revenue.

 

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Commercial services gross profit for the three and nine months ended September 30, 2014 increased by $4.4 million and $4.5 million, respectively, compared to the corresponding 2013 periods due to the factors referenced above.

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

Commercial systems revenue results from our sales to wireless carriers and state and local governments incorporating our licensed software for enablement of 9-1-1 call routing and computer-aided responder dispatch, including next generation NG9-1-1 technology and location-based wireless services and text messaging. It also includes revenue from the sale of patents and licensing of our intellectual property including payments for past patent infringement liabilities, upfront and non-refundable license fees, and royalty fees. In all cases, revenue from the licensing of our intellectual property is recognized when all four of the revenue recognition criteria are met. Revenue from our larger NG9-1-1 deployments incorporating our software and third party components is recognized as long term contracts using percentage of completion accounting. License prices for our carrier software are generally a function of its volume of usage in our customers’ networks during the relevant period.

Third quarter 2014 commercial systems revenue was $2.4 million, or 37% less than the third quarter 2013 as a result of $2.1 million lower platforms revenue and $1.3 million lower intellectual property monetization revenue, offset by a $0.9 million increase in NG9-1-1 systems deployment revenue. During the nine months ended September 30, 2014 commercial systems revenue was 23% or $3.5 million higher than the same period in 2013 from increases in NG9-1-1 technology offset by lower intellectual property monetization revenue and a slight decrease in location-based systems revenue.

The direct cost of commercial systems revenue consists primarily of compensation and benefits, third-party hardware and software purchased for integration and resale, travel expenses, consulting fees, as well as the amortization of acquired and capitalized software development.

Direct cost of systems revenue was $2.4 million, or 44%, and $3.8 million, or 29%, lower respectively, in the three and nine months ended September 30, 2014 from the same 2013 periods, as software development cost amortization in 2014 was about $1 million and $2.7 million lower than in 2013 as a result of the write-down of intangible assets in the fourth quarter of 2013, and reflecting lower labor and direct costs related to custom development efforts and cost control.

Third quarter 2014 commercial systems gross profit was flat compared to the third quarter of 2013, and up $7.3 million in the nine months ended September 30, 2014 over the comparable period in 2013, reflecting higher revenue from deployment of NG9-1-1 and platform systems, cost control, and less amortization of software development costs. As a percentage of revenue, gross profit was higher in 2014 due to the impact of non-variable costs on the larger revenue base partially offset by the decrease in intellectual property monetization revenue for the third quarter of 2014 versus 2013.

Government Segment

 

The primary Government Segment customers are U.S. government agencies including the Departments of Defense and Homeland Security, domestic and foreign space programs, and the contractors that supply products and services to these government customers. TCS is a prime contractor on several multi-year, multi-billion dollar contracts, some of which are indefinite delivery, indefinite quantity, or IDIQ, contracts, through which this segment generates much of its revenue.

 

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

Government services revenue is generated from professional communications engineering and field support, cyber security training, program management, help desk outsource, and network design, deployment and management for government agencies, and 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.

Third quarter 2014 government services revenue was $10.0 million, or 29% lower than the third quarter 2013 as a result of about 50% lower professional services revenue resulting from the draw-down of Afghanistan field support personnel, partly offset by a 14% increase in cyber security services. In the nine months ended September 30, 2014, government services revenue was $22.9 million, or 22% lower than the nine months ending September 30, 2013 due to about 40% less field support and maintenance and in-building wireless service business, offset by 10% higher cyber security training revenue and 35% higher global satellite and ground station support services revenue.

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 were lower in the three and nine months ended September 30, 2014 compared to the same periods in 2013 which is correlated with the decline in volume of revenue.

Our gross profit from government services was $6.2 million, or 56% and $11.2 million, or 37% lower in the three and nine month periods ended September 30, 2014, respectively, versus 2013 due mainly to lower volume and margins in field support work.

Government Systems Revenue, Cost of Revenue, and Gross Profit:

We generate government systems revenue from the sale of secure wireless communication systems, and the integration of these systems into customer networks. Our government systems revenue also includes electronic components sold mainly to domestic and foreign space programs.

Government systems revenue increased $6.4 million, or 37%, in the three months ended September 30, 2014 as compared to the same periods in 2013 due to 45% higher deployable communication system sales systems and 8% higher revenue from electronic components. Government systems revenue was about the same for the nine months ended September 30, 2014 compared to the same periods in 2013.

The cost of our government systems revenue consists of purchased components, compensation and benefits, the costs of third-party contractors, facilities cost, and travel. These costs have varied over the periods as a direct result of changes in volume. Most equipment and third-party costs are variable for our different products, so that margins fluctuate between periods based on pricing and product mix.

Our government systems gross profit increased $2.0 million, or 87% in the 2014 third quarter, and $1.1 million, or 12% in the nine months ended September 30, 2014, compared to the same periods in 2013 due mainly to the higher components volume and adjusted pricing. Government systems gross profit as a percentage of revenue was 18% and 20% for the three and nine months ended September 30, 2014, and was 13% and 18% for the three and nine months ended September 30, 2013, respectively.

Revenue Backlog

We had unfilled orders, or funded contract and total backlog at September 30, as follows:

 

Funded contract backlog represents contracts for which fiscal year funding has been appropriated by our customers (mainly federal agencies) and for hosted services (mainly for wireless carriers). Backlog is computed by multiplying the most recent month’s contract or subscription revenue by the months remaining under the existing long-term agreements, which is considered to be the best available information for anticipating revenue under those agreements.

 

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Our 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. The timing and amounts of government contract funding may be adversely affected by federal budget policy decisions, like handling of sequestration and continuing resolutions, and can lead to delays in procurement of our products and services due to lack of funding. 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:

 

Our research and development (“R&D”) expense consists of compensation, benefits, and a proportionate share of facilities and corporate overhead, as well as costs associated with using third-party laboratory and testing resources. We expense such costs as they are incurred until technological feasibility has been reached and we believe that capitalized costs will be recoverable, upon which we capitalize and amortize them over the product’s expected life. Technological feasibility is established for our software when a detailed program design is completed. We incur R&D costs to enhance existing software products as well as to create new products, including software hosted in network operation centers.

We develop software used mainly by network operators and device manufacturers. In 2013 and 2014 to date, our R&D efforts have been focused on 9-1-1 software and updates to location-based products, including our toolkits and application program interfaces for markets beyond network operators. We also invested in updating and expanding our secure wireless communication technology products for government customers and applications for network operators, telematics supply chain, and network security. We continue to obtain patents for some of our developers’ innovations.

 

R&D expense was $2.6 million and $6.4 million higher for the three and nine months ended September 30, 2014, respectively, than for the same periods in 2013, reflecting more expenditures on R&D projects related to 9-1-1, ground terminal products and components, and commercial software. The total of capitalized and expensed R&D spending for the nine months ended September 30, 2014 was about the same as the comparable 2013 periods. In addition to company deliverables, our R&D expenditures and acquisitions have yielded a portfolio of 373 patents as of September 30, 2014, and about 300 patent applications pending. We are executing a program of monetizing this portfolio through patent and license sales and other arrangements with partners and licensees.

Sales and marketing expense:

 

Our sales and marketing expenses include fixed and variable compensation and benefits, trade show expenses, travel costs, advertising and public relations costs, as well as a proportionate share of facility-related costs which are expensed as incurred. Our marketing efforts also include speaking engagements and industry conferences. We sell our solutions through our direct sales force and we leverage relationships with original equipment manufacturers and large network operators as channels for our technology. We sell our products and services to agencies and departments of the U.S. government primarily through direct sales professionals, and to foreign customers through agency and subcontractor arrangements.

Sales and marketing expenses were flat for the three months ended September 30, 2014 compared to the same period in 2013.  Sales and marketing expenses were $2.7 million lower for the nine months ended September 30, 2014 compared to the same periods in 2013, respectively.  The reductions in spending for the nine months ended September 30, 2014, reflect decreases in personnel and travel expenses starting in the third quarter of 2013.

 

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General and administrative expense:

 

General and administrative (“G&A”) expense primarily represents management, finance, legal (including intellectual property management), human resources, and internal information system functions. These costs include compensation, benefits, professional fees, travel, and a proportionate share of rent, utilities, and other facilities costs which are expensed as incurred.

G&A expense was $2.7 million and $6.6 million lower in the three and nine months ended September 30, 2014 compared to the same periods in 2013 reflecting efficiency improvements including personnel cost reductions associated with second half of 2013 actions.

Depreciation and amortization of property and equipment:

 

Depreciation and amortization of property and equipment represents the period costs associated with our investment in information technology and telecommunications equipment, software, furniture and fixtures, and leasehold improvements, as well as amortization of capitalized software developed for internal use, including hosted applications. We compute depreciation and amortization using the straight-line method over the estimated useful lives of the assets, generally five years for furniture, fixtures, and leasehold improvements, and three to seven years for other types of assets including, computers, software, and telephone equipment.

Depreciation expense decreased year-over-year due to the effect of our 2013 impairment charges on the remaining depreciable base, partly offset by the depreciation on additions to property and equipment since the first quarter of 2014.

Amortization of acquired intangible assets:

 

Acquired intangible assets are amortized over their estimated useful lives of four to nineteen years. Amortization of acquired intangible assets was lower in the three and nine months ended September 30, 2014 compared to the same periods in 2013 because the lower accounting basis following a fourth quarter 2013 write-down.

Interest expense:

 

Interest expense is incurred under bank and other notes payable, convertible note financing, and capital lease obligations. Financing expense amortization results from deferral of costs incurred at the time of contracting for financing facilities, which are then amortized over the terms of the facilities.

 

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Interest and financing expenses were lower in the three and nine months ended September 30, 2014 compared to the same periods in 2013 due mainly to lower amortization of deferred financing fees reflecting the write-off of deferred 2012 bank term loan-related expenses and prorated write-off of deferred 4.5% convertible note financing fees as those notes have been retired. Interest on our convertible note financings decreased slightly in the three and nine months ended September 30, 2014 compared to the same periods in 2013 due to lower outstanding borrowings during the periods, partly offset by the effect of a higher average rate. For the nine months ended September 30, 2014 interest on our bank and other notes payable was $0.3 million higher than for the same period in 2013 due to a higher average borrowing balance on our Senior Credit Facility, offset by lower interest on seller notes as payments were made. Further financing details are in the Liquidity and Capital Resources section below.

Other income (expenses), net:

Other income (expenses), net, includes interest income earned and realized gains on investment accounts and foreign currency transaction gain or loss, which is dependent on fluctuation in exchange rates. Other income (expenses), net also includes the effects of foreign currency revaluation on our cash, receivables, and deferred revenues that are stated in currencies other than U.S dollars, and adjustments to any estimated payments under earn-out arrangements that were part of the consideration for our acquisitions.

Income taxes:

As of September 30, 2014, the Company continued to provide a valuation allowance for all federal and some state deferred tax assets as management’s evaluation that the Company’s ability to realize such deferred tax assets did not meet the “more likely than not” criteria. The Company continually evaluates facts representing both positive and negative evidence in the determination of its ability to realize the deferred tax assets reported in footnotes to the annual financial statements. For the nine months ended September 30, 2014, we have recorded tax expense of $2.2 million, substantially all of which is noncash accrual of deferred liability. In the third quarter of 2014, we completed our reconciliation of the 2013 income tax return to the 2013 tax provision. As part of our reconciliation we identified an error in the calculation of our prior year valuation allowance of $1.3 million while such error was deemed immaterial to our prior year financials, we corrected the effect of that error and updated our estimate of the effect of recoverability of net operating loss carryforward benefits associated with book/tax differences in goodwill accounting, resulting in the recording of a noncash accrual in the quarter of a net deferred tax liability.

Net loss:

 

Net loss was $1.8 million higher in the three months ended September 30, 2014, compared to the same period in 2013, mainly due to personnel cost reductions in the second half of 2013, and a decrease in interest expense due to the debt 2013 refinancing and by  the increase in income tax expense. Net loss was $1.5 million lower in the nine months ended September 30, 2014, compared to the same period in 2013 mainly due to personnel cost reductions in the second half of 2013, efficiency improvements, less interest expense due to the 2013 debt refinancing offset by an increase income tax provision, and other factors discussed above.     

 

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Liquidity and Capital Resources

 

Capital resources: We have funded our operations, acquisitions, and capital expenditures primarily using cash generated by our operations, debt and capital leases, and issuance of public equity.

Sources and uses of cash: At September 30, 2014, our cash and marketable securities balance was $56.1 million, down from $60.4 million at September 30, 2013 and down from $63.5 million at the beginning of the quarter. At September 30, 2014, our liquidity also included $30 million of unused borrowing availability under our Revolving Loan Facility and $11.2 million of undrawn bank Delayed Draw Term Loan Facility under our Senior Credit Facilities for retirement of remaining convertible notes due November 1, 2014. Additionally up to $18.9 million Delayed Draw Term Loan Facility may be available in the second quarter of 2015 for general corporate purposes if certain covenant requirements are met. Income recognized during the nine months ended September 30, 2014 is not subject to current income taxes due to the use of loss carryforwards generated in prior years. Debt, net of cash and securities, was $79.2 million at September 30, 2014 down from $91.5 million at September 30, 2013.

Operations: Cash used in operating activities was $1.6 million for the nine months ended September 30, 2014 compared to cash provided by $38.6 million for the nine months ended September 30, 2013. Changes in working capital were due to the timing of billings, collections, and vendor payments.

Investing activities: In the nine months ended September 30, 2014, we invested an additional $11.5 million in investment grade marketable securities classified as available-for-sale. In the nine months ended September 30, 2014, in connection with acquiring a small location-based application business serving customers in Europe and the Middle East under a plan to wind-down its separate operations, the seller provided $15 million of funding, which we expect to be sufficient to complete the wind-down over a period of two years or less. For the nine months ended September 30, 2014 and 2013 fixed asset additions were $5.3 million and $12.5 million, respectively, and investments in development of software for resale which had reached the stage of development calling for capitalization were $1 million and $1.9 million, respectively.

Financing activities: In the nine months ended September 30, 2014, we made $17.4 million in scheduled payments on bank and capital lease borrowings including our final promissory note installment of $4.8 million to the sellers of microDATA, and made our final $0.3 million microDATA earn-out payment. During the three month period ended September 30, 2014, we repurchased $3.4 million of our 4.5% Convertible Senior Notes which was financed using our Delayed Draw Term Loan Facility. We funded $1.9

 

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million and $3.5 million, respectively, of fixed asset additions under capital leases during the nine months ended September 30, 2014 and 2013.

Senior debt: The Company has borrowing capacity under our $130 million Senior Credit Facilities (the “Senior Credit Facilities” or “Credit Agreement”) in accordance with a June 25, 2013 agreement, as amended June 9, 2014. The Senior Credit Facilities include (i) a $56.5 million term loan A facility (“Term Loan A Facility”), (ii) a $43.5 million delayed draw term loan facility (“Delayed Draw Term Loan Facility”), and (iii) a $30 million revolving loan facility (“Revolving Loan Facility”).The Senior Credit Facilities also include a $25 million incremental loan arrangement subject to the Company’s future needs and bank approval, although no assurance can be given that this incremental loan amount will be available to us when and if needed. November 3, 2014, we used $11.2 million of the Delayed Draw Term Loan Facility to retire the remaining 4.5% Convertible Senior Notes. Under the agreement, $18.9 million of the remaining Delayed Draw Term Loan Facility will be available to us in the second quarter of 2015 subject to the Company meeting certain financial covenants. Any amount of the Delayed Draw Term Loan Facility not drawn on April 30, 2015 will expire unused. The banks will hold at least $35 million of the Company’s cash and marketable securities until December 15, 2015. No changes were made to the pricing of any of the loans or the amount we may borrow under the $30 million Revolving Loan Facility.

On June 25, 2013, we borrowed $56.5 million under the Term Loan A Facility and used proceeds for (i) repayment of the remaining balance under our 2012 Term Loan, (ii) approximately $16 million for working capital and general corporate purposes, and (iii) fees and expenses associated with the new facility. On September 30, 2013, we borrowed an additional $10 million under the Delayed Draw Term Loan Facility which was used toward the purchase of 4.5% convertible notes. Additional liquidity is available through the undrawn $30 million Revolving Loan Facility for working capital and other general corporate purposes, replacing the revolving line under the 2009 Loan and Security Agreement which has been paid off.

Borrowings under the Term Loan A Facility, the Revolving Loan Facility or the Delayed Draw Term Loan Facility may be at rates based on the Eurodollar/LIBOR (beginning at L +3.75%) or ABR (beginning at ABR + 2.75%), which may be adjusted as provided in the Credit Agreement. The Term Loan A Facility, the Delayed Draw Term Loan Facility, and the Revolving Loan Facility have a maturity date of March 31, 2018, unless extended as provided in the Credit Agreement. Beginning October 1, 2013, the Term Loan A Facility and the Delayed Term Loan Facility are to be paid in consecutive quarterly installments of $0.4 million on the first day of each fiscal quarter, increasing to $0.8 million in the quarter ending December 31, 2014, to $1.2 million in the quarter ending December 31, 2016, and to $1.6 million in the quarter ending December 31, 2017, with the remaining principal due at maturity. Additional Delayed Draw Term Loan Facility borrowings would be repaid on the same dates and in the same proportions as the Term Loan A Facility and the existing Delayed Draw Term Loan Facility borrowings, with the remaining principal due at maturity. The Senior Credit Facilities are also subject to possible mandatory repayments from excess cash flow and other sources, such as net cash proceeds of debt or equity issuances, asset sales, casualty insurance claims, and other recovery events as described in the Credit Agreement. A repayment of $3.9 million from excess cash flow and other sources was paid on April 1, 2014. During the continuance of an event of default, at the request of the required lenders, all outstanding loans shall bear interest at a rate per annum equal to the rate that would otherwise be applicable thereto plus 2%, and shall be payable from time to time on demand.

The Senior Credit Facilities are secured by substantially all of the Company’s tangible and intangible assets, including intellectual property. The Credit Agreement contains customary representations and warranties of the Company and customary covenants and events of default. Availability under the Revolving Loan Facility and the Delayed Draw Term Loan Facility is subject to certain conditions, including the continued accuracy of the Company’s representations and warranties and compliance with covenants.

Interest Rate Hedging Activities: In August 2014, we entered into an interest rate swap agreement with a $32.1 million initial notional amount representing approximately 50% of the outstanding balances of the Term Loan A Facility and the Delayed Term Loan Facility to reduce the variability of cash interest payments due to changes in the interest rates. The interest rate swap results in us paying a fixed rate of 5.165% on the notional amount of the swap until its June 25, 2018 maturity. The notional amount of the swap changes over its term to reflect approximately 50% of the outstanding expected Term Loan A Facility and Delayed Draw Term Loan Facility balances. Interest rate reset and interest rate payment dates mirror those of the underlying Term Loan A and Delayed Draw Term Loans. The swap is expected to exactly offset changes in expected cash flows due to fluctuations in the one month LIBOR rate over the term of the hedge for the portion of our debt equal to the notional amount. The interest rate swap fair value as of September 30, 2014 was a $0.1 liability. For the three months ended September 30, 2014, the hedge was highly effective and no gains or losses were recognized in earnings.

7.75% Convertible Notes: On May 8, 2013, we completed privately negotiated exchange agreements with noteholders and retired $50 million of our outstanding 4.5% Convertible Senior Notes due 2014 issued in 2009 (“2014 Notes”) in exchange for $50 million of new 7.75% Convertible Senior Notes due 2018 (“2018 Notes”). The 2018 Notes were issued pursuant to an indenture, dated as of May 8, 2013 (the “Indenture”), between the Company and The Bank of New York Mellon Trust Company, N.A., as trustee (the “Trustee”). We offered the 2018 Notes to certain holders of the 2014 Notes in reliance on the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended. The 2018 Notes bear interest at a rate of 7.75% per year, payable semiannually in arrears in cash on June 30 and December 30 of each year, beginning on December 30, 2013. Holders may convert the 2018 Notes at

 

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their option prior to June 30, 2018. The 2018 Notes have the same conversion rate as the 2014 Notes, which are 96.637 shares of Class A common stock per one thousand dollars principal amount of 2018 Notes, equivalent to a conversion price of $10.348 per share of Class A common stock. Shares of the Company’s Class A common stock into which the 2018 Notes are convertible have been reserved for issuance by the Company. We may redeem some or all of the 2018 Notes at any time on or after June 30, 2014, at the redemption prices set forth in the Indenture plus accrued and unpaid interest to the redemption date. In addition, subject to certain exceptions, holders may require us to repurchase, for cash, all or part of their 2018 Notes upon a “fundamental change” (as defined in the Indenture) at a price equal to the purchase prices set forth in the Indenture, plus accrued and unpaid interest to, but excluding, the fundamental change purchase date. The Indenture contains customary terms and covenants, including that upon certain events of default occurring and continuing, either the Trustee or the holders of not less than 25% in aggregate principal amount of the 2018 Notes then outstanding may declare the entire principal amount of all the 2018 Notes plus accrued interest, if any, to be immediately due and payable.

4.5% Convertible Notes: In 2009, we sold $103.5 million of 4.5% Convertible Senior Notes due 2014. We have since retired $42.3 million, including $3.4 million retired in the third quarter of 2014, and exchanged $50 million of the notes so that the remaining balance outstanding is $11.2 million at September 30, 2014. On November 3, we used the additional funding available through our Delayed Term Loan Facility to retire the outstanding balance of the 2014 Notes. The 2014 Notes are not registered and were offered under Rule 144A of the Securities Act of 1933. Concurrent with the issuance of the 2014 Notes, we entered into convertible note hedge transactions and warrant transactions, also detailed below, that were intended to reduce the potential dilution associated with the conversion of the 2014 Notes. Holders may convert the 2014 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 is equivalent to a conversion price of approximately $10.35 per share of Class A common stock. The effect of the convertible note hedge and warrant transactions which will terminate upon retirement of the 2014 Notes, described below, is an increase in the effective conversion premium of the 2014 Notes to $12.74 per share.

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 2014 Notes and do not affect the holders’ rights under the 2014 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 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 permanent equity in Additional paid-in capital, and will not recognize subsequent changes in fair value as long as the instruments remain classified as equity. As a result of the repurchase and exchange of $88.9 million of the outstanding 2014 Notes, the convertible note hedge was adjusted to reflect the reduced amount of outstanding 2014 Notes. The convertible note hedge transactions’ originally covering 10 million shares was adjusted to cover proportionally fewer shares of Class A common stock. The warrants are not affected by the retirement of 2014 Notes.

Seller Notes: On July 6, 2012, we issued $14.3 million in 6% promissory notes as part of the consideration paid for the acquisition of microDATA which were fully paid off in accordance with their terms on June 30, 2014.

We believe that we have sufficient capital resources with cash generated from operations as well as cash on hand to meet our anticipated cash operating expenses, working capital, and capital expenditure and debt service needs for the next twelve months. In addition to using our Bank Credit Facility, we may also consider raising capital in the public markets as a means to meet our capital needs and to invest in our business. Although we may need to return to the capital markets, establish new credit facilities, or raise capital in private transactions in order to meet our capital requirements, we can offer no assurances that we will be able to access these potential sources of funds on terms acceptable to us or at all.

 

 

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Contractual Commitments

As of September 30, 2014, our most significant commitments are term debt, non-cancelable operating leases, purchase obligations, and obligations under capital leases. We lease certain furniture and computer equipment under capital leases. We lease office space and equipment under non-cancelable operating leases. Purchase obligations represent contracts for parts and services in connection with our government satellite services and systems offerings. Our commitments consisted of the following:

 

¹The cash payments due for Senior credit facility include estimated interest payments based on the LIBOR plus a fixed spread that were effective at the balance sheet date.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

There have not been any material changes to our interest rate or our foreign currency risk as described in Item 7A of our 2013 Annual Report on Form 10-K, except that the interest rate risk on about $32.1 million of our floating rate bank debt has now been hedged via the swap agreement described in Note 1.

 

Item 4. Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, and summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective at a reasonable assurance level as of September 30, 2014.

There have been no changes in the Company’s internal control over financial reporting during the latest fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. — OTHER INFORMATION

Item 1. Legal Proceedings

Some customers seek indemnification under their contractual arrangements with the Company for claims and other costs associated with defending lawsuits alleging infringement of patents through their use of our products and services, and the use of our products and services in combination with products and services of other vendors. In some cases we have agreed to assume the defense of the case. In others, the Company will negotiate with these customers in good faith because the Company believes its technology does not infringe the cited patents and due to specific clauses within the customer contractual arrangements that may or may not give rise to an indemnification obligation. The Company cannot predict the outcome of such matters and the resolutions could have a material effect on our consolidated results of operations, financial position, or cash flows. Due to the inherent difficulty of predicting the outcome of litigation and other legal proceedings and uncertainties regarding the Company’s existing litigation and other legal proceedings, the Company is unable to estimate the amount or range of reasonably possible loss in excess of amounts accrued. The Company’s assessments are based on estimates and assumptions that have been deemed reasonable by management, but

 

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that may prove to be incomplete or inaccurate, and unanticipated events and circumstances may occur that might cause the Company to change those estimates and assumptions. Therefore, it is possible that an unfavorable resolution of one or more pending litigation or other contingencies could have a material adverse effect on the Company’s consolidated financial statements in a future fiscal period.

The application and interpretation of applicable state and local sales and other tax laws to certain of our service and system offerings in certain jurisdictions is uncertain. In accordance with generally accepted accounting principles, the Company makes a provision for a liability for taxes when it is both probable that the liability has been incurred and the amount of the liability or range of liability can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted if necessary. At June 30, 2014, the Company is subject to an ongoing state and local tax audit by the Washington State Department of Revenue. As this and other tax audits progress in the normal course of business, the Company will review and adjust a provision for loss as appropriate.

Other than the items discussed immediately above, we are not currently subject to any other material legal proceedings. However, we may from time to time become a party to various legal proceedings arising in the ordinary course of our business.

Item 1A. Risk Factors

There have not been any material changes to the information previously disclosed in Item 1A. Risk Factors in our 2013 Annual Report on Form 10-K.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine and Safety Disclosures

None.

Item 5. Other Information

(a) None.

(b) None.

Item 6. Exhibits

 

 

 

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized on the 10th day of November 2014.

 

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated.

 

 

 

 

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