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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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|x | Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ---------------------------------------------------------------------------------------

For the quarterly period ended: March 31, 2006



| ̈ | Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ----------------------------------------------------------------------------------------

Commission file number: 1-8443



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TELOS CORPORATION

(Exact name of
registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Maryland                                                       |  | 52-0880974                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|19886 Ashburn Road, Ashburn, Virginia                          |  | 20147-2358                          
|(Address of principal executive offices)                       |  | (Zip Code)                          

(703) 724-3800

(Registrants telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)



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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 ̈No  x

Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer ̈Accelerated Filer ̈Non-Accelerated Filer  x

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

As of
June 5, 2006, the registrant had outstanding 21,171,202 shares of Class A Common Stock, no par value; and 4,037,628 shares of Class B Common Stock, no par value.



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TELOS CORPORATION AND SUBSIDIARIES

INDEX

PART I.
FINANCIAL INFORMATION



|                           |  |                                                                                                                |  |      
|-------------------------- |  | -------------------------------------------------------------------------------------------------------------- |  | -----
|                           |  |                                                                                                                |  | Page 
|Item 1.                    |  | Financial Statements:                                                                                          |  |      
|                           |  |                                                                                                               
|                           |  | Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2006 and 2005 (unaudited) |  | 3    
|                           |  | Condensed Consolidated Balance Sheets as of March 31, 2006 (unaudited) and December 31, 2005                   |  | 4-5  
|                           |  | Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2006 and 2005 (unaudited) |  | 6    
|                           |  | Notes to Condensed Consolidated Financial Statements (unaudited)                                               |  | 7-22 
|                           |  |                                                                                                               
|Item 2.                    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                          |  | 23-33
|                           |  |                                                                                                               
|Item 3.                    |  | Quantitative and Qualitative Disclosures about Market Risk                                                     |  | 34   
|                           |  |                                                                                                               
|Item 4.                    |  | Controls and Procedures                                                                                        |  | 34   
|                          
|PART II.
OTHER INFORMATION
|                           |  |                                                                                                               
|Item 1.                    |  | Legal Proceedings                                                                                              |  | 35   
|                           |  |                                                                                                               
|Item 1A.                   |  | Risk Factors                                                                                                   |  | 36   
|                           |  |                                                                                                               
|Item 3.                    |  | Defaults upon Senior Securities                                                                                |  | 41   
|                           |  |                                                                                                               
|Item 6.                    |  | Exhibits                                                                                                       |  | 42   
|                           | 
|SIGNATURE                  |  | 43                                                                                                            



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PART IFINANCIAL INFORMATION

TELOS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(amounts in thousands)



|                                             |  |                             |        |   |                 |   |        |  
|-------------------------------------------- |  | --------------------------- | ------ | - | --------------- | - | ------ | -
|                                             |  | Three Months EndedMarch 31, |       
|                                             |  | 2006                        |        |   | 2005 (Restated) |  
|Revenue                                      |  |                             |        |   |                 |   |        |  
|Products                                     |  | $                           | 10,335 |   |                 | $ | 22,004 |  
|Services                                     |  |                             | 14,839 |   |                 |   | 13,008 |  
|                                             |  |                             |        |   |                 |   |        |  
|                                             |  |                             | 25,174 |   |                 |   | 35,012 |  
|                                             |  |                             |        |   |                 |   |        |  
|Costs and expenses                           |  |                             |        |   |                 |   |        |  
|Cost of sales - Products                     |  |                             | 9,302  |   |                 |   | 17,611 |  
|Cost of sales - Services                     |  |                             | 11,377 |   |                 |   | 9,894  |  
|Selling, general and administrative expenses |  |                             | 10,413 |   |                 |   | 7,030  |  
|                                             |  |                             |        |   |                 |   |        |  
|                                             |  |                             | 31,092 |   |                 |   | 34,535 |  
|                                             |  |                             |        |   |                 |   |        |  
|Operating (loss) income                      |  |                             | (5,918 | ) |                 |   | 477    |  
|Other income (expenses)                      |  |                             |        |   |                 |   |        |  
|Other income                                 |  |                             | 11     |   |                 |   | 33     |  
|Losses from affiliate                        |  |                             | (92    | ) |                 |   |       |  
|Interest expense                             |  |                             | (2,120 | ) |                 |   | (2,139 | )
|                                             |  |                             |        |   |                 |   |        |  
|Loss before income taxes                     |  |                             | (8,119 | ) |                 |   | (1,629 | )
|Provision for income taxes                   |  |                             |       |   |                 |   |       |  
|                                             |  |                             |        |   |                 |   |        |  
|Loss from continuing operations              |  |                             | (8,119 | ) |                 |   | (1,629 | )
|Discontinued operations:                     |  |                             |        |   |                 |   |        |  
|Gain on sale of TCC, net of tax              |  |                             |       |   |                 |   | 1,000  |  
|                                             |  |                             |        |   |                 |   |        |  
|Net loss                                     |  | $                           | (8,119 | ) |                 | $ | (629   | )
|                                             |  |                             |        |   |                 |   |        |  

The accompanying notes are an integral part of these condensed consolidated financial statements.



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TELOS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(amounts in thousands)



|                                                                                                    |  |                          |        |                  |   |       
|--------------------------------------------------------------------------------------------------- |  | ------------------------ | ------ | ---------------- | - | ------
|                                                                                                    |  | March 31,2006(Unaudited) |        | December 31,2005
|ASSETS                                                                                              |  |                          |        |                  |   |       
|Current assets                                                                                      |  |                          |        |                  |   |       
|Cash and cash equivalents (includes restricted cash of $54 at March 31, 2006 and December 31, 2005) |  | $                        | 64     |                  | $ | 62    
|Accounts receivable, net of reserve of $615 and $493, respectively                                  |  |                          | 17,913 |                  |   | 24,913
|Inventories, net of obsolescence reserve of $118 and $121, respectively                             |  |                          | 4,496  |                  |   | 4,318 
|Other current assets                                                                                |  |                          | 2,464  |                  |   | 1,804 
|                                                                                                    |  |                          |        |                  |   |       
|Total current assets                                                                                |  |                          | 24,937 |                  |   | 31,097
|                                                                                                    |  |                         
|Property and equipment, net of accumulated depreciation of $14,617 and $14,310, respectively        |  |                          | 9,342  |                  |   | 9,321 
|Other assets                                                                                        |  |                          | 1,276  |                  |   | 1,444 
|                                                                                                    |  |                          |        |                  |   |       
|Total assets                                                                                        |  | $                        | 35,555 |                  | $ | 41,862
|                                                                                                    |  |                          |        |                  |   |       

The accompanying notes are an integral part of these condensed consolidated financial statements.



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TELOS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(amounts in thousands)



|                                                                  |  |                          |          |   |                  |   |         |  
|----------------------------------------------------------------- |  | ------------------------ | -------- | - | ---------------- | - | ------- | -
|                                                                  |  | March 31,2006(Unaudited) |          |   | December 31,2005 |  
|LIABILITIES, REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS DEFICIT |  |                          |          |   |                  |   |         |  
|Current liabilities                                               |  |                          |          |   |                  |   |         |  
|Accounts payable                                                  |  | $                        | 23,560   |   |                  | $ | 19,053  |  
|Accrued compensation and benefits                                 |  |                          | 4,731    |   |                  |   | 4,457   |  
|Deferred revenue                                                  |  |                          | 5,237    |   |                  |   | 5,631   |  
|Capital lease obligations  short-term                            |  |                          | 554      |   |                  |   | 536     |  
|Other current liabilities                                         |  |                          | 3,960    |   |                  |   | 3,205   |  
|                                                                  |  |                          |          |   |                  |   |         |  
|Total current liabilities                                         |  |                          | 38,042   |   |                  |   | 32,882  |  
|                                                                  |  |                         
|Senior credit facility                                            |  |                          | 7,374    |   |                  |   | 12,159  |  
|Senior subordinated notes                                         |  |                          | 5,179    |   |                  |   | 5,179   |  
|Capital lease obligations                                         |  |                          | 9,169    |   |                  |   | 9,239   |  
|Senior redeemable preferred stock (Note 4)                        |  |                          | 8,704    |   |                  |   | 8,599   |  
|Public preferred stock (Note 4)                                   |  |                          | 72,307   |   |                  |   | 71,008  |  
|                                                                  |  |                          |          |   |                  |   |         |  
|Total                                                             |  |                          | 140,775  |   |                  |   | 139,066 |  
|                                                                  |  |                          |          |   |                  |   |         |  
|Stockholders deficit                                             |  |                          |          |   |                  |   |         |  
|Common stock                                                      |  |                          | 78       |   |                  |   | 78      |  
|Additional paid-in capital                                        |  |                          | 103      |   |                  |   |        |  
|Accumulated deficit                                               |  |                          | (105,401 | ) |                  |   | (97,282 | )
|                                                                  |  |                          |          |   |                  |   |         |  
|Total stockholders deficit                                       |  |                          | (105,220 | ) |                  |   | (97,204 | )
|                                                                  |  |                          |          |   |                  |   |         |  
|Total liabilities and stockholders deficit                       |  | $                        | 35,555   |   |                  | $ | 41,862  |  
|                                                                  |  |                          |          |   |                  |   |         |  

The accompanying notes are an integral part of these condensed consolidated financial statements.



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TELOS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(amounts in thousands)



|                                                                                                   |  |                              |        |   |      |   |        |  
|-------------------------------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                                   |  | Three Months Ended March 31, |       
|                                                                                                   |  | 2006                         |        |   | 2005 |  
|Operating activities:                                                                              |  |                              |        |   |      |   |        |  
|Loss from continuing operations                                                                    |  | $                            | (8,119 | ) |      | $ | (1,629 | )
|Adjustments to reconcile loss from continuing operations to cash provided by operating activities: |  |                              |        |   |      |   |        |  
|Dividends and accretion of preferred stock as interest expense                                     |  |                              | 1,404  |   |      |   | 1,510  |  
|Stock-based compensation                                                                           |  |                              | 103    |   |      |   |       |  
|Depreciation and amortization                                                                      |  |                              | 428    |   |      |   | 473    |  
|Other noncash items                                                                                |  |                              | 121    |   |      |   | (21    | )
|Changes in other operating assets and liabilities                                                  |  |                              | 9,098  |   |      |   | 5,737  |  
|                                                                                                   |  |                              |        |   |      |   |        |  
|Cash provided by continuing operating activities                                                   |  |                              | 3,035  |   |      |   | 6,070  |  
|                                                                                                   |  |                              |        |   |      |   |        |  
|Investing activities:                                                                              |  |                              |        |   |      |   |        |  
|Net proceeds from sale of TCC                                                                      |  |                              |       |   |      |   | 1,000  |  
|Purchase of property and equipment                                                                 |  |                              | (374   | ) |      |   | (427   | )
|                                                                                                   |  |                              |        |   |      |   |        |  
|Cash (used in) provided by investing activities                                                    |  |                              | (374   | ) |      |   | 573    |  
|                                                                                                   |  |                              |        |   |      |   |        |  
|Financing activities:                                                                              |  |                              |        |   |      |   |        |  
|Repayment of borrowings under senior credit facility, net                                          |  |                              | (4,785 | ) |      |   | (6,832 | )
|Increase in book overdrafts                                                                        |  |                              | 2,178  |   |      |   | 308    |  
|Payments under capital leases                                                                      |  |                              | (52    | ) |      |   | (123   | )
|                                                                                                   |  |                              |        |   |      |   |        |  
|Cash used in financing activities                                                                  |  |                              | (2,659 | ) |      |   | (6,647 | )
|                                                                                                   |  |                              |        |   |      |   |        |  
|Increase (decrease) in cash and cash equivalents                                                   |  |                              | 2      |   |      |   | (4     | )
|Cash and cash equivalents at beginning of period                                                   |  |                              | 62     |   |      |   | 67     |  
|                                                                                                   |  |                              |        |   |      |   |        |  
|Cash and cash equivalents at end of period                                                         |  | $                            | 64     |   |      | $ | 63     |  
|                                                                                                   |  |                              |        |   |      |   |        |  

The accompanying notes are an integral part of these condensed consolidated financial statements.



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TELOS CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. General

The accompanying consolidated financial statements include the accounts of Telos and its subsidiaries, including Ubiquity.com, Inc., a wholly owned
subsidiary, Xacta Corporation and Telos Delaware, Inc., all of whose issued and outstanding share capital is owned by the Company (collectively, the Company). The Company has applied the equity method of accounting for its investment in
Enterworks, Inc. (Enterworks). In December 2003, the Company purchased a 50% interest in Enterworks International, Inc. (EI) which, at the time of the transaction, was a wholly owned subsidiary of Enterworks. Given the
Companys indirect investment in Enterworks International, Inc. via Enterworks, and its direct 50% interest in Enterworks International, Inc. the Company is required to consolidate Enterworks International, As the Companys investment in
Enterworks International was immaterial to its financial position and, as this investment was acquired on December 24, 2003, its results of operations for 2003, Enterworks International was not consolidated for 2003. See Note 2 
Investment in Enterworks. Significant intercompany transactions have been eliminated.

In the opinion of the Company, the accompanying
consolidated financial statements reflect all adjustments (which include only normal recurring adjustments) and reclassifications necessary for their fair presentation in conformity with accounting principles generally accepted in the United States
of America. Interim results are not necessarily indicative of fiscal year performance for a variety of reasons including, but not limited to, the impact of seasonal and short-term variations. The Company has continued to follow the accounting
policies (including its critical accounting policies) set forth in the consolidated financial statements included in its 2005 Annual Report on Form 10-K filed with the Securities and Exchange Commission. These financial statements should be read in
conjunction with the consolidated financial statements and notes thereto included in the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2005.

Reclassifications and Restatements

Certain reclassifications and restatements have been made to
prior year financial statements to conform to the classifications used in the current period. The reclassification and restatement adjustments to amounts previously presented in the consolidated statements of operations are summarized below:



|                                                 |  |                       |        |             |   |         |           |  |             |  |   |       
|------------------------------------------------ |  | --------------------- | ------ | ----------- | - | ------- | --------- |  | ----------- |  | - | ------
|Three Months Ended March 31, 2005 (in
thousands) |  | As PreviouslyReported |        | Adjustments |   |         | Reference |  | As Restated
|Revenue                                          |  | $                     | 34,962 |             | $ | (34,962 | )         |  | a           |  | $ |      
|Products                                         |  |                       |       |             |   | 22,004  |           |  | a           |  |   | 22,004
|Services                                         |  |                       |       |             |   | 13,008  |           |  | a, c        |  |   | 13,008
|                                                 |  |                       |        |             |   |         |           |  |             |  |   |       
|                                                 |  | $                     | 34,962 |             | $ | 50      |           |  |             |  | $ | 35,012
|                                                 |  |                       |        |             |   |         |           |  |             |  |   |       
|Cost of sales                                    |  | $                     | 27,455 |             | $ | (27,455 | )         |  | b           |  | $ |      
|Products                                         |  |                       |       |             |   | 17,611  |           |  | b           |  |   | 17,611
|Services                                         |  |                       |       |             |   | 9,894   |           |  | b, c        |  |   | 9,894 
|                                                 |  |                       |        |             |   |         |           |  |             |  |   |       
|                                                 |  | $                     | 27,455 |             | $ | 50      |           |  |             |  | $ | 27,505
|                                                 |  |                       |        |             |   |         |           |  |             |  |   |       

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|a - | Restatement of aggregate Revenue into Product Revenue and Services Revenue:
|--- | ---------------------------------------------------------------------------

| | The Company previously reported Revenue in the aggregate on the face of the statements of operations. The Company has restated the revenue amounts so that Product Revenue and
Services Revenue are presented separately, consistent with the criteria set forth in Rule 5-03(b) of Regulation S-X.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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|b - | Restatement of aggregate Cost of Sales into Product Cost of Sales and Services Cost of Sales:
|--- | ---------------------------------------------------------------------------------------------

| | The Company previously reported Cost of Sales in the aggregate on the face of the statements of operations. The Company has restated the Cost of Sales amounts so that Product Cost
of Sales and Services Cost of Sales are presented separately, consistent with the criteria set forth in Rule 5-03(b) of Regulation S-X.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|c - | Restatement of warranty expense, warranty liability and revenue associated with non-separately priced warranties. The restatement resulted in an increase in Revenue and an increase
in Cost of Sales by $50,000. It also decreased deferred revenue and increased Other Current Liabilities by $50,000.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Recent Accounting Pronouncements

In June 2005, the Financial Accounting Standards Board (the FASB) issued Statement No. 154, Accounting Changes and Error Corrections, which replaces Accounting Principles Board Opinion
No. 20, Accounting Changes and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. Statement No. 154 requires that a voluntary change in accounting principle be applied
retrospectively with all prior period financial statements presented on the new accounting principle. Statement No. 154 also requires that a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for
prospectively as a change in estimate, and correction of errors in previously issued financial statements should be termed a restatement. Statement No. 154 is effective for accounting changes and correction of errors made in fiscal
years beginning after December 15, 2005, and was adopted by the Company on January 1, 2006. See disclosures above under the Reclassifications and Restatements caption.

In December 2004, the FASB issued Statement No. 153, Exchanges of Nonmonetary Assets - An Amendment of APB Opinion No. 29,
which eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets that do not culminate an earning process under APB Opinion No. 29, Accounting for Nonmonetary Transactions. Statement
No. 153 requires that the measurement be based on the recorded amount of the assets relinquished for nonmonetary exchanges that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the
entity are expected to change significantly as a result of the exchange. This standard is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of this standard has not yet affected
the Companys financial position or results of operations.

In November 2004, the FASB issued Statement No. 151,
Inventory Costs - an amendment of ARB No. 43, Chapter 4. Statement No. 151 clarifies the accounting guidance included in Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory
Pricing related to abnormal amounts of idle facility expense, freight, handling and spoilage costs. This statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of so
abnormal, as specified by ARB No. 43. In addition, this statement requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. Statement No. 151 is
effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of this standard has not yet affected the Companys financial position or results of operations.



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Revenue Recognition

Revenues are recognized in accordance with SEC Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements as amended by SAB 104, Revenue Recognition. The Company
considers amounts earned upon evidence that an arrangement has been obtained, services are delivered, fees are fixed or determinable, and collectibility is reasonably assured. Additionally, revenues on arrangements requiring the delivery of more
than one product or service are recognized in accordance with EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables except as the pronouncement states, on contracts where higher-level GAAP (such as SOP 97-2 as
described below) prevails.

The Company recognizes revenues for software arrangements upon persuasive evidence of an arrangement, delivery
of the software, and determination that collection of a fixed or determinable license fee is probable. Revenues for software licenses sold on a subscription basis are recognized ratably over the related license terms. For arrangements where the sale
of software licenses are bundled with other products, including software products, upgrades and enhancements, post-contract customer support (PCS), and installation, the relative fair value of each element is determined based on
vendor-specific objective evidence (VSOE). VSOE is defined by Statement of Position 97-2, Software Revenue Recognition (SOP 97-2), and Statement of Position 98-9, Modification of SOP 97-2, Software Revenue
Recognition With Respect to Certain Transactions (SOP 98-9), and is limited to the price charged when the element is sold separately or if the element is not yet sold separately, the fair value assigned under the residual method or
the price set by management having the relevant authority. If VSOE does not exist for the allocation of revenue to the various elements of the arrangement, all revenue from the arrangement is deferred until the earlier of the point at which
(1) such VSOE does exist or (2) all elements of the arrangement are delivered. PCS revenues, upon being unbundled from a software license fee, are recognized ratably over the PCS period.

Substantially all of the Companys contracts are contracts with the U.S. Government involving the complex delivery of technology products and
services. Accordingly, these contracts are within the scope of the AICPAs Audit and Accounting Guide for Audits of Federal Government Contractors. To the extent contracts are incomplete at the end of an accounting period; revenue is recognized
on the percentage-of-completion method using costs incurred in relation to total estimated costs.

Stock-Based Compensation

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123(R), Share Based Payment (SFAS
No. 123(R)), a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25, (APB No. 25) Accounting for Stock Issued to
Employees. SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, be recognized in the income statement based on their fair values.

Prior to January 1, 2006, the Company accounted for stock-based compensation using the intrinsic value based method in accordance with APB
No. 25. Under APB No. 25, the Company recognized no compensation cost for employee stock options, as the options granted had an exercise price equal to the fair value of the underlying common stock on the date of grant. The Company has
applied the disclosure provisions of SFAS No. 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation and Disclosure, an amendment of FASB Statement No. 123. Under those provisions, the Company provided
pro forma disclosures as if the fair value measurement provisions of SFAS No. 123 had been used in determining compensation expense. The Company used the Black-Scholes option-pricing model to determine the pro forma impact under SFAS Nos. 123
and 148 on the Companys net income. The model utilizes certain information, such as the interest rate on a risk-free security maturing generally at the same time as the option being valued and requires certain other assumptions, such as the
expected amount of time an option will be outstanding until it is exercised or expired, to calculate the fair value of stock options granted. Such amount disclosed for the quarter ended March 31, 2005 was $40,000.

Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123(R), using the modified prospective transition
method. Under this transition method, stock-based compensation costs recognized in the income statement for the quarter ended March 31, 2006, include: (a) compensation costs for all unvested stock options that were granted prior to
December 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123; and (b) compensation expense for all share-based payments granted on or after December 31, 2005, based on grant
date fair value estimated in accordance with the provisions of SFAS 123(R). Results for prior periods have not been restated.



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Note 2. Investment in Enterworks

Enterworks, Inc.

As of March 31, 2006, the Company owns 671,968 shares of common stock of
Enterworks, Inc. (Enterworks), 729,731 shares of Series A-1 Preferred Stock and 1,793,903 shares of Series B-1 Preferred Stock, as a result of Enterworks recapitalization which occurred on October 14, 2005. This equates to a
fully diluted ownership percentage of 19.4%. Prior to the recapitalization, the Company owned 17,153,059 shares of Enterworks common stock, 1,785,714 shares of Series B Convertible Preferred Stock and held warrants to purchase 6,374,997 underlying
common stock shares. This equated to a fully diluted ownership percentage of 21.5%. The Company accounts for its investment in Enterworks as prescribed by APB Opinion No. 18, The Equity Method of Accounting for Investments in Common
Stock.

All notes receivable from Enterworks previously owned by the Company totaling $4.0 million were converted into 215,500 shares
of Enterworks common stock and 729,731 shares of Series A-1 Preferred Stock, as a result of the Enterworks recapitalization mentioned above. Approximately $3.3 million of such notes were received in exchange for rent and professional services
performed by the Company, pursuant to a lease and an inter-company services agreement. In accordance with APB Opinion No. 18 and Emerging Issues Task Force Issue No. 98-13 Accounting by an Equity Method Investor for Investee Losses
when the Investor has Loans to and Investments in Other Securities of the Investee, the Company reduced the carrying amounts of the notes to zero during 2004 and 2003, as the Companys share of the Enterworks losses exceeded the carrying
value of the notes. All of such notes issued to the Company in 2003 and 2002 included a provision for repayment of four times principal and accrued interest in the event that Enterworks liquidates, enters into dissolution or seeks bankruptcy
protection. The remaining $.7 million was acquired as a result of a purchase agreement with a third-party in August 2005, whereby the Company acquired 1,785,714 shares of Enterworks Series B Convertible Preferred Stock, 1,875,000 warrants to
purchase Enterworks common stock, and $.7 million of Enterworks Demand 10% Convertible Promissory Notes.

Enterworks losses for the first
quarter of 2006 amounted to approximately $400,000, and in accordance with APB 18 the Company recorded $92,000 of equity losses from Enterworks as losses from affiliate, reducing its investment in Enterworks to zero.

On April 30, 2006, Enterworks completed a transaction in which it purchased 100% of the common stock of a small content publishing company. In
consideration for this purchase, Enterworks issued approximately 8.1 million shares of its common stock to the acquired companys stockholders. As of April 30, 2006, Telos ownership in Enterworks, on a fully diluted basis, was
reduced to 12.6%.

In December 2003, the Company entered into a two-year Original Equipment Manufacturer (OEM) software license
agreement (SLA) with Enterworks that, pursuant to an earn-out provision is comprised of cumulative license fees and/or Company services to Enterworks equal to at least $2.0 million. The Company provided initial consideration of $1.0
million, comprised of a $100,000 cash payment and Company services in the amount of $900,000, including $300,000 for rent and services from July 2003 to December 2003, and an additional $600,000 for rent and services for 2004. In addition to the
above-described exchange, as part of the December 2003 agreement, the Company agreed to pay royalties of $1.0 million for a period of two years and, upon payment of cumulative license fees and/or company services to Enterworks equal to at least $2.0
million, will own a worldwide, non-exclusive, perpetual, irrevocable, royalty-free, fully paid-up license for the Enterworks Process Exchange (EPX) software. As of December 31, 2004, the Company paid approximately $294,000 in
such royalties. In December 2004, the Company entered into an amended agreement with Enterworks in which Enterworks acknowledged that the Company had met the earn-out requirements and now owns the above-mentioned license. As part of the amended
agreement, the Company paid an additional $350,000 and waived the $400,000 fee for rent and services for 2005. Additionally, in exchange for a one-time fixed fee of $300,000, and for $15,000 per month thereafter, Enterworks agreed to provide the
Company with maintenance and OEM technical product support for two years, commencing in January of 2005. The one-time fixed fee is being amortized over two years.



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In accordance with FASB Statement No. 142, Goodwill and Other Intangible Assets,
intangible assets acquired shall be initially recognized and measured at fair value. As such, the Company has capitalized $850,000 in consideration paid for EPX software ($100,000 in 2003 and $750,000 in 2004), and has reflected this asset on the
balance sheet in Other Assets.

In May 2006, the Company and Enterworks amended their agreement for services and sublease
(Agreement for Services and Sublease) effective as of January 1, 2006. Pursuant to the agreement, Telos shall continue to sublease office space in its Ashburn facility and provide certain general, administrative and support
services to Enterworks, for an aggregate amount of $210,000 per year, payable in 12 equal installments of $17,500 per month.

Pursuant to
its terms, upon execution of the Agreement for Services and Sublease, the equivalent of five monthly payments, or $87,500, for the period from January 1, 2006 through May 31, 2006, became due to Telos from Enterworks. Under the terms
of the Agreement for Services and Sublease, Enterworks must bring such arrearage current by June 30, 2006.

Enterworks International, Inc.

In December 2003, the Company purchased a 50% interest in Enterworks International (EI), which at the time of the
transaction was a wholly owned subsidiary of Enterworks, for $500,000. Pursuant to the terms of the stock purchase agreement and the stockholder agreement (Agreement) setting forth the transaction, the Company agreed to fund up to 50% of
EIs 2004 operating costs for an amount not to exceed $300,000 in 2004 (and certain direct expenses that amounted to $89,000 in 2004), and 50% of such operating costs and certain expenses thereafter, which amounted to approximately $164,000 for
the first quarter of 2006, $140,000 for the first quarter of 2005, and $607,000 for all of 2005. Beginning in 2004, any such costs have been consolidated with the Companys results of operations.

Pursuant to the Agreement, the Company and Enterworks are required to fund the operations of EI according to a funding schedule set forth in the
Agreement. For calendar year 2005, Enterworks was unable to fund its proportionate share of the scheduled funding, which amounted to $664,000 as of October 14, 2005, and as such the $664,000 was funded and expensed by the Company. However,
as a result of Enterworks recapitalization effort, the $664,000 was converted into 1,793,903 shares of Enterworks Series B-1 Preferred Stock and was recorded as an investment in Enterworks. As discussed above, amounts capitalized for
this investment were evaluated for impairment and adjusted accordingly.

As a result of additional funding by the Company late in 2005, the
Company funded an additional $58,000 for EI on behalf of Enterworks. In 2006, Enterworks has been unable to fund its proportionate share of the scheduled funding, which amounted to $245,000 as of March 31, 2006. Consistent with subsection
3.4(d) of the Agreement, the non-defaulting party (Telos) has the right to transfer ownership (pursuant to a Penalty Ownership calculation) of the defaulting partys interest in EI. The Agreement also provides for a cure period for the
defaulting party, which has been waived. On May 19, 2006, the Company provided notice to Enterworks of its default and, pursuant to the waiver of the cure period by Enterworks, exercised its rights under the Agreement to transfer the
calculated ownership percentage to the Company. The amount of the Enterworks default set forth in the notice was approximately $303,000. As a result of such exercise of its rights per the Agreement, the Company now owns 80.0% of EI.
Accordingly, the Company has consolidated Enterworks portion of such costs, $245,000 and $203,000 for the quarters ended March 31, 2006 and 2005, respectively. Therefore, total costs attributable to EI that are consolidated with the
Companys results of operations for March 31, 2006 and 2005, were $409,000 and $343,000 for those respective periods.



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Note 3. Debt Obligations

Senior Revolving Credit Facility

In April 2005, the Company renewed, on amended terms, the $22.5 million Senior Revolving
Credit Facility (as amended, the Facility) with Wells Fargo Foothill, Inc. (Wells Fargo Foothill) (formerly known as Foothill Capital Corporation) that was originally scheduled to mature on October 21, 2005. The amended
terms included, primarily a revolving line limit of $15 million with an interest rate of Wells Fargo prime rate plus 1%, and an extension of its maturity date to October 21, 2008. Pursuant to the terms of the Facility, in lieu of
having interest charged at the rate based on the Wells Fargo prime rate, the Company has the option to have interest on all or a portion of the advances on such Facility be charged at a rate of interest based on the LIBOR Rate, plus 4%. Borrowings
under the Facility are collateralized by substantially all of the Companys assets including inventory, equipment, and accounts receivable. The amount of available borrowings fluctuates based on the underlying asset-borrowing base, as defined
in the Facility agreement.

Effective April 2005, the interest rate is the Wells Fargo prime rate plus 1% (as of March 31,
2006 the Wells Fargo prime rate was 7.75%) or 5.75%, whichever is higher. The effective weighted average interest rates (including various fees charged pursuant to the Facility agreement) on the outstanding borrowings under the Facility
were 9.9% and 9.4% for the quarters ended March 31, 2006 and 2005, respectively.

The Facility has various covenants that may, among
other things, affect the ability of the Company to merge with another entity, sell or transfer certain assets, pay dividends and make other distributions beyond certain limitations. The Facility also required the Company to meet certain financial
covenants, including tangible net worth and earnings before interest, taxes, depreciation and amortization (EBITDA), as defined in the Facility. Since the Facilitys inception, certain financial covenants have been amended and restated to more
accurately reflect the Companys performance. The financial covenants were amended and restated in August 2004, to eliminate the tangible net worth requirement.

At March 31, 2006, the Company was not in compliance with certain of its covenants pursuant to the Facility. Due to the late filing of the 2005 Form 10-K, the Company had not provided audited annual financial
statements to the bank within the required 90-day period. In addition, certain EBITDA covenants were not achieved. Accordingly, as of June 20, 2006, the Company has obtained waivers for any such covenant violations, and the Company and Wells Fargo
Foothill have agreed upon modified EBITDA covenants to more accurately reflect the Companys future performance based upon revised projections. In addition, the Company and Wells Fargo Foothill have amended the Facility, to temporarily provide
for a four-month over-advance in the amount of $3.0 million, the available balance of which declines over the term, which ends July 31, 2006. Such over-advance is subject to certain additional covenants and reporting requirements, including a
minimum sales requirement.

At March 31, 2006, the Company had outstanding borrowings of $7.4 million and unused borrowing
availability of $3.0 million on the Facility. As of March 31, 2006, the interest rate on the Facility was 8.75%.

Senior Subordinated Notes

In 1995, the Company issued Senior Subordinated Notes (Notes) to certain shareholders. Such Notes are classified as either
Series B or Series C. The Series B Notes are secured by the Companys property and equipment. The Series C Notes are unsecured. The maturity date of such Notes has been extended to October 31, 2008, with interest rates ranging from 14% to
17%, and paid quarterly on January 1, April 1, July 1, and October 1 of each year. In consideration for such extension, the Company agreed to pay a one-time fee of 1%. The Notes can be prepaid at the Companys
option; however, the Notes contain a cumulative payment premium of 13.5% per annum payable upon certain circumstances, which include, but are not limited to, an initial public offering of the Companys common stock or a significant
refinancing (qualifying triggering event), to the extent that sufficient net proceeds from either of the above events are received to pay such cumulative prepayment premium. Due to the contingent nature of the cumulative premium payment,
any associated premium expense can only be quantified and recorded subsequent to the occurrence of such a qualifying triggering event. At March 31, 2006, if such a qualifying triggering event had occurred, the cumulative premium payment would
have been approximately $15.2 million.



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The balance of the Series B and C Notes was $2.5 million and $2.7 million, respectively, at March 31, 2006 and
December 31, 2005.

The following are maturities of obligations presented by year (in thousands):



|                         |  |      |  |                |       
|------------------------ |  | ---- |  | -------------- | ------
|                         |  | Year |  | Obligation Due
|Senior Subordinated Debt |  | 2008 |  | $              | 5,1791
|Senior Credit Facility   |  | 2008 |  | $              | 7,3742

---

|1 | Pursuant to Section 17 of a Subordination Agreement entered into in conjunction with the
Facility, the senior subordinated note holders and the Company have entered into an agreement to extend the maturity date of the Notes to October 31, 2008.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|2 | Balance due represents balance as of March 31, 2006, however, the Facility is a
revolving credit facility with fluctuating balances based upon the eligible underlying asset-borrowing base and the varying working capital requirements of the Company.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Note 4. Redeemable Preferred Stock

Senior Redeemable Preferred Stock

The components of the authorized, issued and outstanding senior
redeemable preferred stock (Senior Redeemable Preferred Stock) are 1,250 Series A-1 and 1,750 Series A-2 senior redeemable preferred shares, respectively, each with $.01 par value. The Senior Redeemable Preferred Stock carries a
cumulative per annum dividend rate of 14.125% of its liquidation value of $1,000 per share. The dividends are payable semiannually on June 30 and December 31 of each year. The liquidation preference of the Senior Redeemable Preferred Stock
is the face amount of the Series A-1 and A-2 ($1,000 per share), plus all accrued and unpaid dividends. The Company was required to redeem all shares and accrued dividends outstanding on October 31, 2005. However, on April 14, 2005,
Toxford Corporation, the holder of 72.6% of the Senior Redeemable Preferred Stock, extended the maturity of its instruments to October 31, 2008. Subject to limitations set forth below, the Company was scheduled to redeem 27.4% of the
outstanding shares and accrued dividends outstanding on October 31, 2005. Among the limitations with regard to the mandatory redemptions of the Senior Redeemable Public Preferred Stock is the legal availability of funds, pursuant to Maryland
law. Accordingly, due to the Companys current financial position, it is precluded by Maryland law from making the scheduled payment. As the Senior Redeemable Preferred Stock is not due on demand, or callable, within twelve months from
March 31, 2006, the remaining 27.4% is also classified as noncurrent.

The Senior Redeemable Preferred Stock is senior to all other
present equity of the Company, including the 12% Cumulative Exchangeable Redeemable Preferred Stock. The Series A-1 ranks on a parity with the Series A-2. The Company has not declared dividends on its Senior Redeemable Preferred Stock since its
issuance. At March 31, 2006 and 2005, cumulative undeclared, unpaid dividends relating to Senior Redeemable Preferred stock totaled $5.7 million and $5.3 million, respectively.

12% Cumulative Exchangeable Redeemable Preferred Stock

A maximum of 6,000,000 shares of 12%
Cumulative Exchangeable Redeemable Preferred Stock (the Public Preferred Stock), par value $.01 per share, has been authorized for issuance. The Company initially issued 2,858,723 shares of the Public Preferred Stock pursuant to the
acquisition of the Company during fiscal year 1990. The Public Preferred Stock was recorded at fair value on the date of original issue, November 21, 1989, and the Company makes periodic accretions under the interest method of the excess of the
redemption value over the recorded value. Such accretion for the three months ended March 31, 2006 and 2005 was $344,000 and $451,000, respectively. The Company declared stock dividends totaling 736,863 shares in 1990 and 1991. Since 1991, no
other dividends, in stock or cash, have been declared. In November 1998, the Company retired 410,000 shares of the Public Preferred Stock. The total number of shares issued and outstanding at March 31, 2006 was 3,185,586. The stock trades over
the NASDAQ/ OTCBB Exchange.

Since 1991, the Company has not declared or paid any dividends on its Public Preferred Stock, based upon its
interpretation of restrictions in its Articles of Amendment and Restatement, limitations in the terms of the Public Preferred Stock instrument, specific dividend payment restrictions in the Facility entered into with Wells Fargo Foothill, to which
the Public Preferred Stock is subject, and other senior obligations, and limitations pursuant to Maryland law. Pursuant to their terms, the Company is scheduled to redeem the Public Preferred Stock in five annual tranches during the period 2005
through 2009. However, due to its substantial senior obligations, limitations set forth in the covenants in the Facility, foreseeable capital and operational requirements, restrictions and prohibitions of its Articles of Amendment and Restatement,
and provisions of Maryland law, the Company did not make the first scheduled redemption payment, and assuming insufficient liquidity to undertake any stock redemption (which is presently unquantifiable), the Company believes that the likelihood is
that it will not be able to make the remaining four scheduled redemption payments as set forth in the terms of the Public Preferred Stock. Accordingly, the Public Preferred Stock is not payable on demand, nor callable, for failure to redeem the
Public Preferred Stock in accordance with the redemption schedule set forth in the instrument. The Company has therefore classified these securities as noncurrent liabilities on the balance sheet as of March 31, 2006 and December 31, 2005.



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The Company and certain of its subsidiaries are parties to the Facility agreement with Wells Fargo
Foothill, whose term expires on October 21, 2008. Under the Facility, the Company agreed that, so long as any credit under the Facility is available and until full and final payment of the obligations under the Facility, it would not make any
distribution or declare or pay any dividends (other than common stock) on its stock, or purchase, acquire, or redeem any stock, or exchange any stock for indebtedness, or retire any stock. The Company continues to actively rely upon the Facility and
expects to continue to do so until the Facility agreement expires on October 21, 2008.

Accordingly, as stated above, the Company will
continue to classify the entirety of its obligation to redeem the Public Preferred Stock as a long-term obligation. The Wells Fargo Foothill Facility prohibits, among other things, the redemption of any stock, common or preferred, until
October 21, 2008. The Public Preferred Stock by its terms cannot be redeemed if doing so would violate the terms of an agreement regarding the borrowing of funds or the extension of credit which is binding upon the Company or any subsidiary of
the Company, and it does not include any other provisions that would otherwise require any acceleration of the redemption of or amortization payments with respect to the Public Preferred Stock. Thus, the Public Preferred Stock is not and will not be
due on demand, nor callable, within twelve months from March 31, 2006. This classification is consistent with ARB No. 43 and FASB Statement No. 78 (FASB 78), Classification of Obligations that are Callable by the
Creditor.

Paragraph 7 of Chapter 3A of ARB No. 43 defines a current liability, as follows:

The term current liabilities is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing
resources properly classifiable as current assets, or the creation of other current liabilities. As a balance sheet category, the classification is intended to include obligations for items that have entered into the operating cycle, such as
payables incurred in the acquisition of materials and supplies to be used in the production of goods or in providing services to be offered for sale; collections received in advance of the delivery of goods or performance of services; and debts that
arise from operations directly related to the operating cycle, such as accruals for wages, salaries, commissions, rentals, royalties, and income and other taxes. Other liabilities whose regular and ordinary liquidation is expected to occur within a
relatively short period of time, usually 12 months, are also intended for inclusion, such as short-term debts arising from the acquisition of capital assets, serial maturities of long-term obligations, amounts required to be expended within 1 year
under sinking fund provisions, and agency obligations arising from the collection or acceptance of cash or other assets for the account of third persons.

Paragraph 5 of FASB 78, provides the following:

The current liability classification is also intended
to include obligations that, by their terms, are due on demand or will be due on demand within one year (or operating cycle, if longer) from the balance sheet date, even though liquidation may not be expected within that period. It is also intended
to include long-term obligations that are or will be callable by the creditor either because the debtors violation of a provision of the debt agreement at the balance sheet date makes the obligation callable or because the violation, if not
cured within a specified grace period, will make the obligation callable

If, pursuant to the terms of the Public Preferred
Stock, the Company does not redeem the Public Preferred Stock in accordance with the scheduled redemptions described above, the terms of the Public Preferred Stock require the Company to discharge its obligation to redeem the Public Preferred Stock
as soon as the Company is capable and permitted to do so.

On any dividend payment date after November 21, 1991, the Company may
exchange the Public Preferred Stock, in whole or in part, for 12% Junior Subordinated Debentures that are redeemable upon terms substantially similar to the Public Preferred Stock and subordinated to all indebtedness for borrowed money and like
obligations of the Company. As disclosed above, the Company considered this exchange in evaluating the classification of the Public Preferred Stock as of December 31, 2004 and, subsequently, concluded that, for the reasons stated above, it did
not have the ability to affect such an exchange.



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##### Table of Contents

The Public Preferred Stock accrues a semi-annual dividend at the annual rate of 12% ($1.20) per share,
based on the liquidation preference of $10 per share and is fully cumulative. Dividends in additional shares of the Public Preferred Stock for 1990 and 1991 were paid at the rate of 6% of a share for each $.60 of such dividends not paid in cash.
Dividends on the Public Preferred Stock are paid by the Company, when and if declared by the Board of Directors, and are required to be paid out of legally available funds in accordance with Maryland law. For the cash dividends payable since
December 1, 1995, the Company has accrued $41.1 million as of March 31, 2006, and $37.3 million as of March 31, 2005.

In
accordance with SFAS 150, both the Senior Redeemable Preferred Stock and the Public Preferred Stock have been reclassified from equity to liability. Consequently, for the three months ended March 31, 2006 and 2005, dividends totaling $1.0
million were accrued and reported as interest expense in the respective periods. Prior to the effective date of SFAS 150 on July 1, 2003, such dividends were charged to stockholders accumulated deficit. The aggregate fair value of the
public preferred stock at March 31, 2006 was $47.8 million.

The carrying value of the accrued Paid-in-Kind (PIK)
dividends on the Public Preferred Stock for the period 1992 through June 1995 was $4.0 million. Had the Company accrued cash dividends on the outstanding shares of the Public Preferred Stock for this time period, the total amount accrued would have
been $13.4 million. The Companys Charter, Section 2(a) states, Any dividends payable with respect to the Exchangeable Preferred Stock (Public Preferred Stock) during the first six years after the Effective Date (November
20, 1989) may be paid (subject to restrictions under applicable state law), in the sole discretion of the Board of Directors, in cash or by issuing additional full paid and nonassessable shares of Exchangeable Preferred Stock .
Accordingly, the Board had the discretion to pay the dividends for the referenced period in cash or by the issuance of additional shares of Public Preferred Stock. During the period in which the Company stated its intent to pay PIK dividends, the
Company stated its intention to amend its charter to permit the payment of these by the issuance of additional shares of Public Preferred Stock. In consequence, as required by applicable accounting requirements, the accrual for these dividends was
recorded at the estimated fair value (as the average of the ask and bid prices) on the dividend date of the shares of Public Preferred Stock that would have been (but were not) issued. This accrual was $9.4 million lower than the accrual would be if
the intent was only to pay the dividend in cash, at that date or any later date.

In March 2006, the Company engaged Jefferies Quarterdeck,
a nationally known investment bank, to explore strategic alternatives with respect to it Xacta subsidiary or one or more lines of business of its Xacta subsidiary. The objective of the Company is, if such a process could yield sufficient cash
proceeds, to use the proceeds to partially or completely recapitalize its balance sheet. There can be no assurance as to the outcome of this process, or as to the time frame in which this process might be completed.

The Board concluded, in consequence of the commencement of this process by Jefferies Quarterdeck and the ability to pay cash dividends derived from a
transaction or transactions sufficient to meet such obligation, that the accrual of PIK dividends for the period 1992 through June 1995 was no longer appropriate. Since 1995, the Company has disclosed in the footnotes to its audited financial
statements the carrying value of the accrued PIK dividends on the Public Preferred Stock for the period 1992 through June 1995 was $4.0 million, and that had the Company accrued cash dividends during this time period, the total amount accrued would
have been $13.4 million. The objective of the Company to utilize the proceeds of this strategic process with respect to its Xacta subsidiary to partially or completely recapitalize its balance sheet, therefore, is inconsistent with any continued
intent to pay a PIK dividend by the issuance of any additional shares of Public Preferred Stock. Accordingly on May 12, 2006, the Board of Directors voted to confirm that the Companys intent with respect to the payment of dividends on the
Public Preferred Stock for this period changed from its previously stated intent to pay PIK dividends to that of an intent to pay cash dividends, although, as stated above, there can be no assurance whether or as to the time frame in which the
strategic process with respect to the Companys Xacta subsidiary might enable the Company to pay such dividends. The Company is therefore changing the accrual from $4.0 million to $13.4 million, the result of which will be to increase the
Companys negative shareholder equity by the difference between those two amounts, $9.4 million, by recording an additional $9.4 million charge to interest expense for the second quarter of 2006, resulting in a balance of $82.2 million (pro
forma as of April 30, 2006) for the principal amount and all accrued dividends on the Public Preferred Stock. This action is a change in accounting estimate as defined in SFAS 154, Accounting Changes and Error Corrections which
replaces APB No. 20, Accounting Changes and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements.



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Note 5. Reportable Business Segments

As of March 31, 2006, the Companys operations are comprised of two operating segments, Managed Solutions and Xacta.

Managed Solutions: Develops, markets and sells integration services that address a wide range of government information technology (IT) requirements. Offerings consist of innovative IT solutions that consists of industry
leading IT products from original equipment manufacturers (OEMs) with complimentary integration and managed support services provided by Telos. Manageed Solutions also provides general IT consulting and integration services in support of
various U.S. Government customers.

Xacta:Develops, markets and sells government-validated secure enterprise solutions to the U.S.
Government and financial institutions, to address the growing demand for information security solutions. Xacta provides Secure Wireless LAN solutions, Enterprise Messaging solutions, Identity Management solutions, Information Security Consulting
services and IT Security Management software solutions.

The accounting policies of the reportable segments are the same as those referred
to in Note 1 -General. The Company evaluates the performance of its operating segments based on revenue, gross profit and segment profit (loss) before income taxes and interest income or expense.



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##### Table of Contents

Summarized financial information concerning the Companys reportable segments for the three months ended
March 31, 2006 and 2005 are set forth in the following table. The other column includes corporate related items.



|                                  |  |                    |        |   |       |   |        |           |  |       |       |  |   |        |  
|--------------------------------- |  | ------------------ | ------ | - | ----- | - | ------ | --------- |  | ----- | ----- |  | - | ------ | -
|                                  |  | Three Months Ended |       
|                                  |  | Managed Solutions  |        |   | Xacta |   |        | Other (1) |  | Total |      
|March 31, 2006                    |  |                    |        |   |       |   |        |           |  |       |       |  |   |        |  
|External revenues                 |  | $                  | 9,428  |   |       | $ | 15,746 |           |  | $     |      |  | $ | 25,174 |  
|Gross profit                      |  |                    | 245    |   |       |   | 4,250  |           |  |       |      |  |   | 4,495  |  
|Segment loss (2)                  |  |                    | (1,922 | ) |       |   | (3,996 | )         |  |       |      |  |   | (5,918 | )
|Total assets                      |  |                    | 8,885  |   |       |   | 16,733 |           |  |       | 9,937 |  |   | 35,555 |  
|Capital expenditures              |  |                    |       |   |       |   | 109    |           |  |       | 265   |  |   | 374    |  
|Depreciation and amortization (3) |  |                    | 3      |   |       |   | 133    |           |  |       | 291   |  |   | 428    |  
|                                  |  |                    |        |  
|                                  |  | ManagedSolutions   |        |   | Xacta |   |        | Other (1) |  | Total |      
|March 31, 2005                    |  |                    |        |   |       |   |        |           |  |       |       |  |   |        |  
|External revenues                 |  | $                  | 13,349 |   |       | $ | 21,663 |           |  | $     |      |  | $ | 35,012 |  
|Gross profit                      |  |                    | 2,109  |   |       |   | 5,398  |           |  |       |      |  |   | 7,507  |  
|Segment profit (2)                |  |                    | 335    |   |       |   | 142    |           |  |       |      |  |   | 477    |  
|Total assets                      |  |                    | 5,366  |   |       |   | 22,160 |           |  |       | 9,814 |  |   | 37,340 |  
|Capital expenditures              |  |                    | 8      |   |       |   | 197    |           |  |       | 222   |  |   | 427    |  
|Depreciation and amortization (3) |  |                    | 84     |   |       |   | 137    |           |  |       | 252   |  |   | 473    |  

---

|(1) | Corporate assets are property and equipment, cash and other assets.
|--- | -------------------------------------------------------------------

|(2) | Segment profit (loss) represents operating income (loss).
|--- | ---------------------------------------------------------

|(3) | Depreciation and amortization include amounts relating to property and equipment, capital leases and spare parts inventory.
|--- | ---------------------------------------------------------------------------------------------------------------------------

In the first quarters of 2006 and 2005, the Company derived substantially all of its revenue from contracts and subcontracts with the U.S. Government.
The Company does not have any material international revenues, profit (loss), assets or capital expenditures. The Companys business is not concentrated in any specific geographical area within the United States. The Company has six separate
facilities located in various states, the District of Columbia and Germany.



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Note 6. Contingencies and Subsequent Events

The Company budgeted EBITDA of $(3.0) million for the three months ended March 31, 2006, and excluding non-budgeted legal costs of $2.7 million, achieved
$(2.8) million of EBITDA for the period. Subsequent to March 31, 2006, approximately $1.2 million of such legal costs have been reimbursed by the Companys insurers. Total expenses related to litigation were (exclusive of any such
reimbursement) $3.5 million for the first quarter of 2006, and $4.1 million for the 12 months ending December 31, 2005. Such extraordinary legal expenses have adversely affected cash flow.

The Company derives substantially all of its revenue from U.S. Government contracting, and as such it is annually subject to the seasonality of the U.S.
Government purchasing. As the U.S. Government fiscal year ends on September 30, it is not uncommon for U.S. Government agencies to award extra tasks in the weeks immediately prior to the end of its fiscal year in order to avoid the loss of
unexpended fiscal year funds. As a result of this cyclicality, the Company has historically experienced higher revenues in its third and fourth fiscal quarters, ending September 30, and December 31, respectively, with the pace of orders
substantially reduced during the January to June time period. During the three month period ending March 31, 2006, this seasonal reduction in orders and extraordinary litigation expense, have combined to adversely affect the Companys EBITDA
and cash flows. As the anticipated U.S. Government orders are realized during the third and fourth quarters of 2006, the Company, based upon current projected EBITDA, believes its liquidity will improve during these periods. The Company further
believes such projected improvements in its liquidity later in 2006 will be sufficient to generate adequate amounts of cash to meet the Companys needs for operating expenses, debt service requirements, and planned capital expenditures for
2006.

The Company is actively working with its vendors, partners and subcontractors to mitigate the effect of these cash flow constraints
during this period. Additionally, as discussed in Note 3  Debt Obligations, the Company and Wells Fargo Foothill have amended the Senior Revolving Credit Facility to provide the Company with a four-month over-advance in the amount of $3
million. There can be no assurances as to the continuing ability of the Company to successfully work with vendors, partners and subcontractors or Wells Fargo Foothill to mitigate these current cash flow constraints.

These consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business. As described in Note 3  Debt Obligations, the Company has obtained waivers and less restrictive cash flow covenants with respect to its Senior Revolving Credit Facility. Although no assurances can
be given, the Company expects that it will be in compliance throughout the term of the amended credit facility with respect to the financial and other covenants. Also, as more fully described in Note 4  Redeemable Preferred Stock, the Company
has engaged Jefferies Quarterdeck, a nationally known investment bank, to explore strategic alternatives for the sale of its Xacta subsidiary or one or more lines of business of its Xacta subsidiary. The Company intends to vigorously pursue such a
process, with the objective, if such a process could yield sufficient cash proceeds, of using the proceeds to partially or completely recapitalize its balance sheet, although, as stated above, there can be no assurance whether, or as to the time
frame in which, the strategic process with respect to the Companys Xacta subsidiary might enable the Company to retire its debt obligations and/or pay dividends and/or partially or completely retire its redeemable preferred stock. While the
Company intends to make every effort to successfully consummate such a transaction, including by assisting a proposed purchaser in obtaining necessary regulatory approvals, there can be no certainty as to the timeframe of such process completion or
the amount of proceeds that would be realized as a result of such transaction.

As noted in Note 4  Redeemable Preferred Stock, on
May 12, 2006, the Board of Directors voted to confirm that the Companys intent with respect to the payment of dividends on the Public Preferred Stock for the period 1992 through June 1995 changed from its previously stated intent to pay
PIK dividends to that of an intent to pay cash dividends. The Company is therefore changing the accrual from $4.0 million to $13.4 million, the result of which will be to increase the Companys negative shareholder equity by the difference
between those two amounts, $9.4 million, by recording an additional $9.4 million charge to interest expense for the second quarter of 2006, resulting in a balance of $82.2 million (pro forma as of April 30, 2006) for the principal amount and
all accrued dividends on the Public Preferred Stock. This action is a change in accounting estimate as defined in SFAS 154, Accounting Changes and Error Corrections, which replaces APB No. 20, Accounting Changes and FASB
Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. The pro forma consolidated balance sheet as of April 30, 2006, and consolidated statement of operations for the period then ended are as follows:



|                            |  |                                   |          |   |                      |   |        |                                             |  |   |          |  
|--------------------------- |  | --------------------------------- | -------- | - | -------------------- | - | ------ | ------------------------------------------- |  | - | -------- | -
|                            |  | Unaudited April 30, 2006 Balances |          |   | Pro FormaAdjustments |   |        | Pro Forma Unaudited April 30, 2006 Balances | 
|Consolidated Balance Sheet  |  |                                   |          |   |                      |   |        |                                             |  |   |          |  
|Current assets              |  | $                                 | 31,583   |   |                      | $ |       |                                             |  | $ | 31,583   |  
|Property and equipment, net |  |                                   | 9,312    |   |                      |   |       |                                             |  |   | 9,312    |  
|Other assets                |  |                                   | 1,343    |   |                      |   |       |                                             |  |   | 1,343    |  
|Current liabilities         |  |                                   | 41,295   |   |                      |   |       |                                             |  |   | 41,295   |  
|Public preferred stock      |  |                                   | 72,741   |   |                      |   | 9,428  |                                             |  |   | 82,169   |  
|Accumulated deficit         |  |                                   | (106,543 | ) |                      |   | (9,428 | )                                           |  |   | (115,971 | )



|                                     |  |                                   |        |   |                      |   |        |                                             |  |   |         |  
|------------------------------------ |  | --------------------------------- | ------ | - | -------------------- | - | ------ | ------------------------------------------- |  | - | ------- | -
|                                     |  | Unaudited April 30, 2006 Balances |        |   | Pro FormaAdjustments |   |        | Pro Forma Unaudited April 30, 2006 Balances | 
|Consolidated Statement of Operations |  |                                   |        |   |                      |   |        |                                             |  |   |         |  
|Revenue                              |  | $                                 | 38,842 |   |                      | $ |       |                                             |  | $ | 38,842  |  
|Operating loss                       |  |                                   | (6,206 | ) |                      |   |       |                                             |  |   | (6,206  | )
|Interest expense                     |  |                                   | 2,825  |   |                      |   | 9,428  |                                             |  |   | 12,253  |  
|Loss before income taxes             |  |                                   | (9,031 | ) |                      |   | (9,428 | )                                           |  |   | (18,459 | )



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##### Table of Contents

Legal Proceedings

The Company is a party to the litigation set forth below.

SecureInfo

As previously reported in the Form 8-K on March 27, 2006 regarding the current status of litigation with SecureInfo Corporation (see Item 8.01
Other Events), the Company has entered into a settlement agreement with SecureInfo in which all parties dismissed, with prejudice, all pending claims, including the patent infringement counterclaim. As part of the settlement agreement, Telos agreed
to not pursue legal action for patent infringement against SecureInfo for a period of three years from the date of the agreement. In addition, the parties have entered into various business arrangements including software licensing agreements, an
Original Equipment Manufacturer (OEM) agreement and a reseller agreement. A joint stipulation of dismissal was filed on March 22, 2006 with the United States District Court for the Eastern District of Virginia.

Costa Brava

As previously reported, Costa Brava
Partnership III, L.P. (Costa Brava), a holder of the Companys Public Preferred Stock, filed a lawsuit in the Circuit Court of Baltimore City in the State of Maryland (Complaint) against the Company, its directors, and
certain of its officers. According to Amendment No. 6 to Schedule 13D filed by Costa Brava on October 18, 2005, Costa Brava owns 15.9% of the outstanding Public Preferred Stock.

On January 9, 2006, the Company filed a motion to dismiss the Complaint or, in the alternative, to stay the action until the Special Litigation
Committee had sufficient time to properly investigate and respond to Costa Bravas demands. On the same day, the Company officers and directors each filed a motion to dismiss for lack of personal jurisdiction and failure to state a claim. The
oral arguments were heard on February 28, 2006 before Judge Albert J. Matricciani, Jr.

On February 8, 2006, Wynnefield Small Cap
Value, L.P. (Wynnefield) filed a motion to intervene as a matter of right, and in the alternative at the discretion of the court. On February 23, 2006, Telos filed a motion to stay the intervention proceedings pending resolution of
its motion to dismiss. The judge issued the order to stay on February 27th.

On March 30, 2006, the court granted the
Companys motions in part and denied them in part. The motion to dismiss filed by the directors was granted with respect to Director Stewart, but denied in all other parts. The motion to dismiss filed by the officers was denied. In the motion
filed by the Company, the motion to dismiss was granted with respect to Costa Bravas demand for an appointment of a receiver to take charge of the Companys assets and operate the business. In addition, the court granted the motion to
dismiss the specific counts of the Complaint with respect to any derivative claims based on transactions or events that occurred prior to January 25, 2005, but denied the motion with respect to the derivative claims based on transactions or
events that occurred on or after January 25, 2005. The judge also denied the alternative request for a stay.

The Companys
answer to the complaint was filed on April 28, 2006.

On May 12, 2006, Telos opposed Wynnefields motion to intervene at a
hearing. On May 16, 2006, the court issued an order denying Wynnefields motion to intervene as a matter of right, but granted the motion on permissive grounds since Wynnefield is similarly situated with Costa Brava although their
interests are not identical.

On May 22, 2006, a status conference took place with all the parties before Judge Matricciani. The
trial date is currently set to begin on April 9, 2007.

On May 25, 2006, an Amended Order was entered by Judge Matricciani,
designating Wynnefield Partners as the Plaintiff with Costa Brava in the Lawsuit.



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##### Table of Contents

On May 26, 2006, Costa Brava and Wynnefield Partners filed a Motion for Preliminary Injunction
asking the Court to enjoin the Company from selling Xacta Corporation (Xacta) or any of the assets of Xacta, until the litigation is resolved on the merits. The opposition to the motion is due on June 26, 2006.

At this early stage of the litigation in which the jurisdiction and the parties have just been established, it is impossible to reasonably determine the
degree of probability related to Costa Bravas success in any of its assertions. Although there can be no assurance as to the ultimate outcome of this litigation, the Company and its officers and directors strenuously deny Costa Brava claims,
will vigorously defend the matter, and oppose the relief sought.

Other Litigation

In addition, the Company is a party to litigation arising in the ordinary course of business. In the opinion of management, while the results of such
litigation cannot be predicted with any reasonable degree of certainty, the final outcome of such known matters will not, based upon all available information, have a material adverse effect on the Companys consolidated financial position,
results of operations or cash flows.



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##### Table of Contents

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

Government oversight

As a U.S. Government contractor, the Company is subject to oversight by many agencies and entities of
the U.S. Government that may investigate and make inquiries of the Companys business practices and conduct audits of contract performance and cost accounting. Depending on the results of any such audits and investigations, the U. S. Government
may make claims against the Company. Under U.S. Government procurement regulations and practices, an indictment of a U.S. Government contractor could result in that contractor being fined and/or suspended for a period of time from eligibility for
bidding on, or for the award of, new U.S. Government contracts. A conviction could result in debarment for a specified period of time. To the best of managements knowledge, there are no pending investigations, inquiries, claims or audits
against the Company likely to have a material adverse effect on the Companys business or its consolidated results of operations, cash flows or financial position.

General



| |  |  | Xacta IA Manager: Used by many Federal Government Agencies and financial institutions, Xacta IA Manager is an industry leading security risk and compliance management software
application that Telos has been developing and enhancing for nearly seven years. Now in its fourth major release, numerous, largely user-request, enhancements have been made to the product since its original release in August 2000. In the first
quarter of 2006, the Company continued to invest in implementing user-requested enhancements to Xacta IA Manager. Some of these requested enhancements have been incorporated in a recent software release identified as Service Pack (SP) 5.
SP5 includes a wide range of enhancements to include such things as support for new Federal Information Security Management Act (FISMA) guidance. Also in the first quarter of 2006, the Company initiated work on SP6, an extensive and very
significant Xacta IA Manager upgrade that is scheduled for release in the third quarter of 2006. SP6 will consist of numerous enhancements to Xacta IA Manager to include a new graphical user interface that is intended to greatly improve the overall
user-experience. SP6 will also include extensive enhancements to the product architecture designed to improve the scalability and precision of the Xacta IA Manager Continuous Assessment software module.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Xacta Access Control List (ACL) Manager: In the first quarter of 2006, the Company identified a number of enhancements needed to make Xacta ACL Manager more
competitive in the market place. These enhancements have been provided to the software developer and appropriate software modifications are being made. The Company anticipates this work to result in a number of incremental upgrade releases between
now and the end of 2006.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Xacta Secure Wireless: In the first quarter of 2006, the Company began to develop new wireless solutions that leverage our ability to keep pace with the ever changing
technology associated with Wireless LANs (Local Area Networks). Specifically, the Company completed a Wireless LAN Solutions Module, and built the foundation for Air Force Generation 2 Wireless Solution. Further,
the Company initiated work on solutions that feature Blackberry Voice/Messaging, a Voice over Internet Protocol with hand sets, and finally a video surveillance solution.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Xacta Secure Messaging: Automated Message Handling System (AMHS) is the U.S. Governments exclusive certified stand-alone messaging application. The AMHS
stand-alone architecture is more efficient and cost effective than competitive client/server architectures as it enables users to access their messages securely from a single server using a simple web browser. AMHS provides numerous advanced message
management capabilities such as retrospective search and simplified user profiling, which functionality is essential to large organizations that have time-sensitive formal message requirements. This application has been successfully fielded to many
critical government organizations. AMHS has been selected by the U.S. Air Force, Army, and Navy and Marines (collectively, the U.S. Military Services) as their network-centric (NETCENTRIC) enterprise messaging capability.
AMHS has also been adopted by the U.S. Coast Guard and various other U.S. Government agencies and organizations. In the first quarter of 2006, the Company worked on a number of enhancements to AMHS that will enable it to operate in low-bandwidth
environments, support other message formats like United States Message Text Format (USMTF), and support industry-standard e-mail protocols (i.e., Simple Mail Transport Protocol). These enhanced capabilities will be released over the
coming year and should serve to further differentiate the Company from the competition and potentially provide access to new markets/opportunities.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

New Contract Vehicles: In the first quarter of 2006, the Company invested in getting Xacta IA
Manager, Xacta IA Consulting Services, and Xacta Secure Messaging solutions added to the GSA SmartBuy Enterprise Software Initiative (ESI) Blanket Purchase Agreement (BPA). SmartBuy is the latest enterprise software agreement that
the Federal Government has signed with its major suppliers. SmartBuy is a preferred vehicle for purchasing enterprise software solutions and supporting services because it provides for pre-negotiated discounts on such products and
services.

Backlog

The Companys
total backlog was $113.1 million and $89.2 million at March 31, 2006 and 2005, respectively. Backlog was $118.3 million at December 31, 2005. The total backlog of each of the segments at March 31, 2006 and 2005 was as follows: Managed
Solutions Group - $20.5 million and $8.7 million, respectively; and Xacta - $92.6 million and $80.5 million, respectively.

Such backlog
amounts include both funded backlog (unfilled firm orders for the Companys products for which funding has been both authorized and appropriated) and unfunded backlog (firm orders for which funding has not been appropriated). Funded backlog as
of March 31, 2006 and 2005 was $67.0 million and $80.0 million, respectively.



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##### Table of Contents

Consolidated Results of Operations

The Companys operating cycle involves many types of solution, product and service contracts with varying delivery schedules. Accordingly, results of a particular quarter, or quarter-to-quarter comparisons of
recorded sales and operating profits, may not be indicative of future operating results and the following comparative analysis should therefore be viewed in such context.

The condensed consolidated statements of operations include the results of Telos Corporation and its wholly owned subsidiaries. The Company budgeted EBITDA of $(3.0) million for the three months ended March 31,
2006, and excluding non-budgeted legal costs of $2.7 million, achieved $(2.8) million of EBITDA for the period. Subsequent to March 31, 2006, approximately $1.2 million of such legal costs have been reimbursed.

The principal element of the Companys operating expenses as a percentage of sales for the three months ended March 31, 2006 and 2005 are as
follows:



|                                |  |                             |    |  |       |   
|------------------------------- |  | --------------------------- | -- |  | ----- | --
|                                |  | Three Months EndedMarch 31, |   
|                                |  | 2006                        |    |  | 2005  |   
|Sales                           |  | 100.0                       | %  |  | 100.0 | % 
|Cost of sales                   |  | 82.1                        |    |  | 78.5  |   
|SG&A expenses                   |  | 41.4                        |    |  | 20.1  |   
|                                |  |                             |    |  |       |   
|Operating (loss) income         |  | (23.5                       | )  |  | 1.4   |   
|Other income                    |  |                            |    |  | 0.1   |   
|Losses from affiliate           |  | (0.4                        | )  |  |      |   
|Interest expense                |  | (8.4                        | )  |  | (6.1  | ) 
|                                |  |                             |    |  |       |   
|Loss before income taxes        |  | (32.3                       | )  |  | (4.6  | ) 
|Income tax expense              |  |                            |    |  |      |   
|                                |  |                             |    |  |       |   
|Loss from continuing operations |  | (32.3                       | )  |  | (4.6  | ) 
|Gain on sale of TCC             |  |                            |    |  | 2.8   |   
|                                |  |                             |    |  |       |   
|Net loss                        |  | (32.3                       | )% |  | (1.8  | )%
|                                |  |                             |    |  |       |   



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##### Table of Contents

Financial Data by Market Segment

Sales, gross profit, and gross margin by market segment for the periods designated below are as follows:



|                        |  |                             |        |   |      |   |        |  
|----------------------- |  | --------------------------- | ------ | - | ---- | - | ------ | -
|                        |  | Three Months EndedMarch 31, |       
|                        |  | 2006                        |        |   | 2005 |  
|Sales                   |  |                             |        |   |      |   |        |  
|Managed Solutions Group |  | $                           | 9,428  |   |      | $ | 13,349 |  
|Xacta                   |  |                             | 15,746 |   |      |   | 21,663 |  
|                        |  |                             |        |   |      |   |        |  
|Total                   |  | $                           | 25,174 |   |      | $ | 35,012 |  
|                        |  |                             |        |   |      |   |        |  
|Gross Profit            |  |                             |        |   |      |   |        |  
|Managed Solutions Group |  | $                           | 245    |   |      | $ | 2,109  |  
|Xacta                   |  |                             | 4,250  |   |      |   | 5,398  |  
|                        |  |                             |        |   |      |   |        |  
|Total                   |  | $                           | 4,495  |   |      | $ | 7,507  |  
|                        |  |                             |        |   |      |   |        |  
|Gross Margin            |  |                             |        |   |      |   |        |  
|Managed Solutions Group |  |                             | 2.6    | % |      |   | 15.8   | %
|Xacta                   |  |                             | 27.0   | % |      |   | 24.9   | %
|Total                   |  |                             | 17.9   | % |      |   | 21.4   | %

The Companys sales for the first quarter of 2006 were $25.2 million, a decrease of $9.8
million or 28.1% compared to the first quarter 2005 sales of $35.0 million. Such decrease consists of a $5.9 million decrease in sales from Xacta, primarily attributable to a decrease in Secure Wireless revenue from customer delays in
contracted site installations. The $3.9 million decrease in sales from Managed Solutions is primarily due to a large purchase under the ARISS (Army Recruiting Information Security System) laptop resale program in the first quarter of 2005 that the
Company does not expect to recur in the near term.

The Companys cost of sales for the first quarter of 2006 was $20.7 million, a
decrease of $6.8 million compared to the same period in 2005, due primarily to the decrease in sales.

The Companys gross profit for
the first quarter of 2006 decreased by $3.0 million to $4.5 million compared to the same period in 2005. Gross margin decreased to 17.9% from 21.4% in the comparable period in 2005, primarily attributable to higher margin on the ARISS laptop resale
program in the first quarter of 2005. The timing of the ARISS laptop resale program was also the primary cause for the decline in gross margin (from 20% to 10%) for products revenue, displayed on a nonsegmented basis on the face of the statements of
operations, between the three month periods ended March 31, 2005 and 2006. The gross margin for services revenue, displayed on a nonsegmented basis on the face of the statements of operations, remained relatively constant between the periods,
slightly declining from 24.0% to 23.3%.

The Companys selling, general, and administrative expense (SG&A) for the
first quarter of 2006 was $10.4 million, an increase of approximately $3.4 million or 48.1% compared to the same period in 2005, primarily due to $3.5 million of litigation expenses, as fully discussed in Note 6  Contingencies and Subsequent
Events.

The Companys operating loss for the first quarter of 2006 was $5.9 million, an increase of $6.4 million compared to $.5
million of operating income in the same period in 2005, primarily attributable to high margin on the ARISS laptop resale program in the first quarter of 2005, and litigation expenses in the first quarter of 2006, as explained above.

The Company recorded a full valuation allowance against its deferred tax assets as of March 31, 2005 and December 31, 2005. The Company
maintained its full valuation position during the quarter ended March 31, 2006.

The Companys net loss for the first quarter of
2006 was $8.2 million, an increase of $7.5 million compared to $.6 million net loss in the same period in 2005.



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##### Table of Contents

Liquidity and Capital Resources

In addition to the Companys common stock, the Companys capital structure consists of a revolving credit facility, subordinated notes, capital lease obligations, and redeemable preferred stock.

Senior Revolving Credit Facility

In April 2005,
the Company renewed, on amended terms, the $22.5 million Senior Revolving Credit Facility (as amended, the Facility) with Wells Fargo Foothill, Inc. (Wells Fargo Foothill) (formerly known as Foothill Capital Corporation) that
was originally scheduled to mature on October 21, 2005. The amended terms included, primarily a revolving line limit of $15 million with an interest rate of Wells Fargo prime rate plus 1%, and an extension of its maturity date to
October 21, 2008. Pursuant to the terms of the Facility, in lieu of having interest charged at the rate based on the Wells Fargo prime rate, the Company has the option to have interest on all or a portion of the advances on such Facility be
charged at a rate of interest based on the LIBOR Rate, plus 4%. Borrowings under the Facility are collateralized by substantially all of the Companys assets including inventory, equipment, and accounts receivable. The amount of available
borrowings fluctuates based on the underlying asset-borrowing base, as defined in the Facility agreement.

The Facility has various
covenants that may, among other things, affect the ability of the Company to merge with another entity, sell or transfer certain assets, pay dividends and make other distributions beyond certain limitations. The Facility also required the Company to
meet certain financial covenants, including tangible net worth and earnings before interest, taxes, depreciation and amortization (EBITDA), as defined in the Facility. Since the Facilitys inception, certain financial covenants have been
amended and restated to more accurately reflect the Companys performance. The financial covenants were amended and restated in August 2004, to eliminate the tangible net worth requirement.

At March 31, 2006, the Company was not in compliance with certain of its covenants pursuant to the Facility. Certain EBITDA covenants were not
achieved. Accordingly, as of June 20, 2006, the Company has obtained waivers for any such covenant violations, and the Company and Wells Fargo Foothill have agreed upon modified EBITDA covenants to more accurately reflect the Companys future
performance based upon revised projections. In addition, the Company and Wells Fargo Foothill have amended the Facility, to temporarily provide for a four-month over-advance in the amount of $3.0 million, the available balance of which declines over
the term, which ends July 31, 2006. Such over-advance is subject to certain additional covenants and reporting requirements, including a minimum sales requirement.

At March 31, 2006, the Company had outstanding borrowings of $7.4 million and unused borrowing availability of $3.0 million on the Facility. As of March 31, 2006, the interest rate on the Facility was 8.75%.

For the three months ended March 31, 2006, cash provided by continuing operating activities was $3.0 million. Cash used in investing
activities was approximately $.4 million. Cash used in financing activities was approximately $2.7 million.

Senior Subordinated Notes

The Companys Senior Subordinated Notes (Notes) totaled $5.2 million at March 31, 2006. The maturity date of such Notes has been
extended to October 31, 2008, with interest rates ranging from 14% to 17%, and paid quarterly on January 1, April 1, July 1, and October 1 of each year. In consideration for such extension, the Company agreed to
pay a one-time fee of 1%. During the first three months of 2006 and 2005, the Company paid $187,000 in interest to subordinated note holders. In addition, these notes have a cumulative prepayment premium of 13.5% per annum payable only upon
certain circumstances, which if in effect, would be approximately $15.2 million at March 31, 2006. See Note 3  Debt Obligations.



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##### Table of Contents

Redeemable Preferred Stock

The Company currently has two primary classes of redeemable preferred stock - Senior Redeemable Preferred Stock and Public Preferred Stock. Each class carries cumulative dividend rates of 12% to 14.125%. At
March 31, 2006, the total carrying amount of redeemable preferred stock, including accumulated and unpaid dividends was $81.0 million. The Company accrues dividends and provides for accretion related to the redeemable preferred stock. During
the first three months of 2006 and 2005, the Company recorded $1.1 million of dividends on the two classes of redeemable preferred stock.

Senior Redeemable Preferred Stock

Redemption for all shares of the Senior Redeemable Preferred Stock
plus all accrued dividends on those shares was scheduled, subject to limitations detailed below, on October 31, 2005. However, on April 14, 2005, Toxford Corporation, the holder of 72.6% of the Senior Redeemable Preferred Stock, extended
the maturity of its instruments to October 31, 2008. Among the limitations with regard to the scheduled redemptions of the Senior Redeemable Public Preferred Stock is the legal availability of funds, pursuant to Maryland law. Accordingly, due
to the Companys current financial position, it is precluded by Maryland law from making the scheduled payment. As the Senior Redeemable Preferred Stock is not due on demand, or callable, within twelve months from March 31, 2007, the
remaining 27.4% is also classified as noncurrent.

Public Preferred Stock

Redemption Provisions

Redemption for the Public
Preferred Stock is contractually scheduled from 2005 through 2009. Since 1991, the Company has not declared or paid any dividends on its Public Preferred Stock, based upon its interpretation of restrictions in its Articles of Amendment and
Restatement, limitations in the terms of the Public Preferred Stock instrument, specific dividend payment restrictions in the Facility entered into with Wells Fargo Foothill, and other senior obligations and limitations pursuant to Maryland law.
Pursuant to their terms, the Company is scheduled, but not required, to redeem the Public Preferred Stock in five annual tranches during the period 2005 through 2009. However, due to its substantial senior obligations, limitations set forth in the
covenants in the Facility, foreseeable capital and operational requirements, restrictions and prohibitions of its Articles of Amendment and Restatement, and provisions of Maryland law, and assuming sufficient liquidity to undertake any stock
redemption (which is presently unquantifiable), the Company believes the likelihood is that it will not be able to meet the redemption schedule set forth in the terms of the Public Preferred Stock instrument. Moreover, the Public Preferred Stock is
not payable on demand, nor callable, for failure to redeem the Public Preferred Stock in accordance with the redemption schedule set forth in the instrument. Therefore, the Company has classified these securities as noncurrent liabilities in the
balance sheet as of December 31, 2005 and March 31, 2006.

The Company and certain of its subsidiaries are parties to the
Facility agreement with Wells Fargo Foothill, whose term expires on October 21, 2008. Under the Facility, the Company agreed that, so long as any credit under the Facility is available and until full and final payment of the obligations under
the Facility, it would not make any distribution or declare or pay any dividends (other than common stock) on its stock, or purchase, acquire, or redeem any stock, or exchange any stock for indebtedness, or retire any stock. The Company continues to
actively rely upon the Facility and expects to continue to do so until the Facility agreement expires on October 21, 2008.

Accordingly, as stated above, the Company will continue to classify the entirety of its obligation to redeem the Public Preferred Stock as a long-term obligation. The Wells Fargo Foothill Facility prohibits, among other things, the
redemption of any stock, common or preferred, until October 21, 2008. The Public Preferred Stock by its terms cannot be redeemed if doing so would violate the terms of an agreement regarding the borrowing of funds or the extension of credit
which is binding upon the Company or any subsidiary of the Company, and it does not include any other provisions that would otherwise require any acceleration of the redemption of or amortization payments with respect to the Public Preferred Stock.
Thus, the Public Preferred Stock is not and will not be due on demand, nor callable, within twelve months from March 31, 2006. This classification is consistent with ARB No. 43 and FASB Statement No. 78 (FASB 78),
Classification of Obligations that are Callable by the Creditor.



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##### Table of Contents

Paragraph 7 of Chapter 3A of ARB No. 43 defines a current liability, as follows:

The term current liabilities is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing
resources properly classifiable as current assets, or the creation of other current liabilities. As a balance sheet category, the classification is intended to include obligations for items that have entered into the operating cycle, such as
payables incurred in the acquisition of materials and supplies to be used in the production of goods or in providing services to be offered for sale; collections received in advance of the delivery of goods or performance of services; and debts that
arise from operations directly related to the operating cycle, such as accruals for wages, salaries, commissions, rentals, royalties, and income and other taxes. Other liabilities whose regular and ordinary liquidation is expected to occur within a
relatively short period of time, usually 12 months, are also intended for inclusion, such as short-term debts arising from the acquisition of capital assets, serial maturities of long-term obligations, amounts required to be expended within 1 year
under sinking fund provisions, and agency obligations arising from the collection or acceptance of cash or other assets for the account of third persons.

Paragraph 5 of FASB 78, provides the following:

The current liability classification is also intended
to include obligations that, by their terms, are due on demand or will be due on demand within one year (or operating cycle, if longer) from the balance sheet date, even though liquidation may not be expected within that period. It is also intended
to include long-term obligations that are or will be callable by the creditor either because the debtors violation of a provision of the debt agreement at the balance sheet date makes the obligation callable or because the violation, if not
cured within a specified grace period, will make the obligation callable

If, pursuant to the terms of the Public Preferred
Stock, the Company does not redeem the Public Preferred Stock in accordance with the scheduled redemptions described above, the terms of the Public Preferred Stock require the Company to discharge its obligation to redeem the Public Preferred Stock
as soon as the Company is capable and permitted to do so. Therefore, by its very terms, the Public Preferred Stock is not due on demand or callable for failure to make a scheduled payment pursuant to its redemption provisions and is properly
classified as a noncurrent liability.

However, on any dividend payment date after November 21, 1991, the Company may exchange the
Public Preferred Stock, in whole or in part, for 12% Junior Subordinated Debentures that are redeemable upon terms substantially similar to the Public Preferred Stock and subordinated to all indebtedness for borrowed money and like obligations of
the Company.

Dividend Provisions

The
Public Preferred Stock accrues a semi-annual dividend at the annual rate of 12% ($1.20) per share, based on the liquidation preference of $10 per share and is fully cumulative. Dividends in additional shares of the Public Preferred Stock for 1990
and 1991 were paid at the rate of 6% of a share for each $.60 of such dividends not paid in cash. Dividends on the Public Preferred Stock are paid by the Company, when and if declared by the Board of Directors, and are required to be paid out of
legally available funds in accordance with Maryland law. For the cash dividends payable since December 1, 1995, the Company has accrued $41.1 million as of March 31, 2006 and $37.3 million as of March 31, 2005.

In accordance with SFAS 150, both the Senior Redeemable Preferred Stock and the Public Preferred Stock have been reclassified from equity to liability.
Consequently, for the three months ended March 31, 2006 and 2005, dividends totaling $1.0 million were accrued and reported as interest expense in the respective periods. Prior to the effective date of SFAS 150 on July 1, 2003, such
dividends were charged to stockholders accumulated deficit. The aggregate fair value of the public preferred stock at March 31, 2006 was $47.8 million.



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The carrying value of the accrued Paid-in-Kind (PIK) dividends on the Public Preferred Stock
for the period 1992 through June 1995 was $4.0 million. Had the Company accrued cash dividends on the outstanding shares of the Public Preferred Stock for this time period, the total amount accrued would have been $13.4 million. The Companys
Charter, Section 2(a) states, Any dividends payable with respect to the Exchangeable Preferred Stock (Public Preferred Stock) during the first six years after the Effective Date (November 20, 1989) may be paid (subject to
restrictions under applicable state law), in the sole discretion of the Board of Directors, in cash or by issuing additional full paid and nonassessable shares of Exchangeable Preferred Stock . Accordingly, the Board had the discretion
to pay the dividends for the referenced period in cash or by the issuance of additional shares of Public Preferred Stock. During the period in which the Company stated its intent to pay PIK dividends, the Company stated its intention to amend its
charter to permit the payment of these by the issuance of additional shares of Public Preferred Stock. In consequence, as required by applicable accounting requirements, the accrual for these dividends was recorded at the estimated fair value (as
the average of the ask and bid prices) on the dividend date of the shares of Public Preferred Stock that would have been (but were not) issued. This accrual was $9.4 million lower than the accrual would be, if the intent was only to pay the dividend
in cash, at that date or any later date.

In March 2006, the Company engaged Jefferies Quarterdeck, a nationally known investment bank, to
explore strategic alternatives with respect to it Xacta subsidiary or one or more lines of business of its Xacta subsidiary. The objective of the Company is, if such a process could yield sufficient cash proceeds, to use the proceeds to partially or
completely recapitalize its balance sheet. There can be no assurance as to the outcome of this process, or as to the time frame in which this process might be completed.

The Board concluded, in consequence of the commencement of this process by Jefferies Quarterdeck and the ability to pay cash dividends derived from a transaction or transactions sufficient to meet such obligation,
that the accrual of PIK dividends for the period 1992 through June 1995 was no longer appropriate. Since 1995, the Company has disclosed in the footnotes to its audited financial statements the carrying value of the accrued PIK dividends on the
Public Preferred Stock for the period 1992 through June 1995 was $4.0 million, and that had the Company accrued cash dividends during this time period, the total amount accrued would have been $13.4 million. The objective of the Company to utilize
the proceeds of this strategic process with respect to its Xacta subsidiary to partially or completely recapitalize its balance sheet, therefore, is inconsistent with any continued intent to pay a PIK dividend by the issuance of any additional
shares of Public Preferred Stock. Accordingly on May 12, 2006, the Board of Directors voted to confirm that the Companys intent with respect to the payment of dividends on the Public Preferred Stock for this period changed from its
previously stated intent to pay PIK dividends to that of an intent to pay cash dividends, although, as stated above, there can be no assurance whether or as to the time frame in which the strategic process with respect to the Companys Xacta
subsidiary might enable the Company to pay such dividends. The Company is therefore changing the accrual from $4.0 million to $13.4 million, the result of which will be to increase the Companys negative shareholder equity by the difference
between those two amounts, $9.4 million, by recording an additional $9.4 million charge to interest expense for the second quarter of 2006, resulting in a balance of $82.2 million (pro forma as of April 30, 2006) for the principal amount and
all accrued dividends on the Public Preferred Stock. This action is a change in accounting estimate as defined in SFAS 154, Accounting Changes and Error Corrections which replaces APB No. 20, Accounting Changes and FASB
Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. See pro forma disclosures at Note 6  Contingencies and Subsequent Events.



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Borrowing Capacity

At March 31, 2006, the Company had outstanding debt and long-term obligations of $103.3 million, consisting of $7.4 million under the Facility, $5.2 million in subordinated debt, $9.7 million in capital lease
obligations and $81.0 million in redeemable preferred stock classified as liability in accordance with FAS 150.

The Company budgeted
EBITDA of $(3.0) million for the three months ended March 31, 2006, and excluding non-budgeted legal costs of $2.7 million, achieved $(2.8) million of EBITDA for the period. Subsequent to March 31, 2006, approximately $1.2 million of such legal
costs have been reimbursed by the Companys insurers. Total expenses related to litigation were (exclusive of any such reimbursement) $3.5 million for the first quarter of 2006, and $4.1 million for the 12 months ending December 31, 2005. Such
extraordinary legal expenses have adversely affected cash flow.

The Company derives substantially all of its revenue from U.S. Government
contracting, and as such it is annually subject to the seasonality of the U.S. Government purchasing. As the U.S. Government fiscal year ends on September 30, it is not uncommon for U.S. Government agencies to award extra tasks in the weeks
immediately prior to the end of its fiscal year in order to avoid the loss of unexpended fiscal year funds. As a result of this cyclicality, the Company has historically experienced higher revenues in its third and fourth fiscal quarters, ending
September 30, and December 31, respectively, with the pace of orders substantially reduced during the January to June time period. During the three month period ending March 31, 2006, this seasonal reduction in orders and extraordinary litigation
expense, have combined to adversely affect the Companys EBITDA and cash flows. As the anticipated U.S. Government orders are realized during the third and fourth quarters of 2006, the Company, based upon current projected EBITDA, believes its
liquidity will improve during these periods. The Company further believes such projected improvements in its liquidity later in 2006 will be sufficient to generate adequate amounts of cash to meet the Companys needs for operating expenses,
debt service requirements, and planned capital expenditures for 2006.

The Company is actively working with its vendors, partners and
subcontractors to mitigate the effect of these cash flow constraints during this period. Additionally, as discussed in Note 3  Debt Obligations, the Company and Wells Fargo Foothill have amended the Senior Revolving Credit Facility to provide
the Company with a four-month over-advance in the amount of $3 million. There can be no assurances as to the continuing ability of the Company to successfully work with vendors, partners and subcontractors or Wells Fargo Foothill to mitigate these
current cash flow constraints.

These consolidated financial statements have been prepared on a going concern basis, which contemplates the
realization of assets and the satisfaction of liabilities in the normal course of business. As described in Note 3  Debt Obligations, the Company has obtained waivers and less restrictive cash flow covenants with respect to its Senior
Revolving Credit Facility. Although no assurances can be given, the Company expects that it will be in compliance throughout the term of the amended credit facility with respect to the financial and other covenants. Also, as more fully described in
Note 4  Redeemable Preferred Stock, the Company has engaged Jefferies Quarterdeck, a nationally known investment bank, to explore strategic alternatives for the sale of its Xacta subsidiary or one or more lines of business of its Xacta
subsidiary. The Company intends to vigorously pursue such a process, with the objective, if such a process could yield sufficient cash proceeds, of using the proceeds to partially or completely recapitalize its balance sheet, although, as stated
above, there can be no assurance whether, or as to the time frame in which, the strategic process with respect to the Companys Xacta subsidiary might enable the Company to retire its debt obligations and/or pay dividends and/or partially or
completely retire its redeemable preferred stock. While the Company intends to make every effort to successfully consummate such a transaction, including by assisting a proposed purchaser in obtaining necessary regulatory approvals, there can be no
certainty as to the timeframe of such process completion or the amount of proceeds that would be realized as a result of such transaction.

Contractual
Obligations and Off-Balance Sheet Arrangements

The following summarizes the Companys contractual obligations at March 31,
2006, both on and off balance sheet, and their anticipated impact upon the Companys liquidity and cash flow in future periods (in thousands):



|                                      |  |       |         |                        |   |            |  |             |         |               |   |       |  |   |      
|------------------------------------- |  | ----- | ------- | ---------------------- | - | ---------- |  | ----------- | ------- | ------------- | - | ----- |  | - | -----
|                                      |  |       |         | Payments due by Period
|                                      |  | Total |         | 2006                   |   | 2007 -2009 |  | 2010 - 2012 |         | 2013 andlater
|Long-term debt (1)                    |  | $     | 12,552  |                        | $ |           |  | $           | 12,552  |               | $ |      |  | $ |     
|Capital lease obligations (2)         |  |       | 18,191  |                        |   | 1,904      |  |             | 5,505   |               |   | 5,402 |  |   | 5,380
|Operating lease obligations (2)       |  |       | 2,261   |                        |   | 537        |  |             | 1,383   |               |   | 341   |  |   |     
|Senior preferred stock (3)            |  |       | 8,704   |                        |   |           |  |             | 8,704   |               |   |      |  |   |     
|Public preferred stock redemption (4) |  |       | 72,307  |                        |   |           |  |             | 72,307  |               |   |      |  |   |     
|                                      |  |       |         |                        |   |            |  |             |         |               |   |       |  |   |      
|Total                                 |  | $     | 114,015 |                        | $ | 2,441      |  | $           | 100,451 |               | $ | 5,743 |  | $ | 5,380
|                                      |  |       |         |                        |   |            |  |             |         |               |   |       |  |   |      

---

|(1) | Includes amounts due October 31, 2008, pursuant to senior credit facility and senior subordinated note agreements.
|--- | ------------------------------------------------------------------------------------------------------------------

|(2) | Includes total lease payments.
|--- | ------------------------------

|(3) | Includes dividends accrual of $6.0 million. See Note 4  Redeemable Preferred Stock.
|--- | ------------------------------------------------------------------------------------

|(4) | Includes dividends and accretion accrual of $63.5 million, payment of which presumes conditions precedent being satisfied. See Note 4  Redeemable Preferred Stock.
Additionally, as discussed in Note 6  Contingencies and Subsequent Events, additional dividends in the amount of $9.4 million will be recorded in the second quarter of 2006.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Recent Accounting Pronouncements

In June 2005, the FASB issued Statement No. 154, Accounting Changes and Error Corrections, which replaces APB Opinion No. 20, Accounting Changes and FASB Statement No. 3,
Reporting Accounting Changes in Interim Financial Statements. Statement No. 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new
accounting principle. Statement No. 154 also requires that a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for prospectively as a change in estimate, and correction of errors in previously issued
financial statements should be termed a restatement. Statement No. 154 is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005, and was adopted by the Company on
January 1, 2006. See disclosures under the Reclassifications and Restatements caption.

In December 2004, the FASB
issued Statement No. 153, Exchanges of Nonmonetary Assets - An Amendment of APB Opinion No. 29, which eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets that do not
culminate an earning process under APB Opinion No. 29, Accounting for Nonmonetary Transactions. Statement No. 153 requires that the measurement be based on the recorded amount of the assets relinquished for nonmonetary
exchanges that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. This standard is effective for nonmonetary
asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of this standard has not yet affected the Companys financial position or results of operations. The potential effect of Statement No. 153 in
future financial statements is currently being considered.

In November 2004, the FASB issued Statement No. 151, Inventory
Costs - an amendment of ARB No. 43, Chapter 4. Statement No. 151 clarifies the accounting guidance included in Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory Pricing related to
abnormal amounts of idle facility expense, freight, handling and spoilage costs. This statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of so abnormal, as specified
by ARB No. 43. In addition, this statement requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. Statement No. 151 is effective for inventory costs
incurred during fiscal years beginning after June 15, 2005. The adoption of this standard has not yet affected the Companys financial position or results of operations. The potential effect of Statement No. 151 in future financial
statements is currently being considered.

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements.
Without limiting the foregoing, the words believes, anticipates, plans, expects and similar expressions are intended to identify forward-looking statements. There are a number of important factors that
could cause the Companys actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth below under the caption Certain Factors That May Affect
Future Results.



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Certain Factors That May Affect Future Results

A number of uncertainties exist that could adversely affect the Companys future operating results, including, without limitation, general economic
conditions that may include the cost and continued availability of the Company to secure adequate capital and financing to support its business; the ability to attract and retain personnel; the impact of adverse economic conditions on the
Companys customers and suppliers; the ability to sell assets or to obtain alternative sources of commercially reasonable refinancing for the Companys debt; or the ability to successfully restructure the Company without costly and/or
extended litigation related to such restructuring. Additional uncertainties include the Companys ability to convert contract backlog to revenue, the success of the Companys investment in Enterworks and Xacta and the Companys access
to ongoing development, product support and viable channel partner relationships with its partners and suppliers.

While in the past the
Company has not experienced contract terminations with the U.S. Government, the U.S. Government can terminate at its convenience. Should such a termination occur the Companys operating results could be adversely impacted.

Due to heightened security awareness and the ongoing military and peacekeeping actions in Iraq and Afghanistan, all U.S. Government programs, especially
those pertaining to national security, have been subject to extensive review and reprioritization as evidenced by the Homeland Defense Act, and the continued funding requirements of the U.S. activities in Iraq and Afghanistan. While the Company
believes its products and services are well positioned to benefit from such reprioritization of U.S. Government demands, the magnitude of recent and prospective events pertaining to national security serves to emphasize how the Companys high
percentage of revenue derived from business with the U.S. Government could alternatively be dramatically, swiftly and adversely impacted.

In addition, as a high percentage of the Companys revenue is derived from business with the U.S. Government, the Companys operating results could also be adversely impacted should the U.S. Governments annual budget not be
approved in a timely fashion.

The Company has many patents and patents pending, trademarks and copyrights and other valuable proprietary
information and has taken reasonable and prudent steps to protect its intellectual property. With regard to the Companys wholly-owned subsidiary, Xacta, whose software products require constant monitoring as it develops future releases and
creates additional intellectual property, vigilant oversight of such intellectual property rights is imperative. All of the Companys propriety solutions require constant oversight with regard to the development and protection of their
respective intellectual property. Accordingly, any event that brings into question the Companys ownership of its intellectual property and propriety solutions could materially and adversely impact the Company.



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Item 3. Quantitative and Qualitative Disclosures about Market Risk

The Company is exposed to
interest rate volatility with regard to its variable rate debt obligations under its Senior Credit Facility. Effective April 2005, interest on the Facility is charged at 1% over the Wells Fargo prime rate (as of March 31, 2006 the
Wells Fargo prime rate was 7.75%), or 5.75%, whichever is higher. The effective average interest rates, including all bank fees, for the first three months of 2006 and 2005 were 9.9% and 9.4%, respectively. The Facility had an
outstanding balance of $7.4 million at March 31, 2006.

Item 4. Controls and Procedures

The Companys chief executive officer and chief
financial officer have evaluated the Companys disclosure controls and procedures (as defined in Rule 13a-15(e)) and Rule 15d-15(e) under the Exchange Act), as of March 31, 2006, and concluded that those disclosure controls and procedures
are effective in timely alerting them to any material changes in information required to be included in the Companys periodic Securities and Exchange Commission filings.

There were no changes in the Companys internal controls over financial reporting during the last fiscal quarter that have materially affected, or
are reasonably likely to materially affect, the Companys internal control over financial reporting.

The Company intends to continue
its diligent review and evaluation of the design and effectiveness of the controls, with the intention of continuous improvements to such controls, and to correct in a timely manner any significant deficiencies and material weaknesses that may be
discovered. The Companys goal is to provide senior management with detailed information and timely access to all material information concerning the business. While the Company believes the present design of its disclosure controls and
procedures effectively achieves its objectives, additional regulatory requirements, such as Sarbanes-Oxley Section 404 - Management Assessment of Internal Controls, scheduled for implementation by the Company by December 2007, and future
unforeseen events may cause the Company to significantly modify such disclosure controls and procedures.



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PART IIOTHER INFORMATION

Item 1. Legal Proceedings

The Company is a party to the litigation set forth below.

SecureInfo

As previously reported in the Form 8-K on
March 27, 2006 regarding the current status of litigation with SecureInfo Corporation (see Item 8.01 Other Events), the Company has entered into a settlement agreement with SecureInfo in which all parties dismissed, with prejudice, all
pending claims, including the patent infringement counterclaim. As part of the settlement agreement, Telos agreed to not pursue legal action for patent infringement against SecureInfo for a period of three years from the date of the agreement. In
addition, the parties have entered into various business arrangements including software licensing agreements, an Original Equipment Manufacturer (OEM) agreement and a reseller agreement. A joint stipulation of dismissal was filed on March 22,
2006 with the United States District Court for the Eastern District of Virginia.

Costa Brava

As previously reported, Costa Brava Partnership III, L.P. (Costa Brava), a holder of the Companys Public Preferred Stock, filed a
lawsuit in the Circuit Court of Baltimore City in the State of Maryland (Complaint) against the Company, its directors, and certain of its officers. According to Amendment No. 6 to Schedule 13D filed by Costa Brava on
October 18, 2005, Costa Brava owns 15.9% of the outstanding Public Preferred Stock.

On January 9, 2006, the Company filed a
motion to dismiss the Complaint or, in the alternative, to stay the action until the Special Litigation Committee had sufficient time to properly investigate and respond to Costa Bravas demands. On the same day, the Company officers and
directors each filed a motion to dismiss for lack of personal jurisdiction and failure to state a claim. The oral arguments were heard on February 28, 2006 before Judge Albert J. Matricciani, Jr.

On February 8, 2006, Wynnefield Small Cap Value, L.P. (Wynnefield) filed a motion to intervene as a matter of right, and in the
alternative at the discretion of the court. On February 23, 2006, Telos filed a motion to stay the intervention proceedings pending resolution of its motion to dismiss. The judge issued the order to stay on February 27th.

On March 30, 2006, the court granted the Companys motions in part and denied them in part. The motion to dismiss filed by the directors was
granted with respect to Director Stewart, but denied in all other parts. The motion to dismiss filed by the officers was denied. In the motion filed by the Company, the motion to dismiss was granted with respect to Costa Bravas demand for an
appointment of a receiver to take charge of the Companys assets and operate the business. In addition, the court granted the motion to dismiss the specific counts of the Complaint with respect to any derivative claims based on transactions or
events that occurred prior to January 25, 2005, but denied the motion with respect to the derivative claims based on transactions or events that occurred on or after January 25, 2005. The judge also denied the alternative request for a
stay.

The Companys answer to the complaint was filed on April 28, 2006.

On May 12, 2006, Telos opposed Wynnefields motion to intervene at a hearing. On May 16, 2006, the court issued an order denying
Wynnefields motion to intervene as a matter of right, but granted the motion on permissive grounds since Wynnefield is similarly situated with Costa Brava although their interests are not identical.

On May 22, 2006, a status conference took place with all the parties before Judge Matricciani. The trial date is currently set to begin on
April 9, 2007.

On May 25, 2006, an Amended Order was entered by Judge Matricciani, designating Wynnefield Partners as the
Plaintiff with Costa Brava in the Lawsuit.



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On May 26, 2006, Costa Brava and Wynnefield Partners filed a Motion for Preliminary Injunction
asking the Court to enjoin the Company from selling Xacta Corporation (Xacta) or any of the assets of Xacta, until the litigation is resolved on the merits. The opposition to the motion is due on June 26, 2006.

At this early stage of the litigation in which the jurisdiction and the parties have just been established, it is impossible to reasonably determine the
degree of probability related to Costa Bravas success in any of its assertions. Although there can be no assurance as to the ultimate outcome of this litigation, the Company and its officers and directors strenuously deny Costa Brava claims,
will vigorously defend the matter, and oppose the relief sought.

Other Litigation

In addition, the Company is a party to litigation arising in the ordinary course of business. In the opinion of management, while the results of such
litigation cannot be predicted with any reasonable degree of certainty, the final outcome of such known matters will not, based upon all available information, have a material adverse effect on the Companys consolidated financial position,
results of operations or cash flows.

Item 1A. Risk Factors

In addition to other information in this Form 10-Q, the following risk factors should be carefully
considered in evaluating the Company and its business because these factors currently have a significant impact or may have a significant impact on the Companys business, operating results or financial condition. Actual results could differ
materially from those projected in the forward-looking statements contained in this Form 10-Q as a result of the risk factors discussed below and elsewhere in this Form 10-Q.

The Companys ability to maintain sufficient liquidity and access to capital markets, including the ability to successfully restructure its balance sheet may have a significant impact on its business. The
Company derives substantially all of its revenue from U.S. Government contracting, and as such it is annually subject to the seasonality of the U.S. Government purchasing. As the U.S. Government fiscal year ends on September 30, it is not uncommon
for U.S. Government agencies to award extra tasks in the weeks immediately prior to the end of its fiscal year in order to avoid the loss of unexpended fiscal year funds. As a result of this cyclicality, the Company has historically experienced
higher revenues in its third and fourth fiscal quarters, ending September 30, and December 31, respectively, with the pace of orders substantially reduced during the January to June time period. During the three month period ending March 31, 2006,
this seasonal reduction in orders and extraordinary litigation expense, have combined to adversely affect the Companys EBITDA and cash flows. As the anticipated U.S. Government orders are realized during the third and fourth quarters of 2006,
the Company, based upon current projected EBITDA, believes its liquidity will improve during these periods. The Company further believes such projected improvements in its liquidity later in 2006 will be sufficient to generate adequate amounts of
cash to meet the Companys needs for operating expenses, debt service requirements, and planned capital expenditures for 2006.

The Company is
actively working with its vendors, partners and subcontractors to mitigate the effect of these cash flow constraints during this period. Additionally, as discussed in Note 3  Debt Obligations, the Company and Wells Fargo Foothill have amended
the Senior Revolving Credit Facility to provide the Company with a four-month over-advance in the amount of $3 million. There can be no assurances as to the continuing ability of the Company to successfully work with vendors, partners and
subcontractors or Wells Fargo Foothill to mitigate these current cash flow constraints.

These consolidated financial statements have been prepared on a
going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As described in Note 3  Debt Obligations, the Company has obtained waivers and less restrictive cash flow
covenants with respect to its Senior Revolving Credit Facility. Although no assurances can be given, the Company expects that it will be in compliance throughout the term of the amended credit facility with respect to the financial and other
covenants. Also, as more fully described in Note 4  Redeemable Preferred Stock, the Company has engaged Jefferies Quarterdeck, a nationally known investment bank, to explore strategic alternatives for the sale of its Xacta subsidiary or one or
more lines of business of its Xacta subsidiary. The Company intends to vigorously pursue such a process, with the objective, if such a process could yield sufficient cash proceeds, of using the proceeds to partially or completely recapitalize its
balance sheet, although, as stated above, there can be no assurance whether, or as to the time frame in which, the strategic process with respect to the Companys Xacta subsidiary might enable the Company to retire its debt obligations and/or
pay dividends and/or partially or completely retire its redeemable preferred stock. While the Company intends to make every effort to successfully consummate such a transaction, including by assisting a proposed purchaser in obtaining necessary
regulatory approvals, there can be no certainty as to the timeframe of such process completion or the amount of proceeds that would be realized as a result of such transaction.

The Company depends on the U.S. Government for a significant portion of its sales. The Companys sales are highly concentrated with the U.S. Government. The customer relationship with the U.S. Government
involves certain risks that are unique. In each of the past three years, approximately 96 percent of the Companys net sales were to the U.S. Government. U.S. defense spending has historically been cyclical. Defense budgets have received their
strongest support when perceived threats to national security raise the level of concern over the countrys safety. As these threats subside, spending on the military tends to decrease. Accordingly, while Department of Defense funding has grown
rapidly over the past few years, there is no assurance that this trend will continue. Rising budget deficits, the cost of the Global War on Terrorism and increasing costs for domestic programs continue to put pressure on all areas of discretionary
spending, which could ultimately impact the defense budget. Wartime support for defense spending could wane if the countrys troop deployments in support of operations in Iraq and Afghanistan are reduced. A decrease in U.S. Government defense
spending or changes in spending allocation could result in one or more of the Companys programs being reduced, delayed or terminated. Reductions in the Companys existing programs, unless offset by other programs and opportunities, could
adversely affect its ability to sustain and grow its future sales and earnings.



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U.S. Government contracts generally are not fully funded at inception and are subject to termination. The
Companys U.S. Government sales are funded by customer budgets, which operate on an October-to-September fiscal year. In February of each year, the President of the United States presents to the Congress the budget for the upcoming fiscal year.
This budget proposes funding levels for every federal agency and is the result of months of policy and program reviews throughout the Executive branch. From February through September of each year, the appropriations and authorization committees of
Congress review the Presidents budget proposals and establish the funding levels for the upcoming fiscal year in appropriations and authorization legislation. Once these levels are enacted into law, the Executive Office of the President
administers the funds to the agencies. There are two primary risks associated with this process. First, the process may be delayed or disrupted. Changes in congressional schedules, negotiations for program funding levels or unforeseen world events
can interrupt the funding for a program or contract. Second, funds for multi-year contracts can be changed in subsequent years in the appropriations process. In addition, the U.S. Government has increasingly relied on indefinite delivery, indefinite
quantity (IDIQ) contracts and other procurement vehicles that are subject to a competitive bidding and funding process even after the award of the basic contract, adding an additional element of uncertainty to future funding levels.
Delays in the funding process or changes in funding can impact the timing of available funds or can lead to changes in program content or termination at the governments convenience. The loss of anticipated funding or the termination of
multiple or large programs could have an adverse effect on the Companys future sales and earnings.

Government oversight.As a U.S. Government
contractor, the Company is subject to oversight by many agencies and entities of the U.S. Government that may investigate and make inquiries of the Companys business practices and conduct audits of contract performance and cost accounting.
Depending on the results of any such audits and investigations, the U. S. Government may make claims against the Company. Under U.S. Government procurement regulations and practices, an indictment of a U.S. Government contractor could result in that
contractor being fined and/or suspended for a period of time from eligibility for bidding on, or for the award of, new U.S. Government contracts. A conviction could result in debarment for a specified period of time. To the best of managements
knowledge, there are no pending investigations, inquiries, claims or audits against the Company likely to have a material adverse effect on the Companys business or its consolidated results of operations, cash flows or financial position.

The Companys earnings and margins depend on its ability to perform under its contracts. The Companys contracts require management to
make various assumptions and projections about the outcome of future events over a period of several years. These projections can include future labor productivity and availability, the nature and complexity of the work to be performed, the cost and
availability of materials, the impact of delayed performance, and the timing of product deliveries. If there is a significant change in one or more of these assumptions, circumstances or estimates, or if the Company is unable to control the costs
incurred in performing under these contracts, the profitability of one or more of these contracts may be adversely affected.

The Companys
earnings and margins depend on subcontractor performance and raw material and component availability and pricing.The Company relies on subcontractors and other companies to provide raw materials, major components and subsystems for its products
or to perform a portion of the services that the Company provides to its customers. Occasionally, the Company relies on only one or two sources of supply, which, if disrupted, could have an adverse effect on the Companys ability to meet its
commitments to customers. The Company depends on these subcontractors and vendors to fulfill their contractual obligations in a timely and satisfactory manner in full compliance with customer requirements. If one or more of the Companys
subcontractors or suppliers is unable to satisfactorily provide on a timely basis the agreed-upon supplies or perform the agreed-upon services, the Companys ability to perform its obligations as a prime contractor may be adversely affected.

The Companys future success will depend, in part, on its ability to develop new technologies and maintain a qualified workforce to meet the needs
of its customers.Virtually all of the products produced and sold by the Company are highly engineered and require sophisticated manufacturing and system integration techniques and capabilities. Both the government and commercial markets in
which the Company operates are characterized by rapidly changing technologies. The product and program needs of the Companys government and commercial customers change and evolve regularly. Accordingly, the Companys future performance in
part depends on its ability to identify emerging technological trends, develop and manufacture competitive products, and bring those products to market quickly at cost-effective prices. In addition, because of the highly specialized nature of its
business, the Company must be able to hire and retain the skilled and appropriately qualified personnel necessary to perform the services required by the Companys customers. If the Company is unable to develop new products that meet
customers changing needs or successfully attract and retain qualified personnel, future sales and earnings may be adversely affected.



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Developing new technologies entails significant risks and uncertainties that may not be covered by indemnity or
insurance.While the Company maintains insurance for some business risks, it is not possible to obtain coverage to protect against all operational risks and liabilities. The Company generally seeks indemnification where the U.S. Government is
permitted to extend indemnification under applicable law.

Operating results may fluctuate and future revenues and profitability are uncertain.

The Companys operating results have varied and may fluctuate significantly in the future as a result of a variety of factors, many of which are
outside its control. These factors include the following:



| |  |  | the long sales and implementation cycles for, and potentially large order sizes of, some of the Companys security solutions and the timing and execution of individual customer
contracts;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the mix of all products and services sold during a period;
| | - |  | ----------------------------------------------------------



| |  |  | success in marketing and market acceptance of the Companys solutions by existing customers and by new customers;
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | changes in marketing expenses related to promoting and distributing the Companys products and services;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | customer renewal rates and turnover of customers of the Companys services;
| | - |  | ---------------------------------------------------------------------------



| |  |  | continued development of the Companys direct and indirect distribution channels for our security solutions both in the U.S. and abroad;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in the level of spending for security and information technology-related products and services by enterprise customers;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in the level of spending for security and information technology-related products and services by enterprise customers;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------



| |  |  | the impact of price changes in the Companys security services or competitors products and services; and
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | general economic and market conditions as well as economic and market conditions specific to the security and information technology industries.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------

Operating results may be adversely affected by the uncertain geopolitical environment and unfavorable economic and market conditions.

Adverse economic conditions worldwide have contributed to downturns in the information technology industry in the past and could impact the Companys business in the
future, resulting in:



| |  |  | reduced demand for the Companys products and services as a result of a decrease in spending by our customers;
| | - |  | --------------------------------------------------------------------------------------------------------------



| |  |  | increased price competition for the Companys products and services; and
| | - |  | ------------------------------------------------------------------------



| |  |  | higher overhead costs as a percentage of revenues.
| | - |  | --------------------------------------------------

Recent political
turmoil in many parts of the world, including terrorist and military actions, may continue to put pressure on global economic conditions. If the economic and market conditions in the United States and globally do not continue to improve, or if they
deteriorate, the Company may experience material adverse impacts on our business, operating results, and financial condition as a consequence of the above factors or otherwise. To address these risks the Company must, among other things:



| |  |  | successfully market our services to new and existing customers;
| | - |  | ---------------------------------------------------------------



| |  |  | attract, integrate, train, retain and motivate qualified personnel;
| | - |  | -------------------------------------------------------------------



| |  |  | respond to competitive developments;
| | - |  | ------------------------------------



| |  |  | successfully introduce new products and services; and
| | - |  | -----------------------------------------------------



| |  |  | successfully introduce enhancements to our products and services to address new technologies and standards and changing market conditions
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------

The business environment is highly competitive and, if we do not compete effectively, we may suffer price reductions, reduced gross margins and loss of market share.

Some of the Companys security solutions have lengthy sales and implementation cycles.

The Company markets the majority of its security solutions directly to government customers. The sale and implementation of our services to these entities typically
involves a lengthy education process and a significant technical evaluation and commitment of capital and other resources. This process is also subject to the risk of delays associated with customers internal budgeting and other procedures for
approving large capital expenditures, deploying new technologies within their networks and testing and accepting new technologies that affect key operations. As a result, the sales and implementation cycles associated with certain of the
Companys services can be lengthy, potentially lasting from three to nine months. The Companys quarterly and annual operating results could be materially harmed if orders forecasted for a specific customer for a particular quarter are not
realized.



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The Company relies on its intellectual property, and any failure to protect, or any misappropriation of, its
intellectual property could harm its business.

The Companys success depends on its internally developed technologies, patents and other
intellectual property. Despite its precautions, it may be possible for a third party to copy or otherwise obtain and use the Companys trade secrets or other forms of our intellectual property without authorization. Furthermore, the laws of
foreign countries may not protect the Companys proprietary rights in those countries to the same extent U.S. law protects these rights in the United States. In addition, it is possible that others may independently develop substantially
equivalent intellectual property. If the Company does not effectively protect its intellectual property, its business could suffer. In the future, the Company may have to resort to litigation to enforce its intellectual property rights, to protect
its trade secrets or to determine the validity and scope of the proprietary rights of others. This type of litigation, regardless of its outcome, could result in substantial costs and diversion of management and technical resources.

The Company also licenses third-party technology that is used in its products and services to perform key functions. These

third-party technology licenses may not continue to be available on commercially reasonable terms or at all. The Companys business could suffer if it lost the
rights to use these technologies. A third-party could claim that the licensed software infringes a patent or other proprietary right. Litigation between the licensor and a third-party or between the Company and a third-party could lead to royalty
obligations for which the Company is not indemnified or for which indemnification is insufficient, or the Company may not be able to obtain any additional license on commercially reasonable terms or at all. The loss of, or the Companys
inability to obtain or maintain, any of these technology licenses could delay the introduction of new products or services until equivalent technology, if available, is identified, licensed and integrated. This could harm the Companys
business.

The Company could become subject to claims of infringement of intellectual property of others, which could be costly to defend and which
could harm our business.

Claims relating to infringement of intellectual property of others or other similar claims have been made against the Company
in the past and could be made against it in the future. Any claims, with or without merit, could be time-consuming, result in costly litigation and diversion of technical and management personnel, cause delays or require the Company to develop
non-infringing technology or enter into royalty or licensing agreements. Royalty or licensing agreements, if required, may not be available on acceptable terms or at all. If a successful claim of infringement were made against the Company, it could
be required to pay damages or have portions of its business enjoined. If the Company could not develop non-infringing technology or license the infringed or similar technology on a timely and cost-effective basis, the Companys business could
be harmed.

The Company depends on key personnel to manage its business effectively and may not be successful in attracting and retaining such
personnel.

The Company depends on the performance of its senior management team and other key employees. The Companys success also depends on its
ability to attract, integrate, train, retain and motivate these individuals and additional highly skilled technical and sales and marketing personnel. In addition, the Companys stringent hiring practices for its personnel, which consist of
background checks into prospective employees criminal and financial histories, further limit the number of qualified persons for these positions. The Company has no employment agreements with any of its key executives that prevent them from
leaving the Company at any time. The loss of the services of any of the Companys senior management team or other key employees or failure to attract, integrate, train, retain and motivate additional key employees could harm its business.

Compliance with rules and regulations concerning corporate governance is costly and could harm the Companys business.

The Sarbanes-Oxley Act mandates, among other things, that companies adopt new corporate governance measures and imposes comprehensive reporting and disclosure
requirements, sets stricter independence and financial expertise standards for audit committee members and imposes increased civil and criminal penalties for companies, their Chief Executive Officers and Chief Financial Officers and Directors for
securities law violations. For example, Section 404 of the Sarbanes-Oxley Act requires companies to do a comprehensive and costly evaluation of their internal controls. These laws, rules and regulations have increased the scope, complexity and
cost of our corporate governance, reporting and disclosure practices, and our compliance efforts have required significant management attention. It has become more difficult and more expensive for the Company to obtain director and officer liability
insurance. Further, Board members, the Chief Executive Officer and the Chief Financial Officer could face an increased risk of personal liability in connection with the performance of their duties. As a result, the Company may have difficulty
attracting and retaining qualified Board members and executive officers, which could harm its business.



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Any potential future acquisitions, strategic investments, divestitures or mergers may subject the Company to
significant risks, any of which could harm the Companys business.

The Companys long-term strategy may include identifying and acquiring,
investing in or merging with suitable candidates on acceptable terms or divesting from certain business lines or activities. In particular, over time, the Company may acquire, make investments in, or merge with providers of product offerings that
complement its business or divest from activities. Mergers, acquisitions, and divestitures include a number of risks and present financial, managerial and operational challenges, including:



| |  |  | diversion of management attention from running its existing business;
| | - |  | ---------------------------------------------------------------------



| |  |  | possible additional material weaknesses in internal control over financial reporting;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | increased expenses including legal, administrative and compensation expenses related to newly hired or terminated employees;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  |  | increased costs to integrate the technology, personnel, customer base and business practices of the acquired company with the Company;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------



| |  |  | potential exposure to material liabilities not discovered in the due diligence process;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | potential adverse effects on reported operating results due to possible write-down of goodwill and other intangible assets associated with acquisitions; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | acquisition financing may not be available on reasonable terms or at all.
| | - |  | -------------------------------------------------------------------------

Any acquired business, technology, service or product could significantly under-perform relative to the Companys expectations, and may not achieve the benefits we expect from possible acquisitions. For all these reasons, the
Companys pursuit of an acquisition, investment, divestiture, or merger could cause our actual results to differ materially from those anticipated.



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##### Table of Contents

Item 3. Defaults upon Senior Securities

Senior Redeemable Preferred Stock

The Company has not declared dividends on its Senior Redeemable Preferred Stock, Series A-1 and A-2, since issuance. At March 31, 2006, total
undeclared unpaid dividends accrued for financial reporting purposes are $5.7 million for the Series A-1 and A-2 Preferred Stock. The Company was required to redeem all shares and accrued dividends outstanding on October 31, 2005. However, on
April 14, 2005, Toxford Corporation, the holder of 72.6% of the Senior Redeemable Preferred Stock, extended the maturity of its instruments to October 31, 2008. Subject to limitations set forth below, the Company was scheduled to redeem
27.4% of the outstanding shares and accrued dividends outstanding on October 31, 2005. Among the limitations with regard to the mandatory redemptions of the Senior Redeemable Public Preferred Stock is the legal availability of funds, pursuant
to Maryland law. Accordingly, due to the Companys current financial position, it is precluded by Maryland law from making the scheduled payment.

12% Cumulative Exchangeable Redeemable Preferred Stock

Through November 21, 1995, the Company had the option to pay
dividends in additional shares of Preferred Stock in lieu of cash (provided there were no restrictions on payment as further discussed below). As more fully explained in the next paragraph, dividends are payable by the Company, provided that the
Company has legally available funds under Maryland law and is able to pay dividends under its charter and other senior financing documents, when and if declared by the Board of Directors, commencing June 1, 1990, and on each six month
anniversary thereof. Dividends in additional shares of the Preferred Stock for 1990 and 1991 were paid at the rate of 6% of a share for each $.60 of such dividends not paid in cash. Dividends for the years 1992 through 1994, and for the dividend
payable June 1, 1995, were accrued under the assumption that such dividend would be paid in additional shares of preferred stock and were valued at $4.0 million. Had the Company accrued these dividends on a cash basis, the total amount accrued
would have been $13.4 million, and, as more fully disclosed in Note 6  Contingencies and Subsequent Events, the Company accrued an additional $9.4 million in interest expense in the second quarter of 2006. For the cash dividends payable since
December 1, 1995, the Company has accrued $42.6 million as of March 31, 2006.

Since 1991, the Company has not declared or paid
any dividends on its Public Preferred Stock, based upon its interpretation of restrictions in its Articles of Amendment and Restatement, limitations in the terms of the Public Preferred Stock instrument, specific dividend payment restrictions in the
Facility entered into with Wells Fargo Foothill, to which the Public Preferred Stock is subject, and other senior obligations, and limitations pursuant to Maryland law. Pursuant to their terms, the Company is scheduled to redeem the Public Preferred
Stock in five annual tranches during the period 2005 through 2009. However, due to its substantial senior obligations, limitations set forth in the covenants in the Facility, foreseeable capital and operational requirements, restrictions and
prohibitions of its Articles of Amendment and Restatement, and provisions of Maryland law, the Company did not make the first scheduled redemption payment, and assuming insufficient liquidity to undertake any stock redemption (which is presently
unquantifiable), the Company believes that the likelihood is that it will not be able to make the remaining four scheduled redemption payments as set forth in the terms of the Public Preferred Stock. Accordingly, the Public Preferred Stock is not
payable on demand, nor callable, for failure to redeem the Public Preferred Stock in accordance with the redemption schedule set forth in the instrument. The Company has therefore classified these securities as noncurrent liabilities on the balance
sheet as of March 31, 2006 and December 31, 2005, and throughout all of 2005.



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Item 6. Exhibits



|               |  |                                                                                                                                                                                             
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description of Exhibit                                                                                                                                                                      
|3.1            |  | Articles of Amendment and Restatement of the Company, dated January 14, 1992. (Incorporated by reference to Exhibit 4 to the Companys Form 8-K filed on January 29,
1992)                  
|               | 
|3.2            |  | Amended and Restated Bylaws of the Company, as amended on March 8, 2000 (Incorporated by reference to Exhibit 10.104 to the Companys Form 10-K report for the year ended December 31,
2005)
|               | 
|10.105*        |  | Waiver and Tenth Amendment to Loan and Security Agreement between Telos Corporation, a Maryland corporation, and Wells Fargo Foothill, Inc.                                                 
|               | 
|31.1*          |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                          
|               | 
|31.2*          |  | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                          
|               | 
|32*            |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                      

---

|* | filed herewith
|- | --------------

Part II items 2, 4 and 5 are not applicable and have
been omitted.



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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                    |  |  |  |                                     
|------------------- |  |  |  | ------------------------------------
|Date: June 22, 2006 |  |  |  | TELOS CORPORATION                   
|                    |  | 
|                    |  |  |  | /s/ John B. Wood                    
|                    |  |  |  | John B. Wood Chief Executive Officer



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