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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: September 30, 2004



| ̈ | 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 of Incorporation)                 |  | (I.R.S. Employer Identification No.)
|                                         | 
|19886 Ashburn Road, Ashburn, Virginia    |  | 20147-2358                          
|(Address of principal executive offices) |  | (Zip Code)                          



Registrants
Telephone Number,

including area code: (703) 724-3800



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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  x    NO ̈



|                                                                       |  |                                                   
|---------------------------------------------------------------------- |  | --------------------------------------------------
|Title of Class                                                         |  | Number of Shares Outstanding on September 30, 2004
|Class A Common Stock, no par value                                     |  | 21,171,202                                        
|Class B Common Stock, no par value                                     |  | 4,037,628                                         
|Series A-1 Redeemable Preferred Stock, $.01 par value                  |  | 1,250                                             
|Series A-2 Redeemable Preferred Stock, $.01 par value                  |  | 1,750                                             
|12% Cumulative Exchangeable Redeemable Preferred Stock, $.01 par value |  | 3,185,586                                         



The registrants 12 % Cumulative
Exchangeable Redeemable Preferred Stock is traded on the NASDAQ/OTCBB Exchange (TLSRP).



Number of pages in this report (excluding exhibits): 28



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##### Table of Contents

TELOS CORPORATION AND SUBSIDIARIES



INDEX



|          |  |                                                                                                                             |  |      
|--------- |  | --------------------------------------------------------------------------------------------------------------------------- |  | -----
|          |  |                                                                                                                             |  | Page 
|          |  | PART I. FINANCIAL INFORMATION                                                                                               |  |      
|          |  |                                                                                                                            
|Item 1.   |  | Financial Statements:                                                                                                       |  |      
|          |  |                                                                                                                            
|          |  | Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2004 and 2003 (unaudited) |  | 3    
|          |  | Condensed Consolidated Balance Sheets as of September 30, 2004 (unaudited) and December 31, 2003                            |  | 4-5  
|          |  | Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003 (unaudited)           |  | 6    
|          |  | Notes to Condensed Consolidated Financial Statements (unaudited)                                                            |  | 7-16 
|          |  |                                                                                                                            
|Item 2.   |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                       |  | 17-24
|          |  |                                                                                                                            
|Item 3.   |  | Quantitative and Qualitative Disclosures about Market Risk                                                                  |  | 25   
|          |  |                                                                                                                            
|Item 4.   |  | Controls and Procedures                                                                                                     |  | 25   
|          |  |                                                                                                                            
|          |  | PART II. OTHER INFORMATION                                                                                                  |  |      
|          |  |                                                                                                                            
|Item 1.   |  | Legal Proceedings                                                                                                           |  | 26   
|          |  |                                                                                                                            
|Item 3.   |  | Defaults upon Senior Securities                                                                                             |  | 26   
|          |  |                                                                                                                            
|Item 6.   |  | Exhibits and Reports on Form 8-K                                                                                            |  | 27   
|          | 
|SIGNATURE |  | 28                                                                                                                         



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PART IFINANCIAL INFORMATION



TELOS CORPORATION AND SUBSIDIARIES



CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(amounts in thousands)



|                                                      |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|----------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                      |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                      |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003   |  
|Revenue                                               |  | $                               | 31,710 |   |                                | $ | 30,329 |      |  | $ | 80,976 |   |  | $ | 62,564 |  
|                                                      |  |                                 |        |  
|Costs and expenses                                    |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Cost of sales                                         |  |                                 | 20,375 |   |                                |   | 23,964 |      |  |   | 60,128 |   |  |   | 50,446 |  
|Selling, general and administrative expenses          |  |                                 | 7,570  |   |                                |   | 4,083  |      |  |   | 16,630 |   |  |   | 12,316 |  
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Operating income (loss)                               |  |                                 | 3,765  |   |                                |   | 2,282  |      |  |   | 4,218  |   |  |   | (198   | )
|Other income (expenses)                               |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Other income                                          |  |                                 | 8      |   |                                |   |       |      |  |   | 13     |   |  |   | 9      |  
|Gain on sale of 50% interest in Telos OK, LLC         |  |                                 |       |   |                                |   |       |      |  |   |       |   |  |   | 10,121 |  
|Interest expense                                      |  |                                 | (2,241 | ) |                                |   | (2,146 | )    |  |   | (6,635 | ) |  |   | (3,354 | )
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Income (loss) before taxes                            |  |                                 | 1,532  |   |                                |   | 136    |      |  |   | (2,404 | ) |  |   | 6,578  |  
|Income tax provision                                  |  |                                 |       |   |                                |   | (1,147 | )    |  |   |       |   |  |   | (3,154 | )
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss)                                     |  |                                 | 1,532  |   |                                |   | (1,011 | )    |  |   | (2,404 | ) |  |   | 3,424  |  
|Accretion and dividends of redeemable preferred stock |  |                                 |       |   |                                |   |       |      |  |   |       |   |  |   | (3,133 | )
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss) attributable to common equity       |  | $                               | 1,532  |   |                                | $ | (1,011 | )    |  | $ | (2,404 | ) |  | $ | 291    |  
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  



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)



|                                                                                                        |  |                              |        |                  |   |       
|------------------------------------------------------------------------------------------------------- |  | ---------------------------- | ------ | ---------------- | - | ------
|                                                                                                        |  | September 30,2004(Unaudited) |        | December 31,2003
|ASSETS                                                                                                  |  |                              |        |                  |   |       
|Current assets                                                                                          |  |                              |        |                  |   |       
|Cash and cash equivalents (includes restricted cash of $54 at September 30, 2004 and December 31, 2003) |  | $                            | 61     |                  | $ | 64    
|Accounts receivable, net of reserve of $399 and $487, respectively                                      |  |                              | 29,326 |                  |   | 17,232
|Inventories, net of obsolescence reserve of $83 and $546, respectively                                  |  |                              | 4,515  |                  |   | 3,967 
|Other current assets                                                                                    |  |                              | 1,630  |                  |   | 2,068 
|                                                                                                        |  |                              |        |                  |   |       
|Total current assets                                                                                    |  |                              | 35,532 |                  |   | 23,331
|                                                                                                        |  |                             
|Property and equipment, net of accumulated depreciation of $12,721 and $12,475, respectively            |  |                              | 9,319  |                  |   | 9,368 
|Other assets                                                                                            |  |                              | 846    |                  |   | 912   
|                                                                                                        |  |                              |        |                  |   |       
|Total assets                                                                                            |  | $                            | 45,697 |                  | $ | 33,611
|                                                                                                        |  |                              |        |                  |   |       



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



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##### Table of Contents

TELOS CORPORATION AND SUBSIDIARIES



CONDENSED CONSOLIDATED BALANCE SHEETS



(amounts in thousands)



|                                            |  |                               |         |   |                  |   |         |  
|------------------------------------------- |  | ----------------------------- | ------- | - | ---------------- | - | ------- | -
|                                            |  | September 30,2004 (Unaudited) |         |   | December 31,2003 |  
|LIABILITIES AND STOCKHOLDERS DEFICIT       |  |                               |         |   |                  |   |         |  
|Current liabilities                         |  |                               |         |   |                  |   |         |  
|Accounts payable                            |  | $                             | 13,211  |   |                  | $ | 8,392   |  
|Accrued compensation and benefits           |  |                               | 7,295   |   |                  |   | 5,520   |  
|Deferred revenue                            |  |                               | 8,202   |   |                  |   | 8,296   |  
|Capital lease obligations  short-term      |  |                               | 502     |   |                  |   | 457     |  
|Other current liabilities                   |  |                               | 1,994   |   |                  |   | 2,042   |  
|                                            |  |                               |         |   |                  |   |         |  
|Total current liabilities                   |  |                               | 31,204  |   |                  |   | 24,707  |  
|                                            |  |                              
|Senior credit facility                      |  |                               | 10,022  |   |                  |   | 6,497   |  
|Senior subordinated notes                   |  |                               | 5,179   |   |                  |   | 5,179   |  
|Capital lease obligations                   |  |                               | 9,861   |   |                  |   | 10,243  |  
|Senior redeemable preferred stock           |  |                               | 8,069   |   |                  |   | 7,751   |  
|Public preferred stock                      |  |                               | 63,957  |   |                  |   | 59,425  |  
|                                            |  |                               |         |   |                  |   |         |  
|Total                                       |  |                               | 128,292 |   |                  |   | 113,802 |  
|                                            |  |                               |         |   |                  |   |         |  
|Stockholders deficit                       |  |                               |         |   |                  |   |         |  
|Common stock                                |  |                               | 78      |   |                  |   | 78      |  
|Retained deficit                            |  |                               | (82,673 | ) |                  |   | (80,269 | )
|                                            |  |                               |         |   |                  |   |         |  
|Total stockholders deficit                 |  |                               | (82,595 | ) |                  |   | (80,191 | )
|                                            |  |                               |         |   |                  |   |         |  
|Total liabilities and stockholders deficit |  | $                             | 45,697  |   |                  | $ | 33,611  |  
|                                            |  |                               |         |   |                  |   |         |  



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)



|                                                                                     |  |                                |        |   |      |   |         |  
|------------------------------------------------------------------------------------ |  | ------------------------------ | ------ | - | ---- | - | ------- | -
|                                                                                     |  | Nine Months EndedSeptember 30, |       
|                                                                                     |  | 2004                           |        |   | 2003 |  
|Operating activities:                                                                |  |                                |        |   |      |   |         |  
|Net (loss) income                                                                    |  | $                              | (2,404 | ) |      | $ | 3,424   |  
|Adjustments to reconcile net income (loss) to cash provided by operating activities: |  |                                |        |   |      |   |         |  
|Gain on sale of TelosOK LLC                                                          |  |                                |       |   |      |   | (10,121 | )
|Dividends and accretion of preferred stock as interest expense                       |  |                                | 4,849  |   |      |   | 1,568   |  
|Depreciation and amortization                                                        |  |                                | 1,102  |   |      |   | 1,233   |  
|Other noncash items                                                                  |  |                                | (88    | ) |      |   | 3,406   |  
|Changes in other operating assets and liabilities                                    |  |                                | (6,322 | ) |      |   | 160     |  
|                                                                                     |  |                                |        |   |      |   |         |  
|Cash used in operating activities                                                    |  |                                | (2,863 | ) |      |   | (330    | )
|                                                                                     |  |                                |        |   |      |   |         |  
|Investing activities:                                                                |  |                                |        |   |      |   |         |  
|Net proceeds from sale of TelosOK LLC                                                |  |                                |       |   |      |   | 3,994   |  
|Purchase of property and equipment                                                   |  |                                | (832   | ) |      |   | (119    | )
|                                                                                     |  |                                |        |   |      |   |         |  
|Cash (used in) provided by investing activities                                      |  |                                | (832   | ) |      |   | 3,875   |  
|                                                                                     |  |                                |        |   |      |   |         |  
|Financing activities:                                                                |  |                                |        |   |      |   |         |  
|Proceeds from (repayment of) borrowings under senior credit facility, net            |  |                                | 3,525  |   |      |   | (3,482  | )
|Increase (decrease) in book overdrafts                                               |  |                                | 505    |   |      |   | (8      | )
|Payments under capital leases                                                        |  |                                | (338   | ) |      |   | (249    | )
|                                                                                     |  |                                |        |   |      |   |         |  
|Cash provided by (used in) financing activities                                      |  |                                | 3,692  |   |      |   | (3,739  | )
|                                                                                     |  |                                |        |   |      |   |         |  
|Decrease in cash and cash equivalents                                                |  |                                | (3     | ) |      |   | (194    | )
|Cash and cash equivalents at beginning of period                                     |  |                                | 64     |   |      |   | 358     |  
|                                                                                     |  |                                |        |   |      |   |         |  
|Cash and cash equivalents at end of period                                           |  | $                              | 61     |   |      | $ | 164     |  
|                                                                                     |  |                                |        |   |      |   |         |  



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 condensed consolidated financial statements are unaudited and include the accounts of Telos Corporation (Telos) and its
wholly owned subsidiaries Xacta Corporation and Telos Delaware, Inc. (collectively, the Company). Significant intercompany transactions have been eliminated.



In the opinion of the Company, the accompanying 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 2003 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, 2003.



Reclassifications



Certain reclassifications have been made to prior year financial statements to conform to the classifications used in the current period.



Recent Accounting Pronouncements



In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities,
an Interpretation of Accounting Research Bulletin No. 51. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity, if equity investors in an entity do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. In December 2003, the FASB completed deliberations of proposed
modifications to FIN 46 resulting in multiple effective dates in 2003 and 2004 based on the nature as well as the creation date of the variable interest entity. The revised FIN 46 will be effective for non-SPE variable interest entities created
prior to February 1, 2003 no later than the first quarter of 2004. For variable interest entities created or acquired after January 31, 2003, the provisions of FIN 46 must be applied. The adoption of FIN 46 did not materially affect the results of
operations or financial position of the Company. For further discussion, see Note 2  Investment in Enterworks.



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Stock-Based Compensation



The Company accounts for stock-based compensation consistent with Accounting Principles Board (APB) Opinion No. 25, Accounting for
Stock Issued to Employees. Under APB 25, compensation cost is measured as the excess, if any, of the fair market value of the Companys common stock at the date of grant over the exercise price of the option granted.



Pursuant to the Telos Corporation 1996 Stock Option Plan, the Company,
effective January 22, 2004, granted to certain employees 2.2 million options with a strike price of $0.62, which represents managements best estimate of the current fair value per share and, in addition, accelerated the vesting schedule of
options previously granted to certain key employees. Additionally, pursuant to the 2000 Xacta Stock Option Plan, the Company granted 1.6 million options to certain employees with a strike price of $0.75 per share. While the Company had intended to
include such grants as a subsequent event on Form 10-K for the year ended December 31, 2003, certain of the grants were determined to require amendments to the respective option agreements which were not consummated until May 10, 2004.



Effective May 10, 2004, the Telos Corporation 1996 Stock Option Plan was
amended by the Board of Directors so as to increase the total amount of authorized shares of Class A common stock to 7,345,433, an increase of 700,459 shares, and to reflect those shares owned by Mr. Wood that were not exercised under the 1993 Stock
Option Plan.



Additionally, the Company granted a total of
330,000 options under the Telos Corporation 1996 Stock Option Plan (260,000 options granted to new hires; and 70,000 options granted to the directors to meet the Boards objective that all directors have the same number of options), and 205,000
options to new hires under the 2000 Xacta Stock Option Plan during the third quarter of 2004.



Had compensation expense for the Companys stock options been recognized based on the fair value of the options at the grant dates, using the methodology prescribed by the Statement of Financial Accounting
Standards No. 123, Accounting for Stock-Based Compensation, the Companys net (loss) income would have been as follows (in thousands):



|                                                                    |  |                                 |       |      |                                |        |      |  |   |        |   |  |   |    
|------------------------------------------------------------------- |  | ------------------------------- | ----- | ---- | ------------------------------ | ------ | ---- |  | - | ------ | - |  | - | ---
|                                                                    |  | Three Months EndedSeptember 30, |       |      | Nine Months EndedSeptember 30,
|                                                                    |  | 2004                            |       | 2003 |                                |        | 2004 |  |   | 2003  
|Net income (loss)                                                   |  | $                               | 1,532 |      | $                              | (1,011 | )    |  | $ | (2,404 | ) |  | $ | 291
|Deduct: Stock-based compensation expense under fair value reporting |  |                                 | 45    |      |                                | 64     |      |  |   | 284    |   |  |   | 209
|                                                                    |  |                                 |       |      |                                |        |      |  |   |        |   |  |   |    
|Pro forma net income (loss)                                         |  | $                               | 1,487 |      | $                              | (1,075 | )    |  | $ | (2,688 | ) |  | $ | 82 
|                                                                    |  |                                 |       |      |                                |        |      |  |   |        |   |  |   |    



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Note 2. Investment in Enterworks



As of September 30, 2004, the Company owns 17,153,059 common stock shares of Enterworks, Inc. (Enterworks) and
holds warrants to purchase 4,499,997 underlying common stock shares which equates to a fully diluted ownership percentage of 21.5%. The Company accounts for its investment in Enterworks under the equity method of accounting as prescribed by APB 18,
The Equity Method of Accounting for Investments in Common Stock.



The Company also owns notes receivable from Enterworks totaling $3.3 million. Such notes were received in exchange for rent and professional services performed by the Company pursuant to a lease and an intercompany
services agreement. In accordance with APB 18 and EITF 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 has reduced the
carrying amounts of the notes to zero during 2003 and 2002, as the Companys share of the Enterworks losses exceeded the carrying value of the notes. All such notes, issued to the Company in 2003 and 2002, include a provision for
repayment of four times principal and accrued interest in the event that Enterworks liquidates, enters into dissolution, or seeks bankruptcy protection.



In December 2003, the Company purchased a 50% interest in Enterworks International, formerly a wholly owned subsidiary of Enterworks, for $500,000.
Pursuant to the terms of the Stock Purchase Agreement and the related Stockholders Agreement, the Company agreed to fund up to 50% of Enterworks Internationals 2004 operating costs for an amount not to exceed $300,000, and 50% of such
operating costs thereafter. The Company has determined its interest in Enterworks International is a variable interest and has consolidated Enterworks International pursuant to the provisions of FIN 46.



Separately, in December 2003, the Company entered into a two-year Original
Equipment Manufacturer (OEM) software license agreement (SLA) with Enterworks, which, 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 payment and Company services of $900,000, including $300,000 past due 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, the Company has agreed to pay royalties of $1.0 million over the course of the next 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 September 30, 2004, the Company has paid approximately $153,000 in such royalties. The Company has capitalized the
$100,000 license payment to Enterworks as a fixed asset. In accordance with APB18 and EITF 98-13, the Company has accounted for the SLA as losses from affiliates.



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Note 3. Debt Obligations



Senior Revolving Credit Facility



On October 21, 2002, the Company entered into a $22.5 million Senior Credit Facility Agreement (Facility) with Wells Fargo Foothill, Inc.
(Wells Fargo Foothill) (formerly known as Foothill Capital Corporation) that matures on October 21, 2005. 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 eligible underlying asset-borrowing base, as defined in the Facility agreement.



The Company paid an origination fee of $225,000 at the date of closing. Unused borrowing availability on the Facility was
$765,000 at September 30, 2004; however, such availability fluctuates on a daily basis based upon the amount of eligible underlying assets in the borrowing base. Interest on the Facility is charged at 1.25% over the Wells Fargo prime rate (as of
September 30, 2004 the Wells Fargo prime rate was 4.75%), or 5.75%, whichever is higher. The weighted average interest rates were 6.3% and 6.8% for the nine months ended September 30, 2004 and 2003, respectively.



The Facility has various covenants, which 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 requires the Company to meet certain financial covenants, including cash
flow targets based on EBITDA as defined in the Facility. The Company and Wells Fargo Foothill have agreed upon modified cash flow covenants through October 21, 2005. For the quarter ended September 30, 2004, the Company was in compliance with the
covenants contained in the Facility.



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 is October 31, 2005, with interest rates ranging from 14% to 17%, and paid quarterly on January 1, April 1, July 1, and October 1 of each year. The Notes can be prepaid at the Companys option. 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 September 30, 2004, if such a qualifying triggering event had occurred, the cumulative premium payment would be approximately $12.7 million.



The Company retired $3 million of the Series B Notes in October 2002 upon the
initial funding of the Facility. In consideration for a requested accelerated payment, the note holders waived the prepayment penalty on such Notes, which were due May 2003.



The balance of the Series B and C Notes was $2.5 million and $2.7 million, at September 30, 2004 and December 31, 2003,
respectively.



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



|                         |  |      |  |                |        
|------------------------ |  | ---- |  | -------------- | -------
|                         |  | Year |  | Obligation Due
|Senior Subordinated Debt |  | 2005 |  | $              | 5,1791 
|Senior Credit Facility   |  | 2005 |  | $              | 10,0232

---

|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 a date no earlier than October 31, 2005.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|2 | Balance due represents balance as of September 30, 2004, 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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##### Table of Contents

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, 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 is required to redeem all shares and accrued dividends outstanding on October 31, 2005. Mandatory redemptions are subject to legal availability of funds and required to be paid from excess cash flows, as defined in
the Corporate Charter. The Senior Redeemable Preferred Stock is senior to all other present and future equity of the Company. The Series A-1 is senior to the Series A-2. The Company has not declared dividends on its Senior Redeemable Preferred Stock
since its issuance. At September 30, 2004 and December 31, 2003 cumulative undeclared, unpaid dividends relating to Series A-1 and A-2 Redeemable Preferred Stock totaled $5.1 million and $4.8 million, respectively. The Company recorded senior
redeemable preferred stock dividends of $107,000 and $318,000 for the three and nine months ended September 30, 2004, respectively, and $107,000 and $317,000 for the three and nine months ended September 30, 2003, 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 quarters ended September 30, 2004 and 2003 was $555,000 and $506,000, respectively, and for the nine months ended September 30, 2004 and 2003 was $1.7 million and $1.5 million, 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.



Since 1991, the Company has not declared or paid any dividends on its Public
Preferred Stock based upon its interpretation of restrictions in its corporate charter, limitations in the terms of the Public Preferred Stock, specific dividend payment restrictions in the $22.5 million Facility entered into with Wells Fargo
Foothill, other senior obligations, and limitations pursuant to Maryland law. Pursuant to the terms of the Public Preferred Stock, the Company is scheduled to redeem the Public Preferred Stock in five annual tranches during the period 2005 through
2009. In accordance with such terms, the Public Preferred Stock, which has a 20-year maturity, is scheduled to be redeemed on the 16th, 17th, 18th, and 19thanniversaries
of November 21, 1989, leaving 20% to be redeemed at maturity. Due to its substantial senior obligations, limitations set forth in the covenants in the Facility, foreseeable capital and operational requirements, corporate charter restrictions and
prohibitions, and provisions of Maryland law, and assuming sufficient liquidity to undertake any stock redemption (which is presently unquantifiable), the Company believes that the likelihood is that it will not be able to meet the redemption
schedule set forth in the terms of the Public Preferred Stock.



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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.



The Public Preferred Stock accrues a semiannual 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 were paid at the rate of 6% of a share for each $.60 of such
dividends not paid in cash. Any such dividends payable by the Company, when and if declared by the Board of Directors, commencing June 1, 1990, and on each six month anniversary thereafter were paid out of legally available funds in accordance with
Maryland law. For the years 1992 through 1994 and for the dividend payable June 1, 1995, the Company has accrued undeclared dividends in additional shares of Public Preferred Stock. Such accrued dividends were valued at $4.0 million. Had the Company
accrued these dividends on a cash basis, the total amount accrued would have been $15.1 million. For the cash dividends payable since December 1, 1995, the Company has accrued $36.9 million as of September 30, 2004. In 2003, the Company recorded
cumulative exchangeable redeemable preferred stock dividends of $3.8 million.



In accordance with SFAS 150, and as reported beginning with the Form 10-Q for the quarter ended September 30, 2003, both the Senior Redeemable Preferred Stock and the Public Preferred Stock have been reclassified from
equity to liability. Consequently, the accretion and dividends accrued in the three and nine months ended September 30, 2004 of $1.6 million and $4.8 million were recorded as interest expense. Pursuant to the disclosure provisions of FAS 107, the
Public Preferred Stock traded on the NASDAQ/OTCBB Exchange (TLSRP) at $3.75 per share on September 30, 2004, and accordingly the aggregate fair value of such publicly traded stock was $11.9 million.



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Note 5. Reportable Business Segments



As of September 30, 2004, the Companys operations are comprised of two operating segments, IT Solutions Group and
Xacta. The segment information below has been reclassified to conform to managements internal operating structure implemented during the fourth quarter of 2003. Principally, the Company has included the results of its wireless and messaging
product line (previously included as part of the Products Group segment) in the Xacta segment. Prior to December 2003, the Company had two operating segments: the Products Group and the Xacta Group.



IT Solutions Group: develops, markets and sells
integration services that address a wide range of Government Information Technology (IT) requirements. Specific offerings consist of reselling leading IT products from major original equipment manufacturers (OEMs), which are augmented by
Telos with various value-added support services. The IT Solutions Group also provides general IT support services that support various U.S. government programs and initiatives.



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 has become a highly respected brand name in the field of information security. In order to capitalize on the strength of the Xacta name,
Telos has combined all of its security-oriented solutions into Xacta. As a result, the Companys Secure Wireless LAN solutions, Enterprise Messaging solutions, Enterprise Credentialing solutions, and all Information Assurance Consulting
services that were previously in the Products Group, are now marketed and sold as Xacta solutions. In addition to leveraging the strength of the Xacta brand name, this change serves to simplify the respective messages of Telos and Xacta for our
customers and our employees. Moving forward, all security-related offerings will be marketed and sold as Xacta solutions.



Results from another former Systems and Support Services Group operating at Ft. Sill were also included in the Companys financial results until its
deconsolidation in July 2000. At such time, the Company contributed its Ft. Sill net assets to TelosOK LLC. On March 10, 2003, the Company sold its interest in TelosOK LLC. See Note 6 - Sale of Telos Interest in TelosOK LLC.



The accounting policies of the reportable segments are the same as those
referred to in Note 1. The Company evaluates the performance of its operating segments based on revenue, gross margin 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 and nine
months ended September 30, 2004 and 2003 are set forth in the following table. The other column includes corporate related items.



|                                  |  |                    |        |                   |       |   |          |  |       |        |              |   |        |       |   |          |   |       |   |        |  |   |        |  |   |        |  
|--------------------------------- |  | ------------------ | ------ | ----------------- | ----- | - | -------- |  | ----- | ------ | ------------ | - | ------ | ----- | - | -------- | - | ----- | - | ------ |  | - | ------ |  | - | ------ | -
|                                  |  | Three Months Ended |        | Nine Months Ended |      
|                                  |  | IT Solutions       |        |                   | Xacta |   | Other(1) |  | Total |        | IT Solutions |   |        | Xacta |   | Other(1) |   | Total |  
|September 30, 2004                |  |                    |        |                   |       |   |          |  |       |        |              |   |        |       |   |          |   |       |   |        |  |   |        |  |   |        |  
|External revenues                 |  | $                  | 5,695  |                   |       | $ | 26,015   |  | $     |       |              | $ | 31,710 |       | $ | 25,056   |   |       | $ | 55,920 |  | $ |       |  | $ | 80,976 |  
|Gross margin                      |  |                    | 302    |                   |       |   | 11,033   |  |       |       |              |   | 11,335 |       |   | 2,130    |   |       |   | 18,718 |  |   |       |  |   | 20,848 |  
|Segment (loss) profit (3)         |  |                    | (1,605 | )                 |       |   | 5,370    |  |       |       |              |   | 3,765  |       |   | (2,608   | ) |       |   | 6,826  |  |   |        |  |   | 4,218  |  
|Total assets                      |  |                    | 4,644  |                   |       |   | 30,768   |  |       | 10,285 |              |   | 45,697 |       |   | 4,644    |   |       |   | 30,768 |  |   | 10,285 |  |   | 45,697 |  
|Capital expenditures              |  |                    |       |                   |       |   | 80       |  |       | 48     |              |   | 128    |       |   |         |   |       |   | 205    |  |   | 627    |  |   | 832    |  
|Depreciation and amortization (2) |  |                    | 64     |                   |       |   | 62       |  |       | 86     |              |   | 212    |       |   | 260      |   |       |   | 143    |  |   | 533    |  |   | 936    |  
|                                  |  |                    |        |                   |       |   |          | 
|                                  |  | ITSolutions        |        |                   | Xacta |   | Other(1) |  | Total |        | ITSolutions  |   |        | Xacta |   | Other(1) |   | Total |  
|September 30, 2003                |  |                    |        |                   |       |   |          |  |       |        |              |   |        |       |   |          |   |       |   |        |  |   |        |  |   |        |  
|External revenues                 |  | $                  | 19,116 |                   |       | $ | 11,213   |  | $     |       |              | $ | 30,329 |       | $ | 32,007   |   |       | $ | 30,557 |  | $ |       |  | $ | 62,564 |  
|Gross margin                      |  |                    | 2,649  |                   |       |   | 3,716    |  |       |       |              |   | 6,365  |       |   | 2,822    |   |       |   | 9,296  |  |   |       |  |   | 12,118 |  
|Segment profit (loss)(3)          |  |                    | 393    |                   |       |   | 1,889    |  |       |       |              |   | 2,282  |       |   | (714     | ) |       |   | 516    |  |   |       |  |   | (198   | )
|Total assets                      |  |                    | 14,113 |                   |       |   | 2,852    |  |       | 20,084 |              |   | 37,049 |       |   | 14,113   |   |       |   | 2,852  |  |   | 20,084 |  |   | 37,049 |  
|Capital expenditures              |  |                    | 2      |                   |       |   | 17       |  |       | 30     |              |   | 49     |       |   | 9        |   |       |   | 34     |  |   | 76     |  |   | 119    |  
|Depreciation and amortization(2)  |  |                    | 85     |                   |       |   | 59       |  |       | 248    |              |   | 392    |       |   | 246      |   |       |   | 205    |  |   | 782    |  |   | 1,233  |  

---

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

|(2) | Depreciation and amortization include amounts relating to property and equipment, capital leases and spare parts inventory.
|--- | ---------------------------------------------------------------------------------------------------------------------------

|(3) | Segment profit (loss) represents operating income (loss).
|--- | ---------------------------------------------------------



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 five separate facilities located in various states, the District of Columbia and Germany.



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##### Table of Contents

Note 6. Sale of TelosOK LLC



On March 10, 2003 the Company and other TelosOK LLC investors (Purchaser) entered into a unit purchase agreement
whereby the Company sold all of its 50% interest in TelosOK LLC for a total cash consideration of $4.0 million. The Company had accounted for its investment in TelosOK LLC under the equity method and, at the time of this transaction, had a negative
basis for its investment. The parties also agreed to certain payments to the Company through March 2004, to recover the Companys fixed infrastructure costs associated with providing certain accounting and support services. During the first
quarter of 2004, the Company has recorded $0.1 million of these payments as other service revenue.



Pursuant to a separate agreement, the Company provided certain accounting and support services to TelosOK LLC through March 2004. An amount of $0.1
million has been recorded as other service revenue during the first quarter related to this agreement.



As additional consideration for the sale of the Telos membership units, the Company and TelosOK LLC committed to certain noncompete and
nonsolicitation agreements between the two parties. The nonsolicitation commitment provided for a sole exception relating to the employment by TelosOK LLC of the former President, CEO and Director of the Company. At the
effective date of closing, all Telos Corporation employees serving as officers of TelosOK LLC resigned said positions in TelosOK LLC.



Upon the sale of its interest in TelosOK LLC, the Company recognized a gain of approximately $10.1 million, comprised of $6.1 million of deferred gain and
$4.0 million of gain from the proceeds received on March 10, 2003. The deferred gain was recorded in July 2000 as a result of Staff Accounting Bulletin No. 81, Gain Recognition on the Sale of a Business or Operating Assets to a Highly
Leveraged Entity, which required the gain be deferred until the Company disposed of its interest in TelosOK LLC.



Note 7. Contingencies



As referenced in Form 10-K for the fiscal year ended December 31, 2003 (Item 7 - Managements Discussion and Analysis of Financial Condition and
Results of Operations), the Company implemented a Discretionary Incentive Bonus Plan (the Bonus Plan) and accrued $2.0 million for such period. Based upon current and projected performance, an accrual of $2.0 million for the Bonus Plan
was recorded in the third quarter of 2004.



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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 which 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. Although the outcome of any investigations or inquiries cannot be predicted, in the opinion of management, which is unaware of any pending investigations
and inquiries, to the best of its knowledge, there are no claims, audits or investigations against the Company likely to have a material adverse affect on the Companys business or its consolidated results of operations, cash flows or financial
position.



General



The Company continues to invest in creating value-added solutions in an
effort to address the ever increasing market for systems integration services and secure enterprise solutions. For example, with the release of Xacta Web C&A® 4.0 in March of 2003, Xacta achieved its vision of developing a continuous business process which enables automated and
continuous security risk and compliance management. The Continuous Assessment functionality provided in the Xacta 4.0 release allows organizations to manage security compliance and risk in an automated and on-going manner. Additionally,
Xacta recently introduced Xacta IA Manager which
provides continuous and automated vulnerability management and remediation, allowing organizations to identify and remediate vulnerabilities from a centralized location. When fully deployed Xacta IA Manager will save systems administrators time and
effort as well as keep the network aware of new vulnerabilities that can appear daily.



The Companys messaging solution is called the Automated Message Handling System (AMHS). AMHS version 2003 was approved by the Defense
Information Systems Agency and released in July of 2003 after extensive evaluation and testing. AMHS 2003 is the U.S. Governments exclusive certified stand-alone messaging application. The AMHS 2003 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. In addition to its more intuitive user interface, AMHS 2003 provides outbound
message processing and numerous advanced message management capabilities such as retrospective search and simplified user profiling, which functionality is essential to large organizations with time sensitive formal message requirements. Such
retrospective search and user profiling capabilities facilitate message distribution to important staff elements, as well as research and coordination of formal message origination and response.



Backlog



The Companys total backlog was $103.1 million and $51.0 million at September 30, 2004 and 2003, respectively. Backlog
was $40.2 million at December 31, 2003, and $52.1 million at June 30, 2004. The total backlog of each of the segments at September 30, 2004 and 2003 was as follows: IT Solutions Group - $7.3 million and $11.0 million, respectively; and Xacta - $95.8
million and $40.0 million, respectively.



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##### Table of Contents

Exit from the Systems and Support Services Business



The Company sold its 50% interest in TelosOK LLC, on March 10, 2003, which is reported in Note 6 - Sale of TelosOK LLC. The
primary business of TelosOK LLC was to provide post-deployment and post-production software and systems development and support services including technology insertion, system redesign and software re-engineering. The largest customer of TelosOK LLC
was the U.S. Armys Communications and Electronics Command (CECOM) with significant operations at Ft. Sill in Lawton, Oklahoma. TelosOK LLC tasks were performed on a time and materials basis and on a firm fixed price basis.



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.



Results of Continuing Operations



The
condensed consolidated statements of operations include the results of Telos Corporation and its wholly owned subsidiaries. The Company substantially achieved its operating goals while experiencing slower than anticipated order volume.



The principal element of the Companys operating expenses as a
percentage of sales for the three and nine months ended September 30, 2004 and 2003 are as follows:



|                             |  |                                 |   |  |                                |    |  |       |    |  |       |  
|---------------------------- |  | ------------------------------- | - |  | ------------------------------ | -- |  | ----- | -- |  | ----- | -
|                             |  | Three Months EndedSeptember 30, |   |  | Nine Months EndedSeptember 30, |   
|                             |  | 2004                            |   |  | 2003                           |    |  | 2004  |    |  | 2003  |  
|Sales                        |  | 100.0                           | % |  | 100.0                          | %  |  | 100.0 | %  |  | 100.0 | %
|Cost of sales                |  | 64.2                            |   |  | 79.0                           |    |  | 74.3  |    |  | 80.6  |  
|SG&A expenses                |  | 23.9                            |   |  | 13.5                           |    |  | 20.5  |    |  | 19.7  |  
|                             |  |                                 |   |  |                                |    |  |       |    |  |       |  
|Operating income (loss)      |  | 11.9                            |   |  | 7.5                            |    |  | 5.2   |    |  | (0.3  | )
|Gain on sale of TelosOK, LLC |  |                                |   |  |                               |    |  |      |    |  | 16.2  |  
|Interest expense             |  | (7.1                            | ) |  | (7.0                           | )  |  | (8.2  | )  |  | (5.4  | )
|                             |  |                                 |   |  |                                |    |  |       |    |  |       |  
|Income (loss) before taxes   |  | 4.8                             |   |  | 0.5                            |    |  | (3.0  | )  |  | 10.5  |  
|Income tax expense           |  |                                |   |  | (3.8                           | )  |  |      |    |  | (5.0  | )
|                             |  |                                 |   |  |                                |    |  |       |    |  |       |  
|Net income (loss)            |  | 4.8                             | % |  | (3.3                           | )% |  | (3.0  | )% |  | 5.5   | %
|                             |  |                                 |   |  |                                |    |  |       |    |  |       |  



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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 EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                   |  | 2004                            |        |   | 2003                           |   |        | 2004 |  |   | 2003   |  
|Sales              |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|IT Solutions Group |  | $                               | 5,695  |   |                                | $ | 19,116 |      |  | $ | 25,056 |   |  | $ | 32,007 |  
|Xacta              |  |                                 | 26,015 |   |                                |   | 11,213 |      |  |   | 55,920 |   |  |   | 30,557 |  
|                   |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total              |  | $                               | 31,710 |   |                                | $ | 30,329 |      |  | $ | 80,976 |   |  | $ | 62,564 |  
|                   |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Gross Margin       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|IT Solutions Group |  | $                               | 302    |   |                                | $ | 2,649  |      |  | $ | 2,130  |   |  | $ | 2,822  |  
|Xacta              |  |                                 | 11,033 |   |                                |   | 3,716  |      |  |   | 18,718 |   |  |   | 9,296  |  
|                   |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total              |  | $                               | 11,335 |   |                                | $ | 6,365  |      |  | $ | 20,848 |   |  | $ | 12,118 |  
|                   |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Gross Margin       |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|IT Solutions Group |  |                                 | 5.3    | % |                                |   | 13.9   | %    |  |   | 8.5    | % |  |   | 8.8    | %
|Xacta              |  |                                 | 42.4   | % |                                |   | 33.1   | %    |  |   | 33.5   | % |  |   | 30.4   | %
|Total              |  |                                 | 35.7   | % |                                |   | 21.0   | %    |  |   | 25.7   | % |  |   | 19.4   | %



The Companys
sales for the third quarter of 2004 were $31.7 million, an increase of $1.4 million or 4.6% over the third quarter 2003 sales of $30.3 million. Such increase consists of a $14.8 million increase in sales from Xacta, offset by a $13.4 million
decrease in sales from the IT Solutions Group. The increase in Xacta sales is primarily attributable to increased sales of its wireless and messaging solutions. The IT Solutions group continues to perform in accordance with the Companys plans.



The Companys cost of sales for the third quarter of 2004
was $20.4 million, a decrease of $3.6 million compared to the same period in 2003.



The Companys gross profit for the third quarter in 2004 increased by $5.0 million to $11.3 million compared to the same period in 2003. Gross margin increased to 35.7% from 21.0% in the comparable period in
2003. The wireless and messaging business areas yielded higher than expected margins due to the sale of Xacta developed solutions that are core to the businesses. The Company has modified the business model with the IT Solutions Group. This change
resulted in decreased revenue but consistent margins from year to year although quarterly margins may vary depending on customer requirements.



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##### Table of Contents

The Companys selling, general, and administrative expense (SG&A) for the third
quarter of 2004 was $7.6 million, an increase of approximately $3.5 million or 85.4% compared to the same period in 2003, due primarily to the bonus accrual recorded in the third quarter of 2004.



The Companys operating income for the third quarter of 2004 was $3.8
million, an increase of $1.5 million compared to $2.3 million of operating income in the same period in 2003.



The Companys interest expense increased by approximately $95,000 to $2.2 million in the third quarter in 2004 compared to the same period in 2003.



The Company recorded a provision for income taxes for the
quarter ended September 30, 2004 and 2003 of $0 and $1.1 million, respectively. The Company recorded a full valuation allowance against its deferred tax assets as of December 31, 2003. The Company maintained its full valuation position during the
quarter ended September 30, 2004.



The Companys net
income for the third quarter of 2004 was $1.5 million, an increase of $2.5 million compared to $1.0 million net loss in the same period in 2003.



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##### Table of Contents

Liquidity and Capital Resources



The Companys capital structure consists of a revolving credit facility, subordinated notes, redeemable preferred
stock, and common stock.



At September 30, 2004, the Company
had outstanding debt and long-term obligations of $97.6 million, consisting of $10.0 million under the Facility, $5.2 million in subordinated debt, $10.4 million in capital lease obligations and $72.0 million in preferred stock classified as
liability in accordance with FAS 150.



Based on current
requirements, management considers the Companys borrowing capacity sufficient to fund its capital and liquidity needs.



Revolving Credit Facility



On October 21, 2002, the Company entered into a $22.5 million Senior Credit Facility Agreement (Facility) with Wells Fargo Foothill that
matures on October 21, 2005. Borrowings under the Facility are collateralized by substantially all of the Companys assets including inventory, equipment and accounts receivables. The amount of borrowings fluctuates based on the eligible
underlying asset borrowing base, as defined in the Facility agreement. Unused borrowing availability on the Facility was $765,000 at September 30, 2004; however, such availability fluctuates on a daily basis based on the amount of underlying assets
in the borrowing base. Interest on the Facility is charged at 1.25% over the Wells Fargo prime rate (as of September 30, 2004 the Wells Fargo prime rate was 4.75%), or 5.75%, whichever is higher.



The Facility has various covenants, which, 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 requires the Company to meet certain financial covenants, including cash
flow targets based on EBITDA as defined in the Facility. The Company and Wells Fargo Foothill have agreed upon modified cash flow covenants through October 21, 2005. For the quarter ended September 30, 2004, the Company was in compliance with the
covenants contained in the Facility.



For the nine months ended
September 30, 2004, cash used by operating activities was $2.9 million. Cash used in investing activities was approximately $.8 million. Cash provided in financing activities was approximately $3.7 million.



Senior Subordinated Notes



The Companys subordinated notes (Notes) totaled $5.2
million at September 30, 2004. These Notes bear interest at rates between 14% and 17%, due and payable on October 31, 2005. During the first nine months of 2004, the Company paid $567,000 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 $12.7 million at September 30, 2004. 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 September 30, 2004, the total carrying amount of redeemable preferred stock, including accumulated and unpaid dividends was $72.0 million. The Company accrues
dividends and provides for accretion related to the redeemable preferred stock. During the first nine months of 2004, the Company recorded $3.2 million of dividends on the two classes of redeemable preferred stock. Mandatory redemption for all
shares of the Senior Redeemable Preferred Stock plus all accrued dividends on those shares is due on October 31, 2005. Subject to numerous preconditions and restrictions, more specifically set forth below, 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 corporate charter, limitations in the terms of the Public Preferred Stock, specific dividend payment restrictions
in the $22.5 million Facility entered into with Wells Fargo Foothill, other senior obligations, and limitations pursuant to Maryland law. Pursuant to the terms of the Public Preferred Stock, the Company is scheduled to redeem the Public Preferred
Stock in five annual tranches during the period 2005 through 2009. In accordance with such terms, the Public Preferred Stock, which has a 20 year maturity, is scheduled to be redeemed on the 16th, 17th, 18th, and 19thanniversaries of November 21, 1989, leaving 20% to be redeemed at maturity. Due to its present substantial senior obligations, limitations set forth in the covenants in the Facility, foreseeable capital and operational requirements,
corporate charter restrictions and prohibitions, and provisions of Maryland law, and assuming sufficient liquidity to undertake any such stock redemption (which is presently unquantifiable), the Company believes that the likelihood is that it will
not be able to meet the redemption schedule set forth in the terms of the Public Preferred Stock.



The Company believes that its ability to successfully restructure its debt obligations could affect the Companys future operating results and that
for a variety of reasons, the Company believes it will more likely than not be unable to meet the redemption schedule set forth in the terms of the Companys Public Preferred Stock.



On March 26, 2004, the Companys Board of Directors authorized the Companys management to commence the process of
planning for and, if appropriate, implementing the activities set forth below. Before any definitive action is undertaken in connection with such authorization (including without limitation any issuance, redemption or exchange of any equity
securities of the Company), further review and approval by the Board is required.



In an effort to address its capital structure and the adverse impact of SFAS150 (Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity), which reclassified the redeemable
preferred stock from equity to liability (see Note 4  Redeemable Preferred Stock), the Company intends to immediately engage such professional service providers it deems reasonable and appropriate to advise management with regard to such debt
restructuring and/or recapitalization and any other transaction. The Company contemplates that such engagement will include, but may not be limited to, consideration of a swap of all debt instruments into common shares, the filing of an S-8 or other
appropriate filings in order to issue the remaining authorized, but un-issued shares of Public Preferred Stock or to take such other steps as may be recommended to facilitate such debt restructuring and/or recapitalization. The Company will continue
to use its best efforts to reach a decision on such debt restructuring and/or recapitalization within a reasonable time frame. There is no assurance that any such transaction can or will be effected, or if effected what the form of such transaction
would be or when it might occur.



None of the Companys
present directors has any material financial interest in any holder of the Senior Redeemable Preferred Stock or the Subordinated Notes. Also, other than directors fees and stock options received for their service as members of the Board of Directors
of the Company or fees for service as members of the Companys Proxy Board, none of the non-executive directors receive any consulting or advisory fees or other compensation from the Company or any of its subsidiaries. Subject to further
review, the full Board will continue to address the Companys capital structure and any recommendations of the professional service providers pertaining thereto.



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Recent Accounting Pronouncements



In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an
Interpretation of Accounting Research Bulletin No. 51. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity, if equity investors in an entity do not have the characteristics of a controlling
financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. In December 2003, the FASB completed deliberations of proposed modifications
to FIN 46 resulting in multiple effective dates in 2003 and 2004 based on the nature as well as the creation date of the variable interest entity. The revised FIN 46 will be effective for non-SPE variable interest entities created prior to February
1, 2003 no later than the first quarter of 2004. For variable interest entities created or acquired after January 31, 2003, the provisions of FIN 46 must be applied. The adoption of FIN 46 did not materially affect the results of operations or
financial position of the Company. For further discussion, see Note 2 - Investment in Enterworks.



Forward-Looking Statements



This Annual 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



The following important factors could cause actual results to differ materially from those indicated by forward-looking
statements made in this Quarterly Report on Form 10-Q and presented elsewhere by management from time to time.



A number of uncertainties exist that could affect the Companys future operating results, including, without limitation, general economic conditions
which may include, and adversely affect, the cost and continued availability of the Company to secure adequate capital and financing to support its business; 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 its debt obligations. 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. Interest on the
Facility is charged at 1.25% over the Wells Fargo prime rate (as of September 30, 2004 the Wells Fargo prime rate was 4.75%), or 5.75%, whichever is higher. The weighted average interest rates for the first nine months of 2004 and 2003 were 6.3% and
6.8%, respectively. The Facility had an outstanding balance of $10.0 million at September 30, 2004.



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-14(c) and Rule 15d-14(c) under the Exchange Act), within 90 days prior to
the filing of this quarterly report, 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.



Since such evaluation, such
officers are unaware of any significant subsequent changes in the Companys internal controls or in other factors that could significantly affect internal controls, including any corrective actions with regard to significant deficiencies and
material weaknesses.



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



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 September 30, 2004, total undeclared unpaid dividends accrued for financial reporting purposes are $5.1 million for the Series A-1 and A-2
Preferred Stock.



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). 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 corporate 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 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 $15.1 million. For the cash dividends payable since December 1, 1995
the Company has accrued $36.9 million as of September 30, 2004.



Since 1991, the Company has not declared or paid any dividends on its Public Preferred Stock, based upon its interpretation of restrictions in its corporate charter, limitations in the terms of the Public Preferred Stock, specific dividend
payment restrictions in the $22.5 million Facility entered into with Wells Fargo Foothill, and other senior obligations and limitations pursuant to Maryland law. Pursuant to the terms of the Public Preferred Stock, the Company is to redeem the
Public Preferred Stock in five annual tranches during the period 2005 through 2009. In accordance with such terms, the Public Preferred Stock, which has a 20 year maturity, is scheduled to be redeemed on the 16th, 17th,
18th, and 19thanniversaries of November 21, 1989, leaving 20% to be redeemed at maturity. Due to its substantial senior obligations, limitations set forth in the covenants in the Facility, foreseeable capital and
operational requirements, corporate charter restrictions and prohibitions, and provisions of Maryland law, and assuming sufficient liquidity to undertake any stock redemption (which is presently unquantifiable), the Company believes that the
likelihood is that it will not be able to meet the redemption schedule set forth in the terms of the Public Preferred Stock.



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Item 6. Exhibits and Reports on Form 8-K



(a) Exhibits:



| | 1) | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002;
| | -- | ---------------------------------------------------------------------------------------------------



| | 2) | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002;
| | -- | ---------------------------------------------------------------------------------------------------



| | 3) | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
| | -- | ----------------------------------------------------------------------------------------------------------------------



(b) Reports on Form 8-K:



| | 1) | Form 8-K filed April 9, 2004. Item 5. Announcing intent to obtain professional advice concerning potential recapitalization of Telos Corporation.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------



| | 2) | Form 8-K filed July 2, 2004. Item 4. Announcing notice by certifying accountants of their decision not to stand for reelection.
| | -- | -------------------------------------------------------------------------------------------------------------------------------



| | 3) | Form 8-K filed August 4, 2004. Item 4. Announcing the engagement of new certifying accountants.
| | -- | -----------------------------------------------------------------------------------------------



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: November 22, 2004 |  | TELOS CORPORATION                                                                                           
|                        | 
|                        |  | /s/ EDWARD L. WILLIAMS                                                                                      
|                        |  | Edward L. Williams Interim Chief Financial
Officer (Principal Financial Officer & Principal Account
Officer)



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