Telos Corp

NASDAQ:TLS

Earnings Call Analysis

Earnings Call Transcript 2023-Q3

[Operator]

Good day. Thank you for standing by. Welcome to Telos Corporation's Third Quarter 2023 Earnings Call. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to turn the conference over to your first speaker today,

Allison Phillipp. Please go ahead.

[Allison Phillipp, executive]

Good morning. Thank you for joining us to discuss Telos Corporation's Third Quarter 2023 Financial Results. With me today is John Wood, Chairman and CEO of Telos and Mark Bendza, Executive Vice President and CFO of Telos. Let me quickly review the format of today's presentation. John will begin with brief remarks on our third quarter 2023 results and Telos' strategic priorities. Then Mark will cover the financials in more detail and discuss guidance for the fourth quarter and full year 2023 as well as provide some high-level comments on 2024 and before turning it back to John to wrap up. Then we'll open the line for Q&A, where Mark Griffin, Executive Vice President of Security Solutions will also join us.

The earnings press release was issued earlier today and is posted on the Telos Investor Relations website, where this call is being simultaneously webcast. Additionally, we have provided presentation slides on our Investor Relations website. Before we begin, we want to emphasize that some of our statements on this call are forward-looking statements and are made under the safe harbor provisions of the federal securities laws. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could materially differ for various reasons including the factors described in today's earnings press release and the comments made during this conference call and in our SEC filings.

We do not undertake any duty to update any forward-looking statements. In addition, during today's call, we will discuss non-GAAP financial measures, which we believe are useful as supplemental and clarifying measures to help investors understand Telos' financial performance. These non-GAAP financial measures should be considered in addition to and not as a substitute for or in isolation from GAAP results. You can find additional disclosures regarding these non-GAAP financial measures, including reconciliations with comparable GAAP results in our earnings press release and on the Investor Relations portion of our website. Please also note that financial comparisons are year-over-year unless otherwise specified. The webcast replay of this call will be available for the next year on our company website under the Investor Relations link.

With that, I'll turn the call over to John.

[John Wood, executive]

Thank you, Allison, and good morning, everyone. Let's begin today on Slide 3. I'm pleased to report that Telos has again overdelivered on all key financial metrics in the third quarter. Mark will discuss the details of our financial performance later in the call. At a high level, we delivered $36.2 million of revenue in the third quarter, above our guidance range of $30 million to $34 million. Gross margin was 36% above our guidance range of 30.4% to 34.2%. Adjusted EBITDA was a $1.3 million loss and was above the top end of our guidance range of negative $8 million to negative $6 million.

Lastly, we returned to positive cash flow from operations this quarter. Many factors enabled our team to achieve these results, including better-than-expected performance from key programs and Security Solutions like TSA PreCheck strong program management and Secure Networks to support margin performance and management of operating expenses to support profitability while also funding growth investments. With 3 quarters complete, we have successfully managed 2023 to better than originally expected results year-to-date. Given this performance and our outlook for the remainder of the year, we are again in a position to raise our full year guidance on all metrics.

Now let's turn to Slide 4 to discuss our recent business highlights and updates. First and foremost, I'm pleased to announce that Telos in close coordination with TSA, achieved the formal launch of our TSA PreCheck program in the third quarter Telos' official TSA PreCheck enrollment website is operational and the website address is in our earnings presentation and press release. Our capability to process TSA PreCheck renewals is fully operational, and our capability to process new enrollments will continue to ramp up as we onboard physical sites across the country over the next several quarters. We look forward to steadily growing this offering in the coming quarters and years into a long-term, steady value-creating program for Telos.

Beyond TSA PreCheck, we continue to achieve high renewal rates with our exact customer base, both in government and commercial sectors. Government customers included the National Geospatial Intelligence Agency the Federal Bureau of Investigation, the U.S. State Department, the Defense Intelligence Agency, the Social Security Administration, the U.S. Environmental Protection Agency and a classified customer. Commercial customers included Zscaler, Ernst & Young, stackArmor and a large confidential customer in the technology sector. We were also awarded renewals for cyber services at the Defense Health Agency the General Service Administration and the U.S. Department of Homeland Security. Additionally, we secured a new award for our automated message handling system with the joint cryptologic mission simulation program through the National Security Agency.

Lastly, the Secure Networks team obtained a new contract with the U.S. Air Force for a new secure network installation, building on our 3 decade-long relationship with the U.S. Air Force. I will now turn the call over to Mark Bendza, who will discuss the third quarter 2023 financial results, guidance for the fourth quarter and full year 2023 and a preliminary outlook for 2024. Mark?

[Mark Bendza, executive]

Thank you, John, and thank you, everyone, for joining us today. Let's turn to Slide 5. As John mentioned, we completed the third quarter with revenue gross margin and adjusted EBITDA all above the high end of our guidance range. And we are, therefore, again able to raise the midpoint of our full year guidance while also narrowing the guided ranges. Getting into more detail on the third quarter, total revenues declined 43% year-over-year and grew 10% sequentially to $36.2 million due to sequential growth in both Security Solutions and Secure Networks.

Revenues for our Security Solutions business declined 39% year-over-year and grew 15% sequentially to $19.8 million. Security Solutions revenues were above the top end of our third quarter guidance range due to outperformance on important programs, including higher-than-forecasted TSA PreCheck renewal volume, a rebound in customer mission activity on a confidential program and revenues on a cybersecurity program that accelerated from the fourth quarter to the third quarter. Security Solutions contributed 55% of total company revenues up from 51% in the comparable period last year.

The large year-over-year revenue drivers for Security Solutions were consistent with our expectations as communicated on prior earnings calls. Stable recurring revenues in our Information Assurance business were offset by revenue contraction in Secure Communications and Telos ID as a result of a program loss in Secure Communications at the end of 2022 and lower revenues on 2 ongoing programs in Telos ID. Combined, these 3 programs represented a $16.6 million year-over-year headwind in the quarter.

Turning to Secure Networks. As expected, revenues declined 47% year-over-year and grew 4% sequentially to $16.4 million, in line with our third quarter guidance range. The year-over-year revenue headwinds in secured networks were also consistent with our expectations as communicated on prior earnings calls. 3 large programs that primarily came to a successful completion in 2022 and lower revenues on an ongoing program drove a $17 million headwind in the quarter.

Turning to profitability. GAAP gross margin expanded over 300 basis points to 36% due to a higher weighting of revenues from our higher-margin Security Solutions business and more than 500 basis points of margin expansion in Secure Networks, partially offset by margin contraction and Security Solutions. Amortization of previously capitalized software development costs was a meaningful year-over-year headwind to GAAP gross margin in the third quarter and will remain an important component of our cost of sales from the third quarter onwards. In accordance with GAAP accounting, we expense software development costs as research and development expense until we meet certain milestones. After which, we begin to capitalize software development costs as an intangible asset on our balance sheet.

Lastly, we amortized the intangible assets related to revenue-generating activities through cost of sales after the software has completed its development phase. As a result of the successful formal launch of the TSA PreCheck program in the third quarter, we have now started amortizing the TSA PreCheck software development costs that have been capitalized over the past few years. Accordingly, going forward, we will report gross margin on a GAAP basis as well as on a non-GAAP basis, excluding stock-based compensation and depreciation and amortization.

We believe non-GAAP gross margin is a useful supplemental and clarifying measure to help investors better understand the core economics of gross margin during the current reporting period, excluding non-cash expenses and some costs expended in prior quarters and years. We will continue to guide gross margin on a GAAP basis. With that background, non-GAAP gross margin expanded 684 basis points to 41.5% and due to a higher weighting of revenues from our higher-margin Security Solutions business, 626 basis points of margin expansion in Security Solutions and 480 basis points of margin expansion in Secure Networks.

GAAP gross profit exceeded the high end of our forecasted range by approximately $1.2 million and GAAP gross margin exceeded the high end of our guidance range by 180 basis points. GAAP gross margin for our Security Solutions business contracted 77 basis points to 47.3%, primarily as a result of the commencement of amortization of previously capitalized software development costs associated with the TSA PreCheck program. Security Solutions GAAP gross margin was consistent with our forecasted range.

Security Solutions non-GAAP gross margin expanded 626 basis points to 57.4%, due to more favorable revenue mix. GAAP gross margin for our Secure Networks business expanded 509 basis points to 22.3% due to the successful completion of lower-margin programs at the end of 2022 and exceeded our forecast due to margin outperformance on multiple programs across the portfolio due to strong program cost management.

Secure Networks non-GAAP gross margin was not meaningfully different from GAAP gross margin. Adjusted EBITDA was a $1.3 million loss and exceeded the top end of our guidance range by $4.7 million due to $2.9 million of better-than-forecasted gross profit excluding depreciation and amortization as well as $1.8 million of lower than previously forecasted below-the-line expenses, which primarily represents the management reserve that we disclosed in our prior earnings call.

Now let's turn to free cash flow and liquidity. We returned to positive cash flow from operations in the third quarter due to favorable working capital dynamics. Cash flow from operations was an $846,000 inflow and free cash flow was a $3 million outflow. We ended the quarter with approximately $100 million of cash, no debt and an undrawn $30 million senior secured revolving credit facility with an additional $30 million expansion feature. Our balance sheet continues to be a competitive advantage and remains well positioned to support the company through a wide range of operating conditions and strategic opportunities.

Let's turn to Slide 6 to discuss our guidance for the fourth quarter. For the fourth quarter, we forecast sales in a range of $30 million to $34 million and an adjusted EBITDA loss of $6.5 million to $4.5 million. We forecast Security Solutions revenues to decline high 30% to low 30% year-over-year and secured networks revenues to decline low 30% to mid-20% year-over-year, both primarily due to the same dynamics that have persisted throughout 2023. GAAP gross margin is expected to be down approximately 350 basis points to 225 basis points year-over-year primarily due to higher amortization of capitalized software development costs.

Cash below-the-line expenses, which adjust for capitalized software development costs, stock-based compensation, restructuring costs and depreciation and amortization are forecasted to be approximately $3 million higher year-over-year, primarily due to planned growth investments focused on business development, information assurance, Telos ACA and TSA PreCheck.

Let's turn to Slide 7 to discuss our updated guidance for the full year. We are again raising the midpoint of all full year guided metrics and also narrowing our guided ranges. During our 3 earnings calls of 2023, we have now reaffirmed our full year guidance once and raised the midpoint of guidance twice. Our fourth quarter guidance implies full year revenues of $134 million to $138 million, representing a $6.5 million increase to guidance at the midpoint. We're forecasting full year GAAP gross margin in a range of 36.8% to 37% or a 125 basis point increase at the midpoint.

Lastly, updated guidance includes adjusted EBITDA ranging from a $9 million loss to a $7 million loss or an $8.5 million increase at the midpoint. Over the course of 2023, our revenue guidance has improved due to strong renewal rates and information assurance and secure communications, new contract wins in secure communications, better-than-expected performance on TSA PreCheck, favorable supply chain performance in Secure Networks and expanded revenues on a pre-existing program in Secure Networks. GAAP gross margin guidance has improved due to high-margin new business wins and revenue outperformance on higher-margin programs and Security Solutions, and strong program management and Secure Networks.

Lastly, adjusted EBITDA guidance has improved over the course of the year due to improved gross profit from higher revenues and gross margins, combined with multiple quarters of cost management that started with our restructuring in the first quarter. Now before I turn the call back over to John, I'd like to provide an overview of some of the key variables that will ultimately determine the 2024 guidance that we will provide on our fourth quarter earnings call in March.

At this stage, we believe our total 2024 potential revenue opportunity exceeds $200 million and is highly dependent on 2 pending new business opportunities in Security Solutions, and the ramp of our TSA PreCheck program. All of which should become more visible before our fourth quarter earnings call in March. Let's break this down into 2 components: pre-existing programs and pending new business opportunities. Starting with pre-existing programs. As communicated on our second quarter earnings call in August, there is a 2024 revenue headwind of approximately a few tens of millions of dollars embedded in our pre-existing programs, inclusive of growth from TSA PreCheck. These headwinds need feedback fills with new business wins late this year or early next year. The ultimate size of the headwinds embedded in pre-existing programs will primarily depend on the performance of TSA PreCheck. In particular, the pace and timing of opening new enrollment locations and annual fluctuations in overall market transaction volume.

Turning to pending new business opportunities, again, as communicated on our second quarter earnings call in August, new business award decisions tend to be seasonally weighted to late in the calendar year or early the following calendar year. We are currently awaiting final award decisions on numerous pending new business proposals, representing approximately $610 million of total contract value and approximately $115 million of potential 2024 revenue.

The ultimate revenue contribution realized in 2024 from pending new business opportunities will depend on win rates and program start dates. Approximately 85% or nearly $100 million of potential 2024 revenue from pending new business opportunities is concentrated in [ two ] long-term recurring revenue opportunities and Security Solutions with award decisions anticipated before March of 2024. There may also be additional opportunities to generate revenue from task orders on new contract vehicles and Secure Networks over the course of 2024.

Lastly, turning to gross margins. substantially all pending new business opportunities reside in Security Solutions and substantially the entire revenue headwind on pre-existing programs resides in Secure Networks. Accordingly, Security Solutions revenue could represent as much as 70% to 80% of total company revenue in 2024. The overall company gross margin profile in 2024 is expected to be roughly comparable to 2023 as the margin benefit of higher revenue contribution from our higher-margin Security Solutions segment will be offset by margin contraction in each of Security Solutions and Secure Networks in part as a result of higher amortization of capitalized software through cost of sales and revenue mix within each segment.

With that, I'll pass it back to John, who will wrap up on Slide 8.

[John Wood, executive]

Thanks, Mark. Let's move to Slide 8. In summary, we exceeded quarterly expectations and delivered results above the high end of the guidance range on all financial metrics. Our TSA PreCheck program formally launched this quarter and was a key factor in our overperformance. We look forward to steadily growing this offering into an important source of recurring revenue in the coming quarters and years.

We raised full year guidance for the second consecutive quarter as we continue to focus on managing 2023 to better-than-originally expected results through high-margin new business wins, program management, cost discipline, implementation of our restructuring and reinvestment in growth. As we look ahead, the potential revenue opportunity for 2024 is encouraging as we eagerly await the outcome of pending new business opportunities in Security Solutions.

Lastly, our balance sheet remains highly liquid and a competitive advantage, well positioned to support the company both operationally and strategically. And with that, we're happy to take any questions.

[Mark Bendza, executive]

Operator, please open the line for Q&A, and we ask the call participants to please be mindful of others in the queue by asking only one question. Thank you.

[Operator]

[Operator Instructions] Our first question comes from the line of Zach Cummins with B. Riley Securities.

[Zach Cummins, analyst]

Good morning, Mark and John, congrats on a solid quarter here and appreciate the additional color around the puts and takes for 2024. Just to that point, I mean, it seems like the opportunity is really concentrated in 2 large programs within Security Solutions. So John, can you go ahead and handicap how you're feeling about your chances of winning in each of these engagements and kind of give us a sense of how you're progressing through kind of the decision process at this point?

[John Wood, executive]

Yes. I think these are two opportunities of customers that we've known well for a long time, and I feel good about the potential of the outcomes for sure is that, I also mentioned that we mentioned task orders and other contract vehicles. We have -- when we go after contracts, there are really 2 types of contracts. One has -- one contract vehicle has a financial amount for sure, per year, and these are the 2 contracts we're talking about.

But other contracts have a significant amount of ceiling. So previously, we had a contract called [ Net sense ]which had a lot of ceiling on it. And over the course of roughly 18 to 20 years, we did about $1.6 billion or $1.5 billion on that contract. So we're really pursuing both kinds of contracts we're emphasizing these two because they have financial certainty around them.

[Operator]

This question comes from the line of Rudy Kessinger with D.A. Davidson.

[Rudy Kessinger, analyst]

For question on TSA PreCheck, can you give any color about how much it contributed in the quarter? Where are you trending on your market share on renewals and also on -- with new enrollment, how many sites are you up to? When do you think you'll be fully rolled out? And just again, what's kind of the time line you're thinking of to get the full 1/3 market share?

[Mark Bendza, executive]

Rudy, it's Mark Bendza here. So I'll try to give some color there. Keep in mind, though, we're not really going to be giving a lot of detail on PreCheck financial performance. We don't really do that on any other programs. So we're not going to go into a lot of detail on this call or future calls on PreCheck financial performance. But what I will say is that we feel we're off to a good start here. The performance on PreCheck was the single largest driver of our beat in the quarter.

The market overall is currently trending very well, both on new enrollments and renewals. What we're seeing is that the market is -- it's quite a quite a bit bigger today than it was from the pre-COVID highs. New enrollments, for example, are approximately double what they were during the pre-COVID highs. So we're pleased so far with how that program is ramping for us. Like I said, it's similar to speak in the quarter. And we're very encouraged by what we're seeing so far. On more operational aspect of the program, let me turn it over to Mark Griffin.

[Mark Griffin, executive]

Yes. Thank you. One of your questions was how many sites we currently have. That's 26 sites. I wanted to remind everyone that our ability to ramp to the full complement of sites that we have talked about will occur by the end -- we also wanted to remind everybody that our experience level in ramping site is shown in the effort and work we did on the 2020 census. Also the sites that we have at over 100 facilities in the aviation security space at airports and also our experience at the DoD, where we have well over 100 biometric sites that were deployed on numerous contracts. So our ability to ramp quickly and expeditiously with our partner, Office Depot, we're confident that, that will progress very rapidly as we move forward.

[Operator]

This question comes from the line of Alex Henderson with Needham.

[Alex Henderson, analyst]

I was hoping you could talk about what is in the contracts a little bit? Is it Xacta? Is it AMHS? What's going on within the mix of what you're trying to sell to these customers. And I was hoping you could give us any update on goes to while you're at it. .

[John Wood, executive]

Alex, this is John. So broadly speaking, the vast majority of everything we're bidding on is inside of our Security Solutions segment. And it's a combination of different capabilities that we deliver from a cybersecurity services to identity applications. Those are the kind of things that we're focusing on these days, which we think has a -- which we think we're well positioned for. And [ GO ], we see as becoming more of a feature of some of the capabilities that we have out there, where we're able to hide what we're doing, if you will, from people that are interested in finding out what we're up to. So I would say the vast majority of everything we're doing in Security Solutions.

[Alex Henderson, analyst]

So no, no mention of Xacta on that?

[John Wood, executive]

No, Xacta, it would be a component as well. So any time we can -- and I think I've said this previously, any time we can, we're going to be bundling our Security Solutions together which gives us a differentiated offering to our customers.

[Operator]

This question comes from the line of Nehal Chokshi with Northland Capital Markets.

[Nehal Chokshi, analyst]

Yes. And congratulations on the successful second quarter. [indiscernible] be in raise and as well as from TSA initial ramp here. My question is on the initial view on CY '24, especially the swings of those 2 contracts in order for them to contribute up to $100 million in calendar what would be the presumption of those contract start times?

[John Wood, executive]

Start to be around Q1. Q1, early Q2, Nehal.

[Nehal Chokshi, analyst]

Okay. And when you say a $115 million of total calendar '24 revenue contribution from the various contracts are up and then the $10 million of total contract value that implies you're basically talking about average 5-year duration for these contracts that are in their mature phase of the pipeline?

[John Wood, executive]

I think that's fair. However, when you look at our complete pipeline, our complete pipeline is well in excess of $3 billion, and that pipeline can range from a couple of years to 10-year kind of contracts.

[Nehal Chokshi, analyst]

Okay. And within that pipeline, the remaining $2.4 billion, how much of that do you think will be awarded sometime in calendar '24 that could start to ramp within calendar '25?

[John Wood, executive]

I don't know that off the top of my head. Do you know off the top of your head I don't know that answer off the top of my head. I would say that the -- what we're giving you in terms of the dollars of $600 million. Those have been submitted and those are pending awards. So we're giving you what, if you will, the tail end of the pipeline, there will be a continuous input of additional opportunities into the pipeline each quarter. So I would expect that pipeline to continue to mature. And as it matures, we'll continue to update the market. Thank you.

[Operator]

I'm showing no further questions at this time. I would now like to turn the call back to John Wood for closing remarks.

[John Wood, executive]

Thank you, operator. First of all, I just want to thank our shareholders for your ongoing support. We had a second consecutive quarter of raising our full year outlook and that's a testament to my team's unwavering commitment to delivering for our customers and our shareholders in 2023 and beyond. We've made good progress during '23 to rebuilding our core revenue base through -- we have had really strong renewal rates on our existing business.

We've cultivated and centralized a very productive business development and new business development pipeline, and we continue to invest in really solid future growth opportunities. And the basic point I want to make is we're really just getting started. With robust recession-resistant end markets and well-funded customers and decades long track record of serving some of the world's most security-conscious organizations we think Telos is a really strong foundation for the future. And we just want to thank you again for your support. Thanks a lot, everybody.

[Operator]

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.