Earnings Call Transcript - TLS Q3 2024

Operator, Operator

Good day and thank you for standing by. Welcome to the Telos Corporation Third Quarter 2024 Earnings Call. At this time all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today’s session is being recorded. I would now like to hand the conference over to your first speaker today, Allison Phillips. Allison, you have the floor.

Allison Phillips, Vice President

Good morning. Thank you for joining us to discuss Telos Corporation's third quarter 2024 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. Mark will begin with remarks on our third quarter 2024 results. Next, John will discuss business highlights from the quarter. Then Mark will follow-up with fourth quarter guidance before turning back to John to wrap up. We will then open the line for Q&A. Mark Griffin, Executive Vice President of Security Solutions will also join us. The third quarter financial results were issued earlier today and are 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 financial results summary 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's 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 measures, including reconciliations with comparable GAAP results in our third quarter financial results summary 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 Mark.

Mark Bendza, Executive Vice President and CFO

Thank you, Allison, and good morning, everyone. Let's begin today on Slide 3. I'm pleased to report that Telos has delivered revenue near the top end of the guidance range and adjusted EBITDA above the top end of the guidance range. We delivered $23.8 million of revenue in the quarter compared to guidance of $22 million to $24 million. Security solutions delivered $18.3 million or 77% of total revenue, which was in line with the top end of our guidance range due to strong performance across the portfolio relative to forecast. Security Solutions revenue grew 3% sequentially due to double-digit sequential growth in Telos ID primarily as a result of the ongoing ramp of our TSA PreCheck program. We expect sequential growth in our Security Solutions business to accelerate in the fourth quarter as our large program with the defense manpower data center or DMDC begins to ramp. DMDC is the large program award that was under protest earlier this year and has since been resolved and is currently generating revenue. Secure networks delivered $5.5 million or 23% of total revenue, in line with guidance. Secure networks revenue declined sequentially and year-over-year as expected, due to the ramp down of existing programs. As previously reported, secure networks has gained access to new contract vehicles in recent quarters and has cultivated a large pipeline of new business opportunities that we are currently pursuing to replenish the backlog. Turning to margins. As we mentioned on our last earnings call, we continue to assess opportunities to reduce our cost base in order to maximize our operating leverage, incremental margins and cash flow as we return to growth in 2025. As we also stated in our last earnings call, our guidance does not include any charges that could result from such actions. During the quarter, we assessed our cost structure and investment priorities to reduce costs and reallocate resources to support large programs that are currently ramping in Security Solutions. As a result, we discontinued the development and sale of selected solutions or parts of solutions that were not generating acceptable returns. The restructuring as well as an assessment of our intangible assets, resulted in an $11.7 million noncash impairment of capitalized software assets, including $5.3 million in cost of sales and the $1.4 million restructuring charge, including $400,000 in cost of sales. In total, we took a $13.1 million charge in the quarter, $5.7 million of which was recorded in cost of sales and impacted GAAP gross margin. GAAP gross margin was 13.2%. Excluding the $5.7 million impairment and restructuring charge and cost of sales, gross margin expanded 130 basis points year-over-year to 37.3% and was above the top end of our guidance range. In addition, cash gross margin expanded 250 basis points year-over-year to 44%. Cash gross margin was above our guidance range and was also the company's highest cash gross margin since the IPO in 2020. Strong revenue, cash gross margin over performance and cost reductions resulted in adjusted EBITDA above the top end of the guidance range. Adjusted EBITDA was a $4.1 million loss compared to guidance of an $8 million loss to a $6.5 million loss. Lastly, cash flow from operations and free cash flow both improved sequentially. Cash flow from operations was a $7.1 million outflow and free cash flow was a $9.9 million outflow. Now I'll turn the call over to John for an overview of recent business highlights. John?

John Wood, Chairman and CEO

Thanks, Mark, and good morning, everyone. Let's turn to Slide 4. We continue to make steady progress on the TSA PreCheck program. As Mark previously indicated, this program is the main driver for the sequential growth in the third quarter in our Telos ID business and it remains well on track to becoming our single largest program in 2024. We have continued to successfully accelerate the expansion of our network of enrollment centers by more than doubling our footprint from 83 to 173 locations over the past three months. Additionally, it's important to point out that we continue to prioritize our expansion in key markets geographically distributed across 29 states around the country. These states comprise approximately 79% of the population of the United States. We plan to build on this progress and continue the growth of our footprint in the coming quarters with the expectation of reaching 500 locations in 2025. Most importantly, we are thrilled to be working with TSA to effectively grow this important national security program and provide its critical service to the community of U.S. travelers. Next, I'd like to provide an update on the status of the program award protest discussed on our prior earnings calls. The first program is with the defense manpower data center or DMDC. Within the United States Department of Defense and is worth up to $485 million to Telos over five years. As expected, the protest on this program was resolved in favor of Telos and our prime partner by the end of September and we are currently generating revenues as the program operations ramp. We look forward to working with our partner to provide exceptional support to our customer in this program for years to come. The second program is with the Department of Homeland Security or DHS. This program with DHS is worth up to $40 million to Telos over five years. And as previously communicated, we expect this protest to be resolved in the fourth quarter. In addition, I'd like to report on several other business outcomes since our last earnings call. Our Xacta business has received new orders with several new customers including the United States Air Force Office of Special Investigations as well as renewals from the Social Security Administration, the Federal Bureau of Investigation, the Defense Intelligence Agency, Infor, Siemens and other key customers. We received renewals for cyber services from the General Services Administration, the Defense Health Agency, and other government customers. The automated message handling system business continues to achieve high renewal rates with its customer base. In particular, this quarter, the business realized renewals from the Department of Homeland Security, the Department of the Treasury and several other government customers. Finally, we received a new contract with the United States Army in our secure networks business. I'll now turn the call over to Mark, who will discuss fourth quarter guidance. Mark?

Mark Bendza, Executive Vice President and CFO

Thanks, John. Let's turn to Slide 5. For the fourth quarter, we expect revenue to grow 3% to 11% sequentially to a range of $24.5 million to $26.5 million. And we expect an adjusted EBITDA loss of $4.5 million to $3.5 million. Sequential revenue growth will be driven by Security Solutions. We forecast Security Solutions to grow low teens to low 20% sequentially, driven by the accelerating ramp of TSA PreCheck enrollments and our new program with the defense manpower data center or DMDC that I mentioned earlier. We expect secure networks revenues to decline sequentially in the fourth quarter due to the steady decline in backlog in advance of new business wins that will typically be awarded in the fourth quarter of 2024 and the first quarter of 2025. As previously mentioned, Secure Networks has gained access to new contract vehicles in recent quarters and has cultivated a large pipeline of new business opportunities that we are pursuing to replenish the backlog for 2025 and beyond. As a result of forecasted strong sequential growth in Security Solutions in the fourth quarter, combined with the sequential decline in secure networks, we expect Security Solutions to contribute over 80% of total company revenues in the fourth quarter. GAAP gross margin is expected to expand by 170 basis points to 230 basis points year-over-year primarily due to the favorable mix shift from our lower-margin secure network business to our higher-margin Security Solutions business. Cash gross margin is expected to expand by 465 basis points to 580 basis points year-over-year for the same reason. Cash below the line expenses, which adjust for capitalized costs, stock-based compensation, restructuring costs, and D&A are forecast to be approximately $4 million lower year-over-year due to lower incentive compensation expense and the benefits of cost actions taken in the third quarter. Lastly, we will provide further detail about our 2025 outlook on our fourth quarter earnings call in March. But in the meantime, the 2025 revenue drivers that we outlined on prior earnings calls have not changed. We forecast a return to year-over-year revenue growth in 2025. Revenues in 2025 will be comprised of several key components. First, we expect our existing business, excluding TSA PreCheck and the DMDC and DHS programs that we won in the first quarter of 2024 to generate approximately $60 million to $65 million of revenue in 2025. Assuming the DHS protest is resolved in our favor, the DMDC and DHS programs could generate over $100 million of revenue in some years. But for modeling purposes, we're assuming a more modest $60 million to $85 million in a typical year at full run rate. We believe we have the potential to achieve the typical year run rate in 2025. Third, we are targeting a pro-rata market share of the TSA PreCheck market after we complete the rollout of our 500 enrollment locations, and those locations mature into productive sites for a full calendar year. We expect to complete the rollout of our 500 enrollment locations by the end of 2025, and we believe the TSA PreCheck market is approximately a $200 million market based on our current pricing structure. Although we do not expect to achieve our pro-rata market share in 2025, we expect TSA PreCheck revenues to ramp as we continue to roll out our enrollment locations over the course of next year. Lastly, we have a large pipeline of new business opportunities, especially in secure networks, and will be submitting proposals during the fourth quarter government buying season. Any new business wins during the fourth quarter of 2024 or the first quarter of 2025 will have the potential to contribute revenue next year. And with that, I'll turn it back to John.

John Wood, Chairman and CEO

Thanks Mark. Let's turn to Slide 6. In summary, we delivered revenues near the top end of the guidance range and exceeded guidance on adjusted EBITDA. Additionally, we are thrilled the protest on the DMDC program was resolved in our favor. We are now generating revenues on this program as we ramp operations and look forward to working with our partner to provide exceptional support to our customer for years to come. We've continued rapid expansion of our network of TSA PreCheck enrollment locations to 173—more than doubling our footprint since the last earnings call. We continue to expect we'll reach 500 locations in 2025. Finally, with this recent positive news, we expect to achieve sequential revenue growth in the fourth quarter. And with that, we're happy to take questions.

Mark Bendza, Executive Vice President and CFO

Operator, please open the line for Q&A. Thank you.

Operator, Operator

At this time, we will conduct a question-and-answer session. Our first question comes from Bradley Clark with BMO.

Bradley Clark, Analyst

Congrats on the protest resolution. Can you just review the DMDC contract was up to $485 million? What are some of the puts and takes around what ultimately determines how much that contract can be given the $485 million ceiling, like, what are the factors that determine where you land below that ceiling?

Mark Bendza, Executive Vice President and CFO

So Bradley, it's Mark Bendza. On that program, there are a couple of different revenue streams. There's a base service revenue stream, which is a recurring revenue stream that we have a high level of visibility into; that's approximately $25 million. The remainder of the revenues are a combination of third-party hardware, software technology that we integrate into the overall solution for our customer that revenue stream can fluctuate quarter-to-quarter and year-to-year. So overall, for modeling purposes, we're calling it $60 million to $85 million a year. But in any given year, you could be over $100 million in total. Our best estimate at this point on a low year would be about $60 million. Now in those numbers, I tend to lump together DMDC and DHS. DHS is a small piece of that. Of the $60 million to $85 million that I quote, we're only including about 2% to 8% in that range for DHS, which is the smaller program of the two.

Bradley Clark, Analyst

Okay. And then can you remind us of the margin profile of this work compared to the remainder of your Security Solution business?

Mark Bendza, Executive Vice President and CFO

Yes. So the margin profile varies quite a bit depending on which revenue stream. I don't want to get into the details of the market profile for each revenue stream. But overall, on a blended basis, in those two programs combined, I would describe it as being dilutive to cash gross margins. Now in my prepared remarks, I talked about buckets of revenue for 2025. Some of those are accretive to margins, while some are dilutive to margins. Overall, in 2025, I'd say we're probably going to be a couple hundred basis points lower on cash gross margins and slightly lower on cash gross margin, but of course, on a significantly higher revenue base.

Operator, Operator

Our next question comes from Zach Cummins with B. Riley.

Zach Cummins, Analyst

I really wanted to focus on the restructuring actions that you decided to take care of late Q3, early Q4. Can you give us a little more detail on maybe some of the business lines that are going away and eventually how this could result in maybe more of a margin uplift when we look at the revenue ramp next year?

John Wood, Chairman and CEO

Sure, Zach. It's John. So, the solutions that we ended up deciding not to continue selling are our advanced cyber-analytics and our ghost solution. Basically, we just weren't seeing the uptick in sales that we wanted to. And as a result, we just decided, let's sell quickly and move on.

Mark Bendza, Executive Vice President and CFO

Yes. In fact, what I'll add to that is current revenues in those two solutions are effectively de minimis at this point. So there will be no revenue headwind as a result of that decision. And really, as we looked at the portfolio, we have these substantial programs in hand, but we are ramping quickly. We wanted to maximize the benefit of operating leverage, incremental margins, and cash flows heading into 2025 as a result of the ramp of those programs. So we took a hard look at the overall portfolio to identify where we could be shifting resources from higher risk, lower return opportunities to the lower risk, higher return opportunities that we have in hand.

Zach Cummins, Analyst

And one follow-up question is just around the pipeline going into a key buying season, especially for secure networks. Can you give us a sense of maybe the size of some of these opportunities that you're bidding on and confidence in securing some of this business as you go through the award process here in the next couple of quarters?

Mark Bendza, Executive Vice President and CFO

Yes, maybe I'll start, and then Mark Griffin and John can supplement. So we have a pretty meaningful portfolio of opportunities that are either already submitted or that we're currently working on. You can think of it as somewhere around 20 opportunities or so. About a third of those are already submitted. The balance are in process. In total, you're looking at nine figures of total contract value to Telos. Next year, of course, depending on win rates and when these programs start, there's potential for a couple of tens of millions or more of revenue in 2025. But again, there's a lot of contingencies around that. It's a little early to try to give direction on what that number is for next year or to guide it. We'll do that in March. But it's a pretty solid portfolio of opportunities that are actively in process. We see if Mark Griffin or John has anything to add.

Mark Griffin, Executive Vice President of Security Solutions

This is Mark Griffin. I don't have anything to add other than the total portfolio right now on the pipeline is around $4.1 billion referencing about 245 opportunities, of which what Mark indicated was a subset of that.

Operator, Operator

Our next question comes from Rudy Kessinger with D.A. Davidson.

Rudy Kessinger, Analyst

If I go back a year ago in your Q3 call last year, at that point in time, you guys said you believe you had a total 2024 potential revenue opportunity that exceeded $200 million. And obviously, yes, fell well short of that this year. You're kind of painting a picture, I know you're not giving a number, but with the pieces you gave, you're kind of painting the picture of ballpark $150 million-ish of revenue for next year. I guess I'm just curious what risk lies within that kind of number and in particular on the two large programs of $60 million to $85 million. How are you getting to that $60 million to $85 million? And what's the risk that year from now those contracts are only doing $30 million to $40 million next year?

Mark Bendza, Executive Vice President and CFO

Yes. The big difference between last year and this year. Last year, we were clear about this on the call, but last year, our comments were based on the $645 million of proposals that we had submitted. And we won a good chunk of those proposals in March, and then they were protected and slipped to the right for the lion's share of this year. Now in the fourth quarter, we're starting to generate revenues on this program. So that was a big driver of that delta. But a really good outcome on the new business wins relative to what we had submitted at the time of that call. And then, of course, the risk for revenue recognition in 2024 ended up being around the protest. Now fast forward to today, the revenue growth that we're talking about for next year are programs that are in hand that we're currently generating revenues on and ramping. As we talk about the $60 million to $85 million, I would describe it in this way. Of the $60 million to $85 million, there's $2 million to $8 million in the DHS program, which is still under protest. I think we said on the last call and this one as well that we're expecting that to be resolved in the fourth quarter based on feedback we've received. So that $2 million to $8 million needs to be resolved. And then, of course, there's a range there depending on how much share of that program we get from quarter-to-quarter, year-to-year. And within that, it can range from $2 million to $8 million. For the balance of the revenue of $60 million to $85 million, we have a high degree of visibility into $25 million of it. And the balance is the third-party hardware and software that I referred to earlier that we integrated into the overall solution for the customer that portion is variable and can fluctuate quarter-to-quarter, year-to-year. We think we have a pretty good understanding of what that revenue stream would look like in a typical year. Given that 2025 would be the first full year of execution on that program. We don't have multiple years of history on this overall scope of work. Of course, we have decades of history on this program on a smaller scope of work, but this is a significantly bigger scope of work on this program. So we don't have the history of years and decades of revenue to use that as a basis for the $60 million to $85 million. But relative to the $100 million that it could be in any given year, we think $60 million to $85 million is a pretty prudent haircut on the total potential. Does that answer your question?

Rudy Kessinger, Analyst

It does. That's very helpful color, racking it out there. I appreciate that. I also wanted to ask on PreCheck. The ramp has certainly picked up in locations I know you're saying get to the 500 locations next year not going to have full 1/3 market share for the full year. But I guess I'm curious, with the locations you have now, we assumed you were getting 1/3 market share with your currently live locations that would indicate about $22 million, $23 million of annualized PreCheck revenue today. I'm curious, are you getting a 1/3 market share at those existing 70-ish locations? And if not, like how quickly are you seeing yourselves get to 1/3 market share with some of the locations you rolled out earlier this year?

Mark Bendza, Executive Vice President and CFO

Yes. We don't have a contract area around each of those locations, but I can answer it a different way based on the average location that we have opened currently. And when you extrapolate that out to 500 locations, we are currently capturing the portion of overall market share that we would expect based on the locations we have opened today. And at the same level of productivity, the locations we have opened today hold as we roll out the 500 locations, we should be on track to capture a pro-rata market share of enrollees.

Operator, Operator

Our next question comes from Nehal Chokshi with Northland Capital Markets.

Nehal Chokshi, Analyst

Congrats on the solid bottom line results and guidance here. It's good to see that. Of this DMDC $485 million total contract value, is there any portion of that $485 million that may not be realized over the course of that five years? Or is that $60 million low point simply a reflection of timing of subcontracted revenue?

Mark Bendza, Executive Vice President and CFO

So of the $485 million, $125 million is the base services revenue that I described as having a high level of visibility. The difference between the $125 million and the $485 million is the third-party hardware and software that we integrate into the overall solution. The amount of that over the five years, we'll have to see. But our best estimate is that the two combined shouldn't be less than $60 million in a typical year and could be over— it could be approaching $100 million in some peak years. It's really going to be driven by the needs and the demands of the program.

John Wood, Chairman and CEO

So what I would say is that unlike other contract vehicles we have, this is a single-award contract for what is essentially one of the largest biometric applications in the government. It's the program that drives the common access card among other things, which gets you access to all the military bases and all the military networks around the world. So this particular contract is very important to the customer; it's very important to the mission. So in general, if they have the requirement to spend the money, they're going to. And we've had a relationship with this customer since 1995. This one we know very, very well. I think it's actually our longest-serving customer that we have as a company. So, this customer understands missions. And just by way of color, we have something like 40, 18-wheelers of equipment coming our way. So, there are all kinds of different things that we're doing for this customer.

Nehal Chokshi, Analyst

And then you also announced being named one of 20 vendors of a $13 billion base infrastructure management contract for the Air Force. Is that revenue from that award expected in calendar '25? Is that part of your calendar '25 buildup that you talked about, Mark?

Mark Bendza, Executive Vice President and CFO

So that—any future task orders and revenues that would come from that vehicle would be included in the bucket of new business wins that I referred to, that I did not quantify, but it's not included in any of the quantified buckets that I listed.

John Wood, Chairman and CEO

And the reason for that, Nehal, is that in this particular case, this contract is competed at the task order level by these 23 or 24 bidders of which we are one. We compete on a task for this time. And we would expect to get our fair share of this work over time given that we've done a tremendous amount of work with the Air Force previously on another contract we had called Netsense, where we were able to deliver something like $1.6 billion worth of value to the Air Force doing essentially the same kind of stuff.

Nehal Chokshi, Analyst

And just to be clear, has there been any material task orders from this new contract vehicle been issued yet?

Mark Griffin, Executive Vice President of Security Solutions

The task orders are just coming out now. The government has released, I believe, three and we're bidding on one of them right now. In the past quarter or two, we'll also bid on others as they come out. So it's just started once the protest was resolved and the playing field was announced. So we're in the process now of bidding on those, and we expect some resolution shortly on hopefully awards.

Nehal Chokshi, Analyst

Okay. And then for calendar '25, what you're basically talking about is you have a bunch of contracts in hand, but you're not expecting them to be matured within calendar '25. At some point in time, calendar '25, '27, they would be mature though. Once these contracts reach their mature state, what's your confidence level that you will be a material positive free cash flow? And what kind of free cash flow do you think that could be?

John Wood, Chairman and CEO

So I'm not going to comment directly on free cash flow, but what I will say is this, Nehal. My management team is compensated on two things: revenue growth and being free cash flow positive.

Mark Bendza, Executive Vice President and CFO

Yes. And Nehal, I guess what I'll add to that is in the past, we talked about just as a rule of thumb, approximately $200 million of revenue being free cash flow breakeven and $165 million of revenue being adjusted EBITDA breakeven. Some of these revenue changes that we have ramping, in particular because the PreCheck has a very favorable working capital profile. So the free cash flow breakeven point is probably lower than $200 million now. And we think we are on a good path to get there.

Nehal Chokshi, Analyst

What would you expect the incremental operating profit for incremental revenue above that $200 million sort of breakeven rate, which might be too high to be?

Mark Bendza, Executive Vice President and CFO

Yes. I don't want to get on a slippery slope, but the guiding '25 on this call, but we feel my earlier comments around the restructuring and the movement of resources that I talked about. The actions that we took were all towards moving resources towards these programs in a way that would allow us to maximize the benefit of that V-shaped recovery revenue in 2025. So we'll say more on the March call in terms of P&L detail.

Operator, Operator

This concludes the question-and-answer session. I would now like to turn it back to John Wood for closing remarks.

John Wood, Chairman and CEO

I want to thank our shareholders for your ongoing support. I'm very pleased with the recent positive news on our program award with the defense manpower data center and the continued progress with the TSA PreCheck program. Both these programs are key components of our future growth plans. Furthermore, we are focused on replenishing secure networks backlog through the recently won new contract vehicles and a large cultivated pipeline of new business opportunities. Finally, the team continues to prioritize the expansion of our pipeline and driving new business capture to enable additional growth for the company. Based on all of this, I look forward to 2025, and I remain excited about the long-term outlook for the company with robust and recession-resistant end markets, well-funded customers, and a decades-long track record of serving the world's most security-conscious organizations. Telos has a strong foundation for the future. Thank you, everybody.

Operator, Operator

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