Earnings Call Transcript - TLS Q1 2024

Operator, Operator

Good day, and thank you for standing by. Welcome to the Telos Corporation First Quarter 2024 Earnings Call. Please be advised, this conference is being recorded. I would now like to hand the conference over to your speaker today, Allison Phillipp, please go ahead.

Allison Phillipp, Presenter

Good morning. Thank you for joining us to discuss Telos Corporation's First 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 first quarter 2024 results. Next, John will discuss business highlights from the first quarter. Mark will follow this up with the second quarter guidance and insights on the financial outlook for the company before turning back to John to wrap up. We will then open the line for Q&A, and 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, in 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 to 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 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 Mark.

Mark Bendza, CFO

Thank you, Allison, and good morning, everyone. Let's begin today on Slide 3. I am pleased to report that Telos has again over-delivered on key financial metrics in the first quarter, exceeding both revenue and profit guidance. Overall, it was a straightforward quarter with better-than-guided performance across key financial metrics, leading to a meaningful beat on profit and cash flow. Let's get into some of the details. We delivered $29.6 million of revenue in the first quarter or approximately $600,000 above our guidance range of $28 million to $29 million. Security Solutions delivered $18.6 million of revenue, which was above the top end of our guidance range due to modest out-performance across all lines of business. Secure Networks delivered approximately $11 million of revenue, in line with the top end of our guidance range. GAAP gross margin was 37%, above our guidance due to cost management on fixed price contracts in Security Solutions, better-than-expected utilization of direct labor in Secure Networks and a slightly better overall weighting of revenues to our higher-margin Security Solutions business. Security Solutions generated approximately 63% of total company revenues in the first quarter of 2024 versus 56% in the first quarter of 2023, a favorable variance that is expected to widen as the year progresses. Cash gross margin was a notable 42.2%, expanding 249 basis points year-over-year and representing our second highest quarter since our IPO in 2020. Revenues and gross margins both above forecast resulted in gross profit above what was incorporated into our adjusted EBITDA guidance range. In addition, R&D and SG&A expenses were better than forecasted due to timing of spending and higher-than-forecasted capitalization of software development costs. As a result, adjusted EBITDA also exceeded the top end of our guidance range. Adjusted EBITDA was a $2.3 million loss compared to our guidance range of a $5.5 million loss to a $5 million loss. Lastly, cash flow from operations was a $350,000 outflow and free cash flow was a $3.6 million outflow. Free cash flow improved from a $4.1 million outflow in the first quarter of 2023. So overall, it was a clean quarter with solid execution throughout the portfolio. I will now turn it over to John for an overview of business highlights. John?

John Wood, CEO

Thanks, Mark, and good morning, everyone. Let's turn to Slide 4. As communicated on our last earnings call in March, Telos has teaming agreements in place with prime partners who in the first quarter received awards from the federal government worth up to $525 million to Telos' Security Solutions business over 5 years. It's not uncommon for award decisions of this magnitude to be protested by incumbents or other bidders as part of a customary post-award protest period provided by the government, and that's the case here. These awards have been protested, and finalization of the award is subject to resolution of the protests. Given the typical protest time table, resolution is expected in the second quarter and assuming a favorable outcome revenues are expected to ramp throughout the balance of the year. We look forward to the conclusion of these protests as these awards represent pre-existing programs requiring a timely and smooth transition to ensure uninterrupted service to the federal government. Beyond these awards, it's important to highlight since 2023, we have won positions on 5 new federal contract vehicles, including most recently, a vehicle through which the United States Marine Corps will procure modernized capabilities for telecommunications and network infrastructure at all required Marine Corps bases, posts, camps, and stations globally. In the aggregate, these 5 new contract vehicles provide Telos with market access to compete for new business opportunities that represent a $12 billion addressable market. We will continue to pursue additional contract vehicles that will further increase our access to new federal markets over time. In addition, I'm pleased to report on several other key outcomes since our last earnings call. Our Xacta business has received new orders with the U.S. Air Force Services Center as well as a major technology company and a federal government customer. Additionally, the Xacta business has achieved renewals with several key customers including the U.S. 16th Air Force, the U.S. National Geospatial Intelligence Agency, the U.S. Defense Intelligence Agency, the U.S. Department of Energy, a professional services company, and a leading cloud computing company. The company has received services renewals with the U.S. Department of Homeland Security, the U.S. Office of Naval Intelligence, and a federal executive department. Our Automated Message Handling System business achieved a major contract renewal with a branch of the U.S. Armed Forces. And finally, within our Telos ID business, transaction volumes in our TSA PreCheck program have sequentially ramped every quarter for the last 4 quarters, including the first quarter of 2024. We continue to work closely with TSA to ensure our preexisting enrollment locations are operating at the absolute highest possible standards necessary for a national security program of this magnitude, before accelerating our rollout of additional on-site enrollment centers around the country. We opened 2 additional enrollment locations in April with more expected in the coming quarters. I will now turn the call over to Mark who will discuss second quarter guidance.

Mark Bendza, CFO

Thanks, John. Let's turn to Slide 5. For the second quarter, we expect revenue in a range of $25 million to $28 million and an adjusted EBITDA loss of $8 million to $6 million. We forecast Security Solutions revenue to be down high single digits to up mid-single digits percent year-over-year, primarily driven by a nonrecurring perpetual license sale in the second quarter of 2023, offset by growth in TSA PreCheck in 2024. We forecast Secure Networks revenue to decline low 40% to mid-30% year-over-year due to the ongoing reductions in backlog that we expect to persist sequentially throughout the year. Our second quarter guidance, combined with our first quarter reported revenue, implies first half revenue of $54.6 million to $57.6 million and compares favorably with the approximately $55 million of first half revenue that we outlined in the 2024 modeling inputs provided in the appendix of our fourth quarter earnings presentation. Overall, we expect total company revenue to return to sequential growth in the third or fourth quarter, subject to favorable resolution of protests. GAAP gross margin is expected to be down approximately 750 basis points to 425 basis points year-over-year, primarily due to higher amortization of capitalized software development costs in Security Solutions and a nonrecurring perpetual license sale in the comparable period last year, partially offset by a more favorable revenue contribution from our higher-margin Security Solutions business in 2024. Cash gross margin is expected to be down 250 basis points to flat year-over-year. Cash below-the-line expenses, which adjust for capitalized software development costs, stock-based compensation, restructuring costs, and D&A are forecast to be approximately $1.9 million to $2.1 million higher year-over-year, primarily due to investment in growth initiatives. Lastly, our full-year outlook is substantially unchanged. And we've made only minor adjustments to the full-year modeling inputs provided in the appendix. And with that, I'll turn it back to John.

John Wood, CEO

Thanks, Mark. Let's turn to Slide 6. In summary, we once again exceeded expectations and delivered results above the high end of the guidance range on key financial metrics in the first quarter. We've made substantial progress on new business capture during the first quarter. And we expect Security Solutions and total company revenues to return to sequential growth in the third or fourth quarter, subject to favorable resolution of protests. And with that, we're happy to take questions.

Mark Bendza, CFO

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

Our first question comes from Zach Cummins with B. Riley Securities.

Zach Cummins, Analyst

I guess I'll try to make a multipart question. One for John, could you speak to just the protesting process? I appreciate the timeline. And just curious if they give you any sort of indications or updates along the way? Anything you can share incrementally on the protesting process? And then part two is just on a TSA PreCheck program. Nice to hear that you've ramped volumes every quarter since its launch. But just curious if we could get more insight into how you're thinking about the rollout timeline for new locations. And now that all 3 vendors are live on the program if there's been any notable changes in transaction volumes.

John Wood, CEO

Thank you for the question, Zach. The protest process usually takes 100 days. We anticipate an outcome this quarter regarding both of the new awards we announced last quarter. We don't have daily insights into the protest process as we are not involved in it. However, as mentioned before, a very small percentage of these programs are decided against the winning bidder. Therefore, we are confident about moving forward with these initiatives. Regarding TSA PreCheck, I'm happy to share that we will be accelerating the rollout of our Office Depot locations and we expect to expand this into the second quarter, aiming for 500 stores by 2025.

Mark Bendza, CFO

Yes. And Zach, I think what I'd add to that with respect to transaction volumes, as we've said, they've ramped nicely over the last few quarters. In terms of having all the participants come into the market in terms of the 3 participants, that was already factored into the prior guidance and modeling inputs that we've provided. Does that answer your question, Zach?

Zach Cummins, Analyst

Yes, it does. I appreciate answering my questions, and best of luck for the rest of the quarter.

Operator, Operator

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

Rudy Kessinger, Analyst

I guess I'm kind of curious, this $100 million of revenue from existing contracts this year. How much from those existing contracts is going to fall in '25? So if it's $100 million this year, how much is that going to decline to in '25?

Mark Bendza, CFO

Yes. So really, what we've said in the past, and I think it applies here as well. In a typical year, we expect a few tens of millions of headwinds from prior year revenues. So if you think about the $100 million that's recurring in '24, I'd say, in '25, that $100 million becomes approximately $70 million. And then you're adding on from there the additional revenue from these programs that would come on board subject to resolution of the protest. We've given you an indication of what that could be in a typical year. And then we have additional revenue from TSA PreCheck as we continue to make progress on rolling out our Office Depot locations. And then, of course, any other additional new business wins that we realized late this year, early next year, that's the typical seasonality pattern of new business wins. Does that answer your question, Rudy?

Operator, Operator

Our next question comes from Bradley Clark with BMO Capital Markets.

Bradley Clark, Analyst

On the TSA side, one of the strategies is obviously opening the number of locations. Is there anything else that Telos is doing to sort of differentiate its TSA offering now that sort of the competitive landscape is set? Is there anything from pricing or marketing that could actually fall into the expense line that we should be considering aside from new locations?

Mark Griffin, Executive VP, Security Solutions

Brad, it's Mark Griffin. I'll answer it first. First, I wanted to say how pleased we are with our strategic relationship with Office Depot for the TSA PreCheck program. This direct-to-consumer opportunity is of great value to TSA and the program. So as we roll out, obviously, from a marketing and an expansion point of view, that's a key partner that will be very critical for us as we do that. From an expense line, I'm going to turn it over to Mark. But right now, I'm not anticipating major expenses in that area other than our commitment to our strategic partner, Office Depot and the expansion in those areas.

Mark Bendza, CFO

I agree with that. I have nothing to add to what Griffin has already said.

Operator, Operator

Our next question comes from Alex Henderson with Needham.

Alex Henderson, Analyst

I was struck by how many renewals you have announced here. And in that context, you've also maintained the full year numbers. So I assume that these renewals were as expected and not changing the overall trajectory. Is that a fair statement?

Mark Bendza, CFO

Yes, I think that's a fair statement, Alex. Our track record on renewals is excellent. Our customers tend to be very sticky. And so we had another excellent quarter on renewals, and that's what we expected coming into the year.

Alex Henderson, Analyst

And as you look forward into the back half of the year and into the first half of next year, over the next 12 months, what does the renewal pipeline look like?

Mark Griffin, Executive VP, Security Solutions

On the contract renewal, the Security Solutions contracts have a high renewal percentage, whereas we see a lower renewal volume on the Secure Networks side. Therefore, I anticipate that most of the business in Security Solutions will renew and expand, supported by the additional contract vehicles that John mentioned. Those five contract vehicles will also be included in the portfolio for both Secure Networks and Security Solutions. This suggests a growth area, not just from contract renewals but also from new contract vehicles that will enhance the portfolio.

John Wood, CEO

The Security Solutions business primarily generates recurring revenue, with consistent renewals coming in. In contrast, the Secure Networks side has programs that progress through distinct phases, leading to the revenue Mark references during calls. Therefore, view Security Solutions as a source of recurring revenue and Secure Networks as generating more episodic revenue.

Alex Henderson, Analyst

I guess what I'm trying to ask, and maybe I'll just try it a different way, is the same question. Is there more or less than normal renewals in the headlights or is it just the same level of typical renewals? We're trying to ascertain the potential change in the rate of renewals as opposed to what the closure rates look like?

John Wood, CEO

Yes. So it's about the same, Alex. And we would anticipate it to continue. There are 4 big points for us in the company. One is to continue our extreme focus on our current customers. The second is to very much accelerate the ramp of Office Depot locations, so that's going to accelerate the ramp of revenue for TSA PreCheck. And the third is to execute against new business wins that we previously announced. And the fourth is to focus on continuing to deliver new business awards. So our pipeline continues to grow, and it continues to be an opportunity for us to see top line.

Operator, Operator

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

Nehal Chokshi, Analyst

The five new federal contract vehicles you've secured represent a $12 billion addressable market. Can you clarify whether this figure is annualized or represents a total over a certain number of years, and if it's over a specific period, how many years that entails? Additionally, what margin profile do you anticipate for this $12 billion addressable market that you are now able to compete in?

John Wood, CEO

Yes. So 2 of the awards are in the Secure Networks bucket, if you will. Two of the awards are in what I'll call our enterprise bucket, which is the entire company. And then one is in Security Solutions. As far as the margin profile goes, the period of performance on these can range anywhere from 5 to 10 years. And I'm going to turn to Mark on the margins, if you don't mind.

Mark Griffin, Executive VP, Security Solutions

Yes, the margin profiles would follow what we have as projected and modeled as far as Security Solutions and Secure Networks. So those margin profiles would basically follow that based on what John indicated is the breakout of that total overall market value.

John Wood, CEO

For the analysts on the call, please note that each of these awards includes several other recipients. Consequently, we refer to it as an addressable market because we must compete at the task order level for these awards. This means we face limited competition at this level, unlike the previous two awards we discussed, where we were part of a team competing for a single award. This difference makes those other awards more predictable in terms of revenue distribution. In contrast, these awards serve as contract vehicles with substantial ceilings. For each award, we need to compete at the task order level, and these task orders can range from approximately $2 million to $100 million, adding some nuance to the discussion.

Nehal Chokshi, Analyst

Yes, that's definitely helpful. And then in past quarters, you've been talking about your bidding pipeline, size sort of bidding pipeline, how that's been growing. Did you give an update? If not, can you do so?

John Wood, CEO

Sure. So outside of these awards, those vehicles that have been won, there's an additional roughly $3.2 billion worth of pipeline, and that's unfactored without renewals.

Nehal Chokshi, Analyst

Got it. Great. And that's up from what last quarter?

John Wood, CEO

To be honest, I don't want our analysts to fall into the trap of measuring it from quarter to quarter because it's going to change. Some bids will come in, and some bids will go out. We'll reject certain bids while accelerating others. However, in general, we prefer to see a pipeline like this because we want it to be at least ten times our potential.

Operator, Operator

Ladies and gentlemen, this does conclude the Q&A portion of today's conference. I'd like to turn the call back over to John Wood.

John Wood, CEO

Well, first of all, I just want to thank our shareholders for your ongoing support. And as we've said here on the call, I'm very pleased with the progress we've made on our new business capture in the first quarter. I'm looking forward to finally getting to sequential revenue growth in the third or the fourth quarter. And obviously, subject to the resolution of the protests that we've talked about previously. These contracts will have the potential to significantly and very positively impact our performance, along with us opening up Office Depot locations for TSA PreCheck. I think the other thing I want to remain focused on is our pipeline expansion. I mentioned several quarters ago that we were going to go back to the markets that we know best. And I think we're seeing the kind of results that we expect to have for a company that knows the U.S. federal government and adjacent markets around it. So I remain very excited about the outlook for the company and with robust and recession-resistant end markets, with well-funded customers and a decades-long track record of serving the world's most security-conscious organizations. Telos really does have a very strong foundation for the future. So I just want to say, again, on behalf of all of us here at Telos, thank you.

Operator, Operator

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.