Telos Corporation (TLS) Q4 2021 Earnings Report, Transcript and Summary

Good day and thank you for standing by. Welcome to Telos Corporation's Fourth Quarter 2021 Earnings Conference Call. At this time all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to hand the conference over to Christina Mouzavires. Please go ahead.

Good morning. Thank you for joining us to discuss Telos Corporation's fourth quarter and full year 2021 financial results. With me today is John Wood, Chairman and Chief Executive Officer of Telos; and Mark Bendza, Chief Financial Officer of Telos. Let me quickly review the format of today's presentation. John will begin with brief remarks on our 2021 year-end results and Telos' strategic priorities, and Mark will cover the financials and guidance for 2022. Then we'll open the line for questions and answers 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 measures, including reconciliations and comparable GAAP results in our earnings press release and on the Investor Relations page of the Telos website. 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.

Thank you, Christina, and good morning, everyone. Let's begin today on Slide 3. While I'm excited about the future of Telos, I'm also disappointed with two customer delays that we've had on large programs. We've tried our best to sync up with the timing of these programs, but encountered issues that were not predictable at the time. Mark will discuss our performance later on this call, but at a high level, we delivered 43% revenue growth in the fourth quarter and 35% revenue growth for the year or 59% for the year adjusted for the wind down of the 2020 Census program. Gross profit increased 38% for the year, finishing at $86 million. We delivered $8.8 million of adjusted EBITDA and 13.8% of adjusted EBITDA margin for the fourth quarter and $24.4 million of adjusted EBITDA and 10.1% adjusted EBITDA margin for the year. And we reported adjusted EPS of $0.27 for the year, an increase of $0.42 year-over-year. Now let's turn to Slide 4. In 2021, we welcomed several new and accomplished leaders to the Telos team while we had other leaders who announced their retirements. As announced in January, Jeff Wright, who served as the Executive Vice President and General Counsel of the company since 2013, retired. Jeff will remain with the company to assist in the transition of his responsibilities and will handle several ongoing projects. Effective February 1, Hutch Robbins has been appointed as the Executive Vice President and General Counsel at Telos. Hutch brings more than 28 years of experience providing counsel to publicly traded companies on business and corporate matters, dispute resolution and avoidance and litigation. Additionally, we promoted Troy Bertram to Senior Vice President of Sales. He will lead our channel, direct federal and commercial sales efforts, and we'll continue to expand our sales channel and cloud partnerships. Troy joined Telos last year, bringing with him more than 25 years of experience with government and transformative technology companies. In January of 2022, we announced changes to our Board of Directors. We welcomed Brad Jacobs, who will serve on the Audit Committee, and Derrick Dockery, who will serve on the Management Development and Compensation Committee and the Nominating Committee. We also announced that Bernard Bailey will not stand for reelection after serving on the Board for 16 years. And on behalf of the company, I want to thank Bernard for his leadership and substantial contributions to Telos. Now let's turn to Slide 5 to discuss our new reporting business segment structure. As disclosed in the 10-K that we will issue for 2021, our business will now be broken out into two reporting business segments: Security Solutions and Secure Networks. Our Security Solutions segment is focused on cybersecurity and cloud security solutions, which include our Xacta, Telos Ghost, IDTrust360 and our Automated Message Handling System, or AMHS, as well as other offerings that are in the works. Our Security Solutions segment generated $123.5 million in revenue in fiscal 2021, representing 51% of total revenues. We believe this business segment will generate approximately 60% of our total revenue over time. Security Solutions has grown at a compounded annual growth rate of approximately 13% over the last three years. Our Secure Networks segment provides secure networking architectures and solutions to our customers through secure mobility solutions and network management and defense services. Secure Networks generated approximately $118.9 million in revenue in fiscal year 2021 or 49% of total revenues. Secure Networks has grown at a compounded annual growth rate of 32% over the last three years, with the segment growing at an impressive 90% in 2021 alone. We remain confident of long-term opportunities in both business segments. Now moving to Slide 6, we will discuss where we stand now since our IPO. Since our IPO we have taken several actions that have positioned Telos well for the future. We bolstered our financial flexibility and improved our cash flow, invested for the long-term and also expanded margins. Launched our channel ecosystem, expanded our customer base and cultivated our team. We ended 2021 with financial flexibility. We repaid all our debt. We remain highly liquid with a cash balance of approximately $127 million. And we are approaching positive cash flow. Since our IPO, we have made significant investments in our business to support continued long-term growth. We doubled our total investments in our sales and marketing functions. Our sales and marketing investments were focused on building out our direct federal enterprise and channel teams. These sales professionals are focused on expanding our security solutions, primarily Xacta, Telos Ghost, IDTrust360 and acquiring new customers largely in regulated industries. And we've expanded our gross margins and adjusted EBITDA margins while making these investments. Furthermore, since our IPO, we made two inorganic investments. We acquired the remaining equity interest in Telos ID and we acquired Diamond Fortress Technologies, a manufacturer of patented, touchless, fingerprinting, and other mobile-enabled technologies that are integral to the continued expansion of IDTrust360 services at both the enterprise and the consumer level. We built and launched our multifaceted channel program, the Telos CyberProtect Partner Program to enable Telos to reach a broader set of customers and markets. We recruited and signed partners across our ecosystem, giving us access to new verticals, such as healthcare, state, local and education or SLED and commercial enterprises while augmenting our presence in the federal market. We signed two large distributors which provide access to thousands of new customers, vendors, and resellers. We launched our first multi-partner, go-to-market partnership called FASTTR, which stands for Faster Authority To Operate or ATO with Splunk, Telos and ThreatAlert for regulated markets. And while we did not expect the channel to begin producing in 2021, we did have a few deals transact to the channel, allowing us to pressure test the system. Our business development efforts have helped maintain and expand a strong customer base through renewals and new wins. We added more than two dozen marque customers to our customer base, including AT&T, and Collins Aerospace, IBM, M.C. Dean, Oracle, Red Hat, stackArmor, VMware and Wickr among others. We worked with over 300 different customers in 2021. I am proud of the hardworking accountable and family-friendly culture we've cultivated at Teos fueled by the talented employees who serve our customers every day. In the last nine months, we made seven new placements on our senior leadership team and Board of Directors as part of a reorganization aimed at better aligning leadership for the demands of a growing public company. We have an accomplished employee base. 75% of our U.S.-based employees have a technical background and 62% of our U.S.-based employees hold a security clearance. We have consistently been named a winner as a top place to work from publications, such as Energage, the Washington Business Journal and the Washington Post. Let me turn to some comments on the industry landscape and a number of recent initiatives in Washington D.C. that present opportunities for Telos. Congress has finally reached agreement on FY2022 appropriations legislation, which will provide billions of dollars in cybersecurity funding to federal agencies, including many Telos customers. The final spending bill boosts cybersecurity funding in several areas of note, including for the Department of Defense, Infrastructure Cybersecurity and Risk Management Operations. Funding is also included in these final FY2022 appropriations bills to help implement President Biden's executive order on cybersecurity issued in May of 2021. That executive order, which drew heavily on guidance from the National Institute of Standards and Technology or NIST, directed federal agencies to accelerate migration to the cloud and make greater use of zero trust architecture, both of which are addressed by Telos solutions. To carry out that executive order, the Office of Management and Budget released its final zero trust architecture strategy for federal agencies. The goals of which are organized using the Cybersecurity Infrastructure and Security Agency’s or CISA’s Zero Trust Maturity Model. Agencies will be required to meet specific zero trust security goals by the end of FY2024. And they must develop zero trust migration plans that meet the requirements and include budget planning for those efforts. We continue to see increased federal, state and commercial market interest for secure, fully integrated, enterprise class, hybrid and multi-cloud environments that support Everything-As-A-Service. We call it X-As-A-Service or XAAS. Our business developers are positioning Telos cloud platform, fully equipped and integrated with our suite of products, including Xacta, Ghost and IDTrust360 to accelerate cloud modernization while aligning compliance with the administration's latest cybersecurity mandates, including zero trust architecture and the Department of Homeland Security, Cybersecurity and Infrastructure Security Agency, cybersecurity divisions, continuous diagnostics and mitigation activities for strengthening the security posture of our customers. One of our security solutions, Telos Ghost, complement, zero trust security. This creates an additional layer of defense against intruders by hiding critical resources and users in an anonymous undiscoverable network. Telos Ghost protects assets of critical infrastructure from unauthorized access. Xacta streamlines and automates the critical processes of the leading cybersecurity standards and frameworks, particularly the Federal Risk and Authorization Management Program or FedRAMP allowing all process participants to collaborate within the same Xacta application to attain a FedRAMP ATO, which facilitates faster migration to the cloud. Xacta is also a trailblazer in adopting the open security controls assessment language or OSCAL for short, which is a multi-format framework adopted by FedRAMP to allow security professionals to automate security assessment, auditing and continuous monitoring processes. Here are some other initiatives to be aware of. The executive branch is putting emphasis on greater use of automation in the FedRAMP process and on supply chain risk management, which are also focus areas for Telos. NIST is developing a ransomware profile, based on the NIST cybersecurity framework, which is specifically intended to help organizations manage ransomware related risk. And Telos solutions will support this. In addition, the FedRAMP process is now being adopted at the state level and state ramp will likely expand the market for Telos FedRAMP offerings. We believe there could ultimately be an increased need for the solutions supplied by Telos, driven by the additional federal cyber security funding appropriated by Congress and the additional security goals agencies will be required to achieve. And finally, the emergence of new conflicts in Europe have elevated the cyber threat level globally and further underscores the urgency of cybersecurity best practices. I will now turn the call over to Mark, who discuss fourth quarter and full year 2021 results and our guidance for the first quarter and full year of 2022. Mark?

Thank you, John. And thank you everyone for joining us today. Let's turn to Slide 7. I'm pleased with our results this quarter. We completed a challenging year with a strong fourth quarter and delivered on our guidance. We reported sales at the midpoint of our guidance range and adjusted EBITDA above the high end of our range. During the fourth quarter, we achieved 43% sales growth, a 51% increase in gross profit, 196 basis points of gross margin expansion, record adjusted EBITDA, a 13.8% adjusted EBITDA margin and $0.19 improvement in adjusted EPS. Free cash flow was a $7.2 million outflow as expected, representing an $8.2 million improvement over the same period last year. Now let's get into the details starting with revenues. Fourth quarter revenues grew 43% from $44.9 million in 2020 to $64.1 million in 2021. Fourth quarter revenues for our security solutions business grew 37% from $24.7 million in 2020 to $33.9 million in 2021. Strong growth in security solutions was primarily driven by our Telos ID business where all major programs, including our confidential healthcare program with the federal government contributed to growth in the quarter. Unlike earlier quarters in 2021, the wind down of our contract with the U.S. census bureau did not present a year-over-year headwind in the fourth quarter. Growth in Telos ID was partially offset by year-over-year declines in information assurance and secure communications. The decline in information assurance reflects the quarterly lumpiness and perpetual license sales that are characteristic of the current revenue model in that business. Perpetual license sales in the fourth quarter of 2020 were unusually high due to the timing of large sales that benefited the quarter and created a difficult year-over-year comparison with the fourth quarter of 2021. Half of all perpetual license sales in 2020 occurred in the fourth quarter of that year. If commercial customer preferences increasingly drive the revenue model in that business over time from a perpetual license model, which is more common historically with our government customers to a subscription model, which is more common with our commercial customers. We expect the quarterly year-over-year comparisons to become more consistent and predictable over time. But of course, the trade-off will be less revenue recognition and growth in the short-term. Then we would otherwise realize under a perpetual license model. The decline in secure communications reflects lower volume on a single large contract with a classified government customer. Total fourth quarter revenues for our secure networks business grew 49% from $20.2 million in 2020 to $30.1 million in 2021. This significant increase was driven by the same two large programs that have driven growth for secure networks throughout 2021. The rollout continued for a contract to provide security modules and kits to support the upgrade of Theater Deployable Communications for the U.S. Air Force and site work continued on a five-year U.S. Army contract to support the migration and modernization of telephone communications systems throughout the Pacific region. As expected during the quarter and as discussed on our third quarter earnings call, supply chain constraints with one of our subcontractors deferred several million dollars of revenue from the fourth quarter of 2021 into 2022. The impact of these constraints was partially offset by revenue on other programs within secure networks that accelerated from 2022 into the fourth quarter of 2021. The net impact is a few million dollars of revenue flipping from 2021 into 2022. Now let's discuss profitability and cash flow. Fourth quarter gross profit increased 51% from $16 million in 2020 to $24.1 million in 2021. Fourth quarter gross margin increased 196 basis points from 35.7% in 2020 to 37.7% in 2021. Cost of sales included $672,000 of stock compensation expense, which did not exist in the same period last year. Excluding the impact of stock compensation expense, gross margins increased 301 basis points to 38.8%. Security Solutions drove gross margin expansion for the company primarily due to excellent profitability and Telos ID partially offset by lower margins due to less favorable sales mix in Secure Networks. Security Solutions gross margins expanded over 8 percentage points from 47.4% in 2020 to a record 55.7% in 2021 driven by favorable sales mix within Telos ID. Secure Networks gross margins contracted approximately 400 basis points from 21.5% in 2020 to 17.5% in 2021 due to higher revenue recognition on lower margin programs in the quarter. SG&A and R&D expense increased by $3.9 million from $25.7 million in 2020 to $29.6 million in 2021. The $3.9 million increase was primarily driven by stock compensation expense that we did not have in the prior year period as well as higher sales and marketing expense, partially offset by lower G&A expense due to the elimination of executive bonuses as a result of the company underperforming its financial plan for the year. Operating income before stock compensation expense increased from a loss of $9.7 million in 2020 to a profit of $7.4 million in 2021. Operating income benefited from higher gross profit driven by both sales growth and gross margin expansion as well as lower G&A expense due to the elimination of executive bonuses, partially offset by higher R&D and sales and marketing expense. Adjusted net income increased from a loss of $4.1 million in 2020 to a profit of $7.3 million in 2021. The corresponding adjusted quarterly earnings per share increased from a loss of $0.08 per share in 2020 to a profit of $0.11 per share in 2021. EBITDA adjusted for the impact of stock compensation expense increased by $11.5 million from a loss of $2.6 million in 2020 to a profit of $8.8 million in 2021. Adjusted EBITDA margin was 13.8% during the quarter. The $8.8 million of adjusted EBITDA in the quarter was $3.9 million above the top end of our guidance range of $3.9 million to $4.9 million. The $3.9 million outperformance above the top end of our guidance range was primarily the result of four items including lower cost as a result of actions we took to restructure and defer expenses associated with the TSA PreCheck program to better align the timing of expenses with the timing of revenues on that program. Higher than expected, capitalization of research and development expense, lower G&A expense, and a resolution with a defense contract management agency on final rates for incurred costs from prior years. Free cash flow improved by $8.2 million from an outflow of $15.4 million in the fourth quarter of 2020 to an outflow of $7.2 million in the fourth quarter of 2021. The $8.2 million improvement and free cash flow was primarily driven by $4.6 million of higher net income, excluding stock compensation expense and $7.5 million of improved working capital dynamics partially offset by $3.5 million of higher capital expenditures. For the full year, cash from operations was a $7.3 million inflow and free cash flow was a $5.9 million outflow. Let’s turn to Slide 8 to recap our full year 2021 performance compared to our original 2021 guidance. Overall, 2021 was a disappointing year due to the impact of customer delays beyond our control on two large programs that proved to be insurmountable. At the midpoint, our original 2021 guidance included $34.5 million of adjusted EBITDA and an 11.9% adjusted EBITDA margin. Customer delays on major programs eliminated approximately $21 million of profit from our 2021 performance. Accordingly, everything else held equal. We were on a path to generate only $13.5 million of adjusted EBITDA and a 5.7% adjusted EBITDA due to the de-leveraging effect of markedly lower than planned revenues against our cost base. But through outperformance compared to plan elsewhere in our portfolio, most notably in Telos ID revenue and margin performance as well as below the line cost discipline and actions we took to restructure and defer expenses associated with delayed programs. We delivered $24.4 million of adjusted EBITDA for the full year and preserved double-digit adjusted EBITDA margins. Although, we are disappointed with the impact of the customer delays, we are proud of our team for focusing on what they can control, outperforming in other parts of the portfolio and taking the actions necessary to deliver double-digit adjusted EBITDA margins for our shareholders. Now let’s turn to Slide 9 to discuss a special accounting topic relevant to our 2022 guidance. In our past communications regarding the TSA PreCheck program, we have estimated size of the revenue opportunity based on gross revenue accounting assuming Telos would be treated as the principle to the transaction with the TSA PreCheck applicant for accounting purposes under ASC 606. However, the application of ASC 606 in this particular case can be open to interpretation. Accordingly, we engaged an independent third-party to conduct a technical accounting review of the program and to provide an opinion on the application of ASC 606. We also worked closely with our auditors. Through this process, we have determined Telos to be an agent as defined by ASC 606, as it relates to the per applicant fee for service collected by Telos and paid to the TSA and FBI as part of Telos’ enrollment services offering. Therefore, in accordance with ASC 606, Telos will record revenue from applicants for this service net of the fees paid to the TSA and the FBI as part of the arrangement. Under net revenue accounting, revenue recognition is 64% lower than gross revenue recognition on new enrollments and 61% lower on renewals. Profit, however, is unchanged and margins are significantly higher. The underlying profitability, cash flow and fundamental economics of the transaction with the applicant are unchanged. With that backdrop, let’s turn to Slide 10, to discuss our outlook for 2022. For 2022, we forecast sales in a range of $226 million to $257 million based on the net revenue accounting illustrated on the prior slide. This compares to sales of approximately $226 million to $276 million based on gross revenue accounting. Our guidance includes $226 million to $245 million of revenue before any benefit from the TSA PreCheck program and $12 million of nets revenue or $31 million of gross revenue from PreCheck at the top end of the range. The bottom end of the range includes no PreCheck revenue. Adjusted EBITDA is the same under gross revenue accounting and net revenue accounting. We forecasted adjusted EBITDA of $21 million to $28 million, including approximately $3 million of contribution from PreCheck at the top end of the range. Before any benefit from PreCheck, we forecast Security Solutions revenue to grow plus or minus mid-single-digits, including modest contribution to growth from higher software sales. Security Solutions grows mid-teens at the top end of the guidance range, including $12 million of PreCheck net revenue or approximately 31% on a gross revenue equivalent basis. We forecast Secure Networks revenue to be down mid-single-digits to high-single-digits due to a $30 million headwind from the completion of two large programs, partially offset by new business in the second half of the year. Gross margins are likely to be higher as a result of higher Secure Networks gross margins, margin accretion from PreCheck and a slightly higher waiting of revenues to Security Solutions as compared to last year. We expect below the line expenses, excluding stock compensation expense to be approximately $3 million to $13 million higher due to higher depreciation and amortization, TSA readiness, sales and marketing and other G&A expenses. Upside opportunities include faster than expected PreCheck ramp higher end market demand due to the current threat environment, increased demand for multi-cloud environment solutions as a service, better than expected sales force productivity, higher secured networks new business, and lower below the line expenses, especially at the high end of the guidance range. Over the course of this year, we’ll be monitoring the returns on our investments very closely and making adjustment as needed to manage margins and cash flow. Let’s turn to Slide 11, to discuss our guidance for the first quarter. For the first quarter, we forecast sales in a range of $44 million to $48 million and adjusted EBITDA of negative $2 million to positive $2 million. We forecast Security Solutions revenues to be up mid teens, primarily due to continued strength in a confidential healthcare program with the federal government. We expect no PreCheck revenues in the first quarter. We expect Secure Networks revenues to be down low 30% to mid-40% due to a $14 million headwind on a large program that is coming to successful completion in 2022. Gross margin is expected to be up to 10 percentage points higher due to significantly higher Security Solutions gross margin and favorable mix shift between Security Solutions and Secure Networks compared to the same quarter last year. Below the line expenses, excluding stock compensation expense are expected to be approximately $4 million to $6 million higher due to the ramp and investment that occurred during the second half of 2021. Lastly, before passing it back to John, I’d like to provide an update on the filing of our 2021 10-K. As previously discussed, the filing of our 10-K was delayed primarily due to delays in completing our first annual SOX 404 assessment of our internal control over financial reporting. On Monday of this week, our auditors notified us that they needed additional time to complete certain testing and internal quality control of their SOX 404 audit. We intend to file our 10-K in the coming weeks. As previously disclosed, we and our auditors have identified material weaknesses within some of our internal processes that we are in process of remediating and will be disclosed in our 10-K. At this time, no audit adjustments are expected. With that, I’ll pass it back to John who will wrap on Slide 12.

Thanks a lot, Mark. Obviously, we’ve had a lot going on in 2021 and we’re very excited about the prospects of 2022 and proud the accomplishments we achieved in our first full year as a public company. We developed our leadership team and Board of Directors, we focused on what we could control and delivered growth and margin expansion, notwithstanding the very disappointing customer delays, our major programs. And we reported a strong finish to a challenging year, delivering on our fourth quarter guidance. We’re closely monitoring our returns and our investments and we’re focused on striking the right balance between investing in our future and managing our costs, our margins and cash flows. And with that operator, I’d like to – please open the line for Q&A. Thank you.

Thank you. [Operator Instructions] Our first question comes from Zach Cummins with B. Riley Securities. Your line is open.

Yes. Hi, good morning, John and Mark. Thanks for taking my questions. Mark, just starting off with Security Solutions the growth outlook mid-teen year-over-year growth, even inclusive of TSA PreCheck. Can you give us a sense of kind of what has really changed in that number versus what you provided in mid-November in your preliminary outlook?

Yes. So the main difference there is the ongoing delay in TSA PreCheck. When I gave the 2022 outlook on the third quarter call, I think what I indicated for Security Solutions was year-over-year growth in the high 30s with primary – substantially all of that growth coming from PreCheck. And the assumption there was that we would receive the authority to operate by the end of 2021. Here we are mid-March we have not received the authority to operate yet. And so you’re seeing a difference in the assumption on TSA PreCheck there at the top end of the range. So on a gross basis – on a gross basis, including our PreCheck assumption, you will see Security Solutions growing in the low 30s versus the high 30s that I indicated. The delta there is the difference in the PreCheck assumption. And then the difference between the low 30s and the mid-teens is the difference between gross revenue accounting on PreCheck and net revenue accounting on PreCheck.

Understood and...

So apples to apples – if you were to compare apples-to-apples, it would be high 30s growth versus low 30s growth and that difference being the delay in PreCheck.

Got it. Got it. Understood. And just to the point on TSA PreCheck, I mean, any sort of updates you can give us on kind of what is cost causing the ongoing delay? And at the high end of your guidance, I mean, would the assumption that you’ll receive the ATO for TSA PreCheck?

Exactly. This is Mark Griffin. We still remain optimistic for an ATO in 2022. The timing of the TSA ATO still is solely within TSA’s control. So we do remain very optimistic that we will get it. And as Mark indicated, we have our in our forecast still getting the ATO in 2022.

Understood. And Mark on secure networks on that side of the business, I mean down mid single digits to high single digits, I believe for the full year guidance. I mean, can you give us a little more insight into kind of the assumptions baked into that number. I know you have two larger programs rolling off. But I was just kind of curious if there’s other opportunities to offset some of those programs?

Yes. So, you are right, Zach. The main driver there is the approximately $30 million headwind year-over-year in the – as a result of the wind down of the two large programs that drove the growth in that business in 2021. And then that’s going to be partially backfilled by new business that we’re pursuing here in 2022. You’ll see that mostly in the second half of the year. But our assumptions on new business wins do not fully backfill the wind down in those two large programs.

Understood. And final question for me. Nice to see some of the adjusted EBITDA margins kind of remain intact despite the delays with these larger programs. But how should we be thinking about free cash flow generation just based on the current adjusted EBITDA guidance you’ve given?

Yes. So on free cash flow, my rule of thumb, and I think this is the way I encourage folks to think about free cash flow for us. If you look at – think of it as adjusted EBITDA minus CapEx that’ll give you free cash flow approximately, approximately free cash flow before any impact from working capital. And so, for 2021, if you call it, roughly $25 million of adjusted EBITDA approximately in the middle of the range, we’ve given you about $12 million of CapEx in capitalized software in the assumptions in the appendix – the modeling assumptions in the appendix. So that gets you to about $13 million of free cash before working capital. And so from there, you got to think about some working capital assumptions that haven’t gone so far is to put out working capital assumptions. It’s kind of going to depend on how working capital behaves towards the end of the year here. But with sales, excluding PreCheck approximately flattish, and then PreCheck having a pretty favorable working capital profile. It would point us to better free cash flow this year than we had last year and potentially positive free cash flow.

Understood. Well, thanks for taking my questions and best luck with the remainder of the quarter.

Zach, thanks.

Thank you. Our next question comes from the line of Brad Clark with BMO. Your line is open.

Hi. Thank you for taking my question. I wanted to ask about the CMS contract and really an update there. On the prior call you took it out of your fiscal year 2022 guidance, which I assume inherently the same in this update. But would you be able to just provide your thinking around that contract? I understand CMS, over the past year or so has awarded other types of contracts to solution providers and looking for really an understanding of what to expect with that business going forward, whether FY2022 or mostly beyond FY2022? And any risk reward we should be thinking about?

Hello, this is Mark Griffin. Yes, on the CMS program, we are still very much in line with expansion for that contract and the ability for that contract to expand. And so from a futures point of view, although you’re right, it’s not in our 2022 plan right now. We do feel as though the Medicare and Medicaid fraud and abuse objective of that organization to fingerprint and certify health care providers is still a requirement and still exists. So although I don’t have an update on the timing at this time, we still remain optimistic that it is a valid and an opportunity for Telos to grow into that space.

Okay. And then just another follow-up for me. With regard to the sales force, you’ve obviously done a lot of hiring over the past say year and a half, a lot focused on the commercial market. Could you able to provide an update on where you are in the scale general market investment process? Is there still hiring to be done perhaps to further expand into some of these commercial internal opportunities? Just an update on really the shaping side of your sales force and plans for expansion over the next 12 or so months. Thank you.

Yes. This is Mark Griffin again. So as far as the sales force is concerned, we rounded out that sales force primarily at the end of 2021 with the last of the hires. And so we increased our direct carrying sales force and channel market to enhance the federal sales force that we had. So now we’re having the sales force listen to the customers and expand their knowledge base to position those products whether it be Xacta, Ghost or IDTrust360 not only with the channel, but the state and local education markets that we spoke about earlier. So from a marketing point of view, the marketing group, obviously, are supporting those sales force with sales books and sales plans. So from my perspective, those groups are fairly fleshed out now as far as staffing. Now it’s – we’re into an execution stage where we’re starting to build the pipeline and starting to build the backlog for sales opportunity although we’re seeing the sales cycle on some of these are a little bit longer than what we anticipated, which is why we historically have said that we’ll see some results from those organizations in the second half of this year.

I think the main point as well, Mark, is that the pipeline has expanded relatively significantly for us outside of the four walls of the federal government. And so we are seeing a relatively significant increase in our funnel, which as we’ve talked about previously, we should see the result of in the second half of 2022.

Great. Thank you.

Thank you. Our next question comes from Rudy Kessinger with D.A. Davidson. Your line is open.

Hi, thanks for taking by question. So on TSA, on the Q3 call, it was mid-November, and you said you expected to get the ATO by the end of the year. So kind of a six-week window where you expected to get it. And now if I look at the low end of your guidance assumptions, zero from TSA, you’re essentially saying, here we sit in March and it could fall at any point in the year. So how do you go from expecting to get it within six weeks to now not really being able to point us to when you expect to get it over the next nine months?

Mark Griffin again. The working relationship we have with TSA is primarily confidential as it relates to the details, but we are going through a government process. And so our expectation on our speed and compliance with that process was one expectation that we had set. We still believe we will rather expeditiously get through that process. But because it’s a government ATO process and it’s – they’re controlling the process, I don’t have any updates beyond that estimate at this point that we will get it in 2022. I’m not able to pick a specific date in 2022 at this time.

So Rudy, this is John. And I’m going to say, I’m going to be a little more blunt about it. In the past, when we’ve given time lines, those time lines have been given as a result of information we’ve gotten from the customer. And as everybody knows, we have missed those time lines. And as a result, there’s just a tremendous amount of frustration, I’m sure, that you feel, I know that I feel as a very large investor, and I’m sure that the rest of the investment community feels. So, we said, okay, if we assume that nothing happens in PreCheck, what’s it look like? What’s this case look like? What does Telos look like? And so we created this model, this low end of the model. Do I actually think that’s going to be the case? I don’t. I do believe we’re going to get PreCheck. I know that it’s at the highest levels of the organization inside of TSA. I know that it’s very important. But to this point, it’s been a very frustrating process for us because when we were first awarded the contract back in January of 2020, the initial indication from the customers that we were supposed to have our ATO by September of 2020. And for various reasons, that didn’t happen, again, beyond our control. So that’s why we’re putting in that low-end case. We want the market to understand that we can still work to a profitable level without it. Obviously, we want TSA in there clearly. We – I believe, fundamentally, TSA is going to be a very, very important part of the growth of the company. But I, for one, have been just sort of tired of throwing out dates. When Mark sent out – Mark Bendza, on the Q3 call, set out sort of – we didn't give guidance, to be very clear to everybody on this call here, we gave a framework, and that framework said that we presuppose we'd have an approval by Jan 1 for the ATO. Well, that didn't happen. So again, what we're trying to do here with – for purposes of 2022 and beyond is not leave our investor base frustrated as we leave 2022. We want our investor base to be very happy that they've made the investment and stuck with the company. So that's my two cents on, Rudy.

Okay. Fair enough. And then so if I take into consideration this $30 million headwind you're facing in Secure Networks, if I just do some quick math. Say, I exclude $30 million from your 2021 revenue, you would have grown 18% rather than 35%. And then if I look at the guide in 2022, I assume zero from TSA and so I take $6 million out of your revenue midpoint that would drive you to $235.5 million. And again, I compare it to 2021 ex $30 million to adjust for that headwind. You'd only be looking for 11% growth in 2022 versus 18% in 2021 ex the TSA and ex that $30 million headwind. And just in light of the number of additional sales reps you've added, the number of partners you've added, why are we not seeing results from those investments faster? And why the lower growth profile even after I make those adjustments?

Yes. So first, I want to address your point about Secure Networks. On the Secure Network side, when we come to a successful conclusion on a program generally speaking, we're back with that same customer rebidding additional opportunities with that same customer. So we don't see it as the same kind of risk profile that perhaps you're putting the odds on, if you will. As it relates to the 2022 performance on the investment in commercial sales and channel sales, we do expect to see very good take up in the second half of the year, but we're not going to put numbers in until we feel like the numbers are there. And so right now, I think we have in front of us the case that says, this is what we see. And as we see more things happening in the quarter, we'll be sure to update our numbers to the Street. And Mark, I'll turn it to you and see if you have any additional points on that.

The only additional points I've just put on what John had indicated there is – and I kind of mentioned it earlier is the hiring of the sales force and the training of the sales force to know the solution and to position that with the customer is taking a little bit longer than what I think we had originally anticipated. And so I think we will see growth in the last half of the year. And as we do see growth earlier, we will update those positions. But I think it's really just the onboarding of the sales, the positioning of those with the customer, listening to our customers on the value of our solutions will drive additional growth beyond what we currently have, John.

Okay. And then just lastly, the accounting change in TSA makes perfect sense to me. I guess just – you're saying $12 million net on $31 million gross. That's 39% gross margin if you were recognizing it on a gross revenue basis, obviously, understanding going forward is on a net basis. But as we think about it from a modeling perspective, if I think about in 2023, if I take whatever, 2 million to 3 million sign-ups times 85 per times your share, 1/3. What kind of gross margin should we apply to the gross revenue to get to your net revenue on a longer-term basis? I guess where can that 39% gross margin go in 2023 and beyond as you get fully ramped with TSA?

So Rudy, I would think of it as – so thinking of it on a net basis here, the revenue is pretty much all margin on a net basis and then you're going to have probably – you get very good operating leverage there. So I'd say we have about call it, high single-digit millions, high single-digit to double-digit millions of relatively fixed cost in that program. So as those net revenues ramp, you'll see the margins expand with it, both gross and adjusted EBITDA margins ramp with it. So that's how I would think about modeling it over the medium term as you get to a run rate number.

Okay. Got it. Thanks for taking my questions.

Thank you. Our next question comes from Alex Henderson with Needham and Company. Your line is open.

Thanks. So you delayed your report because of the issues associated with the material weakness in your process and then didn't actually get that resolved. You put out the change in the accounting here on 606. Shouldn't that have been vetted pre-IPO? And shouldn't it have been consistent with what you had – was doing anyway? So shouldn't you have known that before you IPO-ed? And then on top of that, you're giving us guidance now on two segments, but masking the difference between Ghost and Xacta, which are very different than ID 360 Trust. Why aren't you putting this into a – into three segments so that we can get reasonable transparency? It seems like the transparency is not there that we need to properly analyze the situation based on some of these changes. The other point that I want to address a little bit upfront is can you give us some sense of what is going on in terms of Ghost. You haven't mentioned that at all. And then, also the lack of transparency on the reason behind Medicare, Medicaid dropping completely out, and the reason for the continuous delays. Yes, we realize it's a government program and we realize governments can be fickle, but you should give us some sense of the reason that this is occurring, as opposed to just the fact that it's a government program. Can you please be a little bit more upfront about why TSA is persistently delaying and by the way, the comment that it was supposed to be by September for the ATO. The original expectation was actually June, July. So it's actually slipped out a lot more than you're indicating, so please address some of those pieces?

Just to be clear when I said June – when I said September, I meant September of 2020, the job was awarded January of 2020, and the initial indication by the customers that we would've been had our ATO 270 days after the award in January of 2020. And that didn't happen. And then to address your point about…

Can you address the reasons please?

I have to turn it over to Mark because as far as I know that we – I don't think I actually can.

No, Alex. The TSA is largely a confidential program. And so we're not able to talk the specifics of where we're at in the ATO process. The ATO process is a security compliance process. And so we can't divulge basically the details behind that program are where we're at in that program because of security concerns as it relates to that program. So we still remain optimistic for an ATO in 2022. The timing of the ATO is purely in TSAs control at this point.

Is this a function of your process on how you deliver the data? Is it a situation where they're uncomfortable with their security posture? I mean, there's got to be some broader explanation than we can't talk about it at all. This hardly seems reasonable. Excuse me?

We've said this in the past. What we said is that the customer was very concerned about Ransomware and so they had to go true up all their own systems first, and then they had to go after the other high priority systems of which this is one, but we're just not through the process yet.

So you're saying that it's still a security process in their operations that's causing the issue?

Yes, sir. Mark correct me if I'm wrong,

Alex, by nature, an ATO is authority to operate. It's run by the security group within TSA. So we are engaging with that group within TSA, and that's largely a confidential operation in a program and run by TSA. So we're operating under TSA rules and we'll get our ATO when TSA completes their process.

Okay. So going back to some of the other issues, there's no mention of progress on Ghost at all. Can you talk about what's going on there?

Sure. Before I do that though, I'd like to talk about the segment reporting. We mentioned that we saw with that special confidential customer that we were able to sell more or less our services-as-a-solution. And these are Xacta as a service, Ghost as a service, IDTrust as a service that's happening more and more throughout the government. And so we see a big opportunity for us to continue to do that, which is going to take advantage of each of the different capabilities inside our security solutions. So it does make sense for them to be two segments versus one, at least in our opinion, Alex. When you think about Ghost, the opportunity for Ghost is really an embedded opportunity. It's – we announced as an example, Johnson Controls, we've now been inputted into their line card with separate pricing. Johnson Controls has a quota that they're running their own sales force through where they're selling Ghosts as a service through their cameras. And then they will be adding Ghost as a service through their HVAC systems, et cetera. All of that stuff we've announced, I think previously, just to – we didn't think we needed to bring it up again today, but so I apologize that we didn't bring it up today.

So is there any progress in the timing of it? When do you expect this to ramp any comment material?

It's going to create revenue for us in the second half of this year. And, that's coming directly back from Johnson Controls. So their own feeling is that this will be a very significant differentiator for their own sales force compared to other cloud-based cameras as a service. And so they see this as a significant differentiator for them over the other cloud-based camera providers. And so we – I think we'll see – we'll see, good uptick from that. I also think that you'll see Ghost being embedded as components of other capabilities over time. And so that's how we expect to sell it. It won't really end up being sold direct to the end user, by and large, there are obviously examples where it is sold directly to end users, but the bigger opportunity is embedded.

So the product embedding – embedded – that it's going to be embedded in will be launched by Johnson Controls by the middle of the year. And therefore it can ramp into the back half. Is that?

No, it's – it'll be launched by the first part of April.

Right. So it's launching in April and that says six months plus cell cycle therefore start to kick in the back half?

I think that's correct.

Right. Going back to Xacta, can you talk about your penetration of the cloud customers, where the Microsoft and Amazon sales organizations are in reselling your product and why that business isn't ramping at a steeper rate in your expectations?

Well, we have seen – we are seeing our customers who are also our partners begin to sell us through their own channel. AWS has sold four or five different opportunities for us. Microsoft has sold two or three for us. I think we'll be announcing in my opinion probably the most significant announcement we've made around cloud providers this quarter where it's not just around, if you will the government or FedRAMP, it's really an announcement that's related to them using us around their global footprint. And I think that's going to be a very exciting thing for us where they've given us their own internal financial models about what they expect it to mean. And so when we announce that we'll give – we'll put more detail around it, but generally speaking, Alex, the other cloud providers have started out really in our sweet spot, whether it would be FedRAMP or it be the intelligence community. So whether you're talking about Oracle or IBM or excuse me, Oracle or Microsoft or AWS that's really where they're starting us is, is in those sweet spots that we are in. These – this other cloud provider is really thinking of us as a way for them to accelerate cloud adoption globally as a way to differentiate themselves over the other players. So like I said, we're very excited about it. We will be announcing it in the worst case in April. But it's a relationship that's been under discussion now for the last year and change.

So just going back to the original question, when do you expect this cloud customers or the cloud sales organizations to materially impact and drive exactly growth to a much higher rate of growth than is currently guided to in the current outlook?

Like I said, we've – we're keeping it, I think Q3, Q4 is the timeframe to be thinking about where you'll see significant financial impact from the cloud providers, Alex, which is in line with what I think we've been saying previously.

All right, I'll see the floor. Thanks.

Thank you.

Thank you. The next question comes from Nehal Chokshi with Northland Capital Markets. Your line is open.

Yes. Thank you. In the slide deck, I mentioned modest growth contribution from higher software sales. Can you help range? What type of growth does that actually mean for Xacta and Ghost on a year-over-year basis?

Embedded in the guide it's relatively modest. It's a – think of it as a few million dollars year-over-year of additional information assurance software sales.

Okay.

I also think it as has a change in the model Nehal from mostly perpetual to mostly pay as you go or subscription based. So your order flow may be a lot higher based on the timing, but the revenue impact will obviously be affected if you see my point.

Yes. So between those two answers few million year-over-year increase includes the negative impact of going from mostly perpetual to consumption.

That's correct.

And so if you were to normalize, if it were all perpetual stating all perpetual, what type of year-over-year growth on a percentage basis, would we be looking at? I'm guessing that a few million would be a single digits or year-over-year growth. And so if you normalize for these – for that perpetual to consumption, what does that mean in terms of year-over-year growth then?

So I don't know that we've actually looked at it that way. We've just said that since it's going that way, this is what – how we believe the numbers will look. I'd have – we'd have to get back to you with the details on that Nehal.

Okay. You also...

Because it all comes down to timing, right.

True.

When the deal comes in, right? So we'd have to get back to you.

Yes. Understood. And then you also mentioned an answer to one of the other questions that you are seeing sales cycle expand a bit. Can you expand upon why you think that's happening?

Yes. It's Mark Griffin. The comment was related to – in the both not only in the government, but also in the commercial side requirements that the customers have for certain fields and certain options within the tools that we sell and the software that we sell. So from a development point of view, we're also having to update and enhance the products to address some of the commercial and some of the state and local markets with product enhancements. And so that's extending some of the sales cycle while we add, make those modifications to the product in order to complete those opportunities.

I see. Understand. Okay. And then just on a 10K following to delay, Mark, I thought I heard you basically say that the delay is a associated with the Sarbanes-Oxley compliance needs of the auditor and nothing to do with the weakness and controls identified. Is that correct?

Correct. So we're going through our first SOX 404 audit this year. So it's the first time that both we and our auditors have gone through that process together. First time you go through that process especially for a newly public company, it's never been through the process before. It is a long and thorough and involved process. So that's really been the driver of the delay. We're at the tail end here. Our auditors are going through their own internal quality check process of their audit and how they conducted it. So until that is completed, we have to hold off on filing our K. But it's not directly driven by the material weaknesses, but rather just the ongoing duration of the process. One other thing worth pointing out, historically, we filed our K over the last five years, three of the five times we filed in early April. And the other two years of the last five years, we filed on either the very last day of March or a few days before. So relative to prior years, we're still on track here. But we became a large accelerated filer for the first time as of the end of this year, which accelerated our filing date by a month. So technically, at this point, the 10-K is late, but relative to prior years, we're still on track.

Understood. My last line of question is on TSA. To be clear, none of the other two TSA Gen2 PreCheck contract providers have been given an authority to operate yet, correct?

That's correct.

Okay. And then I think just a few days ago, Accenture Federal Services was recently awarded TSA $199 million win over a seven year period for consolidating three credentialing systems into a single platform to improve how TSA responds to threats. Any relevance or delays you're seeing on the ATO then?

So just to be clear, so that contract, we termed internally as big credit. So...

I think - say it more slowly, so you may not that.

We have an internal classification of that we call it big Cred. And so that contract has been held by Accenture, then IBM and now back to Accenture, and it's the modernization behind the scenes of TSA for that contract. So you're correct, $199 million seven year contract. And so we hope that contract would eventually add some efficiencies and some improvements to some of the processes we're seeing on the programs mentioned in the press release. So no immediate impact because, this contract has been around for a while. And so they've recompeted it and opened it up again, and it was awarded. We hope in the future there's a modernization of TSA back-end infrastructure that would facilitate contract like we have today.

I guess it sounds like this modernization and consolidation should help with the cybersecurity posture, and that seems to be the main thing that's been holding back the authority to operate. Where is that reasoning incorrect?

TSA back-end systems historically have needed modernization, and this is a contract that hopefully addresses that. I'm not disagreeing with your comment.

Okay. Thank you.

Thank you. Our next question comes from Andrew King from Colliers Securities. Your line is open.

Hey, there. Thanks for taking my question. Just a few clarifications on the TSA contract. Once you receive the authority to operate, if a customer goes to the TSA website in order to renew or to enroll in TSA PreCheck, how is that awarded to one of the three companies on the contract?

Alex – sorry, Andrew. Mark Griffin. The – on the TSA website, the positioning offers for each, offer that is eligible at the time and has their ATO will be presented on the website and a consumer will be able to pick a rotating offering on that website on the offer or the company of their choice at that point. So it's a rotating offer on TSA's website where you can enroll or renew. You'll be – the consumer will be given a choice.

Okay. Got it. And then looking at the market of this contract, how quickly do you think you can get to one-third share given that one of the other companies on the contract is obviously the incumbent and the other, clearly has the large portion of travelers mind share and a clear strategy for cross-selling with current travelers and the consumer-based products.

Sure. We would hope that within a year or two, we would be at one year share – or one-third share.

Any clarification as to how you get there and how you compete with the other people on the contract offerings?

Sure. As part of our strategy and offering that we had presented to TSA, we're expanding on enrollment sites to approximately 500 retail locations, which is doubling the current enrollment site offering that the incumbent has. So we're doubling enrollment sites. So that's part of the strategy is convenience for the customer to make enrollment easier and more convenient for the consumers. That's one of the strategies that we will be employing.

Okay.

Thank you. This will conclude today's question-and-answer session. I will now turn the call back over to Mr. John Wood for closing remarks.

Thank you very much. I just want to thank everybody for their support. I know it's been a very sort of rough and tumble year for 2021 for us. But despite that, I'm very proud of my team for what we've been able to do to capitalize on what we had in front of us in any event. And we see, obviously, an increased emphasis on cybersecurity across both the commercial and the government world. Our solutions will continue to take us out into 2022 and beyond, and I do see our take-up accelerating. So I just want to say to everybody on the call here today, thank you very much for listening and for your ongoing support. Thanks a lot.

Thank you. This concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day.